**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

| **(Mark One)**                                       |                                                                                           |
|------------------------------------------------------|------------------------------------------------------------------------------------------------|
| **x**                                                | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| **For the fiscal year ended December 31, 2005** |
| **Or**                                               |
| **o**                                                | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES ACT OF 1934**      |

 

**For the transition periodfrom              to            .**

**CommissionFile Number:  000-50990**

**TowerGroup, Inc.**

(Exact name of registrantas specified in its charter)

| **Delaware**                                                     | **13-3894120**                        |
|------------------------------------------------------------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) | (I.R.S. Employer  Identification No.) |
| **120 Broadway, 14****th**** Floor**                        | ** **                            |
| **New  York, New York**                                          | **10271**                             |
| (Address of  principal executive offices)                        | (Zip Code)                            |

 

**(212) 655-2000**

(Registrant’s telephonenumber, including area code)

**Securities registeredpursuant to Section 12(b) of the Act:**

**None**

**Securities registeredpursuant to Section 12(g) of the Act:**

**CommonStock, $0.0l par value per share**

Indicate by check mark if theregistrant is a well-known seasoned issuer, as defined in Rule 405 ofSecurities Act.  Yes   x   No   o

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 orSection 15(d) of the Act. Yes   o   No   x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant was requiredto file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes   x   No   o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of the registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K.   x

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer: in Rule 12b-2 of the ExchangeAct.  (Check one):

| **Large accelerated  filer   **o | **Accelerated  filer   **x | **Non-accelerated  filer   **o |
|-------------------------------------------------|-------------------------------------------|-----------------------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Act).  Yes   o   No   x

The aggregate market valueof the registrant’s common stock held by non-affiliates on June 30, 2005(based on the closing price on the Nasdaq National Market) on such date wasapproximately $264,037,653.

As of March 10, 2006, the registrant had19,855,841 shares of common stock outstanding. 

**DOCUMENTSINCORPORATED BY REFERENCE:**

Part III of this Form 10-K incorporatesby reference certain information from the registrant’s definitive ProxyStatement with respect to the registrant’s 2006 Annual Meeting of Shareholders,to be filed not later than 120 days after the close of the registrant’s fiscalyear (the “Proxy Statement”).

 

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**TABLE OF CONTENTS**

|                   | ** **                                                                                                              | **Page** |
|-------------------|-------------------------------------------------------------------------------------------------------------------------|----------|
| **PART I**   |                                                                                                                    |
| Item 1.           | Business                                                                                                                | 3        |
| Item 1A.          | Risk Factors                                                                                                            | 36       |
| Item 1B.          | Unresolved Staff  Comments                                                                                              | 50       |
| Item 2.           | Properties                                                                                                              | 50       |
| Item 3.           | Legal Proceedings                                                                                                       | 50       |
| Item 4.           | Submission of Matters to  a Vote of Security Holders                                                                    | 51       |
| **PART II**  |                                                                                                                    |
| Item 5.           | Market for The  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities | 51       |
| Item 6.           | Selected Consolidated  Financial Data                                                                                   | 53       |
| Item 7.           | Management’s Discussion  and Analysis of Financial Condition and Results of Operations                             | 55       |
| Item 7A.          | Quantitative and  Qualitative Disclosures about Market Risk                                                             | 83       |
| Item 8.           | Financial Statements and  Supplementary Data                                                                            | 87       |
| Item 9.           | Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure                                   | 130      |
| Item 9A.          | Controls and Procedures                                                                                                 | 130      |
| Item 9B.          | Other Information                                                                                                       | 131      |
| **PART III** |                                                                                                                    |
| Item 10.          | Directors and Executive  Officers of the Registrant                                                                     | 131      |
| Item 11.          | Executive Compensation                                                                                                  | 131      |
| Item 12.          | Security Ownership of  Certain Beneficial Owners and Management and Related Stockholder Matters                         | 131      |
| Item 13.          | Certain Relationships  and Related Transactions                                                                         | 131      |
| Item 14.          | Principal Accounting  Fees and Services                                                                                 | 131      |
| **PART IV**  |                                                                                                                    |
| Item 15.          | Exhibits, Financial Statement Schedules                                                                                 | 132      |

 

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**PART I**

**Item 1.**                        BUSINESS

**Overview**

As used in this Form 10-K, references tothe “Company”, “we”, “us”, or “our” refer to Tower Group, Inc. and itssubsidiaries, including its insurance companies, Tower Insurance Company of NewYork (“TICNY”), Tower National Insurance Company (“TNIC”) and its managinggeneral agency, Tower Risk Management Corporation (“TRM”), unless the contextsuggests otherwise.

Through our subsidiaries Tower Insurance Company ofNew York, Tower National Insurance Company and Tower Risk ManagementCorporation, we offer a broad range of specialized property and casualtyinsurance products and services to small to mid-sized businesses and toindividuals in New York State and the surrounding areas. By targeting selectunderserved market segments and expeditiously delivering needed products andservices, we position ourselves to obtain favorable policy terms, conditionsand pricing, thereby creating opportunities for favorable underwriting results.Our commercial lines products provide insurance coverage to businesses such asretail and wholesale stores, grocery stores, restaurants, artisan contractorsand residential and commercial buildings, while our personal lines productscurrently focus on modestly valued homes and dwellings.

We provide coverage formany different market segments, including nonstandard risks that do not fit theunderwriting criteria of standard carriers due to factors such as type ofbusiness, location and premium per policy. As of December 31, 2005 TICNYis licensed in fifteen states and TNIC is licensed in sixteen states. TRM,through its managing general agency, produces business on behalf of otherinsurance companies, referred to as “issuing companies”, and primarily focuseson commercial risks with higher per policy premium, including risks that TICNYhad not been able to target due to, among other things, licensing and surpluslimitations. TICNY also reinsures a modest amount of the premiums written byTRM’s issuing companies. In addition, TRM earns fee revenues by providingclaims administration and reinsurance intermediary services to its issuingcompanies and to other insurance companies.

**Strategy**

The business modelthat we have developed in the 16 years since we began our operations hasallowed us to create and support a much larger premium base and insurancecompany infrastructure than otherwise would have been possible with the limitedpre-IPO capital base. Through retained earnings generated from our operationsin 2005 and the infusion of the proceeds from our IPO and the concurrentprivate placement in October 2004, we increased the statutory surplus inour insurance company and are pursuing continued profitable growth through thefollowing strategies:

·       ***Reducing our Dependence on Reinsurance and OtherInsurance Companies.*** Theadditional capital from the IPO and the concurrent private placement hasallowed us to retain a greater percentage of our premium writings and therebyreduce our use of quota share reinsurance in TICNY. It has also provided uswith greater flexibility to selectively retain a larger portion of the businesspreviously placed with other insurance companies while continuing to utilizeTRM to generate commissions on premiums placed with other insurance companiesand non-risk bearing, service income.

·       ***Improvingour Rating to Attract Customers in Other Market Segments.***Asa result of the infusion of $98.0 million of the proceeds of the IPO andconcurrent private placement into our insurance company operation, on October 26, 2004, TICNY received a ratingupgrade from A.M. Best to “A-” (Excellent) from “B++” (Very Good). Our A.M. Best ratingreflects A.M. Best’s opinion of TICNY’s financial strength and is not anevaluation directed to investors in neither our common stock nor arecommendation to buy, sell or hold our common stock. Ratings are anincreasingly important factor in establishing the competitive position ofinsurance companies. 

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Thereis no guarantee that TICNY will maintain the improved rating. An increase inrating positions us to write policies in rating-sensitive market segments thatTICNY was not previously able to access, especially policies written by TRM’sissuing companies. Tower National Insurance Company is also rated “A-”(Excellent) by A.M. Best.

·       ***Expanding Territorially.***TICNY is presentlylicensed in fifteen states including New York State as of December 31,2005. We believe that the insurance products and services that we currentlyoffer carry strong market demand. On March 25, 2005, Tower Group, Inc.closed on its purchase of the outstanding common stock of North American LumberInsurance Company and renamed it Tower National Insurance Company. Thisacquisition will allow us to continue executing our plan to expandterritorially first in New Jersey, followed by expansion into other states. On August 5,2005, following our shell acquisition strategy, we announced our execution ofan agreement to acquire MIIX Insurance Company of New York (MIIX), an insurancecompany with licenses in New York and New Jersey. Closing of the transaction isexpected to occur during early 2006 and is contingent upon a variety ofconditions including approval of the transaction by the New York StateInsurance Department. In the event of closing, we will pay $225,000 in cash aswell as an amount equal to MIIX’s statutory surplus which was approximately$7.8 million as of December 31, 2004. MIIX has no liabilities forinsurance losses. MIIX’s assets consist of U.S. Treasuries and cash. We alsoexpect to make similar shell acquisitions in the future in order to offerproducts in various market segments in the same territory. In addition, weformed a Program Underwriting Unit to expand on our regional distributionapproach and allow us greater access to established, highly focused andnarrowly defined industry classes of business with which we are familiar butwhich are typically distributed over a broader geographical area.

·       ***Acquiring Books of Business.***Weintend to continue to acquire books of business that fit our underwritingcompetencies from competitors, managing agents and other producers. In September 2004,the Company entered into a Commercial Renewal Rights Agreement with OneBeaconInsurance Group LLC and some of its insurance company subsidiaries pursuant towhich we have acquired OneBeacon’s rights to seek to renew a block ofcommercial lines insurance policies in New York State. Through the OneBeaconrenewal rights transaction, we were able to add approximately 363 retail agentsthroughout New York State to expand our number of appointed agents. As we enterother states, we will continue to expand our distribution capability byappointing quality wholesale and retail agents. As of December 31, 2005,on an inception to date basis, the premiums written or produced subject to theOneBeacon Renewal Rights agreement were $39.6 million and the new businesswritten or produced through former OneBeacon producers that we appointed inconnection with the renewal rights transaction were $22.1 million.

·       ***Expanding Non-Risk-Bearing Fee-Generating Services.***We plan to continue to generate commission and fee incomethrough our insurance services operation by offering managing generalunderwriting, reinsurance intermediary and claims administration services.

·       ***ContinuingImplementation of Technological Improvements.***We plan tocontinue our implementation of technology-based initiatives such as Web*Plus,*ourweb-based platform for quoting and capturing policy submissions from ouragents, in order to improve customer service and further lower our underwritingexpense ratio.

**Business Segments**

We operate in threebusiness segments:

·       ***Insurance****.*Inour insurance segment, TICNY and TNIC provide commercial lines policies tobusinesses and personal lines policies to individuals in New York State. TICNY’scommercial lines 

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products includecommercial multiple-peril, monoline general liability, commercial umbrella,monoline property, workers’ compensation and commercial automobile policies. Itspersonal lines products consist of homeowners, dwelling and other liabilitypolicies. See “Item 1.—Insurance Segment Products”.

·       ***Reinsurance****.*Inour reinsurance segment, TICNY accepts or assumes reinsurance directly from TRM’sissuing companies or indirectly from reinsurers that provide reinsurancecoverage directly to these issuing companies. As a reinsurer, TICNY assumes amodest amount of the risk on the premiums that TRM produces. While thisreinsurance business historically has not been profitable, the commissionincome generated by TRM on the production of this business has exceeded any underwritinglosses from the reinsurance assumed on this business. See “Item 1.—InsuranceServices Segment Products and Services”.

·       ***Insurance Services****.*In our insurance services segment, TRM, as a managinggeneral agency, generates commission income by producing premiums on behalf ofits issuing companies and generates fees by providing claims administration andreinsurance intermediary services. TRM does not assume any risk on businessproduced by it. All of the risk is written by the issuing companies and cededto a variety of reinsurers pursuant to reinsurance programs arranged by TRMworking with outside reinsurance intermediaries. Placing risks through TRM’sissuing companies allowed us to underwrite larger policies and gain exposure tomarket segments unavailable to TICNY due to rating, financial size,geographical licensing limitations, or other factors. Through its issuingcompanies, TRM produces commercial package, monoline general liability,monoline property, commercial automobile and commercial umbrella products. See “Item1.—Insurance Services Segment Products and Services”.

Prior to our IPO, TICNY’s limited capital, rating andlicensing constrained its ability to write and retain large premium volume. Consequently,TICNY made extensive use of quota share reinsurance to manage the level of riskit retains in relation to its capital. In 1995, we formed TRM in order toproduce business for other insurance companies that TICNY was precluded fromwriting due to TICNY’s limited capital, rating and licensing. TRM also enabledus to earn fee revenue and to lower our underwriting expense ratio by creatingeconomies of scale and sharing some of the cost of developing and maintaining afull insurance infrastructure. In order for us to obtain reinsurance for TRM’sissuing companies, the reinsurers often require TICNY to assume reinsurancepremiums directly from TRM’s issuing companies or from reinsurers that reinsurethe premiums written by these companies.

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The following tablesummarizes the focus of our three segments:

| ** **                         | ** ** | **Insurance (TICNY & TNIC)**                                                                                                                                                              | ** ** | **Reinsurance (TICNY)**                                                                                                  | ** ** | **Insurance Services (TRM)**                                                                                                |
|------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------|
|                               | ** ** | **Risk Bearing**                                                                                                                                                                                   | ** ** | **Risk Bearing**                                                                                                         | ** ** | **Non-Risk Bearing**                                                                                                        |
| **Premium Size**                   |       | Small (under $25,000 premium per policy)  Medium ($25,000 to $150,000 premium per policy)  Large (over $150,000 per policy)                                                                        |       | TICNY assumes a modest portion of the premiums  written by TRM’s issuing companies on all business produced by TRM. |       | Small (under $25,000 premium per policy)  Medium ($25,000 to $150,000 premium per policy)  Large (over $150,000 per policy) |
| **Pricing Tier**                   |       | Standard and Non-Standard (TICNY) Preferred (TNIC).                                                                                                                                                |       |                                                                                                                     |       | Preferred, Standard and Non-Standard                                                                                        |
| **Emphasized Classes of Business** |       | Retail and wholesale stores, grocery stores, restaurants, artisan contractors,  apartment buildings  Homeowners, dwelling and other non-auto related personal lines products                       |       |                                                                                                                     |       | Residential and commercial buildings                                                                                        |
| **Territory**                      |       | New York State and other eastern seaboard states  (TICNY)  Massachusetts, New Jersey and other eastern seaboard states (TNIC)                                                                      |       |                                                                                                                     |       | New York, New Jersey, Pennsylvania and incidental  locations throughout the country, but primarily in the Northeast         |
| **Coverages**                      |       | Businessowners Policy Commercial Package Policy  Monoline Commercial Property Monoline General Liability Commercial Umbrella  Commercial Auto  Workers’ Compensation  Homeowners and Dwelling |       |                                                                                                                     |       | Commercial Package Policy Monoline Commercial  Property Monoline General Liability Commercial Auto                          |
| **Services**                       |       |                                                                                                                                                                                               |       |                                                                                                                     |       | Reinsurance intermediary  Claims administration                                                                             |

 

***Insurance Segment Products***

In our insurance segment, TICNY offers a broad arrayof commercial and personal lines products. Our insurance segment productscurrently target low severity, low frequency risks with an overall averageannual premium in 2005 of $4,359 policy for commercial lines and $1,043 perpolicy for personal lines. Typically, the liability coverage on these classesof business is not exposed to long-tailed (i.e., many years may pass beforeclaims are reported or settled), complex or contingent risks, such as productsliability, asbestos or environmental claims. These risks are located in NewYork City and the adjacent areas of New York State, a market that we feel, inour lines of business, level of risk and premium size, has historically beenoverlooked by regional and national insurance companies. With the OneBeaconRenewal Rights Agreement, TICNY has expanded its marketing territory to otherareas of New York State, including Long Island, the Hudson River Valley andWestern New York. However, TICNY is maintaining a targeted approach to underwriting;focusing on underserved markets that we believe will permit us to achievefavorable premium rates.

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Thefollowing table shows our gross premiums earned and loss ratio for theinsurance segment’s products for the years ended December 31, 2005 and December 31,2004.

| ** **                 | ** ** | **Year ended  December 31, 2005** | ** **  | **Year ended**

**December 31, 2004** | ** ** |
|----------------------------|------------|--------------------------------------------------|-------------|------------------------------------------------------|------------|
| ** **                 | ** ** | **Gross  Premiums  Earned**                      | ** **  | **Gross  Loss  Ratio**                               | ** ** | **Gross  Premiums  Earned** | ** ** | **Gross  Loss  Ratio** | ** ** |
| ** **                 | ** ** | **($in thousands)**                         | ** **  |
| Commercial  multiple-peril |       | $                                                | 117,814     |                                                 |       | 59.4 | % |   | $ | 77,917 |   |   | 63.1 | % |   |
| Other liability            |       | 22,427                                           |        |                                                 | 77.9       | % |   | 7,525 |   |   | 55.5 | % |   |
| Workers  compensation      |       | 21,059                                           |        |                                                 | 40.8       | % |   | 14,101 |   |   | 61.8 | % |   |
| Commercial auto            |       | 16,722                                           |        |                                                 | 32.6       | % |   | 10,432 |   |   | 31.7 | % |   |
| Homeowners                 |       | 49,150                                           |        |                                                 | 59.0       | % |   | 34,526 |   |   | 45.6 | % |   |
| Fire and allied  lines     |       | 9,002                                            |        |                                                 | 48.1       | % |   | 6,709 |   |   | 55.2 | % |   |
| **All Lines**              | ** ** | **$**                                            | **236,174** | ** **                                           | ** ** | **57.1** | **%** | ** ** | **$** | **151,210** | ** ** | ** ** | **56.1** | **%** | ** ** |

 

*Commercial Multiple-peril.**  *Our commercial multiple-peril products includecommercial package policies, businessowners policies and landlord packagepolicies. Our commercial package policies provide property and casualtycoverages and focus on classes of business such as retail and wholesale stores,grocery stores, restaurants and residential and commercial buildings. We havewritten commercial package policies since TICNY commenced operations in 1990. Ourbusinessowners policies provide property and liability coverages to small businesses.We introduced this product in 1997 to provide broader built-in coverages forbusinesses in the standard and preferred pricing tiers at lower rates than oncommercial package policies. Our landlord package policy provides property andcasualty coverage for three- and four-family dwellings with a maximum coveragelimit of $700,000. As of December 31, 2005, approximately 38,656commercial multiple-peril products were in place, including 22,741 commercialpackage policies and 11,179 landlord package policies and 4,736 businessownerspolicies.

*Other Liability.**  *We offer other liability products in personal andcommercial lines. Our commercial products are comprised of monoline commercialgeneral liability and commercial umbrella policies. We write commercial generalliability policies for risks that do not have property exposure or whoseproperty exposure is insured elsewhere. Primarily, we target residential andcommercial buildings, as well as artisan contractors for monoline generalliability. Our commercial umbrella policy, introduced in 2002, provides additionalliability coverage with limits of $1,000,000 to $5,000,000 to policyholders whoinsure their primary general liability exposure with TICNY through a businessowners, commercial package policy, or commercial general liability policy. Wehave the ability to offer limits of up to $10,000,000 with facultativereinsurance. As of December 31, 2005, approximately 1,774 monolinecommercial general liability policies and 342 commercial umbrella policies werein force. We also write monoline personal liability policies as an addition toour dwelling fire policies. As of December 31, 2005, TICNY hadapproximately 1,447 comprehensive personal liability policies in force. We alsowrite personal lines excess liability or umbrella policies covering personalliability in excess of the amounts covered under our homeowners and dwellingpolicies. We offer this policy with a $1,000,000 limit. We do not market excessliability policies to individuals unless we also write the underlying homeowner’spolicy. Further, the excess liability is usually handled as an endorsement tothe homeowner’s policy. Also, due to the upgrade in TICNY’s rating from A.M.Best to “A-” (Excellent) from “B++” (Very Good), other liability premiums thatwere formerly produced through TRM are now being written and earned in TICNY.

*Workers’ Compensation.**  *We introduced our workers’ compensation product in1995. Our underwriting focus is on businesses such as restaurants, retailstores, offices, and clothing manufacturers that generally have a lower potentialfor severe injuries to workers from exposure to dangerous machines, elevatedworksites and occupational diseases. This product is currently offered on aguaranteed cost basis 

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at the ratespublished by the New York State Workers’ Compensation Bureau. As of December 31,2005, we had approximately 9,517 workers’ compensation policies in force.

*Commercial Automobile.**  *Our commercial automobile product focuses onnon-fleet business such as contractor and wholesale food delivery vehicles. Weunderwrite primarily medium and lightweight trucks (under 30,000 lbs. grossvehicular weight). Historically unprofitable accounts for this segment of theinsurance industry such as livery, trucking for hire or long-haul truckingoperations are presently excluded under our underwriting guidelines. Wecommenced writing commercial automobile business in 1998. As of December 31,2005, approximately 2,173 commercial automobile policies were in force.

*Homeowners.**  *Our homeowner’s policy is a multiple-peril policyproviding property and liability coverages for one- and two-familyowner-occupied residences. While we are expanding our marketing territoriesthroughout New York State, the homes we currently insure are locatedpredominantly in the greater New York City area. We market both a standard andpreferred homeowner’s product. As of December 31, 2005, approximately51,225 homeowner’s policies were in force.

*Fire and Allied Lines.**  *Our fire and allied lines policies consist ofdwelling policies and monoline commercial property policies. Our dwellingproduct targets owner-occupied dwellings of no more than two families. Thedwelling policy provides optional coverages for personal property and can becombined with an optional endorsement for liability insurance. This provides analternative to the homeowner’s policy for the personal lines customer. As of December 31,2005, we had approximately 16,457 dwelling policies in force. We also writemonoline commercial property policies for insureds that do not meet ourunderwriting criteria for the liability portion of our commercial packagepolicies. The classes of business are the same as those utilized for commercialpackage property risks. Generally, the rates charged on these policies arehigher than those for the same property exposure written on a commercialpackage policy. As of December 31, 2005, approximately 232 monolinecommercial property policies were in force.

***Reinsurance SegmentProducts***

In order for TRM to obtainreinsurance support for the business it produces for its issuing companies,Virginia Surety Company Inc. and State National Insurance Company Inc., TICNYis often required to assume a limited amount of reinsurance on this businessfrom the issuing companies or the issuing companies’ reinsurers. By assumingrisk, we align our interests with the issuing companies and their reinsurers. Whilethis assumed business had historically been unprofitable, the direct commissionincome generated by TRM has historically offset assumed losses. In 2005, TICNYassumed 4.2% of the business produced by TRM, with gross written premiumsassumed of $1.5 million, representing 0.5% of TICNY’s total gross premiumswritten and 1.0% of its net premiums earned.

With respect to VirginiaSurety, TICNY also assumed 100% of the liability above the loss ratio capsunder the 2004 Multiple Lines Quota Share Reinsurance Agreement. These lossratio caps were 95% for the small business program, 115% for the middle marketprogram and 125% for the large lines general liability real estate program. TICNYalso assumed from Virginia Surety the liability for losses not covered underthe original quota share reinsurance treaties between Virginia Surety and itsother reinsurers. Pursuant to an aggregate excess of loss reinsuranceagreement, TICNY also assumed from two Virginia Surety’s quota share reinsurers10.25% of losses in excess of a loss ratio of 68.0% under the small marketprogram, 15.25% of losses in excess of a loss ratio of 68.0% under the middlemarket program and 19.0% of losses in excess of a loss ratio of 63.0% for thelarge lines general liability real estate program. The Virginia Surety MultipleLines Quota Share Reinsurance Agreement was renewed as of January 1, 2006.

In 2005, TICNY assumedfrom State National 100% of the liability above the loss ratio caps under the2005 State National Combined Quota Share Reinsurance Agreement. These lossratio caps were 95% for the small business overflow program, 115% for themiddle market program and 125% for the large lines general liability realestate program. TICNY also assumed from State National the liability for lossesnot covered under the original quota share reinsurance treaties between StateNational and its other 

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reinsurers.Pursuant to an aggregate excess of loss reinsurance agreement, TICNY alsoassumed from State National’s quota share reinsurers 10.25% of losses in excessof a loss ratio of 68.0% under the small market program, 15.25% in excess of68.0% under the middle market program and 19.0% of losses in excess of a lossratio of 63.0 % for the large lines general liability real estate program.

Effective August 1,2005, TICNY agreed to be  the quota sharereinsurer for a book of business covering artisan contractors and general contractorswritten by Accident Insurance Company (“AIC”). Under the terms of the treaty,AIC cedes to TICNY 65% of the premiums written and TICNY allows AIC a 25%ceding commission. In addition, the terms provide for TICNY to pay AIC acontingent commission equal to 30% of any profit accruing to TICNY during eachaccounting period, where profit is calculated as earned premiums, lesscommission, less 15% of ceded earned premiums for reinsurers’expenses, lessincurred losses, less any loss carried forward from the previous accountingperiod. TICNY’s limit of liability under the treaty is capped at 150% of cededgross earned premium, i.e. earned premium gross of ceding commission and afterdeduction of any return premiums and cancellations.

***Insurance ServicesSegment Products and Services***

TRM provides non-riskbearing managing general agency, reinsurance intermediary and claimsadministration services that generate commission and fee income for us. TRMalso provides us with additional market capability to produce business in otherstates, product lines and pricing tiers that TICNY cannot currently access. TRMproduces this business on behalf of its issuing companies, which have higherratings, greater financial resources and more licenses than TICNY.

TRM provides underwriting,claims administration and reinsurance intermediary services to its issuingcompanies by utilizing TICNY’s staff, facilities and insurance knowledge andskills. All of the business produced by TRM for its issuing companies is cededto reinsurers. TRM earns a commission, equal to a specified percentage of cedednet premiums written, which is deducted from the premiums paid to the issuinginsurance companies. TRM’s commission rate varies from year to year dependingon the loss experience of the business produced by TRM. The commission rate in 2005 was 27.1%. TRM alsoperforms claims administration services on behalf of other insurance companies,including companies for which TRM produced business in the past, but as towhich it may no longer act as an underwriting agent.

While TICNY had incurredunderwriting losses from its assumed premiums to support TRM’s business, thoselosses were based upon assumed premiums that represented only a small portionof TRM’s issuing companies. TRM, as a managing general agency, however,generated commissions on all of the premiums produced. As result, TRM hascontributed to both the profitability and the growth of our organization whileat the same time reducing TICNY’s underwriting expense ratio through economiesof scale and the sharing of TICNY operating costs. As consideration for the useof TICNY’s staff, equipment and facilities, TRM reimburses a portion of TICNYunderwriting expenses through an expense sharing agreement. Thesereimbursements were $2.0 million, $3.0 million and $2.2 million in 2005, 2004and 2003, respectively, representing 5.6%, 13.2% and  13.7%, respectively, of TICNY’s total otherunderwriting expenses in those years. TRM also reimburses TICNY for the use ofTICNY’s claims and legal defense staff based upon the hourly billing ratescharged by TRM to its issuing companies. These reimbursements were $4.3million, $4.0 million and $3.6 million in 2005, 2004 and 2003, respectively,representing 3.1%, 4.8% and 4.9%, respectively, of TICNY’s gross loss and lossadjustment expenses in those periods. In addition to lowering TICNY’sunderwriting expenses through expense reimbursement, TRM also contributes thebalance of its revenues after these expense reimbursements to our overallpre-tax income. Those contributions were $2.8 million, $2.0 million and $1.5million in 2005, 2004 and 2003, respectively.

In 2005 and 2004 TRMunderwrote business on behalf of Virginia Surety and State National. VirginiaSurety is rated “A-” (Excellent) and State National is rated “A” (Excellent) by A.M.Best. Virginia Surety and State National are each licensed in all 50 states andthe District of Columbia. Virginia Surety is expected to be TRM’s only issuingcompany in 2006.

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TRM’s business isprimarily sourced through wholesale and retail brokers. See “Item 1.—Product Development and MarketingStrategy—Distribution” for further detail on our producers. The businessTRM writes for its issuing companies is reinsured 100% to various reinsurers inaddition to TICNY, including Tokio Millennium Re Ltd., Hannover Reinsurance(Ireland) Ltd. and E+S Reinsurance (Ireland) Ltd. TRM acts as a reinsuranceintermediary for its issuing companies and arranges for all of the reinsuranceceded. For 2005, all of the reinsurers providing reinsurance for TRM’s issuingcompanies are rated “A-” (Excellent) or better by A.M. Best

*Managing General Agency*

TRM produces business forits issuing companies through various programs, as follows:

*TRM Small BusinessOverflow Program.**  *TRM’ssmall business overflow program, created in 2003, provides additional capacityand the ability to write risks outside of New York for commercial linesproducts of the kind written by TICNY (other than workers’ compensation andlandlord package policies), generating annual premiums per policy of less than$25,000. All the rates, forms and underwriting guidelines for this program areidentical to those used by TICNY.

*TRM Middle Market Program.**  *TRM’s middle market program enables us to accesscommercial lines business for the same classifications of risk written byTICNY, but having annual premiums per policy in excess of $25,000. The middlemarket program also enables us to serve accounts that require a larger insurerthan TICNY or are located outside of New York. For risks that would otherwisequalify for a commercial package policy, this program can offer monolineproperty or general liability coverages where one of the coverage parts doesnot qualify due to overly competitive pricing, lack of capacity, insufficientunderwriting expertise or a restricted underwriting classification. Due to theupgrade in TICNY’s A.M. Best rating to “A-” (Excellent) in late 2004,certain policies in the more rating sensitive middle market program wererenewed in the insurance segment in 2005.

This program focuses onmercantile, residential and commercial building risks and offers propertylimits up to $30.0 million per location. Most of the business is located in NewYork City, with some accounts in other areas of New York State and New Jersey. Priorto 2001, the premium rates for the middle market program were significantlylower than the rates offered by TICNY. Beginning in 2001, the rates in thisprogram were significantly increased, and in 2004 and 2005 they were not substantiallydifferent from those offered by TICNY.

*TRM Large Lines GeneralLiability Real Estate Program.**  *Thisprogram, which we began in 1996, provides monoline general liability policiesfor mercantile, residential and commercial building risks primarily in New YorkCity, generating annual general liability premiums in excess of $100,000. From2001 through 2003, premium rates increased significantly on a cumulative basisfrom 2000 levels and we re-underwrote this program. While the rate levelsstabilized in 2004 and 2005, we continued to obtain modest premium changes. Dueto the upgrade in TICNY’s A.M. Best rating to “A-” (Excellent) in late2004, certain policies in the more rating sensitive large lines program wererenewed in the insurance segment in 2005.

*TRM Claims Service*

TRM’s claims servicedivision provides complete claims adjusting and litigation management servicefor all commercial and personal property and casualty lines of business to TRM’sissuing insurance companies, reinsurers and self-insureds. TRM presently billsits claims administration cost as a value added service to its issuingcompanies and is reimbursed by the issuing companies for the amounts billed. Thefees earned by TRM help offset the total expenses incurred by TICNY’s claimsstaff and allow TICNY to maintain a larger claims infrastructure than it wouldotherwise be able to support with its own premium base. The amount of claimsadministration fees reimbursed by the issuing companies was $4.3 million in2005, $4.0 million in 2004 and $3.6 million in 2003.

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In addition, TRM generatesfees for a profit by providing claims administration, audit and consultingservices to self-insureds and other insurance companies. While TRM has notactively marketed its claims service division, its reputation in claimsadministration and litigation management has brought several opportunities toact as a third-party claims administrator. We plan to expand our claimsadministration services for profit in the future.

*Tower Risk Reinsurance Intermediary Services*

TRM’s reinsuranceintermediary services division provides reinsurance intermediary services to TICNYand to TRM’s issuing companies. Its revenue is derived from a fee sharingagreement with an outside reinsurance intermediary on the premium ceded tovarious reinsurers that reinsure TICNY and TRM’s issuing companies. Its revenuefor performing these services was $0.7 million in 2005, $0.7 million in 2004and $1.1 million in 2003

**ProductDevelopment and Marketing Strategy**

We believe that manyinsurance companies develop and market their products based on an underwritingfocused approach in which they define products based upon their underwritingguidelines and subsequently market those products to producers whose needs fitwithin the bounds of their underwriting criteria. Conversely, while we are adisciplined underwriting organization, our product development and marketingstrategy is to first identify needed products and services from our producersand then to develop profitable products in response to those needs. Afterpositioning our products in this manner, we focus on developing underwritingguidelines that enable us to make an underwriting profit. This approach hasallowed our organization to gain the reputation of being responsive to marketneeds with a highly service oriented approach to our producer base.

When we first beganoperations in 1990, our producers confirmed the need for us to underwrite smallcommercial risks, such as apartment buildings, restaurants and retail stores inurban areas such as New York City that other insurance companies avoided due toa perceived lack of underwriting profitability. In response to this need, wedeveloped commercial package policies that provided limited property andliability coverage customized to meet the needs of this nonstandard marketsegment, as well as underwriting and claims approaches that enabled us toachieve underwriting profitability. Since then, we have continued to developother commercial lines products such as business owners, workers’ compensationand commercial automobile policies, and introduced personal lines products suchas homeowner’s and dwelling policies, to respond to the needs of our customersin other nonstandard segments as well as customers in the preferred andstandard market segments where we generally offer lower rates and broadercoverages for risks that we perceive to have more desirable underwritingcharacteristics.

With the development ofour broad product line offering, we have been able to access markets withsignificant premium volume and opportunity for market penetration. We haveincreased our market share in each of these lines of business. We have beenable to achieve profitable premium growth by keeping our annual premium volumeobjectives in the various lines of business low relative to the overall size ofthe market in those lines. This approach allows us to remain selective in ourunderwriting and to avoid sacrificing profitability for the sake of volume.

In marketing our products,we segment the market based upon industry, location, pricing tiers and premiumsize. For commercial lines products, we have generally focused on specificclasses of business in the real estate, retail, wholesale and serviceindustries such as retail and wholesale stores, residential and commercialbuildings, restaurants and artisan contractors. We target these underservedclasses of business because we believe that they are less complex, have reducedpotential for loss severity and can be easily screened and verified throughphysical or telephonic inspection.

We also have historicallytargeted risks located in urban areas such as New York City that requirespecial underwriting expertise and have generally been avoided by otherinsurance companies. We have 

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hadsuccess targeting markets in geographical areas outside of New York City byfocusing on classes of business such as residential real estate buildings thatother companies have avoided. In 2006 we plan to expand territorially into NewJersey, Pennsylvania and the New England states.

We have also expanded ourproduct offering to various lines of business within the preferred, standard andnon-standard pricing segments. Within the preferred, standard or non-standardmarket segment, we first developed different pricing, coverages andunderwriting guidelines. For example, the pricing for the preferred risksegment is generally the lowest, followed by the standard and non-standard risksegments. The underwriting guidelines are correspondingly stricter forpreferred risks in order to justify the lower premium rates charged for theserisks. Underwriting standards become progressively less restrictive forstandard and non-standard risks.

In addition to segmentingour products by industry, location and pricing tiers, we further classify ourproducts into the following premium size segments: under $25,000 (small),$25,000 to $150,000 (medium) and over $150,000 (large). We have historicallyhad more success in the small premium size segment due to our focus on reducingour underwriting expenses by realizing economies of scale, utilizing technologyand developing efficient business processes. We believe that due to the highercost of underwriting small policies, other insurance companies have not beenable to price competitively in this premium size segment. Our expense advantagehas allowed us to maintain adequate rates through industry cycles. With improvedmarket conditions in recent years, we have seen adequate pricing in the mediumand large premium size segments as reflected by improved operating performanceby TRM and in 2005 by TICNY, which has focused on these premium size segments.

Each year, we analyzevarious market segments and deliver products for each line of business in thosesegments that present the best opportunity to earn an underwriting profit basedon the prevailing market conditions. As a result, the segments on which wefocus will vary from year to year as market conditions change. We expand ourproduct offerings in segments where we believe that we have established theappropriate price, coverage and commission rate to generate the desiredunderwriting profit. Conversely, we aim to reduce our product offerings inmarket segments where competition has reduced opportunities for us to earn anunderwriting profit.

***Distribution***

We generate businessthrough independent wholesale and retail agents and brokers, whom we refer tocollectively as producers. These producers sell policies for us as well as forother insurance companies. We had approximately 808 producers appointed togenerate business in 2005,  including 363former OneBeacon producers.

Approximately 40% of thetotal of TICNY’s gross premiums written and premiums produced by TRM on behalfof its issuing companies in 2005 were derived from our top 10 producers. In2005, Morstan General Agency, CRC Insurance and Davis Agency Inc., produced,11%, 5% and 5%, respectively, of the total of TICNY’s gross premiums writtenand premiums produced by TRM on behalf of its issuing companies. No otherproducer was responsible for more than 5% of TICNY’s gross premiums written andpremiums produced by TRM for its issuing companies in 2005.

We carefully select ourproducers by evaluating several factors such as their need for our products,premium production potential, and loss history with other insurance companiesthat they represent, product and market knowledge and the size of the agency. Wegenerally appoint producers with a total annual premium volume greater than$5,000,000. We expect a new producer to be able to produce at least $250,000 inannual premiums for us during the first year and $500,000 in annual premiumsafter three years. The newly appointed producers that were part of theOneBeacon transaction are providing access to the expiring OneBeacon renewalpolicies, as well as producing new business within our established underwritingguidelines and marketing appetite.

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Commissions paid toproducers in 2005 for TICNY averaged 16.4% of gross premiums earned. For TRMbusiness, average commissions in 2005 were 14.4%. Our commission schedules are1 to 1.5 points higher for wholesalers as compared to retailers in recognitionof the additional duties that wholesalers perform. Also, TICNY has a profitsharing plan that added less than 1⁄2% to overall commission rates in 2005.

Prior to the IPO, we wereable to generate as much premium volume as TICNY’s surplus would supportconsistent with its A.M. Best rating. With the additional capital infusionresulting from the IPO we have increased marketing and business developmentefforts aimed at increasing premium volume in New York City as well as otherareas in New York State. This has been directed at the orientation and trainingof the newly appointed agents. Additionally, with the acquisition of additionalstate licenses, our focus has increased in developing marketing capabilitiesand agency relationships in other northeastern states. Currently, our activitiesare directed toward constructing a producer network in New Jersey. In March 2005we completed the acquisition of North American Lumber Insurance Company, ashell company and renamed it Tower National Insurance Company that is nowlicensed in sixteen states as of December 31, 2005. Additionally on March 1,2005 we announced the formation of a Programs Underwriting Unit to complimentour regional distribution approach. The Program Underwriting Unit will allow usto gain access to established highly focused and narrowly defined books ofbusiness that are distributed over a broader geographical area not accessiblethrough our regional distribution approach. It will also enable us to addgreater value to our existing agents by developing new program opportunitiesfor classes of business that we do not currently underwrite or in which we havea limited market penetration.

To ensure that we obtainprofitable business from our producers, we attempt to position ourselves as ourproducers’ primary provider of the products that we offer. We manage theresults of our producers through a quarterly review to monitor premium volumeand profitability. At the end of each quarter, we produce premium and losshistory reports and develop actuarial ultimate accident year factors in orderto project the profitability of the producers. We continuously monitor theproducers in this manner so we can develop corrective action, if necessary, atany time throughout the year.

**Underwriting**

The underwriting strategyfor controlling our loss ratio is to seek diversification in our products andan appropriate business mix for any given year, emphasizing profitable lines ofbusiness and de-emphasizing unprofitable lines. At the beginning of each year,we establish the target loss ratios for each line of business. We monitor theactual loss ratio throughout the year on a monthly basis. If any line ofbusiness fails to meet its target loss ratio, a cross-functional team comprisedof personnel from the underwriting teams and the corporate underwriting,actuarial, claims and loss control departments meets to develop a correctiveaction plan that may involve revising underwriting guidelines, non-renewingunprofitable segments or entire lines of business and/or rate increases.

During the period of timethat a corrective action plan is being implemented with respect to any productline that fails to meet its target loss ratio, premium for that product line isreduced or maintained depending upon its effect on our total loss ratio. Tooffset the reduction or lack of growth in premium volume for the products thatare undergoing corrective action, we seek to expand our premium writings inexisting profitable lines of business or add new lines of business with betterunderwriting profit potential.

We establish underwritingguidelines for all the products that we underwrite to ensure a uniform approachto risk selection, pricing and risk evaluation among our underwriters and toachieve underwriting profitability. Our underwriting process involves securingan adequate level of underwriting information from our producers, identifyingand evaluating risk exposures and then pricing the risks we choose to accept. Forcertain approved classes of commercial risks and most personal lines policies,we allow our producers to initially bind these risks utilizing rating criteriathat we provide to them. Also, our web-based platform Web*Plus*provides our producers with the capability to submit and receive quotes overthe Internet and contains our risk selection and pricing logic, therebyenabling us to streamline our initial 

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submissionand screening process. If the individual risk does not meet the initialsubmission and screening parameters contained within Web*Plus,*therisk is automatically referred to our assigned underwriter for specific offlinereview. See “Item 1.—Technology”.

Once a risk is bound byour underwriter or producers, our internal or outside loss controlrepresentatives conduct physical inspections of substantially all of theinsured premises to validate the information provided by our producers andprovide a loss control report to our underwriters to make a final evaluation ofthe risk. With the exception of a few typically low risk classes of businesssuch as beauty parlors and offices, all of the new risks that are bound arephysically inspected or subject to a telephone survey, generally within 60 daysfrom the effective date of the policy. If the inspection reveals that the riskinsured under the policy does not meet our established underwriting guidelines,the policy is generally cancelled within the first 60 days from its effectivedate. If the inspection reveals that the risk meets our establishedunderwriting guidelines but the policy was bound with incorrect ratinginformation, the policy is amended through an endorsement based upon thecorrect information. We supplement the inspection by using online data sourcesto further evaluate the building value, claim experience, financial history andcatastrophe exposures of the insured. In addition, we specifically tailorcoverages to match the insured’s exposure and premium requirements. We completeinternal file reviews and audits on a monthly, quarterly and annual basis toconfirm that underwriting standards and pricing programs are being consistentlyfollowed. Our property risks are generally comprised of residential buildings,retail stores and restaurants covered under policies with low building andcontent limits. We carefully underwrite potential catastrophe exposures toterrorism losses. Our underwriting guidelines are designed to avoid propertiesdesignated as, or in close proximity to, high profile or target risks,individual buildings over 25 stories and any site within 500 feet of majortransportation centers, bridges, tunnels and other governmental orinstitutional buildings. In addition, we monitor the concentration of employeesinsured under our workers’ compensation policies and avoid writing risks withmore than 40 employees in any one building. However, please see “Item 1A.—Risks Related to Our Business—wemay face substantial exposure to losses from terrorism, we are currentlyrequired by law to provide coverage against such losses.”  Our property limits profile and the premiumsize of our policies in TICNY have risen as a result of the increase in TICNY’sstatutory surplus due to the capital contribution of $98 million of theproceeds from the IPO and the rating upgrade to “A-” (Excellent) by A.M.Best.

We underwrite our productsthrough four underwriting teams that are each headed by an underwriting managerhaving an average of approximately 16 years of industry experience in theproperty and casualty industry. We have the following five business units:small commercial, middle market, commercial auto, personal lines and programs. Thesebusiness units perform underwriting functions and are supported byprofessionals in the corporate underwriting, actuarial, operations, businessdevelopment and loss control departments. The corporate underwriting departmentis responsible for managing and analyzing the profitability of our entire bookof business, supporting line underwriting with technical assistance, developingunderwriting guidelines, granting underwriting authority, training, developingnew products and monitoring underwriting quality control through audits. Theactuarial department is responsible for monitoring rate adequacy on all of ourproducts and analyzing loss data on a monthly basis. The underwritingoperations department is responsible for developing workflows, conductingoperational audits and providing technical assistance to the underwriting teams.The loss control department conducts loss control inspections on nearly all newcommercial and personal lines business written, utilizing in-house loss controlrepresentatives and outside vendors. The business development department workswith the underwriting teams to manage relationships with our producers.

**Pricing**

We price our products tomake an acceptable underwriting profit. In situations where rates for aparticular line become insufficient to produce satisfactory results, we controlgrowth and reduce our premium volume in that line.

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We generally use actuarialloss costs promulgated by the Insurance Services Office, a company providingstatistical, actuarial and underwriting claims information and related servicesto insurers, as a benchmark in the development of pricing for our products. Wefurther tailor pricing to each specific product we underwrite (other thanworkers’ compensation), taking into account our historical loss experience andindividual risk and coverage characteristics. For workers’ compensationpolicies, we use statistical information provided by the New York CompensationInsurance Rating Board (“NYCRIB”) as a benchmark in developing our pricing.

If a particular businessline is not performing well, we may seek rate increases, which are subject toregulatory approval (See “Item 1.—Regulation”) and market acceptance. Recently, we havebeen successful in increasing our rates. We increased premiums on ourcommercial renewals as measured against expiring premium by 5.5% in 2005 and9.0% in 2004 and 9.0% in 2003. In personal lines we increased premiums by 7.6%in 2005, 9.5% in 2004 and 2.6% in 2003.

Beginning in the latterhalf of 2004 and continuing throughout 2005, the rates for property andcasualty insurance products began to moderate, and for certain products, ratesbegan to decrease due to an increased level of competition. The softening inthe personal lines market for both primary and reinsurance was interrupted by effectsof hurricanes Katrina, Rita and Wilma on the insurance industry. We did nothave any exposure to these hurricanes. However, these changes may still signalthe start of a “soft market” cycle that could restrict or diminish our abilityto obtain rate increases as in the recent past. We cannot predict with anycertainty the direction the market will take during 2006 or thereafter.

**Reinsurance**

We purchase reinsurance toreduce our net liability on individual risks, to protect against possiblecatastrophes, to achieve a target ratio of net premiums written topolicyholders’ surplus and to expand our underwriting capacity. Reinsurancecoverage can be purchased on a facultative basis, where individual risks arereinsured, or on a treaty basis, where a class or type of business is reinsured.We purchase facultative reinsurance to provide limits in excess of the limitsprovided by our treaty reinsurance. Treaty reinsurance falls into threecategories: quota share (also called pro rata), excess of loss and catastrophetreaty reinsurance. Under our quota share reinsurance contracts, we cede apredetermined percentage of each risk for a class of business to the reinsurerand recover the same percentage of each loss and loss adjustment expenses. Wepay the reinsurer the same percentage of the original premium, less a cedingcommission. The ceding commission rate is based upon the ceded loss ratio onthe ceded quota share premiums earned. See “Item 7.—Critical Accounting Policies—Cedingcommissions earned”. Under our excess of loss treaty reinsurance, wecede all or a portion of the liability in excess of a predetermined deductibleor retention. We also purchase catastrophe treaty reinsurance on an excess ofloss basis to protect ourselves from an accumulation of net loss exposures froma catastrophic event or series of events such as terrorist acts, riots,windstorms, hailstorms, tornadoes, hurricanes, earthquakes, blizzards andfreezing temperatures. We do not receive any commission for ceding businessunder excess of loss or catastrophe reinsurance agreements.

The type, cost and limitsof reinsurance we purchase can vary from year to year based upon our desiredretention levels and the availability of quality reinsurance at an acceptableprice. Our excess of loss reinsurance program was renewed on January 1,2006 and Tower Group, Inc. is in discussions with a Bermuda reinsurancecompany in formation to enter into a multi-year quota share reinsuranceagreement. Until this agreement is in place we are retaining all of the riskfor 2006 that would have been ceded to quota share reinsurers. In 2005, weceded 25% of its net premiums written to reinsurers in accordance with itsquota share treaty. Our 2005 Property Catastrophe Program warrants that aminimum 25% quota share cession be in place. If a loss to the PropertyCatastrophe Program occurs after January 1, 2006 but before the inceptionof the proposed multi-year quota share agreement we would be required to retain25% of the loss as if a 25% quota share cession was in place. Our PropertyCatastrophe Reinsurance Program renewed on July 1, 2005.

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In recent years, thereinsurance industry has undergone very dramatic changes. Soft marketconditions created by years of inadequate pricing brought poor results, whichwere exacerbated by the events of September 11, 2001. As a result, marketcapacity was reduced significantly. Reinsurers exited lines of business,significantly raised rates and imposed much tighter terms and conditions wherecoverage was offered, to limit or reduce their exposure to loss.

In an effort to maintainquota share capacity for our business with favorable commission levels, we havebeen accepting loss ratio caps in our reinsurance treaties. Loss ratio caps cutoff the reinsurer’s liability for losses above a specified loss ratio. Theseprovisions have been structured to provide reinsurers with some limit on theamount of potential loss being assumed, while maintaining the transfer ofsignificant insurance risk with the possibility of a significant loss to thereinsurer. We believe our reinsurance arrangements qualify for reinsuranceaccounting in accordance with SFAS 113, *Accounting for ReinsuranceContracts.*The loss ratio caps for our quota share treaties are95.0% for 2005, and were 95.0% in 2004, 92.0% in 2003, 97.5% in 2002 and 100.0%in 2001.

Recently, regulators andother governmental authorities have been investigating certain types ofinsurance and reinsurance arrangements that they allege are intended only tosmooth an insured company or ceding insurer’s earnings rather than to transferinsurance risk. As noted above, we believe our quota share reinsurance meetsall requirements pertaining to risk transfer. However, these investigations,the related legal actions and the accompanying increased scrutiny of “non-traditional”reinsurance arrangements may lead to a change in the applicable accountingstandards or a reduction in the availability of some types of reinsurance. Inturn, these developments could produce higher prices for reinsurance, an increasein the amount of risk we retain, reduced ceding commission revenue, or otherpotentially adverse developments. In that event, we may be required torestructure or reduce use of quota share reinsurance or reduce our premiumwritings. See “Item 1.—Regulation—IndustryInvestigations”.

Regardless of type,reinsurance does not legally discharge the ceding insurer from primaryliability for the full amount due under the reinsured policies. However, theassuming reinsurer is obligated to indemnify the ceding company to the extentof the coverage ceded. To protect our Company from the possibility of areinsurer becoming unable to fulfill its obligations under the reinsurancecontracts, we attempt to select financially strong reinsurers with an A.M.Best rating of “A-” (Excellent) or better and continue to evaluate theirfinancial condition and monitor various credit risks to minimize our exposureto losses from reinsurer insolvencies.

As of December 31,2005, we had unsecured reinsurance recoverables and ceding commissionsreceivable totaling $33.2 million owed by PXRE Reinsurance Company. On February 16,2006, A.M. Best downgraded to “B++”(Very Good)  its former “A-”(Excellent) financial strengthrating on PXRE and issued a negative outlook. On February 24, 2006 A.M.Best downgraded PXRE to “B+”(Very Good) with a negative outlook. We believethat the unsecured reinsurance recoverables and ceding commission receivablesfrom PXRE, none of which are past due nor in dispute, are fully collectible. Ourjudgment is based primarily on PXRE’s capital position as a result of itsrecent capital raising initiatives.

To further minimize ourexposure to reinsurance recoverables, effective October 1, 2003, we haveplaced our quota share reinsurance treaty on a “funds withheld” basis underwhich ceded premiums written are deposited in segregated trust funds from whichwe receive payments for losses and ceding commission adjustments. We also usedthe proceeds from the IPO and the concurrent private placement to increase thecapitalization of our insurance subsidiary. As a result of this increase incapital, our insurance subsidiary has been able to retain more of the risk onthe business it writes, thereby reducing our need for quota share reinsurance.

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Thefollowing table summarizes our reinsurance exposures by reinsurer as of December 31,2005.

| ** **                                | ** ** | ** **                     | ** ** | ** **              | ** ** | ** **          | ** ** | ** **            | ** ** | ** **            | ** ** | ** **             | ** ** | **Amounts in**  | ** ** | ** **            | ** ** |
|-------------------------------------------|------------|--------------------------------|------------|-------------------------|------------|---------------------|------------|-----------------------|------------|-----------------------|------------|------------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                | ** ** | ** **                     | ** ** | ** **              | ** ** | ** **          | ** ** | ** **            | ** ** | ** **            | ** ** | **Funds Held,**   | ** ** | **Trust**            | ** ** | ** **            | ** ** |
| ** **                                | ** ** | ** **                     | ** ** | ** **              | ** ** | ** **          | ** ** | **Prepaid**           | ** ** | ** **            | ** ** | **Ceded Payable** | ** ** | **Accounts or** | ** ** | ** **            | ** ** |
| ** **                                | ** ** | ** **                     | ** ** | **Recoverable on** | ** ** | **and Return** | ** ** | ** **            | ** ** | **and Deferred** | ** ** | **Secured by**    | ** ** | ** **           | ** ** |
| ** **                                | ** ** | **A.M. Best**             | ** ** | **Paid**                | ** ** | ** **          | ** ** | ** Reinsurance** | ** ** | **Commissions**       | ** ** | **Ceding**             | ** ** | **Letters of**  | ** ** | **Net Exposure** | ** ** |
| **Reinsurer**                             | ** ** | ** **                     | ** ** | **Rating**              | ** ** | **Losses**          | ** ** | **Reserves**          | ** ** | **Premium**           | ** ** | **Receivable**         | ** ** | **Commissions**      | ** ** | **Credit**            | ** ** | **to Reinsurer** | ** ** |
| ** **                                | ** ** | **($ in thousands)** | ** ** |
| PXRE Reinsurance Company(1)               |       |                           | B          | +                       |       | $                   | 2,383      |                  | $          | 22,379                |       |                   | $          | —               |       |                  |       | $ | 8,727 |   |   |   | $ | 261 |   |   |   | $ | — |   |   |   | $ | 33,228 |   |   |
| American Re-Insurance Company             |       |                           | A          |                    |       | 2,084               |       | 15,900                |       |                  | 1,252      |                   |       |                 | —     |                  |       |   | 901 |   |   |   | — |   |   |   | 18,335 |   |   |
| Platinum Underwriters Reinsurance Company |       |                           | A          |                    |       | —              |       | 2,357                 |       |                  | 1,645      |                   |       |                 | —     |                  |       |   | 716 |   |   |   | — |   |   |   | 3,286 |   |   |
| SCOR Reinsurance Company                  |       |                           | B          | ++                      |       | 3                   |       | 722                   |       |                  | —     |                   |       |                 | —     |                  |       |   | (13 | ) |   |   | — |   |   |   | 738 |   |   |
| Lloyd’s of London                    |       |                           | A          |                    |       | —              |       | —                |       |                  | 156        |                   |       |                 | —     |                  |       |   | (73 | ) |   |   | — |   |   |   | 229 |   |   |
| Odyssey America Reinsurance Corporation   |       |                           | A          |                    |       | —              |       | —                |       |                  | 8          |                   |       |                 | —     |                  |       |   | (10 | ) |   |   | — |   |   |   | 18 |   |   |
| Hartford Steam Boiler                     |       |                           | A          | ++                      |       | —              |       | —                |       |                  | 241        |                   |       |                 | —     |                  |       |   | 106 |   |   |   | — |   |   |   | 135 |   |   |
| GENRE                                     |       |                           | A          | ++                      |       | —              |       | —                |       |                  | 491        |                   |       |                 | —     |                  |       |   | 174 |   |   |   | — |   |   |   | 317 |   |   |
| American Agricultural Insurance Company   |       |                           | A          |                    |       | —              |       | —                |       |                  | —     |                   |       |                 | —     |                  |       |   | (7 | ) |   |   | — |   |   |   | 7 |   |   |
| Endurance Specialty Insurance, Ltd.       |       |                           | A          | -                       |       | 87                  |       | 409                   |       |                  | 78         |                   |       |                 | —     |                  |       |   | — |   |   |   | 574 |   |   |   | 0 |   |   |
| Tokio Millenium Re Ltd.                   |       |                           | A          | +                       |       | 2,014               |       | 35,091                |       |                  | 18,934     |                   |       |                 | —     |                  |       |   | 52,518 |   |   |   | 3,464 |   |   |   | 57 |   |   |
| Hannover Reinsurance (Ireland) Ltd.       |       |                           | A          |                    |       | 1,010               |       | 14,838                |       |                  | 15,147     |                   |       |                 | —     |                  |       |   | 29,488 |   |   |   | 1,507 |   |   |   | 0 |   |   |
| E+S Reinsurance (Ireland) Ltd.            |       |                           | A          |                    |       | 252                 |       | 3,709                 |       |                  | 3,787      |                   |       |                 | —     |                  |       |   | 7,373 |   |   |   | 375 |   |   |   | 0 |   |   |
| Hannover Rueckversicherungs AG       |       |                           | A          |                    |       | —              |       | 1,573                 |       |                  | 1,551      |                   |       |                 | —     |                  |       |   | 733 |   |   |   | — |   |   |   | 2,391 |   |   |
| Other                                     |       |                           |       |                    |       | —              |       | —                |       |                  | 29         |                   |       |                 | —     |                  |       |   | (3 | ) |   |   | 6 |   |   |   | 26 |   |   |
| Total                                     | ** ** | ** **                     | ** ** |                    | ** ** | **$**               | **7,833**  | ** **            | **$**      | **96,978**            |       | ** **             | **$**      | **43,319**           |       | ** **            | ** ** | **$** | **8,727** |   | ** ** | ** ** | **$** | **92,164** |   | ** ** | ** ** | **$** | **5,926** |   |   |   | **$** | **58,767** |   |   |
|                                           |            |                                |            |                         |            |                     |            |                       |            |                       |            |                        |            |                      |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)           Downgraded to “B+” (Very Good) in February 2006.

***2006 Reinsurance Program***

*QuotaShare Reinsurance.  **We are*in discussionwith a Bermuda reinsurance company in formation to enter into a multi-yearquota share reinsurance agreement. Until this agreement is in place we are  retaining all of the risk for 2006 that wouldhave been ceded to quota share reinsurers. In 2005, we ceded 25% of its netpremiums written to reinsurers in accordance with its quota share treaty. Our2005 Property Catastrophe Program warrants that a minimum 25% quota sharecession be in place. If a loss to the Property Catastrophe Program occurs afterJanuary 1, 2006 but before the inception of the proposed multi-year quotashare agreement we would be required to retain 25% of the loss as if a 25%quota share cession was in place.

*UmbrellaQuota Share Reinsurance.*   The Umbrella QuotaShare Reinsurance, originally effective January 1, 2005, was renewed on January 1,2006, at terms similar to the 2005 terms. The treaty reinsures against umbrellalosses up to $5.0 million per occurrence. We cede 95% of its premiums writtenand retain the remaining 5%. The provisional ceding commission under thistreaty is 30% of ceded premium written. Of the premium ceded, PlatinumUnderwriters Reinsurance, Inc., rated “A” (Excellent) by A.M. Best,reinsures 50% and Hannover Ruckversicherungs AG, rated “A” (Excellent) by A.M.Best, reinsures 50%.

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*Excessof Loss Reinsurance.**  *EffectiveJanuary 1, 2006 we entered into an Excess of Loss Reinsurance Program withsimilar terms as the 2005 Excess of Loss Reinsurance Program. The 2006 Excessof Loss Reinsurance Program was placed with Platinum Underwriters Reinsurance, Inc.,rated “A” (Excellent) by A.M. Best, Endurance Reinsurance Corporation ofAmerica, rated “A-” (Excellent) by A.M. Best, QBE Reinsurance Corporation,rated “A” (Excellent) by A.M. Best, Syndicates from Lloyd’s of London,rated “A” (Excellent) by A.M. Best, Hannover Ruckversicherungs AG, rated “A”(Excellent) by A.M. Best, Aspen Insurance UK limited, rated “A”(Excellent) by A.M. Best and ACE European Group Ltd., rated “A”(Excellent) by A.M. Best. 

*CatastropheReinsurance.*   The 2005 Property CatastropheProgram provides coverage for events occurring through June 30, 2006 andis expected to be renewed on July 1, 2006 with a similar structure to theexpiring program.

*TerrorismReinsurance.*   Pursuant to the Terrorism RiskInsurance Act of 2002 (“Terrorism Act”), TICNY must offer insureds the optionto purchase coverage for certified acts of terrorism for an additional premiumor decline such coverage. When the coverage is not purchased, we endorse thepolicy to exclude coverage for certified acts of terrorism, but losses from anact of terrorism that is not a certified event may be covered in any case. Also,even for certified acts of terrorism, losses from fire following the act ofterrorism are covered.

The Terrorism Act reimburses up to 90% of the lossesto commercial insurers due to certified acts of terrorism in excess of adeductible. Our deductible in 2004 was 10% of our 2003 direct earned premium oncommercial lines. Our deductible in 2005 is 15% of our 2004 direct earned premiumson commercial lines

On December 17, 2005,Congress passed a two-year extension of the Terrorism Act though December 31,2007 with the passage of the Terrorism Risk Insurance Extension Act of 2005 (“TRIEA”).Under the terms of the extension, TICNY’s deductible will increase to 17.5% ofdirect earned premium in 2006 and 20% in 2007. The minimum size of thetriggering event will be increased from the current $5 million to $50 millionfor the last nine months of 2006 and $100 million for 2007. As a consequence ofthese changes, potential losses from a terrorist attack could be substantiallylarger than previously expected. Potential future changes to TRIEA could alsoadversely affect our ability to obtain reinsurance on favorable terms,including pricing, and may affect our underwriting strategy, rating, and otherelements of our operation.

***2005 Reinsurance Program***

*QuotaShare Reinsurance.**  *EffectiveJanuary 1, 2005, TICNY entered into a quota share treaty to reinsureagainst losses up to $1.0 million per occurrence on the gross premiums writtenin the insurance segment. Under the terms of the treaty, TICNY cedes 25% of itsnet premiums written and retains the remaining 75%. The provisional cedingcommission under this treaty is 39.1% of ceded net premiums written. Of thepremium ceded, Tokio Millennium Re Ltd. (“Tokio Millennium”), rated “A+”(Superior) by A.M. Best, reinsures 50%, Hannover Reinsurance (Ireland)Ltd., rated “A” (Excellent) by A.M. Best, reinsures 40% and E+SReinsurance (Ireland) Ltd. (collectively “Hannover”), rated “A” (Excellent) by A.M.Best, reinsures the remaining 10%. The 2005 quota share treaty contains variousexclusions and provides coverage for 100% of extra-contractual obligations andlosses in excess of policy limits. To reduce TICNY’s credit exposure toreinsurance, the quota share reinsurance has been placed on a “funds withheld”basis. Under the terms of the reinsurance treaty, TICNY guarantees to creditthe reinsurers with a 3% annual effective yield on the monthly balance of thisaccount.

Effective January 1, 2005, TICNY entered into aquota share treaty to reinsure against umbrella losses up to $5.0 million peroccurrence. Under the terms of the treaty TICNY cedes 95% of its premiumswritten and retained the remaining 5%. The provisional ceding commission underthis treaty is 30% of ceded premium written. Of the premium ceded, PlatinumUnderwriters Reinsurance, Inc., rated “A” 

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(Excellent) by A.M.Best, reinsures 50% and Hannover Ruckversicherungs AG, rated “A” (Excellent) by A.M.Best, reinsures 50%.

Effective December 1, 2005, TICNY entered into aquota share treaty to reinsure against umbrella losses up to $5 million peroccurrence on a book of commercial umbrella business produced by a third partymanaging general agent, W. H. Greene. Under the terms of the treaty TICNY cedes80% of its premium written and retains the remaining 20%. The flat cedingcommission under this treaty is 29% of ceded written premium. Of the premiumceded, Endurance Reinsurance Corporation of America, rated “A-” (Excellent) by A.M.Best, reinsures 50%, AXIS Reinsurance Company, rated “A” (Excellent) by A.M.Best, reinsures 20% and NGM Insurance Company, rated “A” (Excellent) by A.M.Best, reinsures 10%.

*Excessof Loss Reinsurance.**  *EffectiveJanuary 1, 2005 TICNY entered into an Excess of Loss Reinsurance Programwith the same terms as the 2004 Excess of Loss Reinsurance Treaty. The 2005Excess of Loss Reinsurance Program was placed with American Re-InsuranceCompany (“Am Re”), rated “A” (Excellent) by A.M. Best, PlatinumUnderwriters Reinsurance, Inc., rated “A” (Excellent) by A.M. Best,Endurance Specialty Insurance, Ltd., rated “A-” (Excellent) by A.M. Best,syndicates from Lloyd’s of London, rated “A” (Excellent) by A.M. Best, andHannover Ruckversicherungs AG, rated “A” (Excellent) by A.M. Best.

*Catastrophe Reinsurance.*   The2004 Property Catastrophe Program provided coverage for events occurringthrough June 30, 2005 and was renewed on July 1, 2005 with a similarstructure to the expiring program.

***2004 Reinsurance Program***

*QuotaShare Reinsurance.**  *EffectiveJanuary 1, 2004, TICNY entered into a quota share treaty to reinsureagainst losses up to $1.0 million per occurrence on the gross premiums writtenin the insurance segment. Under the terms of the treaty, TICNY ceded 60% of itsnet premiums written and retained the remaining 40%. In accordance with treatyterms, TICNY elected to reduce the quota share cession from 60% to 25% on October 1,2004. The provisional ceding commission under this treaty was 39.1% of cedednet premiums written. Of the premium ceded, Tokio Millennium, rated “A+”(Superior), reinsured 331¤3%;Converium Reinsurance (North America) Inc. (“Converium), rated “B-” (Fair) by A.M.Best, reinsured 331¤3%;Hannover Reinsurance (Ireland) Ltd., rated “A” (Excellent) by A.M. Best,reinsured 262¤3%and E+S Reinsurance (Ireland) Ltd., rated “A” (Excellent), reinsured theremaining 62¤3%.The 2004 quota share treaty contained various exclusions and provided coveragefor 100% of extra-contractual obligations and losses in excess of policy limits.To reduce TICNY’s credit exposure to reinsurance, the quota share reinsurancewas placed on a “funds withheld” basis. Under the terms of the reinsurancetreaty, TICNY guaranteed to credit the reinsurers with a 2.5% annual effectiveyield on the monthly balance of this account.

In September 2004, A.M. Best downgraded therating of Converium to “B-” (Fair) and Converium was placed into run-off by itsparent company. As a result, on September 2, 2004, we delivered notice toConverium under our quota share treaty of our intent to terminate theirparticipation under the quota share treaty on a cut-off basis effective November 1,2004 (subsequently extended to December 31, 2004). Subsequently we reachedan agreement with Converium, Tokio Millennium and Hannover to effect a novationof Converium’s quota share treaty to those other reinsurers effective January 1,2004, as a result of which Tokio and Hannover agreed to each take 50% ofConverium’s share under the quota share treaty. In connection with theagreement, Tokio, Hannover and TICNY agreed to fully release Converium for anyliabilities under the quota share treaty. In addition, we decided to retain theunearned premiums and risks as of December 31, 2004 that would have beenceded to Converium absent the novation.

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Effective October 1, 2004, TICNY entered into aquota share treaty to reinsure against equipment breakdown losses up to $35million per occurrence. Under the terms of the treaty, TICNY cedes 100% of itspremium written to The Hartford Steam Boiler Inspection and Insurance Company,rated “A++” (Superior) by A.M. Best. The flat ceding commission under thistreaty is 30%. A nominal amount of premium was ceded to this treaty in 2004. Thetreaty is placed on a continuous basis, therefore the above terms were ineffect during 2005 and will be in effect in 2006.

*Excessof Loss Reinsurance.**  *EffectiveJanuary 1, 2004 TICNY entered into an Excess of Loss Reinsurance Programwhereby our reinsurers were liable for 100% of the ultimate net losses inexcess of $1 million for all lines of business we write, up to $10 million oflimit. The program provided coverage in several layers. The first layer, whichapplied to multiple lines of business, afforded coverage for property businessup to $1 million in excess of $1 million for each risk, with a per occurrencelimit of $3 million, and for casualty business and for workers’ compensationlosses, up to $1 million in excess of $1 million per occurrence. The excess ofloss program then bifurcated into separate workers’ compensation and propertylayers. The workers’ compensation layers afforded coverage for workers’compensation business up to $3 million in excess of $2 million for eachoccurrence, and for up to $5 million in excess of $5 million for eachoccurrence, with a maximum of $5 million for any one life. The property layersafforded coverage for property business up to $3 million in excess of $2million for each risk, subject to a per occurrence limit of $6 million, and forup to $5 million in excess of $5 million for each risk, with a maximum of $5million for each occurrence. The excess of loss treaties contained varioussub-limits or exclusions for specific lines of business, provided coverage for90% of extra-contractual obligations and losses in excess of policy limits, andallowed TICNY to recover allocated loss adjustment expenses on a pro rata basisin proportion to net loss. The 2004 excess of loss reinsurance treaties wereplaced with Am Re, rated “A” (Excellent) by A.M. Best, PlatinumUnderwriters Reinsurance, Inc., rated “A” (Excellent) by A.M. Best,Endurance Specialty Insurance, Ltd., rated “A-” (Excellent) by A.M. Best,syndicates from Lloyd’s of London, rated “A” (Excellent) by A.M. Best,Hannover Ruckversicherungs AG, rated “A” (Excellent) by A.M. Best, andAspen Insurance UK Limited, rated “A” (Excellent) by A.M. Best.

*Catastrophe Reinsurance.**  *Effective July 1, 2004, the 2003 PropertyCatastrophe Program described below was extended until August 31, 2004 andprovided coverage in four layers on a per occurrence basis for losses up to $55million, less our net retention of the first $5 million of losses. Effective September 1,2004, we entered into a property catastrophe reinsurance program that providescoverage in five layers for losses up to $75 million, less our retention of thefirst $15 million of losses through June 30, 2005. The program coveredaggregations of net exposures on our in force, new, renewal and assumedpersonal and commercial property as well as auto physical damage and inlandmarine business, subject to certain exclusions, including mold claims,terrorists events and nuclear, chemical and biochemical attacks. In the eventof a catastrophic event that results in a loss under this program, we mustreinstate the amount of cover exhausted by the loss on a one-time basis bypaying an additional premium to the reinsurers. Each year we select the amountof catastrophic reinsurance that we believe will be necessary to protect ourCompany against catastrophic events. We believe the amount of catastrophiccoverage is sufficient to cover our probable maximum loss from a once in a onehundred year catastrophic event. Our catastrophic reinsurers include AmericanAgricultural Insurance Company, rated “A” (Excellent) by A.M. Best,Folksamerica Reinsurance Company, rated “A” (Excellent) by A.M. Best,Odyssey America Reinsurance Corporation, rated “A” (Excellent) by A.M.Best, PXRE Reinsurance Company, rated “B+” (in 2006) (Very Good) by A.M.Best, and syndicates from Lloyd’s of London, rated “A” (Excellent) by A.M.Best.

**Investments**

We derive investment income from our invested assets. Weinvest TICNY’s statutory surplus and funds to support its loss and lossadjustment expense reserves and its unearned premium reserves. Due tohistorically limited amounts of statutory surplus and net retention by TICNY,our net investment income 

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had not been significant. Ourinvestment income, however, has increased beginning in 2002 as TICNY’s investedassets increased due to TICNY’s increased net premiums written and surplus aswell as from its $98.0 million of new investments as a direct result of acapital contribution of a portion of the IPO proceeds. Our net investmentincome was $15.0 million in 2005, compared to $5.1 million in 2004.

Our primary investment objectives are to preservecapital and maximize after-tax investment income. Our strategy is to purchasedebt securities in sectors that represent the most attractive relative valueand to maintain a moderate equity exposure. As of December 31, 2005, thefixed maturity securities represented approximately 91% of the fair marketvalue of our investment portfolio and equity securities representedapproximately 9%. Historically, we have emphasized liquidity to meet our claimsobligations and debt service and to support our obligation to remit cededpremium (less ceding commission and claims payments) to our quota sharereinsurers on a quarterly basis. Accordingly we have traditionally maintainedbetween 8% and 10% of our portfolio in cash and cash equivalents. As of December 31,2005, cash and cash equivalents represented approximately 9.8% of the total offair market value of our investment portfolio and cash and cash equivalents. 

Our investments are managed by an outside assetmanagement company, Hyperion Capital Management, Inc., a New York basedinvestment management firm. Hyperion has authority and discretion to buy andsell securities for us, subject to guidelines established by our Board ofDirectors. We may terminate our agreement with Hyperion upon 30 days notice. Ourinvestment policy is conservative, as approximately 88.4% of the fixed incomeportion of our investment portfolio is rated A or higher as of December 31,2005. The current equity target is 10% of the investment portfolio. The maximumallocation to equities, which results from market appreciation, is 20% of theinvestment portfolio. We monitor our investment results on a monthly basis toreview the performance of our investments, determine whether any investmentshave been impaired and monitor market conditions for investments that wouldwarrant any revision to our investment guidelines. Hyperion also provides uswith a comprehensive quarterly report providing detailed information on ourinvestment results as well as prevailing market conditions. Our investmentresults are also reviewed quarterly by the Board of Directors.

See “Item 7.—Investments” for further information on thecomposition and results of our investment portfolio.

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Thefollowing table shows the market values of various categories of investedassets, the percentage of the total market value of our invested assetsrepresented by each category and the book yield based on market value of eachtype as of the dates and for the periods indicated:

| ** **                                              | ** ** | **As of and for the year ended December 31,** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                                              | ** ** | **2005**                                                                              | ** ** | **2004** | ** ** |
| **Category**                                            | ** ** | ** **                                                                            | ** ** | **Market  Value** | ** ** | **Percent  of Total** | ** ** | **Yield** | ** ** | **Market  Value** | ** ** | **Percent  of Total** | ** ** | **Yield** | ** ** |
| ** **                                              | ** ** | **($ in thousands)**                                                        | ** ** |
| U.S. Treasury  Securities                               |       | $                                                                                     | 7,132      |   |   | 2.0 | % |   | 4.13 | % | $ | 1,784 |   |   | 0.8 | % |   |   | 4.05 | % |   |
| U.S. agency  securities                                 |       | 31,623                                                                                |       |   | 8.8 | % |   | 4.42 | % | 19,636 |   |   | 8.6 | % |   |   | 4.22 | % |   |
| Corporate fixed  maturity securities                    |       | 76,488                                                                                |       |   | 21.3 | % |   | 4.67 | % | 49,381 |   |   | 21.6 | % |   |   | 4.60 | % |   |
| Mortgage-backed  securities                             |       | 96,922                                                                                |       |   | 27.0 | % |   | 5.26 | % | 64,159 |   |   | 28.1 | % |   |   | 4.52 | % |   |
| Asset-backed  securities                                |       | 15,188                                                                                |       |   | 4.2 | % |   | 5.55 | % | 12,473 |   |   | 5.5 | % |   |   | 4.92 | % |   |
| Other taxable  fixed maturity securities                |       | 244                                                                                   |       |   | 0.1 | % |   | 4.96 | % | 243 |   |   | 0.1 | % |   |   | 4.96 | % |   |
| Municipal  securities                                   |       | 90,084                                                                                |       |   | 27.6 | % |   | 3.67 | % | 76,847 |   |   | 33.6 | % |   |   | 3.64 | % |   |
| Common Stocks—at  cost                             |       | 24,558                                                                                |       |   | 6.8 | % |   | — |   |   |   |   | 0.0 | % |   |   |   |   |   |
| Common stocks—at  fair value                       |       | 5,819                                                                                 |       |   | 1.6 | % |   |   |   | 2,368 |   |   | 1.0 | % |   |   |   |   |   |
| Preferred stocks                                        |       | 115                                                                                   |       |   | 0.0 | % |   | 7.27 | % | 117 |   |   | 0.1 | % |   |   | 7.27 | % |   |
| Common trust  securities—statutory business trusts |       | 1,426                                                                                 |       |   | 0.4 | % |   |   |   | 1,426 |   |   | 0.6 | % |   |   |   |   |   |
|                                                         |            |                                                                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The principal change in allocations in 2005 was anincrease in the allocation to common stocks, municipal bonds, mortgage-backedsecurities and corporate bonds. During 2005 we reallocated a portion of theinvestment portfolio to higher yielding investments in equity securities. Thisincludes common shares of a closed-end management investment company investingpredominantly in asset-backed securities and mortgage-backed securities. Wealso invested in publicly traded real estate investment trusts (REITs) and oneprivate placement REIT scheduled for an early 2006 IPO. During 2005 we had netpurchases of mortgage-backed securities, municipal bonds and corporate bonds ofapproximately $108.6 million from investing new cash flow from operations.These new fixed maturity investments offered us favorable yields andfundamental credit quality. At December 31, 2005, the average creditquality of our fixed income investments was AA+ and the duration was 3.96years.

During 2004, the most significant portfolio activitycame during the fourth quarter with the investment of the IPO proceeds of $98.0million. In order to increase the portfolio’s overall tax-exempt allocation,approximately 60% of the proceeds were invested into tax-exempt securities. Dueto the steeper yield curve in the tax-exempt market compared to the taxablemarket, the tax-exempt purchases were focused in longer duration securitiesaveraging approximately six years. To offset these longer duration securities,the taxable bond purchases were concentrated in short durations averaging twoto three years.

In addition, during the fourth quarter of 2004, theeffective duration of the portfolio decreased to 4.17 years compared to4.41 years as of September 30, 2004. The lower duration was primarily dueto the significant cash increase from the net proceeds from the issuance of$26.8 million of subordinated debentures underlying trust preferred securitiesin December 2004.

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Thefollowing table shows the composition of our investment portfolio by remainingtime to maturity at December 31, 2005 and December 31, 2004. Forsecurities that are redeemable at the option of the issuer and have a marketprice that is greater than par value, the maturity used for the table below isthe earliest redemption date. For securities that are redeemable at the optionof the issuer and have a market price that is less than par value, the maturityused for the table below is the final maturity date.

| ** **                                    | ** ** | **As of December 31,** | ** **  | **As of December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|-------------|---------------------------------------|------------|
| ** **                                    | ** ** | **2005**                              | ** **  | **2004**                              | ** ** |
| **Remaining Time to Maturity** | ** ** | ** **                            | ** **  | **Fair Market  Value**           | ** ** | **Percentage of  Fair Market  Value** | ** ** | **Fair Market  Value** | ** ** | **Percentage of  Fair Market  Value** | ** ** |
| ** **                                    | ** ** | **($ in thousands)**        | ** **  |
| Less than one  year                           |       |                                  | $           | 3,873                                 |       |   |   | 1.2 | % |   |   | $ | 3,994 |   |   |   | 1.8 | % |   |
| One to five years                             |       |                                  | 92,961      |                                  |       |   | 28.4 | % |   |   | 43,830 |   |   |   | 19.5 | % |   |
| Five to ten years                             |       |                                  | 113,125     |                                  |       |   | 34.6 | % |   |   | 95,100 |   |   |   | 42.3 | % |   |
| More than ten  years                          |       |                                  | 19,800      |                                  |       |   | 6.1 | % |   |   | 17,440 |   |   |   | 7.8 | % |   |
| Mortgage-backed  securities                   |       |                                  | 96,922      |                                  |       |   | 29.7 | % |   |   | 64,159 |   |   |   | 28.6 | % |   |
| **Total**                                     | ** ** | ** **                            | **326,681** |                                  | ** ** | ** ** | **100.0** | **%** | ** ** | ** ** | **$** | **224,523** |   | ** ** | ** ** | **100.0** | **%** | ** ** |
|                                               |            |                                       |             |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The average credit rating of our fixed maturityportfolio, using ratings assigned to securities by Standard and Poor’s, was AA+at December 31, 2005 and AA+ at December 31, 2004. The followingtable shows the ratings distribution of our fixed income portfolio as of theend of each of the past two years.

| ** **                | ** ** | **As of December 31,** | ** ** | **As of December 31,** | ** ** |
|---------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| ** **                | ** ** | **2005**                              | ** ** | **2004**                              | ** ** |
| **Rating**                | ** ** | ** **                            | ** ** | **Fair Market  Value**           | ** ** | **Percentage of  Fair Market  Value** | ** ** | **Fair Market  Value** | ** ** | **Percentage of  Fair Market  Value** | ** ** |
| ** **                | ** ** | **($ in thousands)**        | ** ** |
| U.S. Treasury  securities |       |                                  | $          | 7,132                                 |       |   |   | 2.2 | % |   |   | $ | 1,784 |   |   |   | 0.8 | % |   |
| AAA                       |       |                                  | 190,980    |                                  |       |   | 58.5 | % |   |   | 140,460 |   |   |   | 62.6 | % |   |
| AA                        |       |                                  | 40,020     |                                  |       |   | 12.3 | % |   |   | 31,641 |   |   |   | 14.1 | % |   |
| A               |       |                                  | 50,546     |                                  |       |   | 15.5 | % |   |   | 35,850 |   |   |   | 16.0 | % |   |
| BBB                       |       |                                  | 19,956     |                                  |       |   | 6.1 | % |   |   | 13,979 |   |   |   | 6.2 | % |   |
| Below BBB                 |       |                                  | 18,047     |                                  |       |   | 5.5 | % |   |   | 809 |   |   |   | 0.3 | % |   |
| **Total**                 | ** ** | ** **                            | **$**      | **326,681**                           |       | ** ** | ** ** | **100.0** | **%** | ** ** | ** ** | **$** | **224,523** |   | ** ** | ** ** | **100.0** | **%** | ** ** |
|                           |            |                                       |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We regularly review ourportfolio for declines in value. If a decline in value is deemed temporary, werecord the decline as an unrealized loss in other comprehensive net income onour consolidated statement of income and accumulated other comprehensive netincome on our consolidated balance sheet. If the decline is deemed “other thantemporary,” we write down the carrying value of the investment and record arealized loss in our consolidated statements of income. As of December 31,2005 and December 31, 2004, we had cumulative net unrealized(losses)/gains on our fixed maturity portfolio of $(4.4) million and $1.0 million,respectively. There were no other than temporary declines in the fair value ofour securities at December 31, 2005 and 2004.

**Lossand Loss Adjustment Expense Reserves**

We maintain reserves forthe payment of claims (incurred losses) and expenses related to adjusting thoseclaims (loss adjustment expenses or LAE). Our loss reserves consist of casereserves, which are reserves for reported claims, and reserves for claims thathave been incurred but have not yet been reported (sometimes referred to as IBNR).The amount of loss reserves for reported claims is based primarily upon aclaim-by-claim evaluation of coverage, liability, injury severity or scope ofproperty 

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damage,and any other information considered pertinent to estimating the exposurepresented by the claim. The amounts of loss reserves for unreported claims andloss adjustment expense reserves are determined using historical information byline of business as adjusted to current conditions. Reserves for LAE areintended to cover the ultimate cost of settling claims, including investigationand defense of lawsuits resulting from such claims. The amount of loss and LAEreserves is determined by us on the basis of industry information, thedevelopment to date of losses on the relevant line of business and anticipatedfuture conditions. Because loss reserves are an estimate of the ultimate costof settling claims, they are closely monitored by us and recomputed at leastquarterly based on updated information on reported claims and a variety of statisticaltechniques. Furthermore, an independent actuary prepares a report each yearconcerning the adequacy of the loss reserves.

***Reconciliation of Loss and Loss Adjustment ExpenseReserves***

The table below shows the reconciliation of reserveson a gross and net basis for each of the last three calendar years, reflectingchanges in losses incurred and paid losses.

| ** **                        | ** ** | **2005**                       | ** **  | **2004**   | ** ** | **2003**    | ** ** |
|-----------------------------------|------------|--------------------------------|-------------|------------|------------|-------------|------------|
| ** **                        | ** ** | **($ in thousands)** | ** **  |
| Balance at  January 1,       |       | $                              | 128,722     |       | $          | 99,475      |       | $ | 65,688 |   |
| Less reinsurance recoverables     |       | (91,773                        | )           | (75,114    | )          | (50,212     | )          |
|                              |       | 36,949                         |        | 24,361     |       | 15,476      |       |
| Incurred related to:              |       |                           |        |       |       |        |       |
| Current year                      |       | 97,006                         |        | 27,259     |       | 14,996      |       |
| Prior years                       |       | (392                           | )           | (199       | )          | 75          |       |
| **Total incurred**                | ** ** | **96,614**                     | ** **  | **27,060** | ** ** | **15,071**  | ** ** |
| Paid related to:                  |       |                           |        |       |       |        |       |
| Current year                      |       | 20,891                         |        | 6,991      |       | 2,084       |       |
| Prior years                       |       | 10,926                         |        | 7,481      |       | 4,102       |       |
| **Total paid**                    | ** ** | **31,817**                     | ** **  | **14,472** | ** ** | **6,186**   | ** ** |
| Net balance at  December 31, |       | 101,746                        |        | 36,949     |       | 24,361      |       |
| Add reinsurance recoverables      |       | 96,978                         |        | 91,773     |       | 75,114      |       |
| **Balance  at December 31,** | ** ** | **$**                          | **198,724** | ** ** | **$**      | **128,722** | ** ** | **$** | **99,475** | ** ** |

 

Our claims reservingpractices are designed to set reserves that in the aggregate are adequate topay all claims at their ultimate settlement value. Thus, our reserves are notdiscounted for inflation or other factors.

***Loss Development***

Shown below is the loss development for businesswritten each year from 1995 through 2005. The table portrays the changes in ourloss and LAE reserves in subsequent years from the prior loss estimates basedon experience as of the end of each succeeding year on the basis of GAAP.

The first line of the table shows, for the yearsindicated, our net reserve liability including the reserve for incurred but notreported losses as originally estimated. For example, as of December 31,2002 we estimated that $15.476 million would be a sufficient reserve to settleall claims not already settled that had occurred prior to December 31,2002 whether reported or unreported to us. The next section of the table shows,by year, the cumulative amounts of losses and loss adjustment expenses paid asof the end of each succeeding year. For example, with respect to the net lossesand loss expense reserve of $15.476 million as of December 31, 2002, bythe end of 2005 (three years later) $9.090 million had actually been paid insettlement of the claims.

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The next section of the table sets forth there-estimates in later years of incurred losses, including payments, for theyears indicated. For example, as reflected in that section of the table, theoriginal reserve of $15.476 million was re-estimated to be $16.461 million at December 31,2005. The increase from the original estimate is caused by a combination offactors, including: (1) reserves being settled for amounts different thanoriginally estimated, (2) reserves being increased or decreased for claimsremaining open as more information becomes known about those individual claimsand (3) more or fewer claims being reported after December 31, 2002than had occurred prior to that date.

The “cumulative redundancy/ (deficiency)” represents,as of December 31, 2005, the difference between the latest re-estimatedliability and the reserves as originally estimated. A redundancy means theoriginal estimate was higher than the current estimate; a deficiency means thatthe current estimate is higher than the original estimate. For example, as of December 31,2005 and based upon updated information, we re-estimated that the reserveswhich were established as of December 31, 2004 were $392,000 redundant.

The bottom part of thetable shows the impact of reinsurance reconciling the net reserves shown in theupper portion of the table to gross reserves.

**Analysisof Loss and Loss Adjustment Reserve Development**

| ** **                                | ** ** | **Year ended December 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                | ** ** | **1995**                                   | ** ** | **1996** | ** ** | **1997** | ** ** | **1998** | ** ** | **1999** | ** ** | **2000** | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                | ** ** | **($ in thousands)**             | ** ** |
| Original Net Liability                    |       | $                                          | 2,239      |   | $ | 3,361 |   | $ | 5,005 |   | $ | 6,184 |   | $ | 6,810 |   | $ | 7,901 |   | $ | 8,620 |   | $ | 15,476 |   | $ | 24,361 |   | $ | 36,949 |   | $ | 101,746 |   |
| Cumulative  payments as of:               |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One year later                            |       | 321                                        |       | 1,035 |   | 1,428 |   | 2,377 |   | 2,560 |   | 3,376 |   | 2,879 |   | 4,103 |   | 7,467 |   | 10,926 |   |   |   |
| Two years later                           |       | 831                                        |       | 1,849 |   | 2,827 |   | 3,890 |   | 4,767 |   | 5,439 |   | 4,906 |   | 6,707 |   | 11,856 |   |   |   |   |   |
| Three years later                         |       | 1,386                                      |       | 2,747 |   | 4,045 |   | 5,439 |   | 6,153 |   | 6,953 |   | 6,376 |   | 9,090 |   |   |   |   |   |   |   |
| Four years later                          |       | 1,928                                      |       | 3,397 |   | 5,191 |   | 6,340 |   | 6,896 |   | 7,896 |   | 7,219 |   |   |   |   |   |   |   |   |   |
| Five years later                          |       | 2,332                                      |       | 4,083 |   | 5,895 |   | 6,714 |   | 7,249 |   | 8,285 |   |   |   |   |   |   |   |   |   |   |   |
| Six years later                           |       | 2,723                                      |       | 4,454 |   | 6,220 |   | 6,935 |   | 7,465 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Seven years later                         |       | 2,970                                      |       | 4,691 |   | 6,413 |   | 6,978 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Eight years later                         |       | 3,132                                      |       | 4,847 |   | 6,423 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Nine years later                          |       | 3,266                                      |       | 4,836 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Ten years later                           |       | 3,251                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net  liability re-estimated as of:        |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One year later                            |       | 2,020                                      |       | 4,154 |   | 5,954 |   | 6,842 |   | 7,493 |   | 9,702 |   | 11,521 |   | 15,551 |   | 24,163 |   | 36,557 |   |   |   |
| Two years later                           |       | 2,506                                      |       | 4,574 |   | 6,262 |   | 7,123 |   | 8,652 |   | 11,684 |   | 11,276 |   | 14,665 |   | 24,815 |   |   |   |   |   |
| Three years later                         |       | 2,839                                      |       | 4,457 |   | 6,428 |   | 7,871 |   | 9,516 |   | 11,458 |   | 10,494 |   | 16,461 |   |   |   |   |   |   |   |
| Four years later                          |       | 2,841                                      |       | 4,544 |   | 6,945 |   | 8,244 |   | 9,210 |   | 10,819 |   | 11,875 |   |   |   |   |   |   |   |   |   |
| Five years later                          |       | 2,926                                      |       | 4,992 |   | 7,169 |   | 7,963 |   | 8,955 |   | 11,944 |   |   |   |   |   |   |   |   |   |   |   |
| Six years later                           |       | 3,250                                      |       | 5,093 |   | 7,057 |   | 7,875 |   | 9,951 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Seven years later                         |       | 3,346                                      |       | 5,065 |   | 7,037 |   | 8,659 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Eight years later                         |       | 3,373                                      |       | 5,141 |   | 7,663 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Nine years later                          |       | 3,453                                      |       | 5,607 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Ten years later                           |       | 3,686                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cumulative Net redundancy/(deficiency)    |       | (1,447                                     | )          | (2,246 | ) | (2,658 | ) | (2,475 | ) | (3,141 | ) | (4,043 | ) | (3,255 | ) | (985 | ) | (454 | ) | 392 |   |   |   |
| Net reserves                              |       | $                                          | 2,239      |   | $ | 3,361 |   | $ | 5,005 |   | $ | 6,184 |   | $ | 6,810 |   | $ | 7,901 |   | $ | 8,620 |   | $ | 15,476 |   | $ | 24,361 |   | $ | 36,949 |   | $ | 101,746 |   |
| Ceded reserves                            |       | 5,744                                      |       | 8,529 |   | 14,800 |   | 15,696 |   | 17,410 |   | 20,601 |   | 29,017 |   | 50,211 |   | 75,114 |   | 91,773 |   | 96,978 |   |
| Gross reserves                            |       | $                                          | 7,983      |   | $ | 11,890 |   | $ | 19,805 |   | $ | 21,880 |   | $ | 24,220 |   | $ | 28,502 |   | $ | 37,637 |   | $ | 65,687 |   | $ | 99,475 |   | $ | 128,722 |   | $ | 198,724 |   |
| Net re-estimated                          |       | $                                          | 3,686      |   | $ | 5,607 |   | $ | 7,663 |   | $ | 8,659 |   | $ | 9,951 |   | $ | 11,944 |   | $ | 11,875 |   | $ | 16,461 |   | $ | 24,815 |   | $ | 36,557 |   |   |   |
| Ceded re-estimated                        |       | 12,849                                     |       | 17,005 |   | 18,382 |   | 22,803 |   | 28,477 |   | 33,080 |   | 40,852 |   | 54,409 |   | 75,075 |   | 91,199 |   |   |   |
| Gross re-estimated                        |       | $                                          | 16,535     |   | $ | 22,612 |   | $ | 26,045 |   | $ | 31,462 |   | $ | 38,428 |   | $ | 45,024 |   | $ | 52,727 |   | $ | 70,870 |   | $ | 99,890 |   | $ | 127,756 | ** ** | ** ** | ** ** |
| Cumulative Gross  redundancy/(deficiency) |       | (8,552                                     | )          | (10,722 | ) | (6,240 | ) | (9,582 | ) | (14,208 | ) | (16,522 | ) | (15,090 | ) | (5,183 | ) | (415 | ) | 966 |   |   |   |

*** ***

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***Analysis of Reserves***

Thefollowing table shows our net outstanding case loss reserves and IBNR by lineof business as of December 31, 2005.

| ** **                 | ** ** | **Outstanding Case  Loss Reserves** | ** ** | **IBNR**   | ** ** |
|----------------------------|------------|-----------------------------------------------|------------|------------|------------|
| ** **                 | ** ** | **($ in thousands)**                | ** ** |
| Commercial  Multiple Peril |       |                                          | $          | 21,600     |       |   | $ | 32,603 |   |
| Other Liability            |       |                                          | 5,227      |       |       | 9,843 |   |
| Workers  Compensation      |       |                                          | 4,730      |       |       | 5,143 |   |
| Commercial  Automobile     |       |                                          | 2,099      |       |       | 3,487 |   |
| Homeowners                 |       |                                          | 9,457      |       |       | 5,152 |   |
| Fire and Allied  Lines     |       |                                          | 1,109      |       |       | 1,296 |   |
| **All Lines**              | ** ** | ** **                                    | **$**      | **44,222** |       | ** ** | **$** | **57,524** | ** ** |

 

In 2004 and 2005 we had favorable development in ournet losses from prior accident years  of$199,000 and $392,000, respectively.

We carefully monitor our gross, ceded and net lossreserves by segment and line of business to ensure that they are adequate,since a deficiency in reserves will indicate inadequate pricing on our productsand may impact our financial condition.

Our actuariesutilize several methodologies to project losses and corresponding reserves. Thesemethodologies generally are classified into three types:

·       Lossdevelopment projections. Loss development projection methods are characterizedby determination of loss development factors utilizing patterns of lossdevelopment from incurred and paid losses for prior accident years. This is themain methodology utilized for each accident year except for the most currentaccident year.

·       Lossratio projections. There also is significant weight given to the loss ratioprojections. Loss ratio projections determine the loss ratio for the currentyear based upon applying inflation, or trend, and the effect of rate changes tothe loss ratios from the prior years. This method is given weight for thecurrent accident year when there is high volatility in the reported developmentpatterns at early ages.

·       Frequencyand severity projections. Frequency and severity projections are characterizedby development of numbers of claims reported and average claims severity, andthese methods are utilized as a check on the other methods.

Based upon these methods our actuaries determine abest estimate of the loss reserves. All of these methods are standard actuarialapproaches and have been utilized consistently since 2003.

We are not aware of any claims trends that haveemerged or that would cause future adverse development that have not alreadybeen considered in existing case reserves and in our current loss developmentfactors.

Also, in New York State, lawsuits for negligence,subject to certain limitations, must be commenced within three years from thedate of the accident or are otherwise barred. Accordingly, our exposure to IBNRfor accident years 2003 and prior is limited although there remains thepossibility of adverse development on reported claims. Due to the reservestrengthening in 2002 and close monitoring and analysis of reserves, we believeour loss reserves are adequate. This is reflected by the loss development as ofDecember 31, 2005 showing developed redundancies since 2003. However,there are no assurances that future loss development and trends will be consistentwith our past loss development history, and so 

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adverse loss reservesdevelopment remains a risk factor to our business. See “Item 1A.—Risks Related to Our Business—Ifour actual loss and loss adjustment expenses exceed our loss reserves, ourfinancial condition and results of operations could be significantly adverselyaffected.”

Thenet loss reserves for the most recent accident years on a consolidated basis asof December 31, 2005 were $76.1 million for accident year 2005 and $12.7million for accident year 2004. A redundancy or (deficiency) in net reservesfor these years would impact our income before income taxes by the following :

| ** **                              | ** ** | **Accident Year** | ** ** |
|-----------------------------------------|------------|------------------------|------------|
| **Redundancy / (Deficiency)** | ** ** | ** **             | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                              | ** ** | **($ millions)**  | ** ** |
| 10%                                     |       | $                      | 1.3        |   | $ | 7.6 |   |
| 5%                                      |       | 0.6                    |       | 3.8 |   |
| (5%)                                    |       | (0.6                   | )          | (3.8 | ) |
| (10%)                                   |       | (1.3                   | )          | (7.6 | ) |
|                                         |            |                        |            |  |  |  |  |  |  |

 

**Claims**

Our claims divisioncombines the services of our staff defense, coverage and appellate attorneyswith a traditional multi-line insurance claims adjusting staff. See “Item 1.—Business Segments—Insurance ServicesSegment Products and Services” for a description of TRM’s claim servicefee-based operations.

The claims division seeksto provide expedient, fair and consistent claims handling, while controllingloss adjustment expenses. Handling the claims adjustment and defense ofinsureds in-house enables us to accurately evaluate coverage, promptly postaccurate loss and loss adjustment expense reserves, maintain the highestpolicyholders service standards and aggressively defend against liabilityclaims. In addition, through the use of a claims database that capturesdetailed statistics and information on every claim, our underwriting and losscontrol departments are able to access information to assist them in themonitoring of the various lines of business and identifying adverse losstrends, giving them the ability to make informed underwriting and pricingdecisions.

The claims division isdivided into eight units: auto claims, workers’ compensation claims, propertyclaims, liability claims, coverage, in-house defense, administration andprocessing, and subrogation and recovery. Our in-house legal staff consists ofapproximately 16 attorneys who are managed by two co-managing attorneysreporting to the Senior Vice President Claims.

The continued developmentof in-house expertise in all areas remains a primary goal of the claimsdivision. We have continued to build an in-house defense team in order tohandle a substantial percentage of lawsuits in New York State and vigorouslydefend against fraudulent and frivolous lawsuits. Given the high cost ofcoverage counsel in those instances where coverage may be an issue, we formedan in-house coverage law firm. Our claims staff and in-house attorneys handleall of our claims and the majority of our lawsuits internally. Approximately75% of all lawsuits arising from our insurance company operation are currentlyhandled in-house. This approach enables us to maintain a high level of serviceto our policyholders and vigorously defend non-meritorious and frivolous claimswhile controlling loss adjustment expenses. We have also formed a full timestaff of in-house liability field investigators to replace a traditionallyoutsourced claims function. We have also built an experienced team of fieldproperty adjusters to push down costs and to ensure high quality claimsexperience for our commercial and personal lines property policyholders.

Ultimately, the claimsdivision endeavors to provide a prompt response to the needs of policyholdersin all first-party losses. Rapid review of the loss, confirmation of coverageand speedy payment to the insured is the ongoing commitment of our claimsdivision. With respect to third-party claims, our approach is the thoroughinvestigation of all claims as soon as reported, in order to separate thosethat should be 

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resolvedthrough settlement from those that should be denied and/or defended. Suspiciousor fraudulent first- and third-party claims are always aggressivelyinvestigated and defended.

**Technology**

We seek to leveragetechnology and make use of business process redesign in order to gain operatingefficiencies and effectiveness. For example, we were able to eliminateredundant keying of policy information by upgrading our policy data entry system. This has enabled us tocontrol the growth of our clerical staff and improve our customer service. Wehave implemented a number of technology improvements and redesign of businessprocesses, including an on-line imaging system, a data warehouse that housesboth claims and underwriting data to provide management reporting and aweb-based platform (Web*Plus*)**for quoting and capturing policy submissions directly fromour producers.

We utilize HewlettPackard/Compaq servers that run the Microsoft Windows Server 2000 operatingsystem. Backups of server data and programs are made to tape daily and aretaken to an off-site facility by an outside vendor. We have begun migrating ourproduction servers to an offsite location. This secure facility will providefully redundant power, air conditioning, communications and 24-hoursupport. With this off site premise, we will have two operational data centers,one primary and one secondary, to handle disaster recovery needs.

***WebPlus***®

Since April 2003, wehave been using Web*Plus,*ourweb-based software platform for quoting and capturing policy submissionsdirectly from our producers. Web*Plus* allows ourproducers to submit, rate and, where permitted by the program, bind smallpremium accounts. Through a rules based engine, we have implemented ourunderwriting guidelines within Web*Plus.*Throughan ongoing monthly, quarterly and annual management review and analysis of thebook of business, we confirm the risk quality and loss ratio profile ofpolicies processed in Web*Plus.*Weutilize Web*Plus*for all of our personal lines businessand landlord package policies. We started using Web*Plus*inApril 2003 and within twelve months approximately 94% of our personallines policies were being processed through Web*Plus.*Webelieve that this technology reduces underwriter involvement in each policyapplication, as well as improves our ability to validate and capture allrelevant policy information early in the submission process and at a singlepoint. We believe that Web*Plus*hassignificantly reduced our expense associated with processing business, improvedcustomer service and made it easier for our producers to do business with us. In  2004, we added workers’ compensation andautomobile to the suite of products that can be submitted to us through Web*Plus,*and we are now developing commercial package andautomobile policies capability.

Web*Plus*wasdeveloped for us by AgencyPort Insurance Services, Inc. (“AgencyPort”), atechnology Company specializing in the property and casualty insuranceindustry, in exchange for our commitment to invest $1 million in AgencyPort.  In addition, we licensed AgencyPort’s KeyOncesoftware development kit (SDK), which AgencyPort utilized to develop Web*Plus.*Wealso obtained a warrant to acquire common shares in AgencyPort. On January 7,2004 TICNY exercised this warrant in full for 1,072,525 common shares ofAgencyPort, for $1 million less $663,000 paid towards the development of Web*Plus*resultingin a payment of $337,000. These payments have been capitalized as software andare being amortized over three years. The 1,072,525 shares representedapproximately 25% of the outstanding shares of AgencyPort as of December 31,2005. We do not exercise significant influence over AgencyPort and we do nothave any representation on the Board of Directors of AgencyPort. Therelationship is primarily one of AgencyPort as a licensor and developer ofsoftware for our benefit. Accordingly, we do not account for our investment inAgencyPort on the equity method. We have assigned no value to the sharesacquired as AgencyPort as of December 31, 2005. As of December 31,2003, we held another warrant to acquire an additional 30% of the outstandingshares of AgencyPort. On August 31, 2004, we entered into an agreementwith AgencyPort to eliminate this warrant in consideration for certain rightsgranted to us including access to certain software source code. We received thesource code upon execution of the agreement.

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Our technology plancurrently envisions that we will expand our use of Web*Plus*toadditional products and other business functions (such as claims submission andreporting). We also intend to exploit technological improvements and economiesof scale realized through premium growth to continue to lower our underwritingexpense ratio while offering a strong value proposition to our producer base.

**Competition**

We compete with a large number of other companies inour selected lines of business, including major U.S. and non-U.S. insurers andother regional companies, as well as mutual companies, specialty insurancecompanies, underwriting agencies and diversified financial services companies.We compete for business on the basis of a number of factors, including price,coverages offered, customer service, relationship with producers (includingease of doing business, service provided and commission rates paid), financialstrength and size and rating by independent rating agencies.

As our territorial expansion has progressed within NewYork State, we have developed an increased number of competitors. In ourcommercial lines business, our competitors include The St. Paul TravelersInsurance Company, Hartford Insurance Company, Safeco, Hannover InsuranceCompanies, Magna Carta Companies, Greater New York Mutual Insurance Company,OneBeacon Insurance Company, Selective, Utica First Insurance Company,Middlesex Mutual and Erie Insurance Company. In our personal lines business, wecompete against companies such as Allstate Insurance Company, State FarmCompanies, The St. Paul Travelers Companies, Inc., Hartford InsuranceCompany, OneBeacon Insurance Group, New York Central Insurance Company,Commercial Mutual Insurance Company, Preferred Mutual Insurance Company andOtsego Mutual Fire Insurance Company.

The soft market that existed until sometime in 2001was characterized by pricing based competition, with a number of competitorsattempting to gain or retain market share by charging premium rates thatultimately proved to be inadequate. The losses suffered by many of thesecompanies have resulted in their insolvencies or exit from our chosen markets. Thepricing environment in the hard market prevalent in 2004 was such thatcompetition tends to focus more on the non-pricing factors listed above. Duringthe last quarter of 2004 and continuing throughout 2005 a moderation of thepricing environment within the commercial insurance marketplace became evidentas pricing increases on renewing policies lessened.

We seek to distinguishourselves from our competitors by providing a broad product line offering andtargeting those market segments that we believe are underserved and thereforeprovide us with the best opportunity to obtain favorable policy terms,conditions and pricing. We believe that by offering several different lines ofbusiness, we are able to compete effectively against insurance companies thatoffer limited products. We also seek to limit the extent to which we mustdirectly compete with the companies listed above by positioning our products inunderserved market segments and adjusting our premium volume in these marketsegments depending upon the level of competition. We have historically targetedrisks located in New York City and adjacent areas, as we feel this is a marketthat historically has not been emphasized by regional and national insurancecompanies. As our territorial expansion has encompassed all of New York Stateand other northeastern states, we have maintained our marketing approach. Wewill continue to compete with other companies by quickly and opportunisticallydelivering products that respond to our producers’ needs, which may bedetermined by other companies’ insolvencies or voluntary withdrawals fromparticular market segments. Our ability to quickly develop and replace variousproducts that had previously been offered by Empire Insurance Group when wepurchased the renewal rights to the Empire business in 2001 is an example ofthis capability. In addition to being responsive to market needs, we also focuson assisting our producers with placing business by offering rating andsubmission capability through Web*Plus*and rating disks, as well as by providing our producers with clear and conciseunderwriting guidelines. We also compete by focusing on reducing our producers’costs of doing business with us. For example, we directly bill ourpolicyholders on most of our policies with a per policy premium below $10,000and provide customer service support to policyholders on behalf of ourproducers. This 

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increasedservice allows us to deliver value to our producers other than through highercommission rates. Finally, our success in reducing liability claims coststhrough cost effective and aggressive claims handling has reduced the cost ofliability insurance premiums for our policyholders. This capability also helpsus compete with other insurance companies. Notwithstanding the positivecompetitive factors discussed above, many of our competitors have greaterfinancial and marketing resources and higher ratings from rating agencies thanwe do, which may have an adverse effect on our ability to compete with them.

**Ratings**

Many insurance buyers, agents and brokers use theratings assigned by A.M. Best and other rating agencies to assist them inassessing the financial strength and overall quality of the companies fromwhich they are considering purchasing insurance. TICNY was assigned a letterrating of “B+” (Very Good) by A.M. Best in 1997 and was upgraded to “B++”(Very Good) in 2003. In October 2004, TICNY was upgraded to “A-”(Excellent) by A.M. Best, the 4th highest of 15 rating categories used by A.M.Best. In evaluating a company’s financial strength, A.M. Best reviews thecompany’s profitability, leverage and liquidity, as well as its book ofbusiness, the adequacy and soundness of its reinsurance, the quality andestimated market value of its assets, the adequacy of its loss and loss expensereserves, the adequacy of its surplus, its capital structure, the experienceand competence of its management and its market presence. This rating isintended to provide an independent opinion of an insurer’s financial strengthand is not an evaluation directed at investors. There is no guarantee thatTICNY will maintain the improved rating. In addition during 2005 TNIC, a newlyacquired shell company, was also rated “A-” (Excellent) by A.M. Best.

In April 2003, in connection with the issuance ofsubordinated debentures underlying trust preferred securities, TICNY alsoreceived an insurer financial strength rating from Standard & Poor’s. Thisrating provides an assessment of the financial strength of an insurance companyand its capacity to meet obligations to policyholders on a timely basis. TICNY’smost recent rating from Standard & Poor’s is “BB+” with a stableoutlook.

With the rating upgradefrom A.M. Best, TICNY is positioned to enter into new market segments thatwill provide additional premium growth opportunities. Some segments of theinsurance market are rating sensitive. This means that customers in thosesegments require that their insurance company have a minimum financial strengthand/or a minimum rating. Additional rating sensitivity is created by someinsurance companies writing umbrella policies, who will not issue a policyunless the underlying primary carrier has a minimum rating. We believe that the“A-” (Excellent)  rating will allow TICNYto participate in rating sensitive markets such as the middle market segmentdescribed in “Item 1.—BusinessSegments—Insurance Services Segment Products and Services”, currentlyserved by TRM through the use of TRM’s issuing companies. Likewise, with thehigher rating, we believe TICNY will be able to attract many large premiumaccounts in the monoline liability and preferred property lines of business,where insureds also tend to be rating sensitive.

**Employees**

All of our employees areemployed directly by TICNY. As of December 31, 2005, the total number offull-time equivalent employees of TICNY was 360 of which 286 are in New YorkCity, 48 are in the Long Island, New York branch and 26 are in the Buffalo, NewYork branch. None of these employees are covered by a collective bargainingagreement. We have employment agreements with our senior executive officers. Theremainder of our employees are at-will employees.

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**Regulation**

***U.S. Insurance Holding Company Regulation of Tower***

Tower, as the parent ofTICNY and TNIC, is subject to the insurance holding company laws of New York.These laws generally require TICNY and TNIC to register with the New YorkInsurance Department and to furnish annually financial and other informationabout the operations of companies within the holding company system. Generallyunder these laws, all material transactions among companies in the holdingcompany system to which TICNY or TNIC is a party, including sales, loans,reinsurance agreements and service agreements, must be fair and reasonable and,if material or of a specified category, require prior notice and approval ornon-disapproval by the New York Insurance Department.

***Changes of Control***

Before a person can acquire control of a New Yorkinsurance company, prior written approval must be obtained from theSuperintendent of Insurance of the State of New York. Prior to grantingapproval of an application to acquire control of a New York insurer, theSuperintendent of Insurance of the State of New York will consider such factorsas: the financial strength of the applicant, the integrity and management ofthe applicant’s Board of Directors and executive officers, the acquirer’s plansfor the management of the applicant’s Board of Directors and executiveofficers, the acquirer’s plans for the future operations of the domesticinsurer and any anti-competitive results that may arise from the consummationof the acquisition of control. Pursuant to the New York insurance holdingcompany statute, “control” means the possession, direct or indirect, of thepower to direct or cause the direction of the management and policies of thecompany, whether through the ownership of voting securities, by contract (excepta commercial contract for goods or non-management services) or otherwise. Controlis presumed to exist if any person directly or indirectly owns, controls orholds with the power to vote 10% or more of the voting securities of thecompany; however, the New York State Insurance Department, after notice and ahearing, may determine that a person or entity which directly or indirectlyowns, controls or holds with the power to vote less than 10% of the votingsecurities of the company, “controls” the company. Because a person acquiring10% or more of our common stock would indirectly control the same percentage ofthe stock of the TICNY, the insurance change of control laws of New York wouldlikely apply to such a transaction.

These laws may discouragepotential acquisition proposals and may delay, deter or prevent a change ofcontrol of Tower, including through transactions, and in particular unsolicitedtransactions, that some or all of the stockholders of Tower might consider tobe desirable.

***Legislative Changes***

From time to time, various regulatory and legislativechanges have been proposed in the insurance industry. Among the proposals thathave in the past been or are at present being considered are the possibleintroduction of Federal regulation in addition to, or in lieu of, the currentsystem of state regulation of insurers and proposals in various statelegislatures (some of which proposals have been enacted) to conform portions oftheir insurance laws and regulations to various model acts adopted by theNational Association of Insurance Commissioners (“NAIC”). We are unable topredict whether any of these laws and regulations will be adopted, the form inwhich any such laws and regulations would be adopted, or the effect, if any,these developments would have on our operations and financial condition.

In 2002, in response to the tightening of supply incertain insurance and reinsurance markets resulting from, among other things,the September 11, 2001 terrorist attacks, the Terrorism Act was enacted. TheTerrorism Act is designed to ensure the availability of insurance coverage forforeign terrorist acts in the United States of America. This law established aFederal assistance program through the end of 2005 to 

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help the commercialproperty and casualty insurance industry cover claims related to futureterrorism-related losses and requires such companies to offer coverage forcertain acts of terrorism. As a result, we are prohibited from adding certainterrorism exclusions to the policies written by TICNY. Although TICNY isprotected by federally funded terrorism reinsurance as provided for in theTerrorism Act, there is a substantial deductible that must be met, the paymentof which could have an adverse effect on our results of operations. On December 17,2005, Congress passed a two-year extension of the Terrorism Act though December 31,2007, under the terms of the extension, Tower deductible will increase to 17.5%of direct earned premium in 2006 and 20% in 2007. The minimum size of thetriggering event will be increased from the current $5 million to $50 millionfor the last nine months of 2006 and $100 million in 2007.  As a consequence of these changes, potentiallosses from a terrorist attack could be substantially larger than previouslyexpected. Potential future changes to the Terrorism Act could also adverselyaffect our ability to obtain reinsurance on favorable terms, including pricing,and may affect our underwriting strategy, rating, and other elements of ouroperation.

In October 2003, NewYork State enacted a version of the NAIC Producer Licensing Model Act (the “Act”),which provides uniform procedures and guidelines for the licensing of insurancebrokers and agents. The applicable provisions of the Act took effect January 1,2004. The Act is primarily directed toward assisting New York insurance agentsand brokers to transact business in other states on a non-resident basis. Thelaw includes provisions to increase uniformity among states in regard toproducer licensing. We do not anticipate that this law will have a materialimpact on us.

***State Insurance Regulation***

State insurance authorities have broad regulatorypowers with respect to various aspects of the business of U.S. insurancecompanies. The primary purpose of such regulatory powers is to protectindividual policyholders. The extent of such regulation varies, but generallyhas its source in statutes that delegate regulatory, supervisory andadministrative power to state insurance departments. Such powers relate to,among other things, licensing to transact business,  accreditation of reinsurers, admittance ofassets to statutory surplus, regulating unfair trade and claims practices,establishing reserve requirements and solvency standards, regulatinginvestments and dividends, approving policy forms and related materials incertain instances and approving premium rates in certain instances. Stateinsurance laws and regulations require TICNY and TNIC to file financialstatements with insurance departments everywhere it will be licensed to conductinsurance business, and its operations are subject to examination by thosedepartments.

TICNY and TNIC prepare statutory financial statementsin accordance with statutory accounting principles (“SAP”) and proceduresprescribed or permitted by the New York Insurance Department and theMassachusetts Department of Insurance, respectively. As part of theirregulatory oversight process, state insurance departments conduct periodicdetailed examinations of the books and records, financial reporting, policyfilings and market conduct of insurance companies domiciled in their states,generally once every three to five years. Examinations are generally carriedout in cooperation with the insurance departments of other states underguidelines promulgated by the NAIC.

The terms and conditionsof reinsurance agreements generally are not subject to regulation by any U.S.state insurance department with respect to rates or policy terms. As apractical matter, however, the rates charged by primary insurers do have aneffect on the rates that can be charged by reinsurers.

***Insurance Regulatory Information System Ratios***

The Insurance RegulatoryInformation System, or IRIS, was developed by the NAIC and is intendedprimarily to assist state insurance departments in executing their statutorymandates to oversee the financial condition of insurance companies operating intheir respective states. IRIS identifies thirteen industry ratios and specifies“usual values” for each ratio. Departure from the usual values on four or more 

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of theratios can lead to inquiries from individual state insurance commissioners asto certain aspects of an insurer’s business. For 2005 TICNY’s results wereoutside the usual values for two IRIS ratios and within the usual values foreleven IRIS ratios. In 2005, the change in net writings ratio was affected bythe 116% increase in net premiums written due to the reduction in our quotashare ceding percentage effective October 1, 2004 which continuedthroughout 2005 as well as growth in gross premiums written. The estimatedcurrent reserve deficiency to policyholders’ surplus was affected by the 261%increase in net premiums earned due to the reduction in our quota share cedingpercentage effective October 1, 2004 which continued throughout 2005 as wellas growth in gross premiums earned. For 2005 TNIC’s results were outside theusual values for two IRIS ratios and within the usual values for eleven IRISrations. The two IRIS ratios that were outside the usual values were grosschange in policyholders’ surplus and net change in adjusted policyholders’surplus. Both ratios were outside of the usual values as a result of thebeginning surplus of zero and an ending surplus of $10.1 million from ourcapital contribution.

***New York State Dividend Limitations***

TICNY’s ability to paydividends is subject to restrictions contained in the insurance laws andrelated regulations of New York. Under New York law, TICNY may pay dividendsout of statutory earned surplus. In addition, the New York Insurance Departmentmust approve any dividend declared or paid by TICNY that, together with alldividends declared or distributed by TICNY during the preceding 12 months,exceeds the lesser of (1) 10% of TICNY’s policyholder’s surplus as shownon its latest statutory financial statement filed with the New York InsuranceDepartment or (2) 100% of adjusted net investment income during thepreceding twelve months. TICNY declared approximately $2,050,000, $850,000 and$363,000 in dividends to Tower in 2005, 2004, and 2003, respectively. As of December 31,2005, the maximum distribution that TICNY could pay without prior regulatoryapproval was approximately $4.0 million.

***Massachusetts Dividend Limitations***

TNIC my not pay anydividend that, together with all dividends declared or distributed by TNICduring the preceding twelve months, excluding pro rata distributions of anyclass of the TNIC’s own securities, exceeds the greater of (1) 10% of TNIC’spolicyholders’ surplus as of the end of the preceding calendar year or (2) TNIC’snet income for the next preceding calendar year, until thirty days after theCommissioner has received notice of the intended dividend and not objected insuch time. Because TNIC has not yet commenced insurance operations it has nopositive unassigned surplus. Therefore, it may not pay dividends at this timewithout the approval of the Massachusetts Commissioner of Insurance.

***Risk-Based Capital Regulations***

The New York InsuranceDepartment requires domestic property and casualty insurers to report theirrisk-based capital based on a formula developed and adopted by the NAIC thatattempts to measure statutory capital and surplus needs based on the risks inthe insurer’s mix of products and investment portfolio. The formula is designedto allow the New York Insurance Department to identify potentialweakly-capitalized companies. Under the formula, a company determines its “risk-basedcapital” by taking into account certain risks related to the insurer’s assets(including risks related to its investment portfolio and ceded reinsurance) andthe insurer’s liabilities (including underwriting risks related to the natureand experience of its insurance business). At December 31, 2005 TICNY andTNIC’s risk-based capital levels exceeded the minimum level that would triggerregulatory attention. In their 2005 statutory statements, TICNY and TNIC haveboth complied with the NAIC’s risk-based capital reporting requirements.

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***Statutory Accounting Principles***

SAP is a basis of accounting developed to assistinsurance regulators in monitoring and regulating the solvency of insurancecompanies. It is primarily concerned with measuring an insurer’s surplus topolicyholders. Accordingly, statutory accounting focuses on valuing assets andliabilities of insurers at financial reporting dates in accordance withappropriate insurance law and regulatory provisions applicable in each insurer’sdomiciliary state.

GAAP is concerned with a company’s solvency, but it isalso concerned with other financial measurements, such as income and cash flows.Accordingly, GAAP gives more consideration to appropriate matching of revenueand expenses and accounting for management’s stewardship of assets than doesSAP. As a direct result, different assets and liabilities and different amountsof assets and liabilities will be reflected in financial statements prepared inaccordance with GAAP as opposed to SAP.

Statutory accountingpractices established by the NAIC and adopted, in part, by the New York andMassachusetts regulators determine, among other things, the amount of statutorysurplus and statutory net income of TICNY and TNIC and thus determine, in part,the amount of funds that are available to pay dividends to us.

***Guaranty Associations***

In New York and in the Commonwealth of Massachusettsand in most of the jurisdictions where TICNY and TNIC are currently licensed to transact business there is arequirement that property and casualty insurers doing business within thejurisdiction participate in guaranty associations, which are organized to paycontractual benefits owed pursuant to insurance policies issued by impaired,insolvent or failed insurers. These associations levy assessments, up toprescribed limits, on all member insurers in a particular state on the basis ofthe proportionate share of the premium written by member insurers in the linesof business in which the impaired, insolvent or failed insurer is engaged. Somestates permit member insurers to recover assessments paid through full orpartial premium tax offsets.

In none of the past fiveyears has the assessment in any year levied against TICNY been material. Propertyand casualty insurance company insolvencies or failures may result inadditional security fund assessments to TICNY and TNIC at some future date. Atthis time we are unable to determine the impact, if any; such assessments mayhave on the consolidated financial position or results of operations. We haveestablished liabilities for guaranty fund assessments with respect to insurersthat are currently subject to insolvency proceedings and assessments by thevarious workers’ compensation funds. See “Note 13. Commitments andContingencies”.

***TRM***

The activities of TRM are subject to licensingrequirements and regulation under the laws of New York and New Jersey. TRM’sbusiness depends on the validity of, and continued good standing under, thelicenses and approvals pursuant to which it operates, as well as compliancewith pertinent regulations. TRM therefore devotes significant effort towardmaintaining its licenses to ensure compliance with a diverse and complexregulatory structure.

Licensing laws andregulations vary from jurisdiction to jurisdiction. In all jurisdictions, theapplicable licensing laws and regulations are subject to amendment orinterpretation by regulatory authorities. Generally such authorities are vestedwith relatively broad and general discretion as to the granting, renewing andrevoking of licenses and approvals. Licenses may be denied or revoked forvarious reasons, including the violation of such regulations, conviction ofcrimes and the like. Possible sanctions which may be imposed include thesuspension of individual employees, limitations on engaging in a particularbusiness for specified periods of time, revocation of licenses, censures,redress to clients and fines. In some 

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instances,TRM follows practices based on interpretations of laws and regulationsgenerally followed by the industry, which may prove to be different from theinterpretations of regulatory authorities.

***Industry Investigations***

The insurance industry recently has become the subjectof increasing scrutiny with respect to insurance broker and agent compensationarrangements and sales practices. The New York State Attorney General and otherstate and Federal regulators have commenced investigations and otherproceedings relating to compensation and bidding arrangements between producersand issuers of insurance products and unsuitable sales practices by producerson behalf of either the issuer or the purchaser. The practices currently underinvestigation include, among other things, allegations that so-calledcontingent commission arrangements may conflict with a broker’s duties to itscustomers that certain brokers and insurers may have engaged inanti-competitive practices in connection with insurance premium quotes. The NewYork State Attorney General has recently entered into a settlement agreementwith two large insurance brokers. These investigations and proceedings areexpected to continue, and new investigative proceedings may be commenced, inthe future. These investigations and proceedings could result in legalprecedents and new industry-wide practices or legislation, rules orregulations that could significantly affect our industry and may also causestock price volatility for companies in the insurance industry. Contingentcommissions under our producers’ profit sharing plan amounted to less than 1⁄4%of our overall commission expense in 2004 and less than 1⁄2% in 2005.

Recently, regulators and other governmentalauthorities have been investigating certain types of insurance and reinsurancearrangements that they allege are intended only to smooth an insured company orceding insurer’s earnings rather than to transfer insurance risk. We believeour quota share reinsurance meets all requirements pertaining to risk transfer.However, these investigations, the related legal actions and the accompanyingincreased scrutiny of “non-traditional” reinsurance arrangements may lead to achange in the applicable accounting standards or a reduction in the availabilityof some types of reinsurance. In turn, these developments could produce higherprices for reinsurance, an increase in the amount of risk we retain, reducedceding commission revenue, or other potentially adverse developments. In thatevent, we may be required to restructure or reduce our use of quota sharereinsurance or reduce our premium writings.

The Company received aninquiry from the New York Insurance Department on April 15, 2005 relatingto risk transfer under its 2004 quota share reinsurance agreement effective January 1,2004. The Company provided information in response to this inquiry and on August 8,2005 the New York Insurance Department concluded that, based upon its review ofthe additional information provided by the Company, the 2004 quota share treatycomplies with the risk transfer provisions.

**Note on Forward-Looking Statements**

Some of the statements under “Item 1A Risk Factors,” “Item7 Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” “Item 1 Business” and elsewhere in this Form 10-K may includeforward-looking statements that reflect our current views with respect tofuture events and financial performance. These statements includeforward-looking statements both with respect to us specifically and theinsurance sector in general. Statements that include the words “expect,” “intend,”“plan,” “believe,” “project,” “estimate,” “may,” “should,” “anticipate,” “will”and similar statements of a future or forward-looking nature identify forward-lookingstatements for purposes of the Federal securities laws or otherwise.

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Allforward-looking statements address matters that involve risks anduncertainties. Accordingly, there are or will be important factors that couldcause our actual results to differ materially from those indicated in thesestatements. We believe that these factors include, but are not limited to,those described under “Item 1A.—Risk Factors” and the following:

·       ineffectivenessor obsolescence of our business strategy due to changes in current or futuremarket conditions;

·       developmentsthat may delay or limit our ability to enter new markets as quickly as weanticipate;

·       increasedcompetition on the basis of pricing, capacity, coverage terms or other factors;

·       greaterfrequency or severity of claims and loss activity, including as a result ofnatural or man-made catastrophic events, than our underwriting, reserving orinvestment practices anticipate based on historical experience or industrydata;

·       theeffects of acts of terrorism or war;

·       developmentsin the world’s financial and capital markets that adversely affect theperformance of our investments;

·       changesin regulations or laws applicable to us, our subsidiaries, brokers orcustomers;

·       acceptanceof our products and services, including new products and services;

·       changesin the availability, cost or quality of reinsurance and failure of ourreinsurers to pay claims timely or at all;

·       changesin the percentage of our premiums written that we ceded to reinsurers;

·       decreaseddemand for our insurance or reinsurance products;

·       lossof the services of any of our executive officers or other key personnel;

·       theeffects of mergers, acquisitions and divestitures;

·       changesin rating agency policies or practices;

·       changesin legal theories of liability under our insurance policies;

·       changesin accounting policies or practices; and

·       changesin general economic conditions, including inflation, interest rates and otherfactors.

The foregoing review ofimportant factors should not be construed as exhaustive and should be read inconjunction with the other cautionary statements that are included in this Form 10-K.We undertake no obligation to publicly update or review any forward-lookingstatement, whether as a result of new information, future developments orotherwise.

If one or more of these orother risks or uncertainties materialize, or if our underlying assumptionsprove to be incorrect, actual results may vary materially from what we project.Any forward-looking statements you read in this Form 10-K reflect ourviews as of the date of this Form 10-K with respect to future events andare subject to these and other risks, uncertainties and assumptions relating toour operations, results of operations, growth strategy and liquidity. Allsubsequent written and oral forward-looking statements attributable to us orindividuals acting on our behalf are expressly qualified in their entirety bythis paragraph. Before making an investment decision, you should specificallyconsider all of the factors identified in this Form 10-K that could causeactual results to differ.

**Item 1A.**                RiskFactors

An investment in ourcommon stock involves a number of risks. You should carefully consider thefollowing information about these risks, together with the other informationcontained in this Form 10-K, in considering whether to invest in or holdour common stock. Additional risks not presently known to us, 

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or thatwe currently deem immaterial may also impair our business or results ofoperations. Any of the risks described below could result in a significant ormaterial adverse effect on our financial condition or results of operations,and a corresponding decline in the market price of our common stock. You couldlose all or part of your investment.

This Form 10-K alsocontains forward-looking statements that involve risks and uncertainties. Ouractual results could differ materially from those anticipated in theforward-looking statements as a result of certain factors, including the risksdescribed below and elsewhere in this Form 10-K. See “Item 1.—Note on Forward-Looking Statements”.

**RisksRelated to Our Business**

**If our actual loss and loss adjustment expenses exceedour loss reserves, our financial condition and results of operations could besignificantly adversely affected.**

Our results of operationsand financial condition depend upon our ability to assess accurately thepotential losses associated with the risks that we insure and reinsure. Weestablish loss reserves to cover our estimated liability for the payment of alllosses and loss adjustment expenses incurred under the policies that we write. Lossreserves include case reserves, which are established for specific claims thathave been reported to us, and reserves for claims that have been incurred butnot reported (or “IBNR”). To the extent that loss and loss adjustment expensesexceed our estimates, we will be required to immediately recognize the lessfavorable experience and increase loss reserves, with a corresponding reductionin our net income in the period in which the deficiency is identified. Forexample, over the past ten years we have experienced adverse development ofreserves for losses and loss adjustment expenses incurred in prior years. In2002, following an annual review by an outside actuarial consulting company ofTICNY’s net loss and loss adjustment reserves, we increased such reserves by$2.9 million.

With respect to losses onthe property coverage portion of our commercial and personal lines policies,the primary component of our loss reserve is a case reserve, which is posted bythe assigned examiner shortly after the loss is reported. The extent of thedamage is evaluated through a primarily fact-based loss assessment process. Propertylosses are typically reported within days of occurrence and case reserves areposted promptly. While this case reserving process is not free of errors indetermining the scope of the loss or deviations at the time the loss is paid,major deviations are infrequent. Consequently, commercial and personal propertylines of business generally do not require significant IBNR nor are theydifficult to predict with a relative amount of certainty. Absent significantchanges by underwriting personnel in risk selection and coverage offered andassuming examiners are properly trained with the requisite experience, lossreserves on property lines of business remain relatively predictable from anactuarial standpoint.

With respect to losses onthe liability coverage portions of our commercial and personal lines policies,the reserving process possesses characteristics that make case and IBNRreserving inherently less susceptible to accurate actuarial estimation. Unlikeproperty losses, liability losses are claims made by third parties of which thepolicyholder may not be aware and therefore may be reported a significant timeafter the occurrence, sometimes years. In addition, as liability claims mostoften involve claims of bodily injury, assessment of the proper case reserve isa far more subjective process than claims involving property damages. Inaddition, the determination of a case reserve for a liability claim is oftenwithout the benefit of information, which develops slowly over the life of theclaim and can subject the case reserve to substantial modification well afterthe claim was first reported. Numerous factors impact the liability casereserving process, such as venue, the amount of monetary damage, the permanenceof the injury, the age of the claimant and many others.

Estimating an appropriatelevel of loss and loss adjustment expense reserves is an inherently uncertainprocess. Accordingly, actual loss and loss adjustment expenses paid will likelydeviate, perhaps substantially, from the reserve estimates reflected in ourconsolidated financial statements. It is possible 

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thatclaims could exceed our loss and loss adjustment expense reserves and have amaterial adverse effect on our financial condition or results of operations.

**TICNY and TRM conduct business in a concentratedgeographical area. Any single catastrophe or other condition affecting lossesin this area could adversely affect our results of operations.**

TICNY currently writesbusiness in concentrated geographic areas, primarily in the southern andwestern portions of New York State, and reinsures business produced by TRM inNew York and to a lesser extent in New Jersey and Pennsylvania. As a result, asingle catastrophe occurrence, destructive weather pattern, terrorist attack,regulatory development or other condition or general economic trend affectingthe region within which TICNY and TRM conduct their business could adverselyaffect our financial condition or results of operations more significantly thanother insurance companies that conduct business across a broader geographicalarea. During our history, we have not experienced any single event that materiallyaffected our results of operations. The most significant single event was theterrorist attacks of September 11, 2001, as a result of which we suffered$391,000 in net losses.

The incidence and severityof catastrophes are inherently unpredictable and our losses from catastrophescould be substantial. The occurrence of claims from catastrophic events islikely to result in substantial volatility in our financial condition orresults of operations for any fiscal quarter or year and could have a material adverseeffect on our financial condition or results of operations and our ability towrite new business. Increases in the values and concentrations of insuredproperty may increase the severity of such occurrences in the future. Althoughwe attempt to manage our exposure to such events, including through the use ofreinsurance, the frequency or severity of catastrophic events could exceed ourestimates. As a result, the occurrence of one or more catastrophic events couldhave a material adverse effect on our financial condition or results ofoperations.

**Wehave not yet arranged quota share insurance for 2006. If we cannot obtainadequate reinsurance protection for the risks we have underwritten, we may beexposed to greater losses from these risks or we may reduce the amount ofbusiness we underwrite, which will reduce our revenues.**

Under state insurance law,insurance companies are required to maintain a certain level of capital insupport of the policies they issue. In addition, rating agencies will reduce aninsurance company’s ratings if the company’s premiums exceed specifiedmultiples of its capital. As a result, the level of TICNY’s statutory surplusand capital limits the amount of premiums that it can write and retain risk on.Historically, we have utilized reinsurance to expand our capacity to write morebusiness than TICNY’s surplus would have otherwise supported. As a result ofthe increase in TICNY’s surplus with proceeds contributed from the IPO, thequota share ceding percentage was reduced from 60% to 25% on October 1,2004 and was maintained at 25% throughout 2005.

From time to time, marketconditions have limited, and in some cases have prevented, insurers fromobtaining the types and amounts of reinsurance that they consider adequate fortheir business needs. For example, beginning in 2001, terms and conditions inthe reinsurance market generally became less attractive for insurers seekingreinsurance. In addition, recent investigations by the New York State AttorneyGeneral, the SEC and other regulatory and government bodies into the use ofnon-traditional reinsurance by certain reinsurers may lead to there-examination of applicable accounting standards or a reduction in theavailability of some types of reinsurance. In turn, these developments couldproduce unfavorable changes in prices, reduced ceding commission revenue orother potentially adverse changes in the terms of reinsurance. Accordingly, wemay not be able to obtain our desired amounts of reinsurance. In addition, evenif we are able to obtain such reinsurance, we may not be able to obtain suchreinsurance from entities with satisfactory creditworthiness or negotiate termsthat we deem appropriate or acceptable.

We do not currently havein place quota share reinsurance for 2006. We are currently in discussions witha Bermuda reinsurance company in formation to enter into a multi-year quotashare reinsurance agreement and in discussions with the Bermuda reinsurer’sparent holding company with respect to a 

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potentialpooling or other risk sharing agreements between our insurance companies andone or more U.S. insurance companies that may be acquired by the Bermudaholding company, which could provide additional capacity to write businessthrough an insurance risk sharing or pooling agreement. The Bermuda reinsurancecompany in formation is not yet able to engage in the reinsurance and insurancebusiness because it has not received all of the necessary regulatory approvalsor completed its capitalization. There can be no assurance that thecapitalization will be completed or that the necessary regulatory approvalswill be granted or that any approval granted will not be subject to conditionsthat restrict operations.

Furthermore, the Bermudaholding company’s acquisition of the U.S. insurance companies will require theapproval of insurance regulators in the respective states of domicile of suchcompanies, and also may need the approval of insurance regulators in stateswhere such companies are admitted. There can be no assurance that the necessaryregulatory approvals will be received.

We have made an investmentin the Bermuda holding company and our Chairman and Chief Executive Officer,Michael H. Lee, is also expected to serve as the Chairman and Chief ExecutiveOfficer of that company. Because we may be deemed to control the Bermudareinsurance company and any U.S. insurance companies that the Bermuda holdingcompany may acquire under the provisions of the New York State InsuranceDepartment and applicable regulations, we cannot enter into the reinsuranceagreements or pooling agreements unless 30 days advance notice is provided tothe New York State Insurance Department proposing our intention to enter intosuch agreements, and the New York State Insurance Department does notdisapprove of these agreements within such period. Accordingly, it is possiblethat the New York State Insurance Department may not approve the terms andconditions of these agreements or it may determine that certain terms andconditions may not be fair or equitable or reasonable and must be revised.

If the Bermuda reinsurancecompany and the U.S. insurance companies are not formed or acquired or ourdiscussions with respect to the multi-year reinsurance agreement and the risksharing or pooling agreements do no result in reaching acceptable terms andexecution, we will seek reinsurance protection and additional capacityelsewhere. However, if we cannot obtain adequate reinsurance protection for therisks we have underwritten, we may be exposed to greater losses from theserisks, which could have a material adverse effect on our financial condition orresults of operation. It we cannot obtain our desired amount of reinsurance oraddition capacity to write business through risk sharing or pooling agreements,we may be forced to reduce the amount of business that we underwrite, whichwill reduce our revenues.

Until the multi-yearreinsurance agreement is in place we are retaining all of the risk for 2006that would have been ceded to quota share reinsurers. In 2005, we ceded 25% ofour net premiums written to reinsurers in accordance with our 2005 quota sharetreaty. The 2005 Property Catastrophe Program, which expires on June 30,2006, requires that a minimum of 25% quota share cession be in place for theprogram. If a loss that is ceded to the Property Catastrophe Program occursafter January 1, 2006 but before the inception of the proposed multi-yearquota share agreement, we would be required to retain 25% of the loss as if thequota share cession was in place.

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**If weare able to obtain reinsurance, our reinsurers may not pay losses in a timelyfashion, or at all, which may cause a substantial loss and increase our costs.**

As of December 31,2005, we had a net balance due in our favor from our reinsurers of $148.1million, consisting of $104.8 million in reinsurance recoverables and $43.3million in prepaid reinsurance premiums. This amount is $15.7 million higherthan TICNY’s statutory capital and surplus at that date. Since October 1,2003, we have sought to manage our exposure to our reinsurers by placing ourquota share reinsurance on a “funds withheld” basis and requiring anynon-admitted reinsurers to collateralize their share of unearned premium andloss reserves. However, we have substantial recoverables from our pre-October 1,2003 reinsurance arrangements that are uncollateralized, in that they are notsupported by letters of credit, trust accounts, “funds withheld” arrangementsor similar mechanisms intended to protect us against a reinsurer’s inability orunwillingness to pay. Our net exposure to our reinsurers totaled $58.8 millionas of December 31, 2005 (representing 8.9% of our total assets on thatdate), including $33.2 million due from PXRE Reinsurance Company which receiveda ratings downgrade to “B+” (Very Good) by A.M. Best on February 24,2006. See “Item 1.—Reinsurance” for a detailed discussion of our reinsuranceexposures. Because we remain primarily liable to our policyholders for thepayment of their claims, in the event that one of our reinsurers under anuncollateralized treaty became insolvent or refused to reimburse us for lossespaid, or delayed in reimbursing us for losses paid, our cash flow and financialresults overall could be materially and adversely affected.

**Ourinsurance company subsidiaries are rated “A-” (Excellent) by A.M. Best,and a decline in this rating or the ratings assigned by other rating agenciescould affect our standing among brokers, agents and insured and cause our salesand earnings to decrease.**

Ratings have becomean increasingly important factor in establishing the competitive position ofinsurance companies. A.M. Best maintains a letter scale rating systemranging from “A++” (Superior) to “F” (In Liquidation). TICNY was upgraded to “A-  ” (Excellent) by A.M. Best,which is the 4th highest of 15 rating levels. There is noguarantee that TICNY will maintain this rating that is subject to, among otherthings, A.M. Best’s evaluation of our capitalization and performance on anongoing basis including our management of terrorism risks, loss reserves andexpenses.

In April 2003, inconnection with the issuance of subordinated debentures underlying trustpreferred securities, TICNY also received an insurer financial strength ratingfrom Standard & Poor’s Rating Services, a division of The McGraw-HillCompanies, Inc. (“Standard & Poor’s”). The most recent ratingfrom Standard & Poor’s is “BB+” with a stable outlook. A “BB+” ratingis the 11th highest of 21 rating levels used by Standard &Poor’s.

Our ratings are subject toperiodic review by, and may be revised downward or revoked at the solediscretion of A.M. Best or Standard & Poor’s. A decline in acompany’s ratings indicating a reduced financial strength or other adversefinancial developments can cause concern about the viability of the downgradedinsurer among its agents, brokers and policyholders, resulting in a movement ofbusiness away from the downgraded carrier to other stronger or more highlyrated carriers. Because many of our agents and brokers (whom we refer to as “producers”)and policyholders purchase our policies on the basis of our current ratings,the loss or reduction of any of our ratings will adversely impact our abilityto retain or expand our policyholder base. The objective of the rating agencies’rating systems is to provide an opinion of an insurer’s financial strength andability to meet ongoing obligations to its policyholders. Our ratings reflectthe rating agencies’ opinion of our financial strength and are not evaluationsdirected to investors in neither common stock nor recommendations to buy, sellor hold our common stock.

**Thefailure of any of the loss limitation methods we employ could have a materialadverse effect on our financial condition or our results of operations.**

Various provisions of ourpolicies, such as limitations or exclusions from coverage or choice of forum,which have been negotiated to limit our risks, may not be enforceable in themanner we intend. At the 

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presenttime we employ a variety of endorsements to our policies that limit exposure toknown risks, including but not limited to exclusions relating to coverage forlead paint poisoning, asbestos and most claims for bodily injury or propertydamage resulting from the release of pollutants.

In addition, the policieswe issue contain conditions requiring the prompt reporting of claims to us andour right to decline coverage in the event of a violation of that condition. Ourpolicies also include limitations restricting the period in which apolicyholder may bring a breach of contract or other claim against the company,which in many cases is shorter than the statutory limitations for such claimsin the states in which we write business. While these exclusions andlimitations reduce the loss exposure to us and help eliminate known exposuresto certain risks, it is possible that a court or regulatory authority couldnullify or void an exclusion or legislation could be enacted modifying orbarring the use of such endorsements and limitations in a way that wouldadversely effect our loss experience, which could have a material adverseeffect on our financial condition or results of operations.

**Wemay face substantial exposure to losses from terrorism and we are currentlyrequired by law to provide coverage against such losses.**

Our location andconcentration of business written in New York City and adjacent areas by ourinsurance company subsidiaries may expose us to losses from terrorism. U.S.insurers are required by state and Federal law to offer coverage for terrorismin certain commercial lines.

In response to the September 11,2001 terrorist attacks, the United States Congress enacted legislation designedto ensure, among other things, the availability of insurance coverage forforeign terrorist acts, including the requirement that insurers offer suchcoverage in certain commercial lines. The Terrorism Risk Insurance Act of 2002(“TRIA”) requires commercial property and casualty insurance companies to offercoverage for certain acts of terrorism and established a Federal assistanceprogram through the end of 2005 to help such insurers cover claims related tofuture terrorism-related losses. The Terrorism Risk Insurance Extension Act of2005 (“TRIEA”) extends the Federal assistance program through 2007, but it alsohas set a per-event threshold that must be met before the federal programbecomes applicable and also increases the insurers’ statutory deductibles.

Pursuant to TRIA, ourinsurance company subsidiaries must offer insureds the option to purchasecoverage for acts of terrorism that are certified as such by the U.S. Secretaryof the Treasury, in concurrence with the Secretary of State and the AttorneyGeneral, for an additional premium or decline such coverage. When the coverageis not purchased, the policy is endorsed to exclude coverage for certified actsof terrorism, but losses from an act of terrorism that is not a certified eventmay be covered in any case. Also, even if coverage for certified acts ofterrorism is excluded, losses from fire following the act of terrorism arecovered. Under TRIA, the Federal government agreed to reimburse commercialinsurers for up to 90% of the losses due to certified acts of terrorism inexcess of a deductible which, for 2005, was set at 15% of the insurer’s directearned commercial lines premiums for the immediately preceding calendar year, *i.e*., 2004.

Under TRIEA, the Federalgovernment now agrees to reimburse commercial insurers only after a per-eventthreshold, referred to as the program trigger, has been reached. In the case ofcertified acts of terrorism taking place after March 31, 2006, the programtrigger has been set at $50 million for industry-wide insured losses occurringin 2006 and $100 million for industry-wide insured losses occurring in 2007. Theamount of the Federal government’s reimbursement drops from 90% to 85% forinsured losses in 2007. In addition, each insurer’s deductible amount is set at17.5% of certain of the insurer’s direct earned commercial lines premiums for2006 and 20% for 2007.  These changesreduce the federal assistance and increase the costs of terrorism riskinsurance program for our insurance company subsidiaries.

A terrorist attack orseries of attacks in New York City or the surrounding areas could have amaterial adverse effect on our results of operations and financial condition. Inaddition, terrorist attacks in these areas could depress economic activity inour core market, which could hurt our business.

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**The effects of emerging claim and coverage issues onour business are uncertain.**

As industry practices andlegal, judicial, social and other environmental conditions change, unexpectedand unintended issues related to claims and coverage may emerge. These issuesmay adversely affect our business by either extending coverage beyond ourunderwriting intent or by increasing the number or size of claims. In someinstances, these changes may not become apparent until some time after we haveissued insurance or reinsurance contracts that are affected by the changes. Asa result, the full extent of liability under our insurance or reinsurancecontracts may not be known for many years after a contract is issued.

One recent example of anemerging claim and coverage issue is New York City sidewalk liability.Effective as of September 14, 2003, a new law enacted by the New York CityCouncil allows an injured party to sue the owner of a commercial buildinglocated in the five boroughs of New York City for any property damage orpersonal injury that was caused by the failure of the owner to maintain thesidewalk abutting the owner’s building in a reasonably safe condition.Previously, the City of New York, and not the building owner, was responsiblefor the maintenance of city sidewalks. We have adjusted our underwritingguidelines to attempt to screen out exposures that present a heightened riskfrom this new law.

**Since we depend on a few producers for a large portionof our revenues, loss of business provided by any one of them could adverselyaffect us.**

Our products are marketedby independent producers. Other insurance companies compete with us for theservices and allegiance of these producers. These producers may choose todirect business to our competitors, or may direct less desirable risks to us. Forthe twelve months ended December 31, 2005, approximately 40% of the totalof TICNY’s gross premiums written and premiums produced by TRM on behalf of itsissuing companies was derived from our top 10 producers. For the twelve monthsended December 31, 2005, Morstan General Agency, CRC Insurance Inc. andDavis Agency Inc produced 11%, 5%, and 5%, respectively, of the total of TICNY’sgross premiums written and the premiums produced by TRM on behalf of itsissuing companies. A significant decrease in business from, or the entire lossof, our largest producer or several of our other large producers would cause usto lose premium and require us to seek alternative producers or to increasesubmissions from existing producers. In the event we are unable to findreplacement producers or increase business produced by our existing producers,our premium revenues would decrease and our business and results of operationswould be materially and adversely affected.

**Our reliance on producers subjects us to their creditrisk.**

With respect to thepremiums produced by TRM for its issuing companies and a limited amount ofpremium volume written by TICNY, producers collect premium from thepolicyholders and forward them to TRM and TICNY. In certain jurisdictions,including New York, when the insured pays premiums for these policies toproducers for payment over to TRM and TICNY, the premiums might be consideredto have been paid under applicable insurance laws and regulations and theinsured will no longer be liable to us for those amounts, whether or not wehave actually received the premiums from the producer. Consequently, we assumea degree of credit risk associated with producers. Although producers’ failuresto remit premiums to us have not caused a material adverse impact on us todate, there have been instances where producers collected premium but did notremit it to us and we were nonetheless required under applicable law to providethe coverage set forth in the policy despite the absence of premium. Becausethe possibility of these events is dependent in large part upon the financialcondition and internal operations of our producers, which in most cases are notpublic information, we are not able to quantify the exposure presented by thisrisk. If we are unable to collect premiums from our producers in the future,our financial condition and results of operations could be materially andadversely affected.

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**We operate in a highly competitive environment. If weare unsuccessful in competing against larger or more well-established rivals,our results of operations and financial condition could be adversely affected.**

The property and casualtyinsurance industry is highly competitive and has historically beencharacterized by periods of significant pricing competition alternating withperiods of greater pricing discipline, during which competition focuses uponother factors. In recent years the market environment was favorable in thatrates increased significantly. During the latter part of 2004 and throughout2005, increased competition in the marketplace became evident and, as a result,rate increases have become moderate. A softening of the market could lead toreduced growth or a reduction in premium volume, adverse effects onprofitability and, ultimately, dislocation in the insurance industry. A.M.Best estimates that the industry wide change in net premiums written in theproperty casualty industry was 0.7% in 2005 compared to 4.7% in 2004 and isestimated to be 3.3% in 2006. The change in industry policyholders’ surplus asestimated by A.M. Best was 6.2% in 2005 compared to 13.6% in 2004 and isestimated to be 8.0% in 2006. In addition, in 2005, A.M. Best estimatednew capital or capacity of $20 billion was raised by the property casualtyinsurance and reinsurance industry. This additional underwriting capacity mayresult in increased competition from other insurers seeking to expand the typesor amount of business they write or cause a shift in focus by some insurers tomaintaining market share at the expense of underwriting discipline. We attemptto compete based primarily on products offered, service, experience, thestrength of our client relationships, reputation, speed of claims payment,perceived financial strength, ratings, scope of business, commissions paid andpolicy and contract terms and conditions. There are no assurances that in thefuture we will be able to retain or attract customers at prices which weconsider to be adequate.

We compete with major U.S.insurers and certain underwriting syndicates, including large nationalcompanies such as The St. Paul Travelers Companies, Inc., AllstateInsurance Company and State Farm Fire and Casualty Company; regional insurerssuch as OneBeacon Insurance Company; and smaller, more local competitors suchas Magna Carta Companies, Utica First Insurance Company, Greater New YorkMutual Insurance Company, Commercial Mutual Insurance Company and Otsego MutualFire Insurance Company. Many of these companies have greater financial,marketing and management resources than we do. Many of these competitors alsohave more experience, better ratings and more market recognition than we do. Weseek to distinguish ourselves from our competitors by providing a broad productline offering and targeting those market segments that provide us with the bestopportunity to earn an underwriting profit. We also compete with othercompanies by quickly and opportunistically delivering products that respond toour producers’ needs.

In addition to competitionin the operation of our business, we face competition from a variety of sourcesin attracting and retaining qualified employees. We also face competitionbecause of entities that self-insure, primarily in the commercial insurancemarket. From time to time, established and potential customers may examine thebenefits and risks of self-insurance and other alternatives to traditionalinsurance. See “Item 1.—Competition”.

**We may experience difficulty in expanding ourbusiness, which could adversely affect our results of operations and financial condition.**

Weplan to expand our licensing or acquire other insurance companies withmulti-state property and casualty licensing in order to expand our product andservice offerings geographically. We also intend to continue to acquire booksof business that fit our underwriting competencies from competitors, managingagents and other producers and to acquire other insurance companies. Thisexpansion strategy may present special risks:

·       Wehave achieved our prior success by applying a disciplined approach tounderwriting and pricing in select markets that are not well served by ourcompetitors. We may not be able to successfully implement our underwriting,pricing and product strategies in companies or books of business we acquire orover a larger operating region;

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·       Wemay not be successful in obtaining the required regulatory approvals to offeradditional insurance products or expand into additional states;

·       Wehave limited acquisition experience and may not be able to efficiently combinean acquired company or block of business with our present financial,operational and management information systems; and

·       Anacquisition could dilute the book value and earnings per share of our commonstock.

We cannot assure you thatwe will be successful in expanding our business or that any new business willbe profitable. If we are unable to expand our business or to manage ourexpansion effectively, our results of operations and financial condition couldbe adversely affected.

**We could be adversely affected by the loss of one ormore principal employees or by an inability to attract and retain staff.**

Our success will depend insubstantial part upon our ability to attract and retain qualified executiveofficers, experienced underwriting talent and other skilled employees who areknowledgeable about our business. We rely substantially upon the services ofour executive management team. Although we are not aware of any planneddepartures or retirements, if we were to lose the services of members of ourmanagement team, our business could be adversely affected. We believe we havebeen successful in attracting and retaining key personnel throughout ourhistory. We have employment agreements with Michael H. Lee, our Chairman of theBoard, President and Chief Executive Officer, and other members of our seniormanagement team. We do not currently maintain key man life insurance policieswith respect to our employees except for Michael H. Lee.

**Our business relationship with the Bermuda reinsurancecompany that may provide our 2006 quota share reinsurance and its affiliatesmay present, and make us vulnerable to, difficult conflicts of interest,related party transactions, business opportunity issues and legal challenges.**

As noted elsewhere (see “Item1A.—Risk Factors—We have not yet arranged quota share insurance for 2006.”), weare in discussions with a Bermuda reinsurance company in formation with respectto a multi-year quota share reinsurance agreement among other matters. We havemade a $15 million investment in the reinsurer’s parent holding company andexpect to own a substantial interest in the holding company. In addition,Michael H. Lee, our Chairman of the Board, President and Chief ExecutiveOfficer, is expected to hold the same positions at the Bermuda holding companyand, as such, will not serve our company on a full-time basis. Furthermore,members of our executive management are expected to resign their positions withus and become executive managers of the Bermuda holding company and its subsidiaries.Conflicts of interest could arise with respect to business opportunities thatcould be advantageous to the Bermuda company or its subsidiaries, on the onehand, and us or any of our subsidiaries, on the other hand.

Because Mr. Lee willhold leadership positions at both Tower and the Bermuda company following theclosing of this offering, potential conflicts of interest may arise should theinterests of Tower, the Bermuda company and Mr. Lee diverge. While weexpect that initially our interests and the Bermuda company should be aligned,they may diverge as the Bermuda company develops additional business.

Mr. Lee’s service asChairman of the Board, President and Chief Executive Officer of both theBermuda holding company and Tower could also raise a potential challenge underanti-trust laws. Section 8 of the Clayton Antitrust Act, or the ClaytonAct, prohibits a person from serving as a director or officer in any twocompeting corporations under certain circumstances. If the Bermuda holdingcompany and Tower are in the future deemed to be competitors with the meaningof the Clayton Act, certain thresholds relating to direct competition betweenTower and the Bermuda holding company are met, and the Department of Justiceand Federal Trade Commission challenge the arrangement, Mr. Lee may berequired to resign his positions with one of the companies, and/or fines orother penalties could be assessed against Mr. Lee and us. To alleviate anypotential for direct competition between the Bermuda 

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holdingcompany and us, proposed arrangements between us and the Bermuda holdingcompany will provide for a division of responsibilities. However, it ispossible that the potential for direct competition with respect to certainclasses of business may exist with respect to the business we and the Bermudaholding company’s subsidiaries may pursue.

**If issuing companies or reinsurers are unwilling toparticipate in insurance arranged by TRM, our financial condition or results ofoperations could be materially adversely affected.**

TRM produces insurance forother insurance companies, which we call TRM’s issuing companies that in turncede 100% of the business to reinsurers, including TICNY. TRM receivescommissions and fees for producing the insurance and arranging the reinsurance.TRM’s ability to generate fee income therefore depends upon the willingness ofissuing companies to write the business produced by TRM, which depends upon thewillingness of reinsurers, including TICNY, to assume the risk on the businessproduced by TRM. Prior to 2006, all of the premiums produced by TRM werewritten through two issuing insurance companies, Virginia Surety Company, Inc.(“Virginia Surety”) and State National Insurance Company, Inc. (“StateNational”). Starting  in 2006, all of TRM’spremiums produced will be issued through Virginia Surety. The contract withthis company is terminable by either party upon 90 days notice. If we areunable to successfully structure a reinsurance transaction that would besatisfactory to this issuing company or if the issuing company is otherwiseunwilling to do business with us, and we are unable to find an additional orreplacement issuing company, we would have to rely on our own insurance companyto write the premium currently produced by TRM for these issuing company orelse forego some or all of this business and the associated fee revenues. Writingthis business in our own insurance company would require us to bear additionalinsurance risk. Depending on our insurance company’s statutory surplus and ourpremium growth, we may not be able to write some or all of this business. Accordingly,the inability to retain or replace a TRM issuing company or to obtainreinsurance acceptable to us or the issuing company could have an adverseeffect on our financial condition or results of operations.

**An issuing company’s insolvency or weakened financialcondition may have an adverse impact on TRM’s revenues.**

In the event of theinsolvency or liquidation of an issuing company or other event having anegative impact on the financial strength of an issuing company, TRM may beunable to collect commissions due on policies written through that issuingcompany and may be unable to collect other fees due such as claimsadministration fees. Commission revenue on policies written through TRM’sissuing companies represented 4.2% of consolidated revenues in 2005 and 10.7%in 2004 and in 2003.

**Our investment performance may suffer as a result ofadverse capital market developments or other factors, which may affect our financialresults and ability to conduct business.**

We invest the premium wereceive from policyholders until it is needed to pay policyholder claims orother expenses. At December 31, 2005, our invested assets consisted of$326.7 million in fixed maturity securities, $5.9 million in equity securitiesat fair value, $24.6 million of equity securities at cost and $1.4 millionin common trust securities—statutory business trusts. Additionally, we held$38.8 million in cash and cash equivalents. In 2005, we earned $15.0 million ofnet investment income representing 6.8% of our total revenues and 47.1% of ourpre-tax income. Our funds are invested by a professional investment advisorymanagement firm under the direction of our management team in accordance withdetailed investment guidelines set by us. See “Item 1.—Investments”. Althoughour investment policies stress diversification of risks, conservation ofprincipal and liquidity, our investments are subject to a variety of investmentrisks, including risks relating to general economic conditions, marketvolatility, interest rate fluctuations, liquidity risk and credit and defaultrisk. (Interest rate risk is discussed below under the heading, “—We may beadversely affected by interest rate changes”). In particular, the volatility ofour claims may force us to liquidate securities, which may cause us to incurcapital losses. If we do not structure our investment portfolio so that it isappropriately matched with our insurance and reinsurance liabilities, we may beforced to liquidate investments prior to maturity at a significant loss tocover such liabilities. 

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Investmentlosses could significantly decrease our asset base and statutory surplus,thereby affecting our ability to conduct business.

**We may be adversely affected by interest rate changes.**

Our operating results areaffected, in part, by the performance of our investment portfolio. Ourinvestment portfolio contains interest rate sensitive instruments, such asbonds, which may be adversely affected by changes in interest rates. Asignificant increase in interest rates could have a material adverse effect onour financial condition or results of operations. Generally, bond pricesdecrease as interest rates rise. Changes in interest rates could also have anadverse effect on our investment income and results of operations. For example,if interest rates decline, investment of new premiums received and fundsreinvested will earn less than expected.

In addition, ourinvestment portfolio includes mortgage-backed securities. As of December 31,2005, mortgage-backed securities constituted approximately 27.0% of ourinvested assets. As with other fixed income investments, the fair market valueof these securities fluctuates depending on market and other general economicconditions and the interest rate environment. Changes in interest rates canexpose us to prepayment risks on these investments. When interest rates fall,mortgage-backed securities are prepaid more quickly than expected and theholder must reinvest the proceeds at lower interest rates. Our mortgage-backedsecurities currently consist of securities with features that reduce the riskof prepayment, but there is no guarantee that we will not invest in othermortgage-backed securities that lack this protection. In periods of increasinginterest rates, mortgage-backed securities are prepaid more slowly, which mayrequire us to receive interest payments that are below the interest rates thenprevailing for longer than expected.

Interest rates are highlysensitive to many factors, including governmental monetary policies, domesticand international economic and political conditions and other factors beyondour control.

**We may require additional capital in the future, whichmay not be available or only available on unfavorable terms.**

Our future capitalrequirements depend on many factors, including our ability to write newbusiness successfully and to establish premium rates and reserves at levelssufficient to cover losses. To the extent that our present capital is insufficientto meet future operating requirements and/or cover losses, we may need to raiseadditional funds through financings or curtail our growth. Based on our currentoperating plan, we believe current capital together with our anticipatedretained earnings, will support our operations without the need to raiseadditional capital. However, we cannot provide any assurance in that regard,since many factors will affect our capital needs and their amount and timing,including our growth and profitability, our claims experience, and theavailability of reinsurance, as well as possible acquisition opportunities,market disruptions and other unforeseeable developments. If we had to raiseadditional capital, equity or debt financing may not be available at all or maybe available only on terms that are not favorable to us. In the case of equityfinancings, dilution to our stockholders could result, and in any case suchsecurities may have rights, preferences and privileges that are senior to thoseof the shares offered hereby. If we cannot obtain adequate capital on favorableterms or at all, our business, financial condition or results of operationscould be materially adversely affected.

**The regulatory system under which we operate, andpotential changes thereto, could have a material adverse effect on ourbusiness.**

TICNYand TNIC are subject to comprehensive regulation and supervision in theirrespective states of domicile. The purpose of the insurance laws andregulations are to protect insureds, not our stockholders. These regulationsare generally administered by the insurance departments in which the individualinsurance companies are domiciled  andrelate to, among other things:

·       standardsof solvency, including risk based capital measurements;

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·       restrictionson the nature, quality and concentration of investments;

·       requiredmethods of accounting;

·       rateand form regulation pertaining to certain of our insurance businesses; and

·       potentialassessments for the provision of funds necessary for the settlement of coveredclaims under certain policies provided by impaired, insolvent or failedinsurance companies.

Significant changes inthese laws and regulations could make it more expensive to conduct our business.The New York Insurance Department for TICNY and the Massachusetts Department ofInsurance for TNIC also conduct periodic examinations of the affairs of theirdomiciled insurance companies and require the filing of annual and otherreports relating to financial condition, holding company issues and othermatters. These regulatory requirements may adversely affect or inhibit ourability to achieve some or all of our business objectives.

TICNY and TNIC  may not be able to obtain or maintainnecessary licenses, permits, authorizations or accreditations in new states weintend to enter, or may be able to do so only at significant cost. In addition,we may not be able to comply fully with or obtain appropriate exemptions from,the wide variety of laws and regulations applicable to insurance companies orholding companies. Failure to comply with or to obtain appropriateauthorizations and/or exemptions under any applicable laws could result inrestrictions on our ability to do business or engage in certain activities thatare regulated in one or more of the jurisdictions in which we operate and couldsubject us to fines and other sanctions, which could have a material adverseeffect on our business. In addition, changes in the laws or regulations towhich our operating subsidiaries are subject could adversely affect our abilityto operate and expand our business or could have a material adverse effect onour financial condition or results of operations.

In recent years, the U.S.insurance regulatory framework has come under increased Federal scrutiny, andsome state legislators have considered or enacted laws that may alter orincrease state regulation of insurance and reinsurance companies and holdingcompanies. Moreover, the National Association of Insurance Commissioners (“NAIC”),which is an association of the insurance commissioners of all 50 states and theDistrict of Columbia, and state insurance regulators regularly re-examineexisting laws and regulations, often focusing on modifications to holdingcompany regulations, interpretations of existing laws and the development ofnew laws. Changes in these laws and regulations or the interpretation of theselaws and regulations could have a material adverse effect on our financialcondition or results of operations. The recent highly publicized investigationsof the insurance industry by the New York State Attorney General and otherregulators and government officials have led to, and may continue to lead to,additional legislative and regulatory requirements for the insurance industryand may increase the costs of doing business.

The activities of TRM aresubject to licensing requirements and regulation under the laws of New York andNew Jersey. TRM’s business depends on the validity of, and continued goodstanding under, the licenses and approvals pursuant to which it operates, as well as compliancewith pertinent regulations.

Licensing laws andregulations vary from jurisdiction to jurisdiction. In all jurisdictions, theapplicable licensing laws and regulations are subject to amendment orinterpretation by regulatory authorities. Generally such authorities are vested withrelatively broad and general discretion as to the granting, renewing andrevoking of licenses and approvals. Licenses may be denied or revoked forvarious reasons, including the violation of such regulations, conviction ofcrimes and the like. Possible sanctions which may be imposed include thesuspension of individual employees, limitations on engaging in a particularbusiness for specified periods of time, revocation of licenses, censures,redress to clients and fines. In some instances, TRM follows practices based onits or its counsels’ interpretations of laws and regulations, or thosegenerally followed by the industry, which may prove to be different from thoseof regulatory authorities.

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**If the assessments we are required to pay areincreased drastically our results of**operations and financial condition will suffer.

TICNY is subject toassessments in New York for various purposes, including the provision of fundsnecessary to fund the operations of the New York Insurance Department and theNew York Security Fund, whichpays covered claims under certain policies provided by impaired, insolvent orfailed insurance companies. In 2005, the assessment for the New York InsuranceDepartment was $589,000 and the New York Security Fund assessment was $941,000.These assessments are generally set based on an insurer’s percentage of thetotal premiums written in New York State within a particular line of business. TheCompany is permitted to assess premium surcharges on workers’ compensationpolicies that are based on statutorily enacted rates. However, assessments bythe various workers’ compensation funds have recently exceeded the permittedsurcharges resulting in additional expenses of $1,143,000 in 2004 and none in2005. As of December 31, 2005 the liability for the various workers’compensation funds, which includes amounts assessed on workers’ compensationpolicies was $2,776,000. This amount is expected to be paid over an eighteenmonth period ending June 30, 2007. As our company grows, our share of anyassessments may increase. However, we cannot predict with certainty the amountof future assessments because they depend on factors outside our control, suchas insolvencies of other insurance companies. Significant assessments couldhave a material adverse effect on our financial condition or results ofoperations. TNIC did not write or assume premiums in 2005. As TNIC writes orassumes premiums it will be subject to regulatory assessments.

**Our ability to meet ongoing cash requirements and paydividends may be limited by our holding c**ompany structure and regulatoryconstraints.

Tower is a holding companyand, as such, has no direct operations of its own. Tower does not expect tohave any significant operations or assets other than its ownership of theshares of its operating subsidiaries. Dividends and other permitted payments from our operatingsubsidiaries are expected to be our primary source of funds to meet ongoingcash requirements, including any future debt service payments and otherexpenses, and to pay dividends, if any, to our stockholders. TICNY is subjectto significant regulatory restrictions limiting its ability to declare and paydividends. As of December 31, 2005, the maximum amount of distributionsthat TICNY could pay to Tower without approval of the New York InsuranceDepartment was $4.0 million. The inability of TICNY to pay dividends and otherpermitted payments in an amount sufficient to enable us to meet our cashrequirements at the holding company level would have a material adverse effecton our operations and our ability to pay dividends to our stockholders. BecauseTNIC has not yet commenced insurance operations it has no positive unassignedsurplus and, therefore, it may not pay dividends at this time without theapproval of the Massachusetts Commissioner of Insurance. While we currentlyintend to pay dividends, if you require dividend income you should carefullyconsider these risks before relying on an investment in our company. For moreinformation regarding restrictions on the payment of dividends. See “Item 5.—Dividend Policy” and “Item 1.—Regulation”.

**Although we have paid cash dividends in the past, wemay not pay cash dividends in the future.**

We have a history ofpaying dividends to our stockholders when sufficient cash is available, and wecurrently intend to pay dividends in each quarter of 2006. However, future cashdividends will depend upon our results of operations, financial condition, cash requirements andother factors, including the ability of our subsidiaries to make distributionsto us, which ability is restricted in the manner previously discussed in thissection. Also, there can be no assurance that we will continue to pay dividendseven if the necessary financial conditions are met and if sufficient cash isavailable for distribution. See “Item 5.—Dividend Policy”.

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**Risks Related to Our Industry**

**The threat of terrorism and military and other actionsmay adversely affect our investment portfolio and may result in decreases inour net income, revenue and assets under management.**

The threat of terrorism,both within the United States and abroad, and military and other actions andheightened security measures in response to these types of threats, may causesignificant volatility and declines in the equity markets in the United States,Europe and elsewhere, as well as loss of life, property damage, additionaldisruptions to commerce and reduced economic activity. Some of the assets inour investment portfolio may be adversely affected by declines in the equitymarkets and economic activity caused by the continued threat of terrorism,ongoing military and other actions and heightened security measures.

We cannot predict at this time whether and the extentto which industry sectors in which we maintain investments may suffer losses asa result of potential decreased commercial and economic activity, or how anysuch decrease might impact the ability of companies within the affectedindustry sectors to pay interest or principal on their securities, or how thevalue of any underlying collateral might be affected.

We can offer no assurances that terrorist attacks orthe threat of future terrorist events in the United States and abroad ormilitary actions by the United States will not have a material adverse effecton our business, financial condition or results of operations.

**Our results ofoperations and revenues may fluctuate as a result of many factors, includingcyclical changes in the insurance industry, which may cause the price of oursecurities to be volatile.**

The results ofoperations of companies in the property and casualty insurance industryhistorically have been subject to significant fluctuations and uncertainties. Ourprofitability can be affected significantly by: 

·       competition;

·       risinglevels of loss costs that we cannot anticipate at the time we price ourproducts;

·       volatileand unpredictable developments, including man-made, weather-related and othernatural catastrophes or terrorist attacks;

·       changesin the level of reinsurance capacity and capital capacity;

·       changesin the amount of loss and loss adjustment expense reserves resulting from newtypes of claims and new or changing judicial interpretations relating to thescope of insurers’ liabilities; and

·       fluctuationsin equity markets and interest rates, inflationary pressures and other changesin the investment environment, which affect returns on invested assets and mayimpact the ultimate payout of losses.

The supply of insurance isrelated to prevailing prices, the level of insured losses and the level ofindustry surplus which, in turn, may fluctuate in response to changes in ratesof return on investments being earned in the insurance and reinsurance industry.As a result, the insurance business historically has been a cyclical industrycharacterized by periods of intense price competition due to excessiveunderwriting capacity as well as periods when shortages of capacity permittedfavorable premium levels. Premium levels for many products have increased inrecent years. However, beginning in the latter part of 2004 and throughout2005, rates for property and casualty insurance products began to moderate, andfor certain products, began to decrease due to increased levels of competition. A.M.Best estimates that the industry wide change in net premiums written in theproperty casualty industry was 0.7% in 2005 compared to 4.7% in 2004 and isestimated to be 3.3% in 2006. The change in industry policyholders’ surplus asestimated by A.M. Best was 6.2% in 2005 compared to 13.6% in 2004 and isestimated to be 8.0% in 2006. In 

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addition,in 2005, A.M. Best estimated new capital or capacity of $20 billion wasraised by the property casualty insurance and reinsurance industry. Thisadditional underwriting capacity may result in increased competition from otherinsurers seeking to expand the types or amount of business they write or causea shift in focus by some insurers to maintaining market share at the expense ofunderwriting discipline. These factors could lead to a significant reduction inpremium rates, less favorable policy terms and fewer submissions for ourunderwriting services. In addition to these considerations, changes in thefrequency and severity of losses suffered by insureds and insurers may affectthe cycles of the insurance business significantly, and we expect to experiencethe effects of such cyclicality. This cyclicality could have a material adverseeffect on our results of operations and revenues, which may cause the price ofour securities to be volatile. 

**Item 1B.**               UnresolvedStaff Comments

The Company has notreceived any written comments from the SEC Commission staff regarding itsperiodic or current reports for 2005.

**Item 2.**                        PROPERTIES

We lease approximately 54,000 square feet of space at120 Broadway, New York, New York, which consists of the entire 14th floor and a portion of the 17th floor. In 2005 , we paid an annual rent of$1,336,000, which increased by the terms of the lease agreement on September 16,2005 to $1,354,000. On September 1, 2005, we executed a Third Amendment toLease for new premises (approximately 94,000 square feet) at 120 Broadway, NewYork, New York for the entire 31st floor and a portion of the 30th floor. The lease commencement date is January 1,2006 and will end on June 30, 2021. We anticipate the surrender of our oldpremises on July 1, 2006. See Note 13—“Commitment and Contingencies”.

During the fourth quarterof 2004, we established two branch offices. The first was in Melville, New York(Long Island Branch) for 17,127 square feet of space at 225 Broadhollow Road,Melville, New York. We entered into a sublease agreement for this property fromApril 15, 2005 until September 30, 2006 and entered into a leaseagreement for the same property for the period commencing October 1, 2006and ending on December 15, 2015  Thesecond branch was for 4,900 square feet of temporary space in Buffalo, New York(Buffalo Branch).

**Item 3.**                        LEGALPROCEEDINGS 

From time to time, we are involved in various legalproceedings in the ordinary course of business. For example, to the extent aclaim asserted by a third party in a law suit against one of our insureds iscovered by a particular policy, we may have a duty to defend the insured partyagainst the claim. These claims may relate to bodily injury, property damage orother compensable injuries as set forth in the policy. Thus, when such alawsuit is submitted to us, in accordance with our contractual duty we appointcounsel to represent any covered policyholders named as defendants in thelawsuit. In addition, from time to time we may take a coverage position (e.g.,denying coverage) on a submitted property or liability claim with which thepolicyholder is in disagreement. In such cases, we may be sued by thepolicyholder for a declaration of its rights under the policy and/or formonetary damages, or we may institute a lawsuit against the policyholderrequesting a court to confirm the propriety of our position. We do not believethat the resolution of any currently pending legal proceedings, eitherindividually or taken as a whole, will have a material adverse effect on ourbusiness, results of operations or financial condition.

In addition to litigationarising from the policies we issue, as with any Company actively engaged inbusiness, from time to time we may be involved in litigation involvingnon-policyholders such as vendors or other third parties with whom we haveentered into contracts and out of which disputes have arisen, or litigationarising from employment related matters, such as actions by employees claimingunlawful 

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treatmentor improper termination. There are no suits of a material nature and of thetype described above presently pending against us.

**Item 4.**                        SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matterssubmitted to a vote of security holders during the fourth quarter of 2005.

**Item 5.**                        MARKETFOR THE REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

**Shareholders**

Our common stock is traded on the Nasdaq NationalMarket System under the ticker symbol “TWGP”. We have one class of authorizedcapital stock for 40,000,000 shares at a par value of $0.01 per share.

On November 8, 2005, the Securities and ExchangeCommission declared our Post-Effective Amendment No. 2 to Form S-1 onForm S-3 Registration Statement effective. This registration covers theresale of up to 500,000 shares of our common stock from time to time by anaffiliate of Friedman, Billings, Ramsey & Co., Inc., the leadunderwriter for the Company’s IPO. We will not receive any of the proceeds fromthe sale of these shares.

As of March 10, 2006,there were 19,855,841 common shares issued and outstanding that were held by217 shareholders of record.

**Price Range of Common Stock**

Our common stock trades on the Nasdaq under the tickersymbol “TWGP”. 

Thehigh and low sales prices for quarterly periods from October 20, 2004 (theCompany’s IPO date) through December 31, 2005 as reported by the Nasdaqwere as follows:

| ** **     | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $        | 14.27      |     | $          | 10.56 |   | — |   | — |   |
| SecondQuarter  |       | $        | 15.75      |     | $          | 10.05 |   | — |   | — |   |
| Third Quarter  |       | $        | 17.14      |     | $          | 13.75 |   | — |   | — |   |
| Fourth Quarter |       | $        | 23.45      |     | $          | 14.30 |   | $ | 12.55 |   | $ | 8.50 |   |
|                |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

**Dividend Policy**

Our Board of Directors currently intends to authorizethe payment of quarterly dividend of $0.025 per share of common stock to ourstockholders of record. Any determination to pay cash dividends will be at thediscretion of our Board of Directors and will be dependent upon our results ofoperations and cash flows, our financial position and capital requirements,general business conditions, legal, tax, regulatory and any contractualrestrictions on the payment of dividends and any other factors our Board ofDirectors deems relevant.

We are a holding company and have no direct operations.Our ability to pay dividends depends, in part, on the ability of TICNY and TNICto pay dividends to us. TICNY and TNIC are subject to significant regulatory restrictions limiting their ability todeclare and pay dividends.

The New York Insurance Department must approve anydividend declared or paid by TICNY that, together with all dividends declaredor distributed by TICNY during the preceding twelve months, exceeds the lesserof (1) 10% of TICNY’s policyholders’ surplus as shown on its lateststatutory financial statements filed with the New York State InsuranceDepartment or (2) 100% of adjusted net investment 

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income during thepreceding twelve months. TICNY declared approximately $2,050,000, $850,000 and$363,000 in dividends to Tower in 2005, 2004, and 2003, respectively. As of December 31,2005, the maximum distribution that TICNY could pay without prior regulatory approvalwas approximately $4.0 million.

TNIC my not pay any dividend that, together with alldividends declared or distributed by TNIC during the preceding twelve months,excluding pro rata distributions of any class of the TNIC’s own securities,exceeds the greater of (1) 10% of TNIC’s policyholders’ surplus as of theend of the preceding calendar year or (2) TNIC’s net income for the nextpreceding calendar year, until thirty days after the Commissioner has receivednotice of the intended dividend and not objected in such time. Because TNIC hasnot yet commenced insurance operations it has no positive  unassigned surplus and, therefore,  it may not pay dividends at this time withoutthe approval of the Massachusetts Commissioner of Insurance.

Pursuant to the terms of the subordinated debenturesunderlying our trust preferred securities, Tower and its subsidiaries cannotdeclare or pay any dividends if we are in default of or if we have elected todefer payments of interest on those debentures.

Effective upon the closing of our IPO, on October 20,2004, we effected a 1.8:1 stock split while maintaining a par value of $0.01after the split, and a restatement of our Certificate of Incorporation which,among other things, classified the Class A and Class B common stockinto one class of common stock and increased the authorized common stock to40,000,000 shares.

TheCompany declared dividends on common and preferred stock as follows in (000’s):

| ** **                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Common stock  dividends declared              |       | $        | 1,959      |     | $          | 493      |       | $ | — |   |
| Class A  common stock dividends declared |       | —   |       | 228      |       | 293      |       |
| Class B  common stock dividends declared |       | —   |       | 281      |       | 1,403    |       |
| Total common stock dividends declared         |       | 1,959    |       | 1,002    |       | 1,696    |       |
| Preferred stock dividends declared            |       | —   |       | —   |       | 158      |       |
| Total dividends  declared                     |       | $        | 1,959      |     | $          | 1,002    |       | $ | 1,854 |   |

 

The Company declared dividends per share on commonstock as follows:

| ** **          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------|------------|----------|------------|----------|------------|----------|------------|
| Common Stock        |       | $        | 0.10       |     | $          | 0.0250   |       | $ | — |   |
| Class A  Stock |       | $        | —     |     | $          | 0.1137   |       | $ | 0.1465 |   |
| Class B Stock  |       | $        | —     |     | $          | 0.1142   |       | $ | 0.5773 |   |

 

Preferred stock dividends of $130,000 and $158,000 forthe twelve months ending December 31, 2004 and the last six months of2003, respectively, were included in interest expense in accordance with SFAS150. The preferred stock dividends for the first six months of 2003 were$158,000 and were recorded as a reduction to stockholders’ equity.

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**Item 6.**                        SELECTEDCONSOLIDATED FINANCIAL INFORMATION

Theselected consolidated income statement data for the years ended December 31,2005, 2004 and 2003 and the balance sheet data as of December 31, 2005 and2004 are derived from our audited financial statements included elsewhere inthis document, which have been prepared in accordance with GAAP and have beenaudited by Johnson Lambert & Co., our independent registered publicaccounting firm. The selected consolidated income statement data for the yearsended December 31, 2001 and the balance sheet data as of December 31,2002, 2001 are derived from our unaudited financial statements. Thesehistorical results are not necessarily indicative of results to be expectedfrom any future period. You should read the following selected consolidatedfinancial information along with the information contained in this document,including “Item 7.—Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andthe consolidated financial statements and related notes included elsewhere inthis Form 10-K.

| ** **                                           | ** ** | **For the year ended December 31,**                                     | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                                                                         | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                           | ** ** | **($ in thousands, except share and per share amounts)** | ** ** |
| **Income Statement Data**                            |       |                                                                                             |       |   |   |   |   |   |   |   |   |
| Gross premiums  written                              |       | $                                                                                                | 300,107    |   | $ | 177,766 |   | $ | 134,482 |   | $ | 106,740 |   | $ | 59,698 |   |
| Ceded premiums  written                              |       | 88,325                                                                                           |       | 79,691 |   | 105,532 |   | 79,411 |   | 48,372 |   |
| Net premiums  written                                |       | $                                                                                                | 211,782    |   | $ | 98,075 |   | $ | 28,950 |   | $ | 27,329 |   | $ | 11,326 |   |
| Net premiums  earned                                 |       | $                                                                                                | 164,436    |   | $ | 45,564 |   | $ | 22,941 |   | $ | 26,008 |   | $ | 6,974 |   |
| Ceding commission  revenue                           |       | 25,218                                                                                           |       | 39,983 |   | 35,605 |   | 21,872 |   | 10,456 |   |
| Insurance services  revenue                          |       | 14,103                                                                                           |       | 16,381 |   | 12,830 |   | 12,428 |   | 14,419 |   |
| Net investment  income                               |       | 14,983                                                                                           |       | 5,070 |   | 2,268 |   | 1,933 |   | 828 |   |
| Net realized gains  (loss) on investments            |       | 122                                                                                              |       | 13 |   | 493 |   | 95 |   | 69 |   |
| Policy billing  fees                                 |       | 892                                                                                              |       | 679 |   | 545 |   | 376 |   | 144 |   |
| Total revenues                                       |       | 219,754                                                                                          |       | 107,690 |   | 74,682 |   | 62,712 |   | 32,890 |   |
| Losses and loss  adjustment expenses                 |       | 96,614                                                                                           |       | 27,060 |   | 15,071 |   | 16,356 |   | 5,339 |   |
| Operating expenses:                                  |       |                                                                                             |       |   |   |   |   |   |   |   |   |
| Direct and ceding commission expenses                |       | 43,839                                                                                           |       | 32,825 |   | 26,158 |   | 19,187 |   | 12,540 |   |
| Other operating expenses(1)                          |       | 42,632                                                                                           |       | 29,954 |   | 22,337 |   | 17,279 |   | 14,388 |   |
| Interest expense                                     |       | 4,853                                                                                            |       | 3,128 |   | 1,462 |   | 122 |   | 73 |   |
| Total expenses                                       |       | 187,938                                                                                          |       | 92,967 |   | 65,028 |   | 52,944 |   | 32,340 |   |
| Income (loss)  before income taxes                   |       | 31,816                                                                                           |       | 14,723 |   | 9,654 |   | 9,768 |   | 550 |   |
| Income tax expense  (benefit)                        |       | 11,062                                                                                           |       | 5,694 |   | 3,374 |   | 4,135 |   | 189 |   |
| Net income (loss)                                    |       | $                                                                                                | 20,754     |   | $ | 9,029 |   | $ | 6,280 |   | $ | 5,633 |   | $ | 361 |   |
| Net income (loss)  available to common  stockholders |       | $                                                                                                | 20,754     |   | $ | 9,029 |   | $ | 6,122 |   | $ | 5,318 |   | $ | 46 |   |
| **Per  Share Data**                                  |       |                                                                                             |       |   |   |   |   |   |   |   |   |
| Basic earnings  (loss) per share                     |       | $                                                                                                | 1.06       |   | $ | 1.23 |   | $ | 1.37 |   | $ | 1.18 |   | $ | 0.01 |   |
| Diluted earnings  (loss) per share                   |       | $                                                                                                | 1.03       |   | $ | 1.06 |   | $ | 1.09 |   | $ | 0.94 |   | $ | 0.01 |   |
| Basic weighted  average outstanding                  |       | 19,571,081                                                                                       |       | 7,335,286 |   | 4,453,717 |   | 4,500,000 |   | 4,500,000 |   |
| Diluted weighted  average per shares outstanding     |       | 20,147,073                                                                                       |       | 8,565,815 |   | 5,708,016 |   | 5,761,949 |   | 4,621,115 |   |
| **Selected Insurance Ratios**                        |       |                                                                                             |       |   |   |   |   |   |   |   |   |
| Gross loss  ratio(2)                                 |       | 56.8                                                                                             | %          | 55.2 | % | 60.8 | % | 63.8 | % | 73.0 | % |
| Gross underwriting  expense ratio(3)                 |       | 30.8                                                                                             | %          | 31.1 | % | 30.0 | % | 31.0 | % | 33.8 | % |
| Gross combined  ratio(4)                             |       | 87.6                                                                                             | %          | 86.3 | % | 90.8 | % | 94.8 | % | 106.8 | % |
| Net loss ratio(5)                                    |       | 58.8                                                                                             | %          | 59.4 | % | 65.7 | % | 62.9 | % | 76.6 | % |
| Net underwriting  expense ratio(6)                   |       | 29.3                                                                                             | %          | 16.2 | % | 4.4 | % | 18.5 | % | 25.7 | % |
| Net combined ratio(7)                                |       | 88.1                                                                                             | %          | 75.6 | % | 70.1 | % | 81.4 | % | 102.3 | % |

 

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| ** **                                      | ** ** | **As of December 31,**                                                            | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| ** **                                      | ** ** | **2005**                                                                                         | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                      | ** ** | **($ in thousands, except share and per share amounts)** | ** ** |
| **Summary  Balance Sheet Data**                 |       |                                                                                             |       |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                       |       | $                                                                                                | 38,760     |   | $ | 55,201 |   | $ | 30,339 |   | $ | 3,399 |   | $ | 13,186 |   |
| Investments at fair market value                |       | 358,599                                                                                          |       | 228,434 |   | 57,349 |   | 39,618 |   | 17,771 |   |
| Reinsurance recoverable                         |       | 104,811                                                                                          |       | 101,173 |   | 84,760 |   | 55,110 |   | 33,085 |   |
| Deferred acquisition costs, net                 |       | 29,192                                                                                           |       | 18,740 |   | 573 |   | — |   | — |   |
| Total assets                                    |       | 657,457                                                                                          |       | 494,147 |   | 286,592 |   | 186,116 |   | 124,008 |   |
| Reserve for losses and loss adjustment expenses |       | 198,724                                                                                          |       | 128,722 |   | 99,475 |   | 65,688 |   | 37,637 |   |
| Unearned premium                                |       | 157,779                                                                                          |       | 95,505 |   | 70,248 |   | 57,012 |   | 37,202 |   |
| Long-term debt and redeemable preferred stock   |       | 47,426                                                                                           |       | 47,426 |   | 29,208 |   | 3,000 |   | 3,000 |   |
| Deferred ceding commission revenue, net         |       | —                                                                                           |       | — |   | — |   | 3,494 |   | 5,984 |   |
| Total stockholders’ equity                 |       | 144,822                                                                                          |       | 129,447 |   | 13,061 |   | 9,067 |   | 3,336 |   |
| **Per Share Data:**                             |       |                                                                                             |       |   |   |   |   |   |   |   |   |
| Book value per share(8)                         |       | $                                                                                                | 7.29       |   | $ | 6.56 |   | $ | 2.96 |   | $ | 2.01 |   | $ | 0.74 |   |
| Diluted book value per share(9)                 |       | $                                                                                                | 7.16       |   | $ | 6.45 |   | $ | 2.38 |   | $ | 1.62 |   | $ | 0.61 |   |
| Dividends declared  per share                   |       |                                                                                             |       |   |   |   |   |   |   |   |   |
| Common Stock                                    |       | $                                                                                                | 0.10       |   | $ | 0.0250 |   | $ | — |   | $ | 0.1048 |   | $ | 0.0486 |   |
| Class A Stock                              |       | $                                                                                                | —     |   | $ | 0.1137 |   | $ | 0.1465 |   | $ | — |   | $ | — |   |
| Class B Stock                              |       | $                                                                                                | —     |   | $ | 0.1142 |   | $ | 0.5773 |   | $ | — |   | $ | — |   |

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(1)           Includes acquisition expenses and other underwritingexpenses (which are general administrative expenses related to underwritingoperations in our insurance company) as well as other insurance servicesexpenses (which are general administrative expenses related to insuranceservices operations).

(2)           The gross loss ratio is calculated by dividing grosslosses (consisting of losses and loss adjustment expenses) by gross premiumsearned.

(3)           The gross underwriting expense ratio is calculated bydividing gross underwriting expenses (consisting of direct commission expensesand other underwriting expenses net of policy billing fees) by gross premiumsearned.

(4)           The gross combined ratio is the sum of the gross lossratio and the gross underwriting expense ratio.

(5)           The net loss ratio is calculated by dividing net lossesby net premiums earned.

(6)           The net underwriting expense ratio is calculated bydividing net underwriting expenses (consisting of direct commission expensesand other underwriting expenses net of policy billing fees and cedingcommission revenue) by net premiums earned. Because the ceding commissionrevenue we earn on our ceded premiums has historically been higher than ourexpenses incurred to produce those premiums, our extensive use of quota sharereinsurance has caused our net underwriting expense ratio to be lower than ourgross underwriting expense ratio under GAAP.

(7)           The net combined ratio is the sum of the net loss ratioand the net underwriting expense ratio.

(8)           Book value per share is based on total stockholders’equity divided by common shares outstanding at year end.

(9)           Diluted book value per share is calculatedbased on total stockholders’ equity divided by the sum of the number of sharesof common stock outstanding plus the appropriate common stock equivalents forstock options, warrants and restricted stock using the treasury stock method.

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**Item 7.**                        MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussionand analysis of our financial condition and results of operations should beread in conjunction with our consolidated financial statements and accompanyingnotes which appear elsewhere in this Form 10-K. It containsforward-looking statements that involve risks and uncertainties. See “Item 1.—Note on Forward-LookingStatements” for more information. Our actual results could differmaterially from those anticipated in these forward-looking statements as aresult of various factors, including those discussed below and elsewhere inthis Form 10-K, particularly under the headings “Item 1A.—Risk Factors” and “Item 1.—Note on Forward-Looking Statements.”

**Overview**

We provide a broad range of property and casualtyinsurance products as well as reinsurance through TICNY and TNIC, our insurancecompany subsidiaries We also provide managing general underwriting, claimsadministration and reinsurance intermediary services through TRM, our insuranceservices subsidiary. TNIC has not written or assumed any premiums in 2005.

We manage these operations through three businesssegments: insurance (commercial and personal lines underwriting), reinsurance,and insurance services (managing general agency, claims administration andreinsurance intermediary operations).

In our insurance segment,TICNY provides commercial and personal lines insurance policies to businessesand individuals. TICNY’s commercial lines products include commercialmultiple-peril (provides both property and liability insurance), monolinegeneral liability (insures bodily injury or property damage liability),commercial umbrella, monoline property (insures buildings, contents or businessincome), workers’ compensation and commercial automobile policies. Its personallines products consist of homeowners, dwelling and other liability policies. Inour reinsurance segment, TICNY assumes reinsurance directly from the insurancecompanies for which TRM produces insurance premiums (which we refer to as TRM’s“issuing companies”) or indirectly from reinsurers that provide reinsurancecoverage directly to these issuing companies. In our insurance servicessegment, TRM generates commission income from its managing general agency byproducing premiums on behalf of its issuing companies and generates fees byproviding claims administration and reinsurance intermediary services. As of December 31,2005 TNIC has not commenced underwriting operations.

**Initial Public Offering**

On June 22, 2004 our Board of Directors approveda 1.8:1 stock split, the maintaining of a par value of $0.01 after the splitand the amendment and restatement of our Certificate of Incorporation whichamong other things combined the Class A and Class B common stock intoone class of common stock and increased the authorized common stock to40,000,000 shares. These actions became effective on October 20, 2004,which is the effective date of our IPO. All consolidated financial statementsand per share amounts have been retroactively adjusted for the above stocksplit and maintaining the par value at $0.01 per share.

On October 20, 2004,we sold 13,000,000 shares in our IPO at $8.50 per share. On the same date, wealso effected a concurrent private placement of 500,000 shares of our commonstock to an affiliate of Friedman, Billings, Ramsey & Co., Inc.,the lead underwriter for our IPO, at a price of $8.50 per share. On November 10,2004 the underwriters exercised their 30-day over-allotment option afterour IPO. Pursuant to this exercise, the underwriters purchased 629,007additional shares of common stock from us and 1,320,993 shares of common stockfrom selling shareholders. We received net cash proceeds of $107,845,000 fromthe offering and concurrent private placement after the underwriting discounts,commissions and offering expenses. The total costs of the IPO and privateplacement were $12,252,000 of 

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which$8,407,000 was for the underwriters discount, and $3,845,000 was for all othercosts. Costs of the IPO have been reflected as a reduction in Paid-in-Capital.

**Purchaseof Shell Company and Intangible Assets**

On March 25, 2005, weclosed on our purchase of the outstanding common stock of a shell insuranceCompany, North American Lumber Insurance Company (“NALIC”), that was renamedTower National Insurance Company. The purchase price was for $1,050,000 andincluded nine active state licenses and two inactive state licenses. The nineactive states licenses are for New Jersey, Connecticut, Massachusetts, RhodeIsland, Vermont, Maryland, Delaware, South Carolina and Wisconsin. The twoinactive states are Pennsylvania and Maine. The inactive state licenses have anadditional contingent purchase price of $75,000 per state payable upon licensereactivation within one year of the closing. Prior to the closing, allliabilities and assets (other than insurance licenses) of Tower NationalInsurance Company were transferred to a liquidating trust. We capitalized thispurchase as an intangible asset related to state licenses with an indefinitelife subject to annual impairment testing. On July 25, 2005, the licensefor Pennsylvania was reactivated and the additional contingent purchase priceof $75,000 was paid. In December 2005, the license for Maine wasreactivated and the additional contingent purchase price of $75,000 was paid. Thetotal amount capitalized as of December 31, 2005, was $1,303,000 andincluded the purchase price, legal fees and a broker’s fee. As of December 31,2005, Tower National Insurance Company was authorized to write business insixteen states.

**Agreement to Acquire a Shell Company**

On August 8, 2005,following our shell acquisition strategy, we announced our execution of anagreement to acquire MIIX Insurance Company of New York (“MIIX”), an insurancecompany with licenses in New York and New Jersey. Closing of the transaction isexpected to occur in early 2006 and is contingent upon a variety of conditionsincluding approval of the transaction by the New York State InsuranceDepartment. In the event of closing, we will pay $225,000 in cash at closing aswell as an amount equal to MIIX’s statutory surplus which was approximately$7.8 million as of December 31, 2004. MIIX has no net liabilities forinsurance losses. MIIX’s assets consist of U.S. Treasuries and cash.

**Marketplace Conditions and Trends**

The property and casualty insurance industry is affectedby naturally occurring industry cycles known as “hard” and “soft” markets. Sincewe began operations in 1990 and continuing into 2000, we operated in a softmarket cycle, generally considered an adverse industry cycle in the propertyand casualty insurance industry. A soft market cycle is characterized byintense competition that results in inadequate pricing, expanded coverage termsand increased commissions paid to distribution sources in order to compete forbusiness. We believe that a hard market began sometime in late 2000. A hardmarket, generally considered a beneficial industry trend, is characterized byreduced competition that results in higher pricing, reduced coverage terms andlower commissions paid to acquire business.

Beginning in late 2004 and in the first half of 2005,segments of both the reinsurance and commercial lines market started to exhibitsigns of a softening market. The market softening was slowed by the effects ofhurricanes Katrina, Rita and Wilma. According to A.M. Best, thesecatastrophic hurricanes in the Gulf states of the United States  caused an estimated $60 billion of insuredlosses for the insurance and reinsurance industries and  triggered the raising of an estimated $20billion of new reinsurance capital or capacity in 2005.

A.M. Best expects that, although significant, thehurricanes of 2005 will only briefly offset industry-wide price softening  in 2006. Price competition has become mostapparent in the larger accounts for the commercial lines, especially the commercialproperty and general  liability. Themid-sized and smaller 

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commercial accounts, thatare our focus, have not experienced the increased competition and pricesoftening as in the larger accounts.

TICNY’s gross premiums written in 2005, 2004 and 2003were $300.1 million, $177.8 million and $134.5 million, respectively. Premiumsproduced by TRM in 2005, 2004 and 2003 were $35.2 million, $53.4 million and$39.5 million, respectively.

A.M. Best estimates thatthe industry wide change in net premiums written in the property casualtyindustry was 0.7% in 2005 compared to 4.7% in 2004 and is estimated to be 3.3%in 2006. The change in industry policyholders’ surplus as estimated by A.M.Best was 6.2% in 2005 compared to 13.6% in 2004 and is estimated to be 8.0% in2006. In addition, in 2005, A.M. Best estimated new capital or capacity of$20 billion was raised by the property casualty insurance and reinsuranceindustry. This additional underwriting capacity may result in increasedcompetition from other insurers in order to generate an adequate return oncapital or cause a shift in focus by some insurers to maintaining market shareat the expense of underwriting discipline. These factors could lead to asignificant reduction in premium rates and less favorable policy terms.However, we believe that premium levels remain relatively attractive in thesizeable underserved market segments where we can continue to maintainunderwriting discipline and selectivity in low hazard classes of business, aswell as adequate pricing and coverage terms. Additionally, our broad productline platform allows us to achieve an optimal business mix in response tovarying market conditions.

**Principal Revenue and Expense Items**

We derive our revenue from the net premiums earned,ceding commissions, direct commission revenue and fees and net investmentincome and net realized gains from investments. The limited surplus in TICNYbefore our October 2004 IPO constrained our ability to write net premiumsbecause we are required to maintain a minimum level of surplus to supportpremiums. As a result, we ceded premiums to generate ceding commissions inTICNY and we produced premiums for TRM’s issuing companies to generate non-riskbearing revenues in our insurance services operation. Consistent with thisstrategy, during the five years ended December 31, 2004, we derived 34.6%and 36.9% of our total revenues from net premiums earned and cedingcommissions, respectively from TICNY and 24.8% of our total revenue from directcommission and fees from our insurance services operation. Our investmentincome and realized gains from investments comprised 3.7% of our total revenuesduring this period. Immediately after the IPO we contributed $98 million of theproceeds from the IPO and the concurrent private placement to TICNY, whichincreased its statutory surplus. Additionally, TICNY received a rating upgradefrom A.M Best to “A-” (Excellent) in October 2004. With the higher ratingwe were able to more fully deploy the additional capital. In 2005, the firstfull calendar year since the IPO and concurrent private placement, TICNYincreased its gross premiums written and maintained its reduced quota shareceding percentage at 25%. As a result, net premiums earned increased to 74.8%of total revenues, ceding commissions decreased to 11.9% of total revenues anddirect commission and fees from our insurance services operation declined to6.4% of total revenues. Our investment income and realized gains frominvestments increased to 6.9% of our total revenues in 2005.

*Netpremiums earned.**  *Premiumswritten include all premiums received by an insurance company during aspecified accounting period, even if the policy provides coverage beyond theend of the year. Premiums are earned over the term of the related policies. Atthe end of each accounting period, the portion of the premiums that are not yetearned are included in the unearned premium reserve and are realized as incomein subsequent periods over the remaining term of the policy. Our policiestypically have a term of 12 months. Thus, for example, for a policy that iswritten on July 1, 2005, one-half of the premiums would be earned in 2005and the other half would be earned in 2006.

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Net premiums earned are the earned portion of our netpremiums written. Net premiums written are equal to the difference betweengross premiums written and premiums ceded to reinsurers, or ceded premiumswritten. Our gross premiums (written and earned) are the sum of both directpremiums from our insurance segment and assumed premiums from our reinsurancesegment. Throughout this Form 10-K, direct and assumed premiums(written or earned) separately or together are also referred to as grosspremiums.

*Netinvestment income and realized gains and losses on investments.**  *We invest our statutory surplus and the fundssupporting our insurance reserves (including unearned premium reserve and thereserves established to pay for losses and loss adjustment expenses) in cash,cash equivalents and securities. Our investment income includes interest anddividends earned on our invested assets. Realized gains and losses on investedassets are reported separately from net investment income. We earn realizedgains when invested assets are sold for an amount greater than their amortizedcost in the case of fixed maturity securities and cost in the case of equitiesand recognize realized losses when invested assets are written down or sold foran amount less than their amortized cost or cost, as applicable.

*Cedingcommission revenues.**  *Weearn ceding commission revenues on the gross premiums written that we cede toreinsurers.

*Directcommission revenues and fees.**  *Directcommission revenues and fees consist of commissions earned by TRM on premiumsproduced by its managing general agency and fees earned from its claimsadministration and reinsurance intermediary services. It also includes policybilling fees that we earn in the course of collecting premiums from ourpolicyholders. This fee is charged primarily on small policies written throughour insurance segment.

Our expenses consist primarily of:

*Lossesand loss adjustment expenses.**  *Weestablish loss and loss adjustment expense reserves in an amount equal to ourestimate of the ultimate liability for claims under our insurance policies andthe cost of adjusting and settling those claims. Our provision for loss andloss adjustment expense reserves in any period, which is the expense recorded,includes estimates for losses incurred during the period and changes inestimates for prior periods.

*Operating expenses.**  *In our insurance and reinsurance segments, we referto the operating expenses that we incur to underwrite risks as underwritingexpenses. Underwriting expenses consist of direct and ceding commissionexpenses and other underwriting expenses. In our insurance services segment, werefer to our operating expenses as insurance services expenses, which consistof direct commission expense and other insurance services expenses. On aconsolidated basis, operating expenses for all three business segments aredivided into direct and ceding commission expenses and other operating expensesas explained below:

·       *Direct and ceding commission expenses.  *We pay directcommission expense to our producers in our insurance segment for the premiumsthat they generate for us. Our managing general agency also pays directcommission expense to our producers in our insurance services segment. Inaddition, TICNY also pays ceding commission expense to TRM’s issuing companiesfor the reinsurance premiums that we assume in our reinsurance segment. Cedingcommission is typically paid on quota share reinsurance agreements, but not onexcess of loss reinsurance agreements.

·       *Other operating expenses.  *Other operating expensesconsist of other underwriting expenses related to TICNY’s underwritingoperations in our insurance and reinsurance segments and other insuranceservices expenses related to our managing general agency and reinsuranceintermediary operations conducted through TRM in our insurance services segment.Other underwriting expenses consist of general administrative expenses such assalaries, rent, office supplies, depreciation and all other operating expensesnot otherwise classified separately and boards, 

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bureaus and taxes, whichare the assessments of statistical agencies for items such as rating manuals,rating plans and experience data, as well as state and local taxes based onpremiums, licenses and fees, assessments for fire patrol and contributions toworkers’ compensation and state and local security funds. Other insuranceservices expenses include general administrative expenses, principallyreimbursements to TICNY for underwriting services, and exclude expenses thatare incurred by TRM’s issuing companies such as boards, bureau and taxes. Italso excludes general administrative expenses related to claims administrationservices, which is billed on an hourly basis to TRM’s issuing companies.

·       *Interest expense.  *We pay interest on our loans, onsubordinated debentures and on segregated assets placed in trust accounts on a “fundswithheld” basis in order to collateralize reinsurance recoverables.

·       *Income taxes.  *Wepay Federal, state and local income taxes and other taxes.

**Measurement of Results**

We use various measures to analyze the growth andprofitability of our three business segments. In the insurance and reinsurancesegments, we measure growth in terms of gross, ceded and net premiums writtenand we measure underwriting profitability by examining our loss, expense andcombined ratios. We also measure our gross and net written premiums to surplusratios to measure the adequacy of capital in relation to premiums written. Inthe insurance services segment, we measure growth in terms of premiums producedby TRM on behalf of other insurance companies as well as fee and commissionrevenue received and we analyze profitability by evaluating income before taxesand the size of such income relative to TICNY’s net premiums earned. On aconsolidated basis, we measure profitability in terms of net income and returnon average equity.

*Premiumswritten.**  *We usegross premiums written to measure our sales of insurance products and, in turn,our ability to generate ceding commission revenues from premiums that we cedeto reinsurers. Gross premiums written also correlates to our ability togenerate net premiums earned. 

*Lossratio.**  *The lossratio is the ratio of losses and loss adjustment expenses incurred to premiumsearned and measures the underwriting profitability of a company’s insurancebusiness. We measure our loss ratio on a gross (before reinsurance), and netbasis (after reinsurance) as well as the loss ratio on the ceded portion (thedifference between gross and net premium) for our insurance and reinsurancesegments. We use the gross loss ratio as measures of the overall underwritingprofitability of the insurance business we write and to assess the adequacy ofour pricing. We use the ceded loss ratio to measure the experience on thepremiums that we cede to reinsurers, including the premiums ceded under ourquota share treaties. Beginning in 2001, the loss ratio on such ceded businesshas determined the ceding commission rate that we earn on ceded premiums. Ournet loss ratio is meaningful in evaluating our financial results, which are netof ceded reinsurance, as reflected in our consolidated financial statements. Inaddition, we use accident year and calendar year loss ratios to measure ourunderwriting profitability. An accident year loss ratio measures losses andloss adjustment expenses for insured events occurring in a particular year,regardless of when they are reported, as a percentage of premium earned duringthat year. A calendar year loss ratio measures losses and loss adjustmentexpense for insured events occurring during a particular year and the change inloss reserves from prior accident years as a percentage of premiums earnedduring that year. 

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*Underwritingexpense ratios.**  *Theunderwriting expense ratio is the ratio of direct and ceding commissionexpenses and other underwriting expenses less policy billing fees to premiumsearned. The underwriting expense ratio measures a company’s operational efficiencyin producing, underwriting and administering its insurance business. Due to ourhistorically high levels of reinsurance, we calculate our underwriting expenseratios on a gross basis (before the effect of ceded reinsurance) and net basis(after the effect of ceded reinsurance). Ceding commission revenue is appliedto reduce our underwriting expenses in our insurance company operation. Becausethe ceding commission rate we earn on our premiums ceded has historically beenhigher than our underwriting expense ratio on those premiums, our extensive useof quota share reinsurance has caused our net underwriting expense ratio to belower than our gross expense ratio. 

*Combinedratio.**  *We usethe combined ratio to measure our underwriting performance. The combined ratiois the sum of the loss ratio and the underwriting expense ratio. We analyze thecombined ratio on a gross (before the effect of reinsurance) and net basis(after the effect of reinsurance). If the combined ratio is at or above 100%,an insurance company is not underwriting profitably and may not be profitableunless investment income is sufficient to offset underwriting losses. 

*Premiumproduced by TRM.**  *TRMoperates a managing general agency that earns commissions on written premiumsproduced on behalf of its issuing companies. Although TRM is not an insurancecompany, we utilize TRM’s access to its issuing companies as a means to expandour ability to generate premiums beyond TICNY’s statutory surplus capacity. Forthis reason, we use written premiums produced by TRM on behalf of its issuingcompanies as well as TRM’s commission revenue to evaluate our ability toachieve growth. 

*Net income and return onaverage equity.**  *We usenet income to measure our profits and return on average equity and to measureour effectiveness in utilizing our shareholders’ equity to generate net incomeon a consolidated basis. In determining return on average equity for a givenyear, net income is divided by the average of shareholders’ equity for thatyear. As the IPO was completed in fourth quarter of 2004, the 2004 full yearreturn on equity was calculated by dividing net income by an averageshareholders’ equity for the year.

**Critical Accounting Policies**

In preparing our consolidated financial statements,management is required to make estimates and assumptions that affect reportedassets, liabilities, revenues and expenses and the related disclosures as ofthe date of the financial statements. Certain of these estimates result fromjudgments that can be subjective and complex. Consequently, actual results maydiffer, perhaps substantially, from the estimates. 

Our most critical accounting policies involve thereporting of reserves for losses (including losses that have occurred but hadnot been reported by the financial statement date) and loss adjustmentexpenses, the reporting of ceding commissions earned, the amount andrecoverability of reinsurance recoverable balances, deferred acquisition costsand investments. 

*Lossand loss adjustment expense reserves.**  *Loss and loss adjustment expense reserves representour best estimate at a particular point in time of the ultimate unpaid cost ofall losses and loss adjustment expenses incurred, including settlement andadministration of losses, based on facts and circumstances then known andincluding losses that have been incurred but not yet been reported. The processof establishing the liability for unpaid losses and loss adjustment expenses iscomplex, requiring the use of informed estimates and judgments. Actuarialmethodologies are employed to assist in establishing these estimates andinclude judgments relative to estimates of future claims severity andfrequency, the length of time before losses will develop to their ultimatelevel, possible changes in the law and other external factors that are oftenbeyond our control. The amount of loss and loss adjustment expense reserves forreported claims is based primarily upon a case-by-case evaluation of coverage,liability, injury severity, and 

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any other informationconsidered pertinent to estimating the exposure presented by the claim. Theamounts of loss and loss adjustment expense reserves for unreported claims aredetermined using historical information by line of insurance as adjusted tocurrent conditions. 

Due to the inherent uncertainty associated with thereserving process, the ultimate liability may differ, perhaps substantially,from the original estimate. Such estimates are regularly reviewed and updatedand any resulting adjustments are included in the current year’s results. Reservesare closely monitored and are recomputed periodically using the most recentinformation on reported claims and a variety of statistical techniques. Specifically,on at least a quarterly basis, we review, by line of business, existingreserves, new claims, changes to existing case reserves and paid losses withrespect to the current and prior years. See “Item 1.—Loss and Loss AdjustmentExpense Reserves” and “Note 3. Property-Casualty Insurance” in the notes to ouraudited financial statements for additional information regarding our lossreserves.

In 2005 and 2004, we had favorable development in ournet losses from prior years accident years of $392,000 and $199,000,respectively and unfavorable development in net losses from prior accidentyears of $75,000 in 2003.

The net loss reserves for the most recent accidentyears on a consolidated basis as of December 31, 2005 were $76.1 millionfor accident year 2005 and $12.7 million for accident year 2004. A 5%deficiency in net reserves for these years would impact our income beforeincome taxes by $3.8 million and $0.6 million for accident years 2005 and 2004,respectively.

*Cedingcommissions earned.**  *We havehistorically relied on quota share, excess of loss and catastrophe reinsuranceto manage our regulatory capital requirements and limit our exposure to loss. Generally,we have ceded a significant portion of our insurance premiums to unaffiliated reinsurersin order to maintain our net leverage ratio at our desired target level.

Ceding commission earned under a quota sharereinsurance agreement is based on the agreed upon commission rate applied tothe amount of ceded premiums written. Ceding commissions are realized as incomeas ceded premiums written are earned. Since 2001, the ultimate commission rateearned on our quota share reinsurance contracts has been determined by the lossratio on the ceded premiums earned. If the estimated loss ratio decreases fromthe level currently in effect, the commission rate increases and additionalceding commissions are earned in the period in which the decrease is recognized.If the estimated loss ratio increases, the commission rate decreases, whichreduces ceding commissions earned. As a result, the same uncertaintiesassociated with estimating loss and loss adjustment expense reserves affect theestimates of ceding commissions earned. We monitor the ceded ultimate lossratio on a quarterly basis to determine the effect on the commission rate ofthe ceded premiums earned that we accrued during prior accounting periods. Theestimated ceding commission income relating to prior years recorded in 2005,2004 and 2003 was a decrease of $1.2 million, an increase of $1.7 million andan increase of $1.3 million, respectively.

*Reinsurancerecoverables.**  *Reinsurancerecoverable balances are established for the portion of the loss reserves thatare ceded to reinsurers. Prepaid reinsurance premiums represent unearnedpremiums that are ceded to reinsurers. These are reported on our balance sheetseparately as assets, instead of being netted against the related liabilities,since reinsurance does not relieve us of our legal liability to policyholdersand ceding companies. We are required to pay losses even if a reinsurer failsto meet its obligations under the applicable reinsurance agreement. Consequently,we bear credit risk with respect to our individual reinsurers and may berequired to make judgments as to the ultimate recoverability of our reinsurancerecoverables. Additionally, the same uncertainties associated with estimatingloss and loss adjustment expense reserves affect the estimates of the amount ofceded reinsurance recoverables. We continually monitor the financial conditionand rating agency ratings of our reinsurers. Non-admitted reinsurers are requiredto collateralize their share of unearned premium and loss reserves either byplacing funds in a trust account meeting the requirements of New York’sRegulation 114 or by providing a letter of 

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credit. In addition, sinceOctober 2003, we have placed our new quota share treaties on a “fundswithheld” basis, under which TICNY retains the ceded premiums written andplaces that amount in segregated trust accounts from which TICNY may withdrawamounts due to it from the reinsurers. Tokio Millennium Re Ltd., a reinsurerunder the October 1, 2003 quota share treaty, posted a letter of credit atDecember 31, 2003 and replaced it with a Regulation 114 trust during thefirst quarter of 2004. At December 31, 2005 approximately 62.6% of ourreinsurance recoverables were collateralized. As of December 31, 2005, wehad unsecured reinsurance recoverables and ceding commissions receivabletotaling $33.2 million owed by PXRE Reinsurance Company. On February 16,2006, A.M. Best downgraded to “B++”(Very Good)  its former “A-”(Excellent)  financial strength rating on PXRE and issueda negative outlook. On February 24, 2006 A.M. Best downgraded PXRE to“B+”(Very Good) with a negative outlook. We believe that the unsecuredreinsurance recoverables and ceding commissions receivable from PXRE, none ofwhich are past due nor in dispute, are fully collectible. Our judgment is basedprimarily on PXRE’s capital position as a result of its recent capital raisinginitiatives.

*Deferredacquisition costs/commission revenues.**  *We defer certain expenses and commission revenuesrelated to producing and reinsuring insurance business, including commissionexpense on gross premiums written, commission income on ceded premiums written,premium taxes and certain other costs related to the acquisition of insurancecontracts. These costs and revenues are capitalized and the resulting asset orliability, deferred acquisition costs/revenues, is amortized and charged toexpense or income in future periods as gross premiums written are earned. Themethod followed in computing deferred acquisition costs/income limits theamount of such deferred amounts to its estimated realizable value. The ultimaterecoverability of deferred acquisition costs is dependent on the continuedprofitability of our insurance underwriting. If our insurance underwritingceases to be profitable, we may have to write-off a portion of our deferredacquisition costs, resulting in a further charge to income in the period inwhich the underwriting losses are recognized. 

*Investments.**  *In accordance with our investment guidelines, ourinvestments consist largely of high-grade marketable fixed maturity securities.Investments are carried at estimated fair value as determined by quoted marketprices or recognized pricing services at the reporting date for those orsimilar investments. Equity investments carried at cost include privateplacement real estate investment trusts (REITs) that are not publicly tradedand common shares of a closed-end management investing company investing inpredominately asset-backed and mortgage-backed securities. Changes inunrealized gains and losses on our investments, net of any deferred tax effect,are included as an element of other comprehensive income, and cumulativeunrealized gains and losses are included as a separate component ofstockholders’ equity. Realized gains and losses on sales of investments aredetermined on a specific identification basis. In addition, unrealizeddepreciation in the value of individual securities that management considers tobe other than temporary is charged to income in the period it is determined. Investmentincome is recorded when earned and includes the amortization of premium anddiscounts on investments. 

*Impairmentof invested assets.**  *Impairmentof investment securities results in a charge to income when a market declinebelow cost is deemed to be other than temporary. We regularly review our fixedmaturity and equity securities portfolios to evaluate the necessity ofrecording impairment losses for other than temporary declines in the fair valueof investments. In general, we focus our attention on those securities whosefair value was less than 80% of their amortized cost or cost, as appropriate,for six or more consecutive months. In evaluating potential impairment, weconsider, among other criteria: the current fair value compared to amortizedcost or cost, as appropriate; the length of time the security’s fair value hasbeen below amortized cost or cost; our intent and ability to retain theinvestment for a period of time sufficient to allow for any anticipatedrecovery in value; specific credit issues related to the issuer; and currenteconomic conditions. Other than temporary impairment losses result in apermanent reduction of the cost basis of the underlying investment. There wereno other than temporary declines in the fair value 

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of our fixed maturity andequity securities recorded during 2005, 2004 and 2003. Significant changes inthe factors we consider when evaluating investments for impairment losses couldresult in a significant change in impairment losses reported in ourconsolidated financial statements. See “Item 1.—Investments” and “Note 2.Investments” for additional detail regarding our investment portfolio at December 31,2005, including disclosures regarding other than temporary declines ininvestment value.

*Intangible assets andpotential impairment.*   The costs of a group ofassets acquired in a transaction is allocated to the individual assetsincluding identifiable intangible assets based on their relative fair values. Identifiableintangible assets with a finite useful life are amortized over the period whichthe asset is expected to contribute directly or indirectly to the future cashflows of the Company. Identifiable intangible assets with finite useful livesare tested for recoverability whenever events or changes in circumstancesindicate that a carrying amount may not be recoverable. An impairment loss isrecognized if the carrying value of an intangible asset is not recoverable andits carrying amount exceeds its fair value. No impairment losses wererecognized in 2005, 2004 and 2003. Significant changes in the factors weconsider when evaluating our intangible assets for impairment losses couldresult in a significant change in impairment losses reported in ourconsolidated financial statements. See “Note 6.- Intangible Assets” in thenotes to our audited financial statements.

**Results of Operations**

We conduct our business in three distinct segments:insurance, reinsurance and insurance services. Because we do not manage ourassets by segments, our investment income is not allocated among our segments. Operatingexpenses incurred by each segment are recorded in each segment directly. Generalcorporate overhead not incurred by an individual segment is allocated basedupon a combination of employee head count, policy count or premiums written,whichever method is most appropriate. 

Our results of operationsare discussed below in two parts. The first part discusses the consolidatedresults of operations. The second part discusses the results of the twounderwriting segments, the  insurance andreinsurance segments, followed by the results of operations of our insuranceservices segment. 

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***ConsolidatedResults of Operations***

| ** **                            | ** ** | **For the year ended December 31,** | ** ** |
|---------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                            | ** ** | **2005**                                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                            | ** ** | **($ in thousands)**                               | ** ** |
| **Revenues**                          |       |                                                         |       |   |   |   |   |
| Premiums earned                       |       |                                                         |       |   |   |   |   |
| Gross premiums earned                 |       | $                                                            | 237,833    |   | $ | 152,509 |   | $ | 122,023 |   |
| Less: Ceded premiums earned           |       | (73,397                                                      | )          | (106,945 | ) | (99,082 | ) |
| Net premiums earned                   |       | 164,436                                                      |       | 45,564 |   | 22,941 |   |
| Total commission  and fee income      |       | 40,213                                                       |       | 57,043 |   | 48,980 |   |
| Net investment  income                |       | 14,983                                                       |       | 5,070 |   | 2,268 |   |
| Net realized  investment gains        |       | 122                                                          |       | 13 |   | 493 |   |
| Total revenues                        |       | 219,754                                                      |       | 107,690 |   | 74,682 |   |
| **Expenses**                          |       |                                                         |       |   |   |   |   |
| Net loss and loss adjustment expenses |       | 96,614                                                       |       | 27,060 |   | 15,071 |   |
| Operating expenses                    |       | 86,471                                                       |       | 62,779 |   | 48,495 |   |
| Interest expense                      |       | 4,853                                                        |       | 3,128 |   | 1,462 |   |
| Total expenses                        |       | 187,938                                                      |       | 92,967 |   | 65,028 |   |
| Income before taxes                   |       | 31,816                                                       |       | 14,723 |   | 9,654 |   |
| Federal and state income taxes        |       | 11,062                                                       |       | 5,694 |   | 3,374 |   |
| **Net  Income**                       | ** ** | **$**                                                        | **20,754** | ** ** | **$** | **9,029** | ** ** | **$** | **6,280** | ** ** |
| **Key  Measures**                     |       |                                                         |       |   |   |   |   |
| Return on average equity              |       | 15.1                                                         | %          | 23.7 | % | 56.8 | % |

 

| **For the year ended December 31($ in thousands)** | ** ** | **2005** | ** ** | **2004**   | ** ** | **2003**  | ** ** |
|---------------------------------------------------------------------------------------|------------|----------|------------|------------|------------|-----------|------------|
| Insurance segment  underwriting profit                                                |       | $        | 19,262     |       | $          | 9,524     |       | $ | 6,567 |   |
| Reinsurance  segment underwriting profit                                              |       | 422      |       | 1,582      |       | 287       |       |
| Total  underwriting profit                                                            |       | 19,684   |       | 11,106     |       | 6,854     |       |
| Insurance  services segment income before income taxes                                |       | 2,840    |       | 1,951      |       | 1,541     |       |
| Net investment  income                                                                |       | 14,983   |       | 5,070      |       | 2,268     |       |
| Net realized  investment gains                                                        |       | 122      |       | 13         |       | 493       |       |
| Corporate  expenses                                                                   |       | 960      |       | 289        |       | 40        |       |
| Interest expense                                                                      |       | 4,853    |       | 3,128      |       | 1,462     |       |
| Federal and state  income taxes                                                       |       | 11,062   |       | 5,694      |       | 3,374     |       |
| **Net income**                                                                        | ** ** | **$**    | **20,754** | ** ** | **$**      | **9,029** | ** ** | **$** | **6,280** | ** ** |

 

*ConsolidatedResults of Operations 2005 Compared to 2004*

*Totalrevenues.*   Total revenues increased by 104.1% to$219.8 million for 2005 compared to $107.7 million for the same period in 2004.The increase is primarily due to the increase in net premiums earned and netinvestment income. Net premiums earned represented 74.8% of total revenues for2005 compared to 42.3% for the same period in 2004. Net investment income,excluding realized capital gains, represented 6.8% and 4.7% of total revenuesfor 2005 and December 31, 2004, respectively. These increases werepartially offset by lower total commission and fee income for 2005 of $40.2million, or 18.3% of total revenue, compared to $57.0 million, or 53.0% oftotal revenue, for the same period in 2004.

*Premiumsearned.*   Net premiums earned increased by 260.9%to $164.4 million in 2005 compared to $45.6 million in 2004. The increase innet premiums earned was due to the overall increase in gross premiums writtenthrough December 31, 2005 and a reduced ceding percentage under our quotashare 

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reinsurance agreement from60% to 25% beginning October 1, 2004 which was maintained throughout 2005.In addition, the net premiums earned in 2005 included all of the $13.1 millionof unearned premiums as of December 31, 2004 that would have been ceded toConverium Reinsurance (North America) Inc. “Converium” absent a novation of ourreinsurance agreement in 2004.  See “Item7—-Insurance Segment Results of Operations” and “Reinsurance Segment Results ofOperations” for further discussion of premiums.

*Commissionand fee income.*   Total commission and fee incomedecreased by 29.5% to $40.2 million in 2005 compared to $57.0 million in 2004. Thisdecrease was due principally to a 36.9% decrease in ceding commission revenuein 2005 as a result of a reduced ceding percentage under our quota sharereinsurance agreement to 25% for the full year of 2005 compared to 60% in thefirst nine months of 2004 and 25% for the last three months of 2004. Our quotashare reinsurance agreements contain provisions whereby the ceding commissionrates vary based on the loss experience of the underlying policies. The Companyrecords ceding commission revenue based on its current estimate of losses andadjustments to the ceding commission revenue are recorded in the period thatthe ceded losses are re-estimated. For 2005 the change in the estimated slidingscale commission rate for commissions earned in prior periods in both theInsurance Segment and the Insurance Services Segment resulted in a netreduction of $1.2 million of commission and fee income in 2005 compared to anet increase in ceding commission and fee income of $1.7 million in 2004. 

*Netinvestment income and realized gains.*   Netinvestment income increased by 195.5% to $15.0 million in 2005 compared to $5.1million in 2004. This resulted from an increase in invested assets to $357.2million as of December 31, 2005 compared to $227.0 million as of December 31,2004, excluding our investments in statutory business trusts underlying ourtrust preferred securities. Net cash flow provided by operations of $128.5million contributed to the increase in invested assets in 2005. On a taxequivalent basis, the yield was 5.2% as of December 31, 2005 and 4.4% asof December 31, 2004.

Net realized capital gains were $122,000 in 2005compared to $13,000 in 2004. The increase in net realized capital gains was theresult of the sale of common stocks and corporate bonds from which the proceedswere reinvested into higher yielding securities.

There was no impact on net realized gains attributableto adjustments for other than temporary impairment of securities held in 2005and 2004.

*Lossand loss adjustment expenses.*   Gross loss andloss adjustment expenses and the gross loss ratio for the Insurance andReinsurance Segments combined in 2005 were $135.2 million and 56.8%,respectively, compared to $84.2 million and 55.2%, respectively, for the sameperiod in 2004. The net loss ratio for the combined segments was 58.8% for 2005and 59.4% for the same period in 2004. The improvement in the net loss ratio in2005 compared to the same period in 2004 was due primarily to the increase innet premiums earned that reduced the effect of catastrophe reinsurance premiumson the net loss ratio and to favorable development from prior years’ reservesof $392,000 in 2005 compared to $199,000 in the same period in 2004. See “Item7—Insurance Segment Results of Operations” and “Reinsurance Segment Results ofOperations” for further discussion.

*Operatingexpenses.*   Operating expenses increased by 37.7%to $86.5 million in 2005 from $62.8 million in 2004. The increase was dueprimarily to the increase in underwriting expenses resulting from the growth inpremiums earned in TICNY, costs related to the OneBeacon transaction, includingestablishing two new offices in Long Island and Western New York, additionalstaffing, compliance expenses incurred as a public company and an increase ininsurance regulatory assessments.

*Interestexpense.*   Our interest expense was $4.9 millionin 2005 compared to $3.1 million in 2004. The increase resulted from anincrease in interest expense of $2.0 million on subordinated debenturesunderlying our trust preferred securities of $47.4 million of which $26.8million were issued in 

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December 2004 and$0.3 million credited to  reinsurers onfunds withheld in segregated trusts as collateral for reinsurance recoverables.This increase was offset by reductions of $0.6 million of interest expense onother borrowings and preferred stock repaid in the fourth quarter of 2004. 

*Incometax expense.*   Our income tax expense was $11.1million for 2005 compared to $5.7 million for the same period in 2004. Theincreased income tax expense was due primarily to the increase in income beforeincome taxes. The effective income tax rate was 34.8% in 2005 compared to 38.7%in 2004. The effective tax rate in2005 was lower due to a proportionally larger benefit of tax-exempt interestincome in 2005 as compared to 2004.

*Net income and return onaverage equity.*   Our net income and annualizedreturn on average equity was $20.8 million and 15.1%, respectively, for 2005compared to $9.0 million and 23.7%, respectively, for the same period in 2004. Althoughnet income increased 129.9% in 2005 compared to 2004, the lower return onaverage equity resulted from the significant increase in average stockholders’equity as our IPO and concurrent private placement were completed in the fourthquarter of 2004. For 2005, the return was calculated by dividing net income of$20.8 million by an average stockholders’ equity of $137.1 million. For 2004,the return  was calculated bydividing  net income of $9.0 million byan average stockholders’ equity of $38.1 million.

*ConsolidatedResults of Operations 2004 Compared to 2003*

*Totalrevenues.**  *Totalrevenues increased by 44.2% in 2004 to $107.7 million compared to $74.7 millionin 2003. The increases were primarily due to the increase in net earnedpremiums, ceding commission and fee income as well as investment income. Netearned premium represented 42.3% of total revenues for 2004 compared to 30.7%in 2003. Ceding commission and fee income represented 53.0% of total revenue in2004 compared to 65.6% in 2003. Net investment income, excluding realizedcapital gains, represented 4.7% and 3.0% of total revenue for 2004 and 2003,respectively.

*Premiumsearned.*   Net premiums earned in 2004 increased by98.6% to $45.6 million compared to $22.9 million in 2003. The increase in netpremiums earned was due to the overall increase of 32.2% in gross premiumswritten in 2004 and to our decision to cede less business in 2004 than 2003. See“Item 7.—Insurance Segment Results of Operations” and “Reinsurance SegmentResults of Operations” for a discussion of premiums and total commissions andfee income.

*Netinvestment income and realized gains.*   Netinvestment income in 2004 increased by 123.6% to $5.1 million compared to$2.3 million in 2003. This increase resulted from the growth in invested assetsprovided by operations, net proceeds from subordinated debentures underlyingtrust preferred securities issued in 2003 for $20.6 million, net proceeds of$107.8 million from the October 2004 IPO and concurrent private placementand an increase of $29.2 million in funds withheld as collateral forreinsurance recoverables. This was offset in part by a decrease in the yield onfixed maturity investments. Invested assets grew $171.1 million from $57.3million at December 31, 2003 to $228.4 million at December 31, 2004. Theyield for our fixed income investments held at December 31, 2004 was 3.9%compared to 5.0% for assets held at December 31, 2003. On a tax equivalentbasis, the yield was 4.4% for 2004 and 5.3% for 2003. The decrease in yield in2004 resulted primarily from a lower available interest rates and an increasedallocation to tax exempt securities.

Net realized capital gains were $13,000 in 2004compared to net realized capital gains of $493,000 in 2003. The 2003 capitalgains were a result of our decision to reduce the weighted average duration ofour fixed maturity securities portfolio to protect the portfolio from rising interestrates by selling certain securities. 

There was no impact on net realized capital gainsattributable to adjustments for other than temporary impairment of securitiesheld during 2004 and 2003.

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*Lossesand loss adjustment expenses.*   Gross loss andloss adjustment expenses and the gross loss ratio for both the insurance andreinsurance segments combined in 2004 were $84.2 million and 55.2%,respectively, compared to $74.2 million and 60.8%, respectively, in 2003. Thenet loss ratio for the combined segments was 59.4% in 2004 and 65.7% in 2003. Theimprovement in the net loss ratio in 2004 compared to 2003 was due primarily toan increase in net premiums earned that reduced the effect of excess andcatastrophe reinsurance premiums on the net loss ratio and to favorabledevelopment from prior years’ reserves of $199,000. See “Item 7.—InsuranceSegment Results of Operations” and “Reinsurance Segment Results of Operations.”

*Operatingexpenses.**  *Totaloperating expenses in 2004 increased by 29.5% to $62.8 million from $48.5 millionin 2003. The increase was due primarily to the increase in underwritingexpenses resulting from the growth in premiums earned in TICNY and produced byTRM, costs related to the OneBeacon transaction including establishing two newoffices in Long Island and Western New York, additional staffing and otherexpenses in preparation for a public company environment, and an increase inregulatory assessments.

*Interestexpenses.*   Our interest expense increased in 2004to $3.1 million compared to $1.5 million in 2003. The increase resulted from anincrease in interest of $1.0 million on subordinated debentures underlying ourtrust preferred securities issued in December, 2004 for $26.8 million and $20.6million issued in 2003. In addition, $1.1 million of interest expense wasincurred as a result of crediting reinsurers on funds withheld in segregatedtrusts as collateral for reinsurance recoverables effective January 1,2004 with an annual effective yield of 2.5%. Lastly, we had an aggregate of$6.0 million of other borrowings issued in February and December 2003that were repaid in 2004 and we recognized a loss on early extinguishment ofdebt of $133,000 in the fourth quarter of 2004. These increases in interestexpense were offset by a $0.5 million reduction in interest on surplus notesrepaid in 2003.

*Incometax expense.*   Our income tax expense in 2004 was$5.7 million compared to $3.4 million in 2003. The increased income tax in 2004was due primarily to an increase in income before income taxes. The effectiveincome tax rate was 38.7% in 2004 compared to 34.9% in 2003. The effective taxrates were affected by TRM’s pre-tax profits which are subject to state incometaxes. See “Note 11. Income Taxes”.

*Net income and return onaverage equity.**  *Netincome and return on average equity in 2004 were $9.0 million and 23.7%,respectively, compared to $6.3 million and 56.8%, respectively, in 2003, whichrepresents a 43.8% increase in net income. Although net income wassignificantly higher in 2004 than in 2003, the lower return on average equityresulted from the significant increase in average shareholders’ equity as theIPO was completed in the fourth quarter of 2004. For the year, the return wascalculated by dividing net income of $9.0 million by an average shareholders’equity of $38.1 million.

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***Insurance SegmentResults of Operations***

| ** **                                          | ** ** | **For the year ended December 31,** | ** **  |
|-----------------------------------------------------|------------|--------------------------------------------------------------|-------------|
| ** **                                          | ** ** | **2005**                                                     | ** **  | **2004** | ** ** | **2003** | ** ** |
| ** **                                          | ** ** | **($ in thousands)**                               | ** **  |
| **Revenues**                                        |       |                                                         |        |   |   |   |   |
| Premiums earned                                     |       |                                                         |        |   |   |   |   |
| Gross premiums earned                               |       | $                                                            | 236,174     |   | $ | 151,210 |   | $ | 120,541 |   |
| Less: Ceded premiums earned                         |       | (73,263                                                      | )           | (106,783 | ) | (98,176 | ) |
| Net premiums  earned                                |       | 162,911                                                      |        | 44,427 |   | 22,365 |   |
| Ceding commission  revenue                          |       | 25,218                                                       |        | 39,983 |   | 35,311 |   |
| Policy billing  fees                                |       | 868                                                          |        | 671 |   | 545 |   |
| **Total**                                           | ** ** | **188,997**                                                  | ** **  | **85,081** | ** ** | **58,221** | ** ** |
| **Expenses**                                        |       |                                                         |        |   |   |   |   |
| Loss and loss adjustment  expenses                  |       |                                                         |        |   |   |   |   |
| Gross loss and loss adjustment expenses             |       | 134,788                                                      |        | 84,840 |   | 73,379 |   |
| Less: Ceded loss and loss adjustment expenses  |       | (39,088                                                      | )           | (57,087 | ) | (58,680 | ) |
| Net loss and loss adjustment expenses               |       | 95,700                                                       |        | 27,753 |   | 14,699 |   |
| Underwriting expenses                               |       |                                                         |        |   |   |   |   |
| Direct commissions expense                          |       | 38,772                                                       |        | 25,349 |   | 20,701 |   |
| Other underwriting expenses                         |       | 35,263                                                       |        | 22,455 |   | 16,254 |   |
| Total  underwriting expenses                        |       | 74,035                                                       |        | 47,804 |   | 36,955 |   |
| **Underwriting  Profit**                            | ** ** | **$**                                                        | **19,262**  | ** ** | **$** | **9,524** | ** ** | **$** | **6,567** | ** ** |
| **Key Measures**                                    |       |                                                         |        |   |   |   |   |
| **Premiums Written**                                |       |                                                         |        |   |   |   |   |
| Gross premiums written                              |       | $                                                            | 298,643     |   | $ | 176,166 |   | $ | 133,263 |   |
| Less: Ceded premiums written                        |       | (88,200                                                      | )           | (79,571 | ) | (105,295 | ) |
| Net premiums written                                | ** ** | **$**                                                        | **210,443** | ** ** | **$** | **96,595** | ** ** | **$** | **27,968** | ** ** |
| **Loss Ratio**                                      |       |                                                         |        |   |   |   |   |
| Gross                                               |       | 57.1                                                         | %           | 56.1 | % | 60.9 | % |
| Net                                                 |       | 58.7                                                         | %           | 62.5 | % | 65.7 | % |
| **Accident Year Loss Ratio**                        |       |                                                         |        |   |   |   |   |
| Gross                                               |       | 57.3                                                         | %           | 56.6 | % | 57.6 | % |
| Net                                                 |       | 59.0                                                         | %           | 61.2 | % | 65.5 | % |
| **Underwriting Expense Ratio**                      |       |                                                         |        |   |   |   |   |
| Gross                                               |       | 31.0                                                         | %           | 31.2 | % | 30.2 | % |
| Net                                                 |       | 29.4                                                         | %           | 16.1 | % | 4.9 | % |
| **Combined Ratio**                                  |       |                                                         |        |   |   |   |   |
| Gross                                               |       | 88.1                                                         | %           | 87.3 | % | 91.1 | % |
| Net                                                 |       | 88.1                                                         | %           | 78.6 | % | 70.6 | % |

 

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*Insurance SegmentResults of Operations 2005 Compared to 2004*

*Grosspremiums.*   Gross premiums written increased by69.5% to $298.6 million for 2005 compared to $176.2 million in 2004. Grosspremiums earned increased by 56.2% to $236.2 million for 2005 compared to$151.2 million in 2004. Factors contributing to these increases include a 29.2%increase in the number of policies in force as of December 31, 2005compared to December 31, 2004 and premium increases on renewed businesswhich averaged 7.6% in personal lines and 5.5% in commercial lines in 2005. Theretention rate was 90% for personal lines and 84% for commercial lines. Additionally,premiums written on business subject to the OneBeacon renewal rights agreement,entered into in September 2004, amounted to $31.4 million during 2005compared to $2.4 million in 2004. New business written during 2005 throughformer OneBeacon producers that we appointed in connection with the renewalrights transaction amounted to $17.3 million compared to $2.6 million in 2004. Also,due to the upgrade in TICNY’s rating from A.M. Best to “A-” (Excellent)from “B++” (Very Good), certain policies in the more rating sensitive largelines and middle market programs in our Insurance Services Segment were renewedin our Insurance Segment.

*Cededpremiums.*   Ceded premiums written increased by10.8% to $88.2 million in 2005 compared to $79.6 million in 2004 as a result ofthe increases in gross premiums written offset by a reduction in the percentageceded under the quota share agreements. For the first nine months of 2004, theceding percentage under our quota share reinsurance agreements was 60% andbeginning October 1, 2004 was 25%. The 2005 quota share reinsuranceagreements maintained the 25% ceding percentage throughout 2005. The effectivequota share ceding percentage was 41.6% in 2004 that also included a $13.1million reduction to ceded written premiums from the retention of the unearnedpremium at December 31, 2004 that would have been ceded to Converium. Followingthe downgrade of Converium ‘s rating and decision by its parent to place thatcompany into runoff in September 2004, we terminated and novated Converium’sparticipation under its 2004 quota share treaty and decided to retain the cededunearned premiums that would have been ceded to Converium absent thetermination. Excluding the $13.1 million that we retained, the effective quotashare ceding percentage would have been 49.1% in 2004 compared to 25% in 2005. See“Note 5. Reinsurance—Converium” in the notes to our audited financialstatements and “Item 1.—Reinsurance—2004 Reinsurance Program” for a furtherdiscussion. Notwithstanding the lower ceding percentage in 2005, ceded premiumswritten in 2005 decreased only 10.8% as a result of the increase in the grosswritten premium by 69.5%

*Netpremiums.*   Net premiums written increased by117.9% to $210.4 million in 2005 compared to $96.6 million in 2004. Netpremiums earned in 2005 increased by 266.7% to $162.9 million compared to $44.4million in 2004. Net premiums earned in 2005 included the entire $13.1 millionof retained unearned premiums as of December 31, 2004 that would have beenceded to Converium. absent a novation of the reinsurance agreement in 2004. Thesepercentage increases were greater  thanthe percentage increase in gross premiums written and earned due to thedecrease in the ceding percentage from 60% in the first nine months of 2004 to25% beginning October 1, 2004 and continuing throughout 2005. 

*Cedingcommission revenue.*   Ceding commission revenuedecreased by 36.9% to $25.2 million in 2005 compared to $40.0 million in 2004due to the reduction in the quota share ceding percentage. An increase in theceded loss ratio on prior years’ quota share agreements resulted in a furtherdecrease in ceding commission revenue of $0.8 million in 2005 compared to anincrease in ceding commission revenue of $1.7 million in 2004.

*Lossand loss adjustment expenses and loss ratio.*   Grossand net losses and loss adjustment expenses were $134.8 million and $95.7million, respectively, for 2005 compared with $84.8 million and $27.8 million,respectively, in 2004. Our gross and net loss ratios were 57.1% and 58.7%,respectively for 2005 as compared with 56.1% and 62.5%, respectively, in 2004. Thedecrease in the net loss ratio in 2005 compared to 2004 resulted from theincrease in net premiums earned which reduced the effect of catastrophe 

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reinsurance premiums onthe net loss ratio. We ceded catastrophe reinsurance premiums equal to 2.5% ofnet premiums earned during 2005 compared to 8.6% during the same period in 2004.There was favorable development from prior years’ loss reserves on both a grossand net basis of approximately $461,000 and $392,000, respectively, in 2005.There was $568,000 adverse development from prior years’ loss reserves on a netbasis in 2004. Loss and lossadjustment expenses are net of reimbursements for loss adjustment expenses madeby TRM pursuant to the expense sharing arrangement between TICNY and TRM.See “Insurance Services Segment Results of Operations” for the amounts of lossand loss adjustment expense reimbursements.

*Underwritingexpenses and underwriting expense ratio.*   Underwritingexpenses, which include direct commission expenses and other underwritingexpenses, were $74.0 million for 2005 as compared with $47.8 million in2004. Our gross expense ratio was 31.0% in 2005 compared to 31.2% in 2004.

The commission portion of the gross expense ratio,which expresses direct commission expense paid to our producers as a percentageof gross premiums earned, was 16.4% in 2005, compared to 16.8% in 2004. Thisdecrease was due primarily to the lower commission on large lines and middlemarket programs written in the Insurance Segment that were previously placedthrough the Insurance Services Segment. This decrease was offset in part by anincrease in producer contingent commission expense.

The underwriting expense portion of the gross expenseratio was 14.6% in 2005 as compared to 14.4% in 2004. The increase inunderwriting expenses was the result of the costs related to the OneBeacontransaction, including establishing two new offices in Long Island and WesternNew York, additional staffing and an increase in insurance regulatoryassessments.

The net underwriting expense ratio was 29.4% in 2005as compared to 16.1% in 2004. This increase was due primarily to the reducedeffects of ceding commission revenue on lowering the gross expense ratio as aresult of the reduction in the quota share ceding percentage from 60% in thefirst nine months of 2004 to 25% beginning October 1, 2004 and continuingthroughout 2005.

*Underwriting profit andcombined ratio.*   The underwriting profit, whichreflects our underwriting results on a net basis after the effects ofreinsurance, was $19.3 million in 2005 and $9.5 million in 2004. The grosscombined ratio was 88.1% in 2005 as compared with 87.3% in 2004. The increase inthe gross combined ratio in 2005 resulted from an increase in the gross lossratio. The net combined ratio was 88.1% in 2005 as compared to 78.6% in 2004. Theincrease in the net combined ratio resulted from an increase in the net expenseratio primarily due to the effects of reduced ceding commission revenue. Notwithstandingthe increase in the net combined ratio in 2005, underwriting profit increaseddue to the overall increase in net premiums earned.

*Insurance SegmentResults of Operations 2004 Compared to 2003*

*Grosspremiums.*   Gross premiums written in 2004increased by 32.2% to $176.2 million from $133.3 million in 2003. Grosspremiums earned increased similarly by 25.4% to $151.2 million in 2004 comparedto $120.5 million in 2003. These increases are attributable to a 12.3% growthin policy count and to a 16.8% increase in average premium size resultingprimarily from rate increases and other pricing actions.

*Cededpremiums.**  *Cededpremiums written in 2004 decreased by 24.4% to $79.6 million compared with$105.3 million in 2003. Although gross written premiums increased in 2004,ceded written premiums declined due to our decision to lower the cedingpercentage under our quota share reinsurance agreements. For the first ninemonths of 2003, the ceding percentage under our quota share reinsuranceagreement was 70% and beginning October 1, 2003 was 80%. The effectivequota share ceding percentage was 77.2% for 2003. For the first nine months of2004, the ceding percentage under our quota share reinsurance agreement was 60%and beginning October 1, 2004 was 25%. The effective quota share ceding 

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percentage was 41.6% in2004 that also included a $13.1 million reduction to ceded written premiumsfrom the retention of the unearned premium at December 31, 2004 that wouldhave been ceded to Converium Re North America. Following the downgrade ofConverium Reinsurance (North America) Inc.’s rating and decision by its parentto place that Company into runoff in September 2004, we terminated andnovated Converium’s participation under its 2004 quota share treaty and decidedto retain the ceded unearned premiums that would have been ceded to Converiumabsent the termination. Excluding the $13.1 million that we retained, theeffective quota share ceding percentage would have been 49.1% in 2004. See “Note5. Reinsurance—Converium” and “Item 1.—Reinsurance—2004 Reinsurance Program”for a further discussion. Despite the reduction in ceded premiums written,ceded premiums earned increased by 8.8% in 2004 resulting from the effect ofearning ceded premiums that were written in 2003 and during the first ninemonths of 2004 under higher quota share ceding percentages as explained above.

*Netpremiums.*   Net premiums written in 2004 increasedby 245.4% to $96.6 million compared to $28.0 million in 2003. This increase wasgreater than the increase in gross premiums written due to the decrease in theeffective ceding quota share percentage from 77.2% in 2003 to 41.6% in 2004which includes the effect of retaining $13.1 million that was not ceded toConverium as discussed above. Net premiums earned, which was not affected bythe Converium novation, increased by 98.6% to $44.4 million in 2004 compared to$22.4 million in 2003. Only 46.0%, or $44.4 million of the net premiums writtenwas earned in 2004, compared to 80.0% or $22.4 million earned in 2003. Thislower earned percentage in 2004 reflects the lag in premiums written and earnedresulting from the growth in premiums written caused by the significantreduction in the quota share ceding percentage. 

*Cedingcommission revenue.**  *Cedingcommission revenue in 2004 increased by 13.2% to $40.0 million compared to$35.3 million in 2003. Despite the reduction in the quota share cedingpercentage, ceding commission revenue increased as a result of an 8.8% increasein ceded premiums earned. Additionally, we experienced an improvement in theceded loss ratios on prior years’ quota share treaties, which increased cedingcommission revenue by $1.7 million in 2004 and $1.3 million 2003.

*Lossand loss adjustment expenses and loss ratio.*   Grossand net losses and loss adjustment expenses in 2004 were $84.8 million and$27.8 million, respectively, compared with $73.4 million and $14.7 million,respectively, in 2003. Our gross and net loss ratios were 56.1% and 62.5%,respectively, in 2004 as compared to 60.9% and 65.7%, respectively, in 2003. Thedecrease in the net loss ratio in 2004 as compared to 2003 was due primarily toan increase in net premiums earned that reduced the effect of excess andcatastrophe reinsurance premiums on the net loss ratio. We ceded excess andcatastrophe reinsurance premiums equal to 15.8% of net premiums earned during2004 compared to 25.0% in 2003. There was $568,000 adverse development fromprior years’ reserves on a net basis in 2004 compared to $50,000 on a net basisin 2003 for the insurance segment. Loss and loss adjustment expenses are net ofreimbursements for loss and loss adjustment expenses made by TRM pursuant tothe expense sharing agreement between TICNY and TRM. See “Item 7.—InsuranceServices Segment Results of Operations” for the amounts of claimsreimbursements.

*Underwritingexpenses and underwriting expense ratio.**  *Underwriting expenses in 2004,which included direct commission expenses and other underwriting expenses, were$47.8 million compared with $37.0 million in 2003. Our gross underwritingexpense ratio was 31.2% in 2004 as compared with 30.2% in 2003. 

The commission portion of our underwriting expenseratio in 2004, which expresses direct commission expense paid to our producersas a percentage of gross premiums earned, was 16.8% compared to 17.2% in 2003. Thecommission ratio in 2003 was affected by the higher commissions paid toproducers in 2002 and recognized as commission expense in 2003 as the relatedpremium was earned.

The portion of the underwriting expense ratiorepresented by other underwriting expenses was 14.4% in 2004 as compared with13.0% in 2003. The increase in underwriting expenses was due to the growth inpremiums earned in TICNY and premiums produced by TRM, costs related to theOneBeacon transaction 

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including establishing twonew offices in Long Island and Western New York, additional staffing of keypositions in preparation for a public Company environment, and an increase inregulatory assessments.

The net underwriting expense ratio in 2004 was 16.1%compared to 4.9% in 2003 which reflects lower ceding commission revenue in 2004due to the reduction in the effective quota share ceding percentage from 77.2%in 2003 to 41.6% in 2004. In addition, other underwriting expenses increased by38.2% to $22.5 million in 2004 compared to $16.3 million in 2003 dueprincipally to the increases mentioned above.

*Underwritingprofits and combined ratio.*   The underwritingprofit reflects our underwriting results on a net basis after the effects ofreinsurance. The underwriting profit in 2004 increased by 45.0% to $9.6 millionfrom $6.6 million in 2003. The net combined ratio was 78.6% in 2004 as comparedwith 70.6% in 2003. The increase in the net combined ratio resulted from anincrease in the net expense ratio, which was primarily due to the effects ofreduced ceding commission revenue in lowering gross expenses. Notwithstandingthe increase in the net combined ratio, underwriting profits increased due tothe overall increase in net premiums earned.

The gross combined ratioin 2004 was 87.3% compared with 91.1% in 2003. The lower gross combined ratioresulted from a lower gross loss ratio due to increased pricing in 2004. 

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***Reinsurance SegmentResults of Operations***

| ** **                                    | ** ** | **For the year  ended December 31,** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                    | ** ** | **($ in thousands)**                           | ** ** |
| **Revenues**                                  |       |                                                     |       |   |   |   |   |
| Premiums earned                               |       |                                                     |       |   |   |   |   |
| Gross premiums earned                         |       | $                                                        | 1,659      |   | $ | 1,299 |   | $ | 1,482 |   |
| Less: Ceded premiums earned                   |       | (134                                                     | )          | (162 | ) | (906 | ) |
| Net premiums earned                           |       | 1,525                                                    |       | 1,137 |   | 576 |   |
| Ceding commission  revenue                    |       | —                                                   |       | — |   | 294 |   |
| **Total**                                     | ** ** | **1,525**                                                | ** ** | **1,137** | ** ** | **870** | ** ** |
| **Expenses**                                  |       |                                                     |       |   |   |   |   |
| Loss and loss adjustment  expenses            |       |                                                     |       |   |   |   |   |
| Gross loss and loss adjustment expenses       |       | 410                                                      |       | (676 | ) | 782 |   |
| Less: Ceded loss and loss adjustment expenses |       | 504                                                      |       | (17 | ) | (410 | ) |
| Net loss and loss adjustment expenses         |       | 914                                                      |       | (693 | ) | 372 |   |
| Underwriting expenses                         |       |                                                     |       |   |   |   |   |
| Ceding commissions expense                    |       | 16                                                       |       | 44 |   | 63 |   |
| Other underwriting expenses                   |       | 173                                                      |       | 204 |   | 148 |   |
| Total underwriting  expenses                  |       | 189                                                      |       | 248 |   | 211 |   |
| **Underwriting  Profit**                      | ** ** | **$**                                                    | **422**    | ** ** | **$** | **1,582** | ** ** | **$** | **287** | ** ** |
| **Key Measures Premiums Written**             |       |                                                     |       |   |   |   |   |
| Gross premiums written                        |       | $                                                        | 1,464      |   | $ | 1,600 |   | $ | 1,219 |   |
| Less: Ceded premiums written                  |       | (125                                                     | )          | (120 | ) | (237 | ) |
| **Net premiums written**                      | ** ** | **$**                                                    | **1,339**  | ** ** | **$** | **1,480** | ** ** | **$** | **982** | ** ** |
| **Loss Ratio**                                |       |                                                     |       |   |   |   |   |
| Gross                                         |       | 24.7                                                     | %          | -52.0 | % | 52.8 | % |
| Net                                           |       | 59.9                                                     | %          | -60.9 | % | 64.7 | % |
| **Accident Year Loss Ratio**                  |       |                                                     |       |   |   |   |   |
| Gross                                         |       | 55.2                                                     | %          | 5.7 | % | 58.6 | % |
| Net                                           |       | 60.0                                                     | %          | 6.5 | % | 60.2 | % |
| **Underwriting Expense Ratio**                |       |                                                     |       |   |   |   |   |
| Gross                                         |       | 11.4                                                     | %          | 19.1 | % | 14.3 | % |
| Net                                           |       | 12.4                                                     | %          | 21.8 | % | -14.4 | % |
| **Combined Ratio**                            |       |                                                     |       |   |   |   |   |
| Gross                                         |       | 36.1                                                     | %          | -33.0 | % | 67.1 | % |
| Net                                           |       | 72.3                                                     | %          | -39.1 | % | 50.3 | % |

 

*Reinsurance SegmentResults of Operations 2005 Compared to 2004*

*Grosspremiums.*   Gross premiums written decreased by8.5% to $1.5 million in 2005 as compared to $1.6 million in 2004. This was dueto the decrease in the premiums produced by TRM for its issuing companies,primarily due to certain policies in the more rating sensitive middle marketand large lines programs renewing in the Insurance Segment offset in part byhigher premium rates.

*Netpremiums.*   Net premiums written decreased 9.5% to$1.3 million in 2005 as compared to $1.5 million in 2004. However, net premiumsearned increased by 34.1% to $1.5 million in 2005 as compared to $1.1 millionin 2004 as a result of a 27.7% increase in gross premiums earned. The increasein gross 

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premiums earned resultedfrom an increase in premiums written in the later part of 2004 and  earned in 2005.

*Lossand loss adjustment expenses and loss ratio.*   Grossloss and loss adjustment expenses were $0.4 million in 2005 as compared tobenefit of $0.7 million in 2004. Net losses were $0.9 million for 2005 ascompared to benefit of $0.7 million in 2004. The gross and net loss ratios in2005 were 24.7% and 59.9%, respectively compared to a negative 52.0% and anegative 60.9% in 2004. The 2005 gross loss and loss adjustment expenses werereduced by a favorable prior year loss reserve development of $0.5 million. Thiswas outweighed, however, by a higher gross loss ratio on current accident yearassumed business and the release of ceded reserves from prior years’ resultingin an increase in the 2005 net loss ratio compared to 2004. The improvement inthe loss ratios in 2004 resulted from the full conversion of the currenttreaties to an aggregate excess of loss basis with improved pricing on thecurrent treaties, improvement in the loss experience of the underlying businessand favorable development of prior years’ gross and net reserves of $0.7million.

*Underwritingexpenses and underwriting expense ratio.*   Underwritingexpenses for the reinsurance segment are comprised of ceding commission expensepaid to TRM’s issuing companies and other third-party reinsurers to acquire theceded premium and this segment’s allocated share of our other underwritingexpenses. Gross underwriting expenses decreased in 2005 to $189,000 as comparedto $248,000 in 2004. Our net underwriting expense ratio decreased to 12.4% for2005 from 21.8% in 2004. The decrease in both the gross and net underwritingexpense ratios was due to lower ceding commission expenses as a smaller portionof the premiums earned require a commission payment and lower otherunderwriting expenses due to the reduced allocation of expenses to thereinsurance segment.

*Underwritingprofit and combined ratio.*   The underwritingprofit from assumed reinsurance in 2005 was $0.4 million compared to $1.6million in 2004. The net combined ratio was 72.3% in 2005 compared to anegative 39.1% in 2004. The higher net combined ratio in 2005 was the result ofa higher net loss ratio while the negative net combined ratio for 2004 was theresult of the negative net loss ratio.

The gross combined ratioincreased to 36.1% in 2005 compared to a negative 33.0% in 2004. The highergross combined ratio in 2005 was the result of a higher gross loss ratio, whilethe negative gross combined ratio for the same period in 2004 was the result ofthe negative gross loss ratio.

*Reinsurance SegmentResults of Operations 2004 Compared to 2003*

*Grosspremiums.*   Gross written premiums writtenincreased by 31.3% to $1.6 million in 2004 as compared to $1.2 million in 2003.The increase was due to an increase in the premiums produced by TRM’s issuingcompanies as well as higher rates charged on reinsurance assumed from theseissuing companies. In 2003 our reinsurance assumed was converted from a prorata reinsurance basis to an excess of loss basis, which significantly reducedthe amount of premiums assumed although treaties written in 2002 stillcontributed somewhat to gross earned premiums in 2003. 

Ceded premiums earned decreased by 82.1% to $162,000in 2004 compared to $906,000 in 2003 because we no longer cede premiums in thissegment to our quota share treaty reinsurers.

Net premiums written increased 50.7% to $1.5 millioncompared with $1.0 million in 2003 due to the increase in gross premiumswritten. Net premiums earned increased by 97.4% to $1.1 million in 2004 ascompared with $0.6 million in 2003 as a result of the increase in net writtenpremiums and the discontinuation of ceding premiums to our quota share treatyreinsurers.

*Lossand loss adjustment expenses and loss ratio.**  *The gross and net loss and lossadjustment expenses in 2004 were a benefit of $0.7 million compared to a $0.8million and $0.4 million expense, respectively, in 2003. Our gross and net lossratios were negative 52.0% and negative 60.9%, respectively in 2004 compared to52.8% and 64.7% in 2003. The improvement in the loss ratios in 2004 resultedfrom the full 

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conversion of the currenttreaties to an aggregate excess of loss basis with improved pricing on thecurrent treaties, improvement in the loss experience of the underlying businessand favorable development of prior years’gross and net reserves of $0.7million.

*Underwritingexpenses and underwriting expense ratios.**  *Gross underwriting expenses in 2004increased to $248,000 as compared to $211,000 in 2003 primarily as a result ofthe increase in gross premiums written which is the basis of the otherunderwriting expense allocation to this segment. Our net underwriting expenseratio increased to 21.8% in 2004 compared to a negative 14.4% in 2003. Thenegative underwriting expense ratio in 2003 resulted from ceding commissionrevenue earned in 2003 on premiums ceded under our 2002 quota share treaty,which exceeded the underwriting expenses incurred.

*Underwritingprofit and combined ratio.**  *The underwriting profit from assumed reinsurance in2004 was $1.6 million compared to $0.3 million in 2003. The net combined ratiowas a negative 39.1% in 2004 compared to 50.3% in 2003. The net combined ratioin 2004 was the result of the negative net loss ratio as explained above. 

The gross combined ratiodecreased to a negative 33.0% in 2004 compared to 67.1% in 2003 due to areduction in the gross loss ratio to negative 52.0% in 2004 compared to 52.8%in 2003. This was offset by an increase in the gross underwriting expense ratioto 19.1% in 2004 compared to 14.3% in 2003 due to increased gross writtenpremiums which is the basis for the allocation of underwriting expenses to thissegment.

***Insurance ServicesSegment Results of Operations***

| ** **                                               | ** ** | **For the year ended December 31,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                               | ** ** | **2005**                                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                               | ** ** | **($ in thousands)**                               | ** ** |
| **Revenue**                                              |       |                                                         |       |   |   |   |   |
| Direct commission  revenue from managing general agency  |       | $                                                            | 9,148      |   | $ | 11,546 |   | $ | 7,984 |   |
| Claims  administration revenue                           |       | 4,268                                                        |       | 4,105 |   | 3,746 |   |
| Reinsurance  intermediary fees(1)                        |       | 688                                                          |       | 730 |   | 1,100 |   |
| Policy billing  fees                                     |       | 23                                                           |       | 8 |   | — |   |
| **Total  Revenues**                                      |       | 14,127                                                       |       | 16,389 |   | 12,830 |   |
| **Expenses**                                             |       |                                                         |       |   |   |   |   |
| Direct  commissions expense paid to producers            |       | 5,051                                                        |       | 7,432 |   | 5,394 |   |
| Other insurance  services expenses(2)                    |       | 1,981                                                        |       | 2,987 |   | 2,247 |   |
| Claims expense  reimbursement to TICNY                   |       | 4,255                                                        |       | 4,019 |   | 3,648 |   |
| **Total  Expenses**                                      |       | 11,287                                                       |       | 14,438 |   | 11,289 |   |
| **Insurance  Services Pre-tax Income**                   | ** ** | **$**                                                        | **2,840**  | ** ** | **$** | **1,951** | ** ** | **$** | **1,541** | ** ** |
| Premiums produced by TRM  on behalf of issuing companies |       | $                                                            | 35,177     |   | $ | 53,445 |   | $ | 39,494 |   |

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(1)          The reinsuranceintermediary fees include commissions earned for placement of reinsurance onbehalf of TICNY.

(2)          Consistsof underwriting expenses reimbursed to TICNY pursuant to an expense sharingagreement.

*Insurance ServicesSegment Results of Operations 2005 Compared to 2004*

*Totalrevenues.*   Total revenues for the insuranceservices segment were $14.1 million in 2005 as compared with $16.4 million in2004. The decrease in total revenues was primarily due to a 20.8% reduction indirect commission revenue to $9.1 million in 2005 compared to $11.5 million in2004 and to a 

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5.8% decrease inreinsurance intermediary fees to $688,000 in 2005, compared to $730,000 in 2004due to the reduction in the quota share treaty ceding percentages. Claimsadministration revenue increased by 4.0% to $4.3 million in 2005 as compared to$4.1 million in 2004. Premiums produced during 2005 on business subject to therenewal rights agreement with OneBeacon amounted to $5.1 million compared to$0.8 million in 2004. New business produced through former OneBeacon producersthat we appointed in connection with the renewal rights transaction amounted to$1.5 million in 2005 compared to $0.7 million in 2004.

For 2005 the decrease in direct commission revenuesresulted from a 34.2% decrease in premiums produced by TRM as certain policieswere renewed in the Insurance Segment and a reduction in commission income of$397,000 resulting from unfavorable loss development on the premiums producedin prior years compared to an increase in commission income of $187,000 in 2004from favorable loss development on the premiums produced in prior years. Thecomposite commission revenue rate increased to 27.1% in 2005 compared to 21.3%in 2004 due to the greater mix of premiums produced in the small and middlemarket programs that carry a higher commission rate.

*Directcommission expense.*   TRM’s direct commissionexpense rate was 14.4% in 2005 compared to 13.9% in 2004. This was due to the4.9% increase in TRM’s small market program in 2005. The small market programcarries a higher commission rate than the large market program.

*Otherinsurance services expenses.*   The amount ofreimbursement for underwriting expenses by TRM to TICNY in 2005 was $2.0million as compared to $3.0 million in 2004. The decrease resulted from the34.2% decrease in premiums produced.

*Claimsexpense reimbursement.*   The amount ofreimbursement by TRM for claims administration pursuant to the terms of theexpense sharing agreement with TICNY in 2005 was $4.3 million as compared to$4.0 million in 2004 due to an increase in the number of claims handled.

*Pre-tax income.*   Despitea reduction in premiums produced, pre-tax income in 2005 increased by 45.6% to$2.8million as compared to $2.0 million in 2004 primarily due to an increase inthe direct commission revenue rate in 2005 compared to 2004.

*Insurance ServicesSegment Results of Operations 2004 Compared to 2003*

*TotalRevenues.*   Total revenues in 2004 increased by27.7% for the insurance services segment to $16.4 million compared to $12.8million in 2003. The increase in total revenue was primarily due to directcommission revenue that increased by 44.6% to $11.5 million in 2004 as comparedto $8.0 million in 2003 and claims administration revenue that increased by9.6% to $4.1 million in 2004 from $3.7 million in 2003. The increase in revenuefrom direct commission revenue and claims administration revenue was offset bya reduction in reinsurance intermediary fees, which decreased by 33.6% to $0.7million in 2004 as compared with $1.1 million in 2003. The reduction inreinsurance intermediary fees was primarily a result of lower ceded premiums inthe insurance segment in 2004 and additional reinsurance intermediary feesrecorded in 2003 pertaining to reinsurance arrangements in 2002.

Direct commission revenue is dependent upon thepremiums and losses on business produced by TRM on behalf of its issuingcompanies. In 2004, direct commission revenues increased as a result ofincreases in premiums produced by TRM and in the commission rate. Premiumsproduced by TRM increased by 35.3% to $53.4 million in 2004 as compared to$39.5 million in 2003 resulting primarily from increases in premiums producedin the middle market and small business overflow programs. The compositecommission revenue rate increased to 21.6% in 2004 from 20.2% in 2003 due togrowth in the middle market program, which carries a higher commission rate, to$18.8 million of premiums produced in 2004 compared to $7.7 million in 2003.Additionally, due to a lower loss ratio on the business placed by TRM,additional commissions of $0.2 million were earned in 2004.

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*Directcommission expense.*   TRM’s direct commissionexpense rate in 2004 was 13.9% compared to 13.7% in 2003. This was due to anincrease in the small business overflow program to $9.9 million of premiumsproduced in 2004 from $6.7 million of premiums produced in 2003. The smallbusiness overflow program has a higher commission rate.

*Otherinsurance services expense.*   The amount ofreimbursement for underwriting expenses by TRM to TICNY in 2004 was $3.0million as compared to $2.2 million in 2003. The increase resulted from theincrease in premiums produced. 

*Claimsexpense reimbursement.*   The amount ofreimbursement by TRM for claims administration pursuant to the terms of theexpense sharing agreement in 2004 was $4.0 million compared with $3.6 millionin 2003 due to an increase in the number of claims handled.

*Pre-tax income.*   Pre-taxincome in 2004 increased by 26.6% to $2.0 million as compared to $1.5 millionin 2003. The increase was due to the 44.6% increase in direct commissionrevenue that was partially offset by a 27.9% increase in expenses for 2004compared to 2003.

**Investments**

We classify our investments in fixed maturitysecurities as available for sale and report these securities at their estimatedfair values based on quoted market prices or a recognized pricing service. Changesin unrealized gains and losses on these securities are reported as a separatecomponent of comprehensive net income, and accumulated unrealized gains andlosses are reported as a component of accumulated other comprehensive netincome in stockholders’ equity. Realized gains and losses are charged orcredited to income in the period in which they are realized. 

The aggregate fair market value of our invested assetsas of December 31, 2005 was $358.6 million. As of that date, our fixedmaturity securities had a fair market value of $326.7 million and amortizedcost of $331.1 million. Equity securities, available for sale, at fair valuewere $5.9 million as of December 31, 2005 and a cost of $6.7 million. Equitysecurities at cost were $24.6 million as of December 31, 2005. Our commontrust securities—statutory business trusts had a fair value and equity value of$1.4 million.

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Thefollowing table provides a breakdown of the amortized cost, aggregate fairvalue and unrealized gains and losses by investment type as of December 31,2005 and December 31, 2004 including estimated fair values for equitysecurities carried at cost.

| ** **                                              | ** ** | **As of December 31,** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                              | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **                                              | ** ** | **Cost or  Amortized**           | ** ** | **Aggregate  Fair** | ** ** | **Unrealized  Gains/** | ** ** | **Cost or  Amortized** | ** ** | **Aggregate  Fair** | ** ** | **Unrealized  Gains/** | ** ** |
| **Category**                                            | ** ** | ** **                            | ** ** | **Cost** | ** ** | **Value** | ** ** | **(Losses)** | ** ** | **Cost** | ** ** | **Value** | ** ** | **(Losses)** | ** ** |
| ** **                                              | ** ** | **($ in thousands)**        | ** ** |
| U.S. Treasury  securities                               |       | $                                     | 7,224      |   | $ | 7,132 |   |   | $ | (92 | ) |   | $ | 1,818 |   | $ | 1,784 |   |   | $ | (34 | ) |   |
| U.S. Agency  securities                                 |       | 31,937                                |       | 31,623 |   |   | (314 | ) |   | 19,640 |   | 19,636 |   |   | (4 | ) |   |
| Corporate fixed  maturity securities                    |       | 77,852                                |       | 76,488 |   |   | (1,364 | ) |   | 48,898 |   | 49,381 |   |   | 483 |   |   |
| Mortgage-backed  securities                             |       | 98,786                                |       | 96,922 |   |   | (1,864 | ) |   | 64,116 |   | 64,159 |   |   | 43 |   |   |
| Asset-backed  securities                                |       | 15,431                                |       | 15,188 |   |   | (243 | ) |   | 12,443 |   | 12,473 |   |   | 30 |   |   |
| Other taxable  fixed maturity securities                |       | 250                                   |       | 244 |   |   | (6 | ) |   | 250 |   | 243 |   |   | (7 | ) |   |
| Municipal  securities                                   |       | 99,643                                |       | 99,084 |   |   | (559 | ) |   | 76,397 |   | 76,847 |   |   | 450 |   |   |
| Preferred stocks                                        |       | 113                                   |       | 115 |   |   | 2 |   |   | 113 |   | 117 |   |   | 4 |   |   |
| Common stocks—at  cost                             |       | 24,558                                |       | 24,053 |   |   | (505 | ) |   | — |   | — |   |   | — |   |   |
| Common stocks—at  fair value                       |       | 6,568                                 |       | 5,819 |   |   | (749 | ) |   | 1,714 |   | 2,368 |   |   | 654 |   |   |
| Common trust  securities—statutory business trusts |       | 1,426                                 |       | 1,426 |   |   | — |   |   | 1,426 |   | 1,426 |   |   | — |   |   |
| **Total**                                               |       | $                                     | 363,788    |   | $ | 358,094 |   |   | $ | (5,694 | ) |   | $ | 226,815 |   | $ | 228,434 |   |   | $ | 1,619 |   |   |
|                                                         |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The following table presents information regarding ourinvested assets that were in an unrealized loss position at December 31,2005 by amount of time in a continuous unrealized loss position.

| ** **                                 | ** ** | **Less than 12 months** | ** **  | **12 months or longer** | ** ** | **Total**            | ** ** |
|--------------------------------------------|------------|----------------------------------------|-------------|----------------------------------------|------------|----------------------|------------|
| **Category**                               | ** ** | ** **                             | ** **  | **Fair  Value**                        | ** ** | **Unrealized  Loss** | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** |
| ** **                                 | ** ** | **($ in thousands)**         | ** **  |
| U.S. Treasury  securities                  |       | $                                      | 4,643       |                                   |       | $                    | (58        | ) |   | $ | 1,228 |   |   | $ | (42 | ) |   | $ | 5,871 |   |   | $ | (100 | ) |   |
| U.S. Agency  securities                    |       | 18,137                                 |        |                                   | (144       | )                    |       | 9,883 |   |   | (196 | ) |   | 28,020 |   |   | (340 | ) |   |
| Corporate fixed  maturity securities       |       | 41,721                                 |        |                                   | (933       | )                    |       | 19,613 |   |   | (690 | ) |   | 61,334 |   |   | (1,623 | ) |   |
| Mortgage-backed  securities                |       | 45,483                                 |        |                                   | (899       | )                    |       | 34,080 |   |   | (1,238 | ) |   | 79,563 |   |   | (2,137 | ) |   |
| Asset-backed  securities                   |       | 11,696                                 |        |                                   | (255       | )                    |       | 728 |   |   | (22 | ) |   | 12,424 |   |   | (277 | ) |   |
| Municipal  securities                      |       | 61,996                                 |        |                                   | (756       | )                    |       | 6,415 |   |   | (129 | ) |   | 68,411 |   |   | (885 | ) |   |
| **Total temporarily impaired  securities** | ** ** | **$**                                  | **183,676** | ** **                             | ** ** | **$**                | **(3,045** | **)** | ** ** | **$** | **71,947** | ** ** | ** ** | **$** | **(2,317** | **)** | ** ** | **$** | **255,623** | ** ** | ** ** | **$** | **(5,362** | **)** | ** ** |
|                                            |            |                                        |             |                                        |            |                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Liquidity and Capital Resources**

***Sources and Uses of Funds***

We are organized as a holding company with threeoperating company subsidiaries, TICNY, TNIC and TRM. The holding Company’sprincipal liquidity needs include interest on debt, income taxes andstockholder dividends. The holding Company’s principal sources of liquidityinclude dividends from TICNY, TNIC and TRM and other permitted payments fromour subsidiaries, as well as financing through borrowings and sales ofsecurities. 

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Under New York law, TICNY is limited in the amount ofdividends it can pay to Tower. Under New York law, TICNY may pay dividends toTower only out of statutory earned surplus. In addition, the New York InsuranceDepartment must approve any dividend declared or paid by TICNY that, togetherwith all dividends declared or distributed by TICNY during the preceding twelvemonths, exceeds the lesser of (1) 10% of TICNY’s policyholders’ surplus asshown on its latest statutory financial statement filed with the New York StateInsurance Department or (2) 100% of adjusted net investment income duringthe preceding twelve months. TICNY declared approximately $2,050,000, $850,000,and $364,000 in dividends to Tower in 2005, 2004, and 2003, respectively. As ofDecember 31, 2005, the maximum distribution that TICNY could pay withoutprior regulatory approval was approximately $4.0 million.

TRM is not subject to any limitations on its dividendsto Tower, other than the basic requirement that dividends may be declared orpaid if the net assets of TRM remaining after such declaration or payment willat least equal the amount of TRM’s stated capital. TRM declared dividends of$2,550,000 in 2005 and none in 2004 and 2003. 

In addition, TNIC my not pay any dividend that,together with all dividends declared or distributed by TNIC during thepreceding twelve months, excluding pro rata distributions of any class of theTNIC’s own securities, exceeds the greater of (1) 10% of TNIC’spolicyholders’ surplus as of the end of the preceding calendar year or (2) TNIC’snet income for the next preceding calendar year, until thirty days after theCommissioner has received notice of the intended dividend and not objected insuch time. Because TNIC has not yet commenced insurance operations it has nopositive retained earning (or unassigned surplus) and therefore it may not paydividends at this time without the approval of the Massachusetts Commissionerof Insurance.

Pursuant to a TaxAllocation Agreement, dated as of January 1, 2001, by and among Tower,TICNY,TNIC and TRM, we compute and pay Federal income taxes on a consolidatedbasis. At the end of each consolidated return year, each entity must computeand pay to Tower its share of the Federal income tax liability primarily basedon separate return calculations. The tax allocation agreement with allows Towerto make certain Code elections in the consolidated Federal tax return. In theevent such Code elections are made, any benefit or liability is accrued or paidby each entity. If a unitary or combined state income tax return is filed, eachentity’s share of the liability is based on the methodology required orestablished by state income tax law or, if none, the percentage of each entity’sseparate income or tax divided by the total separate income or tax reported onthe return. During 2005, TICNY paid $10.0 million and TRM paid $0.7 million toTower under this agreement. 

***Cash Flows from IPO and Private Placement***

On October 20, 2004, we sold 13,000,000 shares inour IPO at $8.50 per share. On the same date, we also effected a concurrentprivate placement of 500,000 shares of our common stock to an affiliate ofFriedman, Billings, Ramsey & Co., Inc., the lead underwriter forour IPO, at a price of $8.50 per share. On November 10, 2004 theunderwriters exercised their 30-day over-allotment option after our IPO. Pursuantto this exercise, the underwriters purchased 629,007 additional shares ofcommon stock from us and 1,320,993 shares of common stock from sellingshareholders. We received net cash proceeds of $107,845,000 from the offeringand concurrent private placement after the underwriting discounts, commissionsand offering expenses. The total costs of the IPO and private placement were$12,252,000 of which $8,407,000 was for the underwriting discount, and$3,845,000 was for all other costs.

Immediately before the closing of the IPO on October 26,2004, the Company redeemed 30,000 shares of our Series A CumulativeRedeemable Preferred Shares for $1.5 million plus accrued interest. After theclosing the Company utilized some of the cash proceeds to pay off a $5.0million loan and accrued interest to CIT Group/Equipment Financing, Inc. TheCompany recognized a loss on early extinguishment of debt of $133,000 in thefourth quarter of 2004. 

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On October 26, 2004 we contributed $98,000,000 inPaid in Capital to TICNY, which in turn invested this cash in its fixed-incomeportfolio.

On June 8, 2005 theCompany contributed $10,000,000 in capital and surplus to TNIC. The gross paidin and contributed surplus at December 31, 2005 for TNIC includes$1,303,000 of intangible assets contributed by us consisting of purchase price,legal fees and broker fees incurred to acquire TNIC.

***Surplus Levels***

TICNY and TNIC are required by law to maintain acertain minimum level of policyholders’ surplus on a statutory basis. Policyholders’surplus is calculated by subtracting total liabilities from total assets. TheNAIC maintains risk based capital (“RBC”) requirements for property andcasualty insurance companies. RBC is a formula that attempts to evaluate theadequacy of statutory capital and surplus in relation to investments andinsurance risks. The formula is designed to allow the state insurancedepartments to identify potential weakly capitalized companies. Under theformula, a Company determines its “risk-based capital” by taking into accountcertain risks related to the insurer’s assets (including risks related to itsinvestment portfolio and ceded reinsurance) and the insurer’s liabilities(including underwriting risks related to the nature and experience of itsinsurance business). Applying the RBC requirements as of December 31,2005, TICNY’s and TNIC’s risk-based capital exceeded the minimum level thatwould trigger regulatory attention. In addition to monitoring RBC to ensureregulatory compliance, we monitor various financial ratios, including gross andnet premiums written to surplus ratios. There were no capital contributions toTICNY in 2005 and $98.0 million and $17.1 were contributed in 2004 and 2003,respectively. In June 2005, we contributed $10.0 million in cash to TNICand an additional $1.3 million for the state insurance licenses we acquired aspart of the 2005 purchase of a shell insurance company that was renamed TNIC.

The statutory surplus thatwe are required to maintain varies depending on the type and amount of revenuethat is derived. The statutory surplus requirements are based upon variouscapital adequacy tests and ratios established by rating agencies and insuranceregulators. Statutory surplus requirements are greater for net premiums earnedthan for premiums that we cede or transfer to reinsurers. Non-risk bearingrevenues that are generated primarily from TRM do not require us to maintainany surplus, except capital necessary to meet TRM’s operating expenses. Forthese reasons, throughout our history before the October 2004 IPO weattempted to reduce our statutory surplus requirement by limiting our netretention of premiums while emphasizing ceding commissions and non-risk bearingrevenues from TRM.

***Cash Flows***

The primary sources of cash flow in TICNY are grosspremiums written, reinsurance commissions from our quota share reinsurers, losspayments by our reinsurers, investment income and proceeds from the sale ormaturity of investments. Funds are used by TICNY for ceded premium payments,which are paid on a net basis after subtracting losses paid on reinsured claimsand reinsurance commissions. TICNY also uses funds for loss payments and lossadjustment expenses on our net business, commissions to producers, salaries andother underwriting expenses as well as to purchase investments and to paydividends to Tower. TRM’s primary sources of cash are premiums produced onbehalf of issuing companies and commission and fee income. TRM’s primary usesof cash are premium payments and fees to issuing companies, net of paid lossesand commission income, commissions to producers and expenses reimbursed toTICNY under an expense sharing agreement. 

TNIC’s primary sources of cash flow are from netinvestment income in that underwriting operations have not commenced as of December 31,2005.

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Our reconciliation of netincome to cash provided from operations is generally influenced by thecollection of premiums in advance of paid losses, the timing of reinsurance andissuing company settlements and the timing of our loss payments. 

*Comparison of YearsEnded December 31, 2005 and 2004*

For 2005, net cash provided by operating activitieswas $128.5 million compared to operating cash flow of $76.1 in 2004. Theincrease in net cash provided by operations in 2005 resulted from an increasein collected premiums as a result of the growth in gross premiums and thereduction in the effective quota share reinsurance ceding percentage from 41.6%in 2004 to 25% in 2005.

Net cash used by investing activities was $143.3million for the year ended December 31, 2005 compared to $177.0 in 2004due principally to the investment in securities with cash provided byoperations. 

In 2005, cash flows fromfinancing activities were a net use of funds of $1.6 million due principally todividend payments to stockholders. Cash flows from financing activities for2004 of $125.7 million included $107.8 million of net proceeds from the IPO andconcurrent private placement in the fourth quarter of 2004 and $26.0 million innet proceeds from the issuance of subordinated debentures in connection withofferings of trust preferred securities in December 2004. In 2004, werepaid $5.6 million of notes payable and redeemed all of our Series Acumulative redeemable preferred shares for $3.0 million. Additionally theCompany collected its employee notes receivable balance of $1.4 million before December 31,2004. The Company paid stockholder dividends of $2.0 million and $1.2 millionin 2005 and 2004, respectively.

*Comparison of YearsEnded December 31, 2004 and 2003*

For the year ended December 31, 2004**net cash provided by operating activities**was $76.1 million compared to operatingcash flow of $22.7 million in 2003. The increase in net cash provided byoperations in 2004 resulted from an increase in collected premiums as a resultof the growth in gross premiums and the reduction in the effective quota sharereinsurance ceding percentage from 77.2% in 2003 to 41.6% in 2004, an increaseof $29.2 million in funds withheld as collateral for reinsurance recoverableand a $15.7 million collection of a receivable for cancelled reinsurance. 

Net cash used by investing activities was $177.0million for the year ended December 31, 2004, compared to $19.0 million in2003 due principally to the investment of $98.0 million of IPO proceeds contributedto and invested by TICNY and cash provided by operations.

Cash flows from financingactivities for 2004 of $125.7 million included $107.8 million of net proceedsfrom the IPO and concurrent private placement in the fourth quarter of 2004 and$26.0 million in net proceeds from the issuance of subordinated debentures inconnection with offerings of trust preferred securities in December, 2004. In2004, we repaid $5.6 million of notes payable and redeemed all of our Series Acumulative redeemable preferred shares for $3.0 million. Additionally, theCompany collected its employee notes receivable balance of $1.4 million before December 31,2004. The Company paid stockholder dividends of $1.2 million and $1.8 millionin 2004 and 2003, respectively.

***Liquidity***

We maintain sufficientliquidity to pay claims, operating expenses and meet our other obligations. Weheld $38.8 million and $55.23 million of cash and cash equivalents at December 31,2005 and 2004, respectively, which included $26.1 and $34.9 million,respectively, which were of short-term duration of less than ninety days andwere recorded as cash equivalents on the balance sheet. We monitor our expectedclaims payment needs and maintain a sufficient portion of our invested assetsin cash and cash equivalents to enable us to fund our claims payments withouthaving to sell longer-duration investments. As of 

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December 31,2005, cash and cash equivalents greatly exceeded the estimated $24.7 million ofnet loss reserves as of that date that we expected to pay within the next year.As necessary, we adjust our holdings of short-term investments and cash andcash equivalents to provide sufficient liquidity to respond to changes in theanticipated pattern of claims payments. See “Item 1.—Investments”.

***Commitments***

Thefollowing table summarizes information about contractual obligations andcommercial commitments. The minimum payments under these agreements as of December 31,2005 were as follows: 

| ** **                        | ** ** | **Payments due by period** | ** **  |
|-----------------------------------|------------|-------------------------------------------|-------------|
| ** **                        | ** ** | **Total**                                 | ** **  | **Less than  1 year** | ** ** | **1-3  years** | ** ** | **4-5  years** | ** ** | **After 5  years** | ** ** |
| ** **                        | ** ** | **($ in thousands)**            | ** **  |
| Subordinated  debentures          |       | $                                         | 47,426      |   |   | $ | — |   |   | $ | — |   | $ | — |   | $ | 47,426 |   |
| Operating lease  obligations      |       | 48,592                                    |        |   | 1,953 |   |   | 6,692 |   | 6,523 |   | 33,424 |   |
| Net loss reserves                 |       | 101,746                                   |        |   | 24,675 |   |   | 41,116 |   | 21,855 |   | 14,100 |   |
| **Total contractual obligations** | ** ** | **$**                                     | **197,764** | ** ** | ** ** | **$** | **26,628** |   | ** ** | **$** | **47,808** | ** ** | **$** | **28,378** | ** ** | **$** | **94,950** | ** ** |

 

The net loss reservespayments due by period in the table above are based upon the loss and lossexpense reserves estimates as of December 31, 2005 and actuarial estimatesof expected payout patterns by line of business. As a result, our calculationof loss reserve payments due by period is subject to the same uncertaintiesassociated with determining the level of reserves and to the additionaluncertainties arising from the difficulty of predicting when claims (includingclaims that have not yet been reported to us) will be paid. For a discussion ofour reserving process. See “Item 1.—Loss and Loss Adjustment Expense Reserves”. Actualpayments of loss and loss adjustment expenses by period will vary, perhapsmaterially, from the above table to the extent that current estimates of lossreserves vary from actual ultimate claims amounts and as a result of variationsbetween expected and actual payout patterns. See “Item 1A.—Risks Related to Our Business—Ifour actual loss and loss adjustment expenses exceed our loss reserves, ourfinancial condition and results of operations could be significantlyaffected”, for a discussion of the uncertainties associated with estimatingloss and loss adjustment expense reserves. This payment pattern also assumestimely reimbursement from our reinsurers. If our reinsurers do not meet theircontractual obligations or a timely basis, the payment assumptions presentedabove could vary materially.

***Capital Resources***

In 2003, we formedtwo statutory business trusts and we own all of the common trust securities ofeach trust. The trusts issued $20.0 million of trust preferred securities inprivate placements and invested the proceeds thereof and the proceeds from thesale of common trust securities in exchange for $20.6 million of juniorsubordinated debentures issued by our holding company. In December 2004,we formed two additional statutory business trusts and we own all of the commonsecurities of each of those trusts. The trusts issued $26 million of trustpreferred securities in a private placement and invested the proceeds thereofand the proceeds from the sale of common trust securities in exchange for $26.8million of junior subordinated debentures issued by our holding company. All ofthe debentures have stated maturities of thirty years. We have the option tocall any or all of the securities at par beginning five years from the date ofissuance. The interest rate on $10.3 million of the subordinated debenturesissued in May 2003 will float quarterly for changes in the three monthLondon Interbank Offered Rate (“LIBOR”) plus 4.1% and may not exceed 12.5%prior to the first call date of May 15, 2008. The interest rate on $10.3million of subordinated debentures issued in September 2003 is acombination fixed and floating rate with a fixed rate of 7.5% during the nocall period of five years after which the interest rate will float quarterlyfor changes in the three month LIBOR interest rate plus 4%. The interest rateon $13.4 million of subordinated debentures issued on December 17, 2004 isfixed at 7.4% for the first five years after which 

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theinterest rate will float quarterly for changes in the three month LIBORinterest rate plus 3.4%. The interest rate on $13.4 million of subordinateddebentures issued on December 21, 2004 will float based on the three monthLIBOR interest rate plus 3.4%. Under the terms for all of the trust preferredsecurities, an event of default may occur upon:

·       non-paymentof interest on the trust preferred securities, unless such non-payment is dueto a valid extension of an interest payment period;

·       non-paymentof all or any part of the principal of the trust preferred securities;

·       ourfailure to comply with the covenants or other provisions of the indentures orthe trust preferred securities; or

·       bankruptcyor liquidation of us or of either of the financing trusts through which thetrust preferred securities were issued.

If an event of defaultoccurs and is continuing, the entire principal and the interest accrued thereonmay be declared to be due and payable immediately.

Pursuant to the terms ofour subordinated debentures, Tower and its subsidiaries cannot declare or payany dividends if we are in default or have elected to defer payments ofinterest on the subordinated debentures.

***Off Balance SheetArrangements***

We have posted anirrevocable letter of credit for $2.0 million for the benefit of OneBeaconInsurance Group LLC (“OneBeacon”) representing the estimated commissions due toOneBeacon for the first year of the Commercial Renewal Rights Agreement dated September 13,2004.

***Inflation***

Property and casualtyinsurance premiums are established before we know the amount of losses and lossadjustment expenses or the extent to which inflation may affect such amounts. Weattempt to anticipate the potential impact of inflation in establishing ourreserves. Inflation in excess of the levels we have assumed could cause lossand loss adjustment expenses to be higher than we anticipated.

Substantial futureincreases in inflation could also result in future increases in interest rates,which in turn are likely to result in a decline in the market value of theinvestment portfolio and cause unrealized losses or reductions in stockholders’equity.

**Item7A.**                QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk is the risk that we will incur losses inour investments due to adverse changes in market rates and prices. Market riskis directly influenced by the volatility and liquidity in the market in whichthe related underlying assets are invested. We believe that we are principallyexposed to three types of market risk: changes in interest rates, changes incredit quality of issuers of investment securities and reinsurers, and changesin equity prices.

***Credit Risk***

Our credit risk is the potential loss in market valueresulting from adverse change in the borrower’s ability to repay itsobligations. Our investment objectives are to preserve capital, generateinvestment income and maintain adequate liquidity for the payment of claims anddebt service. We seek to achieve these goals by investing in a diversifiedportfolio of securities. We manage credit risk through regular review andanalysis of the creditworthiness of all investments and potential investments.

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We also bear credit riskon our reinsurance recoverables and premiums ceded to reinsurers. As of December 31,2005, we had unsecured reinsurance recoverables of $33.2 million owed by PXREReinsurance Company, $18.3 million owed by American Re-Insurance Company and$7.2 million owed by other reinsurers. If any of these reinsurers fails to payits obligations to us, or substantially delays making payments on thereinsurance recoverables, our financial condition and results of operationscould be materially impaired. To mitigate the credit risk associated withreinsurance recoverables, we secure certain of our reinsurance recoverables bywithholding ceded premium and requiring funds to be placed in trust as well asmonitoring our reinsurers’ financial condition and rating agency ratings andoutlook. See “Item 1.—Reinsurance”. In September 2004, A.M. Bestdowngraded the rating of Converium to “B-” (Fair) and Converium was placed intorun-off by its parent company. As a result, in September 2004, wedelivered notice to Converium under our quota share treaty of our intent toterminate their participation under the quota share treaty on a cut-off basiseffective November 1, 2004. Subsequently we reached an agreement withConverium, Tokio Millenium Re Ltd. (“Tokio Millenium”) and Hannover Reinsurance(Ireland) Ltd. and E+S Reinsurance (Ireland) Ltd. (collectively “Hannover”) toeffect a novation of Converium’s quota share treaty to those other reinsurerseffective January 1, 2004, as a result of which Tokio and Hannover agreedto each take 50% of Converium’s share under the quota share treaty. Inconnection with the agreement, Tokio, Hannover and TICNY agreed to fullyrelease Converium for any liabilities under the quota share treaty. As a resultof the novation, we did not retain, and Tokio and Hannover assumed, the earnedpremiums and risks for the period from November 1, 2004 through December 31,2004 that we would have retained if the Converium treaty had been terminatedeffective November 1, 2004. However, we decided to retain the unearnedpremiums and risks as of December 31, 2004 that would have been ceded toConverium absent the termination. See “Item 1.—Reinsurance—2004 Reinsurance Program”.

On February 16, 2006, A.M.Best downgraded to “B++” (Very Good)  itsformer “A-” (Excellent)  financialstrength rating on PXRE and issued a negative outlook. On February 24,2006 downgraded PXRE to “B+ (Very Good) with a negative outlook. We believethat the unsecured reinsurance recoverables and ceding commissions receivablefrom PXRE, none of which are past due nor in dispute, are fully collectible. Ourjudgment is based on PXRE’s capital position as a result of its recent capitalraising initiatives.

We also bear credit risk for premiums produced by TRMand a limited portion, generally a deposit amount, of the direct premiumswritten by TICNY. Producers collect such premiums and remit them to the Companywithin prescribed periods. After receiving a deposit, the TICNY premiums aredirectly billed to insureds. In New York State and other jurisdictions,premiums paid to producers by an insured may be considered to have been paidunder applicable insurance laws and regulations and the insured will no longerbe liable to us for those amounts, whether or not we have actually received thepremium payment from the producer. Consequently, we assume a degree of creditrisk associated with producers. Due to the unsettled and fact specific natureof the law, we are unable to quantify our exposure to this risk.

***Equity Risk***

Equity risk is the risk that we may incur economiclosses due to adverse changes in equity prices. Our exposure to changes inequity prices primarily results from our holdings of common stocks, mutualfunds and other equities. Our portfolio of equity securities available for saleare carried on the balance sheet at fair value. Since only a small percentageof our assets are invested in equity securities, we do not believe that ourexposure to equity price risk is significant.

***Interest Rate Risk***

Interest rate risk is therisk that we may incur economic losses due to adverse changes in interest rates.The primary market risk to the investment portfolio is interest rate riskassociated with investments in 

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fixed maturity securities.Fluctuations in interest rates have a direct impact on the market valuation ofthese securities. The fair value of our fixed maturity securities as of December 31,2005 was $326.7 million.

For fixed maturitysecurities, short-term liquidity needs and the potential liquidity needs forthe business are key factors in managing our portfolio. We use modifiedduration analysis to measure the sensitivity of the fixed income portfolio tochanges in interest rates.

As of December 31, 2005, we had a total of $23.7million of outstanding floating rate debt all of which is outstandingsubordinated debentures underlying our trust securities issued by our whollyowned statutory business trusts carrying an interest rate that is determined byreference to market interest rates. If interest rates increase, the amount ofinterest payable by us would also increase.

***SensitivityAnalysis***

Sensitivity analysis is ameasurement of potential loss in future earnings, fair values or cash flows ofmarket sensitive instruments resulting from one or more selected hypotheticalchanges in interest rates and other market rates or prices over a selected time.In our sensitivity analysis model, we select a hypothetical change in marketrates that reflects what we believe are reasonably possible near-term changesin those rates. The term “near-term” means a period of time going forward up toone year from the date of the consolidated financial statements. Actual resultsmay differ from the hypothetical change in market rates assumed in thisdisclosure, especially since this sensitivity analysis does not reflect theresults of any action that we may take to mitigate such hypothetical losses infair value.

In this sensitivityanalysis model, we use fair values to measure our potential loss. Thesensitivity analysis model includes fixed maturities and short-terminvestments.

For invested assets, weuse modified duration modeling to calculate changes in fair values. Durationson invested assets are adjusted for call, put and interest rate reset features.Durations on tax-exempt securities are adjusted for the fact that the yield onsuch securities is less sensitive to changes in interest rates compared toTreasury securities. Invested asset portfolio durations are calculated on amarket value weighted basis, including accrued investment income, usingholdings as of December 31, 2005.

The following tablesummarizes the estimated change in fair value on our fixed maturity portfolioincluding short-term investments based on specific changes in interest rates asof December 31, 2005:

| **Change in Interest Rate** | ** ** | ** ** | ** ** | **Estimated Increase  (Decrease) in Fair Value  ($ in thousands)** | ** ** | **Estimated Percentage  Increase (Decrease)   in Fair Value** | ** ** |
|--------------------------------------------|------------|------------|------------|--------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| 300 basis point  rise                      |       |       | (40,967    | )                                                                                                |       |                                                                                   | (12.5      | %) |   |
| 200 basis rise                             |       |       | (27,844    | )                                                                                                |       |                                                                                   | (8.5       | %) |   |
| 100 basis rise                             |       |       | (14,133    | )                                                                                                |       |                                                                                   | (4.3       | %) |   |
| As of December 31,  2005              |       |       | 0          |                                                                                             |       |                                                                                   | 0.0        | % |   |
| 50 basis point  decline                    |       |       | 7,017      |                                                                                             |       |                                                                                   | 2.1        | % |   |
| 100 basis point decline                    |       |       | 13,839     |                                                                                             |       |                                                                                   | 4.2        | % |   |

 

The sensitivity analysismodel used by us produces a predicted pre-tax loss in fair value ofmarket-sensitive instruments of $14.1 million or 4.3% based on a 100 basispoint increase in interest rates as of December 31, 2005. This loss amountonly reflects the impact of an interest rate increase on the fair value of ourfixed maturities investments which constituted approximately 91.0% of our totalinvested assets as of December 31, 2005.

Interest expense wouldalso be affected by a hypothetical change in interest rates. As of December 31,2005 we had $23.7 million of floating rate debt obligations. Assuming thisamount remains constant, a hypothetical 100 basis point increase in interestrates would increase annual interest expense by $237,000, a 

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200 basis point increasewould increase interest expense by $474,000 and a 300 basis point increasewould increase interest expense by $711,000.

With respect to investmentincome, the most significant assessment of the effects of hypothetical changesin interest rates on investment income would be based on Statement of FinancialAccounting Standards No. 91,*Accounting forNonrefundable Fees and Costs Associated with Originating or Acquiring Loans andInitial Direct Costs of Leases*(“FAS 91”), issued by the FinancialAccounting Standards Board (“FASB”), which requires amortization adjustmentsfor mortgage backed securities. The rates at which the mortgages underlyingmortgage backed securities are prepaid, and therefore the average life ofmortgage backed securities, can vary depending on changes in interest rates(for example, mortgages are prepaid faster and the average life of mortgage backedsecurities falls when interest rates decline). The adjustments for changes inamortization, which are based on revised average life assumptions, would havean impact on investment income if a significant portion of our mortgage backedsecurities holdings had been purchased at significant discounts or premiums topar value. As of December 31, 2005, the par value of our mortgage backedsecurities holdings was $101.8 million and the book value of our mortgagebacked securities holdings was $98.8 million. This equates to an average priceof 97.0% of par. Since few of our mortgage backed securities were purchased atmore than three points (below 97% and above 103%) from par, a FAS 91 adjustmentwould not have a significant effect on investment income.

Furthermore, significanthypothetical changes in interest rates in either direction would not have asignificant effect on principal redemptions, and therefore investment income,because of the prepayment protected mortgage securities in the portfolio. Themortgage backed securities portion of the portfolio totaled 25.2% as of December 31,2005. Of this total, only 1.9% was in agency pass through securities, whichhave the highest amount of prepayment risk from declining rates. The remainderof our mortgage backed securities portfolio is invested in agency plannedamortization class collateralized mortgage obligations, non-agency residentialnon-accelerating securities, and commercial mortgage backed securities.

The planned amortizationclass collateralized mortgage obligation securities maintain their average lifeover a wide range of prepayment assumptions, while the non-agency residentialnon-accelerating securities have five years of principal lock-out protectionand the commercial mortgage backed securities have very onerous prepayment andyield maintenance provisions that greatly reduce the exposure of thesesecurities to prepayments.

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**ITEM 8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

**Indexto Consolidated Financial Statements**

|                                                                                                                            | ** ** | **Page** |
|----------------------------------------------------------------------------------------------------------------------------|------------|----------|
| Management Report on  Internal Control Over Financial Reporting                                                            |       | 88       |
| Report of Independent  Registered Public Accounting Firm—Internal Control Over Financial Reporting                    |       | 89       |
| Report of Independent  Registered Public Accounting Firm—Consolidated Financial Statements                            |       | 90       |
| Consolidated Balance  Sheets at December 31, 2005 and 2004                                                            |       | 91-92    |
| Consolidated Statements  of Income and Comprehensive Net Income for the years ended December 31,  2005, 2004 and 2003 |       | 93       |
| Consolidated Statements  of Stockholders’ Equity for the years ended December 31, 2005, 2004 and  2003           |       | 94       |
| Consolidated Statements  of Cash Flows for the years ended December 31, 2005, 2004 and 2003                           |       | 95-96    |
| Notes to Consolidated Financial Statements                                                                                 |       | 97       |

 

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**CONSOLIDATED FINANCIAL STATEMENTS**

**Management’s Annual Report on Internal Control OverFinancial Reporting**

Management of Tower Group, Inc. (together withits consolidated subsidiaries, the “Company”) is responsible for establishingand maintaining adequate internal control over financial reporting. Managementconducted an assessment of the effectiveness, as of December 31, 2005, ofthe Company’s internal control over financial reporting, based on the frameworkestablished in *Internal Control-Integrated Framework Issuedby the Committee Sponsoring Organizations of the Treadway Commission*  (COSO). Based on our assessment under thatframework, management concluded that the Company’s internal control overfinancial reporting was effective as of December 31, 2005.

Our internal control over financial reporting is aprocess designed by or under the supervision of our principal executive andprincipal financial officers to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accountingprinciples. Our internal control over financial reporting includes policies andprocedures that(1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect transactions and dispositionsof assets; (2) provide reasonable assurance that transactions are recordedas necessary to permit preparation of financial statements in accordance withgenerally accepted accounting principles, and that receipts and expendituresare being made only in accordance with authorizations of management and thedirectors of the Company; and (3) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use, or dispositionof the Company’s assets that could have a material effect on our financialstatements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements.

Management’s assessment ofthe effectiveness of the Company’s internal control over financial reporting asof December 31, 2005 has been audited by Johnson Lambert & Co.,an independent registered accounting firm, as stated in their report includedherein, which expresses unqualified opinions on management’s assessment and onthe effectiveness of the Company’s internal control over financial reporting asof December 31, 2005.

February 17, 2006

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**Reportof Independent Registered Public Accounting Firm**

To the Board of DirectorsTower Group, Inc.

We have audited management’sassessment, included in the accompanying Management’s Annual Report on InternalControl Over Financial Reporting, that Tower Group, Inc and subsidiaries (the “Company”)maintained effective internal control over financial reporting as of December 31,2005, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO). The Company’s management is responsible for maintaining effective internalcontrol over financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting. Our responsibility is to express anopinion on management’s assessment and an opinion on the effectiveness of thecompany’s internal control over financial reporting based on our audit.

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether effective internal control overfinancial reporting was maintained in all material respects. Our audit includedobtaining an understanding of internal control over financial reporting,evaluating management’s assessment, testing and evaluating the design andoperating effectiveness of internal control, and performing such otherprocedures as we considered necessary in the circumstances. We believe that ouraudit provides a reasonable basis for our opinion.

A company’s internal controlover financial reporting is a process designed to provide reasonable assuranceregarding the reliability of financial reporting and the preparation offinancial statements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control over financialreporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

In our opinion, management’sassessment that the Company maintained effective internal control overfinancial reporting as of December 31, 2005, is fairly stated, in allmaterial respects, based on criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO). Also, in our opinion, the Company maintained, in allmaterial respects, effective internal control over financial reporting as of December 31,2005, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO).

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheets of the Company as of December 31,2005 and 2004, and the related consolidated statements of income andcomprehensive net income, changes in stockholders’ equity, and cash flows foreach of the three years in the period ended December 31, 2005 and ourreport dated February 17, 2006 expressed an unqualified opinion thereon.

/s/ JOHNSON LAMBERT &CO.

Reston, Virginia February 17, 2006

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

To the Board of DirectorsTower Group, Inc.

We have audited the accompanying consolidated balancesheets of Tower Group, Inc. and subsidiaries (the “Company”) as of December 31,2005 and 2004 and the related consolidated statements of income andcomprehensive net income, changes in stockholders’ equity and cash flows foreach of the three years in the period ended December 31, 2005. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the Company’s financial statementspresent fairly, in all material respects, the financial position of the Companyas of December 31, 2005 and 2004, and the results of its operations andits cash flows for the three years in the period ended December 31, 2005in conformity with accounting principles generally accepted in the UnitedStates.

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of the Company’s internal control overfinancial reporting as of December 31, 2005 based on criteria establishedin Internal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO) and our report dated February 17,2006 expressed an unqualified opinion thereon.

/s/ JOHNSON LAMBERT &CO.

Reston, VirginiaFebruary 17, 2006

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**TOWER GROUP, INC.CONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                            | ** ** | **December 31,**          | ** **  |
|-----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|-------------|
| ** **                                                                                                            | ** ** | **2005**                       | ** **  | **2004** | ** ** |
| ** **                                                                                                            | ** ** | **($ in thousands)** | ** **  |
| **Assets**                                                                                                            | ** ** | ** **                     | ** **  | ** ** | ** ** |
| Fixed-maturity  securities, available-for-sale, at fair value  (amortized cost $331,123 in 2005 and $223,562 in 2004) |       | $                              | 326,681     |   | $ | 224,523 |   |
| Equity  securities, available-for-sale, at fair value (cost $6,681 in  2005 and $1,827 in 2004)                       |       | 5,934                          |        | 2,485 |   |
| Equity  securities, at cost                                                                                           |       | 24,558                         |        | — |   |
| Common trust  securities—statutory business trusts, equity method                                                |       | 1,426                          |        | 1,426 |   |
| **Total investments**                                                                                                 |       | 358,599                        |        | 228,434 |   |
| Cash and cash  equivalents                                                                                            |       | 38,760                         |        | 55,201 |   |
| Investment income  receivable                                                                                         |       | 3,337                          |        | 1,975 |   |
| Agents’ balances  receivable                                                                                     |       | 46,004                         |        | 33,473 |   |
| Assumed premiums  receivable                                                                                          |       | 1,076                          |        | 1,197 |   |
| Ceding commission  receivable                                                                                         |       | 8,727                          |        | 8,329 |   |
| Reinsurance recoverable                                                                                               |       | 104,811                        |        | 101,173 |   |
| Receivable—claims  paid by agency                                                                                |       | 2,309                          |        | 1,622 |   |
| Prepaid  reinsurance premiums                                                                                         |       | 43,319                         |        | 28,391 |   |
| Deferred  acquisition costs net of deferred ceding commission revenue                                                 |       | 29,192                         |        | 18,740 |   |
| Federal income  taxes and state taxes recoverable                                                                     |       | 365                            |        | 1,975 |   |
| Deferred income  taxes                                                                                                |       | 3,204                          |        | — |   |
| Intangible assets                                                                                                     |       | 5,835                          |        | 4,978 |   |
| Fixed assets, net  of accumulated depreciation                                                                        |       | 7,920                          |        | 5,420 |   |
| Other assets                                                                                                          |       | 3,999                          |        | 3,239 |   |
| **Total  Assets**                                                                                                     | ** ** | **$**                          | **657,457** |   | **$** | **494,147** | ** ** |

 

*(Continued)*

See accompanying notes to the consolidated financial statements.

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**TOWER GROUP, INC.CONSOLIDATED BALANCE SHEETS (Continued)**

| ** **                                                                                                                         | ** ** | **December 31,**                                                                        | ** **  |
|------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------|-------------|
| ** **                                                                                                                         | ** ** | **2005**                                                                                     | ** **  | **2004** | ** ** |
| ** **                                                                                                                         | ** ** | **($ in thousands, except  par value and share amounts)** | ** **  |
| **Liabilities**                                                                                                                    |       |                                                                                         |        |   |   |
| Loss and loss adjustment  expenses                                                                                                 |       | $                                                                                            | 198,724     |   | $ | 128,722 |   |
| Unearned premium                                                                                                                   |       | 157,779                                                                                      |        | 95,505 |   |
| Reinsurance balances  payable                                                                                                      |       | 19,200                                                                                       |        | 2,735 |   |
| Payable to issuing  carriers                                                                                                       |       | 5,252                                                                                        |        | 18,652 |   |
| Funds held as agent                                                                                                                |       | 8,191                                                                                        |        | 785 |   |
| Funds held under  reinsurance agreements                                                                                           |       | 59,042                                                                                       |        | 54,152 |   |
| Accounts payable and  accrued expenses                                                                                             |       | 13,694                                                                                       |        | 12,410 |   |
| Other liabilities                                                                                                                  |       | 2,867                                                                                        |        | 2,726 |   |
| Federal income taxes  payable                                                                                                      |       | 460                                                                                          |        | — |   |
| Deferred income taxes                                                                                                              |       | —                                                                                       |        | 1,587 |   |
| Subordinated debentures                                                                                                            |       | 47,426                                                                                       | ** **  | 47,426 | ** ** |
| **Total Liabilities**                                                                                                              | ** ** | **512,635**                                                                                  | ** **  | **364,700** | ** ** |
| **Stockholders’ Equity**                                                                                                      |       |                                                                                         |        |   |   |
| Common stock ($0.01 par  value per share; 40,000,000 shares authorized, 19,872,672 and 19,826,135  shares issued in 2005 and 2004) |       | 199                                                                                          |        | 198 |   |
| Paid-in-capital                                                                                                                    |       | 112,531                                                                                      |        | 112,375 |   |
| Accumulated other  comprehensive net income                                                                                        |       | (3,352                                                                                       | )           | 1,052 |   |
| Retained earnings                                                                                                                  |       | 37,019                                                                                       |        | 18,224 |   |
| Unearned  compensation—restricted stock                                                                                       |       | (1,465                                                                                       | )           | (1,908 | ) |
| Treasury stock (17,881  shares in 2005 and 88,967 in 2004)                                                                         |       | (110                                                                                         | )           | (494 | ) |
| **Total Stockholders’ Equity**                                                                                                | ** ** | **144,822**                                                                                  | ** **  | **129,447** | ** ** |
| **Total Liabilities and  Stockholders’ Equity**                                                                               | ** ** | **$**                                                                                        | **657,457** | ** ** | **$** | **494,147** | ** ** |

 

See accompanying notes to the consolidated financial statements.

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**TOWER GROUP, INC.CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE NET INCOME**

| ** **                                                                       | ** ** | **Year Ended December 31,**                                                   | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2005**                                                                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                       | ** ** | **($ in thousands, except per  share and share amounts)** | ** ** |
| **Revenues**                                                                     | ** ** | ** **                                                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net premiums earned                                                              |       | $                                                                                            | 164,436    |   | $ | 45,564 |   | $ | 22,941 |   |
| Ceding commission revenue                                                        |       | 25,218                                                                                       |       | 39,983 |   | 35,605 |   |
| Insurance services revenue                                                       |       | 14,103                                                                                       |       | 16,381 |   | 12,830 |   |
| Net investment income                                                            |       | 14,983                                                                                       |       | 5,070 |   | 2,268 |   |
| Net realized gains on investments                                                |       | 122                                                                                          |       | 13 |   | 493 |   |
| Policy billing fees                                                              |       | 892                                                                                          |       | 679 |   | 545 |   |
| Total revenues                                                                   |       | 219,754                                                                                      |       | 107,690 |   | 74,682 |   |
| **Expenses**                                                                     |       |                                                                                         |       |   |   |   |   |
| Loss and loss adjustment expenses                                                |       | 96,614                                                                                       |       | 27,060 |   | 15,071 |   |
| Direct commission expense                                                        |       | 43,839                                                                                       |       | 32,825 |   | 26,158 |   |
| Other operating expenses                                                         |       | 42,632                                                                                       |       | 29,954 |   | 22,337 |   |
| Interest expense                                                                 |       | 4,853                                                                                        |       | 3,128 |   | 1,462 |   |
| Total expenses                                                                   |       | 187,938                                                                                      |       | 92,967 |   | 65,028 |   |
| Income before income taxes                                                       |       | 31,816                                                                                       |       | 14,723 |   | 9,654 |   |
| Income tax expense                                                               |       | 11,062                                                                                       |       | 5,694 |   | 3,374 |   |
| **Net income**                                                                   | ** ** | **$**                                                                                        | **20,754** | ** ** | **$** | **9,029** | ** ** | **$** | **6,280** | ** ** |
| **Comprehensive  Net Income**                                                    |       |                                                                                         |       |   |   |   |   |
| Net income                                                                       |       | $                                                                                            | 20,754     |   | $ | 9,029 |   | $ | 6,280 |   |
| Other  comprehensive income:                                                     |       |                                                                                         |       |   |   |   |   |
| Gross unrealized investment holding (losses) gains  arising during period        |       | (6,664                                                                                       | )          | 44 |   | 617 |   |
| Less: reclassification adjustment for net realized  gains included in net income |       | (122                                                                                         | )          | (13 | ) | (493 | ) |
|                                                                             |       | (6,786                                                                                       | )          | 31 |   | 124 |   |
| Income tax benefit (expense) related to items of  other comprehensive income     |       | 2,382                                                                                        |       | (27 | ) | (42 | ) |
| Total other comprehensive net (losses) income                                    |       | (4,404                                                                                       | )          | 4 |   | 82 |   |
| **Comprehensive Net Income**                                                     | ** ** | **$**                                                                                        | **16,350** | ** ** | **$** | **9,033** | ** ** | **$** | **6,362** | ** ** |
| **Earnings Per Share**                                                           |       |                                                                                         |       |   |   |   |   |
| Basic earnings per common share                                                  |       | $                                                                                            | 1.06       |   | $ | 1.23 |   | $ | 1.37 |   |
| Diluted earnings per common share                                                |       | $                                                                                            | 1.03       |   | $ | 1.06 |   | $ | 1.09 |   |
| **Weighted Average Common Shares  Outstanding:**                                 |       |                                                                                         |       |   |   |   |   |
| Basic                                                                            |       | 19,571,081                                                                                   |       | 7,335,286 |   | 4,453,717 |   |
| Diluted                                                                          |       | 20,147,073                                                                                   |       | 8,565,815 |   | 5,708,016 |   |

 

See accompanying notes to the consolidated financial statements.

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**TOWER GROUP, INC.CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY**

| ** **                                                                       | ** ** | **Common  Stock**              | ** ** | **Class A  Common  Stock** | ** ** | **Class B  Common  Stock** | ** ** | **Paid-in  Capital** | ** ** | **Accumulated  Other  Comprehensive  Net Income** | ** ** | **Retained  Earnings** | ** ** | **Unearned  Compensation-  Restricted  Stock** | ** ** | **Treasury  Stock** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------|------------|---------------------------------|------------|---------------------------------|------------|----------------------|------------|--------------------------------------------------------|------------|------------------------|------------|------------------------------------------------|------------|---------------------|------------|---------------------------------------|------------|
| ** **                                                                       | ** ** | **($ in thousands)** | ** ** |
| **Balance  at December 31, 2002**                                           | ** ** |                           | **$**      | **45**                          | ** ** |                            |       | **$**                | **—** | ** **                                             |       |                   | **$**      | **—**                                     | ** ** |                | **$**      | **2,285**                             | ** ** |   | **$** | **966** | ** ** |   | **$** | **5,771** | ** ** |   | **$** | **—** | ** ** |   |   | **$** | **—** | ** ** |   |   | **$** | **9,067** | ** ** |   |
| Stock repurchase                                                                 |       |                           | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                         |       |                | —     |                                  |       | — |   |   | — |   |   |   | (514 | ) |   |   | (514 | ) |   |
| Capital restructuring                                                            |       |                           | (45        | )                               |       |                            | 21         |                 |       |                                                   | 24         |                   |       | —                                         |       |                | —     |                                  |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Dividends declared                                                               |       |                           | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                         |       |                | —     |                                  |       | (1,854 | ) |   | — |   |   |   | — |   |   |   | (1,854 | ) |   |
| Net income                                                                       |       |                           | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                         |       |                | —     |                                  |       | 6,280 |   |   | — |   |   |   | — |   |   |   | 6,280 |   |   |
| Net unrealized appreciation on securities available  for sale, net of income tax |       |                           | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                         |       |                | 82         |                                  |       | — |   |   | — |   |   |   | — |   |   |   | 82 |   |   |
| **Balance  at December 31, 2003**                                           |       |                           | —     |                            |       |                            | 21         |                 |       |                                                   | 24         |                   |       | 2,285                                          |       |                | 1,048      |                                  |       | 10,197 |   |   | — |   |   |   | (514 | ) |   |   | 13,061 |   |   |
| Capital restructuring                                                            |       |                           | 45         |                            |       |                            | (21        | )                    |       |                                                   | (24        | )                      |       | —                                         |       |                | —     |                                  |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Dividends declared                                                               |       |                           | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                         |       |                | —     |                                  |       | (1,002 | ) |   | — |   |   |   | — |   |   |   | (1,002 | ) |   |
| IPO and private placement, net proceeds                                          |       |                           | 141        |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | 107,704                                        |       |                | —     |                                  |       | — |   |   | — |   |   |   | — |   |   |   | 107,845 |   |   |
| Stock based compensation                                                         |       |                           | 3          |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | 2,395                                          |       |                | —     |                                  |       | — |   |   | (1,908 | ) |   |   | 20 |   |   |   | 510 |   |   |
| Warrant exercise                                                                 |       |                           | 9          |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | (9                                             | )          |                | —     |                                  |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Net income                                                                       |       |                           | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                         |       |                | —     |                                  |       | 9,029 |   |   | — |   |   |   | — |   |   |   | 9,029 |   |   |
| Net unrealized appreciation on securities available  for sale, net of income tax |       |                           | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                         |       |                | 4          |                                  |       | — |   |   | — |   |   |   | — |   |   |   | 4 |   |   |
| **Balance  at December 31, 2004**                                           | ** ** |                           | **198**    | ** **                      |       |                            | **—** | ** **           |       |                                                   | **—** | ** **             |       | **112,375**                                    | ** ** |                | **1,052**  | ** **                            |       | **18,224** | ** ** |   | **(1,908** | **)** |   |   | **(494** | **)** |   |   | **129,447** | ** ** |   |
| Dividends declared                                                               |       |                           | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                         |       |                | —     |                                  |       | (1,959 | ) |   | — |   |   |   | — |   |   |   | (1,959 | ) |   |
| Stock based compensation                                                         |       |                           | 1          |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | 482                                            |       |                | —     |                                  |       | — |   |   | 443 |   |   |   | (32 | ) |   |   | 894 |   |   |
| Warrant exercise                                                                 |       |                           | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | (326                                           | )          |                | —     |                                  |       | — |   |   | — |   |   |   | 416 |   |   |   | 90 |   |   |
| Net income                                                                       |       |                           | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                         |       |                | —     |                                  |       | 20,754 |   |   | — |   |   |   | — |   |   |   | 20,754 |   |   |
| Net unrealized depreciation on securities available  for sale, net of income tax |       |                           | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                         |       |                | (4,404     | )                                     |       | — |   |   | — |   |   |   | — |   |   |   | (4,404 | ) |   |
| **Balance at December 31,  2005**                                           | ** ** |                           | **$**      | **199**                         |       |                            |       | $                    | —     |                                                   |       |                   | $          | —                                         |       |                | $          | 112,531                               |       |   | $ | (3,352 | ) |   | $ | 37,019 |   |   | $ | (1,465 | ) |   |   | $ | (110 | ) |   |   | $ | 144,822 |   |   |

 

See accompanying notes to the consolidated financial statements.

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**TOWER GROUP, INC.CONSOLIDATED STATEMENTSOF CASH FLOWS**

| ** **                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                         | ** ** | **($ in thousands)**             | ** ** |
| **Cash flows from operating  activities:**                                         |       |                                       |       |   |   |   |   |
| Net income                                                                         |       | $                                          | 20,754     |   | $ | 9,029 |   | $ | 6,280 |   |
| Adjustments to  reconcile net income to net cash provided by (used in) operations: |       |                                       |       |   |   |   |   |
| Gain on sale of investments                                                        |       | (122                                       | )          | (13 | ) | (493 | ) |
| Depreciation                                                                       |       | 2,870                                      |       | 1,984 |   | 1,142 |   |
| Amortization of intangible assets                                                  |       | 446                                        |       | 22 |   | — |   |
| Amortization of bond premium or discount                                           |       | 948                                        |       | 365 |   | 24 |   |
| Amortization of debt issuance costs                                                |       | 39                                         |       | 178 |   | 28 |   |
| Amortization of restricted stock                                                   |       | 618                                        |       | 310 |   | — |   |
| Deferred income taxes                                                              |       | (2,409                                     | )          | 3,595 |   | 629 |   |
| (Increase) decrease in  assets:                                                    |       |                                       |       |   |   |   |   |
| Investment income receivable                                                       |       | (1,362                                     | )          | (1,423 | ) | (159 | ) |
| Agents’ balances receivable                                                   |       | (12,531                                    | )          | (11,521 | ) | (2,002 | ) |
| Assumed premiums receivable                                                        |       | 121                                        |       | (200 | ) | 56 |   |
| Receivable for cancelled reinsurance                                               |       | —                                     |       | 15,748 |   | (15,748 | ) |
| Ceding commissions receivable                                                      |       | (398                                       | )          | (346 | ) | 1,321 |   |
| Reinsurance recoverable                                                            |       | (4,325                                     | )          | (16,223 | ) | (29,944 | ) |
| Prepaid reinsurance premiums                                                       |       | (14,928                                    | )          | 27,254 |   | (7,226 | ) |
| Deferred acquisition costs, net                                                    |       | (10,452                                    | )          | (18,168 | ) | (4,067 | ) |
| Federal and state income taxes recoverable                                         |       | 2,070                                      |       | (2,102 | ) | — |   |
| Intangible assets                                                                  |       | (1,302                                     | )          | (5,000 | ) | — |   |
| Other assets                                                                       |       | (600                                       | )          | (2,029 | ) | (819 | ) |
| Increase (decrease) in  liabilities:                                               |       |                                       |       |   |   |   |   |
| Loss and loss adjustment expenses                                                  |       | 70,002                                     |       | 29,247 |   | 33,787 |   |
| Unearned premium                                                                   |       | 62,274                                     |       | 25,257 |   | 13,235 |   |
| Checks outstanding                                                                 |       | 141                                        |       | (2,209 | ) | 1,316 |   |
| Reinsurance balances payable                                                       |       | 16,465                                     |       | (18,053 | ) | (349 | ) |
| Payable to issuing carriers                                                        |       | (13,400                                    | )          | 5,926 |   | 4,369 |   |
| Accounts payable and accrued expenses                                              |       | 1,284                                      |       | 7,475 |   | (1,944 | ) |
| Federal and state income taxes payable                                             |       | —                                     |       | (892 | ) | (1,595 | ) |
| Funds held under reinsurance agreements                                            |       | 12,296                                     |       | 29,198 |   | 24,818 |   |
| Deferred compensation liability                                                    |       | —                                     |       | (1,294 | ) | 85 |   |
| Net cash flows provided by operations                                              |       | 128,499                                    |       | 76,115 |   | 22,744 |   |
| **Cash  flows from investing activities:**                                         |       |                                       |       |   |   |   |   |
| Purchase of fixed assets                                                           |       | (5,370                                     | )          | (3,364 | ) | (2,502 | ) |
| Purchases of investments:                                                          |       |                                       |       |   |   |   |   |
| Fixed-maturity securities                                                          |       | (147,149                                   | )          | (197,129 | ) | (25,560 | ) |
| Equity securities—at fair value                                               |       | (6,568                                     | )          | — |   | — |   |
| Equity securities—at cost                                                     |       | (24,558                                    | )          | — |   | — |   |
| Sale of investments:                                                               |       |                                       |       |   |   |   |   |
| Fixed-maturity securities                                                          |       | 38,325                                     |       | 23,474 |   | 8,992 |   |
| Equity securities                                                                  |       | 1,972                                      |       | 50 |   | 25 |   |
| Net cash flows  used in investing activities                                       |       | (143,348                                   | )          | (176,969 | ) | (19,045 | ) |
|                                                                                    |            |                                            |            |  |  |  |  |  |  |  |

 

*(Continued)*

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**TOWER GROUP, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)**

| ** **                                                          | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                          | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                          | ** ** | **($ in thousands)**             | ** ** |
| **Cash  flows from financing activities:**                          |       |                                       |       |   |   |   |   |
| Repayment of redeemable preferred stock                             |       | $                                          | —     |   | $ | (3,000 | ) | $ | — |   |
| Proceeds from repurchase obligation                                 |       | —                                     |       | — |   | 29,650 |   |
| Repayment of repurchase obligation                                  |       | —                                     |       | — |   | (32,650 | ) |
| Proceeds from issuance of subordinated debentures                   |       | —                                     |       | 26,806 |   | 20,620 |   |
| Purchase of common trust securities—statutory  business trusts |       | —                                     |       | (806 | ) | (620 | ) |
| Proceeds from long-term debt—CIT                               |       | —                                     |       | — |   | 6,000 |   |
| Repayment of long-term debt—CIT                                |       | —                                     |       | (5,588 | ) | (413 | ) |
| Proceeds from surplus notes                                         |       | —                                     |       | — |   | 10,000 |   |
| Repayment of surplus notes                                          |       | —                                     |       | — |   | (10,000 | ) |
| Decrease (increase) in notes receivable from related  parties       |       | —                                     |       | 1,421 |   | (50 | ) |
| Stock repurchase                                                    |       | —                                     |       | — |   | (514 | ) |
| Exercise of stock options                                           |       | 277                                        |       | 200 |   | — |   |
| Exercise of warrants                                                |       | 90                                         |       | — |   | — |   |
| IPO and private placement, net proceeds                             |       | —                                     |       | 107,845 |   | — |   |
| Dividends paid                                                      |       | (1,959                                     | )          | (1,162 | ) | (1,811 | ) |
| Net cash flows (used in)/provided by financing  activities          |       | (1,592                                     | )          | 125,716 |   | 20,212 |   |
| (Decrease) Increase in cash and cash equivalents                    |       | (16,441                                    | )          | 24,862 |   | 23,911 |   |
| Cash and cash equivalents, beginning of year                        |       | 55,201                                     |       | 30,339 |   | 6,428 |   |
| **Cash and cash equivalents, end of year**                          | ** ** | **$**                                      | **38,760** | ** ** | **$** | **55,201** | ** ** | **$** | **30,339** | ** ** |
| **Supplemental disclosures of cash flow  information:**             |       |                                       |       |   |   |   |   |
| Cash paid for income taxes                                          |       | $                                          | 11,479     |   | $ | 5,114 |   | $ | 2,263 |   |
| Cash paid for  interest                                             |       | $                                          | 3,445      |   | $ | 2,261 |   | $ | 1,286 |   |

 

See accompanying notes to the consolidated financial statements.

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**TOWER GROUP, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**Note 1—Summary ofSignificant Accounting Policies**

*Background*

The consolidated financialstatements include the accounts of Tower Group, Inc. (“Tower”) and itswholly-owned subsidiaries, Tower Insurance Company of New York (“TICNY”), TowerNational Insurance Company (“TNIC”) and Tower Risk Management Corporation (“TRM”)(collectively “the Company”). The Company’s stock is traded on the NASDAQNational Market under the symbol “TWGP”.

*Initial Public Offering(“IPO”)*

On June 22, 2004 the Company’s Board of Directorsapproved a 1.8:1 stock split, the maintaining of a par value of $0.01 after thesplit and the amendment and restatement of the Company’s Certificate ofIncorporation which among other things, combined the Class A and Class Bcommon stock into one class of common stock and increased the authorized commonstock to 40,000,000 shares. These actions became effective on October 20,2004, which is the effective date of the Company’s IPO. All consolidatedfinancial statements and per share amounts have been retroactively adjusted forthe above stock split and maintaining the par value at $0.01 per share.

On October 20, 2004, the Securities and ExchangeCommission declared Tower Group, Inc.’s registration statement effective. TheCompany’s IPO was for 13,000,000 shares and was priced at $8.50 per share. Alsoon October 20, 2004 Tower Group, Inc. offered a concurrent privateplacement of 500,000 shares of its common stock to an affiliate of Friedman, Billings,Ramsey & Co., Inc. the lead underwriter for the Company’s IPO, atthe price of $8.50 per share. On November 10, 2004 the underwritersexercised their 30-day over-allotment option. Pursuant to this exercise,the underwriters purchased 629,007 additional shares of common stock from theCompany and 1,320,993 shares of common stock from the selling stockholders atthe IPO price of $8.50 per share, less the underwriting discount. The Companydid not receive any proceeds from the sale of common stock by any sellingstockholder. The Company received net cash proceeds of $107,845,000 from theoffering and concurrent private placement after the underwriting discounts,commissions and offering expenses. The total costs of the IPO and privateplacement were $12,252,000 of which $8,407,000 was for the underwritersdiscount, and $3,845,000 was for all other costs. Costs of the IPO have beenreflected as a reduction in Paid-in-Capital.

On March 25, 2005,Tower Group, Inc. closed on its purchase of the outstanding common stockof a shell insurance Company, North American Lumber Insurance Company (“NALIC”),that was renamed Tower National Insurance Company. As of December 31,2005, Tower National Insurance Company was authorized to write business insixteen states and is subject to comprehensive regulation and supervision,including limitations relating to reserves and statutory surplus, inMassachusetts, its state of domicile. As of December 31, 2005 TNIC has notwritten or assumed any premiums.

*Registration ofConcurrent Private Placement 500,000 Shares*

On November 8, 2005,the Securities and Exchange Commission declared Tower Group, Inc.’sPost-Effective Amendment No. 2 to Form S-1 on Form S-3Registration Statement effective. This registration covers the resale of up to500,000 shares of Tower Group, Inc.’s common stock from time to time by anaffiliate of Friedman, Billings, Ramsey & Co., Inc., the leadunderwriter for the Company’s IPO. The Company will not receive any of theproceeds from the sale of these shares.

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*Description ofBusiness*

TICNY is a property-casualty insurance companyincorporated in the State of New York in June 1989. TICNY obtained itslicense to operate in the State of New York in December 1990, at whichtime it commenced underwriting operations. TICNY provides coverage for manydifferent market segments, including nonstandard risks that do not fit theunderwriting criteria of standard carriers due to factors such as type ofbusiness, location and the relatively small amount of premium per policy. TICNYoffers commercial multiple-peril, monoline general liability, commercialumbrella, monoline property, workers’ compensation and commercial automobilepolicies as well as personal lines products such as homeowners, dwelling andother liability policies. Generally, TICNY targets customers that have areduced potential for loss severity and are not normally exposed tolong-tailed, complex or contingent risks, such as products liability, asbestosor environmental claims. TICNY’s commercial lines products provide insurancecoverages to businesses such as retail and wholesale stores, grocery stores,restaurants, artisan contractors and residential and commercial buildings. Personallines products focus on modestly valued homes and dwellings. TICNY’s productsare marketed through independent agents. All direct premiums are written in theState of New York. As of December 31, 2005, TICNY was authorized to writebusiness in fourteen states.

TNIC is a property and casualty insurance company thatdid not write or assume any premiums in 2005.

TRM is a non-risk-bearing insurance services companythat produces, through its managing general agency, business on behalf of otherinsurance companies (which are referred to as TRM’s issuing companies) andprimarily focuses on commercial risks with higher per policy premium, includingrisks that TICNY historically had not been able to target due to surplus,rating and geographical license constraints. However, since Tower’s IPO andprivate placement in 2004, TICNY has increased its surplus and its A.M.Best rating was upgraded to A- from B++. These changes resulted in TICNYwriting more of the risks previously placed by TRM.TICNY also reinsures aportion of the premiums written by TRM’s issuing companies. The Company usesthese non-risk-bearing insurance services operations to generate commissionincome on premiums produced for other insurance companies. In addition, theinsurance services operation earns fee revenues by providing claimsadministration and reinsurance intermediary services to TRM’s issuing companiesand to other insurance companies. In 2005 and 2004, two companies accounted for100% of the managing general agency commissions of TRM. See “Note 5.Reinsurance” for further description.

Certain activities of the Company are provided byTICNY, DBA the Law Office of Steven Fauth. These activities primarily consistof claims management activities of TICNY and claims management servicesprovided by TRM to other issuing carriers. Mr. Fauth is an officer anddirector of the Company.

During 2003, the Company engaged in significanttransactions with PXRE Reinsurance Company (“PXRE”), which had a significantimpact on the operations and financial statements of the Company. Transactionsbetween PXRE and the Company include reinsurance arrangements, debt financingand equity transactions. To reduce the credit risk associated with having asignificant amount of reinsurance recoverable from PXRE the Company cancelledPXRE’s participation in the 2003 quota share agreement as of September 30,2003. See “Note 5. Reinsurance”.

Additionally, during 2003the Company engaged in significant reinsurance arrangements with AmericanRe-Insurance Company (“Am Re”), which owned all of the Company’s outstandingshares of Series A Cumulative Redeemable Preferred Stock as of December 31,2004. The Series A Cumulative Redeemable Preferred Stock was redeemedduring 2004. Am Re also held warrants for the purchase of common stock thatwere exercised during 2004. See “Note 5. Reinsurance”, “Note 8. Debt”, and “Note9. Capital Stock”.

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*Basis ofPresentation*

The accompanyingconsolidated financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America (“GAAP”).All significant intercompany transactions have been eliminated inconsolidation.

*Use of Estimates*

The preparation offinancial statements in conformity with GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period. Actual results could differ from those estimates.

*Premiums Earned*

Insurance policies issuedor reinsured by the Company are short-duration contracts. Accordingly, premiumrevenue, including direct writings and reinsurance assumed, net of premiumsceded to reinsurers, is recognized as earned in proportion to the amount ofinsurance protection provided, on a pro-rata basis over the terms of theunderlying policies. Unearned premiums represent premium applicable to theunexpired portions of in-force insurance contracts at the end of each year. Prepaidreinsurance premiums represent the unexpired portion of reinsurance premiumsceded.

*Liability for Lossand Loss Adjustment Expense*

The liability for loss andloss adjustment expenses represents management’s best estimate of the ultimate cost of all reported and unreported losses that are unpaid asof the balance sheet date. The liability for loss and loss adjustment expensesis estimated on an undiscounted basis, using individual case-basis valuations,statistical analyses, and various actuarial procedures. The projection offuture claim payment and reporting is based on an analysis of the Company’shistorical experience, supplemented by analyses of industry loss data. Managementbelieves that the reserves for loss and loss adjustment expenses are adequateto cover the ultimate cost of losses and claims to date; however, because ofthe uncertainty from various sources, including changes in reporting patterns,claims settlement patterns, judicial decisions, legislation, and economicconditions, actual loss experience may not conform to the assumptions used in determiningthe estimated amounts for such liability at the balance sheet date. Asadjustments to these estimates become necessary, such adjustments are reflectedin current operations. Because of the nature of the business historicallywritten, the Company’s management believes that the Company has limitedexposure to environmental claim liabilities.

*Reinsurance*

The Company accounts for reinsurance in accordancewith Statement of Financial Accounting Standards No. 113, “Accounting andReporting for Reinsurance of Short-Duration and Long-Duration Contracts” (“SFAS113”). Management believes the Company’s reinsurance arrangements qualify forreinsurance accounting in accordance with SFAS 113. Management has evaluatedits reinsurance arrangements and determined that insurance risk is transferredto the reinsurers. Reinsurance agreements have been determined to beshort-duration prospective contracts and, accordingly, the costs of thereinsurance are recognized over the life of the contract in a manner consistentwith the earning of premiums on the underlying policies subject to thereinsurance contract.

Reinsurance recoverable represents management’s bestestimate of paid and unpaid loss and loss adjustment expenses recoverable fromreinsurers. Ceded losses recoverable are estimated using techniques andassumptions consistent with those used in estimating the liability for loss andloss adjustment expenses. Management believes that reinsurance recoverables asrecorded represent its best estimate of such 

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amounts; however, aschanges in the estimated ultimate liability for loss and loss adjustmentexpenses are determined, the estimated ultimate amount recoverable from thereinsurer will also change. Accordingly, the ultimate recoverable could besignificantly in excess of or less than the amount indicated in theconsolidated financial statements. As adjustments to these estimates becomenecessary, such adjustments are reflected in current operations. Loss and lossadjustment expenses incurred as presented in the consolidated statement ofincome and comprehensive net income are net of reinsurance recoveries.

In preparing financialstatements, management estimates the amounts receivable from reinsurers to beuncollectible based on an assessment of factors including the creditworthinessof the reinsurers and the adequacy of collateral obtained, where applicable. TheCompany recorded no allowance for uncollectible reinsurance at December 31,2005 and 2004 and did not expense any uncollectible reinsurance during 2005,2004 and 2003. Significant uncertainties are inherent in the assessment of thecreditworthiness of reinsurers and estimates of any uncollectible amounts duefrom reinsurers. Any change in the ability of the Company’s reinsurers to meettheir contractual obligations could have a detrimental impact on theconsolidated financial statements and TICNY’s ability to meet its regulatorycapital and surplus requirements.

*Ceding CommissionRevenue*

Commissions on reinsurancepremiums ceded are earned in a manner consistent with the recognition of thecosts of the reinsurance, generally on a pro-rata basis over the terms of thepolicies reinsured. Certain reinsurance agreements contain provisions wherebythe ceding commission rates vary based on the loss experience under the agreements.The Company records ceding commission revenue based on its current estimate ofsubject losses. The Company records adjustments to the ceding commissionrevenue in the period that changes in the estimated losses are determined. Cedingcommissions receivable of $8,727,000 and $8,329,000 as of December 31,2005 and 2004, respectively represent ceding commissions receivable from PXREwhich are not due until final settlement of losses subject to the contracts orcommutation of the agreements.

*Insurance ServicesRevenue*

Direct commission revenuefrom the Company’s managing general underwriting services, which is the largestcomponent of insurance services revenue, is generally recognized and earned asinsurance policies are placed with TRM’s issuing companies. Fees fromreinsurance intermediary services are earned when TICNY or TRM’s issuingcompanies cede premiums to reinsurers. Claims administration fees are earned asservices are performed. See “Note 17. Segment Information” for a furtherdescription of the components of insurance services revenue.

*Cash and CashEquivalents*

Cash and cash equivalents are presented at cost, whichapproximates fair value. The Company considers all highly liquid investmentswith original maturities of three months or less to be cash equivalents. Forthe purpose of presentation in the Company’s statements of cash flows, cashequivalents are short-term, highly liquid investments that are both (a) readilyconvertible to known amounts of cash, and (b) so near to maturity that theypresent insignificant risk of changes in value due to changing interest rates.

The Company maintains itscash balances at several financial institutions. The Federal Deposit InsuranceCorporation secures accounts up to $100,000 at these institutions. Managementmonitors balances in excess of insured limits and believes they do notrepresent a significant credit risk to the Company.

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*Investments*

The Company accounts for its investments in accordancewith Statement of Financial Accounting Standards No. 115, “Accounting forCertain Investments in Debt and Equity Securities” (“SFAS 115”), which requiresthat fixed-maturity and equity securities that have readily determined fairvalues be segregated into categories based upon the Company’s intention forthose securities. In accordance with SFAS 115, the Company has classified itsfixed-maturity and equity securities as available-for-sale. The Company maysell its available-for-sale securities in response to changes in interestrates, risk/reward characteristics, liquidity needs or other factors.

Fixed-maturity securities and equity securities arereported at their estimated fair values based on quoted market prices or arecognized pricing service, with unrealized gains and losses, net of taxeffects, reported as a separate component of comprehensive income instockholders’ equity. Realized gains and losses are determined on the specificidentification method.

Included in equity securities at cost as of December 31,2005 are common shares of a closed-end management investment company investingpredominately in asset-backed securities and mortgage-backed securities with acost of $19,558,000. This investment is carried at cost on the balance sheetbecause there is no publicly traded price quote available. However, managementestimated the fair value for this fund by taking the market prices for all thesecurities in the fund provided by an outside third party pricing service andthen dividing by the number of shares outstanding to determine its price pershare. Also included in equity securities at cost is an investment in a RealEstate Investment Trust (“REIT”) with a cost of $5,000,000 and an estimatedfair value of $5,000,000. The estimated fair value for this security isdetermined based on recent trades and an expected early 2006 IPO price for thissecurity. This single REIT investment has not been registered under theSecurities Act of 1933 and no active market exists for this investment.

Impairment of investment securities results in acharge to operations when a market decline below cost is deemed to beother-than-temporary. The Company regularly reviews its fixed-maturity andequity securities portfolios to evaluate the necessity of recording impairmentlosses for other-than-temporary declines in the fair value of investments. Ingeneral, attention is focused on those securities whose fair value was lessthan 80% of their amortized cost or cost, as appropriate, for six or moreconsecutive months. In evaluating potential impairment, management considers,among other criteria: the current fair value compared to amortized cost orcost, as appropriate; the length of time the security’s fair value has beenbelow amortized cost or cost; management’s intent and ability to retain theinvestment for a period of time sufficient to allow for any anticipatedrecovery in value; specific credit issues related to the issuer; and currenteconomic conditions. Other-than-temporary impairment losses result in apermanent reduction of the cost basis of the underlying investment. During2005, 2004 and 2003, the Company did not record any other-than-temporaryimpairments.

At December 31, 2005and 2004, U.S. Treasury Notes with fair values of approximately $6,597,000 and$651,000, respectively, were on deposit with various states to comply with theinsurance laws of the states in which the Company is licensed.

*Agents’ Balances*

Agents’ balancesreceivable are presented net of an allowance for doubtful accounts of $170,000at December 31, 2005 and $123,000 at December 31, 2004 and 2003, respectively.The allowance for uncollectible amounts is based on an analysis of amountsreceivable giving consideration to historical loss experience and currenteconomic conditions and reflects an amount that, in management’s judgment, isadequate. Uncollectible agent’s balances of $26,000, $27,000 and $0  were written off in 2005, 2004 and 2003,respectively. One agent accounted for approximately 10%,12% and 16%,respectively, of TICNY’s 

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and TRM’sagents’ balances at December 31, 2005, 2004 and 2003 and 11%, 14%and17%  of TICNY’s direct premiums writtenand TRM’s premiums produced in 2005, 2004and 2003, respectively.

*Receivable—ClaimsPaid by Agency*

Receivable—claims paid by agency represent claimpayments due from issuing carriers to reimburse claims paid by TRM on theirbehalf in conjunction with claims administration services. The receivables arepartially secured by funds held totaling $8,191,000 and $785,000 as of December 31,2005 and 2004, respectively. As of December 31, 2005 and 2004, no reservefor uncollectible recoverables was recorded. During 2005, 2004 and 2003, noamounts relating to these receivables were written-off.

With respect to thebusiness produced by TRM for other issuing carriers, agents collect premiumsfrom the policyholders and forward them to TRM. In certain jurisdictions, whenthe insured pays premium for these policies to agents for payment to TRM, thepremium might be considered to have been paid and the insured will no longer beliable to TRM for those amounts, whether or not TRM has actually received thepremiums from the agent. Consequently, TRM assumes a degree of credit riskassociated with agents and brokers. The Company recorded no losses in 2005,2004 and 2003 for this activity.

*DeferredAcquisition Costs and Deferred Ceding Commission Revenue*

Acquisition costsrepresent the costs of writing business that vary with, and are primarilyrelated to, the production of insurance business. Policy acquisition costs aredeferred and recognized as expense as related premiums are earned. Deferredacquisition costs presented in the balance sheet are net of deferred cedingcommission revenue. The Company considers anticipated investment income indetermining the recoverability of these costs and believes they are fullyrecoverable.

*Intangible Assets*

The Company has recorded, as an asset, acquiredidentifiable intangible assets with finite useful lives. In accounting for suchassets, the Company follows “Statement of Financial Accounting Standard No. 142,“Goodwill and Other Intangible Assets” (“SFAS 142”).

The cost of a group ofassets acquired in a transaction is allocated to the individual assetsincluding identifiable intangible assets based on their relative fair values. Identifiableintangible assets with a finite useful life are amortized over the period thatthe asset is expected to contribute directly or indirectly to the future cashflows of the Company. Identifiable intangible assets with finite useful livesare tested for recoverability whenever events or changes in circumstancesindicate that a carrying amount may not be recoverable. Identifiable intangibleassets with indefinite useful lives, such as those related to state insurancelicenses acquired through a shell purchase, are subject to annual impairmenttesting as well. An impairment loss is recognized if the carrying value of anintangible asset is not recoverable and its carrying amount exceeds its fairvalue. No impairment losses were recognized in 2005, 2004 and 2003.

*Fixed Assets*

Furniture, computerequipment, leasehold improvements and software are reported at cost lessaccumulated depreciation and amortization. Depreciation and amortization isprovided using the straight-line method over the estimated useful lives of theassets. The Company estimates the useful life for computer equipment andsoftware is three years, furniture is seven years and leasehold improvements isthe term of the lease.

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*Statutory BusinessTrusts*

In December 2003, theFinancial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46(R),“Consolidation of Variable Interest Entities” (“FIN 46(R)”), which establishesaccounting guidance for consolidation of variable interest entities (“VIE”)that function to support the activities of the primary beneficiary. The primarybeneficiary of a VIE is the entity that absorbs a majority of the VIE’sexpected losses, receives a majority of the VIE’s expected residual returns, orboth, as a result of ownership, controlling interest, contractual relationshipor other business relationship with a VIE. Prior to the implementation of FIN46(R), VIE’s were generally consolidated by an enterprise when the enterprisehad a controlling financial interest through ownership of a majority of votinginterest in the entity. As of December 31, 2004, the Company does notconsolidate interest in its statutory business trusts for which the Companyholds 100% of the common trust securities because Tower is not the primarybeneficiary of the trusts. See “Note 8. Debt”. The Company’s investment incommon trust securities of the statutory business trust are reported ininvestments at equity. The Company reports as a liability the outstandingsubordinated debentures owed to the statutory business trusts.

*Income Taxes*

Pursuant to a TaxAllocation Agreement, dated as of January 1, 2001, Tower, TICNY, TNIC andTRM compute and pay Federal income taxes on a consolidated basis. Deferred taxassets and liabilities are recognized for the future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax basis and foroperating loss and tax credit carry forwards. Deferred tax assets andliabilities are measured using enacted tax rates expected to apply to taxableincome in the years in which those temporary differences are expected to berecovered or settled. The effect on deferred tax assets and liabilities of achange in tax rates is recognized in income in the period that includes theenactment date.

*Treasury Stock*

The Company accounts for the treasury stock at therepurchase price as a reduction to stockholders’ equity as it does not intendto retire the treasury stock held at December 31, 2005.

*Equity CompensationPlans*

The Company accounts for employee stock options usingthe intrinsic value method in accordance with Accounting Principles BoardOpinion No. 25, “Accounting for Stock-Based Compensation” (“APB 25”).Under APB 25, because the exercise price of the Company’s employee stockoptions is equal to the estimated market price of the underlying stock at thedate of the grant, no compensation expense is recognized. The effect ofapplying Statement of Financial Accounting Standards No. 123, “Accountingfor Stock-Based Compensation” (“SFAS 123”), as amended by Statement ofFinancial Accounting Standards No. 148, “Accounting for Stock-BasedCompensation—Transition and Disclosure” (“SFAS 148”)requires pro-forma disclosure of EPS for the impact on the financial statementsas if the stock options were expensed. See “Note 1. Summary of SignificantAccounting Policies—Recent Accounting Developments”.

The Company accounts forrestricted stock shares awarded at fair value at the date awarded as a chargeto Unearned Compensation—Restricted Stock, included as a separate component ofStockholders’ Equity, and a credit to Common Stock and Paid-in-Capital. Thefair value of the shares will amortize ratably over their one to five yearvesting period as a charge to compensation expense and a reduction to UnearnedCompensation—RestrictedStock in Stockholders’ Equity.

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*Segment Reporting*

The Company manages itsoperations through three reportable segments: insurance (commercial andpersonal lines underwriting), reinsurance, and insurance services (managinggeneral agency, claims administration and reinsurance intermediary operations).See “Note 17. Segment Information”.

*Earnings Per Share*

In accordance withStatement of Financial Accounting Standards No. 128, “Earnings Per Share”,the Company measures earnings per share at two levels: basic earnings per shareand diluted earnings per share. Basic earnings per share is calculated bydividing income (loss) allocable to common stockholders by the weighted averagenumber of shares outstanding during the year excluding issued but unvestedrestricted stock shares. Diluted earnings per share is calculated by dividingincome (loss) allocable to common stockholders by the weighted average numberof shares outstanding during the year, as adjusted for the potentially dilutiveeffects of stock options, warrants, unvested restricted stock and/orconvertible preferred stock, unless common equivalent shares are antidilutive.

*Recent AccountingDevelopment*

In December 2004, the Financial AccountingStandards Board (“The FASB”) issued the revised Statement of FinancialAccounting Standards SFAS No. 123-R, an amendment to SFAS 123, whichsuspends APB 25 and requires that the cost of share-based payment transactionsbe recognized in the financial statements after the fiscal quarter beginningafter June 15, 2005. The intended adoption by the Company of SFAS 123-Rhas been postponed to January 2006 per the Securities and ExchangeCommission’s rule amendment promulgated April 14, 2005, that allowscalendar year-end companies to elect to implement SFAS 123-R at the startof their next fiscal year beginning after June 15, 2005. Theimplementation of SFAS 123-R is not expected to have a material effect onthe Company’s financial position or results of operations.

In May 2005, The FASB issued statement SFAS No. 154,“Accounting Changes Error Correction,” that changes the requirements for theaccounting and reporting of a change in accounting principle made in fiscalyears beginning after December 15, 2005. This statement applies to allvoluntary changes in accounting principle. The statement requires that the newaccounting principle be applied to the balances of assets and liabilities as ofthe beginning of the earliest period for which retrospective application ispracticable and that a corresponding adjustment be made to the opening balanceof retained earnings for that period rather than reported in the incomestatement. Management does not expect the adoption of this new accountingpronouncement to have any impact on the Company’s financial statements.

In October 2005, the FASB issued FSP FAS 13-1,“Accounting for Rental Costs Incurred during a Construction Period,” whichrequires a lessee to start to record rental costs on a straight-line basis overthe term of an operating lease starting on the date the lessee is given controlof the leased asset (even during the leasehold improvement construction period).The Company has entered into an amended operating lease for the new space atits New York City Headquarters in September 2005. The Company will incurexpenses under this amended lease beginning January 1, 2006.Theimplementation of FSP FAS13-1 is not expected to have a material effecton the Company’s financial position or results of operations.

In November 2005, theFASB issued FSP FAS 115-1 and FAS 124-1, “Other-Than-TemporaryImpairment and Its Application to Certain Investments.”  The guidance in this FSP addresses thedetermination of when an investment is considered impaired, whether thatimpairment is other than temporary, and the measurement of an impairment loss. TheFSP also includes accounting considerations subsequent to the recognition of another-than temporary impairment and requires certain disclosures aboutunrealized losses that have not been recognized as other-than-temporaryimpairments. This guidance in the FSP is required to be applied to reportingperiods beginning after December 15, 2005. As 

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of December 31,2005 the Company did not hold any investments that would have been consideredother than temporarily impaired had the application of this accounting standardbeen required as of December 31, 2005.

**Note 2—Investments**

Theamortized cost and fair value of investments in fixed-maturity securities aresummarized as follows:

| ** **                   | ** ** | **Amortized  Cost** | ** **  | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|------------------------------|------------|---------------------|-------------|------------------------------|------------|-------------------------------|------------|-----------------|------------|
| **December 31,  2005:** |       |                |        |                         |       |                          |       |            |       |   |   |   |   |
| U.S. Government bonds        |       | $                   | 39,161      |                         |       | $                             | 34         |            |       |   | $ | (440 | ) |   | $ | 38,755 |   |
| Municipal bonds              |       | 99,893              |        |                         | 320        |                          |       |            | (885       | ) |   | 99,328 |   |
| Corporate and other bonds    |       | 93,283              |        |                         | 293        |                          |       |            | (1,900     | ) |   | 91,676 |   |
| Mortgage-backed securities   |       | 98,786              |        |                         | 273        |                          |       |            | (2,137     | ) |   | 96,922 |   |
| **Total**                    | ** ** | **$**               | **331,123** | ** **                   | ** ** | **$**                         | **920**    |            | ** ** | ** ** | **$** | **(5,362** | **)** | ** ** | **$** | **326,681** | ** ** |
| **December 31,  2004:** |       |                |        |                         |       |                          |       |            |       |   |   |   |   |
| U.S. Government bonds        |       | $                   | 21,458      |                         |       | $                             | 80         |            |       |   | $ | (117 | ) |   | $ | 21,421 |   |
| Municipal bonds              |       | 76,647              |        |                         | 597        |                          |       |            | (154       | ) |   | 77,090 |   |
| Corporate and other bonds    |       | 61,341              |        |                         | 810        |                          |       |            | (298       | ) |   | 61,853 |   |
| Mortgage-backed securities   |       | 64,116              |        |                         | 464        |                          |       |            | (421       | ) |   | 64,159 |   |
| **Total**                    | ** ** | **$**               | **223,562** | ** **                   | ** ** | **$**                         | **1,951**  |            | ** ** | ** ** | **$** | **(990** | **)** | ** ** | **$** | **224,523** | ** ** |

 

Asummary of the amortized cost and fair value of the Company’s investments infixed-maturity securities at December 31, 2005 by contractual maturity isshown below (in 000’s):

| ** **                 | ** ** | **Amortized  Cost** | ** **  | **Fair  Value** | ** ** |
|----------------------------|------------|---------------------|-------------|-----------------|------------|
| **Years to Maturity:**     |       |                |        |            |       |
| One or less                |       | $                   | 1,894       |            | $          | 1,892 |   |
| After one through five     |       | 86,025              |        | 84,594          |       |
| After five through ten     |       | 104,616             |        | 103,722         |       |
| After ten                  |       | 39,802              |        | 39,551          |       |
| Mortgage-backed securities |       | 98,786              |        | 96,922          |       |
| **Total**                  | ** ** | **$**               | **331,123** | ** **      | **$**      | **326,681** | ** ** |

 

The actual maturities may differ from contractualmaturities because certain borrowers have the right to call or prepayobligations with or without penalties.

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Thecost and estimated fair value of investments in equity securities are asfollows (in 000’s):

| ** **                       | ** ** | **Cost** | ** ** | **Gross  Unrealized   Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|----------------------------------|------------|----------|------------|------------------------------------|------------|-------------------------------|------------|-----------------|------------|
| **December 31, 2005:**      |       |     |       |                               |       |                          |       |            |       |   |   |   |   |
| Preferred stocks                 |       | $        | 113        |                               |       | $                             | 2          |            |       |   | $ | — |   |   | $ | 115 |   |
| Common stocks—at cost(A)    |       | 24,558   |       |                               | —     |                          |       |            | (505       | ) |   | 24,053 |   |
| Common stocks—at fair value |       | 6,568    |       |                               | 568        |                          |       |            | (1,317     | ) |   | 5,819 |   |
| ** **                       | ** ** | **$**    | **31,239** | ** **                         | ** ** | **$**                         | **570**    |            | ** ** | ** ** | **$** | **(1,822** | **)** | ** ** | **$** | **29,987** | ** ** |
| **December 31, 2004:**      |       |     |       |                               |       |                          |       |            |       |   |   |   |   |
| Preferred stocks                 |       | $        | 113        |                               |       | $                             | 4          |            |       |   | $ | — |   |   | $ | 117 |   |
| Common stocks—at fair value |       | 1,714    |       |                               | 654        |                          |       |            | —     |   |   | 2,368 |   |
| **Total**                        | ** ** | **$**    | **1,827**  | ** **                         | ** ** | **$**                         | **658**    |            |       |   | $ | — |   | ** ** | **$** | **2,485** | ** ** |

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(A)        Included in common stocksat cost as of December 31, 2005 are common shares of a closed-endmanagement investment company investing predominately in asset-backedsecurities and mortgage-backed securities with a cost of $19,558,000 and anestimated fair value of $19,053,000. Because this security in not publiclytraded the investment is carried at cost on the balance sheet and theunrealized loss has not been recorded in comprehensive income. Also included inequity securities at cost is an investment in a Real Estate Investment Trust (“REIT”)with a cost of $5,000,000 and an estimated fair value of $5,000,000. Theestimated fair value for this security is determined based on recent trades andexpected early 2006 IPO price for this security. The single REIT investment hasnot been registered under the Securities Act of 1933 and no active marketexists for this investment.

Majorcategories of the Company’s net investment income are summarized as follows (in000’s):

| ** **                                         | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**  | ** ** |
|----------------------------------------------------|------------|------------|------------|------------|------------|-----------|------------|
| Income:                                            |       |       |       |       |       |      |       |
| Fixed-maturity  securities                         |       | $          | 12,406     |       | $          | 4,868     |       | $ | 2,190 |   |
| Equity securities                                  |       | 2,290      |       | 48         |       | 39        |       |
| Cash and cash  equivalents                         |       | 718        |       | 294        |       | 121       |       |
| Interest on notes  receivable from related parties |       | —     |       | 46         |       | 54        |       |
| Dividends on common  trust securities              |       | 104        |       | 52         |       | —    |       |
| **Total**                                          | ** ** | **15,518** | ** ** | **5,308**  | ** ** | **2,404** | ** ** |
| Expenses:                                          |       |       |       |       |       |      |       |
| Investment  expenses                               |       | 535        |       | 238        |       | 136       |       |
| **Net  investment income**                         | ** ** | **$**      | **14,983** | ** ** | **$**      | **5,070** | ** ** | **$** | **2,268** | ** ** |

 

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Proceedsfrom the sale and maturity of fixed-maturity securities were $38,325,000,$23,474,000 and $8,992,000 in 2005, 2004 and 2003, respectively. Proceeds fromthe sale of equity securities were $1,972,000, $50,000 and $25,000 in 2005,2004 and 2003, respectively. The Company’s gross realized gains and losses oninvestments are summarized as follows (in 000’s):

| ** **                  | ** ** | **2005** | ** ** | **2004**   | ** ** | **2003** | ** ** |
|-----------------------------|------------|----------|------------|------------|------------|----------|------------|
| Fixed maturity  securities: |       |     |       |       |       |     |       |
| Gross realized gains        |       | $        | 67         |       | $          | 137      |       | $ | 493 |   |
| Gross realized losses       |       | (203     | )          | (124       | )          | —   |       |
|                        | ** ** | **(136** | **)**      | **13**     | ** ** | **493**  | ** ** |
| Equity  securities:         |       |     |       |       |       |     |       |
| Gross realized gains        |       | 258      |       | —     |       | —   |       |
| Gross realized losses       |       | —   |       | —     |       | —   |       |
|                        |       | —   |       | —     |       |     |       |
| **Net  realized gains**     | ** ** | **$**    | **122**    | ** ** | **$**      | **13**   | ** ** | **$** | **493** | ** ** |

 

Thefollowing table presents information regarding the Company’s invested assetsthat were in an unrealized loss position at December 31, 2005 by amount oftime in a continuous unrealized loss position (in 000’s).

| ** **                   | ** ** | **Less than 12 Months** | ** **  | **12 Months or Longer** | ** ** | **Total** | ** ** |
|------------------------------|------------|----------------------------------------|-------------|----------------------------------------|------------|-----------|------------|
| ** **                   | ** ** | **Fair**                               | ** **  | **Unrealized**                         | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                   | ** ** | **Value**                              | ** **  | **Loss**                               | ** ** | **value** | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
| U.S. Gov’t bonds        |       | 22,780                                 |        |                                   | (202       | )         |       | 11,111 |   |   | (238 | ) |   | 33,891 |   |   | (440 | ) |   |
| Municipal bonds              |       | 61,996                                 |        |                                   | (756       | )         |       | 6,415 |   |   | (129 | ) |   | 68,411 |   |   | (885 | ) |   |
| Corp. and other  bonds       |       | 53,417                                 |        |                                   | (1,188     | )         |       | 20,341 |   |   | (712 | ) |   | 73,758 |   |   | (1,900 | ) |   |
| Mortgage-backed  securities  |       | 45,483                                 |        |                                   | (899       | )         |       | 34,080 |   |   | (1,238 | ) |   | 79,563 |   |   | (2,137 | ) |   |
| Total fixed  Maturities      |       | 183,676                                |        |                                   | (3,045     | )         |       | 71,947 |   |   | (2,317 | ) |   | 255,623 |   |   | (5,362 | ) |   |
| Equities—at fair  value |       | 5,251                                  |        |                                   | (1,317     | )         |       | — |   |   | — |   |   | 5,251 |   |   | (1,317 | ) |   |
| Equities—at cost        |       | 19,053                                 |        |                                   | (505       | )         |       | — |   |   | — |   |   | 19,053 |   |   | (505 | ) |   |
| **Total**                    | ** ** | **$**                                  | **207,980** | ** **                             | ** ** | **$**     | **(4,867** | **)** | ** ** | **$** | **71,947** | ** ** | ** ** | **$** | **(2,317** | **)** | ** ** | **$** | **279,927** | ** ** | ** ** | **$** | **(7,184** | **)** | ** ** |
|                              |            |                                        |             |                                        |            |           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As of December 31, 2005, 184 securities accountedfor the gross unrealized losses, all of which are deemed to be temporary. Significantfactors influencing management’s determination that unrealized losses weretemporary included the mild severity of the unrealized losses in relation toeach securities cost, the nature of the investments and management’s intent andability to retain the investment for a period of time sufficient to allow foranticipated recovery in value.

Of the 184 securities that were in an unrealized lossposition as of December 31, 2005, 6 were equity investments and the other178 were fixed-maturity investments. For the equity investments 4 are publiclytraded Real Estate Investment Trusts (“REIT’s”) which are made up of realestate related mortgage backed securities. These 4 equity investments make up17% of the gross unrealized loss position for the Company as of December 31,2005. These REIT’s were evaluated for impairment by the Company and deemed tobe only temporarily impaired. Publicly traded mortgage REIT stock prices as asector did not perform well in 2005. The dividends paid on these funds werereduced significantly, which caused their stock prices to decline. Thesedividend reductions resulted from the flattening of the yield curve thatreduced the yield these funds earn from leveraging the portfolios. The stockprices of these mortgage REITs have declined to below their book values pershare, after trading at premiums to book value several months before December 31,2005. Since the decline in the market values is based on the decline in thedividend rates, which could increase again when the yield curve steepens, theCompany deems this decline to be temporary in nature. Additionally, theunderlying value of the securities held by the REITs have not 

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declined in market valueby nearly as much as the stock prices have declined and therefore, theliquidation value of the REITs is greater than the current market value of thestocks. The other 2 equity investments were a high dividend stock fund and anasset backed securities fund both of which had declined less than 3.1% of theirbook values as of December 31, 2005 and are deemed to be temporarilyimpaired.

The Company evaluated the 178 fixed maturity investmentsin an unrealized loss position as of December 31, 2005 for impairment anddeemed them to be only temporarily impaired. The increase in the unrealizedloss on the fixed maturity investments as of December 31, 2005 wasattributable to the general rise in interest rates in 2005. The increasedunrealized loss represents approximately 1.8% of the average market value ofthe fixed maturity portfolio during the year. Interest rates rose approximately50 bps on average during the year (shorter maturities rose more than 50 bps andlonger maturities rose less than 50 bps). Also, the portfolio duration averagedapproximately 4 years during the year. Therefore, based on the interest rateincrease and the portfolio duration, the expected impact on the unrealized losswould have been an increase of approximately 2.0% compared to the actualincrease of only 1.8%, which is evidence that the increase in the unrealizedloss is interest rate driven. Of the 178 fixed maturity investments in anunrealized position, 166 had fair values 5% or lower than their book values andthe other 12 had fair values between 5.1% and 14% lower than their book value.

**Note3—Property—Casualty Insurance Activity**

Premiumswritten, ceded and earned are as follows (in 000’s):

| ** **                   | ** ** | **Direct** | ** **  | **Assumed** | ** ** | **Ceded** | ** ** | **Net**    | ** ** |
|------------------------------|------------|------------|-------------|-------------|------------|-----------|------------|------------|------------|
| **2005**                     |       |       |        |        |       |      |       |       |       |   |   |
| Premiums written             |       | $          | 298,595     |        |       | $         | 1,512      |       |       | $ | (88,325 | ) | $ | 211,782 |   |
| Change in  unearned premiums |       | (62,426    | )           |        | 152        |      |       | 14,928     |       | (47,346 | ) |
| **Premiums  earned**         | ** ** | **$**      | **236,169** | ** **  | ** ** | **$**     | **1,664**  |       | ** ** | **$** | **(73,397** | **)** | **$** | **164,436** | ** ** |
| **2004**                     |       |       |        |        |       |      |       |       |       |   |   |
| Premiums written             |       | $          | 176,166     |        |       | $         | 1,600      |       |       | $ | (79,691 | ) | $ | 98,075 |   |
| Change in  unearned premiums |       | (24,956    | )           |        | (301       | )         |       | (27,254    | )          | (52,511 | ) |
| **Premiums  earned**         | ** ** | **$**      | **151,210** | ** **  | ** ** | **$**     | **1,299**  |       | ** ** | **$** | **(106,945** | **)** | **$** | **45,564** | ** ** |
| **2003**                     | ** ** | ** ** | ** **  | ** **  | ** ** |      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Premiums written             |       | $          | 133,263     |        |       | $         | 1,219      |       |       | $ | (105,532 | ) | $ | 28,950 |   |
| Change in  unearned premiums |       | (12,722    | )           |        | 263        |      |       | 6,450      |       | (6,009 | ) |
| **Premiums earned**          | ** ** | **$**      | **120,541** | ** **  | ** ** | **$**     | **1,482**  |       | ** ** | **$** | **(99,082** | **)** | **$** | **22,941** | ** ** |

 

Thecomponents of the liability for loss and loss adjustment expenses and relatedreinsurance recoverables are as follows (in 000’s):

| ** **                  | ** ** | **Gross  Liability** | ** **  | **Reinsurance  Recoverables** | ** ** |
|-----------------------------|------------|----------------------|-------------|-------------------------------|------------|
| **December 31, 2005:** |       |                 |        |                          |       |   |   |
| Case-basis  reserves        |       | $                    | 100,190     |                          |       | $ | 55,968 |   |   |
| IBNR reserves               |       | 98,534               |        |                          | 41,010     |   |   |
| Recoverable on  paid losses |       | —               |        |                          | 7,833      |   |   |
| **Total**                   | ** ** | **$**                | **198,724** | ** **                    | ** ** | **$** | **104,811** |   |   |
| **December 31, 2004:** |       |                 |        |                          |       |   |   |
| Case-basis  reserves        |       | $                    | 76,793      |                          |       | $ | 55,273 |   |   |
| IBNR reserves               |       | 51,929               |        |                          | 36,500     |   |   |
| Recoverable on  paid losses |       | —               |        |                          | 9,400      |   |   |
| **Total**                   | ** ** | **$**                | **128,722** | ** **                    | ** ** | **$** | **101,173** |   |   |

 

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Activityin the liability for loss and loss adjustment expenses is summarized as follows(in 000’s):

| ** **                        | ** ** | **2005**   | ** **  | **2004**   | ** ** | **2003**    | ** ** |
|-----------------------------------|------------|------------|-------------|------------|------------|-------------|------------|
| Balance at  January 1,       |       | $          | 128,722     |       | $          | 99,475      |       | $ | 65,688 |   |
| Less reinsurance recoverables     |       | (91,773    | )           | (75,114    | )          | (50,212     | )          |
|                              |       | 36,949     |        | 24,361     |       | 15,476      |       |
| Incurred related  to:             |       |       |        |       |       |        |       |
| Current year                      |       | 97,006     |        | 27,259     |       | 14,996      |       |
| Prior years                       |       | (392       | )           | (199       | )          | 75          |       |
| **Total incurred**                | ** ** | **96,614** | ** **  | **27,060** | ** ** | **15,071**  | ** ** |
| Paid related to:                  |       |       |        |       |       |        |       |
| Current year                      |       | 20,891     |        | 6,991      |       | 2,084       |       |
| Prior years                       |       | 10,926     |        | 7,481      |       | 4,102       |       |
| **Total paid**                    | ** ** | **31,817** | ** **  | **14,472** | ** ** | **6,186**   | ** ** |
| Net balance at  December 31, |       | 101,746    |        | 36,949     |       | 24,361      |       |
| Add reinsurance recoverables      |       | 96,978     |        | 91,773     |       | 75,114      |       |
| **Balance  at December 31,** | ** ** | **$**      | **198,724** | ** ** | **$**      | **128,722** | ** ** | **$** | **99,475** | ** ** |

 

Incurred losses and loss adjustment expenses are netof reinsurance recoveries under reinsurance contracts of $38,584,000,$57,104,000, and $59,090,000 in 2005, 2004 and 2003, respectively.

Incurred loss and lossadjustment expenses attributable to insured events of prior years decreased by$392,000 and $199,000 in 2005 and 2004, respectively and increased by $75,000in 2003. Prior year development is based upon numerous estimates by line ofbusiness and accident year. During calendar year 2005 commercial multi perilliability, workers’ compensation, and auto liability had favorable prior yeardevelopment that was partially offset by unfavorable development in other lines.During 2004 the reinsurance operations had favorable prior year developmentthat offset any unfavorable development in the insurance operations. Noadditional premiums or return premiums have been accrued as a result of theseprior year effects. The Company’s management continually monitors claimsactivity to assess the appropriateness of carried case and IBNR reserves,giving consideration to Company and industry trends. See “Note 1—Summary ofSignificant Accounting Policies, Liability for Loss and Loss Adjustment Expense”.

**Note4—Deferred Acquisition Costs and Deferred Ceding Commission Revenue**

Acquisitioncosts incurred and policy-related ceding commission revenue are deferred andamortized to income on property and casualty business as follows (in 000’s):

| ** **                                                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net deferred  acquisition costs (ceding commission revenue), January 1,   |       | $        | 18,740     |     | $          | 573      |       | $ | (3,494 | ) |
| Costs incurred and  deferred during years:                                     |       |     |       |     |       |     |       |
| Commissions and  brokerage                                                     |       | 49,458   |       | 29,732   |       | 22,218   |       |
| Other  underwriting and acquisition costs                                      |       | 36,978   |       | 24,482   |       | 17,779   |       |
| Ceding commission  revenue                                                     |       | (30,337  | )          | (10,379  | )          | (35,415  | )          |
| Net acquisition  costs (ceding commission revenue) deferred during year   |       | 56,099   |       | 43,835   |       | 4,582    |       |
| Amortization                                                                   |       | (45,647  | )          | (25,668  | )          | (515     | )          |
| Net deferred acquisition  costs (ceding commission revenue), December 31, |       | $        | 29,192     |     | $          | 18,740   |       | $ | 573 |   |

 

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**Note 5—Reinsurance**

The Company offers insurance coverage for limits up to$10,000,000 for property risks, $1,000,000/$2,000,000 for liability coveragesand $10,000,000 for workers’ compensation. Through various quota share, excessof loss and catastrophe reinsurance agreements, as described further below, theCompany limits its exposure to a maximum loss on any one risk of $750,000during the period January 1, through December 31, 2005,  $400,000 during the period January 1through September 30, 2004, $750,000 during the period October 1,through December 31, 2004, $450,000 during the period January 1,through September 30, 2003 (after commutation—see discussion below) and$312,500 during the period October 1 through December 31, 2003.

In an effort to manage the cost of quota sharereinsurance in the time of rising cost and limited availability, the Companyimplemented provisions for loss ratio caps to its quota share reinsuranceagreements. These provisions have been structured to provide the reinsurerswith some limit on the amount of potential loss being assumed, whilemaintaining the transfer of significant insurance risk with the possibility ofa significant loss to the reinsurer, and thereby to reduce the cost ofreinsurance. Loss ratio caps cut off the reinsurers’ liability for losses abovea specified loss ratio. The loss ratio caps in the 2005, 2004 and 2003 quotashare agreements were 95.0%, 95.0% and 92.0%, respectively.

The Company is in discussions with a Bermudareinsurance company in formation to enter into a multi-year quota sharereinsurance agreement for 2006. Until this agreement is in place the Company isretaining all of the risk for 2006 that would have been ceded to quota sharereinsurers. In 2005, the Company  ceded25% of its net premiums written to reinsurers in accordance with its quotashare treaty. The Company’s 2005 Property Catastrophe Program warrants that aminimum 25% quota share cession be in place for the program. If a loss to theProperty Catastrophe Program occurs after January 1, 2006 but before theinception of the proposed multi-year quota share agreement the Company would berequired to retain 25% of the loss as if a 25% quota share cession was inplace.

The structure of the Company’s reinsurance programenables the Company to reflect significant reductions in premiums written andearned and also provides income as a result of ceding commissions earnedpursuant to reinsurance contracts. This structure has enabled the Company tosignificantly grow its premium volume while maintaining regulatory capital andother financial ratios generally within expected ranges used for regulatoryoversight purposes. The Company’s participation in reinsurance arrangementsdoes not relieve the Company from its obligations to policyholders.

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Approximatereinsurance recoverables by reinsurer are as follows (in 000’s):

| ** **                                 | ** ** | **Unpaid  Losses** | ** ** | **Paid  Losses** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|--------------------|------------|------------------|------------|-----------|------------|
| **December 31, 2005:**                |       |               |       |             |       |      |       |
| PXRE Reinsurance Company                   |       | $                  | 22,379     |             | $          | 2,383     |       | $ | 24,762 |   |
| American Re-Insurance Company              |       | 15,900             |       | 2,084            |       | 17,984    |       |
| Tokio Millennium Re Ltd.                   |       | 35,091             |       | 2,014            |       | 37,105    |       |
| Hannover Reinsurance (Ireland) Ltd.        |       | 14,838             |       | 1,010            |       | 15,848    |       |
| E+S Reinsurance (Ireland) Ltd.             |       | 3,709              |       | 252              |       | 3,961     |       |
| Hannover Rueckversicherung AG              |       | 1,573              |       | —           |       | 1,573     |       |
| Platinum Underwriters Reinsurance Company. |       | 2,357              |       | —           |       | 2,357     |       |
| Others                                     |       | 1,131              | ** ** | 90               | ** ** | 1,221     |       |
| **Total**                                  | ** ** | **$**              | **96,978** | ** **       | **$**      | **7,833** | ** ** | **$** | **104,811** | ** ** |
| **December 31,  2004:**               |       |               |       |             |       |      |       |
| PXRE Reinsurance Company                   |       | $                  | 33,852     |             | $          | 3,804     |       | $ | 37,656 |   |
| American Re-Insurance Company              |       | 13,298             |       | 1,175            |       | 14,473    |       |
| Tokio Millennium Re Ltd.                   |       | 31,278             |       | 3,317            |       | 34,595    |       |
| Hannover Reinsurance (Ireland) Ltd.        |       | 7,750              |       | 850              |       | 8,600     |       |
| E+S Reinsurance (Ireland) Ltd.             |       | 1,937              |       | 212              |       | 2,149     |       |
| SCOR Reinsurance Company                   |       | 1,323              |       | 9                |       | 1,332     |       |
| Others                                     |       | 2,335              |       | 33               |       | 2,368     |       |
| **Total**                                  | ** ** | **$**              | **91,773** | ** **       | **$**      | **9,400** | ** ** | **$** | **101,173** | ** ** |

 

TheCompany recorded prepaid reinsurance premiums as follows (in 000’s):

| ** **                                 | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|
| ** **                                 | ** ** | **2005**              | ** ** | **2004** | ** ** |
| American  Re-Insurance Company             |       | $                     | 1,252      |   | $ | 1,376 |   |
| Tokio Millennium  Re Ltd.                  |       | 18,934                |       | 13,093 |   |
| Hannover  Reinsurance (Ireland Ltd.)       |       | 15,147                |       | 10,474 |   |
| E+S Reinsurance  (Ireland) Ltd.            |       | 3,787                 |       | 2,619 |   |
| Hannover Rueckversicherung  AG             |       | 1,551                 |       | — |   |
| Platinum  Underwriters Reinsurance Company |       | 1,645                 |       | — |   |
| Others                                     |       | 1,003                 |       | 829 |   |
| **Total**                                  | ** ** | **$**                 | **43,319** | ** ** | **$** | **28,391** | ** ** |

 

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The followingcollateral is available to the Company for amounts recoverable from reinsurers(in 000’s) as of December 31, 2005 and 2004:

| ** **                          | ** ** | **Regulation  114 Trust** | ** ** | **Letters of Credit** | ** ** | **Funds Held** | ** ** | **Total** | ** ** |
|-------------------------------------|------------|--------------------------------|------------|---------------------------------|------------|---------------------|------------|-----------|------------|
| **December 31, 2005**          |       |                           |       |                            |       |                |       |      |       |   |   |   |   |   |   |
| Tokio Millennium Re Ltd.            |       |                           | $          | 10,868                          |       |                |       | $         | —     |   |   |   | $ | 36,384 |   |   | $ | 47,252 |   |
| Hannover Reinsurance (Ireland) Ltd. |       |                           | —     |                            |       |                | 7,430      |      |       |   | 18,126 |   |   | 25,556 |   |
| E+S Reinsurance (Ireland) Ltd.      |       |                           | —     |                            |       |                | 1,857      |      |       |   | 4,532 |   |   | 6,389 |   |
| Others                              |       |                           | —     |                            |       |                | 574        |      |       |   | — |   |   | 574 |   |
| Total                               |       |                           | $          | 10,868                          |       |                |       | $         | 9,861      |   |   |   | $ | 59,042 |   |   | $ | 79,771 |   |
| **December 31, 2004**          |       |                           |       |                            |       |                |       |      |       |   |   |   |   |   |   |
| Tokio Millennium Re Ltd.            |       |                           | $          | 19,345                          |       |                |       | $         | —     |   |   |   | $ | 38,296 |   |   | $ | 57,641 |   |
| Hannover Reinsurance (Ireland) Ltd. |       |                           | —     |                            |       |                | 5,355      |      |       |   | 12,685 |   |   | 18,040 |   |
| E+S Reinsurance (Ireland) Ltd.      |       |                           | —     |                            |       |                | 1,338      |      |       |   | 3,171 |   |   | 4,509 |   |
| Others                              |       |                           | —     |                            |       |                | 796        |      |       |   | — |   |   | 796 |   |
| Total                               |       |                           | $          | 19,345                          |       |                |       | $         | 7,489      |   |   |   | $ | 54,152 |   |   | $ | 80,986 |   |

 

To reduce TICNY’s credit exposure to reinsurance,quota share reinsurance agreements effective October 1, 2003, January 1,2004 and January 1, 2005 were placed on a “funds withheld” basis. Underthese agreements TICNY places the collected ceded premiums written, net ofcommissions and the reinsurers margin, in segregated trusts for the benefit ofTICNY and the reinsurers. TICNY may withdraw funds for loss and loss adjustmentexpense payments and commission adjustments. Segregated assets in trustaccounts amounted to $60,047,000 and $53,888,000 at December 31, 2005 and2004 and are included in invested assets. The Company is obliged under thereinsurance agreements to credit reinsurers with an annual effective yield onthe monthly balance in the funds held under reinsurance agreements liabilityaccounts of 3% in 2005 and 2.5% in 2004. The amounts credited for 2005 and 2004were $1,339,000 and $1,069,000, respectively, and have been recorded asinterest expense.

The Company earns ceding commissions under quota sharereinsurance agreements for 2005, 2004 and 2003 based on a sliding scale ofcommission rates and ultimate treaty year loss ratios on the policies reinsuredunder each of these agreements. The sliding scale includes minimum and maximumcommission rates in relation to specified ultimate loss ratios. The commissionrate and ceding commissions earned increase when the estimated ultimate lossratio decreases and, conversely, the commission rate and ceding commissionsearned decrease when the estimated ultimate loss ratio increases.

As of December 31,2005, the Company’s estimated ultimate loss ratios attributable to thesecontracts are lower than the contractual ultimate loss ratios at which theminimum amount of ceding commissions can be earned. Accordingly, the Companyhas recorded ceding commissions earned that are greater than the minimumcommissions. The relevant estimated ultimate loss ratios and commissions as of December 31,2005 are set forth below (dollars in 000’s):

| **Treaty Year** | ** ** | **Contractual Loss Ratio  at Which Minimum  Ceding Commission   Rate Applies** | ** ** | **Estimated Ultimate  Loss Ratio** | ** ** | **Ceding   Commissions  Earned** | ** ** | **Minimum  Commission** | ** ** | **Maximum Potential  Reduction of Ceding  Commissions  Earned** | ** ** |
|----------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------|------------|-------------------------|------------|--------------------------------------------------------------------------------|------------|
| 2002                 |       |                                                                                                              | 63.0       | %                                            |       |                                  | 56.1       | %                       |       |                                                                           | $          | 29.6 |   |   |   | $ | 23.6 |   |   |   | $ | 6.0 |   |   |
| 2003                 |       |                                                                                                              | 65.6       | %                                            |       |                                  | 58.0       | %                       |       |                                                                           | $          | 30.4 |   |   |   | $ | 24.4 |   |   |   | $ | 6.0 |   |   |
| 2004                 |       |                                                                                                              | 68.0       | %                                            |       |                                  | 55.1       | %                       |       |                                                                           | $          | 29.4 |   |   |   | $ | 10.3 |   |   |   | $ | 8.9 |   |   |
| 2005                 |       |                                                                                                              | 68.0       | %                                            |       |                                  | 55.1       | %                       |       |                                                                           | $          | 14.4 |   |   |   | $ | 10.3 |   |   |   | $ | 4.1 |   |   |

 

Based on the amount of ceded premiums earned, themaximum potential reduction to ceding commissions earned related to an increasein the Company’s estimated ultimate loss ratios is $25.0 million for alltreaties for all four years. The maximum potential reduction for the 2005 treatyyear may increase as 

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additional ceded premiumsare earned in 2006 (assuming the estimated ultimate loss ratio remains thesame). The ceded premiums for the 2002, 2003 and 2004 treaty years have beenfully earned as of December 31, 2005.

The estimated ultimateloss ratios are the Company’s best estimate based on facts and circumstancesknown at the end of each period that losses are estimated. The estimationprocess is complex and involves the use of informed estimates, judgments andactuarial methodologies relative to future claims severity and frequency, thelength of time for losses to develop to their ultimate level, possible changesin law and other external factors. The same uncertainties associated withestimating loss and loss adjustment expense reserves affect the estimates ofceding commissions earned. The Company monitors and adjusts the ultimate lossratio on a quarterly basis to determine the effect on the commission rate andceding commissions earned. The decrease in estimated ceding commission incomerelating to prior years recorded in 2005 was $810,000 and an increase of1,663,000 and $1,326,000, respectively, in 2004 and 2003.

**PMA**

Effective October 1,2003, the Company commuted PMA’s participation under the 2003 quota sharereinsurance treaty. Prior to the commutation, PMA assumed 17.5% of the layer ofcoverage representing the first $500,000 of each loss on policies written orrenewed on or after January 1, 2003. The effect of this commutation was toconclude PMA’s participation in the quota share treaty and to discharge PMAfrom future related liabilities effective October 1, 2003. Loss relatedamounts recoverable from PMA at the commutation date including loss and lossadjustment expense reserve liabilities ceded of $2,700,000 and ceded paidlosses of $4,000,000 that had not yet been recovered from PMA were settled witha payment received from PMA of $3,100,000. The Company also received $2,500,000for ceded unearned premium at the commutation date resulting in a total cashsettlement of $5,600,000. The Company incurred a cost of $800,000 representingconsideration retained by PMA for reinsuring the Company from January 1,2003 to September 30, 2003.

**PXRE**

PXRE participated in various reinsurance agreementswith the Company from 2001 through September 30, 2003, including a quotashare participation in the layer of coverage representing the first $500,000 ofeach loss. Ceded written premiums include $20,261,000 ceded to PXRE in 2003. EffectiveSeptember 30, 2003, the 2003 quota share agreement with PXRE was cancelled.The quota share agreements with PXRE are in run-off. As a result of thecancellation of the 2003 quota share agreement with PXRE as of September 30,2003, the Company was owed $15,748,000 in return premium net of ceding commissionsas of December 31, 2003. This amount was collected in January 2004.

In addition to the ceding commission provisionsdescribed above, the 2002 PXRE quota share agreement contained a provision thatprovided the Company with a non-refundable special commission of $5,000,000,which the Company received in December 2001. The Company deferred thisspecial commission as of December 31, 2001 to be earned over the periodduring which the underlying premiums are earned.

In January 2003, the Company entered into anexcess of loss reinsurance agreement with PXRE Barbados Ltd. (“PXRE Barbados”),an affiliate of PXRE, and remitted $10,000,000 as deposit premium to PXREBarbados as called for by the contract. This excess of loss agreement inuredsolely to the benefit of PXRE in connection with its participation in the 2003quota share agreement with the Company. Effective September 30, 2003, theCompany and PXRE Barbados commuted the excess of loss agreement. As a result ofthe commutation of the agreement, the Company recorded $1,537,000 in cedingcommission revenue in 2003.

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In 2001, the Companyentered into quota share reinsurance and option agreements with PXRE. Under theoption agreement, which was effective on June 30, 2001, PXRE was grantedthe right to purchase 599,400 shares of common stock of the Company for $16.67per share. PXRE paid the Company $5,000,000 for this option, which becomesexercisable on June 30, 2006 and expires on July 31, 2006. Theagreement provides that PXRE’s right to exercise the option terminates if theCompany meets certain conditions. Those conditions included the Companygranting to PXRE a right of first refusal with respect to all quota sharereinsurance cessions made by the Company through December 31, 2005 andpresenting reinsurance submissions to PXRE involving gross written premiums ofat least $25,000,000 per year from 2001 through 2005. The terms and conditionsof the 2001 quota share reinsurance treaty between PXRE and TICNY, includingthe commission rate, were amended to reflect the payment of the $5,000,000under the option agreement. The Company classified the $5,000,000 proceeds forthe stock options as commission income in 2001 and attributed no value to theoptions issued to PXRE due to the $16.67 per share exercise price. On June 8,2005 the Company was notified that, all conditions were met and that PXRE’sright to purchase 599,400 common shares of the Company was terminated.

**Am Re**

The Company hasparticipated in various reinsurance agreements with Am Re. Ceded written premiumsinclude $3,742,000, $2,753,000 and $3,811,000 ceded to Am Re in 2005, 2004 and2003, respectively. Am Re had owned all outstanding shares of the Company’s Series ACumulative Redeemable Preferred Stock and held warrants for the purchase ofcommon stock. See “Note 8. Debt” and “Note 9. Capital Stock”. During 2004, allof the preferred stock was redeemed and the warrants were exercised.

**Converium**

In September 2004, A.M.Best downgraded the rating of Converium Reinsurance (North America) Inc. (“Converium”)to “B-” (Fair) and Converium was placed into run-off by its parent Company. Asa result, on September 2, 2004, the Company delivered notice to Converiumunder our quota share treaty of our intent to terminate Converium’sparticipation on a cut-off basis effective November 1, 2004. Subsequentlythe Company reached an agreement with Converium, Tokio Millenium Re Ltd. (“Tokio”)and Hannover Reinsurance (Ireland) Ltd. and E+S Reinsurance (Ireland) Ltd.(collectively “Hannover”) to effect a novation of Converium’s participationunder the quota share treaty to those other reinsurers effective January 1,2004, as a result of which Tokio and Hannover agreed to each take 50% ofConverium’s share. In connection with the agreement, Tokio, Hannover and theCompany agreed to fully release Converium for any liabilities under the quotashare treaty. As a result of the novation, Tokio and Hannover assumed theearned premiums and related risks for the period from January 1, 2004through December 31, 2004. In addition, the Company has retained theunearned premiums and related risks of as of December 31, 2004 that wouldhave been ceded to Converium absent the novation. The unearned premiums of$13,090,000 were fully earned as of December 31, 2005.

**Note 6—Intangible Assets**

The Company entered into a Commercial Renewal Rights Agreementwith OneBeacon Insurance Group LLC on September 13, 2004 under which ithas acquired OneBeacon’s rights to seek to renew a block of commercial linesinsurance policies in New York State consisting of commercial multiple-peril,worker’s compensation, commercial umbrella, commercial inland marine,commercial auto, fire and allied lines and general liability coverages. Underthe terms of the agreement, the Company did not acquire any in-force business orhistorical liabilities associated with the policies. Pursuant to the agreement,the Company also obtained the rights to establish contractual relationshipswith certain OneBeacon agents. The Company has agreed to pay OneBeacon anamount equal to 5% of the direct premiums written resulting from the Company’srenewal of any subject policies in the first year, 4% in the second year and 

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1% in the third year, withno payments due after the third year, subject to the Company’s obligation topay a minimum of $5,000,000 in the aggregate over the three year period. TheCompany has recorded this transaction as $5,000,000 of intangible assets. Shortlyafter signing this agreement the Company provided an irrevocable letter ofcredit for the benefit of OneBeacon in the amount of $2,000,000 representingthe estimated payments for the first year of the agreement.

The Company hasdetermined that two intangible assets were acquired in this transaction:renewal rights and new agent contractual relationships, both of which weredetermined to be intangible assets with a finite useful life. The renewalrights were recorded at $1,250,000 and will be amortized over ten years inproportion to anticipated renewal premiums to be written during this timeperiod. The new agent contractual relationships have been recorded at$3,750,000 and will be amortized over twenty years on a straight-line basis. During2005 and 2004, the Company recorded amortization expense of $446,000 and$22,000, respectively, on the intangible assets. The weighted averageamortization period of identified intangible assets of finite useful life is17.5 years. The estimated aggregate amortization expense for each of the nextfive years is (in 000’s):

| 2006 |   | $ | 412 |   |
|------|--------|---|-----|--------|
| 2007 |   | $ | 367 |   |
| 2008 |   | $ | 331 |   |
| 2009 |   | $ | 302 |   |
| 2010 |   | $ | 279 |   |

 

On March 25, 2005, Tower Group, Inc. closedon its purchase of the outstanding common stock of a shell property casualtyinsurance company, North American Lumber Insurance Company (“NALIC”), that wasrenamed Tower National Insurance Company. The purchase price was for $1,050,000and included nine active state licenses and two inactive state licenses. Thetwo inactive states are Pennsylvania and Maine. The inactive state licenseshave an additional contingent purchase price of $75,000 per state payable uponlicense reactivation within one year of the closing. Prior to the closing, allliabilities and assets (other than insurance licenses) of Tower NationalInsurance Company were transferred to a liquidating trust. The Companycapitalized these purchases as an intangible asset related to state licenseswith an indefinite life subject to annual impairment testing. Subsequently,during 2005, the two inactive state licenses were reactivated and an additionalcontingent price totaling $150,000 was paid. The total amount capitalized as ofDecember 31, 2005, was $1,303,000 and included the purchase price, legalfees and a broker’s fee.

Thecomponents of intangible assets are summarized as follows (in 000’s):

| ** **                   | ** ** | **Initial Balance** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|------------------------------|------------|--------------------------|------------|-------------------------------|------------|---------|------------|
| **December 31,  2005:** |       |                     |       |                          |       |    |       |   |   |   |   |
| Renewal rights               |       |                     | $          | 1,250                         |       |    |       | $ | (280 | ) |   | $ | 970 |   |
| Agency force                 |       |                     | 3,750      |                          |       |    | (188       | ) |   | 3,562 |   |
| Insurance  Licenses          |       |                     | 1,303      |                          |       |    | —     |   |   | 1,303 |   |
| **Total**                    |       |                     | $          | 6,303                         |       |    |       | $ | (468 | ) |   | $ | 5,835 |   |
| **December 31,  2004:** |       |                     |       |                          |       |    |       |   |   |   |   |
| Renewal rights               |       |                     | $          | 1,250                         |       |    |       | $ | (6 | ) |   | $ | 1,244 |   |
| Agency force                 |       |                     | 3,750      |                          |       |    | (16        | ) |   | 3,734 |   |
| **Total**                    |       |                     | $          | 5,000                         |       |    |       | $ | (22 | ) |   | $ | 4,978 |   |

 

As of December 31, 2005 there was no impairmenton any of the intangible assets as per the Company’s annual impairment testing.See Note 1. “Summary of Significant Accounting Policies, Intangible Assets”.

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**Note 7—Fixed Assets**

The components of fixed assets are summarized asfollows (in 000’s):
|                             | ** ** | **Cost**                     | ** ** | **Accumulated  Depreciation** | ** **        | **Net** | ** ** |
|-----------------------------|------------|------------------------------|------------|-------------------------------|-------------------|---------|------------|
| **December 31, 2005:** |       |                         |       |                          |              |    |       |   |   |
| Furniture                   |       | $ 1,357                 |       |                          | $  (445 | )       |       | $  912 |   |
| Leasehold  improvements     |       | 1,498                        |       |                          | (821              | )       |       | 677 |   |
| Computer  equipment         |       | 6,314                        |       |                          | (4,539            | )       |       | 1,775 |   |
| Software                    |       | 8,608                        |       |                          | (4,052            | )       |       | 4,556 |   |
| Total fixed assets          |       | $ 17,777                |       |                          | $ (9,857     | )       |       | $ 7,920 |   |
| **December 31, 2004:** |       |                         |       |                          |              |    |       |   |   |
| Furniture                   |       | $    626 |       |                          | $  (298 | )       |       | $  328 |   |
| Leasehold  improvements     |       | 1,123                        |       |                          | (649              | )       |       | 474 |   |
| Computer  equipment         |       | 4,954                        |       |                          | (3,716            | )       |       | 1,238 |   |
| Software                    |       | 5,705                        |       |                          | (2,325            | )       |       | 3,380 |   |
| Total fixed  assets         |       | $ 12,408                |       |                          | $ (6,988     | )       |       | $ 5,420 |   |

 

**Note 8—Debt**

**Subordinated Debentures**

During the second and third quarters of 2003, Towerformed two statutory business trusts (“Trust I” and “Trust II”), of which theCompany owns all of the common trust securities. On May 15, 2003 and September 30,2003, Trust I and Trust II, respectively, each issued $10,000,000 floating ratetrust preferred securities totaling $20,000,000 to investment pools. The trustsinvested the proceeds thereof and the proceeds received from the issuance ofthe common trust securities to Tower in exchange for $20,620,000 of floatingrate junior subordinated debentures (“subordinated debentures”) issued by Tower.The subordinated debentures are unsecured obligations of Tower and aresubordinated and junior in right of payment to all present and future seniorindebtedness of Tower. Tower has entered into guarantee agreements, whichprovide for full and unconditional guarantee of the trust securities. Thesubordinated debentures and the floating rate preferred securities issued byTrust I accrue and pay interest quarterly based upon interest that will floaton the 3-month LIBOR, plus 4.10%, which cannot exceed 12.50% prior to May 15,2008. At December 31, 2005 this interest rate was 8.40%. The Trust IIfloating rate preferred securities bear interest at a fixed rate of 7.5% until September 30,2008 and at a variable rate, reset quarterly, equal to the 3-month LIBOR,plus 4.00%, thereafter. The final maturity on the subordinated debentures is May 15,2033 and September 30, 2033 for Trust I and Trust II, respectively, withprepayment at the option of the Company available beginning in 2008. Issuancecosts, primarily legal fees, of $301,000 and $338,000 for the Trust I and TrustII offerings, respectively, were deferred and are being amortized over the termof the subordinated debentures using the effective interest method.

In December 2004, Tower formed two statutorybusiness trusts (“Trust III” and “Trust IV”), of which the Company owns all ofthe common trust securities. On December 7, 2004 and December 17,2004, Trust III and Trust IV, respectively, each issued $13,000,000 floatingrate trust preferred securities totaling $26,000,000 to investment pools. Thetrusts invested the proceeds thereof and the proceeds received from theissuance of the common trust securities to Tower in exchange for $26,806,000 offloating rate junior subordinated debentures (“subordinated debentures”) issuedby Tower. The subordinated debentures are unsecured obligations of Tower andare subordinated and junior in right of payment to all present and futuresenior indebtedness of Tower. Tower has entered into guarantee agreements,which provide for full and unconditional guarantee of the trust securities. TheTrust III preferred securities bear interest that is fixed at 7.4% until December 7,2009 and the coupon will float quarterly thereafter at the three months 

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LIBOR rate plus 3.4%. TheTrust IV preferred securities bear interest that will float based on the 3-monthLIBOR interest rate plus 3.4% and their rate as of December 31, 2005 was7.89%. The final maturity on the subordinated debentures is December 15,2034 and March 15, 2035 for Trust III and Trust IV, respectively, withprepayment at the option of the Company available beginning in 2009. Issuancecosts, primarily legal fees, of $262,000 and $252,000 for the Trust III andTrust IV offerings, respectively, were deferred and are being amortized overthe term of the subordinated debentures using the effective interest method.

Total interest expense incurred for all subordinateddebentures, including amortization of deferred origination costs, was$3,514,000, $1,461,000 and $559,000, respectively for the years ended December 31,2005, 2004 and 2003.

Aggregatescheduled maturities of the subordinated debentures at December 31, 2005are (in 000’s):

| **2033**  |       | $ 20,620     |       |
|-----------|------------|-------------------|------------|
| **2034**  |       | 13,403            |       |
| **2035**  |       | 13,403            |       |
| **Total** | ** ** | **$ 47,426** | ** ** |

 

**CIT Financing Agreement**

On February 21, 2003,Tower entered into a Credit Agreement with The CIT Group/Equipment Financing, Inc.(“CIT”) for borrowings up to $6.0 million. As of December 31, 2003 therewas $5.6 million of debt outstanding that was repaid in 2004 and the agreementwas terminated in October 2004. Interest expense incurred for the yearsended December 31, 2004 and 2003, including amortization of originationcosts, was $283,000 and $158,000 respectively.

**Series ACumulative Redeemable Preferred Stock**

The 60,000 shares of the Company’s Series ACumulative Redeemable Preferred Stock (“the preferred stock”), $0.01 par valuewere held by Am Re. The preferred stock carried a rate of 10.5% per annum withdividends payable quarterly and in arrears, and was redeemable in advance ofthe mandatory redemption dates at the option of the Company. The preferredstock did not have rights to vote with the holders of common stock. In January 2004,the Company redeemed 30,000 of the outstanding shares of the preferred stockfor $1,500,000 and the remaining 30,000 shares were redeemed by the Company in October 2004for $1,500,000 plus accrued interest.

Due to the adoption by theCompany of SFAS 150, the mandatorily redeemable Series A CumulativeRedeemable Preferred Stock of $3,000,000 was reclassified as a liability as of July 1,2003. Preferred stock dividends of $130,000 for 2004 and $158,000 for theperiod from July 1, 2003 through December 31, 2003, were reported asinterest expense. The dividends paid prior to the adoption of SFAS 150 wereaccounted for as a direct reduction to stockholders’ equity.

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**Note 9—Capital Stock**

The roll forward of sharesof common stock is as follows (in 000’s):
|                                                                     | ** ** | **Shares Issued** | ** ** | **Treasury Stock** | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|
| **Increase (decrease)**                                        | ** ** | ** **             | ** ** | **Common  Stocks**      | ** ** | **Class A Common  Stock** | ** ** | **Class B  Common Stock** | ** ** | **(Class A when  applicable)** | ** ** |
| **Balance at January 1, 2003**                                 |       |                   | 4,500      |                    |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Purchased into treasury                                             |       |                   | —     |                    |       |   | — |   |   |   | — |   |   |   | (93 | ) |   |
| Issuance of Class A and Class B common  stock   |       |                   | (4,500     | )                       |       |   | 2,070 |   |   |   | 2,430 |   |   |   | — |   |   |
| **Balance  at December 31, 2003**                              |       |                   | —     |                    |       |   | 2,070 |   |   |   | 2,430 |   |   |   | (93 | ) |   |
| Restricted stock issued to employees                                |       |                   | —     |                    |       |   | 209 |   |   |   | — |   |   |   | — |   |   |
| Stock options exercised                                             |       |                   | 34         |                    |       |   | — |   |   |   | — |   |   |   | 4 |   |   |
| Combined Class A and Class B                              |       |                   | 4,709      |                    |       |   | (2,279 | ) |   |   | (2,430 | ) |   |   | — |   |   |
| IPO                                                                 |       |                   | 13,000     |                    |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Private placement                                                   |       |                   | 500        |                    |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Am Re warrant exercise                                              |       |                   | 947        |                    |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Over-allotment                                                      |       |                   | 629        |                    |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Restricted stock issued to Directors                                |       |                   | 7          |                    |       |   | — |   |   |   | — |   |   |   | — |   |   |
| **Balance  at December 31, 2004**                              |       |                   | 19,826     |                    |       |   | — |   |   |   | — |   |   |   | (89 | ) |   |
| Restricted stock issued to employees                                |       |                   | 9          |                    |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Stock options exercised                                             |       |                   | 33         |                    |       |   |   |   |   |   | — |   |   |   | — |   |   |
| Friedman Billings Ramsey (FBR) warrant exercise)                    |       |                   | —     |                    |       |   | — |   |   |   | — |   |   |   | 75 |   |   |
| Restricted stock issued to directors                                |       |                   | 5          |                    |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Restricted stock forfeited                                          |       |                   | —     |                    |       |   | — |   |   |   | — |   |   |   | (4 | ) |   |
| **Balance at December 31,  2005**                              |       |                   | 19,873     |                    |       |   | — |   |   |   | — |   |   |   | (18 | ) |   |
|                                                                     |            |                        |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As part of the IPO in October 2004, the Companyissued Friedman Billings Ramsey (FBR), the lead underwriter, warrants topurchase 189,000 shares of the Company’s commons stock at an exercise price of$8.50 per share. The warrants are exercisable for a term of four yearsbeginning on October 20, 2004 and expire on October 20, 2009. On October 28,2005, FBR exercised warrants and paid the Company the warrant exercise price of$8.50 per share or $89,820 and were issued 10,567 shares by the Company fromtreasury shares. In addition, FBR exercised 132,300 warrants on October 28,2005 via a cashless exercise which resulted in the issuance of 64,244 shares bythe Company from treasury shares. As of December 31, 2005, FBR has 46,133warrants outstanding which are included in the calculation of diluted EPS.

Thecompany declared dividends on common and preferred stock as follows in (000’s):
|                                               | ** ** | **2005**     | ** ** | **2004**         | ** ** | **2003**                              | ** ** |
|-----------------------------------------------|------------|--------------|------------|------------------|------------|---------------------------------------|------------|
| Common stock  dividends declared              |       | $ 1,959 |       | $  493 |       | $     — |       |
| Class A  common stock dividends declared |       | —       |       | 228              |       | 293                                   |       |
| Class B  common stock dividends declared |       | —       |       | 281              |       | 1,403                                 |       |
| Total common stock dividends declared         |       | 1,959        |       | 1,002            |       | 1,696                                 |       |
| Preferred stock dividends declared            |       | —       |       | —           |       | 158                                   |       |
| Total dividends  declared                     |       | $ 1,959 |       | $ 1,002     |       | $ 1,854                          |       |

 

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The Company declared dividends per share on commonstock as follows:
|                    | ** ** | **2005**    | ** ** | **2004**      | ** ** | **2003**      | ** ** |
|--------------------|------------|-------------|------------|---------------|------------|---------------|------------|
| Common Stock       |       | $ 0.10 |       | $ 0.0250 |       | —        |       |
| Class A Stock |       | —      |       | $ 0.1137 |       | $ 0.1465 |       |
| Class B Stock |       | —      |       | $ 0.1142 |       | $ 0.5773 |       |

 

In 2005, the Company issued 33,000 new common sharesas a result of employee stock option exercises and 14,000 new common shares forits restricted stock grants to certain employees and directors of the Company. During2005, 3,725 restricted stock shares were forfeited due to employee terminationsand have been recorded as additional treasury shares.

The Company incurred restricted stock amortizationexpense in 2005, and 2004 of $402,000 and $201,000, respectively, net of tax,which has been included in reported net income.

The Company issued 946,642additional shares of common stock immediately prior to its IPO in October 2004as a result of the exercise in full of Am Re’s warrant to purchase 1,049,999shares of common stock at an exercise price of $0.76 per share, pursuant to acashless exercise provision, and based upon the IPO price of $8.50 per share.

**Note 10—EquityCompensation Plans**

**2004Long-Term Equity Compensation Plan**

In 2004, the Company’s Board of Directors adopted andits shareholders approved a long-term incentive plan (the “2004 Long-TermEquity Compensation Plan”). With the adoption of the 2004 Long-Term EquityCompensation Plan, no further grants will be made under the 2001 Stock AwardPlan.

The 2004 Long-Term EquityCompensation plan provides for the granting of non-qualified stock options,incentive stock options (within the meaning of Section 422 of the Code),stock appreciation rights (“SARs”), restricted stock and restricted stock unitawards, performance shares and other cash or share-based awards. The currentmaximum number of shares of common stock that may be issued in connection withawards under the plan is 933,707, of which 786,031 may be issued under awardsother than stock options or SARs. As of December 31, 2005, awards inrespect of 250,813 shares have been made under the plan.

**2001 Stock Award Plan**

In December 2000, the Board of Directors adopteda long-term incentive plan (the “2001 Stock Award Plan”). The plan provided fora variety of awards, including incentive or non-qualified stock options,performance shares, SARs or any combination of the foregoing.

Under the 2001 Stock AwardPlan, 450,000 shares may be made the subject of awards granted under the plan. AtDecember 31, 2005, 358,200 shares of common stock have been issued or aresubject to issuance upon the exercise or payment of outstanding awards underthe plan. The remaining 91,800 shares eligible for grants under the plan thathave not been the subject of awards are now eligible under our 2004 Long-TermIncentive Compensation Plan, such that no further awards may be granted underthe 2001 Stock Award Plan.

**Restricted Stock**

In May 2004, the Company’s Board of Directorsauthorized the issuance of 131,888 shares of restricted Common Stock to thePresident and Chief Executive Officer and 8,793 shares of restricted CommonStock to the Senior Vice President, Chief Financial Officer and Treasurer. Theshares vest in installments over a varying period from one to four years fromthe date of grant contingent upon 

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continuous employment withthe Company from the date of grant through the vesting date. During the vestingperiod, the recipients have voting rights and will receive dividends but theshares may not be sold, assigned, transferred, exchanged, pledged or otherwiseencumbered. The fair value of the restricted shares was $1,563,000 on the grantdate. These restricted shares were authorized and issued prior to the adoptionand approval of the 2004 Long-Term Equity Compensation Plan.

In 2005 and 2004, respectively 10,107 and 216,685restricted shares (net of canceled shares) of the Company’s common stock weregranted to certain employees and directors of the Company. The fair value ofthe shares awarded (net of cancellations) in 2005 and 2004, determined on thegrant date, was $174,000 and $2,218,000, respectively.

All restricted stockshares are recorded at fair value at the date of grant as a charge to UnearnedCompensation—RestrictedStock in Stockholders’ Equity and a credit to Common Stock andPaid-in-Capital. These shares will amortize ratably over their vesting periodas a charge to compensation expense and a credit to Unearned Compensation—Restricted Stock in Stockholders’Equity on the balance sheet. In 2005 and 2004, the Company amortizedapproximately $618,000 and $310,000, respectively, as a charge to compensationexpense and a credit to Unearned Compensation—Restricted Stock. During 2005, 3,725 restricted shareswere forfeited resulting in a $32,000 reduction to compensation expense.

**Stock Options**

The following table provides an analysis of stockoption activity during the three years ended December 31, 2005.

 
|                                 | ** ** | **2005**                         | ** **  | **2004**                     | ** ** | **2003**                         | ** **      |
|---------------------------------|------------|----------------------------------|-------------|------------------------------|------------|----------------------------------|-----------------|
| ** **                      | ** ** | **Number of   Shares** | ** **  | **Average  Exercise  Price** | ** ** | **Number of   Shares** | ** **      | **Average  Exercise  Price** | ** ** | **Number of   Shares** | ** ** | **Average  Exercise  Price** | ** ** |
| Outstanding,  beginning of year |       |                             | 472,777     |                         |       |                             | $ 4.73     |   |   |   | 358,200 |   |   |   | $ 2.78 |   |   |   | 408,600 |   |   |   | $ 2.78 |   |   |
| Granted at market  value        |       |                             | —      |                         |       |                             | —          |   |   |   | 161,077 |   |   |   | 8.50 |   |   |   | — |   |   |   | — |   |   |
| Forfeitures and  expirations    |       |                             | (9,072      | )                            |       |                             | 8.50            |   |   |   | (9,000 | ) |   |   | 2.78 |   |   |   | (50,400 | ) |   |   | 2.78 |   |   |
| Exercised                       |       |                             | (32,705     | )                            |       |                             | 2.78            |   |   |   | (37,500 | ) |   |   | 2.78 |   |   |   | — |   |   |   | — |   |   |
| **Outstanding,  end of year**   | ** ** | ** **                       | **431,000** |                         | ** ** | ** **                       | **$ 4.80** |   | ** ** | ** ** | **472,777** |   | ** ** | ** ** | **$ 4.73** |   | ** ** | ** ** | **358,200** |   | ** ** | ** ** | **$ 2.78** |   |   |
| **Exercisable, end of year**    | ** ** | ** **                       | **305,450** |                         | ** ** | ** **                       | **$ 3.38** |   | ** ** | ** ** | **295,320** |   | ** ** | ** ** | **$ 2.78** |   | ** ** | ** ** | **316,260** |   | ** ** | ** ** | **$ 2.78** |   |   |

 

Options outstanding and exercisable as of December 31,2005 are shown on the following schedule:

 
|                                             | ** ** | **Options Outstanding** | ** **  | **Options Exercisable** | ** ** |
|---------------------------------------------|------------|------------------------------|-------------|------------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **                   | ** **  | **Number of  Shares**   | ** ** | **Average  Remaining  Contractual Life** | ** ** | **Average  Exercise  Price** | ** ** | **Number of  Shares** | ** ** | **Average  Exercise  Price** | ** ** |
| Under $4.00                                 |       |                         | 278,995     |                         |       |   | 6.0 years |   |   |   | $ 2.78 |   |   |   | 273,235 |   |   |   | $ 2.78 |   |   |
| $5.00 - $10.00                              |       |                         | 152,005     |                         |       |   | 8.8 years |   |   |   | $ 8.50 |   |   |   | 32,215 |   |   |   | $ 8.50 |   |   |
| **Total Options**                           | ** ** | ** **                   | **431,000** |                         | ** ** | ** ** | **7.0 years** |   | ** ** | ** ** | **$ 4.80** |   | ** ** | ** ** | **305,450** |   | ** ** | ** ** | **$ 3.38** |   |   |
|                                             |            |                              |             |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The Company has elected to follow AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Based Compensation”and related interpretations in accounting for its employee stock options. UnderAPB 25, no compensation expense is recognized upon the granting of stockoptions because the exercise price is equal to the estimated market price atthe date of the grant.

In December 2004, the Financial AccountingStandards Board issued the revised statement SFAS No. 123-R, anamendment to SFAS123, which suspends APB 25 and requires that the cost ofshare-based payment transactions be recognized in the financial statementsafter the fiscal quarter beginning after June 15, 2005. The intendedadoption by the Company of SFAS 123-R has been postponed to 

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January 2006 per theSecurities and Exchange Commission’s rule amendment promulgated April 14,2005, that allows calendar year-end companies to elect to implement SFAS 123-Rat the start of their next fiscal year beginning after June 15, 2005. Theimplementation of SFAS 123-R is not expected to have a material effect onthe Company’s financial position or results of operations.

The fair value of the 2001 options granted wasestimated using the Black-Scholes pricing model as of January 1, 2001, thedate of the initial grant, with the following weighted averageassumptions:  risk free interest rate of4.97%, dividend yield of 1.75%, volatility factors of the expected market priceof the Company’s common stock of 35%, and a weighted-average expected life ofthe options of 7 years.

The fair value of the 2004 options granted wasestimated using the Black-Scholes pricing model as of September 29, 2004,the date of the initial grant, with the following weighted average assumptions:risk free interest rate of 3.8%, dividend yield of 1.2%, volatility factors ofthe expected market price of the Company’s common stock of 30.6% and aweighted-average expected life of the options of 7 years.

Thefollowing table illustrates the effect on net income and earnings per share ifthe Company had applied the fair value recognition provisions of SFAS 123, tostock-based employee compensation (in 000’s, except per share amounts).
|                                                                                                                                              | ** ** | **2005**                | ** ** | **2004**     | ** ** | **2003**     | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|--------------|------------|--------------|------------|
| Net income as  reported                                                                                                                      |       | $ 20,754           |       | $ 9,029 |       | $ 6,280 |       |
| Deduct preferred  stock dividends                                                                                                            |       |                    |       | —       |       | (158         | )          |
| Deduct total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (61                     | )          | (16          | )          | —       |       |
| Net income, pro  forma                                                                                                                       |       | $ 20,693           |       | $ 9,013 |       | $ 6,122 |       |
| Earnings per share                                                                                                                           |       |                    |       |         |       |         |       |
| Basic—as reported                                                                                                                       |       | $   1.06 |       | $ 1.23  |       | $ 1.37  |       |
| Basic—pro forma                                                                                                                         |       | $   1.06 |       | $ 1.23  |       | $ 1.37  |       |
| Fully diluted—as reported                                                                                                               |       | $   1.03 |       | $ 1.06  |       | $ 1.09  |       |
| Fully diluted—pro  forma                                                                                                                |       | $   1.03 |       | $ 1.06  |       | $ 1.09  |       |

 

**Note 11—Income Taxes**

TheCompany files a consolidated Federal income tax return. The provision forFederal, state and local income taxes consists of the following components (in000’s):
|                                                                                  | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current Federal  income tax expense                                              |       | $11,864  |       | $1,462   |       | $2,304   |       |
| Current state  income tax expense                                                |       | 1,607    |       | 638      |       | 441      |       |
| Deferred Federal  and State income tax (benefit) expense     |       | (2,409   | )          | 3,594    |       | 629      |       |
| Provision for income  taxes                                                      |       | $11,062  |       | $5,694   |       | $3,374   |       |

 

Deferred tax assets and liabilities are determinedusing the enacted tax rates applicable to the period the temporary differencesare expected to be recovered. Accordingly, the current period income taxprovision can be affected by the enactment of new tax rates. The net deferredincome taxes on the balance sheet reflect temporary differences between thecarrying amounts of the assets and liabilities for financial reporting purposesand income tax purposes, tax effected at a 35% rate for 2005 and 2004 and 34%for 2003.

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Significantcomponents of the Company’s deferred tax assets and liabilities are as follows(in 000’s):
|                                                                                                          | ** ** | **2005**     | ** ** | **2004**      | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|--------------|------------|---------------|------------|
| Deferred tax asset:                                                                                      |       |         |       |          |       |
| Claims reserve discount                                                                                  |       | $ 4,109 |       | $ 1,601  |       |
| Unearned premium                                                                                         |       | 8,012        |       | 4,698         |       |
| Allowance for doubtful accounts                                                                          |       | 60           |       | 43            |       |
| Employee benefit plans                                                                                   |       | 124          |       | 108           |       |
| Unrealized depreciation of securities                                                                    |       | 1,816        |       | —        |       |
| Other                                                                                                    |       | 33           |       | 157           |       |
| Total deferred tax asset                                                                                 |       | 14,154       |       | 6,607         |       |
| Deferred tax liability:                                                                                  |       |         |       |          |       |
| Deferred acquisition costs net of deferredceding  commission revenue       |       | 10,217       |       | 6,559         |       |
| Depreciation and Amortization                                                                            |       | 453          |       | 952           |       |
| Unrealized appreciation of securities                                                                    |       | —       |       | 664           |       |
| Other                                                                                                    |       | 280          |       | 19            |       |
| Total deferred tax liabilities                                                                           |       | 10,950       |       | 8,194         |       |
| Net deferred  income tax asset/(liability)                                                               |       | $ 3,204 |       | $ (1,587 | )          |

 

In assessing the valuation of deferred tax assets, theCompany considers whether it is more likely than not that some portion or allof the deferred tax assets will not be realized. The ultimate realization ofdeferred tax assets is dependent upon the generation of future taxable incomeduring the periods in which those temporary differences become deductible. Novaluation allowance against deferred tax assets has been established as theCompany believes it is more likely than not the deferred tax assets will berealized.

Theprovision for Federal income taxes incurred is different from that which wouldbe obtained by applying the Federal income tax rate to net income before incometaxes. The items causing this difference are as follows (in 000’s):
|                                                                                | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Theoretical  Federal income tax expense at U.S. statutory rate (35%, 34%, 34%) |       | $11,136  |       | $5,006   |       | $3,282   |       |
| Tax advantaged investments                                                     |       | (928     | )          | (210     | )          | (101     | )          |
| State income taxes net of Federal benefit                                      |       | 1,044    |       | 385      |       | 291      |       |
| Other                                                                          |       | (190     | )          | 513      |       | (98      | )          |
| Provision for income  taxes                                                    |       | $11,062  |       | $5,694   |       | $3,374   |       |

 

**Note 12—Employee BenefitPlans**

The Company maintains a defined contribution EmployeePretax Savings Plan (401(k) Plan) for its employees. The Companycontributes 50% of each participant’s contribution up to 8% of the participant’scompensation. The Company incurred approximately $649,000, $461,000 and$332,000 of expense in 2005, 2004 and 2003, respectively, related to this plan.

The Company sponsored anonqualified deferred compensation plan (“the Plan”) for the Chairman of theBoard, President and Chief Executive Officer of the Company. As of December 31,2002, the Company has granted the maximum amount allowed under the Plan,$1,000,000. Amounts contributed to the Plan earned interest at the rate of 7%per year. During 2004 and 2003, the Company recognized deferred compensationexpense of $44,000 and $85,000, respectively. On May 5, 2004 the Board ofTRM approved the payment of the entire deferred compensation balance andterminated the plan.

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**Note 13—Commitments andContingencies**

From time to time, the Company is involved in variouslegal proceedings in the ordinary course of business. For example, to theextent a claim asserted by a third party in a law suit against one of theCompany’s insureds covered by a particular policy, the Company may have a dutyto defend the insured party against the claim. These claims may relate tobodily injury, property damage or other compensable injuries as set forth inthe policy. Such proceedings are considered in estimating the liability forloss and loss adjustment expenses. The Company is not subject to any otherpending legal proceedings that management believes are likely to have amaterial adverse effect in the financial statements.

TheCompany has lease agreements for office space and equipment. The Company’sfuture minimum lease payments are as follows ($’s in 000’s): 
| 2006       | ** ** | $ 1,953  | ** ** |
|------------|------------|---------------|------------|
| 2007       |       | 3,381         |       |
| 2008       |       | 3,311         |       |
| 2009       |       | 3,261         |       |
| Thereafter |       | 36,686        |       |
| Total      |       | $ 48,592 |       |

 

Total rental expense charged to operations wasapproximately $2,333,000, $1,536,000 and $1,336,000 in 2005, 2004 and 2003,respectively.

On September 1, 2005 the Company executed a ThirdAmendment to its lease for new premises at 120 Broadway, New York, N.Y., whichconsists of the entire 31st floor and a portion of the 30th floor(approximately 93,730 square feet). The Company will surrender its old premisesat 120 Broadway, New York, N.Y., which consists of the entire 14th floor and aportion of the 17th floor (approximately 54,000 square feet) on the expectedsurrender date of July 1, 2006. The amended lease term is for fifteenyears and six months effective on the new premises commencement date of January 1,2006. The new premises commencement date was postponed from October 1,2005 to January1, 2006 per the agreement’s postponement clause which gaveadditional time to the landlord to complete base building work. The effectivedate of the landlord’s completed base building work was December 31, 2005.The Company has agreed to pay the landlord $2,718,083 annually for the firstfive years, $2,905,537 annually for the next five years and for the last fiveand a half years the greater of $2,905,537 annually or the then prevailing fairmarket rent. The Company will receive free rent for the first nine month periodcommencing on the new premises commencement date and will receive $4,502,757for leasehold improvement incentives. The anticipated net cash outflow for theabove amounts, excluding the leasehold improvements incentives, increased theCompany’s future minimum lease payments by $42,059,991.The Company will receivean additional $581,530 from the landlord ten days after the surrender date forthe purchase of scheduled furniture, fixtures and equipment located in thesurrendered premises. The Company intends to execute an operating lease in 2006for the furniture, fixtures and leasehold improvements for the new premises.

TICNY is subject toassessments in New York for various purposes, including the provision of fundsnecessary to fund the operations of the New York Insurance Department and theNew York Property/Casualty Insurance Security Fund, which pays covered claimsunder certain policies provided by impaired, insolvent or failed insurancecompanies and various funds administered by the New York Workers’ CompensationBoard, which pays covered claims under certain policies provided by impaired,insolvent or failed insurance companies The Company was assessed approximately $941,000, $435,000, $340,000 in2005, 2004 and 2003, respectively, for its proportional share of the totalassessment for the Property/Casualty Security Fund and approximately$589,000,$556,000 and  $312,000 and in2005, 2004 and 2003, respectively, for its proportional share of the operatingexpenses of the New York Insurance 

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Department.Property casualty insurance company insolvencies or failures may result inadditional security fund assessments to the Company at some future date. Atthis time the Company is unable to estimate the possible amounts, if any, ofsuch assessments. Accordingly, the Company is unable to determine the impact,if any, such assessments may have on financial position or results ofoperations of the Company. The Company is permitted to assess premiumsurcharges on workers’ compensation policies that are based on statutorilyenacted rates. However, assessments by the various workers’ compensation fundshave recently exceeded the permitted surcharges resulting in additionalexpenses of $0, $1,143,000 and $0 in 2005, 2004 and 2003, respectively. As of December 31,2005 the liability for the various workers’ compensation funds, which includesamounts assessed on workers’ compensation policies was $2,776,000. This amountis expected to be paid over an eighteen month period ending June 30, 2007.

**Note 14—StatutoryFinancial Information and Accounting Policies**

For regulatorypurposes, TICNY, domiciled in the State of New York, and TNIC domiciled in theCommonwealth of Massachusetts, prepare their statutory basis financialstatements in accordance with practices prescribed or permitted by the State ofNew York Insurance Department or the Massachusetts Department of Insurance (“statutorybasis” or “SAP”). The more significant SAP variances from GAAP are as follows:

·       Policyacquisition costs are charged to operations in the year such costs areincurred, rather than being deferred and amortized as premiums are earned overthe terms of the policies.

·       Cedingcommission revenues are earned when ceded premiums are written except forceding commission revenues in excess of anticipated acquisition costs which aredeferred and amortized as ceded premiums are earned. GAAP requires that allceding commission revenues be earned as the underlying ceded premiums areearned over the term of the reinsurance agreements.

·       Certainassets including certain receivables, a portion of the net deferred tax asset,prepaid expenses and furniture and equipment are not admitted.

·       Investmentsin fixed-maturity securities are valued at NAIC value for statutory financialpurposes, which is primarily amortized cost. GAAP requires certain investmentsin fixed-maturity securities to be reported at fair value.

·       Certainamounts related to ceded reinsurance are reported on a net basis within thestatutory basis financial statements. GAAP requires these amounts to be showngross.

·       ForSAP purposes, changes in deferred income taxes relating to temporarydifferences between net income for financial reporting purposes and taxableincome are recognized as a separate component of gains and losses in surplusrather than included in income tax expense or benefit as required under GAAP.

For the years ended December 31, 2005, 2004 and2003, TICNY reported statutory basis net income/ (loss) of $6,249,000, ($5,705,000),and $2,782,000, respectively. At December 31, 2005 and 2004 TICNY reportedstatutory basis surplus as regards policyholders of $132,409,000, and$126,082,000, respectively. As of December 31, 2005 TICNY is required tomaintain $7,900,000 of minimum capital and surplus in accordance with New YorkInsurance Law.

For the year ended December 31, 2005 TNICreported statutory net income of $116,000 and reported statutory basis surplusas regards policyholders of $10,116,000. As of December 31, 2005 TNIC isrequired to maintain $6,350,000 of minimum of capital and surplus in accordancewith the Commonwealth of Massachusetts’ Insurance Law.

Under New York law, TICNY is limited in the amount ofdividends it can pay to Tower. Under New York law, TICNY may pay dividends toTower only out of statutory earned surplus. In addition, the New 

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York Insurance Departmentmust approve any dividend declared or paid by TICNY that, together with alldividends declared or distributed by TICNY during the preceding twelve months,exceeds the lesser of (1) 10% of TICNY’s policyholders’ surplus as shownon its latest statutory financial statement filed with the New York StateInsurance Department or (2) 100% of adjusted net investment income duringthe preceding twelve months immediately preceding the declaration ordistribution of the current dividend increased by the excess, if any, of netinvestment income over dividends declared or distributed during the periodcommencing thirty-six months prior to the declaration or distribution of thecurrent dividend and ending twelve months prior thereto. TICNY declaredapproximately $2,050,000, $850,000, and $363,000 in dividends to Tower in 2005,2004, and 2003, respectively. As of December 31, 2005, TICNY owed Tower$300,000 in dividends payable. As of December 31, 2005, the maximumdistribution that TICNY could pay without prior regulatory approval wasapproximately $4,049,000.

TNIC may not pay anydividend that, together with all dividends declared or distributed by TNICduring the preceding twelve months, excluding pro rata distributions of anyclass of the TNIC’s own securities, exceeds the greater of (1) 10% of TNIC’spolicyholders’ surplus as of the end of the preceding calendar year or (2) TNIC’snet income for the next preceding calendar year, until thirty days after theCommissioner has received notice of the intended dividend and not objected insuch time. Because TNIC has not yet commenced insurance operations it has nopositive unassigned surplus and, therefore, it may not pay dividends at this time without the approval of theMassachusetts Commissioner of Insurance.

**Note 15—Fair Value ofFinancial Instruments**

Statement of Financial Accounting Standards No. 107,“Disclosures about Fair Value of Financial Instruments” (“SFAS 107”) requiresall entities to disclose the fair value of financial instruments, both assetsand liabilities recognized and not recognized in the balance sheet, for whichit is practicable to estimate fair value. The company uses the followingmethods and assumptions in estimating its fair value disclosures for financialinstruments:

***Equity and fixedincome investments:****  *Fairvalue disclosures for investments are included in “Note 2. Investments”.

***Equity securitiesat cost******—******Fair***valuedisclosure for an asset-backed securities fund that is a closed-end managementcompany is based on obtaining market prices for all of the securities in thefund from an outside third party pricing service and then dividing by thenumber of shares outstanding to determine its price per share. The estimatedfair value for the private investment in a Real Estate Investment Trust (REIT)in our portfolio was determined based on an outside pricing service valuing theunderlying schedules.

***Common trustsecurities******—***statutorybusiness trusts:   Common trust securities are investments inrelated parties; as such it is not practical to estimate the fair value ofthese instruments. Accordingly, these amounts are reported using the equitymethod.

***Agents’ balancesreceivable, assumed premiums receivable, receivable-claims paid by agency:****  *The carrying values reported in the accompanyingbalance sheets for these financial instruments approximate their fair values.

***Reinsurancebalances payable, payable to issuing carrier and funds held:****  *The carrying value reported in the balance sheet forthese financial instruments approximates fair value.

***Subordinated debentures:****  *The carrying values reported in the accompanyingbalance sheets for these financial instruments approximate fair value. Fairvalue was estimated using projected cash flows, discounted at rates currentlybeing offered for similar notes.

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**Note 16—Earnings Per Share**

Thefollowing table shows the computation of the company’s earnings per share (in000’s, except shares and per share amounts):
|                                  | ** ** | **Income**      | ** **    | **Shares**        | ** ** | **Per Share** | ** ** |
|----------------------------------|------------|-----------------|---------------|-------------------|------------|--------------------|------------|
| ** **                       | ** ** | **(Numerator)** | ** **    | **(Denominator)** | ** ** | **Amount**         | ** ** |
| **2005**                         |       |            |          |              |       |               |       |   |   |   |   |   |   |
| Net income                       |       |            | $ 20,754 |              |       |               |       |   |   |   |   |   |   |
| Less: preferred  stock dividends |       |            | —        |              |       |               |       |   |   |   |   |   |   |
| Basic EPS                        |       |            | 20,754        |              |       |               | 19,571,081 |   |   |   | $ 1.06 |   |   |
| Effect of dilutive securities:   |       |            |          |              |       |               |       |   |   |   |   |   |   |
| Stock options                    |       |            | —        |              |       |               | 309,508    |   |   |   |   |   |   |
| Unvested  restricted stock       |       |            | —        |              |       |               | 192,237    |   |   |   |   |   |   |
| Warrants                         |       |            | —        |              |       |               | 74,247     |   |   |   |   |   |   |
| Diluted EPS                      |       |            | $ 20,754 |              |       |               | 20,147,073 |   |   |   | $ 1.03 |   |   |
| **2004**                         |       |            |          |              |       |               |       |   |   |   |   |   |   |
| Net income                       |       |            | $ 9,029  |              |       |               |       |   |   |   |   |   |   |
| Less: preferred  stock dividends |       |            | —        |              |       |               |       |   |   |   |   |   |   |
| Basic EPS                        |       |            | 9,029         |              |       |               | 7,335,286  |   |   |   | $ 1.23 |   |   |
| Effect of dilutive  securities:  |       |            |          |              |       |               |       |   |   |   |   |   |   |
| Stock options                    |       |            | —        |              |       |               | 266,712    |   |   |   |   |   |   |
| Unvested  restricted stock       |       |            |          |              |       |               | 112,379    |   |   |   |   |   |   |
| Warrants                         |       |            | 68            |              |       |               | 851,438    |   |   |   |   |   |   |
| Diluted EPS                      |       |            | $ 9,097  |              |       |               | 8,565,815  |   |   |   | $ 1.06 |   |   |
| **2003**                         | ** ** |            |          |              |       |               |       |   |   |   |   |   |   |
| Net income                       |       |            | $ 6,280  |              |       |               |       |   |   |   |   |   |   |
| Less: preferred  stock dividends |       |            | (158          | )                 |       |               |       |   |   |   |   |   |   |
| Basic EPS                        |       |            | 6,122         |              |       |               | 4,453,717  |   |   |   | $ 1.37 |   |   |
| Effect of dilutive  securities:  |       |            |          |              |       |               |       |   |   |   |   |   |   |
| Stock options                    |       |            | —        |              |       |               | 204,300    |   |   |   |   |   |   |
| Warrants                         |       |            | 84            |              |       |               | 1,049,999  |   |   |   |   |   |   |
| Diluted EPS                      |       |            | $ 6,206  |              |       |               | 5,708,016  |   |   |   | $ 1.09 |   |   |

 

Am Re had the right to surrender shares of Series ACumulative Preferred Stock for the exercise of warrants for the liquidationpreference price of $50 per share of preferred stock surrendered. In applyingthe treasury stock method to the warrants, it was assumed that 16,000 preferredshares were liquidated at the beginning of each year presented andcorresponding dividends were reduced. Am Re exercised these warrants in October 2004.These warrants are included in the computation of diluted EPS prior to theirexercise.

PXRE had an optionagreement to purchase 599,400 common shares of the Company for $16.67 per share. See “Note 5. Reinsurance”. These options were not included in thecomputation of diluted EPS in 2004 because their effect would be antidilutive. OnJune 8, 2005 the Company was notified that all conditions were met andthat PXRE’s right to purchase 599,400 common shares of the Company wasterminated.

**Note 17—SegmentInformation**

The Company manages its operations through threebusiness segments: insurance (commercial and personal lines underwriting),reinsurance, and insurance services (managing general agency, claims 

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administration andreinsurance intermediary operations). The Company considers many factors indetermining reportable segments including economic characteristics, productionsources, products or services offered and regulatory environment.

In the insurance segment, TICNY provides commercialand personal lines insurance policies to businesses and individuals. TICNY’scommercial lines products include commercial multiple-peril, monoline generalliability, commercial umbrella, monoline property, workers’ compensation andcommercial automobile policies. Its personal lines products consist ofhomeowners, dwelling and other liability policies.

In the reinsurance segment, TICNY assumes reinsurancedirectly from TRM’s issuing companies or indirectly from reinsurers thatprovide reinsurance coverage directly to the issuing companies. TICNY assumes,as a reinsurer, a modest amount of the risk on the premiums that TRM’s managinggeneral agency produces.

In the insurance services segment, TRM generatescommission revenue from its managing general agency by producing premiums onbehalf of its issuing companies and generates fees by providing claimsadministration and reinsurance intermediary services. Placing risks through TRM’sissuing companies allows the Company to underwrite larger policies and gain exposureto market segments that are unavailable to TICNY due to its rating, financialsize and geographical licensing limitations. TRM does not assume any risk onbusiness produced by it. All of the risk is ceded by the issuing companies to avariety of reinsurers pursuant to reinsurance programs arranged by TRM’sreinsurance intermediary working with outside reinsurance intermediaries. Throughits issuing companies, TRM’s managing general agency offers commercial package,monoline general liability, monoline property, commercial automobile andcommercial umbrella products.

The insurance services segments direct commissionrevenue is from two issuing carriers. Each issuing carrier provides less than10% of the Company’s consolidated total revenues. Although this segment isdependent upon two issuing carriers, it is management’s opinion that the lossof one or both can be remedied by replacement issuing carriers. There is nointercompany commission revenue in the insurance services segment.

The accounting policies of the segments are the sameas those described in the summary of significant accounting policies. TheCompany evaluates segment performance based on segment profit, which excludesinvestment income, realized gains and losses, interest expenses, income taxesand incidental corporate expenses. The Company does not allocate assets tosegments because assets, which consist primarily of investments and fixedassets, are considered in total by management for decision making purposes.

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Business segment results are as follows (in 000’s):
|                                                                                            | ** ** | **2005**                                       | ** ** | **2004**      | ** ** | **2003**                     | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|---------------|------------|------------------------------|------------|
| **Insurance Segment**                                                                      |       |                                           |       |          |       |                         |       |
| Revenues                                                                                   |       |                                           |       |          |       |                         |       |
| Net premiums earned                                                                        |       | $ 162,911                                 |       | $ 44,427 |       | $ 22,365                |       |
| Ceding commission revenue                                                                  |       | 25,218                                         |       | 39,983        |       | 35,311                       |       |
| Policy billing fees                                                                        |       | 868                                            |       | 671           |       | 545                          |       |
| **Total Revenues**                                                                         | ** ** | **188,997**                                    | ** ** | **85,081**    | ** ** | **58,221**                   | ** ** |
| Expenses                                                                                   |       |                                           |       |          |       |                         |       |
| Net loss and loss adjustment expenses                                                      |       | 95,700                                         |       | 27,753        |       | 14,699                       |       |
| Underwriting expenses                                                                      |       | 74,035                                         |       | 47,804        |       | 36,955                       |       |
| **Total Expenses**                                                                         | ** ** | **169,735**                                    | ** ** | **75,557**    | ** ** | **51,654**                   | ** ** |
| Underwriting  Profit                                                                       |       | $ 19,262                                  |       | $ 9,524  |       | $ 6,567                 |       |
| **Reinsurance Segment**                                                                    |       |                                           |       |          |       |                         |       |
| Revenues                                                                                   |       |                                           |       |          |       |                         |       |
| Net premiums earned                                                                        |       | $   1,525                       |       | $ 1,137  |       | $    576 |       |
| Ceding commission revenue                                                                  |       | —                                         |       | —        |       | 294                          |       |
| **Total Revenues**                                                                         | ** ** | **1,525**                                      | ** ** | **1,137**     | ** ** | **870**                      | ** ** |
| Expenses                                                                                   |       |                                           |       |          |       |                         |       |
| Net loss and loss adjustment expenses                                                      |       | 914                                            |       | (693          | )          | 372                          |       |
| Underwriting expenses                                                                      |       | 189                                            |       | 248           |       | 211                          |       |
| Total Expenses                                                                             |       | 1,103                                          |       | (445          | )          | 583                          |       |
| Underwriting  Profit                                                                       |       | $       422 |       | $ 1,582  |       | $    287 |       |
| **Insurance Services Segment**                                                             |       |                                           |       |          |       |                         |       |
| Revenues                                                                                   |       |                                           |       |          |       |                         |       |
| Direct commission revenue from managing general agency                                     |       | $   9,148                       |       | $ 11,546 |       | $ 7,984                 |       |
| Claims administration revenue                                                              |       | 4,268                                          |       | 4,105         |       | 3,746                        |       |
| Reinsurance intermediary fees                                                              |       | 688                                            |       | 730           |       | 1,100                        |       |
| Policy billing fees                                                                        |       | 23                                             |       | 8             |       | —                       |       |
| **Total Revenues**                                                                         | ** ** | **14,127**                                     | ** ** | **16,389**    | ** ** | **12,830**                   | ** ** |
| Expenses                                                                                   |       |                                           |       |          |       |                         |       |
| Direct commissions expense paid to producers                                               |       | 5,051                                          |       | 7,432         |       | 5,394                        |       |
| Other insurance services expenses (Underwriting  expenses reimbursed to TICNY)   |       | 1,981                                          |       | 2,987         |       | 2,247                        |       |
| Claims expense reimbursement to TICNY                                                      |       | 4,255                                          |       | 4,019         |       | 3,648                        |       |
| **Total Expenses**                                                                         | ** ** | **11,287**                                     | ** ** | **14,438**    | ** ** | **11,289**                   | ** ** |
| Insurance Services  Pretax Income                                                          |       | $   2,840                       |       | $ 1,951  |       | $ 1,541                 |       |

 

Underwriting expenses in the insurance segment are netof expense reimbursements that are made by the insurance services segmentpursuant to an expense sharing agreement between TRM and TICNY. In accordancewith terms of this agreement, TRM reimburses TICNY for a portion of TICNY’sunderwriting and other expenses resulting from TRM’s use of TICNY’s personnel,facilities and equipment in underwriting insurance on behalf of TRM’s issuingcompanies. The reimbursement for underwriting and other expenses is calculatedas a minimum reimbursement of 5% of the premiums produced by TRM, and isadjustable according to the terms of the agreement based on the number ofpolicies in force and additional expenses that may be incurred by TRM. Theamount of this reimbursement was $1,981,000 in 2005, $2,987,000 in 2004 and$2,247,000 in 2003. TRM also reimburses TICNY, at cost, for claimsadministration expenses pursuant to the terms of this expense sharing agreement.Claims expenses reimbursed by TRM were $4,255,000 in 2005, $4,019,000 in 2004and $3,648,000 in 2003.

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Thefollowing table reconciles revenues by segment to consolidated revenue (in000’s):
|                             | ** ** | **2005**       | ** ** | **2004**       | ** ** | **2003**      | ** ** |
|-----------------------------|------------|----------------|------------|----------------|------------|---------------|------------|
| Revenue                     |       |           |       |           |       |          |       |
| Insurance segment           |       | $ 188,997 |       | $ 85,081  |       | $ 58,221 |       |
| Reinsurance  segment        |       | 1,525          |       | 1,137          |       | 870           |       |
| Insurance  services segment |       | 14,127         |       | 16,389         |       | 12,830        |       |
| Total segment  revenues     |       | 204,649        |       | 102,607        |       | 71,921        |       |
| Investment income           |       | 14,983         |       | 5,070          |       | 2,268         |       |
| Realized capital  gains     |       | 122            |       | 13             |       | 493           |       |
| Consolidated revenues       |       | $ 219,754 |       | $ 107,690 |       | $ 74,682 |       |

 

The following table reconciles the results of ourindividual segments to consolidated income before taxes (in 000’s):
|                                           | ** ** | **2005**      | ** ** | **2004**      | ** ** | **2003**     | ** ** |
|-------------------------------------------|------------|---------------|------------|---------------|------------|--------------|------------|
| Insurance segment  underwriting profit    |       | $ 19,262 |       | $ 9,524  |       | $ 6,567 |       |
| Reinsurance  segment underwriting profit  |       | 422           |       | 1,582         |       | 287          |       |
| Total  underwriting profit                |       | 19,684        |       | 11,106        |       | 6,854        |       |
| Insurance  services segment pretax income |       | 2,840         |       | 1,951         |       | 1,541        |       |
| Net investment  income                    |       | 14,983        |       | 5,070         |       | 2,268        |       |
| Net realized  investment gains            |       | 122           |       | 13            |       | 493          |       |
| Corporate  expenses                       |       | (960          | )          | (289          | )          | (40          | )          |
| Interest expense                          |       | (4,853        | )          | (3,128        | )          | (1,462       | )          |
| Income before taxes                       |       | $ 31,816 |       | $ 14,723 |       | $ 9,654 |       |

 

**Note 18—Subsequent Events**

As of December 31, 2005, the Company hadunsecured reinsurance recoverables and ceding commissions receivable totaling$33,228,000 owed by PXRE Reinsurance Company. On February 16, 2006, A.M.Best downgraded to “B++” (Very Good) its former “A–” (Excellent) financialstrength rating on PXRE and issued a negative outlook. On February 24,2006 A.M. Best downgraded PXRE to “B+” (Very Good) with a negative outlook.The Company believes that the unsecured reinsurance recoverables and cedingcommissions receivable from PXRE, none of which are past due nor in dispute,are fully collectible. The Company’s judgment is primarily based on PXRE’scapital position as a result of its recent capital raising initiatives.

On February 6, 2006 the Company capitalized a newBermuda holding company for $15 million. Michael H. Lee, Chairman and ChiefExecutive Offices of Tower, is expected to serve as Chairman, Chief ExecutiveOffices and President of the Bermuda holding company. Mr. Lee will devotehis full business time between Tower and the Bermuda holding company. Inaddition, Greg T. Doyle is expected to resign as a director on Tower’s Boardand become a director of the new Bermuda holding company.

Tower Group, Inc.’sBoard of Directors approved a quarterly dividend on February 22, 2006 of$0.025 per share payable March 27, 2006 to stockholders of record as of March 15,2006.

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**Note19—Unaudited Quarterly Financial Information**
|                       | ** ** | **2005**                                                              | ** ** |
|-----------------------|------------|-----------------------------------------------------------------------|------------|
| ** **            | ** ** | **First**                                                             | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Total** | ** ** |
| ** **            | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Revenues              |       | $ 42,670                                                         |       | $ 50,252 |   | $ 59,937 |   | $ 66,895 |   | $ 219,754 |   |
| Net Income            |       | 3,717                                                                 |       | 4,765 |   | 5,708 |   | 6,564 |   | 20,754 |   |
| Net income per share: |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Basic                 |       | 0.19                                                                  |       | 0.24 |   | 0.29 |   | 0.33 |   | 1.06 |   |
| Diluted               |       | 0.19                                                                  |       | 0.24 |   | 0.28 |   | 0.32 |   | 1.03 |   |

 
|                       | ** ** | **2004**                                                              | ** ** |
|-----------------------|------------|-----------------------------------------------------------------------|------------|
| ** **            | ** ** | **First**                                                             | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Total** | ** ** |
| ** **            | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Revenues              |       | $ 21,704                                                         |       | $ 26,190 |   | $ 26,464 |   | $ 33,332 |   | $ 107,690 |   |
| Net Income            |       | 1,322                                                                 |       | 1,999 |   | 2,478 |   | 3,230 |   | 9,029 |   |
| Net income per share: |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Basic                 |       | 0.30                                                                  |       | 0.45 |   | 0.55 |   | 0.20 |   | 1.23 |   |
| Diluted               |       | 0.23                                                                  |       | 0.35 |   | 0.43 |   | 0.19 |   | 1.06 |   |

 
|                       | ** ** | **2003**                                                              | ** ** |
|-----------------------|------------|-----------------------------------------------------------------------|------------|
| ** **            | ** ** | **First**                                                             | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Total** | ** ** |
| ** **            | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Revenues              |       | $ 16,778                                                         |       | $ 17,949 |   | $ 20,536 |   | $ 19,419 |   | $ 74,682 |   |
| Net Income            |       | 1,078                                                                 |       | 1,486 |   | 2,029 |   | 1,687 |   | 6,280 |   |
| Net income per share: |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Basic                 |       | 0.22                                                                  |       | 0.31 |   | 0.46 |   | 0.38 |   | 1.37 |   |
| Diluted               |       | 0.18                                                                  |       | 0.25 |   | 0.46 |   | 0.30 |   | 1.09 |   |

 

**ITEM 9.**                CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS OR ACCOUNTING AND FINANCIAL DISCLOSURE

None.

**ITEM 9A.**        CONTROLAND PROCEDURES

Our management, with the participation of our ChiefExecutive Officer and Chief Financial Officer, has evaluated the effectivenessof the design and operation of our disclosure controls and procedures (asdefined in Exchange Act Rule 13a-15 (e)) as of the end of the periodcovered by this report. Based on that evaluation, the Chief Executive Officerand Chief Financial Officer have concluded that our disclosure controls andprocedures are effective to ensure that material information relating to us andour consolidated subsidiaries is made known to such officers by others withinthese entities, particularly during the period this annual report was prepared,in order to allow timely decisions regarding required disclosure.

There have not been any changes in our internalcontrol over financial reporting during the period covered by this report thathave materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

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**ITEM 9B.**       OTHERINFORMATION

The Company has filed allrequired Form 8-K information during the fourth quarter.

**PART III**

**ITEM 10.**         DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT

The information called for by this Item and notprovided herein will be contained in the Company’s Proxy Statement, which theCompany intends to file within 120 days after the end of the company’s fiscalyear ended December 31, 2005, and such information is incorporated hereinby reference.

The Company has adopted aCode of Business Conduct and Ethics and posted it on its websitehttp://www.twrgrp.com/ under Investor Information and then under CorporateGovernance.

**ITEM 11.**         EXECUTIVECOMPENSATION

The information called forby this item will be contained in the Company’s Proxy Statement, which theCompany intends to file within 120 days after the end of the Company’s fiscalyear ended December 31, 2005, and such information is incorporated hereinby reference.

**ITEM 12.**         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

The information called forby the Item and not provided herein will be contained in the Company’s ProxyStatement, with the Company intends to file within 120 days after the end ofthe Company’s fiscal year ended December 31, 2005, and such information isincorporated herein by reference.

**ITEM 13.**         CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

The information called forby the Item and not provided herein will be contained in the Company’s ProxyStatement, with the Company intends to file within 120 days after the end ofthe Company’s fiscal year ended December 31, 2005, and such information isincorporated herein by reference.

**ITEM 14.**         PRINCIPALACCOUNTING FEES AND SERVICES

The information called forby the Item and not provided herein will be contained in the Company’s ProxyStatement, with the Company intends to file within 120 days after the end ofthe Company’s fiscal year ended December 31, 2005, and such information isincorporated herein by reference.

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**PART IV.**

**ITEM15.**         EXHIBITS, FINANCIALSTATEMENT SCHEDULES

| A.     |   | (1) |   | The financial statements and notes to financial  statements are filed as part of this report in “Item 8. Financial Statements  and Supplementary Data”. |
|--------|--------|-----|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   | (2) |   | The financial statement schedules are listed in the  Index to Consolidated Financial Statement Schedules.                                                         |
|   |   | (3) |   | The exhibits are listed in the Index to Exhibits.                                                                                                                 |

 

The following entireexhibits are included:

| Exhibit 21.1 |   | Subsidiaries of Tower Group, Inc.                   |
|-------------------|--------|----------------------------------------------------------|
| Exhibit 23.1 |   | Consent of Johnson Lambert & Co.                |
| Exhibit 31.1 |   | Certification of CEO to Section 302(a)              |
| Exhibit 31.2 |   | Certification of CFO to Section 302(a)              |
| Exhibit 32   |   | Certification of CEO & CFO to  Section 906 |

 

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

|                             | **TOWER GROUP, INC.** |
|-----------------------------|-----------------------|
| DATED: MARCH 15,  2006 | **BY:**               | /S/ MICHAEL H. LEE |
| ** **                  | **NAME:**             | MICHAEL H. LEE |
| ** **                  | **TITLE:**            | CHAIRMAN OF THE BOARD, PRESIDENT AND CHIEF EXECUTIVE  OFFICER |
|                             |                       |  |  |

 

Pursuantto the requirements of the Securities Act of 1934, this report has been signedby the following persons, dated March 15, 2006, on behalf of the registrantand in the capacities indicated.

|                          | **Signature** | ** **                                                | ** ** |  | **Title** | ** ** |
|--------------------------|---------------|-----------------------------------------------------------|------------|--|-----------|------------|
| /s/ Michael H. Lee       |          | Chairman of the  Board, President and Chief               |
| Michael  H. Lee          |          | Executive Officer  (Principal Executive Officer)          |
| /s/ Francis M. Colalucci |          | Senior Vice  President, Chief Financial Officer and  |
| Francis  M. Colalucci    |          | Treasurer, Director  (Principal Financial Officer,        |
|                     |          | Principal Accounting  Officer)                            |
| /s/ Steven G. Fauth      |          | Senior Vice  President, General Counsel and               |
| Steven  G. Fauth         |          | Secretary, Director                                       |
| /s/ Steven W. Schuster   |          | Director                                                  |
| Steven  W. Schuster      |          |                                                      |
| /s/ Charles A. Bryan     |          | Director                                                  |
| Charles  A. Bryan        |          |                                                      |
| /s/ Gregory T. Doyle     |          | Director                                                  |
| Gregory  T. Doyle        |          |                                                      |
| /s/ Austin P. Young      |          | Director                                                  |
| Austin P. Young          |          |                                                      |

 

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**TOWER GROUP, INC.INDEX TO FINANCIAL STATEMENT SCHEDULES**

| Schedules | ** **                                                                                                              | **Pages** |
|-----------|-------------------------------------------------------------------------------------------------------------------------|-----------|
|      | Report of Independent  Registered Public Accounting Firm on Financial Statement Schedules                          | 135       |
| **I**     | Summary of  Investments—other than investments in related parties                                                  | 136       |
| **II**    | Condensed Financial  Information of the Registrant as of and for the years ended December 31,  2005, 2004 and 2003 | 137       |
| **III**   | Supplementary Insurance  Information for the years ended December 31, 2005, 2004 and 2003                          | 141       |
| **IV**    | Reinsurance for the  years ended December 31, 2005, 2004 and 2003                                                  | 142       |
| **V**     | Valuation and Qualifying  Accounts for the years ended December 31, 2005, 2004 and 2003                            | 143       |
| **VI**    | Supplemental Information Concerning Insurance  Operations for the years ended December 31, 2005, 2004 and 2003     | 144       |

 

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM ONFINANCIAL STATEMENT SCHEDULES**

To the Board ofDirectorsTower Group, Inc.

We have audited the consolidated financial statementsof Tower Group, Inc. and subsidiaries (the “Company”) as of December 31,2005 and 2004, and for each of the three years in the period ended December 31,2005, management’s assessment of the effectiveness of the Company’s internalcontrol over financial reporting as of December 31, 2005, and theeffectiveness of the Company’s internal control over financial reporting as of December 31,2005, and have issued our report thereon dated February 17, 2006. Suchreport is included elsewhere in this Form 10-K. Our audits alsoincluded the financial statement schedules of the Company listed in theaccompanying index at Item 15. These financial statement schedules are theresponsibility of the Company’s management. Our responsibility is to express anopinion based on our audits. In our opinion, such financial statementschedules, when considered in relation to the basic consolidated financialstatements taken as a whole, present fairly, in all material respects, theinformation set forth therein.

/s/ JOHNSON LAMBERT & CO.

Reston, VirginiaFebruary 17, 2006

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**TOWER GROUP, INC.SCHEDULE I—SUMMARY OF INVESTMENTS—OTHER THAN INVESTMENTS INRELATED PARTIES($ in thousands)**

| ** **                                                             | ** ** | **December 31, 2005** | ** **  |
|------------------------------------------------------------------------|------------|---------------------------------|-------------|
| ** **                                                             | ** ** | **Cost**                        | ** **  | **Fair  Value** | ** ** | **Amount  Reflected on  Balance Sheet** | ** ** |
| Fixed maturities:                                                      |       |                            |        |   |   |   |   |   |   |
| Available for sale:                                                    |       |                            |        |   |   |   |   |   |   |
| U.S. Treasury securities and obligations of  U.S. Government agencies  |       | $                               | 39,161      |   | $ | 38,755 |   |   | $ | 38,755 |   |   |
| Corporate securities                                                   |       | 77,852                          |        | 76,488 |   |   | 76,488 |   |   |
| Mortgage-backed securities                                             |       | 98,786                          |        | 96,922 |   |   | 96,922 |   |   |
| Asset-backed securities                                                |       | 15,431                          |        | 15,188 |   |   | 15,188 |   |   |
| Other taxable fixed maturity securities                                |       | 250                             |        | 244 |   |   | 244 |   |   |
| Municipal securities                                                   |       | 99,643                          |        | 99,084 |   |   | 99,084 |   |   |
| **Total  fixed maturities**                                            | ** ** | **331,123**                     | ** **  | **326,681** | ** ** | ** ** | **326,681** |   |   |
| Preferred Stocks                                                       |       | 113                             |        | 115 |   |   | 115 |   |   |
| Common Stocks—at  cost                                            |       | 24,558                          |        | 24,053 |   |   | 24,558 |   |   |
| Common Stock—at  fair value                                       |       | 6,568                           |        | 5,819 |   |   | 5,819 |   |   |
| Common trust  securities—statutory business trusts, equity method |       | 1,426                           |        | 1,426 |   |   | 1,426 |   |   |
| **Total investments**                                                  | ** ** | **$**                           | **363,788** | ** ** | **$** | **358,094** | ** ** | ** ** | **$** | **358,599** |   |   |

 

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**TOWER GROUP, INC.SCHEDULE II—CONDENSED FINANCIAL INFORMATON OF THE REGISTRANTCONDENSED BALANCE SHEETS($ in thousands)**

| ** **                                                                                                     | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                                     | ** ** | **2005**              | ** ** | **2004**              | ** ** |
| **Assets**                                                                                                     |       |                  |       |                  |       |   |   |   |   |
| Fixed-maturity  securities, available for sale, at fair value (amortized cost $5,203 in 2005,  and $0 in 2004) |       |                  | $          | 5,139                 |       |   |   | $ | — |   |   |
| Equity securities,  available for sale , at cost                                                               |       |                  | 7,064      |                  |       |   | — |   |   |
| **Total investments**                                                                                          |       |                  | 12,203     |                  |       |   | — |   |   |
| Cash and cash  equivalents                                                                                     |       |                  | 2,651      |                  |       |   | 26,910 |   |   |
| Investment in  subsidiaries                                                                                    |       |                  | 173,236    |                  |       |   | 147,775 |   |   |
| Common trust  securities—statutory business trusts, equity method                                         |       |                  | 1,426      |                  |       |   | 1,426 |   |   |
| Intangible assets                                                                                              |       |                  | 2,940      |                  |       |   | 4,888 |   |   |
| Amounts due from  subsidiaries                                                                                 |       |                  | 672        |                  |       |   | 100 |   |   |
| Federal and state income  taxes recoverable                                                                    |       |                  | 143        |                  |       |   | — |   |   |
| Other assets                                                                                                   |       |                  | 2,758      |                  |       |   | 1,487 |   |   |
| **Total Assets**                                                                                               | ** ** | ** **            | **$**      | **196,029**           |       | ** ** | ** ** | **$** | **182,586** |   |   |
| **Liabilities**                                                                                                |       |                  |       |                  |       |   |   |   |   |
| Subordinated debentures                                                                                        |       |                  | $          | 47,426                |       |   |   | $ | 47,426 |   |   |
| Accounts payable and  accrued expenses                                                                         |       |                  | 3,781      |                  |       |   | 5,586 |   |   |
| Federal income taxes  payable                                                                                  |       |                  | —     |                  |       |   | 127 |   |   |
| **Total Liabilities**                                                                                          |       |                  | 51,207     |                  |       |   | 53,139 |   |   |
| **Stockholders’ Equity**                                                                                  |       |                  | 144,822    |                  |       |   | 129,447 |   |   |
| **Total Liabilities and  Stockholders’ Equity**                                                           | ** ** | ** **            | **$**      | **196,029**           |       | ** ** | ** ** | **$** | **182,586** |   |   |

 

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**TOWER GROUP, INC.SCHEDULE II—CONDENSEDFINANCIAL INFORMATON OF THE REGISTRANTCONDENSED STATEMENTS OF CASH FLOWS($ in thousands)**
|                                                                                    | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Cash flows from operating activities:**                                          |       |                                       |       |   |   |   |   |
| Net income                                                                         |       | $                                          | 20,754     |   | $ | 9,029 |   | $ | 6,280 |   |
| Adjustments to reconcile net income to net cash (used  in) provided by operations: |       |                                       |       |   |   |   |   |
| Dividends received from  consolidated subsidiaries                                 |       | 3,800                                      |       | 850 |   | 363 |   |
| Equity in undistributed  net income of subsidiaries                                |       | (22,963                                    | )          | (10,544 | ) | (6,888 | ) |
| Amortization of debt  issuance costs                                               |       | 39                                         |       | 178 |   | — |   |
| Amortization of  restricted stock                                                  |       | 618                                        |       | 310 |   | — |   |
| (Increase) decrease in assets:                                                     |       |                                       |       |   |   |   |   |
| Federal and state income  tax recoverable                                          |       | (270                                       | )          | 1,006 |   | (879 | ) |
| Intangible asset                                                                   |       | 1,948                                      |       | (4,888 | ) | — |   |
| Other assets                                                                       |       | (409                                       | )          | (804 | ) | 7 |   |
| (Increase) decrease in liabilities:                                                |       |                                       |       |   |   |   |   |
| Accounts payable and  accrued expenses                                             |       | (1,805                                     | )          | 5,523 |   | 63 |   |
| Payable to subsidiaries                                                            |       | (572                                       | )          | (4,400 | ) | 234 |   |
| Dividends payable                                                                  |       |                                       |       | (160 | ) | — |   |
| Net cash flows (used)  provided by operations                                      |       | 1,140                                      |       | (3,900 | ) | (820 | ) |
| **Cash flows from investing activities:**                                          |       |                                       |       |   |   |   |   |
| Purchase of investments:                                                           |       |                                       |       |   |   |   |   |
| Fixed -maturity  securities                                                        |       | (20,921                                    | )          | — |   | — |   |
| Equity securities                                                                  |       | (7,064                                     | )          | — |   | — |   |
| Sale of investments:                                                               |       |                                       |       |   |   |   |   |
| Fixed—maturity securities                                                     |       | 15,658                                     |       | — |   | — |   |
| Investment in subsidiary                                                           |       | (11,480                                    | )          | (98,096 | ) | (17,105 | ) |
| Net cash flows used in  investing activities                                       |       | (23,807                                    | )          | (98,096 | ) | (17,105 | ) |
| **Cash flows from financing activities:**                                          |       |                                       |       |   |   |   |   |
| Repayment of redeemable  preferred stock                                           |       | —                                     |       | (3,000 | ) | — |   |
| Repayment of long-term  debt—CIT                                              |       | —                                     |       | (5,588 | ) | — |   |
| Decrease in notes  receivable from related parties                                 |       | —                                     |       | 44 |   | — |   |
| Proceeds from issuance  of subordinated debentures                                 |       | —                                     |       | 26,806 |   | 25,588 |   |
| Deferred cost, long-term  debt                                                     |       | —                                     |       | — |   | (786 | ) |
| Purchase of common trust  securities—statutory business trusts                |       | —                                     |       | (806 | ) | — |   |
| Stock repurchase                                                                   |       | —                                     |       | — |   | (514 | ) |
| Exercise of warrants                                                               |       | 277                                        |       | — |   | — |   |
| Exercise of stock  options                                                         |       | 90                                         |       | 200 |   | — |   |
| IPO and private  placement, net proceeds                                           |       | —                                     |       | 107,845 |   | — |   |
| Dividends paid                                                                     |       | (1,959                                     | )          | (1,162 | ) | (1,811 | ) |
| Net cash flows provided  by (used in) financing activities                         |       | (1,592                                     | )          | 124,339 |   | 22,477 |   |
| **Increase  in cash and cash equivalents**                                         |       | (24,259                                    | )          | 22,343 |   | 4,552 |   |
| Cash and cash  equivalents, beginning of year                                      |       | 26,910                                     |       | 4,567 |   | 15 |   |
| **Cash and cash equivalents, end of year**                                         |       | $                                          | 2,651      |   | $ | 26,910 |   | $ | 4,567 |   |
|                                                                                    |            |                                            |            |  |  |  |  |  |  |  |  |

 

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**TOWER GROUP, INC.**

**SCHEDULE II—CONDENSED FINANCIAL INFORMATONOF THE REGISTRANT**

**CONDENSED STATEMENTS OF INCOME ANDCOMPREHENSIVE INCOME($ in thousands)**
|                                                                    | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                         | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                         | ** ** | ** **                                 | ** ** |
| **Revenues**                                                       |       |                                       |       |   |   |   |   |
| Net investment income                                              |       | $                                          | 1,147      |   | $ | 75 |   | $ | 42 |   |
| Net realized  investment loss                                      |       | (63                                        | )          | — |   | — |   |
| Total Revenue                                                      |       | 1,084                                      |       | 75 |   | 42 |   |
| **Equity in net earnings of subsidiaries**                         |       | 22,963                                     |       | 10,544 |   | 6,888 |   |
| **Expenses**                                                       |       |                                       |       |   |   |   |   |
| Other operating  expenses                                          |       | 959                                        |       | 289 |   | 40 |   |
| Interest expense                                                   |       | 3,513                                      |       | 2,015 |   | 854 |   |
| **Income  Before Income Taxes**                                    |       | 19,575                                     |       | 8,315 |   | 6,036 |   |
| Benefit for income taxes                                           |       | (1,179                                     | )          | (714 | ) | (244 | ) |
| **Net Income**                                                     |       | $                                          | 20,754     |   | $ | 9,029 |   | $ | 6,280 |   |
| **Comprehensive  Net Income**                                      | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                         |       | $                                          | 20,754     |   | $ | 9,029 |   | $ | 6,280 |   |
| Other comprehensive  income:                                       |       |                                       |       |   |   |   |   |
| Gross unrealized investmentholdinggains arising  during period     |       | (6,664                                     | )          | 44 |   | 617 |   |
| Less: reclassification adjustment forgains included  in net income |       | (122                                       | )          | (13 | ) | (493 | ) |
|                                                               |       | (6,786                                     | )          | 31 |   | 124 |   |
| Income tax expense related to items ofother  comprehensive income  |       | 2,382                                      |       | (27 | ) | (42 | ) |
| Total other comprehensive net income                               |       | (4,404                                     | )          | 4 |   | 82 |   |
| **Comprehensive  Net Income**                                      | ** ** | **$**                                      | **16,350** | ** ** | **$** | **9,033** | ** ** | **$** | **6,362** | ** ** |

 

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**TOWER GROUP, INC.SCHEDULE II—CONDENSED FINANCIAL INFORMATON OF THE REGISTRANTCONDENSED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY($ in thousands)**
|                                                   | ** ** | **Common  Stock** | ** ** | **Class A  Common  Stock** | ** ** | **Class B  Common  Stock** | ** ** | **Paid-in  Capital** | ** ** | **Accumulated  Other  Comprehensive  Net Income** | ** ** | **Retained  Earnings** | ** ** | **Unearned  Compensation  Restricted  Stock** | ** ** | **Treasury  Stock** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|---------------------------------------------------|------------|-------------------|------------|---------------------------------|------------|---------------------------------|------------|----------------------|------------|--------------------------------------------------------|------------|------------------------|------------|-----------------------------------------------|------------|---------------------|------------|---------------------------------------|------------|
| ** **                                        | ** ** | ** **        | ** ** |
| **Balance  at December 31, 2002**            | ** ** |              | **$**      | **45**                          | ** ** |                            |       | **$**                | **—** | ** **                                             |       |                   | **$**      | **—**                                    | ** ** |                | **$**      | **2,285**                             | ** ** |   | **$** | **966** | ** ** |   |   | **$** | **5,771** | ** ** |   |   | **$** | **—** | ** ** |   |   | **$** | **—** | ** ** |   |   | **$** | **9,067** | ** ** |   |
| Stock repurchase                                  |       |              | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                        |       |                | —     |                                  |       |   | — |   |   |   | — |   |   |   | (514 | ) |   |   | (514 | ) |   |
| Capital  restructuring                            |       |              | (45        | )                               |       |                            | 21         |                 |       |                                                   | 24         |                   |       | —                                        |       |                | —     |                                  |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Dividends declared                                |       |              | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                        |       |                | —     |                                  |       |   | (1,854 | ) |   |   | — |   |   |   | — |   |   |   | (1,854 | ) |   |
| Net income                                        |       |              | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                        |       |                | —     |                                  |       |   | 6,280 |   |   |   | — |   |   |   | — |   |   |   | 6,280 |   |   |
| Net unrealized appreciation on                    |       |              |       |                            |       |                            |       |                 |       |                                                   |       |                   |       |                                          |       |                |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| securities available for  sale, net               |       |              |       |                            |       |                            |       |                 |       |                                                   |       |                   |       |                                          |       |                |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| of income tax                                     |       |              | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                        |       |                | 82         |                                  |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 82 |   |   |
| **Balance  at December 31, 2003**            |       |              | —     |                            |       |                            | 21         |                 |       |                                                   | 24         |                   |       | 2,285                                         |       |                | 1,048      |                                  |       |   | 10,197 |   |   |   | — |   |   |   | (514 | ) |   |   | 13,061 |   |   |
| Capital  restructuring                            |       |              | 45         |                            |       |                            | (21        | )                    |       |                                                   | (24        | )                      |       | —                                        |       |                | —     |                                  |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Dividends declared                                |       |              | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                        |       |                | —     |                                  |       |   | (1,002 | ) |   |   | — |   |   |   | — |   |   |   | (1,002 | ) |   |
| IPO and private  placement, net proceeds          |       |              | 141        |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | 107,704                                       |       |                | —     |                                  |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 107,845 |   |   |
| Stock based  compensation                         |       |              | 3          |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | 2,395                                         |       |                | —     |                                  |       |   | — |   |   |   | (1,908 | ) |   |   | 20 |   |   |   | 510 |   |   |
| Warrant exercise                                  |       |              | 9          |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | (9                                            | )          |                | —     |                                  |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Net income                                        |       |              | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                        |       |                | —     |                                  |       |   | 9,029 |   |   |   | — |   |   |   | — |   |   |   | 9,029 |   |   |
| Net unrealized appreciation on                    |       |              |       |                            |       |                            |       |                 |       |                                                   |       |                   |       |                                          |       |                |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| securities available for  sale, net               |       |              |       |                            |       |                            |       |                 |       |                                                   |       |                   |       |                                          |       |                |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| of income tax                                     |       |              | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                        |       |                | 4          |                                  |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 4 |   |   |
| **Balance  at December 31, 2004**            | ** ** |              | **198**    | ** **                      |       |                            | **—** | ** **           |       |                                                   | **—** | ** **             |       | **112,375**                                   | ** ** |                | **1,052**  | ** **                            |       |   | **18,224** | ** ** |   |   | **(1,908** | **)** |   |   | **(494** | **)** |   |   | **129,447** | ** ** |   |
| Dividends declared                                |       |              | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                        |       |                | —     |                                  |       |   | (1,959 | ) |   |   | — |   |   |   | — |   |   |   | (1,959 | ) |   |
| Stock based  compensation                         |       |              | 1          |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | 482                                           |       |                | —     |                                  |       |   | — |   |   |   | 443 |   |   |   | (32 | ) |   |   | 894 |   |   |
| Warrant exercise                                  |       |              | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | (326                                          | )          |                | —     |                                  |       |   | — |   |   |   | — |   |   |   | 416 |   |   |   | 90 |   |   |
| Net income                                        |       |              | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                        |       |                | —     |                                  |       |   | 20,754 |   |   |   | — |   |   |   | — |   |   |   | 20,754 |   |   |
| Net unrealized  depreciation on                   |       |              | —     |                            |       |                            | —     |                 |       |                                                   | —     |                   |       | —                                        |       |                | (4,404     | )                                     |       |   | — |   |   |   | — |   |   |   | — |   |   |   | (4,404 | ) |   |
| securities available for  sale, net of Income tax |       |              |       |                            |       |                            |       |                 |       |                                                   |       |                   |       |                                          |       |                |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                   |            |                   |            |                                 |            |                                 |            |                      |            |                                                        |            |                        |            |                                               |            |                     |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
| **Balance  at December 31, 2005** | ** ** |   | **$** | **199** | ** ** |   |   | **$** | **—** | ** ** |   |   | **$** | **—** |   |   | $ | 112,531 |   |   | $ | (3,352 | ) |   |   | $ | 37,019 |   |   |   | $ | (1,465 | ) |   |   | $ | (110 | ) |   |   | $ | 144,822 |   |   |
|----------------------------------------|------------|--------|-------|---------|------------|--------|--------|-------|------------|------------|--------|--------|-------|------------|--------|--------|---|---------|--------|--------|---|--------|---|--------|--------|---|--------|--------|--------|--------|---|--------|---|--------|--------|---|------|---|--------|--------|---|---------|--------|--------|

 

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**TOWER GROUP, INC.SCHEDULE III—SUPPLEMENTARY INSURANCE INFORMATION($ in thousands)**
|               | ** ** | **Deferred  Acquisition  Cost, Net of  Deferred  Ceding  Commission  Revenue** | ** **                       | **Future Policy  Benefits,  Losses and  Loss Expenses** | ** ** | **Net Unearned  Premiums** | ** **         | **Net Earned  Premiums** | ** ** | **Benefits,  Losses and  Loss Expenses** | ** **         | **Amortization  of DAC** | ** ** | **Operating  Expenses** | ** **         | **Premiums  Written** | ** ** |
|---------------|------------|------------------------------------------------------------------------------------------|----------------------------------|------------------------------------------------------------------------|------------|---------------------------------|--------------------|-------------------------------|------------|----------------------------------------------------|--------------------|-------------------------------|------------|-------------------------|--------------------|-----------------------|------------|
| ** **    | ** ** | ** **                                                                               | ** **                       |
| **2005**      | ** ** |                                                                                     | ** **                       | ** **                                                             |       |                            | ** **         | ** **                    |       |                                               | ** **         | ** **                    |       |                    | ** **         | ** **            |       |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Segments:** | ** ** |                                                                                     | ** **                       | ** **                                                             |       |                            | ** **         | ** **                    |       |                                               | ** **         | ** **                    |       |                    | ** **         | ** **            |       |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Insurance     |       |                                                                                     | $ 29,184                    | ** **                                                             |       |                            | $ 98,459      | ** **                    |       |                                               | $ 113,657     | ** **                    |       |                    | $ 162,911     | ** **            |       |   | $ 95,700 |   |   |   | $ (45,224 | ) |   |   | $ 35,263 |   |   |   | $ 210,395 |   |   |
| Reinsurance   |       |                                                                                     | 8                                | ** **                                                             |       |                            | 3,287              | ** **                    |       |                                               | 803                | ** **                    |       |                    | 1,525              | ** **            |       |   | 914 |   |   |   | (423 | ) |   |   | 173 |   |   |   | 1,387 |   |   |
| **Total**     | ** ** |                                                                                     | **$ 29,192**                | ** **                                                             |       |                            | **$ 101,746** | ** **                    |       |                                               | **$ 114,460** | ** **                    |       |                    | **$ 164,436** | ** **            |       |   | **$ 96,614** |   | ** ** | ** ** | **$ (45,647** | **)** | ** ** | ** ** | **$ 35,436** |   | ** ** | ** ** | **$ 211,782** |   |   |
| **2004**      |       |                                                                                     |                             | ** **                                                             |       |                            |               | ** **                    |       |                                               |               | ** **                    |       |                    |               | ** **            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Segments:     |       |                                                                                     |                             | ** **                                                             |       |                            |               | ** **                    |       |                                               |               | ** **                    |       |                    |               | ** **            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Insurance     |       |                                                                                     | $ 18,718                    | ** **                                                             |       |                            | $ 34,275      | ** **                    |       |                                               | $ 66,226      | ** **                    |       |                    | $ 44,427      | ** **            |       |   | $ 27,753 |   |   |   | $ (25,028 | ) |   |   | $ 22,455 |   |   |   | $ 96,595 |   |   |
| Reinsurance   |       |                                                                                     | 22                               | ** **                                                             |       |                            | 2,674              | ** **                    |       |                                               | 888                | ** **                    |       |                    | 1,137              | ** **            |       |   | (693 | ) |   |   | (640 | ) |   |   | 204 |   |   |   | 1,480 |   |   |
| **Total**     | ** ** |                                                                                     | **$ 18,740**                | ** **                                                             |       |                            | **$ 36,949**  | ** **                    |       |                                               | **$ 67,114**  | ** **                    |       |                    | **$ 45,564**  | ** **            |       |   | **$ 27,060** |   | ** ** | ** ** | **$ (25,668** | **)** | ** ** | ** ** | **$ 22,659** |   | ** ** | ** ** | **$ 98,075** |   |   |
| **2003**      | ** ** |                                                                                     | ** **                       | ** **                                                             |       |                            | ** **         | ** **                    |       |                                               | ** **         | ** **                    |       |                    | ** **         | ** **            |       |   | ** ** |   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   | ** ** | ** ** | ** ** |   |   |
| **Segments:** | ** ** |                                                                                     | ** **                       | ** **                                                             |       |                            | ** **         | ** **                    |       |                                               | ** **         | ** **                    |       |                    | ** **         | ** **            |       |   | ** ** |   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   | ** ** | ** ** | ** ** |   |   |
| Insurance     |       |                                                                                     | $    544     | ** **                                                             |       |                            | $ 20,036      | ** **                    |       |                                               | $ 14,058      | ** **                    |       |                    | $ 22,365      | ** **            |       |   | $ 14,699 |   |   |   | $    (502 | ) |   |   | $ 16,254 |   |   |   | $ 27,968 |   |   |
| Reinsurance   |       |                                                                                     | 29                               | ** **                                                             |       |                            | 4,325              | ** **                    |       |                                               | 545                | ** **                    |       |                    | 576                | ** **            |       |   | 372 |   |   |   | (13 | ) |   |   | 148 |   |   |   | 982 |   |   |
| **Total**     | ** ** |                                                                                     | **$    573** | ** **                                                             |       |                            | **$ 24,361**  | ** **                    |       |                                               | **$ 14,603**  | ** **                    |       |                    | **$ 22,941**  | ** **            |       |   | **$ 15,071** |   | ** ** | ** ** | **$    (515** | **)** | ** ** | ** ** | **$ 16,402** |   | ** ** | ** ** | **$ 28,950** |   |   |

 

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**TOWER GROUP, INC.SCHEDULE IV—REINSURANCE($ in thousands)**
|                                        | ** ** | **Direct  Amount** | ** **  | **Ceded to  Other  Companies** | ** ** | **Assumed  from Other  Companies** | ** **  | **Net  Amount** | ** ** | **Percentage of  Amount  Assumed  to Net** | ** ** |
|----------------------------------------|------------|--------------------|-------------|-------------------------------------|------------|-----------------------------------------|-------------|-----------------|------------|------------------------------------------------------|------------|
| ** **                             | ** ** | ** **         | ** **  |
| **Year ended December 31,  2005** | ** ** | ** **         | ** **  |                                | ** ** | ** **                              |        |            | ** ** | ** **                                           |       | ** ** | ** ** |   | ** ** | ** ** |   |
| Premiums                               | ** ** | ** **         | ** **  |                                | ** ** | ** **                              |        |            | ** ** | ** **                                           |       | ** ** | ** ** |   | ** ** | ** ** |   |
| Property and Casualty Insurance        |       | $                  | 236,174     |                                |       | $                                       | 73,397      | ** **      |       |                                                 | $          | 1,659 | ** ** |   | $ | 164,436 | ** ** |   | **1.00** | **%** |   |
| Accident and Health Insurance          |       | —             |        |                                | —     | ** **                              |        |            | —     | ** **                                           |       | — | ** ** |   | **0.00** | **%** |   |
| **Total Premiums**                     | ** ** | **$**              | **236,174** | ** **                          |       | **$**                                   | **73,397**  | ** **      |       |                                                 | **$**      | **1,659** | ** ** |   | **$** | **164,436** | ** ** |   | **1.00** | **%** |   |
| **Year  ended December 31, 2004** |       |               |        |                                |       | ** **                              |        |            |       | ** **                                           |       |   |   |   |   |   |   |
| Premiums                               |       |               |        |                                |       | ** **                              |        |            |       | ** **                                           |       |   |   |   |   |   |   |
| Property and Casualty Insurance        |       | $                  | 151,210     |                                |       | $                                       | 106,945     | ** **      |       |                                                 | $          | 1,299 | ** ** |   | $ | 45,564 |   |   | 2.90 | % |   |
| Accident and Health Insurance          |       | —             |        |                                | —     | ** **                              |        |            | —     | ** **                                           |       | — |   |   | 0.00 | % |   |
| **Total  Premiums**                    | ** ** | **$**              | **151,210** | ** **                          |       | **$**                                   | **106,945** | ** **      |       |                                                 | **$**      | **1,299** | ** ** |   | **$** | **45,564** | ** ** |   | **2.90** | **%** |   |
|                                        |            |                    |             |                                     |            |                                         |             |                 |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**TOWERGROUP, INC.**

**SCHEDULE V—VALUATION AND QUALIFYING ACCOUNTSDecember 31, 2005, 2004 and 2003**

| ** **                    | ** ** | **December 31,**          | ** ** |
|-------------------------------|------------|--------------------------------|------------|
| ** **                    | ** ** | **2005**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                    | ** ** | **($ in thousands)** | ** ** |
| Balance,  January 1      |       | $                              | 123        |   | $ | 123 |   | $ | 123 |   |
| Additions                     |       | 73                             |       | 27 |   | — |   |
| Deletions                     |       | (26                            | )          | (27 | ) | — |   |
| **Balance, December 31** | ** ** | **$**                          | **170**    | ** ** | **$** | **123** | ** ** | **$** | **123** | ** ** |

 

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**TOWER GROUP, INC.SCHEDULE VI—SUPPLEMENTAL INFORMATION CONCERNING INSURANCE OPERATIONS($ in thousands)**

| ** ** | ** ** | **Deferred**          | ** ** | **Reserve for  Unpaid  Claims and  Claim** | ** ** | ** **             | ** ** | **Net**               | ** ** | **Net**             | ** ** | **Net**                | ** ** | **Claims and Claims  Adjustment Expenses  Incurred and Related**             | ** ** | ** **                                                                                    | ** ** | **Paid Claims  and Claim** | ** ** | ** **               | ** ** |
|------------|------------|-----------------------|------------|------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|---------------------|------------|------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | **Acquisition  Cost** | ** ** | **Adjustment  Expenses**                             | ** ** | **Discount  Reserves** | ** ** | **Unearned  Premium** | ** ** | **Earned  Premium** | ** ** | **Investment  Income** | ** ** | **Current         Year       ** | ** ** | **Prior        Year       ** | ** ** | **Amortization  of DAC**        | ** ** | **Adjustment  Expenses** | ** ** | **Premium  Written** | ** ** |
| ** ** | ** ** | ** **            | ** ** |
|            |            |                       |            |                                                      |            |                        |            |                       |            |                     |            |                        |            |                                                                                                       |            |                                                                                               |            |                                      |            |                          |            |  |  |

| **2005** |   |   | $ | 29,192 |   |   |   | $ | 101,746 |   |   |   | $ | — |   |   | $ | 114,460 |   | $ | 164,436 |   |   | $ | 14,983 |   |   |   | $ | 97,006 |   |   |   | $ | (392 | )      |   |   | $ | (45,647 | ) |   |   | $ | 31,817 |   |   | $ | 211,782 |   |
|----------|--------|--------|---|--------|--------|--------|--------|---|---------|--------|--------|--------|---|--------|--------|--------|---|---------|--------|---|---------|--------|--------|---|--------|--------|--------|--------|---|--------|--------|--------|--------|---|------|--------|--------|--------|---|---------|---|--------|--------|---|--------|--------|--------|---|---------|--------|
| **2004** |   |   | $ | 18,740 |   |   |   | $ | 36,949  |   |   |   | $ | — |   |   | $ | 67,114  |   | $ | 45,564  |   |   | $ | 5,070  |   |   |   | $ | 27,259 |   |   |   | $ | (199 | )      |   |   | $ | (25,668 | ) |   |   | $ | 14,472 |   |   | $ | 98,075  |   |
| **2003** |   |   | $ | 573    |   |   |   | $ | 24,361  |   |   |   | $ | — |   |   | $ | 14,603  |   | $ | 22,941  |   |   | $ | 2,268  |   |   |   | $ | 14,996 |   |   |   | $ | 75   |   |   |   | $ | (515    | ) |   |   | $ | 6,186  |   |   | $ | 28,950  |   |

 

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Theexhibits listed below and designated with an asterisk are filed with thisreport. The exhibits listed below and not so designated are incorporated byreference to the documents following the descriptions of the exhibits.
| Exhibit   Number            | ** ** | **Description   of Exhibits**                                                                                                                                                                                                                                                                                        |
|-----------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     3.1 |       | Amended and Restated  Certificate of Incorporation of Tower Group, Inc., incorporated by  reference to Exhibit 3.1 to the Company’s Registration Statement on  Form S-1 (Amendment No. 2) (No. 333-115310) filed  on July 23, 2004                                                |
|     3.2 |       | Amended and  Restated By-laws of Tower Group, Inc., incorporated by reference to  Exhibit 3.2 to the Company’s Registration Statement on Form S-1  (Amendment No. 2) (No. 333-115310) filed on July 23,  2004                                                                     |
|     4.1 |       | Specimen Common  Stock Certificate, incorporated by reference to Exhibit 4.1 to the  Company’s Registration Statement on Form S-1 (Amendment  No. 6) (No. 333-115310) filed on September 30, 2004                                                                                      |
|     4.2 |       | Purchase  Agreement, dated as of June 30, 2001, by and between Tower  Group, Inc. and PXRE Reinsurance Ltd., incorporated by reference to  Exhibit 4.2 to the Company’s Registration Statement on Form S-1  (Amendment No. 2) (No. 333-115310) filed on July 23, 2004   |
|     4.3 |       | Warrant issued to  Friedman, Billings, Ramsey & Co., incorporated by reference to  Exhibit 4.3 to the Company’s Registration Statement on Form S-1  (Amendment No. 3) (No. 333-115310) filed on August 25,  2004                                                              |
|   10.1            |       | Employment  Agreement, dated as of August 1, 2004, by and between Tower  Group, Inc. and Michael H. Lee, incorporated by reference to  Exhibit 10.1 to the Company’s Registration Statement on Form S-1  (Amendment No. 3) (No. 333-115310) filed on August 25,  2004        |
|   10.2            |       | Employment  Agreement, dated as of August 1, 2004, by and between Tower Group, Inc.  and Steven G. Fauth, incorporated by reference to Exhibit 10.2 to the  Company’s Registration Statement on Form S-1 (Amendment  No. 3) (No. 333-115310) filed on August 25, 2004        |
|   10.3            |       | Employment  Agreement, dated as of August 1, 2004, by and between Tower  Group, Inc. and Francis M. Colalucci, incorporated by reference to  Exhibit 10.3 to the Company’s Registration Statement on Form S-1  (Amendment No. 3) (No. 333-115310) filed on August 25,  2004  |
|   10.5            |       | Employment  Agreement, dated as of August 1, 2004, by and between Tower  Group, Inc. and Christian K. Pechmann, incorporated by reference to  Exhibit 10.5 to the Company’s Registration Statement on Form S-1  (Amendment No. 3) (No. 333-115310) filed on August 25,  2004 |
|   10.6            |       | Employment  Agreement, dated as of August 1, 2004, by and between Tower  Group, Inc. and Joel Weiner, incorporated by reference to  Exhibit 10.6 to the Company’s Registration Statement on Form S-1  (Amendment No. 3) (No. 333-115310) filed on August 25,  2004           |
|   10.7            |       | 2004 Long-Term  Equity Compensation Plan, incorporated by reference to Exhibit 10.7 to  the Company’s Registration Statement on Form S-1 (Amendment  No. 6) (No. 333-115310) filed on September 30, 2004                                                                               |
|   10.8            |       | 2001 Stock Award  Plan, incorporated by reference to Exhibit 10.8 to the Company’s  Registration Statement on Form S-1 (No. 333-115310)  filed on May 7, 2004                                                                                                                               |

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|   10.9     |   | 2000 Deferred  Compensation Plan, incorporated by reference to Exhibit 10.9 to the  Company’s Registration Statement on Form S-1 (Amendment  No. 6) (No. 333-115310) filed on September 30, 2004                                                                                                                                                                                                                                                        |
|----------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   10.10    |   | Amended &  Restated Declaration of Trust, dated as of May 15, 2003, by and between  Tower Group, Inc., Tower Statutory Trust I and U.S. Bank National  Association, incorporated by reference to Exhibit 10.10 to the Company’s  Registration Statement on Form S-1 (No. 333-115310)  filed on May 7, 2004                                                                                                                                |
|   10.11    |   | Indenture, dated  as of May 15, 2003, by and between Tower Group, Inc. and U.S. Bank  National Association, incorporated by reference to Exhibit 10.11 to the  Company’s Registration Statement on Form S-1 (No. 333-115310)  filed on May 7, 2004                                                                                                                                                                                                 |
|   10.12    |   | Guarantee  Agreement, dated as of May 15, 2003, by and between Tower  Group, Inc. and U.S. Bank National Association, incorporated by  reference to Exhibit 10.12 to the Company’s Registration Statement on  Form S-1 (No. 333-115310) filed on May 7, 2004                                                                                                                                                                                       |
|   10.13    |   | Amended and  Restated Trust Agreement, dated as of September 30, 2003, by and between  Tower Group, Inc., JPMorgan Chase Bank, Chase Manhattan Bank USA,  National Association and Michael H. Lee, Steven G. Fauth and Francis M.  Colalucci as Administrative Trustees of Tower Group Statutory Trust II,  incorporated by reference to Exhibit 10.13 to the Company’s Registration  Statement on Form S-1 (No. 333-115310) filed on  May 7, 2004 |
|   10.14    |   | Junior  Subordinated Indenture, dated as of September 30, 2003, by and between  Tower Group, Inc. and JPMorgan Chase Bank, incorporated by reference to  Exhibit 10.14 to the Company’s Registration Statement on Form S-1  (No. 333-115310) filed on May 7, 2004                                                                                                                                                                                  |
|   10.15    |   | Guarantee  Agreement, dated as of September 30, 2003, by and between Tower  Group, Inc. and JPMorgan Chase Bank, incorporated by reference to  Exhibit 10.15 to the Company’s Registration Statement on Form S-1  (No. 333-115310) filed on May 7, 2004                                                                                                                                                                                            |
|   10.16    |   | Service and  Expense Sharing Agreement, dated as of December 28, 1995, by and between  Tower Insurance Company of New York and Tower Risk Management Corp.,  incorporated by reference to Exhibit 10.16 to the Company’s Registration  Statement on Form S-1 (No. 333-115310) filed on  May 7, 2004                                                                                                                                                     |
|   10.17    |   | Real Estate Lease  and amendments thereto, by and between Broadpine Realty Holding  Company, Inc. and Tower Insurance Company of New York, incorporated by  reference to Exhibit 10.17 to the Company’s Registration Statement on  Form S-1 (Amendment No. 1) (No. 333-115310) filed  on June 24, 2004                                                                                                                                             |
|   10.17(A) |   | Third Amendment  to Lease between Tower Insurance Company of New York and 120 Broadway  Holdings, LLC executed September 1, 2005, incorporated by reference to  Exhibit 10.01 to the Company’s current report on Form 8-K  filed on August 26, 2005                                                                                                                                                                                                          |
|   10.18    |   | License and  Services Agreement, dated as of June 11, 2002, by and between AgencyPort  Insurance Services, Inc. and Tower Insurance Company of New York,  incorporated by reference to Exhibit 10.18 to the Company’s Registration  Statement on Form S-1 (Amendment No. 3) (No. 333-115310)  filed on August 25, 2004                                                                                                                        |
|   10.19    |   | Agreement, dated  as of April 17, 1996, between Morstan General Agency, Inc. and  Tower Risk Management Corp., incorporated by reference to Exhibit 10.19  to the Company’s Registration Statement on Form S-1 (No. 333-115310)  filed on May 7, 2004                                                                                                                                                                                              |

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|   10.20 |   | Managing General  Agency Agreement, dated January 1, 2002, by and between Virginia Surety  Company and Tower Risk Management Corp., incorporated by reference to  Exhibit 10.20 to the Company’s Registration Statement on Form S-1  (Amendment No. 1) (No. 333-115310) filed on June 24,  2004                                                                                           |
|-------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   10.21 |   | General Agency  Agreement by and among State National Insurance Company, Inc., Tower  Insurance Company of New York and Tower Risk Management Corp., incorporated  by reference to Exhibit 10.21 to the Company’s Registration Statement on  Form S-1 (Amendment No. 1) (No. 333-115310) filed  on June 24, 2004                                                                          |
|   10.22 |   | Quota Share Reinsurance  Agreement, dated as of January 1, 2004, by and between Tower Insurance  Company of New York and Converium Reinsurance (North America) Inc.,  incorporated by reference to Exhibit 10.22 to the Company’s Registration  Statement on Form S-1 (Amendment No. 3) (No. 333-115310)  filed on August 25, 2004                                                        |
|   10.23 |   | Quota Share  Reinsurance Agreement, dated as of January 1, 2004, by and between Tower  Insurance Company of New York, Tokio Millennium Re Ltd. and Hannover  Reinsurance (Ireland) Ltd. and E+S Reinsurance (Ireland) Ltd., incorporated  by reference to Exhibit 10.23 to the Company’s Registration Statement on  Form S-1 (Amendment No. 3) (No. 333-115310) filed  on August 25, 2004 |
|   10.24 |   | Amended and  Restated Promissory Note, dated August 2, 2004, by Michael H. Lee in  favor of Tower Risk Management, Inc., incorporated by reference to  Exhibit 10.24 to the Company’s Registration Statement on Form S-1  (Amendment No. 6) (No. 333-115310) filed on  September 30, 2004                                                                                            |
|   10.25 |   | Quota Share  Reinsurance Agreement, dated as of October 1, 2003, by and between Tower  Insurance Company of New York and Tokio Millennium Re Ltd., incorporated by  reference to Exhibit 10.25 to the Company’s Registration Statement on  Form S-1 (No. 333-115310) filed on May 7, 2004                                                                                                      |
|   10.26 |   | Quota Share  Reinsurance Agreement, dated as of January 1, 2003, by and between Tower  Insurance Company of New York and PXRE Reinsurance Company and PMA Capital  Insurance Company, incorporated by reference to Exhibit 10.26 to the  Company’s Registration Statement on Form S-1 (Amendment  No. 1) (No. 333-115310) filed on June 24, 2004                                     |
|   10.27 |   | Aggregate Excess  of Loss Retrocession Agreement, dated as of January 1, 2004, by and  between Converium Reinsurance (North America) Inc. and Tower Insurance  Company of New York, incorporated by reference to Exhibit 10.27 to the  Company’s Registration Statement on Form S-1 (No. 333-115310)  filed on May 7, 2004                                                                     |
|   10.28 |   | Aggregate Excess  of Loss Retrocession Agreement, dated as of January 1, 2004, by and  between Hannover Reinsurance (Ireland) Ltd. and E+S Reinsurance (Ireland)  Ltd. and Tower Insurance Company of New York, incorporated by reference to  Exhibit 10.28 to the Company’s Registration Statement on Form S-1  (No. 333-115310) filed on May 7, 2004                                         |
|   10.29 |   | Excess of  Liability Reinsurance Agreement dated as of January 1, 2004, by and  between State National Insurance Company, Tower Insurance Company of New York  and Tower Risk Management Corporation, incorporated by reference to  Exhibit 10.29 to the Company’s Registration Statement on Form S-1  (No. 333-115310) filed on May 7, 2004                                                   |

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|   10.30 |   | Commercial Renewal Rights Agreement, dated as of  September 13, 2004, by and among OneBeacon Insurance Group LLC, each of  the insurance Company subsidiaries of OneBeacon Insurance Group LLC listed therein  and Tower Group, Inc., incorporated by reference to Exhibit 10.30  to the Company’s Registration Statement on Form S-1 (Amendment  No. 5) (No. 333-115310) filed on September 15, 2004           |
|-------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   10.31 |   | Addendum No. 1 to the Quota Share Reinsurance  Agreement, effective January 1, 2004 by and between Tower Insurance  Company of New York and Converium Reinsurance (North America) Inc.,  incorporated by reference to Exhibit 10.31 to the Company’s Registration  Statement on Form S-1 (Amendment No. 6) (No. 333-115310)  filed on September 30, 2004                                                        |
|   10.32 |   | Addendum  No. 1 to the Quota Share Reinsurance Agreement, effective  January 1, 2004, by and between Tower Insurance Company of New York,  Tokio Millenium Re Ltd. and Hannover Reinsurance (Ireland) Ltd. and E+S  Reinsurance (Ireland) Ltd., incorporated by reference to Exhibit 10.32  to the Company’s Registration Statement on Form S-1 (Amendment  No. 6) (No. 333-115310) filed on September 30, 2004 |
|   10.33 |   | General Agency  Agreement, effective October 1, 2004, by and among State National  Insurance Company Inc., Tower Insurance Company of New York and Tower Risk  Management Corp. (Equipment breakdown business), incorporated by reference to  Exhibit 10.33 to the Company’s Annual Report on Form 10-K  filed on March 22, 2005                                                                                               |
|   10.34 |   | General Agency  Agreement, effective October 1, 2004, by and among State National  Insurance Company Inc., Tower Insurance Company of New York and Tower Risk  Management Corp. (Umbrella business), incorporated by reference to  Exhibit 10.34 to the Company’s Annual Report on Form 10-K  filed on March 22, 2005                                                                                                          |
|   10.35 |   | Excess of  Liabilities Reinsurance Agreement, effective October 1, 2004, by and  among State National Insurance Company Inc., Tower Insurance Company of New  York and Tower Risk Management Corp. (Umbrella business), incorporated by  reference to Exhibit 10.35 to the Company’s Annual Report on  Form 10-K filed on March 22, 2005                                                                                       |
|   10.36 |   | Wrap-Around  Multiline Quota Share Agreement, effective December 1, 2004, by and  between Virginia Surety Company, Inc. and Tower Insurance Company of New  York), incorporated by reference to Exhibit 10.36 to the Company’s  Annual Report on Form 10-K filed on March 22, 2005                                                                                                                                        |
|   10.37 |   | Managing General  Agency Agreement, effective December 1, 2004, by and between Virginia  Surety Company Inc. and Tower Risk Management Corp.), incorporated by  reference to Exhibit 10.37 to the Company’s Annual Report on  Form 10-K filed on March 22, 2005                                                                                                                                                                |
|   10.38 |   | Quota Share  Reinsurance Agreement, effective January 1, 2005, by and among Tower  Insurance Company of New York, Hannover Reinsurance (Ireland) Ltd., E+S  Reinsurance (Ireland) Ltd. and Tokio Millennium Re Ltd.), incorporated by  reference to Exhibit 10.38 to the Company’s Annual Report on  Form 10-K filed on March 22, 2005                                                                                         |
|   10.39 |   | General Agency Agreement,  effective January 1, 2005, by and among State National Insurance Company  Inc., Tower Insurance Company of New York and Tower Risk Management Corp.),  incorporated by reference to Exhibit 10.39 to the Company’s Annual  Report on Form 10-K filed on March 22, 2005                                                                                                                              |

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|   10.40 |   | Amended and Restated Declaration of Trust, dated  December 15, 2004, by and among Wilmington Trust Company, as  Institutional Trustee; Wilmington Trust Company, as Delaware Trustee; Tower  Group, Inc., as Sponsor; and the Trust Administrators Michael H. Lee,  Francis M. Colalucci and Steve G. Fauth, incorporated by reference to  Exhibit 10.04 to the Company’s Current Report on Form 8-K  filed on December 20, 2004                                         |
|-------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   10.41 |   | Indenture between  Tower Group, Inc. and Wilmington Trust Company, as Trustee, dated  December 15, 2004, incorporated by reference to Exhibit 10.03 to  the Company’s Current Report on Form 8-K filed on  December 20, 2004                                                                                                                                                                                                                                             |
|   10.42 |   | Guarantee  Agreement dated December 15, 2004, by and between Tower Group, Inc.  and Wilmington Trust Company, incorporated by reference to Exhibit 10.02  to the Company’s Current Report on Form 8-K filed on  December 20, 2004                                                                                                                                                                                                                                        |
|   10.43 |   | Amended and  Restated Declaration of Trust, dated December 21, 2004, by and among  JPMorgan Chase Bank, National Association, as Institutional Trustee, Chase  Manhattan Bank USA, National Association, as Delaware Trustee; Tower  Group, Inc., as Sponsor; and the Trust Administrators Michael H. Lee,  Francis M. Colalucci and Steve G. Fauth, incorporated by reference to Exhibit 10.04  to the Company’s Current Report on Form 8-K filed on  December 23, 2004 |
|   10.44 |   | Indenture between  Tower Group, Inc. and JPMorgan Chase Bank, National Association, as  Trustee, dated December 21, 2004, incorporated by reference to  Exhibit 10.03 to the Company’s Current Report on Form 8-K  filed on December 23, 2004                                                                                                                                                                                                                            |
|   10.45 |   | Guarantee  Agreement dated December 21, 2004, by and between Tower Group, Inc.  and JPMorgan Change Bank, National Association, incorporated by reference to  Exhibit 10.02 to the Company’s Current Report on Form 8-K  filed on December 23, 2004                                                                                                                                                                                                                      |
|   10.46 |   | Stock Purchase  Agreement by and among Tower Group, Inc. Lawrenceville  Holding, Inc. and MIIX Insurance Company in rehabilitation dated as of  August 1, 2005, incorporated by reference to Exhibit 10.01 to the  Company’s current report on Form 8-K filed on August 8, 2005                                                                                                                                                                                     |
|   21.1  |   | Subsidiaries of  the registrant                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   23.1  |   | Consent of  Johnson Lambert & Co.                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|   31.1  |   | Certification  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by Michael H. Lee                                                                                                                                                                                                                                                                                                                                                                                                        |
|   31.2  |   | Certification  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by Francis M.  Colalucci                                                                                                                                                                                                                                                                                                                                                                                                 |
|   32    |   | Certification of Chief  Executive Officer and Chief Financial Officer, Pursuant to 18 U.S.C.  Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                            |

 

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