**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

| **(Mark  One)** | ** **                                                                                     |
|-----------------|------------------------------------------------------------------------------------------------|
| **x**           | **ANNUAL REPORT PRUSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **      | **For the fiscal year ended December 31, 2006**                                           |
| ** **      | **Or**                                                                                         |
| **o**           | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES ACT OF 1934**      |

 

**Forthe transition periodfrom               to**

**CommissionFile Number:  000-50990**

**Tower Group, 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, 31****st**** Floor**                            | ** ** |                                  |
| **New York, New York**                                               |       | **10271**                             |
| (Address of principal executive offices)                             |       | (Zip Code)                            |
| **(212) 655-2000**                                                   |
| (Registrant’s  telephone number, including area code)           |

 

**Securitiesregistered pursuant to Section 12(b) of the Act:Common Stock, $0.0l par value per share**

**Securitiesregistered pursuant to Section 12(g) of the Act:None**

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

Indicateby check mark if the registrant is not required to file reports pursuant toSection 13 or Section 15(d) of the Act. Yes o   No x

Indicate by check mark whetherthe 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 wasrequired to 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

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer. See definition of “accelerated filer and large acceleratedfiler: in Rule 12b-2 of the Exchange Act.  (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, 2006(based on the closing price on the Nasdaq National Market) on such date wasapproximately $515,117,298.

As of March 5, 2007, the registrant had 23,101,108shares of common stock outstanding. 

**DOCUMENTSINCORPORATED BY REFERENCE:**

Part IIIof this Form 10-K incorporates by reference certain information fromthe registrant’s definitive Proxy Statement with respect to the registrant’s2006 Annual Meeting of Shareholders, to be filed not later than 120 days afterthe close of the registrant’s fiscal year (the “Proxy Statement”).

 

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**TABLEOF CONTENTS**

|            | ** ** | ** **                                                                                                             | ** ** | **Page** |
|------------|------------|------------------------------------------------------------------------------------------------------------------------|------------|----------|
| ** ** |       | **PART I**                                                                                                        |       |     |
| Item 1.    |       | Business                                                                                                               |       | 3        |
| Item 1A.   |       | Risk Factors                                                                                                           |       | 43       |
| Item 1B.   |       | Unresolved Staff Comments                                                                                              |       | 57       |
| Item 2.    |       | Properties                                                                                                             |       | 57       |
| Item  3.   |       | Legal Proceedings                                                                                                      |       | 57       |
| Item 4.    |       | Submission of Matters to a Vote of Security Holders                                                                    |       | 57       |
| ** ** |       | **PART II**                                                                                                       |       |     |
| Item 5.    |       | Market for The Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       | 57       |
| Item 6.    |       | Selected Consolidated Financial Data                                                                                   |       | 59       |
| Item 7.    |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                            |       | 61       |
| Item 7A.   |       | Quantitative and Qualitative Disclosures about Market  Risk                                                            |       | 96       |
| Item 8.    |       | Financial Statements and Supplementary Data                                                                            |       | 100      |
| Item 9.    |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                                  |       | 101      |
| Item  9A.  |       | Controls  and Procedures                                                                                               |       | 101      |
| Item  9B.  |       | Other  Information                                                                                                     |       | 101      |
| ** ** |       | **PART III**                                                                                                      |       |     |
| Item 10.   |       | Directors and Executive Officers of the Registrant                                                                     |       | 101      |
| Item 11.   |       | Executive Compensation                                                                                                 |       | 102      |
| Item 12.   |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                        |       | 102      |
| Item 13.   |       | Certain Relationships and Related Transactions                                                                         |       | 102      |
| Item 14.   |       | Principal Accounting Fees and Services                                                                                 |       | 102      |
| ** ** |       | **PART IV**                                                                                                       |       |     |
| Item 15.   |       | Exhibits, Financial Statement Schedules                                                                                |       | 102      |

 

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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”), and Tower National Insurance Company (“TNIC”), Tower IndemnityCompany of America (“TICA”) and its managing general agency, Tower RiskManagement Corp. (“TRM”), unless the context suggests otherwise.

References to “Preserver” refer to Preserver Group, Inc.and its subsidiaries, including Preserver Insurance Company, Mountain ValleyIndemnity Company and North East Insurance Company and any other direct orindirect subsidiary, unless the context suggests otherwise;

References to “CastlePoint” refer to CastlePointHoldings, Ltd. and its subsidiaries, which include CastlePoint ManagementCorp., CastlePoint Bermuda Holdings, Ltd., CastlePoint Reinsurance Company,Ltd. and CastlePoint Insurance Company, unless the context suggests otherwise.

Through our subsidiaries, we offer a broad range ofspecialized property and casualty insurance products and services to small tomid-sized businesses and to individuals in New York, New Jersey, Massachusettsand Pennsylvania. We provide coverage for many different market segments,including nonstandard risks that do not fit the underwriting criteria ofstandard risk carriers due to factors such as type of business, location andpremium per policy. We provide commercial lines products comprised ofcommercial package, general liability, workers’ compensation and commercialauto policies to businesses such as retail and wholesale stores, grocerystores, restaurants, artisan contractors and residential and commercialbuildings. We also provide personal lines products that currently insuremodestly valued homes and dwellings. These products are distributed throughapproximately 800 retail agents that are serviced through our offices in NewYork City, Buffalo and Long Island. We also distribute our products throughapproximately 60 wholesale agents that are primarily located throughout the NewYork metropolitan area. TICNY and TNIC are currently rated “A-” (Excellent) by A.M.Best.

In March 2005, in an effort to expand ourwritings outside of New York as well as position our products in various marketsegments, we purchased the outstanding common stock of TNIC, a shell insurancecompany that had licenses in various states in the Northeast. A “shellinsurance company” is a licensed insurance company that does not have any netliabilities and does not write any business. We have worked to increase thelicensing of both TNIC and TICNY, which are licensed in 25 and 36 states,respectively. TNIC began writing business in New Jersey, Pennsylvania,Illinois, Massachusetts and New York in 2006.

In February 2006, wesponsored the formation of CastlePoint Holdings, Ltd., a Bermuda holdingcompany organized to provide property and casualty insurance and reinsurancebusiness solutions, products and services primarily to small insurancecompanies and program underwriting agents in the United States. We sponsoredand entered into a long-term strategic relationship with CastlePoint to securea stable source of traditional quota share reinsurance and insurancerisk-sharing capability to support our anticipated future growth. We believethat the formation of CastlePoint and the agreements between our company andCastlePoint further enhance our hybrid business model by reducing certain risksof relying on other reinsurers and issuing carriers. These risks includecyclicality in demand for underwriting and availability of capacity,restrictions on business and underwriting classes and the high costs ofutilizing issuing carriers. Our relationship with CastlePoint also generatescommission and fee income which are an important component of our business. See“Business - Strategic Relationship and Agreements with CastlePoint.”

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**Recent Developments**

We have agreed to enter into various poolingarrangements with CastlePoint Insurance Company to be effective January 1,2007 that are pending the approval of the New York State Department ofInsurance. As a result of these pooling agreements and the reinsuranceagreements that we already have in place with CastlePoint Reinsurance Company,Ltd. (“CastlePoint Reinsurance”), we expect to cede and/or pool a total of 49%of our brokerage business premium and to participate in 50% of the traditionalprogram business premium with CastlePoint in 2007, and we expect to assumeapproximately 15% of the specialty program business premium written by CastlePointInsurance Company in 2007. These pooling arrangements remain subject toregulatory approval. On December 4, 2006, we sold an unused “shell”insurance company, Tower Indemnity Company of America (which was renamedCastlePoint Insurance Company), to CastlePoint, in order to facilitate ourpooling arrangements with CastlePoint. See “Business-Strategic Relationship andAgreements with CastlePoint.”

On November 13, 2006, we signed an agreement toacquire Preserver Group, Inc. (“Preserver”) for a base purchase price of$68.3 million (approximately $64.8 million after deduction for expensesincurred by Preserver, net of tax). A portion of the purchase price paid willbe used to redeem $30.8 million of debt to Preserver’s shareholders at theclosing. In addition, $12 million of Preserver’s trust preferred securitieswill remain outstanding. Preserver is a privately-held company that offersproducts similar to ours in the Northeast, particularly in New Jersey, Maineand Massachusetts. Preserver’s gross written premiums were $88.6 million in2005 and $64.6 million for the nine months ended September 30, 2006.Preserver is rated “B++” (Good) by A.M. Best. On December 7, 2006, A.M.Best placed the ratings of Preserver under review with positive implications.We believe this transaction will accelerate our regional expansion by allowingus to access Preserver’s approximately 300 agents that produce business invarious Northeastern states. The acquisition is subject to regulatory approvalsand is expected to close in the second quarter of 2007. See “Business—Acquisitionof Preserver.”

On November 13, 2006, we entered into the StockPurchase Agreement with a subsidiary of CastlePoint pursuant to which we agreedto issue and sell 40,000 shares of perpetual preferred stock to the subsidiaryfor aggregate consideration of $40 million. The transaction closed on December 4,2006. See “Business—Strategic Relationship and Agreements with CastlePoint.”

On January 22, 2007, the Securities and ExchangeCommission declared effective our registration statement on Form S-3for the sale by the Company of an aggregate of 2,704,000 shares of commonstock, par value $.01 per share, of the Company (“common stock”) and the grantof an option to the underwriters to purchase up to of 405,600 additional sharesof common stock to cover over-allotments, if any, from the Company.

On January 25, 2007, Tower Group Statutory TrustVI (the “Trust”), an affiliated Delaware trust issued $20.0 million offixed/floating rate capital securities (the “Trust Preferred Securities”) in aprivate placement. The Trust Preferred Securities mature in April 2036,are redeemable at the Company’s option at par beginning April 7, 2011, andrequire quarterly distributions of interest by the Trust to the holder of theTrust Preferred Securities. Interest distributions are initially at a fixedrate of 8.155% for the first five years and will then reset quarterly forchanges in the three-month London Interbank Offered Rate (“LIBOR”) plus 300basis points. The Trust simultaneously issued 619 of the Trust’s commonsecurities to the Company for a purchase price of $0.6 million, whichconstitutes all of the issued and outstanding common securities of the Trust.The Trust used the proceeds from the sale of the Trust Preferred Securities andcommon securities to purchase for $20.6 million a Junior Subordinated DebtSecurity due 2037 issued by the Company. The Company does not consolidateinterest in its statutory business trusts for which the Company holds 100% ofthe common trust securities because the Company is not the primary beneficiaryof the trusts. The Company’s investment in common trust securities of thestatutory business trust are reported in investments as equity securities. TheCompany reports as a liability the outstanding 

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subordinated debenturesowed to the statutory business trusts. The net proceeds were used to redeem$20.0 million of the perpetual preferred stock held by a subsidiary ofCastlePoint on January 26, 2007.

On January 26, 2007, the Company closed on itssale of 2,704,000 shares of common stock at an offering price of $31.25 pershare. The Company’s gross proceeds of $84.5 million were reduced by $4.2million for the underwriters’ discount and $1.0 million for other offeringexpenses resulting in approximately $79.3 million of net proceeds. The Companyused $20.0 million of these net proceeds to redeem its remaining $20.0 millionof perpetual preferred stock held by a subsidiary of CastlePoint. As of January 26,2007 all of the Company’s perpetual preferred stock was fully redeemed.

On February 5, 2007the underwriters exercised their over-allotment option in part to purchase340,600 shares of common stock at the offering price of $31.25 per shares. TheCompany received gross proceeds of $10.6 million from this exercise and netproceeds of $10.1 million after the underwriting discount. The partial exerciseof the over-allotment option brought the Company’s aggregate net proceeds fromthe offering and over-allotment option, after underwriting discounts, commissionsand expenses, to approximately $89.4 million.

**CompetitiveStrengths and Strategies**

We believe ourhybrid business model, high growth platform, underwriting and marketsegmentation expertise, low cost infrastructure and proven leadership and experiencedmanagement are competitive strengths, as described below. We plan to utilizethese competitive strengths to continue our profitable growth through thefollowing strategies:

·       ***Hybrid Business Model.*****We utilize a business model under which we (i) retainpremiums to generate investment and underwriting income through the use of ourown capital and (ii) transfer premiums to reinsurers and produce businessfor other insurance companies to generate commission and fee income. Ourbusiness model allows us to create and support a much larger premium base andmore highly developed infrastructure than otherwise would have been possiblewith our capital base. In doing so, we have been able to achieve a return onaverage equity (or ROAE) that we believe is higher than many other insurancecompanies with a traditional business model. From 2002 to 2006, our return onaverage equity averaged 21.6%. Through our strategic relationship withCastlePoint, we have reduced the risk of relying on other reinsurance and issuingcompanies and will be able to maintain and strengthen our hybrid business modelas well as pursue our growth plans. Through reinsurance and pooling, we plan totransfer approximately 49% of our total premiums written and produced toCastlePoint’s reinsurance and insurance company subsidiaries in order togenerate commission and fee income. We will continue to maintain theoperational infrastructure that will market, originate, underwrite and servicethe total premiums written and produced.

·       ***High Growth Platform and Territorial Expansion*.**We have established a track record of growth by expanding our product lineoffering, entering into new territories and acquiring books of business. Ourgross premiums written and premiums produced increased 34.3% on a compoundedannual basis from 2002 to 2006. Our acquisition of Preserver will allow us toincrease our premium writings in the three states in which we are currentlywriting business, New York, New Jersey and Massachusetts, as well as expandinto new states such as Maine, New Hampshire, Rhode Island, Vermont andPennsylvania. Through this acquisition, we will also be able to expand ourbroad product line platform to include personal auto and businessownerspolicies. We also plan to expand into other parts of the United States byestablishing offices and appointing retail agents in those areas as well asappointing wholesale agents throughout the country. We will continue to seekacquisitions of renewal rights, insurance companies and managing generalagencies that will provide us with access to local markets throughout theUnited States.

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·       ***Underwriting and Market Segmentation Expertise.*****We have a strong track record of generating favorableunderwriting results as demonstrated by our weighted average gross loss ratioof 57.0% during the period from 2002 to 2006. We have been able to achievethese underwriting results by focusing on customers that present low tomoderate hazard risks and utilizing our in-house claims and legal defensecapabilities to adjust and defend claims cost-effectively. We also haveutilized our broad product line platform to allocate our capital to the mostprofitable lines of business in response to changing market conditions. Inaddition, we have been able to maintain pricing and coverage discipline inwriting these policies by positioning our products in various market segmentsthat tend to exhibit a reduced level of competition, including nonstandardrisks that may be avoided by standard or preferred market carriers due tounderwriting factors such as type of business, location and premium per policy.

·       ***Entrance into Excess and Surplus Lines Market.*****At present, we generally write our insurance policies inthe preferred and standard market through our retail agents and insurancepolicies in the non-standard market segments through our wholesale agents, allon an “admitted basis.” This means that we are licensed by the states in whichwe sell our policies, and we write our policies using premium rates and formsthat are filed with state insurance regulators. However, we plan to enter theexcess and surplus lines (or E&S) market segment by offering our productsthrough TICNY, which is qualified as a non-admitted company to write E&Sbusiness in Florida and Texas, as well as through a separate non-admittedcompany that we plan to form and capitalize. Non-admitted carriers writing inthe E&S market are not bound by most of the rate and form regulationsimposed on standard market companies, allowing them the flexibility to changethe coverage offered and the rate charged without the time constraints andfinancial costs associated with the filing process. Because we focus onproviding products in underserved market segments through our wholesaledistribution system, we believe we can distribute these products utilizing boththe non-standard market segment on an admitted basis as well as the E&Smarket segment on a non-admitted basis. Having a non-admitted company willprovide us with a means to quickly expand and distribute our productsnationally through the wholesale distribution system.

·       ***Low Cost Infrastructure.*****We have been able to gradually lower our expense ratio byrealizing economies of scale resulting from our growth in total premiumsproduced and managed, and by improving our business processes and integratingtechnology to become more efficient. The commission and fee income that wegenerate from transferring premiums to reinsurers and other insurance companiesalso reduces our expense ratio. Our net expense ratio, which is calculatedafter offsetting our reinsurance commission, was 27.3% and 29.3% in 2006 and2005, respectively. We also expect that acquisitions we may make will generateincremental reductions in our expense ratio as we apply our technology andbusiness processes to the operations of the acquired business in order torealize economies of scale.

·       ***ProvenLeadership and Experienced Management.*****Oursenior management team members average over 20 years of insurance industryexperience. Michael H. Lee, our Chairman of the Board, President and ChiefExecutive Officer, was a founder of the company in 1990 and has an extensiveknowledge and understanding of our business, having played a key role inbuilding several aspects of our operations, including underwriting, finance,claims and systems.

**StrategicRelationship and Agreements with CastlePoint**

We organized and sponsored CastlePoint, a Bermudaholding company, with an initial investment of $15.0 million on February 6,2006. On April 4, 2006, CastlePoint raised $249.9 million, net of expenses,in a private placement offering of newly issued shares, which reduced ourinvestment ownership from 100% to 8.6%. On April 6, 2006, we received awarrant from CastlePoint to purchase an additional 3.7% or 

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1,127,000shares of common stock with a fair value of approximately $4.6 million using aBlack-Scholes option pricing model.

As previously announced, Michael H. Lee serves asChairman and Chief Executive Officer of CastlePoint Holdings, Ltd. and TowerGroup, Inc.

CastlePoint is a Bermuda holding company organized toprovide property and casualty insurance and reinsurance business solutions,products and services primarily to small insurance companies and programunderwriting agents in the United States. Reinsurance is an arrangement bywhich one insurance company, called the reinsurer, agrees to indemnify anotherinsurance (or reinsurance) company, called the ceding company, against all or aportion of the insurance (or reinsurance) risks underwritten by the cedingcompany under one or more policies. Program underwriting agents are insuranceintermediaries that aggregate insurance business from retail and wholesaleagents and manage business on behalf of insurance companies. Their functionsmay include some or all of risk selection, underwriting, premium collection,policy form and design, and client service.

CastlePoint operates through a number of subsidiaries,including CastlePoint Reinsurance, a Bermuda reinsurance company; CastlePointInsurance Company, a New York domiciled insurance company; and CastlePointManagement Corp., which provides insurance services.

For yourconvenience, we have included below definitions of terms used in thisForm 10-K in connection with our relationship with CastlePoint:

·       “brokeragebusiness” refers to broad classes of business that are underwritten on anindividual policy basis by an insurance company’s underwriting staff throughwholesale and retail agents, and for which most or all of the services areprovided by the insurance company as part of the overall product offering;

·       “programbusiness” refers to narrowly defined classes of business that are underwrittenon an individual policy basis by program underwriting agents on behalf ofinsurance companies;

·       “traditionalprogram business” refers to blocks of program business in excess of $5 millionin annual gross written premium that we historically have underwritten,consisting of non-auto related personal lines and the following commerciallines of business: retail stores and wholesale trades, commercial and residentialreal estate, restaurants, grocery stores, office and service industries andartisan contractors;

·       “specialtyprogram business” refers to (i) program business other than traditionalprogram business and (ii) traditional program business that we and CastlePointagree will be deemed to be specialty program business;

·       “insurancerisk-sharing business” refers to various risk sharing arrangements, such as(i) pooling or sharing of premiums and losses between our insurancecompanies and other insurance companies based upon their respective percentageallocations or (ii) appointing other insurance companies as our programunderwriting agents and then having those insurance companies assume throughreinsurance a portion of the business they produce as program underwritingagents;

·       “traditionalquota share reinsurance” refers to a type of reinsurance whereby a reinsurerprovides reinsurance coverage to an insurance company on a pro-rata basis basedon a ceding percentage without any provisions to limit meaningful losses withinthe contractual limits; and

·       “programunderwriting agent” refers to an insurance intermediary that aggregatesbusiness from retail and wholesale agents and manages business on behalf ofinsurance companies, including functions such as risk selection andunderwriting, premium collection, policy form design and client service.

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In April 2006,we entered into a master agreement with CastlePoint (the “Master Agreement”).Pursuant to the Master Agreement and as described more fully in “Business—Reinsurance,”we subsequently entered into the following agreements and arrangements withsubsidiaries of CastlePoint:

·       brokeragebusiness quota share reinsurance agreement between CastlePoint Reinsurance andour subsidiaries, TICNY and TNIC, covering brokerage business historicallywritten by us;

·       traditionalprogram business quota share reinsurance agreement between CastlePointReinsurance and our subsidiaries, TICNY and TNIC, covering program businesshistorically written by us;

·       specialtyprogram business and insurance risk-sharing business quota share reinsuranceagreement between CastlePoint Reinsurance and our subsidiaries, TICNY and TNIC,covering business not historically written by us;

·       aservice and expense sharing agreement with CastlePoint Management; and

·       aprogram management agreement between CastlePoint Management and our subsidiaries,TICNY and TNIC.

The reinsurance agreements and pooling agreement aredescribed in more detail under “Business—Reinsurance—CastlePoint Reinsuranceand Pooling.” Under the service and expense sharing agreement, CastlePointManagement can purchase from us certain insurance company services, such asclaims adjustment, policy administration, technology solutions, underwriting,and risk management services, at cost and market these services to programunderwriting agents on an unbundled basis. The reimbursement for these chargeshave been recorded as “Other administration revenues” in our insurance servicessegment. CastlePoint Management shares with us 50% of the profits and lossesgenerated from marketed services. We charged CastlePoint $0.7 million for suchservices in 2006. Under the program management agreement, CastlePointManagement was appointed by TICNY and TNIC to perform certain underwriting andclaims services with respect to the specialty program business and insurancerisk-sharing business, such as soliciting, underwriting, quoting, binding,issuing and servicing of insurance policies. In circumstances where CastlePointManagement cannot fully perform these functions on its own, CastlePointManagement plans to delegate authority to the program underwriting agents or topurchase services from us under the service and expense sharing agreement.

The program management agreements, the poolingagreements and the service and expense sharing agreement are subject to furtherreview, approval and modification by the New York State Insurance Department.On December 4, 2006, we sold an unused “shell” insurance company, TowerIndemnity Company of America, to CastlePoint in order to facilitate thesepooling arrangements. Tower Indemnity Company of America was renamedCastlePoint Insurance Company.

We believe that the formation of CastlePoint and theagreements between our company and CastlePoint further enhance our hybridbusiness model by reducing certain risks of relying on other reinsurers andissuing carriers. These risks include cyclicality in demand for underwritingand availability of capacity, restrictions on business and underwriting classesand the high costs of utilizing issuing carriers. Our relationship withCastlePoint also generates commission and fee income which are an importantcomponent of our business. Furthermore, we can continue to participate inprogram business though our pooling arrangements while operationally remainingfocused on our core business which is distributed by retail and wholesaleagencies.

On November 13, 2006, we entered into the StockPurchase Agreement with a subsidiary of CastlePoint pursuant to which we agreedto issue and sell 40,000 shares of perpetual preferred stock to the subsidiaryfor aggregate consideration of $40 million. The transaction closed on December 4,2006.

In connection with the issuance and sale of thepreferred stock, we (i) paid a placement fee on December 28, 2006 toCastlePoint’s subsidiary in an amount of $400,000; (ii) agreed to provideto 

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CastlePoint a right offirst refusal to enter into a loss portfolio transfer of existing reserves ofany operating company we may acquire; and (iii) agreed to extend theMaster Agreement for an additional year.

The preferred stock was redeemed on January 26,2007 from the proceeds of the Company’s placement of trust preferred securitiesand from a portion of the proceeds of its common stock offering.

We believe it is importantto maintain and enhance our strategic relationship with CastlePoint asCastlePoint provides a reliable source of reinsurance capacity that will permitus to continue to implement our business strategy. We believe the relationshipcan be enhanced through mutually beneficial transactions, includinginvestments. Our growth plans and business model will require additionalcapital or financing from time to time. These needs will likely occur inconnection with the acquisition of a book of business or another company andcould also occur in other circumstances. Assuming that CastlePoint would bewilling to provide financing, any such transaction with CastlePoint will bemade only after approval by a special committee of independent members of theBoard of Directors after evaluating and comparing the proposed terms of suchtransactions with available alternatives.

**Acquisition ofPreserver**

On November 13, 2006,we entered into a Stock Purchase Agreement (the “Preserver Purchase Agreement”)to acquire all of the outstanding shares of stock of Preserver. The sellers arecertain individuals and trusts and companies affiliated with them. We agreed topay the sellers a base purchase price of $68,250,000, subject to adjustment asdescribed below. This amount will be used to acquire the outstanding shares andto satisfy all of Preserver’s obligations with respect to Preserver’s directtransaction costs and the outstanding principal and accrued and unpaid intereston indebtedness of Preserver owed to the sellers (approximately $30.8 millionprincipal amount as of November 13, 2006). Approximately $12 million oftrust preferred securities issued by a subsidiary of Preserver will remainoutstanding as a liability of Preserver.

**Overview ofPreserver**

Preserver is a privately-held holding company for aregional insurance company group specializing in small commercial and personallines insurance in the Northeast. Preserver’s three insurance companies arerated “B++” (Good) by A.M. Best. It is headquartered in Paramus, NewJersey, with offices in Maine, New Hampshire and New York, and currently has astaff of approximately 163 employees. Preserver offers similar products and hasa similar risk appetite as ours. Upon closing, the acquisition will give usaccess to up to 300 retail agencies working with Preserver that have littleoverlap with our existing distribution. The transaction will accelerate ourNortheast expansion plans by adding premium volume in New Jersey, Maine, NewYork, New Hampshire, Massachusetts, Vermont, Rhode Island and Pennsylvania.

Preserver fits ouracquisition profile due to its access to local distribution systems in theNortheast, and focus on similar types of business as ours. Preserver writes allthe lines of business that we currently write but also adds personal auto and aweb-based program for writing business owners policies to our productportfolio. The acquisition will diversify our geographical footprint, with NewJersey and Maine being Preserver’s largest states in terms of premium volume.We believe Preserver’s business exhibits loss characteristics that are similarto our own, and would expect that the business produced by Preserver followingthe acquisition will generate loss ratios similar to our historical lossratios. Following the acquisition of Preserver, we intend to cause all of ourinsurance subsidiaries (other than the E&S carrier that we plan to form andcapitalize) to enter into a pooling agreement, subject to regulatory approvals,to apportion premium, loss and expense among those companies on a pro ratabasis. If this pooling agreement and our proposed pooling agreement withCastlePoint Insurance Company are approved by insurance regulators, the effectwill be that the premiums written by the Preserver companies will be subject toour reinsurance and pooling agreements with CastlePoint.

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**Business Segments**

We operate in threebusiness segments:

·       *Insurance*. In our insurance segment, TICNY and TNIC providecommercial lines policies to businesses and personal lines policies toindividuals in New York, New Jersey, and Massachusetts. We also provide limitedcommercial lines policies in other Northeast states such as Pennsylvania. Tower’scommercial lines products include commercial multiple-peril, monoline generalliability, commercial umbrella, monoline property, workers’ compensation andcommercial automobile policies. The personal lines products consist ofhomeowners, dwelling and other liability policies. See “Business—InsuranceSegment Products.”

·       *Reinsurance*. In our reinsurance segment in 2006, TICNYaccepted or assumed reinsurance directly from TRM’s issuing companies on a 100%quota share basis. Until December 31, 2005, as a reinsurer, TICNY assumeda modest amount of the risk on the premiums that TRM produced. While thisreinsurance business was not profitable in certain prior periods, thecommission income generated by TRM on the production of this business exceededany underwriting losses from the reinsurance assumed on this business. See “Business—InsuranceServices Segment Products and Services.”

·       *Insurance Services*. Prior to our IPO, TICNY’s limitedcapital, rating and licensing constrained its ability to write and retain largepremium volume. Consequently, TICNY made extensive use of quota sharereinsurance to manage the level of risk it retains in relation to its capital.In 1995, we formed TRM in order to produce business for other insurancecompanies that TICNY was precluded from writing. In order for us to obtainreinsurance for TRM’s issuing companies, the reinsurers often required TICNY toassume reinsurance premiums directly from TRM’s issuing companies or from reinsurersthat reinsured the premiums written by these companies.

In our insurance services segment, we reflectadministration service revenue received from CastlePoint for services providedby TICNY in addition to fees generated from services provided by TRM. In 2007,we will also reflect management fee income and related expenses which willresult from the pooling agreements with CastlePoint, which are effective, January 1,2007 and are pending New York State Department of Insurance approval. 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. Until December 31, 2005, all of the risk was written bythe issuing companies and ceded to a variety of reinsurers pursuant toreinsurance programs arranged by TRM working with outside reinsuranceintermediaries. Placing risks through TRM’s issuing companies allowed us tounderwrite larger policies and gain exposure to market segments previouslyunavailable to TICNY due to its then rating, financial size, geographicallicensing limitations, or other factors. Through its issuing companies, TRMproduces commercial package, monoline general liability, monoline property,commercial automobile and commercial umbrella products. In 2006, thereinsurance on TRM business was ceded to TICNY. See “Business—InsuranceServices Segment Products and Services.”

***Insurance Segment Products***

Tower Group offers a broad array of commercial andpersonal lines products. Our insurance segment (TICNY and TNIC) products targetlow severity, low frequency risks. In 2006, our overall average annual premiumwas $5,130 per policy for commercial lines and $1,161 per policy for personallines.

Typically, the liability coverage on these classes ofbusiness is not exposed to long-tailed (i.e., many years may pass before claimsare reported or settled), complex or contingent risks, such as productsliability, asbestos or environmental claims. These risks are located in bothurban and suburban areas of the 

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Northeastern UnitedStates, a market that we believe, in our lines of business, level of risk andpremium size, has historically been underemphasized by regional and nationalinsurance companies. With the OneBeacon Insurance Group LLC (“OneBeacon”)renewal rights agreement and our pending acquisition of Preserver, we haveexpanded our marketing territory to other areas outside of New York State,including New Jersey, Massachusetts, Maine, New Hampshire, Pennsylvania andVermont and Rhode Island. However, we are maintaining a targeted approach tounderwriting, focusing on underserved markets that we believe will permit us toachieve favorable premium rates.

Thefollowing table shows our gross premiums earned and loss ratio for theinsurance segment’s products for the years ended December 31, 2006, 2005and 2004:

| ** **                  | ** ** | **For the year ended December 31,** | ** **  |
|-----------------------------|------------|------------------------------------------|-------------|
| ** **                  | ** ** | **2006**                                 | ** **  | **2005** | ** ** | **2004** | ** ** |
| ** **                  | ** ** | **Gross  Premiums  Earned**              | ** **  | **Gross Loss  Ratio** | ** ** | **Gross  Premiums  Earned** | ** ** | **Gross Loss  Ratio** | ** ** | **Gross  Premiums  Earned** | ** ** | **Gross Loss  Ratio** | ** ** |
| ** **                  | ** ** | **($ in thousands)**           | ** **  |
| Commercial  multiple-peril  |       | $                                        | 150,292     |   |   | 57.1 | % |   | $ | 117,814 |   |   | 59.4 | % |   | $ | 77,917 |   |   | 63.1 | % |   |
| Other liability             |       | 48,742                                   |        |   | 71.3 | % |   | 22,427 |   |   | 77.9 | % |   | 7,525 |   |   | 55.5 | % |   |
| Workers’  Compensation |       | 33,609                                   |        |   | 39.4 | % |   | 21,059 |   |   | 40.8 | % |   | 14,101 |   |   | 61.8 | % |   |
| Commercial auto             |       | 28,491                                   |        |   | 51.6 | % |   | 16,722 |   |   | 32.6 | % |   | 10,432 |   |   | 31.7 | % |   |
| Homeowners                  |       | 70,419                                   |        |   | 42.3 | % |   | 49,150 |   |   | 59.0 | % |   | 34,526 |   |   | 45.6 | % |   |
| Fire and allied  lines      |       | 12,462                                   |        |   | 36.7 | % |   | 9,002 |   |   | 48.1 | % |   | 6,709 |   |   | 55.2 | % |   |
| **All Lines**               | ** ** | **$**                                    | **344,015** | ** ** | ** ** | **53.2** | **%** | ** ** | **$** | **236,174** | ** ** | ** ** | **57.1** | **%** | ** ** | **$** | **151,210** | ** ** | ** ** | **56.1** | **%** | ** ** |

 

***Commercial Multiple-Peril***

Our commercialmultiple-peril products include commercial package policies, businessownerspolicies and landlord package policies. Our commercial package policies provideproperty and casualty coverage and focus on classes of business such as retailand wholesale stores, restaurants, residential and commercial buildings, andgrocery stores. We have written commercial package policies since TICNYcommenced operations in 1990. Our businessowners policies provide property andliability coverage to small businesses. We introduced this product in 1997 toprovide broader built-in coverage for businesses in the standard and preferredpricing tiers. Our landlord package policy provides property and casualtycoverage for three-and-four-family dwellings with a maximum coverage limit of$700,000. As of December 31, 2006, approximately 40,107 commercialmultiple-peril products were in force, including 23,616 commercial packagepolicies and 11,799 landlord package policies and 4,692 business ownerspolicies.

***Other Liability***

We offer other liabilityproducts in personal and commercial lines. Our commercial products are comprisedof monoline commercial general liability and commercial umbrella policies. Wewrite commercial general liability policies for risks that do not have propertyexposure or whose property exposure is insured elsewhere. Primarily, we targetresidential and commercial buildings, as well as artisan contractors formonoline general liability. Our commercial umbrella policy, introduced in 2002,provides additional liability coverage with limits of $1,000,000 to $5,000,000to policyholders who insure their primary general liability exposure with TICNYthrough a business owners, commercial package policy or commercial generalliability policy. As of December 31, 2006 approximately 3,342 monolinecommercial general liability policies were in force. We also write monolinepersonal liability policies as an addition to our dwelling fire policies andcurrently have 1,259 comprehensive personal liability policies in force. Forcommercial umbrella we have a small number of policies with a limit over $5million.

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***Workers’ Compensation***

We introduced our workers’compensation product in 1995. Our underwriting focus is on businesses such asrestaurants, retail stores, offices, and service risks that generally have alower potential for severe injuries to workers from exposure to dangerousmachines, elevated worksites and occupational diseases. For workers’compensation policies, we use full administered rates provided by the New YorkCompensation Insurance Rating Board, the Rating and Inspection Bureau of NewJersey, the Workers’ Compensation Rating Bureau of Massachusetts and the NCCI indeveloping our pricing in other states. In New Jersey and Massachusetts we alsooffer premium credits based on scheduled criteria. As of December 31,2006, we had approximately 12,106 workers’ compensation policies in force.

***Commercial Automobile***

Our commercial automobileproduct focuses on non-fleet and fleet business such as contractor andwholesale food delivery vehicles. We underwrite primarily medium andlightweight trucks (under 30,000 lbs. gross vehicular weight). Historicallyunprofitable accounts for this segment of the insurance industry such aslivery, trucking for hire or long-haul trucking operations are presentlyexcluded under our underwriting guidelines. We commenced writing commercialautomobile business in 1998. As of December 31, 2006, approximately 3,256commercial automobile policies were in force.

***Homeowners***

Our homeowners policy is amultiple-peril policy providing property and liability coverage for one andtwo-family owner-occupied residences. While we are expanding our marketingterritories throughout New York State, the homes we currently insure arelocated predominantly in the greater New York City area. In the first quarterof 2006 we started writing homeowners business in New Jersey and addedhomeowners business in Massachusetts in December 2006. We market both astandard and preferred homeowners product. As of December 31, 2006,approximately 64,987 homeowners policies were in force.

***Fire and Allied Lines***

Our fire and allied linespolicies consist of dwelling policies and monoline commercial propertypolicies. Our dwelling product targets owner-occupied dwellings of no more thantwo families. The dwelling policy provides optional coverage for personalproperty and can be combined with an optional endorsement for liabilityinsurance. This provides an alternative to the homeowners policy for thepersonal lines customer. As of December 31, 2006, we had approximately19,325 dwelling policies in force. We also write monoline commercial propertypolicies for insureds that do not meet our underwriting criteria for theliability portion of our commercial package policies. The classes of businessare the same as those utilized for commercial package property risks.

***Reinsurance Segment Products***

Until December 31, 2005, in order for TRM toobtain reinsurance support for the business it produced for its issuingcompanies, Virginia Surety Company Inc. (“Virginia Surety”) and State NationalInsurance Company Inc. (“State National”), TICNY was often required to assumethrough retrocession a limited amount of reinsurance on this business from theissuing companies or the issuing companies’ reinsurers. By assuming risk, wealigned our interests with the issuing companies and their reinsurers. Whilethis assumed business was unprofitable in certain prior periods, the directcommission income generated by TRM historically offset assumed losses.

In 2006, TRM producedbusiness through Virginia Surety from January 1 to August 31, and itproduced business through State National beginning on November 1, 2006. In2006, TICNY directly reinsured 100% of the TRM business written by VirginiaSurety and State National.

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***Insurance Services Segment Products and Services***

We reflect administrationservice revenue received from CastlePoint for services provided by TICNY inaddition to fees generated from services provided by TRM. In 2007, we will alsoreflect management fee income and related expenses which will result from thepooling agreements with CastlePoint, which are effective, January 1, 2007pending New York State Department of Insurance approval.

*OtherAdministration Revenue*

TICNY providesadministrative services to CastlePoint, which represents the reimbursement ofcost for services provided pursuant to its Service and Expense SharingAgreement with CastlePoint. Its revenue for performing these services in 2006was $0.7 million. See “Business—Strategic Relationship and Agreements withCastlePoint.”

*Managing GeneralAgency*

TRM provides non-risk bearing managing general agency,reinsurance intermediary and claims administration services that generatecommission and fee income for us. TRM also provides us with additional marketcapability to produce business in other states, product lines and pricing tiersthat TICNY cannot currently access. TRM produces this business on behalf of itsissuing companies, which had higher ratings, greater financial resources andmore licenses than TICNY.

TRM provides underwriting, claims administration andreinsurance intermediary services to its issuing companies by utilizing TICNY’sstaff, facilities and insurance knowledge and skills. All of the businessproduced by TRM for its issuing companies is ceded to reinsurers. TRM earns acommission, equal to a specified percentage of ceded net premiums written,which is deducted from the premiums paid to the issuing insurance companies.TRM’s commission rate varies from year to year depending on the loss experienceof the business produced by TRM. The commission rate was 20.9% and 27.1% in2006 and 2005, respectively. TRM also performs claims administration serviceson behalf of other insurance companies, including companies for which TRMproduced business in the past, but as to which it may no longer act as anunderwriting agent.

In 2005 and 2004 TRM produced business on behalf ofVirginia Surety and State National. In 2006, TRM continued to produce businesson behalf of Virginia Surety and State National on a limited basis, primarilyto retain business in states where TICNY and TNIC are not yet licensed.Virginia Surety is rated “A-” (Excellent) and State National is rated “A”(Excellent) by A.M. Best. Virginia Surety and State National are each licensedin all 50 states and the District of Columbia.

TRM’s business isprimarily sourced through wholesale and retail brokers. See “Business—ProductDevelopment and Marketing Strategy—Distribution” for further detail on ourproducers.

*TRM Claims Service*

TRM’s claims service division provides complete claimsadjusting and litigation management service for all commercial and personalproperty and casualty lines of business to TRM’s issuing insurance companies,reinsurers and self-insureds. TRM presently bills its claims administrationcost as a value added service to its issuing companies and is reimbursed by theissuing companies for the amounts billed. The fees earned by TRM help offsetthe total expenses incurred by TICNY’s claims staff and allow TICNY to maintaina larger claims infrastructure than it would otherwise be able to support withits own premium base. The amount of claims administration fees reimbursed bythe issuing companies was $3.2 million in 2006, $4.3 million in 2005 and $4.1million in 2004.

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 

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servicedivision, its reputation in claims administration and litigation management hasgenerated several opportunities to act as a third-party claims administrator.We plan to expand our claims administration services for profit in the future.

*Tower RiskReinsurance Intermediary Services*

TRM’s reinsuranceintermediary services division provides reinsurance intermediary services toTICNY and 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 $0.6 in 2006, $0.7 million in 2005 and $0.7million in 2004.

**Product Developmentand Marketing Strategy**

We believe that many insurance companies develop andmarket their products based on an underwriting focused approach in which theydefine products based upon their underwriting guidelines and subsequentlymarket those products to producers whose needs fit within the bounds of theirunderwriting criteria. Conversely, while we are a disciplined underwritingorganization, our product development and marketing strategy is to firstidentify needed products and services from our producers and then to developprofitable products in response to those needs. After positioning our productsin this manner, we focus on developing underwriting guidelines that enable usto make an underwriting profit. This demand-driven approach has allowed ourorganization to gain the reputation of being responsive to market needs with ahighly service oriented approach to our producer base.

When we first began operations in 1990, our producersconfirmed the need for us to underwrite small commercial risks, such asapartment buildings, restaurants and retail stores in urban areas such as New YorkCity that other insurance companies avoided due to a perceived lack ofunderwriting profitability. In response to this need, we developed commercialpackage policies that provided limited property and liability coveragecustomized to meet the needs of this nonstandard market segment, as well asunderwriting and claims approaches that enabled us to achieve underwritingprofitability. Since then, we have continued to develop other commercial linesproducts such as business owners, workers’ compensation and commercialautomobile policies, and introduced personal lines products such as homeownersand dwelling policies, to respond to the needs of our customers in othernonstandard segments as well as customers in the preferred and standard marketsegments where we generally offer lower rates and broader coverage for risksthat we perceive to have more desirable underwriting characteristics.

With the development of our broad product lineoffering, we have been able to access markets with significant premium volumeand opportunity for market penetration. We have increased our market share ineach of these lines of business. We have been able to achieve profitablepremium growth by keeping our annual premium volume objectives in the variouslines of business low relative to the overall size of the market in thoselines. This approach allows us to remain selective in our underwriting and toavoid sacrificing profitability for the sake of volume.

We also have historically targeted risks located inurban areas such as New York City that require special underwriting expertiseand have generally been avoided by other insurance companies. We have 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 began to expand territorially into NewJersey, Pennsylvania and the New England states.

In marketing our products, we segment the market basedupon industry, location, pricing tiers, hazard grading and premium size. Forcommercial lines products, we have generally focused on specific classes ofbusiness in the real estate, retail, wholesale and service industries such asretail and wholesale stores, 

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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 have also expanded our product offering to variouslines of business within the preferred, standard and non-standard pricingsegments and we plan to expand to the excess and surplus lines segment. Withinthe preferred, standard or non-standard and E&S market segments, we firstdeveloped different pricing, coverage and underwriting guidelines. For example,the pricing for the preferred risk segment is generally the lowest, followed bythe standard, non-standard and E&S segments. The underwriting guidelinesare correspondingly stricter for preferred risks in order to justify the lowerpremium rates charged for these risks. Underwriting standards becomeprogressively less restrictive for standard, non-standard and E&S risks. Wecurrently write all of our insurance policies in the preferred, standard andnon-standard market segments on an “admitted basis,” meaning that we arelicensed by the states in which we sell our policies, and we write our policiesusing premium rates and forms that are filed with state insurance regulators.We generally distribute policies for risks with preferred and standardunderwriting characteristics through our retail distribution system andpolicies for risks with non-standard underwriting characteristics through ourwholesale distribution system. However, we plan to offer our products in theexcess and surplus market through TICNY, which plans to write business on anon-admitted basis in Florida and Texas, as well as a separate non-admittedcompany that we plan to form and capitalize. Non-admitted carriers are notbound by most of the rate and form regulations imposed on companies writing onan “admitted” basis, allowing them the flexibility to change the coverageoffered and the rate charged without time constraints and financial costsassociated with the filing process. The E&S market allows insurers totailor their rates and policy terms to the particular risk presented andprovides an alternative market for customers with hard-to-place risks that “admitted”carriers may not cover. Because we focus on providing products in underservedmarket segments through our wholesale distribution system, we believe we candistribute these products utilizing both the non-standard pricing tier on anadmitted basis as well an E&S pricing tier on a non-admitted basis. Havinga non-admitted company will provide us with means to quickly expand anddistribute our products nationally through the wholesale distribution system.In addition, we may be able to write more of our policies with non-standardunderwriting characteristics in the E&S market rather than in thenon-standard admitted market in the states where we currently conduct business.

In addition to segmenting our products by industry,location and pricing tiers, we further classify our products into the followingpremium size segments: under $25,000 (small), $25,000 to $150,000 (medium) andover $150,000 (large). We have historically had more success in the smallpremium size segment due to our focus on reducing our underwriting expenses by realizingeconomies of scale, utilizing technology and developing efficient businessprocesses. We believe that due to the higher cost of underwriting smallpolicies, other insurance companies have not been able to price competitivelyin this premium size segment. Our expense advantage has allowed us to maintainadequate rates through industry cycles. With improved market conditions inrecent years, we have seen adequate pricing in the middle market 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 in marketsegments where competition has reduced opportunities for us to earn anunderwriting profit.

***Distribution***

We generate business through independent wholesale andretail agents and brokers, whom we refer to collectively as producers. Theseproducers sell policies for us as well as for other insurance companies. We 

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had 814 producersappointed to generate business in 2006. This includes 299 former OneBeaconproducers that we contracted with in connection with the renewal rightstransaction that occurred in 2004.

As of December 31, 2006, approximately 80% of the2006 gross premiums written, including premiums produced by TRM on behalf ofits issuing companies, were produced by our top 142 producers representing 17%of our active agents and brokers. These producers have annual written premiumsof $500,000 or more. As we build a broader territorial base, the number ofproducers with significant premium volumes with Tower is increasing. In 2005,producers with premium volumes of $500,000 or more numbered 121 and contributed77% of gross premiums written.

Our largest producers in 2006 were Morstan GeneralAgency, Northeast Agencies and Davis Agency Inc. through December 31,2006, these producers accounted for 11%, 7% and 5%, respectively, of the totalof our gross premiums written. No other producer was responsible for more than5% of our gross premiums written.

We carefully select our producers by evaluatingseveral factors such as their need for our products, premium productionpotential, and loss history with other insurance companies that they represent,product and market knowledge and the size of the agency. We generally appointproducers with a total annual premium volume greater than $10,000,000. Weexpect a new producer to be able to produce at least $250,000 in annualpremiums for us during the first year and $500,000 in annual premiums afterthree years. Commissions paid to producers in 2006 for TICNY averaged 16.1% ofgross premiums earned. Our commission schedules are 1 to 1.5 points higher forwholesalers as compared to retailers in recognition of the additional dutiesthat wholesalers perform. Also, we have a profit sharing plan that addedapproximately 1⁄4 to 1⁄2 of 1 percent to overall commission rates in 2006, 2005 and2004.

We have increased marketing and business developmentefforts aimed at increasing premium volume in all areas of New York State aswell as in New Jersey, Pennsylvania and Massachusetts. This has required theidentification, appointment, orientation and training of over 80 newly appointedagents in New Jersey, Pennsylvania and Massachusetts. With the acquisition ofadditional state licenses and approval of our product filings, we havebroadened our agency relationships and marketing capabilities.

Additionally, our proposed acquisition of Preserverwill give us access to up to 300 retail agencies working with Preserver; nomore than 14% of these agencies overlap with our existing retail agencies. ThePreserver transaction accelerates our Northeast expansion plans by addingpremium volume in New Jersey, Maine, New York, New Hampshire, Massachusetts,Vermont, Rhode Island and Pennsylvania.

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 monthly review to monitor premium volume andprofitability. We have access to online premium and loss ratio reports on aproducer basis. Annually we develop actuarial ultimate accident year factors inorder to confirm the continuing profitability of our producers. We continuouslymonitor the producers in this manner so we can develop corrective action, ifnecessary, at any time throughout the year. Corrective action may beimplemented based on the identified problem area, and may include joint andincreasingly frequent business planning in the case of poor production orrenewal retention, the monitoring of risk profiles and reduction of bindingauthority if there is a loss ratio issue or a review of the pertinent agencyagreement requirements to address inadequate adherence to administrative dutiesand responsibilities. Noncompliance could lead to reduction of authority andpotential termination.

**Underwriting**

The underwriting strategy for controlling our lossratio is to seek diversification in our products and an appropriate businessmix for any given year, emphasizing profitable lines of business andde-emphasizing unprofitable lines. At the beginning of each year, we establishthe target loss ratios for each line of 

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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 time that a corrective actionplan is being implemented with respect to any product line that fails to meetits target loss ratio, premium for that product line is reduced or maintaineddepending upon its effect on our total loss ratio. To offset the reduction orlack of growth in premium volume for the products that are undergoingcorrective action, we seek to expand our premium writings in existingprofitable lines of business or add new lines of business with betterunderwriting profit potential.

We establish underwriting guidelines for all theproducts that we underwrite to ensure a uniform approach to risk selection,pricing and risk evaluation among our underwriters and to achieve underwritingprofitability. Our underwriting process involves securing an adequate level ofunderwriting information from our producers, identifying and evaluating riskexposures and then pricing the risks we choose to accept. For certain approvedclasses of commercial risks and most personal lines policies, we allow our producersto initially bind these risks utilizing rating criteria that we provide tothem. Also, our web-based platform WebPlus provides our producers with thecapability to submit and receive quotes over the Internet and contains our riskselection and pricing logic, thereby enabling us to streamline our initialsubmission and screening process. If the individual risk does not meet theinitial submission and screening parameters contained within WebPlus, the riskis automatically referred to our assigned underwriter for specific offlinereview. See “—Technology.”

Once a risk is bound by our underwriter or producers,our internal or outside loss control representatives conduct physicalinspections of substantially all of the insured premises to validate the informationprovided by our producers and provide a loss control report to our underwritersto make a final evaluation of the risk. With the exception of a few typicallylow risk classes of business such as beauty parlors and offices, all of the newrisks that are bound are physically inspected or subject to a telephone survey,generally within 60 days from the effective date of the policy. If theinspection reveals that the risk insured under the policy does not meet ourestablished underwriting guidelines, the policy is generally cancelled withinthe first 60 days from its effective date. If the inspection reveals that therisk meets our established underwriting guidelines but the policy was boundwith incorrect rating information, the policy is amended through an endorsementbased upon the correct information. We supplement the inspection by usingonline data sources to further evaluate the building value, claim experience,financial history and catastrophe exposures of the insured. In addition, wespecifically tailor coverage to match the insured’s exposure and premiumrequirements. We complete internal file reviews and audits on a monthly,quarterly and annual basis to confirm that underwriting standards and pricingprograms are being consistently followed. Our property risks are generallycomprised of residential buildings, retail stores and restaurants covered underpolicies with low building and content limits. We carefully underwritepotential catastrophe exposures to terrorism losses. Our underwriting guidelinesare designed to avoid properties designated as, or in close proximity to, highprofile or target risks, individual buildings over 25 stories and any sitewithin 500 feet of major transportation centers, bridges, tunnels and othergovernmental or institutional buildings. In addition, we monitor theconcentration of employees insured under our workers’ compensation policies andavoid writing risks with more than 50 employees in any one building. However,please see “Risk Factors-Risks Related to Our Business-We may face substantialexposure to losses from terrorism and we are currently required by law toprovide coverage against such losses.” Our property limits profile and thepremium size of our policies in TICNY have risen as a result of the increase inTICNY’s statutory 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.

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We underwrite our productsthrough four underwriting teams that are each headed by an underwriting managerhaving an average of approximately 26 years of industry experience in theproperty and casualty industry. We have the following four business units:small commercial, middle market, commercial auto and personal lines. 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 underwritingteams. The loss control department conducts loss control inspections on nearlyall new commercial and personal lines business written, utilizing in-house losscontrol representatives and outside vendors. The business developmentdepartment works with the underwriting teams to manage relationships with ourproducers.

**Pricing**

We price our products at levels that are projected togenerate 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.

We generally use actuarial loss costs promulgated bythe Insurance Services Office, a company providing statistical, actuarial andunderwriting claims information and related services to insurers, as abenchmark in the development of pricing for our products. We further tailorpricing to each specific product we underwrite (other than workers’compensation), taking into account our historical loss experience andindividual risk and coverage characteristics. For workers’ compensationpolicies, we use full administered rates provided by the New York CompensationInsurance Rating Board, the Rating and Inspection Bureau of New Jersey, theWorkers’ Compensation Rating Bureau of Massachusetts and the NCCI in developingour pricing in other states.

If a particular business line is not performing well,we may seek rate increases, which are subject to regulatory approval and marketacceptance. Recently, we have been successful in achieving preliminary priceincreases. We increased premiums on our commercial renewals as measured againstexpiring premium by 3.3% in 2006 and by 5.5% in 2005. In personal lines weincreased premiums by 9.3% in 2006 and by 7.6% in 2005.

Beginning in the latterhalf of 2004 and continuing throughout 2005 and 2006, the rates for propertyand casualty insurance products began to moderate, and for certain products,rates began to decrease due to an increased level of competition. The softeningin the personal lines market for both primary and reinsurance was interruptedby effects of hurricanes Katrina, Rita and Wilma on the insurance industry. Wedid not have any exposure to these hurricanes. However, these rate changes maystill signal the start of a “soft market” cycle that could restrict or diminishour ability to obtain rate increases as in the recent past. We cannot predictwith any certainty the direction the market will take during 2007 orthereafter.

**Reinsurance**

We purchase reinsurance to reduce our net liability onindividual risks, to protect against possible catastrophes, to achieve a targetratio of net premiums written to policyholders’ surplus and to expand ourunderwriting capacity. Reinsurance coverage can be purchased on a facultativebasis, where individual risks are reinsured, or on a treaty basis, where aclass or type of business is reinsured. We purchase facultative reinsurance toprovide limits in excess of the limits provided by our treaty reinsurance.Treaty 

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reinsurance falls intothree categories: quota share (also called pro rata), excess of loss andcatastrophe treaty reinsurance. Under our quota share reinsurance contracts, wecede a predetermined percentage of each risk for a class of business to thereinsurer and recover the same percentage of losses and loss adjustmentexpenses on the business ceded. We pay the reinsurer the same percentage of theoriginal premium, less a ceding commission. The ceding commission rate is basedupon the ceded loss ratio on the ceded quota share premiums earned. See “Management’sDiscussion and Analysis of Financial Condition and Results ofOperations-Critical Accounting Policies-Ceding commissions earned.” Under ourexcess of loss treaty reinsurance, we cede all or a portion of the liability inexcess of a predetermined deductible or retention. We also purchase catastrophereinsurance on an excess of loss basis to protect ourselves from anaccumulation of net loss exposures from a catastrophic event or series of eventssuch as terrorist acts, riots, windstorms, hailstorms, tornadoes, hurricanes,earthquakes, blizzards and freezing temperatures. We do not receive anycommission for ceding business under excess of loss or catastrophe reinsuranceagreements.

The type, cost and limits of reinsurance we purchasecan vary from year to year based upon our desired retention levels and theavailability of quality reinsurance at an acceptable price. Our excess of lossreinsurance program was renewed on January 1, 2007 and our catastrophereinsurance program was renewed July 1, 2006. On April 1, 2006, weentered into three multi-year quota share agreements with CastlePointReinsurance—see “2006 and 2007 Reinsurance Programs—CastlePoint Reinsurance andPooling.”  Before these agreements werein place, from January 1, to March 31, 2006, we retained all of therisk for 2006 that would have been ceded to quota share reinsurers. In 2005, weceded 25% of our net premiums written to reinsurers in accordance with ourquota share treaty.

In recent years, the reinsurance industry hasundergone very dramatic changes. Soft market conditions created by years ofinadequate pricing brought poor results, which were exacerbated by the eventsof September 11, 2001. As a result, market capacity was reducedsignificantly. Reinsurers exited lines of business, significantly raised ratesand imposed much tighter terms and conditions, where coverage was offered, tolimit or reduce their exposure to loss. The hurricanes that struck Florida andthe Gulf coast in 2004 and 2005 have contributed to this trend, particularly inregard to catastrophe reinsurance.

In an effort to maintain quota share capacity for ourbusiness with favorable commission levels, prior to our agreements withCastlePoint Reinsurance, we accepted loss ratio caps in our reinsurancetreaties. Loss ratio caps cut off the reinsurer’s liability for losses above aspecified loss ratio. These provisions have been structured to providereinsurers with 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 reinsurers. We believe our reinsurance arrangementsqualify for reinsurance accounting in accordance with SFAS 113, Accounting forReinsurance Contracts. The loss ratio caps for our quota share treaties were95.0% in 2005, 95.0% in 2004, 92.0% in 2003, 97.5% in 2002 and 100.0% in 2001.The quota share agreements with CastlePoint Reinsurance effective April l,2006, provide traditional reinsurance terms such as flat ceding commission ornarrow sliding scale commission, and have no loss ratio caps.

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. As notedabove, we believe our quota share reinsurance meets all requirements pertainingto risk transfer. However, these investigations, the related legal actions andthe accompanying increased scrutiny of “non-traditional” reinsurancearrangements may lead to a change in the applicable accounting standards or areduction in the availability of some types of reinsurance. In turn, thesedevelopments could produce higher prices for reinsurance, an increase in theamount 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.

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Regardless of type, reinsurance does not legallydischarge the ceding insurer from primary liability for the full amount dueunder the reinsured policies. However, the assuming reinsurer is obligated toindemnify the ceding company to the extent of the coverage ceded. To protectour company from the possibility of a reinsurer becoming unable to fulfill itsobligations under the reinsurance contracts, we attempt to select financiallystrong reinsurers with an A.M. Best rating of “A-” (Excellent) or betterand continue to evaluate their financial condition and monitor various creditrisks to minimize our exposure to losses from reinsurer insolvencies.

As of December 31, 2005, we had unsecuredreinsurance recoverables and ceding commissions receivable totaling $33.2million owed by PXRE Reinsurance Company (“PXRE”). On February 16, 2006, A.M.Best downgraded PXRE’s financial strength rating to “B++” (Good) from “A-”(Excellent) and issued a negative outlook. On February 24, 2006 A.M.Best downgraded PXRE to “B+” (Good) with a negative outlook. On June 29,2006, to eliminate our exposure to uncollateralized reinsurance recoverablesfrom PXRE, we concluded, through commutation agreements, PXRE’s participationunder various reinsurance agreements with TICNY covering the 2001, 2002 and aportion of the 2003 policy periods. Ceded loss and loss adjustment expenserecoverables of $20.5 million, ceded paid losses of $2.4 million andceding commissions receivable of $8.7 million, totaling $31.6 million ofunsecured recoverables were settled with a payment from PXRE of $26.7 million,which represents an estimate of the present value of these recoverables. Thisresulted in a $4.8 million pre-tax charge, of which $1.6 million was recognizedin loss and loss adjustment expenses and $3.2 million was recognized as areduction to ceding commission income in the second quarter of 2006. Inaddition, on the same date, novation agreements were executed with PXRErelating to other reinsurance agreements covering business written in 2001,2002 and 2003 by other insurance companies and managed on their behalf by TRM.As a result of the novation, TICNY assumed loss reserves of $12.2 million forwhich it received as consideration $11.4 million in cash and other assetsand TRM recorded a reduction in commission liabilities of $0.2 million,the total of which resulted in a $0.6 million pre-tax charge. As a result ofthe commutation and novation agreements, which were effective as of June 29,2006, PXRE was discharged from future obligations under the reinsuranceagreements. There are no other agreements outstanding with PXRE.

To further minimize our exposure to reinsurancerecoverables, our quota share reinsurance treaties, from October 1, 2003 toDecember 31, 2005, were, placed on a “funds withheld” basis under whichceded premiums written are deposited in segregated trust funds from which wereceive payments for losses and ceding commission adjustments. Our reinsurancereceivables from CastlePoint Reinsurance are collateralized in a New YorkRegulation 114 compliant trust account. We also used the proceeds from the IPOand the concurrent private placement to increase the capitalization of TICNY.As a result of this increase in capital, we have been able to retain more ofthe risk on the business we write, thereby reducing our need for quota sharereinsurance.

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The following tablesummarizes our reinsurance exposures by reinsurer as of December 31, 2006:

| ** **                                 | ** ** | ** **              | ** ** | ** **              | ** ** | ** **          | ** ** | ** **      | ** ** | ** **            | ** ** | **Funds Held,**        | ** ** | **Amounts in**     | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|-------------------------|------------|-------------------------|------------|---------------------|------------|-----------------|------------|-----------------------|------------|-----------------------------|------------|-------------------------|------------|------------|------------|
| ** **                                 | ** ** | ** **              | ** ** | ** **              | ** ** | ** **          | ** ** | **Prepaid**     | ** ** | ** **            | ** ** | **Ceded Payable**      | ** ** | **Trust Accounts** | ** ** | **Net**    | ** ** |
| ** **                                 | ** ** | ** **              | ** ** | **Recoverable on** | ** ** | **and Return** | ** ** | ** **      | ** ** | **and Deferred** | ** ** | **or Secured by** | ** ** | **Exposure**            | ** ** |
| ** **                                 | ** ** | **A.M. Best**      | ** ** | **Paid**                | ** ** | ** **          | ** ** | **Reinsurance** | ** ** | **Commissions**       | ** ** | **Ceding**                  | ** ** | **Letters of**     | ** ** | **to**     | ** ** |
| **Reinsurer**                              | ** ** | ** **              | ** ** | **Rating**              | ** ** | **Losses**          | ** ** | **Reserves**    | ** ** | **Premiums**          | ** ** | **Receivable**              | ** ** | **Commission**          | ** ** | **Credit** | ** ** | **Reinsurer** | ** ** |
| ** **                                 | ** ** | **(in thousands)** | ** ** |
| Munich Reinsurance  America Inc.(1)        |       |                    | A          |                    |       | $                   | 2,706      |            | $          | 15,318                |       |                        | $          | —                  |       |       |       | $ | — |   |   |   | $ | 396 |   |   |   | $ | — |   |   | $ | 17,628 |   |
| Platinum Underwriters  Reinsurance Inc.    |       |                    | A          |                    |       | (5                  | )          | 6,121           |       |                  | 2,609      |                        |       |                    | —     |       |       |   | 480 |   |   |   | — |   |   | 8,245 |   |
| SCOR Reinsurance Company                   |       |                    | A-         |                    |       | 63                  |       | 49              |       |                  | —     |                        |       |                    | —     |       |       |   | (13 | ) |   |   | — |   |   | 125 |   |
| Lloyds of London                           |       |                    | A          |                    |       | —              |       | 16              |       |                  | 1,276      |                        |       |                    | —     |       |       |   | 108 |   |   |   | — |   |   | 1,184 |   |
| Odyssey America  Reinsurance Corporation   |       |                    | A          |                    |       | —              |       | —          |       |                  | 51         |                        |       |                    | —     |       |       |   | — |   |   |   | — |   |   | 51 |   |
| Hartford Steam Boiler  Group               |       |                    | A++        |                    |       | 4                   |       | —          |       |                  | 408        |                        |       |                    | —     |       |       |   | 223 |   |   |   | — |   |   | 189 |   |
| General Reinsurance  Corp.                 |       |                    | A++        |                    |       | —              |       | —          |       |                  | 830        |                        |       |                    | —     |       |       |   | 289 |   |   |   | — |   |   | 541 |   |
| CastlePoint Reinsurance  Company Ltd. |       |                    | A-         |                    |       | 2,493               |       | 31,660          |       |                  | 81,000     |                        |       |                    | —     |       |       |   | 19,845 |   |   |   | 95,308 |   |   | — |   |
| Endurance Specialty  Insurance, Ltd.  |       |                    | A-         |                    |       | 28                  |       | 57              |       |                  | 110        |                        |       |                    | —     |       |       |   | — |   |   |   | 85 |   |   | 110 |   |
| Tokio Millenium  Re Ltd.              |       |                    | A+         |                    |       | 1,634               |       | 31,796          |       |                  | 170        |                        |       |                    | —     |       |       |   | 27,956 |   |   |   | 5,644 |   |   | — |   |
| Hannover Reinsurance  (Ireland) Ltd.  |       |                    | A          |                    |       | 836                 |       | 14,429          |       |                  | 192        |                        |       |                    | 2,590      |       |       |   | 14,997 |   |   |   | 3,050 |   |   | — |   |
| E&S Reinsurance  (Ireland) Ltd.   |       |                    | A          |                    |       | 209                 |       | 3,603           |       |                  | —     |                        |       |                    | 647        |       |       |   | 3,696 |   |   |   | 763 |   |   | — |   |
| XL Reinsurance  America Inc.          |       |                    | A+         |                    |       | —              |       | —          |       |                  | 72         |                        |       |                    | —     |       |       |   | 1 |   |   |   | — |   |   | 71 |   |
| Aspen Insurance  UK Ltd.              |       |                    | A          |                    |       | —              |       | 1               |       |                  | 121        |                        |       |                    |       |       |       |   | 19 |   |   |   | — |   |   | 103 |   |
| QBE  Reinsurance Corp.                |       |                    | A          |                    |       | —              |       | 350             |       |                  | 270        |                        |       |                    | —     |       |       |   | 26 |   |   |   | — |   |   | 594 |   |
| AXIS Reinsurance Company                   |       |                    | A          |                    |       | —              |       | 854             |       |                  | 1,245      |                        |       |                    | —     |       |       |   | 330 |   |   |   | — |   |   | 1,769 |   |
| Endurance Reinsurance  Corp. of America    |       |                    | A-         |                    |       | —              |       | 2,138           |       |                  | 2,325      |                        |       |                    | —     |       |       |   | 830 |   |   |   | — |   |   | 3,633 |   |
| NGM Insurance Company                      |       |                    | A          |                    |       | —              |       | 427             |       |                  | 446        |                        |       |                    | —     |       |       |   | 165 |   |   |   | — |   |   | 708 |   |
| Arch  Reinsurance Co.                 |       |                    | A          |                    |       | —              |       | —          |       |                  | 109        |                        |       |                    | —     |       |       |   | — |   |   |   | — |   |   | 109 |   |
| Hannover  Rueckversicherung AG        |       |                    | A          |                    |       | (5                  | )          | 3,220           |       |                  | 2,242      |                        |       |                    | —     |       |       |   | 369 |   |   |   | — |   |   | 5,088 |   |
| Ace Tempest Reinsurance  Company Ltd. |       |                    | A+         |                    |       | —              |       | —          |       |                  | 58         |                        |       |                    | —     |       |       |   | — |   |   |   | — |   |   | 58 |   |
| Max Re Ltd.                           |       |                    | A-         |                    |       | —              |       | —          |       |                  | 58         |                        |       |                    | —     |       |       |   | — |   |   |   | — |   |   | 58 |   |
| Ariel Reinsurance  Co. Ltd.           |       |                    | A-         |                    |       | —              |       | —          |       |                  | 79         |                        |       |                    | —     |       |       |   | — |   |   |   | — |   |   | 79 |   |
| Federal  Insurance Co.           |       |                    | A++        |                    |       | —              |       | —          |       |                  | 89         |                        |       |                    | —     |       |       |   | — |   |   |   | — |   |   | 89 |   |
| Montpelier  Reinsurance Ltd.          |       |                    | A-         |                    |       | —              |       | —          |       |                  | 91         |                        |       |                    | —     |       |       |   | — |   |   |   | — |   |   | 91 |   |
| Others                                     |       |                    |       |                    |       | (2                  | )          | 3               |       |                  | 212        |                        |       |                    | —     |       |       |   | 12 |   |   |   | — |   |   | 201 |   |
| Total                                      |       |                    | ** ** | ** **              | ** ** | **$**               | **7,961**  |            | **$**      | **110,042**           | ** ** | ** **                  | **$**      | **94,063**              | ** ** | ** ** | ** ** | **$** | **3,237** | ** ** | ** ** | ** ** | **$** | **69,729** | ** ** | ** ** | ** ** | **$** | **104,850** |   | ** ** | **$** | **40,724** |   |
|                                            |            |                         |            |                         |            |                     |            |                 |            |                       |            |                             |            |                         |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)             Formerly American Re-Insurance Company.

***2006 and 2007Reinsurance Programs***

*Quota Share Reinsurance.  *FromJanuary 1 to March 31, 2006, we retained all of the risk for 2006that would have been ceded to quota share reinsurers. Effective April 1,2006, we entered into three multi-year 

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quota share reinsuranceagreements with CastlePoint Reinsurance, which are described under “CastlePointReinsurance and Pooling” below.

*Umbrella Quota Share Reinsurance.  *TheUmbrella Quota Share Reinsurance Treaty, originally effective January 1,2005, was renewed on January 1, 2006 at terms similar to the 2005 terms.The treaty reinsures against umbrella losses up to $5.0 million peroccurrence. We cede 95% of premiums written and retain the remaining 5%. Theprovisional ceding commission under this treaty is 30% of ceded premiumwritten. Of the premium ceded, Platinum Underwriters Reinsurance, Inc.,rated “A” (Excellent) by A.M. Best, reinsures 50% and HannoverRueckversicherungs AG, rated “A” (Excellent) by A.M. Best, reinsures50%. The Umbrella Quota Share Reinsurance Treaty was renewed on January 1,2007, on terms similar to the 2006 terms. Of the premiums ceded, Hannover Rueckversicherung AG,rated “A” (Excellent) by A.M. Best, reinsures 40%, Platinum UnderwritersReinsurance, Inc., rated “A” (Excellent) by A.M. Best, reinsures 40%and AXIS Reinsurance Company, rated “A” (Excellent) by A.M. Best reinsures20%.

*Excess of 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 UnderwritersReinsurance, Inc., rated “A” (Excellent) by A.M. Best, EnduranceReinsurance Corporation of America, 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 Rueckversicherung AG, rated “A” (Excellent) by A.M. Best,Aspen Insurance UK Limited, rated “A” (Excellent) by A.M. Best andACE European Group Ltd., rated “A” (Excellent) by A.M. Best. OnMay 1, 2006, CastlePoint Reinsurance became a participant of the Multi-lineand the First Property Excess of Loss layers, on a new and renewal basis.Certain excess reinsurers agreed to reduce their percentage participation as ofthe same date to enable CastlePoint Reinsurance to participate in these twolayers. The Excess of Loss Reinsurance Program was renewed on January 1,2007, on terms similar to the 2006 program, and with the addition of a newCasualty Clash Excess of Loss layer and a new Workers’ Compensation Excess ofLoss layer. The 2007 Excess of Loss Reinsurance Program was placed withPlatinum Underwriters Reinsurance, Inc., 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 Rueckversicherung AG, rated“A” (Excellent) by A.M. Best and Aspen Insurance UK Limited, rated “A”(Excellent) by A.M. Best.

*W.H. Greene Umbrella Quota Share and ExcessReinsurance.  *Effective December 1, 2005, weentered into a quota share agreement to reinsure against umbrella losses up to$5 million per occurrence on a book of commercial umbrella business produced bya third party managing general agent, W.H. Greene. Under the terms of thetreaty we ceded 80% of premium written and retained the remaining 20%. The flatceding commission under this treaty was 29% of ceded premium written. Of thepremium ceded, Endurance Reinsurance Corporation of America, rated “A-”(Excellent) by A.M. Best, reinsured 50%, AXIS Reinsurance Company, rated“A” (Excellent) by A.M. Best, reinsured 20% and NGM Insurance Company,rated “A” (Excellent) by A.M. Best, reinsured 10%. EffectiveMay 1, 2006, we entered into an excess of loss reinsurance agreement tocover losses in excess of $5 million up to $10 million per occurrenceon the same book of commercial umbrella business. Under the terms of theagreement, we ceded 75% of premium written and retained the remaining 25%. Theflat ceding commission under this agreement was 29% of ceded written premium.Of the premium ceded, Endurance Reinsurance Corporation of America, rated “A-” (Excellent) by A.M. Best, reinsured 30%, AXIS Reinsurance Company,rated “A” (Excellent) by A.M. Best, reinsured 40% and NGM InsuranceCompany, rated “A” (Excellent) by A.M. Best, reinsured 5%. Both agreementswere renewed on December 1, 2006, with the same A rated reinsurers, atsimilar terms except that our retention under the excess of loss reinsuranceagreement has been reduced from 25% to 20%.

*Catastrophe Reinsurance.  *The2006 Property Catastrophe Program provides coverage for events occurringthrough June 30, 2007 and is expected to be renewed on July 1, 2007with a similar structure to 

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the expiring program.CastlePoint Reinsurance participates in the first three layers of the 2006Property Catastrophe Program.

*Terrorism Reinsurance.  *In2002, in response to the tightening of supply in certain insurance andreinsurance markets resulting from, among other things, the September 11,2001, terrorist attacks, the Terrorism Insurance Act (“TRIA”) was enacted. TRIAis designed to ensure the availability of insurance coverage for foreignterrorist acts in the United States of America. This law established a federalassistance program through the end of 2005 to help the commercial property andcasualty insurance industry cover claims related to future terrorism-relatedlosses and requires such companies to offer coverage for certain acts ofterrorism. As a result, we are prohibited from adding certain terrorismexclusions to the policies written by TICNY and TNIC. Although TICNY and TNICare protected by federally funded terrorism reinsurance as provided for byTRIA, there is a substantial deductible that must be met, the payment of whichcould have an adverse effect on our results of operations.

On December 17, 2005, Congress passed a two-yearextension of TRIA though December 31, 2007 with the passage of theTerrorism Risk Insurance Extension Act (“TRIEA”). Under the terms of TRIEA, theminimum size of the triggering event increased from $5 million to$50 million for 2006 and to $100 million in 2007. Tower’s deductibleincreased to 17.5% of direct earned premium in 2006 and will increase to 20% in2007. If the program trigger is reached, the federal government will reimbursecommercial insurers for 85% of their insured loses from the certified act ofterrorism in excess of their statutory deductible. Under TRIEA, federalassistance for insured terrorism losses has been reduced as compared to theassistance previously available under TRIA. As a consequence of these changes,potential losses from a terrorist attack could be substantially larger thanpreviously expected. The failure to extend TRIEA beyond December 31, 2007or the extension of TRIEA on terms less favorable to insurers 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.

*CastlePoint Reinsurance andPooling.  *In April 2006, we entered into thefollowing quota share reinsurance agreements with CastlePoint Reinsurance:

·       Brokerage business quotashare reinsurance agreement between TICNY and TNIC and CastlePoint Reinsurance,covering brokerage business historically written by Tower. Under this agreementwe cede between 25% and 45% (with the percentage determined by us) of ourbrokerage business to CastlePoint Reinsurance and receive an initial cedingcommission of 34%;

·       Traditional programbusiness quota share reinsurance agreement between TICNY and TNIC andCastlePoint Reinsurance, covering program business historically written by us.Under this agreement we cede 50% of our traditional program business toCastlePoint Reinsurance and share premium revenue and losses in proportion tothe parties’ respective quota share of participation. Expenses will be deemed  to be approximately 30% of business ceded. Inthe event that, after allowing for the ceding commissions, (1) the reinsurancepremium is insufficient to cover losses, we will be required to make anadditional premium payment; and (2) the reinsurance premium paid is inexcess of the losses attributable to the business covered by the agreement,CastlePoint Reinsurance will be required to return to us a portion of thepremium paid; and

·       Specialty program businessand insurance risk-sharing business quota share reinsurance agreement betweenTICNY and TNIC and CastlePoint Reinsurance and, covering business nothistorically written by us. Under this agreement we cede 85% of our netretention on specialty program business to CastlePoint Reinsurance and receivea ceding commission of 30%, subject to a minimum of 30% and a maximum of 36%.

In addition, CastlePoint Reinsurance participates asof May 1, 2006 as a reinsurer of our insurance companies, TICNY and TNIC,under certain layers of their existing property and casualty excess of lossreinsurance program. Further, CastlePoint Reinsurance participates as ofJuly 1, 2006 as a reinsurer in the 

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property catastropheexcess of loss reinsurance program of our insurance companies, TICNY and TNIC,with a 30% participation in the first three layers.

We have agreed to enter into various poolingagreements with CastlePoint Insurance Company, to be effective January 1,2007, pending New York State Department of Insurance approval, including(i) a brokerage business pooling agreement (covering business historicallywritten by Tower), (ii) a traditional program business pooling agreement(covering program business historically written by Tower) and (iii) aspecialty program business pooling agreement (covering business nothistorically written by Tower).

The Master Agreement provides that, subject to thereceipt of any required regulatory approvals, CastlePoint will manage thetraditional program business and the specialty program business pools, and wewill manage the brokerage business pool. The pool managers are required topurchase property and casualty excess of loss reinsurance and property catastropheexcess of loss reinsurance from third party reinsurers to protect the netexposure of the pool participants. In purchasing the property catastropheexcess of loss reinsurance, the pool manager may retain risk equating to no morethan 10% of the combined surplus of Tower and CastlePoint Insurance Company(referred to as the pooled catastrophe retention). Under the brokerage poolingagreement for 2007, CastlePoint Insurance Company has agreed to assume thegreater of (i) its actual pooling percentage or (ii) 30% of propertycatastrophe premiums and risks. In addition, with respect to each of the pools,any of the participating companies will have the option to require the poolmanager to increase the pooled catastrophe retention by an amount up to 10% ofCastlePoint Reinsurance’s surplus provided that CastlePoint Reinsurancereinsures this increase to the pooled catastrophe retention.

The following chartis a summary of the percentage of business being ceded by us under the quotashare reinsurance agreements with CastlePoint Reinsurance and the poolingagreements with CastlePoint, and the provisional ceding commissions andmanagement fee percentages applicable under such agreements:

| **Quota Share  Reinsurance Agreement**                            | ** ** | ** ** | ** ** | **Quota Share  Cession (%)** | ** ** | **Range of  Cession (%)**                                                                  | ** ** | **Provisional Ceding  Commission (1)** |
|-------------------------------------------------------------------|------------|------------|------------|------------------------------|------------|--------------------------------------------------------------------------------------------|------------|----------------------------------------|
| Brokerage business                                                |       | 40         |       | 25  to 45                    |       | 34% until April 1,  2007, subject to a minimum of 31% and a maximum of 36% thereafter |
| Traditional program  business                                     |       | 50         |       | 50  to 75                    |       | shared, based upon quota  share particiaption and is estimated to be approximately 30%     |
| Specialty program business and insurance  risk-sharing   business |       | 85         |       | 75 to 85                     |       | 30%, subject to a minimum of 30% and a maximium of  36%                                    |

 

| **Pooling  Agreement**        | ** ** | ** **                       | ** ** | **Initial Pooling  Cession (%)** | ** ** | **Range of  Cession (%)**                                                                  | ** ** | **Provisional Management  Fee Percentage(1)** |
|-------------------------------|------------|----------------------------------|------------|----------------------------------|------------|--------------------------------------------------------------------------------------------|------------|-----------------------------------------------|
| Brokerage business            |       | 15  (with respect to  2007 only) |       | 25  to 45                        |       | 34% until April 1,  2007, subject to a minimum of 31% and a maximum of 36% thereafter |
| Traditional program  business |       | 50                               |       | 50  to 85                        |       | Expenses are shared,  based upon pool participation                                        |
| Specialty program business    |       | 85                               |       | 50 to 85                         |       | Expenses are shared, based upon pool participation                                         |

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(1)          Subject to adjustmentbased on the net loss ratio of the business covered by the applicable agreement.

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The parties to the Master Agreement agreed to exercisegood faith, and to cause their respective subsidiaries to exercise good faith,to carry out the intent of parties in the event the specific agreementscontemplated by the Master Agreement must be revised to comply with regulatoryrequirements. For example, if the ceding commissions under the quota sharereinsurance agreements or the management fee percentages under the poolingagreements must be adjusted to comply with regulatory requirements, each partywill use its best good faith efforts to structure the transaction so that theceding company cedes premiums at a combined ratio equal to 95% for thebrokerage business and 93% for each of the traditional program business and thespecialty program business. In addition, to the extent the transfers of anypolicies require regulatory review or approval, the Master Agreement requiresthe parties to cooperate fully and in good faith to take various actions withrespect to the policies to be transferred by us to CastlePoint, includinggiving required notices and providing appropriate services relating to thepolicies, so as to implement such transfers in a timely and efficient manner.

The quota share reinsurance agreements and the poolingagreements have a term of four years (as extended by mutual agreement from theinitial term of three years), subject to regulatory approval and certain earlytermination rights of the parties. In addition, each party to each of thepooling agreements may terminate its participation in the applicable poolingagreement upon 12 months notice. Further, we and CastlePoint have modifiedthe program management agreements to provide that they can be terminated by anyparty upon 60 days’ notice. We and CastlePoint have also agreed that neitherof us will cause nor permit our respective subsidiaries to exercise such annualtermination right in the quota share reinsurance agreements and the poolingagreements or the 60 days’ notice termination right in the programmanagement agreements. This agreement not to exercise the annual terminationright or 60 days’ notice termination right does not affect the other earlytermination provisions.

***2005 Reinsurance Program***

*Quota Share Reinsurance.  *EffectiveJanuary 1, 2005, TICNY entered into a quota share treaty to reinsureagainst losses up to $1.0 million per occurrence on the gross premiumswritten in the insurance segment. Under the terms of the treaty, TICNY cedes25% of its net premiums written and retains the remaining 75%. The provisionalceding commission under this treaty is 39.1% of ceded net premiums written. Ofthe premium 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 quotashare treaty contains various exclusions and provides coverage for 100% ofextra-contractual obligations and losses in excess of policy limits. To reduceTICNY’s credit exposure to reinsurance, the quota share reinsurance has beenplaced on a “funds withheld” basis. Under the terms of the reinsurance treaty,TICNY guarantees to credit the reinsurers with a 3% annual effective yield onthe monthly balance of this account.

Effective January 1, 2005, TICNY entered into aquota share treaty to reinsure against umbrella losses up to $5.0 millionper occurrence. Under the terms of the treaty TICNY ceded 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” (Excellent) by A.M. Best,reinsured 50% and Hannover Ruckversicherung 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 millionper occurrence on a book of commercial umbrella business produced by a thirdparty managing general agent, W. H. Greene. Under the terms of thetreaty TICNY ceded 80% of its premium written and retained the remaining 20%. Theflat ceding commission under this treaty is 29% of ceded premium written. Ofthe premium ceded, 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%.

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*Excess of LossReinsurance.**  *Effective January 1, 2005 TICNY entered into anExcess of Loss Reinsurance Program with the same terms as the 2004 Excess ofLoss Reinsurance Treaty. The 2005 Excess of Loss Reinsurance Program was placedwith Munich Reinsurance America Inc (formerly known as American Re-InsuranceCompany), rated “A” (Excellent) by A.M. Best, Platinum UnderwritersReinsurance, Inc., rated “A” (Excellent) by A.M. Best, EnduranceSpecialty Insurance, Ltd., rated “A-” (Excellent) by A.M. Best,syndicates from Lloyd’s of London, rated “A” (Excellent)by A.M. Best, and Hannover Ruckversicherung AG, rated “A”(Excellent) by A.M. Best.

*Catastrophe Reinsurance.**  *The 2004 Property Catastrophe Program providedcoverage for events occurring through June 30, 2005 and was renewed onJuly 1, 2005 with a similar structure to the expiring program.

**Investments**

We derive investmentincome from our invested assets. We invest our insurance companies’ statutorysurplus and funds to support their loss and loss adjustment expense reservesand unearned premium reserves. Our investment income increased significantlybeginning in 2004 as TICNY’s invested assets increased due to increased netpremiums written and surplus as well as the $98.0 million capitalcontribution of a portion of the IPO proceeds.

Our primary investmentobjectives are to preserve capital and maximize after-tax investment income.Our strategy is to purchase debt securities in sectors that represent the mostattractive relative value and to maintain a moderate equity exposure. As of December 31,2006, the fixed maturity securities represented approximately 89% of the fairmarket value of our investment portfolio and equity securities representedapproximately 11%. Historically, we have emphasized liquidity to meet ourclaims obligations and debt service and to support our obligation to remitceded premium (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 31,2006, cash and cash equivalents represented approximately 17.8% of the total offair market value of our investment portfolio and cash and cash equivalents. Ourhigher year end 2006 cash position was due to the relatively flat yield curveand management’s decision to invest new funds short term and not taking onadditional interest rate risk associated with longer term investments as wellas the $39.6 million of new cash from the perpetual preferred stockoffering. These funds will be reinvested longer term by our investment manageras we see advantages in the fixed maturity market.

Our investments aremanaged by an outside asset management company, Hyperion Brookfield AssetManagement, Inc. (“Hyperion”), a New York based investment managementfirm. Hyperion has authority and discretion to buy and sell securities for us,subject to guidelines established by our Board of Directors. We may terminateour agreement with Hyperion upon 30 days’ notice. Our investment policy isconservative, as approximately 83.0% of the fixed income portion of ourinvestment portfolio is rated A or higher as of December 31, 2006. Thecurrent 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.

Our investment income was$23.0 million in 2006, compared to $15.0 million in 2005. Additionally,in 2006, invested assets increased as a result of $134.0 million of netcash flow from operations and an increase in the investment yield.

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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,** | ** ** |
|------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **2006**                                                                              | ** ** | **2005** | ** ** |
| ** **                               | ** ** | **Market  Value**                                                                     | ** ** | **Percent  of Total** | ** ** | **Yield** | ** ** | **Market  Value** | ** ** | **Percent  of Total** | ** ** | **Yield** | ** ** |
| **Category**                             | ** ** | ** **                                                                            | ** ** | **($ in thousands)** | ** ** |
| U.S. Treasury  Securities                |       | $                                                                                     | 14,459     |   |   | 3.1 | % |   | 4.49 | % | $ | 7,132 |   |   | 2.0 | % |   |   | 4.13 | % |   |
| U.S. agency  securities                  |       | 30,674                                                                                |       |   | 6.6 | % |   | 4.96 | % | 31,623 |   |   | 8.8 | % |   |   | 4.42 | % |   |
| Corporate fixed  maturity securities     |       | 122,685                                                                               |       |   | 26.4 | % |   | 5.35 | % | 76,488 |   |   | 21.3 | % |   |   | 4.67 | % |   |
| Mortgage-backed  securities              |       | 129,257                                                                               |       |   | 28.0 | % |   | 6.15 | % | 96,922 |   |   | 27.0 | % |   |   | 5.26 | % |   |
| Asset-backed  securities                 |       | 16,917                                                                                |       |   | 3.6 | % |   | 5.46 | % | 15,188 |   |   | 4.2 | % |   |   | 5.55 | % |   |
| Other taxable fixed  maturity securities |       | —                                                                                |       |   | 0.0 | % |   |   |   | 244 |   |   | 0.1 | % |   |   | 4.96 | % |   |
| Municipal  securities                    |       | 100,575                                                                               |       |   | 21.7 | % |   | 3.68 | % | 99,084 |   |   | 27.6 | % |   |   | 3.67 | % |   |
| Common stocks                            |       | 43,781                                                                                |       |   | 9.4 | % |   |   |   | 30,377 |   |   | 8.4 | % |   |   |   |   |   |
| Preferred stocks                         |       | 5,672                                                                                 |       |   | 1.2 | % |   | 6.34 | % | 115 |   |   | 0.0 | % |   |   | 7.27 | % |   |
|                                          |            |                                                                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

For 2006, the principal change in allocations was anincrease to common stocks, mortgage-backed securities and corporate bonds. During2006 we allocated a portion of the investment portfolio to higher yieldinginvestments in equity securities. This includes common shares of a closed-endmanagement investment company investing predominantly in asset-backedsecurities and mortgage-backed securities. During 2006 we used approximately$134.0 million of new cash flow from operations to purchase mortgage-backed securities,corporate bonds and equity securities. These new fixed maturity investmentsoffered us favorable yields while maintaining fundamental credit quality. At December 31,2006 the average credit quality of our fixed income investments was AA and the durationwas 3.67 years.

The principal change in 2005 was an increase in theallocation to common stocks, municipal bonds, mortgage-backed securities andcorporate bonds. During 2005 we allocated a portion of the investment portfolioto higher yielding investments in equity securities. This includes commonshares of a closed-end management investment company investing predominantly inasset-backed securities and mortgage-backed securities. We also invested inpublicly traded real estate investment trusts (REITs) and one private placementREIT that went public in 2006. During 2005 we had net purchases ofmortgage-backed securities, municipal bonds and corporate bonds ofapproximately $108.6 million from investing new cash flow from operations. Thesenew fixed maturity investments offered us favorable yields and fundamentalcredit quality. At December 31, 2005, the average credit quality of ourfixed income investments was AA+ and the duration was 3.97 years.

The following table showsthe composition of our fixed maturity portfolio by remaining time to maturityat December 31, 2006 and December 31, 2005. For securities that areredeemable at the option of the issuer and have a market price that is greaterthan par value, the maturity used for the table below is the earliestredemption date. For securities that are redeemable at the option of the issuerand have a market price that is less than par value, the maturity used for thetable below is the final maturity date.

| ** **                                    | ** ** | **As of December 31,** | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| ** **                                    | ** ** | **2006**                              | ** ** | **2005**                              | ** ** |
| **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                            |       |                                  | $          | 7,309                                 |       |   |   | 1.8 | % |   |   | $ | 3,873 |   |   |   | 1.2 | % |   |
| One to five years                             |       |                                  | 136,041    |                                  |       |   | 32.8 | % |   |   | 92,961 |   |   |   | 28.4 | % |   |
| Five to ten years                             |       |                                  | 125,584    |                                  |       |   | 30.3 | % |   |   | 113,125 |   |   |   | 34.6 | % |   |
| More than ten years                           |       |                                  | 16,376     |                                  |       |   | 4.0 | % |   |   | 19,800 |   |   |   | 6.1 | % |   |
| Mortgage-backed  securities                   |       |                                  | 129,257    |                                  |       |   | 31.2 | % |   |   | 96,922 |   |   |   | 29.7 | % |   |
| **Total**                                     | ** ** | ** **                            | **$**      | **414,567**                           |       | ** ** | ** ** | **100.0** | **%** | ** ** | ** ** | **$** | **326,681** |   | ** ** | ** ** | **100.0** | **%** | ** ** |
|                                               |            |                                       |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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Theaverage credit rating of our fixed maturity portfolio, using ratings assignedto securities by Standard and Poor’s, was AA at December 31, 2006 and AA+at December 31, 2005. The following table shows the ratings distributionof our fixed income portfolio as of the end of each of the past two years.

| ** **                | ** ** | **As of December 31,** | ** ** | **As of December 31,** | ** ** |
|---------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| ** **                | ** ** | **2006**                              | ** ** | **2005**                              | ** ** |
| **Rating**                | ** ** | ** **                            | ** ** | **Fair Market  Value**           | ** ** | **Percentage of  Fair Market  Value** | ** ** | **Fair Market  Value** | ** ** | **Percentage of  Fair Market  Value** | ** ** |
| ** **                | ** ** | **($ in thousands)**        | ** ** |
| U.S. Treasury  securities |       |                                  | $          | 14,459                                |       |   |   | 3.5 | % |   |   | $ | 7,132 |   |   |   | 2.2 | % |   |
| AAA                       |       |                                  | 214,934    |                                  |       |   | 51.8 | % |   |   | 190,980 |   |   |   | 58.5 | % |   |
| AA                        |       |                                  | 46,843     |                                  |       |   | 11.3 | % |   |   | 40,020 |   |   |   | 12.3 | % |   |
| A                    |       |                                  | 68,135     |                                  |       |   | 16.4 | % |   |   | 50,546 |   |   |   | 15.5 | % |   |
| BBB                       |       |                                  | 44,675     |                                  |       |   | 10.8 | % |   |   | 19,956 |   |   |   | 6.1 | % |   |
| Below BBB                 |       |                                  | 25,521     |                                  |       |   | 6.2 | % |   |   | 18,047 |   |   |   | 5.5 | % |   |
| **Total**                 | ** ** | ** **                            | **$**      | **414,567**                           |       | ** ** | ** ** | **100.0** | **%** | ** ** | ** ** | **$** | **326,681** |   | ** ** | ** ** | **100.0** | **%** | ** ** |
|                           |            |                                       |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We account for our investments in accordance withStatement of Financial Accounting Standards No. 115, *“Accountingfor Certain Investments in Debt and Equity Securities”*(“SFAS 115”),which requires that fixed-maturity securities and equity securities that havereadily determined fair values be segregated into categories based upon ourintention for those securities. In accordance with SFAS 115, we classifiedour fixed-maturity and equity securities as available-for-sale. We may sell ouravailable-for-sale securities in response to changes in interest rates,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. Changes in unrealized gains and losses on thesesecurities are reported as a separate component of comprehensive net income,and accumulated unrealized gains and losses, net of tax effects, reported as aseparate component of accumulated other comprehensive income in stockholders’equity. During the third quarter of 2006, we reclassified our entire balance ofequity securities at cost to equity securities at fair value in compliance withGAAP for insurance companies. Realized gains and losses are charged or creditedto income in the period in which they are realized and are determined on thespecific identification method.

On November 3, 2005, the FASB issued FSP FAS 115-1and FAS 124-1, *“Other-Than-TemporaryImpairment and Its Application to Certain Investments.”* The guidancein this FSP addresses the determination of when an investment is consideredimpaired, whether that impairment is other than temporary, and the measurementof an impairment loss. The FSP also includes accounting considerationssubsequent to the recognition of an other than temporary impairment andrequires certain disclosures about unrealized losses that have not been recognizedas other-than-temporary impairments. The guidance in this FSP applies toreporting periods beginning after December 15, 2005.

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Impairment of investment securities results in acharge to operations when a market decline below cost is deemed to beother-than-temporary. As of December 31, 2006, we reviewed ourfixed-maturity and equity securities portfolios to evaluate the necessity ofrecording impairment losses for other-than-temporary declines in the fair valueof investments in accordance with the provisions of this FSP. We determinedthat we did not hold any investments that we considered other-than-temporarilyimpaired. As of December 31, 2006, and December 31, 2005, cumulativenet unrealized losses on our fixed maturity portfolio were $2.1 million and$4.4 million, respectively. There were no other than temporary declines in thefair value of our securities at December 31, 2006 and December 31,2005.

The aggregate fair market value of our invested assetsexcluding cash and cash equivalents as of December 31, 2006 was $464.0 million.As of that date, our fixed maturity securities had a fair market value of$414.6 million and amortized cost of $416.6 million. Equity securities,available for sale, at fair value were $49.5 million as of December 31,2006 with a cost of $48.0 million.

Thefollowing table provides a breakdown of the amortized cost, aggregate fairvalue and unrealized gains and losses by investment type as of December 31,2006 and December 31, 2005.

| ** **                              | ** ** | **As of December 31,  2006** | ** ** | **As of December 31,  2005** | ** ** |
|-----------------------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|
| ** **                              | ** ** | **Cost or  Amortized  Cost** | ** ** | **Aggregate  Fair  Value**        | ** ** | **Unrealized  Gains/  (Losses)** | ** ** | **Cost or  Amortized  Cost** | ** ** | **Aggregate  Fair  Value** | ** ** | **Unrealized  Gains/  Losses** | ** ** |
| **Category**                            | ** ** |                              | ** ** | ** **                        |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| U.S. Treasury securities                |       |                              | $          | 14,594                            | ** ** |   |   | $ | 14,459 | ** ** |   |   | $ | (135 | ) |   |   | $ | 7,224 | ** ** |   |   | $ | 7,132 | ** ** |   |   | $ | (92 | ) |   |
| U.S. Agency securities                  |       |                              | 30,699     | ** **                        |       |   | 30,674 | ** ** |   |   | (25 | ) |   |   | 31,937 | ** ** |   |   | 31,623 | ** ** |   |   | (314 | ) |   |
| Corporate fixed maturity securities     |       |                              | 122,868    | ** **                        |       |   | 122,685 | ** ** |   |   | (183 | ) |   |   | 77,852 | ** ** |   |   | 76,488 | ** ** |   |   | (1,364 | ) |   |
| Mortgage-backed securities              |       |                              | 130,373    | ** **                        |       |   | 129,257 | ** ** |   |   | (1,116 | ) |   |   | 98,786 | ** ** |   |   | 96,922 | ** ** |   |   | (1,864 | ) |   |
| Asset-backed securities                 |       |                              | 17,165     | ** **                        |       |   | 16,917 | ** ** |   |   | (248 | ) |   |   | 15,431 | ** ** |   |   | 15,188 | ** ** |   |   | (243 | ) |   |
| Other taxable fixed maturity securities |       |                              | —     | ** **                        |       |   | — | ** ** |   |   | — |   |   |   | 250 | ** ** |   |   | 244 | ** ** |   |   | (6 | ) |   |
| Municipal securities                    |       |                              | 100,943    | ** **                        |       |   | 100,575 | ** ** |   |   | (368 | ) |   |   | 99,643 | ** ** |   |   | 99,084 | ** ** |   |   | (559 | ) |   |
| Common stocks.                          |       |                              | 42,344     | ** **                        |       |   | 43,781 | ** ** |   |   | 1,437 |   |   |   | 31,126 | ** ** |   |   | 29,872 | ** ** |   |   | (1,254 | ) |   |
| Preferred stocks                        |       |                              | 5,627      | ** **                        |       |   | 5,672 | ** ** |   |   | 45 |   |   |   | 113 | ** ** |   |   | 115 | ** ** |   |   | 2 |   |   |
| **Total.**                              | ** ** |                              | **$**      | **464,613**                       | ** ** |   |   | **$** | **464,020** | ** ** |   |   | **$** | **(593** | **)** |   |   | **$** | **362,362** | ** ** |   |   | **$** | **356,668** | ** ** |   |   | **$** | **(5,694** | **)** |   |

 

Thefollowing table presents information regarding our invested assets that were inan unrealized loss position at December 31, 2006 by amount of time in acontinuous 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** | ** ** |
| U.S. Treasury securities               |       | $                                      | 4,095       |                                   |       | $               | (10        | ) |   | $ | 5,801 |   |   | $ | (151 | ) |   | $ | 9,896 |   |   | $ | (161 | ) |   |
| U.S. Agency securities                 |       | 6,525                                  |        |                                   | (21        | )               |       | 12,151 |   |   | (118 | ) |   | 18,676 |   |   | (139 | ) |   |
| Corporate fixed maturity securities    |       | 25,550                                 |        |                                   | (237       | )               |       | 42,748 |   |   | (1,052 | ) |   | 68,298 |   |   | (1,289 | ) |   |
| Mortgage-backed securities             |       | 28,669                                 |        |                                   | (213       | )               |       | 59,868 |   |   | (1,566 | ) |   | 88,537 |   |   | (1,779 | ) |   |
| Asset-backed securities.               |       | 995                                    |        |                                   | (3         | )               |       | 14,180 |   |   | (282 | ) |   | 15,175 |   |   | (285 | ) |   |
| Municipal securities                   |       | 20,213                                 |        |                                   | (94        | )               |       | 45,390 |   |   | (613 | ) |   | 65,603 |   |   | (707 | ) |   |
| Equities                               |       | 25,960                                 |        |                                   | (275       | )               |       | 2,816 |   |   | (463 | ) |   | 28,776 |   |   | (738 | ) |   |
| Total temporarily  impaired securities | ** ** | **$**                                  | **112,007** | ** **                             | ** ** | **$**           | **(853**   | **)** | ** ** | **$** | **182,954** | ** ** | ** ** | **$** | **(4,245** | **)** | ** ** | **$** | **294,961** | ** ** | ** ** | **$** | **(5,098** | **)** | ** ** |

 

**Loss and LossAdjustment 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 asIBNR). The amount of loss reserves for reported claims is based primarily upona claim-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 ofstatistical techniques. Furthermore, an independent actuary prepares a reporteach year concerning the adequacy of the loss reserves.

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

Thetable below shows the reconciliation of reserves on a gross and net basis foreach of the last three calendar years, reflecting changes in losses incurredand paid losses.

| ** **                    | ** ** | **For  the year ended December 31,** | ** **  |
|-------------------------------|------------|--------------------------------------------------------------------|-------------|
| ** **                    | ** ** | **2006**                                                           | ** **  | **2005** | ** ** | **2004** | ** ** |
| ** **                    | ** ** | **($ in thousands)**                                     | ** **  |
| Balance at  January 1    |       | $                                                                  | 198,724     |   | $ | 128,722 |   | $ | 99,475 |   |
| Less reinsurance recoverables |       | (96,978                                                            | )           | (91,773 | ) | (75,114 | ) |
|                          |       | 101,746                                                            |        | 36,949 |   | 24,361 |   |
| Incurred related  to:         |       |                                                               |        |   |   |   |   |
| Current year                  |       | 135,863                                                            |        | 97,006 |   | 27,259 |   |
| Prior years                   |       | (2,340                                                             | )           | (392 | ) | (199 | ) |
| PXRE commutation              |       | 1,602                                                              |        | — |   | — |   |
| **Total incurred**            | ** ** | **135,125**                                                        | ** **  | **96,614** | ** ** | **27,060** | ** ** |
| Paid related to:              |       |                                                               |        |   |   |   |   |
| Current year                  |       | 30,605                                                             |        | 20,891 |   | 6,991 |   |
| Prior years                   |       | 13,767                                                             |        | 10,926 |   | 7,481 |   |
| **Total paid**                | ** ** | **44,372**                                                         |        | 31,817 |   | 14,472 |   |
| Net balance at  end of period |       | 192,499                                                            |        | 101,746 |   | 36,949 |   |
| Add reinsurance recoverables  |       | 110,042                                                            |        | 96,978 |   | 91,773 |   |
| **Balance  at end of period** | ** ** | **$**                                                              | **302,541** | ** ** | **$** | **198,724** | ** ** | **$** | **128,722** | ** ** |

 

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 ReserveDevelopment***

Shown below is the lossreserve development for business written each year from 1996 through 2006. Thetable portrays the changes in our loss and LAE reserves in subsequent yearsfrom the prior loss estimates based on experience as of the end of eachsucceeding year on the basis of GAAP.

The first line of thetable shows, for the years indicated, our net reserve liability including thereserve for incurred but not reported losses as originally estimated. Forexample, as of December 31, 2000 we estimated that $7,901,000 would be asufficient reserve to settle all claims not already settled that had occurredprior to December 31, 2000 whether reported or unreported to us. The nextsection of the table shows, by year, the cumulative amounts of losses and lossadjustment expenses paid as of the end of each succeeding year. For example,with respect to the net losses and loss expense reserve of $7,901,000 as of December 31,2000, by December 31, 2006 (six years later) $8,736,000 had actually beenpaid in settlement of the claims.

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The next section of thetable sets forth the re-estimates in later years of incurred losses, includingpayments, for the years indicated. For example, as reflected in that section ofthe table, the original reserve of $7,901,000 was re-estimated to be $12,666,000at December 31, 2006. The increase from the original estimate is caused bya combination of factors, including: (1) reserves being settled foramounts different than originally estimated, (2) reserves being increasedor decreased for claims remaining open as more information becomes known aboutthose individual claims and (3) more or fewer claims being reported after December 31,2000 than had occurred prior to that date.

The “cumulativeredundancy/ (deficiency)” represents, as of December 31, 2006, thedifference between the latest re-estimated liability and the reserves asoriginally estimated. A redundancy means the original estimate was higher thanthe current estimate; a deficiency means that the current estimate is higherthan the original estimate. For example, as of December 31, 2006 and basedupon updated information, we re-estimated that the reserves which wereestablished as of December 31, 2005 were $738,000 redundant, and excludingthe PXRE commutation were $2,340,000 redundant.

Thebottom part of the table shows the impact of reinsurance reconciling the netreserves shown in the upper portion of the table to gross reserves.

| ** **                                    | ** ** | **Year  ended December 31,** | ** ** |
|-----------------------------------------------|------------|-----------------------------------|------------|
| ** **                                    | ** ** | **1996**                          | ** ** | **1997** | ** ** | **1998** | ** ** | **1999** | ** ** | **2000** | ** ** | **2001*** | ** ** | **2002*** | ** ** | **2003*** | ** ** | **2004*** | ** ** | **2005*** | ** ** | **2006** | ** ** |
| ** **                                    | ** ** | **($ in thousands)**    | ** ** |
| Original Net  Liability                       |       | $                                 | 3,361      |   | $ | 5,005 |   | $ | 6,184 |   | $ | 6,810 |   | $ | 7,901 |   | $ | 8,620 |   | $ | 15,476 |   | $ | 24,361 |   | $ | 36,949 |   | $ | 101,746 |   | $ | 192,499 |   |
| Cumulative  payments as of:                   |       |                              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One year later                                |       | 1,035                             |       | 1,428 |   | 2,377 |   | 2,560 |   | 3,376 |   | 2,879 |   | 4,103 |   | 7,467 |   | 10,926 |   | 13,748 |   |   |   |
| Two years later                               |       | 1,849                             |       | 2,827 |   | 3,890 |   | 4,767 |   | 5,439 |   | 4,906 |   | 6,707 |   | 11,856 |   | 4,455 |   |   |   |   |   |
| Three years later                             |       | 2,747                             |       | 4,045 |   | 5,439 |   | 6,153 |   | 6,953 |   | 6,376 |   | 9,090 |   | 2,872 |   |   |   |   |   |   |   |
| Four years later                              |       | 3,397                             |       | 5,191 |   | 6,340 |   | 6,896 |   | 7,896 |   | 7,219 |   | 4,480 |   |   |   |   |   |   |   |   |   |
| Five years later                              |       | 4,083                             |       | 5,895 |   | 6,714 |   | 7,249 |   | 8,285 |   | 6,691 |   |   |   |   |   |   |   |   |   |   |   |
| Six years later                               |       | 4,454                             |       | 6,220 |   | 6,935 |   | 7,465 |   | 8,736 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Seven years later                             |       | 4,691                             |       | 6,413 |   | 6,978 |   | 7,715 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Eight years later                             |       | 4,847                             |       | 6,423 |   | 7,116 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Nine years later                              |       | 4,836                             |       | 6,523 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Ten years later                               |       | 4,933                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net liability  re-estimated as of:            |       |                              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One year later                                |       | 4,154                             |       | 5,954 |   | 6,842 |   | 7,493 |   | 9,702 |   | 11,521 |   | 15,551 |   | 24,163 |   | 36,557 |   | 101,008 |   |   |   |
| Two years later                               |       | 4,574                             |       | 6,262 |   | 7,123 |   | 8,652 |   | 11,684 |   | 11,276 |   | 14,665 |   | 24,815 |   | 40,654 |   |   |   |   |   |
| Three years later                             |       | 4,457                             |       | 6,428 |   | 7,871 |   | 9,516 |   | 11,458 |   | 10,494 |   | 16,461 |   | 29,034 |   |   |   |   |   |   |   |
| Four years later                              |       | 4,544                             |       | 6,945 |   | 8,244 |   | 9,210 |   | 10,819 |   | 11,875 |   | 19,603 |   |   |   |   |   |   |   |   |   |
| Five years later                              |       | 4,992                             |       | 7,169 |   | 7,963 |   | 8,955 |   | 11,944 |   | 13,293 |   |   |   |   |   |   |   |   |   |   |   |
| Six years later                               |       | 5,093                             |       | 7,057 |   | 7,875 |   | 9,951 |   | 12,666 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Seven years later                             |       | 5,065                             |       | 7,037 |   | 8,659 |   | 10,584 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Eight years later                             |       | 5,141                             |       | 7,663 |   | 9,158 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Nine years later                              |       | 5,607                             |       | 8,085 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Ten years later                               |       | 5,883                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cumulative Net redundancy/(deficiency)        |       | (2,522                            | )          | (3,080 | ) | (2,974 | ) | (3,774 | ) | (4,765 | ) | (4,673 | ) | (4,127 | ) | (4,673 | ) | (3,705 | ) | 738 |   |   |   |
| PXRE commutation                              |       | 0                                 |       | 0 |   | 0 |   | 0 |   | 0 |   | 0 |   | 0 |   | 196 |   | 870 |   | 1,602 |   |   |   |
| Cumulative net redundancy/(deficiency)        |       |                              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| excluding PXRE                                |       | (2,522                            | )          | (3,080 | ) | (2,974 | ) | (3,774 | ) | (4,765 | ) | (4,673 | ) | (4,127 | ) | (4,477 | ) | (2,835 | ) | 2,340 |   |   |   |
| Net reserves                                  |       | $                                 | 3,361      |   | $ | 5,005 |   | $ | 6,184 |   | $ | 6,810 |   | $ | 7,901 |   | $ | 8,620 |   | $ | 15,476 |   | $ | 24,361 |   | $ | 36,949 |   | $ | 101,746 |   | $ | 192,499 |   |
| Ceded reserves                                |       | 8,529                             |       | 14,800 |   | 15,696 |   | 17,410 |   | 20,601 |   | 29,017 |   | 50,211 |   | 75,114 |   | 91,773 |   | 96,978 |   | 110,042 |   |
| Gross reserves                                |       | $                                 | 11,890     |   | $ | 19,805 |   | $ | 21,880 |   | $ | 24,220 |   | $ | 28,502 |   | $ | 37,637 |   | $ | 65,687 |   | $ | 99,475 |   | $ | 128,722 |   | $ | 198,724 |   | $ | 302,541 |   |
| Net re-estimated                              |       | $                                 | 5,883      |   | $  | 8,085 |   | $ | 9,158 |   | $ | 10,584 |   | $  | 12,666 |   | $  | 13,293 |   | $  | 19,603 |   | $  | 29,034 |   | $  | 40,654 |   | $ | 101,008 |   |   |   |
| Ceded re-estimated                            |       | 18,451                            |       | 20,418 |   | 25,718 |   | 32,142 |   | 37,587 |   | 44,446 |   | 58,175 |   | 77,879 |   | 93,580 |   | 94,713 |   |   |   |
| Gross re-estimated                            |       | $                            | 24,334     |   | $ | 28,503 |   | $  | 34,876 |   | $  | 42,726 |   | $  | 50,253 |   | $  | 57,739 |   | $  | 77,778 |   | $ | 106,913 |   | $ | 134,234 |   | $ | 195,721 |   |   |   |
| Cumulative Gross redundancy/(deficiency)  . . |       | (12,444                           | )          | (8,698 | ) | (12,996 | ) | (18,506 | ) | (21,751 | ) | (20,102 | ) | (12,091 | ) | (7,438 | ) | (5,512 | ) | 3,003 |   |   |   |

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*                      The cumulative payments were lower thanwould have been expected as a result of the PXRE commutation for 2001, 2002,2003, 2004 and 2005 by $2,321, $10,288, $18,926, $18,926 and $18,926,respectively.

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**Analysis of Lossand Loss Adjustment Reserve Development**

***Analysis of Reserves***

The following table shows our net outstanding caseloss reserves and IBNR by line of business as of December 31, 2006:

| ** **                  | ** ** | **Outstanding Case  Loss Reserves** | ** ** | **IBNR**   | ** ** |
|-----------------------------|------------|-----------------------------------------------|------------|------------|------------|
| ** **                  | ** ** | **($ in thousands)**                | ** ** |
| Commercial  Multiple Peril  |       |                                          | $          | 50,655     |       |   | $ | 48,136 |   |
| Other Liability             |       |                                          | 17,237     |       |       | 25,408 |   |
| Workers’  Compensation |       |                                          | 8,681      |       |       | 7,222 |   |
| Commercial  Automobile      |       |                                          | 6,819      |       |       | 4,684 |   |
| Homeowners                  |       |                                          | 13,194     |       |       | 7,859 |   |
| Fire and Allied  Lines      |       |                                          | 2,020      |       |       | 584 |   |
| **All Lines**               |       |                                          | **$**      | **98,606** |       | ** ** | **$** | **93,893** | ** ** |

 

In 2006 we had favorable development in our net lossesfrom prior accident years of $738,000. Excluding the PXRE commutation for 2006we had favorable development of $2,340,000.

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.

The paid development, incurred development, theBornhuetter Ferguson (B-F) method, and loss ratio projections are thepredominate methodologies our actuaries utilize to project losses andcorresponding reserves. Based upon these methods our actuaries determine a bestestimate of the loss reserves. All of these methods are standard actuarialapproaches and have been utilized consistently since 2003. The selecteddevelopment factors within the paid and incurred development methods arederived from our data while the loss ratio method is used for the most recentaccident year when there is high volatility in the development patterns. TheB-F method combines the loss ratio method and the loss development method todetermine loss reserves by adding an expected development (loss ratio timespremium times percent unreported) to the case reserves.

The incurred method relies on historical developmentfactors derived from changes in our incurred estimates of claims paid and casereserves over time. The paid method relies on our claim payment patterns andultimate claim costs. The incurred method is sensitive to changes in casereserving practices over time. Thus if case reserving practices change overtime the incurred method may produce significant variations in estimates ofultimate losses. The paid method relies on actual claim payments and thereforeis not sensitive to changes in case reserve estimates.

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Thelow end of the range of our sensitivity analysis was derived by giving moreweight to the lowest estimate among the four methods for each line of businessand accident year. Similarly the high end of the range of our sensitivityanalysis was derived by giving more weight to the highest estimate among thefour methods for each line of business and accident year. We believe thatchanging the weighting for the four methods by line of business and accidentyear better reflects reasonably likely outcomes than adjusting selecteddevelopment patterns or other variables within each method. We believe theresults of the sensitivity analysis, which are summarized in the table below,constitute a reasonable range of expected outcomes of our reserve for net lossand loss adjustment expense:

| ** **                   | ** ** | **Range of Reserve Estimates** | ** **  |
|------------------------------|------------|-----------------------------------------------|-------------|
| ** **                   | ** ** | **High**                                      | ** **  | **Low** | ** ** | **Carried** | ** ** |
| Commercial  Multiple Peril   |       | $                                             | 104,147     |   | $ | 92,966 |   | $ | 98,791 |   |
| Other Liability              |       | 43,685                                        |        | 37,236 |   | 42,645 |   |
| Workers’  Compensation. |       | 18,595                                        |        | 15,422 |   | 15,903 |   |
| Commercial Auto              |       | 13,384                                        |        | 8,711 |   | 11,503 |   |
| Homeowners.                  |       | 22,539                                        |        | 16,302 |   | 21,054 |   |
| Fire and Allied  Lines       |       | 2,969                                         |        | 2,345 |   | 2,603 |   |
| **All Lines**                | ** ** | **$**                                         | **205,319** | ** ** | **$** | **172,982** | ** ** | **$** | **192,499** | ** ** |

 

The resulting range derived from our sensitivityanalysis would have increased net reserves by $12.8 million and or decrease netreserves by $19.5 million.

Two key assumptions that materially impact theestimate of loss reserves are the loss ratio estimate for the current accidentyear and the loss development factor selections for all other accident years. TheCompany has made only minor changes to the key assumptions used during the lastthree annual reserve estimates.

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 the date of the accident or areotherwise barred. Accordingly, our exposure to IBNR for accident years 2003 andprior is limited although there remains the possibility of adverse developmenton reported claims. Due to the reserve strengthening in 2002 and closemonitoring and analysis of reserves, we believe our loss reserves are adequate.This is reflected by the loss development as of December 31, 2006 showingdeveloped redundancies since 2003. However, there are no assurances that futureloss development and trends will be consistent with our past loss developmenthistory, and so adverse loss reserves development remains a risk factor to ourbusiness. See “Risk Factors—Risks Related to Our Business—If our actual loss and lossadjustment expenses exceed our loss reserves, our financial condition andresults of operations could be significantly adversely affected.”  See Critical Accounting Policies—Loss andLoss Adjustment Expense Reserves.”

**Claims**

Our claims division combines the services of our staffdefense, coverage and appellate attorneys with a traditional multi-lineinsurance claims adjusting staff. See “-Business Segments-Insurance ServicesSegment Products and Services” for a description of TRM’s claim servicefee-based operations.

The claims division seeks to provide expedient, fairand consistent claims handling, while controlling loss adjustment expenses.Handling the claims adjustment and defense of insureds in-house enables us toaccurately evaluate coverage, promptly post accurate loss and loss adjustmentexpense reserves, maintain the highest policyholders service standards andaggressively defend against liability claims. In addition, 

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through the use of aclaims database that captures detailed statistics and information on every claim,our underwriting and loss control departments are able to access information toassist them in the monitoring of the various lines of business and identifyingadverse loss trends, giving them the ability to make informed underwriting andpricing decisions.

The claims division is divided into eight units: autoclaims, workers’ compensation claims, property claims, liability claims,coverage, in-house defense, administration and processing, and subrogation andrecovery. Our in-house legal staff consists of approximately 24 attorneys whoare managed by two co-managing attorneys reporting to the Senior VicePresident, Claims.

The continued development of in-house expertise in allareas remains a primary goal of the claims division. We have continued to buildan in-house defense team in order to handle a substantial percentage oflawsuits in New York State and vigorously defend against fraudulent andfrivolous lawsuits. Given the high cost of coverage counsel in those instanceswhere coverage may be an issue, we formed an in-house coverage law firm. Ourclaims staff and in-house attorneys handle all of our claims and the majorityof our lawsuits internally. Approximately 75% of all lawsuits arising from ourinsurance company operation are currently handled in-house. This approachenables us to maintain a high level of service to our policyholders andvigorously defend non-meritorious and frivolous claims while controlling lossadjustment expenses. We have also formed a full time staff of in-houseliability field investigators to replace a traditionally outsourced claimsfunction. We have also built an experienced team of field property adjusters tocontrol costs and to ensure high quality claims experience for our commercialand 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 resolved through settlement from those that should be deniedand/or defended. Suspicious or fraudulent first- and third-party claims arealways aggressively investigated and defended.

**Technology**

We seek to leverage technology and make use ofbusiness process redesign in order to gain operating efficiencies andeffectiveness. For example, we were able to eliminate redundant keying ofpolicy information by upgrading our policy data entry system. More recently, weimplemented an integrated voice response system to provide producers andinsureds 24 x 7 access to policy billing information. These have 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 on­line imaging system, a data warehouse that houses bothclaims and underwriting data to provide management reporting and a web-basedplatform (WebPlus) for quoting and capturing policy submissions directly fromour producers.

All mission criticalsystems run on fully redundant hardware in an off-site secure facility withfully redundant power, air conditioning, communications and 24-hoursupport. We utilize Hewlett Packard servers that run the Microsoft WindowsServer 2000/2003 operating system and a Netapp Storage Area Network to storeall business data. System and data are backed up to tape daily and are taken toan off­site facility by an outside vendor.

**WebPlus ®**

Since April 2003, we have been using WebPlus, ourweb-based software platform for quoting and capturing policy submissionsdirectly from our producers. WebPlus applies our underwriting guidelines toallow our producers to submit, rate and, where appropriate, bind small premiumaccounts. A recently 

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added simple endorsementcapability improves clerical efficiency and customer service. Through an ongoingmonthly, quarterly and annual management review and analysis of the book ofbusiness, we confirm the risk quality and loss ratio profile of policiesprocessed in WebPlus. We utilize WebPlus for all of our personal lines businessand landlord package policies, as well as the majority of workers’ compensationand commercial auto policies. We believe that this technology reducesunderwriter involvement in each policy application, as well as improves ourability to validate and capture all relevant policy information early in thesubmission process and at a single point. We believe that WebPlus hassignificantly reduced our expense associated with processing business, improvedcustomer service and made it easier for our producers to do business with us.

WebPlus was developed for us by AgencyPort InsuranceServices, Inc. (“AgencyPort”), a technology company specializing in theproperty and casualty insurance industry, in exchange for our commitment toinvest $1 million in AgencyPort. In addition, we licensed AgencyPort’s KeyOncesoftware development kit, which AgencyPort utilized to develop WebPlus. We alsoobtained 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 ofWebPlus resulting in a payment of $337,000. These payments have beencapitalized as software and are being amortized over three years. The 1,072,525shares represented approximately 25% of the outstanding shares of AgencyPort asof December 31, 2006. We do not exercise significant influence overAgencyPort and we do not have any representation on the Board of Directors ofAgencyPort. The relationship is primarily one of AgencyPort as a licensor anddeveloper of software for our benefit. Accordingly, we do not account for ourinvestment in AgencyPort on the equity method. We have assigned no value to theshares of AgencyPort as of December 31, 2006. 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.

Our technology plancurrently envisions that we will expand our use of WebPlus to additionalproducts and other business functions (such as payment and reporting). We alsointend to exploit technological improvements and economies of scale realizedthrough premium growth to continue to lower our underwriting expense ratiowhile 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,coverage offered, customer service, relationship with producers (including easeof 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 and in other states, we have developed an increased number ofcompetitors. In our commercial lines business, our competitors include The St.Paul Travelers Companies, Inc., Hartford Insurance Company, Safeco,Hanover Insurance Companies, Magna Carta Companies, Greater New York MutualInsurance Company, OneBeacon Insurance Group, Selective, Utica First InsuranceCompany, Middlesex Mutual and Erie Insurance Company. In our personal linesbusiness, we compete against companies such as Allstate Insurance Company,State Farm Companies, The St. Paul Travelers Companies, Inc., HartfordInsurance Company, OneBeacon Insurance Group, New York Central InsuranceCompany, Commercial Mutual Insurance Company, Preferred Mutual InsuranceCompany and Otsego Mutual Fire Insurance Company.

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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.The pricing environment in the hard market prevalent in 2004 was such thatcompetition tended to focus more on the non-pricing factors listed above.During the last quarter of 2004 and continuing throughout 2005 a moderation ofthe pricing environment within the commercial insurance marketplace becameevident as pricing increases on renewing policies lessened. The catastrophelosses of 2004 and 2005 produced increased pricing and reduced capacity forcatastrophe exposed property. However, a softening of the non-catastrophemarket in 2006 has led to more aggressive pricing in specific segments of thecommercial lines of business, particularly in those lines of business andaccounts with larger annual premiums.

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 and submissioncapability through WebPlus and rating disks, as well as by providing ourproducers with clear and concise underwriting guidelines. We also compete byfocusing on reducing our producers’ costs of doing business with us. Forexample, we directly bill our policyholders on most of our policies with a perpolicy premium below $10,000 and provide customer service support topolicyholders on behalf of our producers. This increased service allows us todeliver value to our producers other than through higher commission rates.Finally, our success in reducing liability claims costs through cost effectiveand aggressive claims handling has reduced the cost of liability insurancepremiums for our policyholders. This capability also helps us compete withother insurance companies. Notwithstanding the positive competitive factorsdiscussed above, many of our competitors have greater financial and marketingresources and higher ratings from rating agencies than we do, which may have anadverse 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+” (Good) by A.M. Best in 1997 and was upgraded to “B++”(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 addition, during 2005 TNIC was also rated “A-” (Excellent) 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 

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an independent opinion ofan insurer’s financial strength and is not an evaluation directed at investors.There is no guarantee that TICNY and TNIC will maintain the improved rating.

In April 2003, inconnection with the issuance of subordinated debentures underlying trustpreferred securities, TICNY also received an insurer financial strength ratingfrom Standard & Poor’s. This rating provides an assessment of thefinancial strength of an insurance company and its capacity to meet obligationsto policyholders on a timely basis. TICNY’s most recent rating from Standard &Poor’s is “BBB-” with a stable outlook.

**Employees**

All of our employees areemployed directly by TICNY. As of December 31, 2006 the total number offull-time equivalent employees of TICNY was 403 of which 306 are in New YorkCity, 68 are in the Long Island, New York branch and 25 are in the Buffalo, NewYork branch and 4 are in the other branch offices. None of these employees arecovered by a collective bargaining agreement. We have employment agreementswith a number of our senior executive officers. The remainder of our employeesare at-will employees.

**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 Yorkand Massachusetts respectively. These laws generally require TICNY and TNIC toregister with their respective domiciliary state insurance department (“InsuranceDepartment”) and to furnish annually financial and other information about theoperations of companies within the holding company system. Generally underthese laws, all material transactions among companies in the holding companysystem to which TICNY or TNIC is a party, including sales, loans, reinsuranceagreements and service agreements, must be fair and reasonable and, if materialor of a specified category, require prior notice and approval ornon-disapproval by the Insurance Department.

***Changes of Control***

Before a person can acquire control of a New Yorkinsurance company, prior written approval must be obtained from theSuperintendent or the Commissioner of the Insurance Department (“Superintendent”).Prior to granting approval of an application to acquire control of an insurer,the Superintendent considers such factors as: the financial strength of theapplicant, the integrity and management of the applicant’s Board of Directorsand executive officers, the acquirer’s plans for the future operations of thedomestic insurer and any anti-competitive results that may arise from theconsummation of the acquisition of control. Pursuant to insurance holdingcompany laws, “control” means the possession, direct or indirect, of the powerto direct or cause the direction of the management and policies of the company,whether through the ownership of voting securities, by contract (except acommercial 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 Insurance Department, after notice and a hearing, maydetermine that a person or entity which directly or indirectly owns, controlsor holds with the power to vote less than 10% of the voting securities of thecompany, “controls” the company. Because a person acquiring 10% or more of ourcommon stock would indirectly control the same percentage of the stock of theTICNY and TNIC, the insurance change of control laws of New York andMassachusetts would likely apply to such a transaction.

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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 tothe tightening of supply in certain insurance and reinsurance markets resultingfrom, among other things, the September 11, 2001 terrorist attacks, theTerrorism Act was enacted. The Terrorism Act is designed to ensure theavailability of insurance coverage for foreign terrorist acts in the UnitedStates of America. This law established a Federal assistance program throughthe end of 2005 to help the commercial property and casualty insurance industrycover claims related to future terrorism-related losses and requires suchcompanies to offer coverage for certain acts of terrorism. As a result, we areprohibited from adding certain terrorism exclusions to the policies written byTICNY and TNIC. Although TICNY and TNIC are protected by federally fundedterrorism reinsurance as provided for in the Terrorism Act, there is asubstantial deductible that must be met, the payment of which could have anadverse 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 from17.5% in 2006 to 20% of direct earned premium in 2007. The minimum size of thetriggering event will be increased from the current $50 million for 2006 to$100 million in 2007.  As a consequenceof these changes, potential losses from a terrorist attack could besubstantially larger than previously expected. Potential future changes to theTerrorism Act could also adversely affect our ability to obtain reinsurance onfavorable terms, including pricing, and may affect our underwriting strategy,rating, and other elements of our operation.

***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 ofreinsurers, admittance of assets to statutory surplus, regulating unfair tradeand claims practices, establishing reserve requirements and solvency standards,regulating investments and dividends, approving policy forms and relatedmaterials in certain instances and approving premium rates in certain instances.State insurance 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 

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departments of otherstates under guidelines promulgated by the NAIC. The New York InsuranceDepartment recently completed an examination of TICNY as of December 31,2004.

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 moreof the ratios can lead to inquiries from individual state insurancecommissioners as to certain aspects of an insurer’s business. For 2006 TICNY’sresults were outside the usual values for one IRIS ratio and within the usualvalues for twelve IRIS ratios. In 2006 the gross change in policyholders’surplus was affected by the $49.6 million of capital contributions. Wecontributed to TICNY the proceeds from the perpetual preferred stock offeringand the sale of TICA during December 2006. For 2006 TNIC’s results wereoutside the usual values for two IRIS ratios and within the usual values foreleven IRIS rations. The two IRIS ratios that were outside the usual valueswere changes in net premiums written as TNIC did not write any business in 2005and the gross agents’ balances to policyholders’ surplus which reflects agents’balance in comparison to TNIC’s statutory surplus. TNIC cedes 85% of its businessto TICNY and this greatly reduces its statutory surplus and elevates this ratiobeyond normalized levels.

***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 $4,600,000, $2,050,000and $850,000 in dividends to Tower in 2006, 2005, and 2004, respectively. As ofDecember 31, 2006, the maximum distribution that TICNY could pay withoutprior regulatory approval was approximately $10.5 million.

***Massachusetts Dividend Limitations***

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. In addition, dividends may only be paid out of unassigned funds. Asof December 31, 2006, TNIC’s maximum dividend it could pay without theapproval of the Massachusetts Commissioner of Insurance was $0.1 million.

***Risk-Based Capital Regulations***

The New York andMassachusetts Insurance Departments require domestic property and casualtyinsurers to report their risk-based capital based on a formula developed andadopted by the NAIC that attempts to measure statutory capital and surplusneeds based on the risks in the insurer’s mix of products 

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andinvestment portfolio. The formula is designed to allow the 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). At December 31, 2006 TICNY and TNIC’s risk-basedcapital levels exceeded the minimum level that would trigger regulatoryattention. In their 2006 statutory statements, TICNY and TNIC have bothcomplied with the NAIC’s risk-based capital reporting requirements.

***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.

***Guaranty Associations***

In New York and Massachusetts and in most of thejurisdictions where TICNY and TNIC are currently licensed to transact businessthere is a requirement that property and casualty insurers doing businesswithin the jurisdiction participate in guaranty associations, which areorganized to pay contractual benefits owed pursuant to insurance policiesissued by impaired, insolvent or failed insurers. These associations levy assessments,up to prescribed limits, on all member insurers in a particular state on thebasis of the proportionate share of the premium written by member insurers inthe lines of business in which the impaired, insolvent or failed insurer isengaged. Some states permit member insurers to recover assessments paid throughfull or partial premium tax offsets.

In none of the past fiveyears has the assessment in any year levied against TICNY been material.Property and 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 14.—Commitments andContingencies” in the notes to our audited consolidated financial statementsincluded elsewhere in this report.

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***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 instances, TRM follows practices based oninterpretations of laws and regulations generally followed by the industry,which may prove to be different from the interpretations of regulatoryauthorities.

***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 performed investigations and other proceedingsrelating to compensation and bidding arrangements between producers and issuersof insurance products and unsuitable sales practices by producers on behalf ofeither the issuer or the purchaser. The practices under investigation included,among other things, allegations that so-called contingent commissionarrangements may conflict with a broker’s duties to its customers that certainbrokers and insurers may have engaged in anti-competitive practices inconnection with insurance premium quotes. The New York State Attorney Generalhas recently entered into a settlement agreement with two large insurancebrokers. These investigations and proceedings may continue, and newinvestigative proceedings may be commenced, in the future. These investigationsand proceedings could result in legal precedents and new industry-widepractices or legislation, rules or regulations that could significantlyaffect our industry and may also cause stock price volatility for companies inthe insurance industry. Contingent commissions under our producers’ profitsharing plan amounted to less than 1⁄4% to 1⁄2% of 1 percent to our overallcommission expense in 2006, 2005 and 2004.

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 theavailability of some types of reinsurance. In turn, these developments couldproduce higher prices for reinsurance, an increase in the amount of risk weretain, reduced ceding commission revenue, or other potentially adversedevelopments. In that event, we may be required to restructure or reduce ouruse of quota share reinsurance 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.

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**Note onForward-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 mayinclude forward-looking statements that reflect our current views with respectto future 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 identifyforward-looking statements for purposes of the Federal securities laws orotherwise.

All forward-lookingstatements address matters that involve risks and uncertainties. Accordingly,there are or will be important factors that could cause our actual results todiffer materially from those indicated in these statements. We believe thatthese factors include, but are not limited to, those described under “Item 1A.—Risk Factors” and thefollowing:

·       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 cede 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 of important factors should notbe construed as exhaustive and should be read in conjunction with the othercautionary statements that are included in this Form 10-K. Weundertake no obligation to publicly update or review any forward-lookingstatement, whether as a result of new information, future developments orotherwise.

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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 reflectour views as of the date of this Form 10-K with respect to futureevents and are subject to these and other risks, uncertainties and assumptionsrelating to our operations, results of operations, growth strategy andliquidity. All subsequent written and oral forward-looking statementsattributable to us or individuals acting on our behalf are expressly qualifiedin their entirety by this paragraph. Before making an investment decision, youshould specifically consider all of the factors identified in this Form 10-Kthat could cause actual results to differ.

**Item 1A.**                RiskFactors

An investment in our common stock involves a number ofrisks. You should carefully consider the following information about theserisks, together with the other information contained in this Form 10-K,in considering whether to invest in or hold our common stock. Additional risksnot presently known to us, or that we currently deem immaterial may also impairour business or results of operations. Any of the risks described below couldresult in a significant or material adverse effect on our financial conditionor results of operations, and a corresponding decline in the market price ofour common stock. You could lose all or part of your investment.

This Form 10-Kalso contains 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.”

**Risks Related toOur Business**

**Ifour actual loss and loss adjustment expenses exceed our loss reserves, ourfinancial condition and results of operations could be significantly adverselyaffected.**

Our results of operations and financial conditiondepend upon our ability to assess accurately the potential losses associatedwith the risks that we insure and reinsure. We establish loss reserves to coverour estimated liability for the payment of all losses and loss adjustmentexpenses incurred under the policies that we write. Loss reserves include casereserves, which are established for specific claims that have been reported tous, and reserves for claims that have been incurred but not reported (or “IBNR”).To the extent that loss and loss adjustment expenses exceed our estimates, wewill be required to immediately recognize the less favorable experience andincrease loss reserves, with a corresponding reduction in our net income in theperiod in which the deficiency is identified. For example, over the past tenyears we have experienced adverse development of reserves for losses and lossadjustment expenses incurred in prior years: In 2002, following an annualreview by an outside actuarial consulting company of TICNY’s net loss and lossadjustment reserves, we increased such reserves by $2.9 million.

Although loss reserves on property lines of businesstend to be relatively predictable from an actuarial standpoint, the reservingprocess for losses on the liability coverage portions of our commercial andpersonal lines policies 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. As liability claims most often involveclaims of bodily injury, assessment of the proper case reserve is a far moresubjective process than claims involving property damages. In addition, thedetermination of a case reserve for a liability claim is often without thebenefit of information, which develops slowly over the life of the claim andcan subject the case reserve to substantial modification well after the claimwas first reported. Numerous factors impact the liability case reserving 

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process, such as venue,the amount of monetary damage, the permanence of the injury, the age of theclaimant and many others.

Estimating an appropriate level of loss and lossadjustment expense reserves is an inherently uncertain process. Accordingly,actual loss and loss adjustment expenses paid will likely deviate, perhapssubstantially, from the reserve estimates reflected in our consolidatedfinancial statements. It is possible that claims could exceed our loss and lossadjustment expense reserves and have a material adverse effect on our financialcondition or results of operations.

Many of our quota share reinsurance agreements containprovisions for a ceding commission under which the commission rate that we receivevaries inversely with the loss ratio on the ceded premiums, with highercommission rates corresponding to lower loss ratios and vice-versa. The lossratio depends on our estimate of the loss and loss adjustment expense reserveson the ceded business. As a result, the same uncertainties associated withestimating loss and loss adjustment expense reserves affect the estimates ofceding commissions earned. If and to the extent that we have to increase ourreserves on the business that is subject to these reinsurance agreements, wemay have to reduce the ceding commission rate, which would amplify thereduction in our net income in the period in which the increase in our reservesis made.

**TICNY,TRM and TNIC conduct business in a concentrated geographical area. Any singlecatastrophe or other condition affecting losses in this area could adverselyaffect our results of operations.**

TICNY currently writes business in a concentratedgeographic area, primarily in the southern and western portions of New YorkState, and reinsures business produced by TRM in New York and to a lesserextent in New Jersey and Pennsylvania. TNIC currently writes business primarilyin New Jersey, along with Pennsylvania, Massachusetts and New York. As aresult, a single catastrophe occurrence, destructive weather pattern, terroristattack, regulatory development or other condition or general economic trendaffecting the region within which TICNY, TNIC and TRM conduct their businesscould adversely affect our financial condition or results of operations moresignificantly than other insurance companies that conduct business across abroader geographical area. During our history, we have not experienced anysingle event that materially affected our results of operations. The mostsignificant single event was the terrorist attacks of September 11, 2001,as a result of which we suffered $391,000 in net losses.

The incidence and severity of catastrophes areinherently unpredictable and our losses from catastrophes could be substantial.The occurrence of claims from catastrophic events is likely to result insubstantial volatility in our financial condition or results of operations forany fiscal quarter or year and could have a material adverse effect on ourfinancial condition or results of operations and our ability to write newbusiness. Increases in the values and concentrations of insured property mayincrease the severity of such occurrences in the future. Although we attempt tomanage our exposure to such events, including through the use of reinsurance,the frequency or severity of catastrophic events could exceed our estimates. Asa result, the occurrence of one or more catastrophic events could have amaterial adverse effect on our financial condition or results of operations.

**Weare heavily dependent on CastlePointfor underwriting capacity and commissionand fee income.**

We are and will be heavily dependent on CastlePointfor underwriting capacity and commission and fee income through reinsurance andpooling agreements. For the period ended December 31, 2006, CastlePointassumed approximately 38% of our gross premiums written through reinsurance.Effective January 1, 2007, CastlePoint will assume, through a combinationof pooling and reinsurance, approximately 49% of our brokerage businesspremiums. By our mutual agreement with CastlePoint, the terms of our quotashare reinsurance agreements and pooling agreements with CastlePoint have beenextended by an additional year, so that we currently have a four yearcommitment from CastlePoint, subject to certain early termination rights, forCastlePoint to assume from us a substantial portion of our premiums. However,we currently do not have any arrangements in place with CastlePoint to maintainits 

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reinsurance agreements orpooling agreements with us after four years. There is no assurance that thesearrangements will remain in place beyond their current term and we may not beable to readily replace these arrangements if they terminate. If we are unableto continue or replace our current reinsurance arrangements on equallyfavorable terms, our underwriting capacity and commission and fee income woulddecline, we may experience a downgrade in our A.M. Best rating, and ourresults of operations would be adversely affected.

**Ifwe cannot obtain adequate reinsurance protection for the risks we haveunderwritten, we may be exposed to greater losses from these risks or we mayreduce the amount of business we underwrite, which will reduce our revenues.**

Under state insurance law, insurance companies are requiredto maintain a certain level of capital in support of the policies they issue.In addition, rating agencies will reduce an insurance company’s ratings if thecompany’s premiums exceed specified multiples of its capital. As a result, thelevel of TICNY’s and TNIC’s statutory surplus and capital limits the amount ofpremiums that they can write and on which they can retain risk. Historically,we have utilized reinsurance to expand our capacity to write more business thanTICNY’s surplus would have otherwise supported.

From time to time, market conditions have limited, andin some cases have prevented, insurers from obtaining the types and amounts ofreinsurance that they consider adequate for their business needs. For example,beginning in 2001, terms and conditions in the reinsurance market generallybecame less attractive for insurers seeking reinsurance. In addition, recentinvestigations by the New York State Attorney General, the SEC and otherregulatory and government bodies into the use of non-traditional reinsurance bycertain reinsurers have led to the re-examination of applicable accountingstandards, which we believe has led to a reduction in the availability of sometypes of reinsurance. In turn, these developments could produce unfavorable changesin prices, reduced ceding commission revenue or other potentially adversechanges in the terms of reinsurance. Accordingly, we may not be able to obtainour desired amounts of reinsurance. In addition, even if we are able to obtainsuch reinsurance, we may not be able to obtain such reinsurance from entitieswith satisfactory creditworthiness or negotiate terms that we deem appropriateor acceptable.

We have entered into multi-year quota sharereinsurance agreements with CastlePoint and have agreed to enter into poolingagreements with CastlePoint to be effective January 1, 2007, subject toregulatory approvals, which should provide sufficient capacity to write thebusiness that we are currently producing. Because we have made an investment inCastlePoint and our Chairman and Chief Executive Officer, Michael H. Lee,serves as the Chairman and Chief Executive Officer of that company, we havebeen deemed, under the provisions of the New York State Insurance Law andapplicable regulations, to be under common control with CastlePoint and anyU.S. insurance companies that CastlePoint may acquire and we may be deemed tobe under common control under the laws and regulations of other states in whichour or CastlePoint’s insurance subsidiaries are domiciled. As a result, wecannot be bound by any reinsurance agreements or pooling agreements unless 30days advance notice is provided to the New York State Insurance Departmentproposing our intention to enter into such agreements, and the New York StateInsurance Department does not disapprove of these agreements within suchperiod. There can be no assurance that the New York State Insurance Departmentwill approve the terms and conditions of these agreements.

If discussions with respect to reinsurance or poolingagreements and the regulatory approval process do not result in reachingacceptable terms and execution, we will seek reinsurance protection andadditional capacity elsewhere. However, if we cannot obtain adequatereinsurance protection for the risks we have underwritten, we may be exposed togreater losses from these risks, which could have a material adverse effect onour financial condition and results of operation. If we cannot obtain ourdesired amount 

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of reinsurance oradditional capacity to write business through risk sharing or poolingagreements, we may be forced to reduce the amount of business that weunderwrite, which will reduce our revenues.

**Ifwe are able to obtain reinsurance, our reinsurers may not pay losses in atimely fashion, or at all, which may cause a substantial loss and increase ourcosts.**

As of December 31, 2006, we had a net balance duein our favor from our reinsurers of $215.3 million, consisting of $118.0million in reinsurance recoverables, $3.2 million in ceding commissions receivableand $94.1 million in prepaid reinsurance premiums. This amount is $4.9 millionhigher than TICNY’s and TNIC’s statutory capital and surplus at that date.Since October 1, 2003, we have sought to manage our exposure to ourreinsurers by placing our quota share reinsurance on a “funds withheld” basisand requiring any non-admitted reinsurers to collateralize their share ofunearned premium and loss reserves. However, we have substantial recoverablesfrom our pre-October 1, 2003 reinsurance arrangements that areuncollateralized, in that they are not supported by letters of credit, trustaccounts, “funds withheld” arrangements or similar mechanisms intended toprotect us against a reinsurer’s inability or unwillingness to pay. Our netexposure to our reinsurers totaled $40.7 million as of December 31, 2006.Because we remain primarily liable to our policyholders for the payment oftheir claims, in the event that one of our reinsurers under an uncollateralizedtreaty became insolvent or refused to reimburse us for losses paid, or delayedin reimbursing us for losses paid, our cash flow and financial results could bematerially and adversely affected. As of December 31, 2006, our largestbalance due from any one reinsurer was approximately $115.2 million, which wasdue from CastlePoint Reinsurance. However, because our reinsurance withCastlePoint Reinsurance is collateralized by a Regulation 114 compliant trustaccount, our net exposure to CastlePoint Reinsurance on that date was $0. Ourlargest net balance due from any one reinsurer that was not collateralized wasapproximately $17.6 million, which was due from Munich Reinsurance America Inc.(formerly American Re-Insurance Company), which is rated “A” by A.M. Best.

**Our insurancecompany subsidiaries are rated “A-” (Excellent) by A.M. Best, and adecline in this rating or the ratings assigned by other rating agencies couldaffect our standing among brokers, agents and insureds and cause our sales andearnings to decrease.**

Ratings have become an increasingly important factorin establishing the competitive position of insurance companies. A.M. Bestmaintains a letter scale rating system ranging from “A++” (Superior) to “F” (InLiquidation). TICNY was upgraded to “A-” (Excellent) by A.M. Best, whichis the 4th highest of 15 rating levels. In 2005, TNICreceived an “A-” (Excellent) rating from A.M. Best. These ratings aresubject to, among other things, A.M. Best’s evaluation of ourcapitalization and performance on an ongoing basis including our management ofterrorism and natural catastrophe risks, loss reserves and expenses, and thereis no guarantee that TICNY and TNIC will maintain these ratings.

In April 2003, in connection with the issuance ofsubordinated debentures underlying trust preferred securities, TICNY alsoreceived an insurer financial strength rating from Standard & Poor’sRating Services, a division of The McGraw-Hill Companies, Inc. (“Standard &Poor’s”). The most recent rating from Standard & Poor’s is “BBB-” witha stable outlook.

Our ratings are subject to periodic review by, and maybe revised downward or revoked at the sole discretion of A.M. Best orStandard & Poor’s. A decline in a company’s ratings indicating areduced financial strength or other adverse financial developments can causeconcern about the viability of the downgraded insurer among its agents, brokersand policyholders, resulting in a movement of business away from the downgradedcarrier to other stronger or more highly rated carriers. Because many of ouragents and brokers (whom we refer to as “producers”) and policyholders purchaseour policies on the basis of our current ratings, the loss or reduction of anyof our ratings will adversely impact our ability to retain or expand ourpolicyholder base. The objective of the rating agencies’ rating systems is toprovide an opinion of an insurer’s financial strength and ability to meetongoing obligations to its policyholders. Our ratings 

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reflect the ratingagencies’ opinion of our financial strength and are not evaluations directed toinvestors in our common stock, nor are they recommendations to buy, sell orhold our common stock.

**The failure of anyof the loss limitation methods we employ could have a material adverse effecton our financial condition or our results of operations.**

Various provisions of our policies, such aslimitations or exclusions from coverage or choice of forum, which have beennegotiated to limit our risks, may not be enforceable in the manner we intend.At the present time we employ a variety of endorsements to our policies thatlimit exposure to known risks, including but not limited to exclusions relatingto coverage for lead paint poisoning, asbestos and most claims for bodilyinjury or property damage resulting from the release of pollutants.

In addition, the policies we issue contain conditionsrequiring the prompt reporting of claims to us and our right to declinecoverage in the event of a violation of that condition. Our policies alsoinclude limitations restricting the period in which a policyholder may bring abreach of contract or other claim against the company, which in many cases isshorter than the statutory limitations for such claims in the states in whichwe write business. While these exclusions and limitations reduce the lossexposure to us and help eliminate known exposures to certain risks, it ispossible that a court or regulatory authority could nullify or void anexclusion or legislation could be enacted modifying or barring the use of suchendorsements and limitations in a way that would adversely effect our lossexperience, which could have a material adverse effect on our financialcondition or results of operations.

**We may facesubstantial exposure to losses from terrorism and we are currently required bylaw to provide coverage against such losses.**

Our location and concentration of business written inNew York City and adjacent areas by our insurance company subsidiaries mayexpose us to losses from terrorism. U.S. insurers are required by state andFederal law to offer coverage for terrorism in certain commercial lines.

***TerrorismReinsurance.******  ***In2002, in response to the tightening of supply in certain insurance andreinsurance markets resulting from, among other things, the September 11,2001, terrorist attacks, the Terrorism Insurance Act (“TRIA”) was enacted. TRIAis designed to ensure the availability of insurance coverage for foreignterrorist acts in the United States of America. This law established a federalassistance program through the end of 2005 to help the commercial property andcasualty insurance industry cover claims related to future terrorism-relatedlosses and requires such companies to offer coverage for certain acts ofterrorism. As a result, we are prohibited from adding certain terrorismexclusions to the policies written by TICNY and TNIC. Although TICNY and TNICare protected by federally funded terrorism reinsurance as provided for byTRIA, there is a substantial deductible that must be met, the payment of whichcould have an adverse effect on our results of operations.

On December 17, 2005, Congress passed a two-yearextension of TRIA though December 31, 2007 with the passage of theTerrorism Risk Insurance Extension Act (“TRIEA”). Under the terms of TRIEA, theminimum size of the triggering event increased from $5 million to $50 millionfor 2006 and to $100 million in 2007 and Tower’s deductible increased to 17.5%of direct earned premium in 2006 and will increase to 20% in 2007. If theprogram trigger is reached, the federal government will reimburse commercial insurersfor 85% of their insured loses from the certified act of terrorism in excess oftheir statutory deductible. Under TRIEA, federal assistance for insuredterrorism losses has been reduced as compared to the assistance previouslyavailable under TRIA. As a consequence of these changes, potential losses froma terrorist attack could be substantially larger than previously expected. Thefailure to extend TRIEA beyond December 31, 2007 or the extension of TRIEAon terms less favorable to insurers could also adversely affect our ability toobtain reinsurance on favorable terms, including pricing, and may affect ourunderwriting strategy, rating, and other elements of our operation.

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**The effects ofemerging claim and coverage issues on our business are uncertain.**

As industry practices and legal, judicial, social andother environmental conditions change, unexpected and unintended issues relatedto claims and coverage may emerge. These issues may adversely affect ourbusiness by either extending coverage beyond our underwriting intent or byincreasing the number or size of claims. In some instances, these changes maynot become apparent until some time after we have issued insurance or reinsurancecontracts that are affected by the changes. As a result, the full extent ofliability under our insurance or reinsurance contracts may not be known formany years after a contract is issued.

**Since we depend ona core of selected producers for a large portion of our revenues, loss ofbusiness provided by any one of them could adversely affect us.**

Our products are marketed by independent producers.Other insurance companies compete with us for the services and allegiance ofthese producers. These producers may choose to direct business to ourcompetitors, or may direct less desirable risks to us., Approximately 80% ofthe 2006 gross premiums written, including premiums produced by TRM on behalfof its issuing companies, were produced by our top 142 producers, representing17% of our active agents and brokers. These producers have annual writtenpremiums of $500,000 or more. As we build a broader territorial base, thenumber of producers with significant premium volumes with Tower is increasing.In 2005, producers with premium volumes of $500,000 or more numbered 121 andcontributed 77% of gross premiums written.

Our largest producers in 2006 were Morstan GeneralAgency, Northeast Agencies and Davis Agency Inc. As of December 31, 2006,these producers accounted for 11%, 7% and 5%, respectively, of the total of ourgross premiums written. No other producer was responsible for more than 5% ofour gross premiums written.

A significant decrease in business from, or the entireloss of, our largest producer or several of our other large producers wouldcause us to lose premium and require us to seek alternative producers or toincrease submissions from existing producers. In the event we are unable tofind replacement producers or increase business produced by our existingproducers, our premium revenues would decrease and our business and results ofoperations would be materially and adversely affected.

**Our reliance onproducers subjects us to their credit risk.**

With respect to the premiums produced by TRM for itsissuing companies and a limited amount of premium volume written by TICNY andTNIC, producers collect premium from the policyholders and forward them to TRM,TICNY and TNIC. In certain jurisdictions, including New York and New Jersey,when the insured pays premiums for these policies to producers for payment overto TRM, TICNY and TNIC, the premiums might 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 thepremiums from the producer. Consequently, we assume a degree of credit riskassociated with producers. Although producers’ failures to remit premiums to ushave not caused a material adverse impact on us to date, there have beeninstances where producers collected premium but did not remit it to us and wewere nonetheless required under applicable law to provide the coverage setforth in the policy despite the absence of premium. Because the possibility ofthese events is dependent in large part upon the financial condition andinternal operations of our producers, which in most cases are not publicinformation, we are not able to quantify the exposure presented by this risk.If we are unable to collect premiums from our producers in the future, ourfinancial condition and results of operations could be materially and adverselyaffected.

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**We operate in a highlycompetitive environment. If we are unsuccessful in competing against larger ormore well-established rivals, our results of operations and financial conditioncould be adversely affected.**

The property and casualty insurance industry is highlycompetitive and has historically been characterized by periods of significantpricing competition alternating with periods of greater pricing discipline,during which competition focuses on other factors. Beginning in 2000, themarket environment was increasingly favorable as rates increased significantly.During the latter part of 2004 and throughout 2005, increased competition inthe marketplace became evident and, as a result, average rate increases havebecome moderate. The catastrophe losses of 2004 and 2005 produced increasedpricing and reduced capacity for insurance of catastrophe-exposed property.However, a softening of the non-catastrophe-exposed market in 2006 has led tomore aggressive pricing in specific segments of the commercial lines business,particularly in those lines of business and accounts with larger annualpremiums. A.M. Best estimates that the industry wide change in netpremiums written in the property casualty industry was 2.6% in 2006 compared to0.2% in 2005 and is estimated to be 0.1% in 2007. The change in industrypolicyholders’ surplus as estimated by A.M. Best was 5% in 2006 comparedto 9.1% in 2005 and is estimated to be 7.4% in 2007. In addition, in 2005, A.M.Best estimated new capital or capacity of $20 billion was raised by theproperty casualty insurance and reinsurance industry. This additionalunderwriting capacity may result in increased competition from other insurersseeking to expand the types or amount of business they write or cause a shiftin focus by some insurers to maintaining market share at the expense ofunderwriting discipline. We attempt to compete based primarily on productsoffered, service, experience, the strength of our client relationships,reputation, speed of claims payment, perceived financial strength, ratings,scope of business, commissions paid and policy and contract terms andconditions. There are no assurances that in the future we will be able toretain or attract customers at prices which we consider to be adequate.

We compete with major U.S. insurers and certainunderwriting syndicates, including large national companies such as St. PaulTravelers Companies, Inc., Allstate Insurance Company and State Farm Fireand Casualty Company; regional insurers such as OneBeacon Insurance Company,Selective Insurance Company, Harleysville Insurance Company, Hanover Insuranceand Peerless Insurance Company and smaller, more local competitors such asGreater New York Mutual, Magna Carta Companies and Utica First InsuranceCompany. Many of these companies have greater financial, marketing andmanagement resources than we do. Many of these competitors also have moreexperience, better ratings and more market recognition than we do. We seek todistinguish ourselves from our competitors by providing a broad product lineoffering 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 competition in the operation of ourbusiness, we face competition from a variety of sources in attracting andretaining qualified employees. We also face competition because of entitiesthat self-insure, primarily in the commercial insurance market. From time totime, established and potential customers may examine the benefits and risks ofself-insurance and other alternatives to traditional insurance.

**We may experiencedifficulty in expanding our business, which could adversely affect our resultsof operations and financial condition.**

In addition to our recentacquisition of Preserver, we plan to continue to expand our licensing oracquire other insurance companies with multi-state property and casualtylicensing in order to expand our product and service offerings geographically.We also intend to continue to acquire books of business that fit our underwritingcompetencies from competitors, managing agents and other producers and toacquire other insurance companies. This expansion strategy may present specialrisks:

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·       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;

·       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 that we will be successful inexpanding our business or that any new business will be profitable. If we areunable to expand our business or to manage our expansion effectively, ourresults of operations and financial condition could be adversely affected.

**We could beadversely affected by the loss of one or more principal employees or by aninability to attract and retain staff.**

Our success will depend in substantial part upon ourability to attract and retain qualified executive officers, experiencedunderwriting talent and other skilled employees who are knowledgeable about ourbusiness. We rely substantially upon the services of our executive managementteam. If we were to lose the services of members of our key management team,our business could be adversely affected. We believe we have been successful inattracting and retaining key personnel throughout our history. We haveemployment agreements with Michael H. Lee, our Chairman of the Board, Presidentand Chief Executive Officer, and four other members of our senior managementteam. We do not currently maintain key man life insurance policies with respectto our employees except for Michael H. Lee.

**Our businessrelationship with CastlePoint and its affiliates may present, and make usvulnerable to, difficult conflicts of interest, related party transactions, businessopportunity issues and legal challenges.**

As noted elsewhere, we have invested in CastlePoint,which we organized and sponsored with an initial investment of $15.0 million onFebruary 6, 2006 and in which we currently own an 8.6% interest (togetherwith warrants to acquire an additional 3.7% interest). In addition, Michael H.Lee, our Chairman of the Board and Chief Executive Officer, holds the samepositions at CastlePoint and, as such, will not serve our company on afull-time basis. Furthermore, some former members of our executive managementhave resigned their positions with us and become executive managers ofCastlePoint. Conflicts of interest could arise with respect to businessopportunities that could be advantageous to CastlePoint or its subsidiaries, onthe one hand, and us or any of our subsidiaries, on the other hand.

Because Mr. Lee holds leadership positions atboth Tower and CastlePoint, potential conflicts of interest may arise. While webelieve that our interests and CastlePoint do not currently conflict, they maydiverge as CastlePoint develops additional business.

Mr. Lee’s service as Chairman of the Board andChief Executive Officer of both CastlePoint and Tower could also raise apotential challenge under anti-trust laws. Section 8 of the ClaytonAntitrust Act, or the Clayton Act, prohibits a person from serving as adirector or officer in any two competing corporations under certaincircumstances. If CastlePoint and Tower are in the future deemed to becompetitors within the meaning of the Clayton Act, certain thresholds relatingto direct competition between Tower and CastlePoint are met, and the Departmentof Justice and Federal Trade Commission challenge the arrangement, Mr. Leemay be required to resign his positions with one of the companies, and/or finesor other penalties could be assessed against Mr. Lee and us. To alleviateany potential for direct competition with CastlePoint, arrangements between usprovide for a division of responsibilities. 

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However, it is possiblethat the potential for direct competition with respect to certain classes ofbusiness may exist with respect to the business we and CastlePoint may pursue.

**Our investmentperformance may suffer as a result of adverse capital market developments orother factors, which may affect our financial results and ability to conductbusiness.**

We invest the premium we receive from policyholdersuntil it is needed to pay policyholder claims or other expenses. At December 31,2006, our invested assets consisted of $414.6 million in fixed maturitysecurities, $49.5 million in equity securities at fair value. Additionally, weheld $100.6 million in cash and cash equivalents. As of December 31, 2006,we earned $23.0 million of net investment income representing 7.7% of our totalrevenues and 40.8% of our pre-tax income. Our funds are invested by aprofessional investment advisory management firm under the direction of ourmanagement team in accordance with detailed investment guidelines set by us.Although our investment policies stress diversification of risks, conservationof principal and liquidity, our investments are subject to a variety ofinvestment risks, including risks relating to general economic conditions,market volatility, interest rate fluctuations, liquidity risk and credit anddefault risk. (Interest rate risk is discussed below under the heading, “—Wemay be adversely affected by interest rate changes.”) In particular, thevolatility of our claims may force us to liquidate securities, which may causeus to incur capital losses. If we do not structure our investment portfolio sothat it is appropriately matched with our insurance and reinsuranceliabilities, we may be forced to liquidate investments prior to maturity at asignificant loss to cover such liabilities. Investment losses couldsignificantly decrease our asset base and statutory surplus, thereby affectingour ability to conduct business.

**We may be adverselyaffected by interest rate changes.**

Our operating results are affected, in part, by theperformance of our investment portfolio. Our investment portfolio containsinterest rate sensitive instruments, such as bonds, which may be adverselyaffected by changes in interest rates. A significant increase in interest ratescould have a material adverse effect on our financial condition or results ofoperations. Generally, bond prices decrease as interest rates rise. Changes ininterest rates could also have an adverse effect on our investment income andresults of operations. For example, if interest rates decline, investment ofnew premiums received and funds reinvested will earn less than expected.

In addition, our investment portfolio includesmortgage-backed securities. As of December 31, 2006, mortgage-backedsecurities constituted approximately 27.8% of our invested assets. As withother fixed income investments, the fair market value of these securitiesfluctuates depending on market and other general economic conditions and theinterest rate environment. Changes in interest rates can expose us toprepayment 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 highly sensitive to many factors,including governmental monetary policies, domestic and international economicand political conditions and other factors beyond our control.

**We may requireadditional capital in the future, which may not be available or may only beavailable on unfavorable terms.**

Our future capital requirements depend on manyfactors, including our ability to write new business successfully and toestablish premium rates and reserves at levels sufficient to cover losses. Tothe extent that our present capital is insufficient to meet future operatingrequirements and/or cover losses, we may 

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need to raise additionalfunds through financings or curtail our growth. Based on our current operatingplan, we believe our current capital together with the proceeds of thisoffering, our proposed concurrent issuance of trust preferred securities andour anticipated retained earnings, will support our operations without the needto raise additional capital. However, we cannot provide any assurance in thatregard, since many factors will affect our capital needs and their amount andtiming, 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 regulatorysystem under which we operate, and potential changes thereto, could have amaterial adverse effect on our business.**

TICNY and TNIC aresubject to comprehensive regulation and supervision in their respective statesof domicile. The purpose of the insurance laws and regulations are to protectinsureds, not our stockholders. These regulations are generally administered bythe insurance departments in which the individual insurance companies aredomiciled and relate to, among other things:

·       standardsof solvency, including risk based capital measurements;

·       restrictionson the nature, quality and concentration of investments;

·       requiredmethods of accounting;

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

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

·       transactionswith affiliates.

Significant changes in these laws and regulationscould make it more expensive to conduct our business. The New York InsuranceDepartment for TICNY and the Massachusetts Division of Insurance for TNIC alsoconduct periodic examinations of the affairs of their domiciled insurancecompanies and require the filing of annual and other reports relating tofinancial condition, holding company issues and other matters. These regulatoryrequirements may adversely affect or inhibit our ability to achieve some or allof 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.

Because we have been deemed an affiliate ofCastlePoint by the New York Insurance Department, any material transaction oragreement between our insurance subsidiaries and CastlePoint may be subject toregulatory review and resulting modification to address any concerns thatregulators may raise. If we do 

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not obtain the approvals ofthese regulatory authorities, or if our agreements are subject to substantialmodifications, we may not be able to fully implement our business strategy,which would have an adverse impact on our financial condition and results ofoperations.

In recent years, the U.S. insurance regulatoryframework has come under increased Federal scrutiny, and some state legislatorshave considered or enacted laws that may alter or increase state regulation ofinsurance and reinsurance companies and holding companies. Moreover, theNational Association of Insurance Commissioners (“NAIC”), which is anassociation of the insurance commissioners of all 50 states and the District ofColumbia, and state insurance regulators regularly re-examine existing laws andregulations, often focusing on modifications to holding company regulations,interpretations of existing laws and the development of new laws. Changes inthese laws and regulations or the interpretation of these laws and regulationscould have a material adverse effect on our financial condition or results ofoperations. The highly publicized investigations of the insurance industry bythe New York State Attorney General and other regulators and governmentofficials have led to, and may continue to lead to, additional legislative andregulatory requirements for the insurance industry and may increase the costsof doing business.

The activities of TRM are subject to licensingrequirements and regulation under the laws of New York, New Jersey and otherstates where it does business. TRM’s business depends on the validity of, andcontinued good standing under, the licenses and approvals pursuant to which itoperates, as well as compliance with pertinent regulations.

Licensing laws and regulations vary from jurisdictionto jurisdiction. In all jurisdictions, the applicable licensing laws andregulations are subject to amendment or interpretation by regulatoryauthorities. Generally such authorities are vested with relatively broad andgeneral discretion as to the granting, renewing and revoking of licenses andapprovals. Licenses may be denied or revoked for various reasons, including theviolation of such regulations, conviction of crimes and the like. Possiblesanctions which may be imposed include the suspension of individual employees,limitations on engaging in a particular business for specified periods of time,revocation of licenses, censures, redress to clients and fines. In someinstances, TRM follows practices based on its or its counsel’s interpretationsof laws and regulations, or those generally followed by the industry, which mayprove to be different from those of regulatory authorities.

**If the assessmentswe are required to pay are increased drastically our results of operations andfinancial condition will suffer.**

TICNY and TNIC are subject to assessments in New Yorkfor various purposes, including the provision of funds necessary to fund theoperations of the New York Insurance Department and the New York Security Fund,which pays covered claims under certain policies provided by impaired,insolvent or failed insurance companies. In 2006, the assessment for the NewYork Insurance Department was $1,470,000 and the New York Security Fundassessment was $2,042,000. These assessments are generally set based on an insurer’spercentage of the total premiums written in New York State within a particularline of business. The Company is permitted to assess premium surcharges onworkers’ compensation policies that are based on statutorily enacted rates.However, assessments by the various workers’ compensation funds have recentlyexceeded the permitted surcharges resulting in a (reduction) additionalexpenses of $(127,000), $0 and $1,143,000 in 2006, 2005 and 2004, respectively.As of December 31, 2006 the liability for the various workers’compensation funds, which includes amounts assessed on workers’ compensationpolicies, was $4,463,000. This amount is expected to be paid over an eighteenmonth period ending June 30, 2008. 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.

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**Our ability to meetongoing cash requirements and pay dividends may be limited by our holdingcompany structure and regulatory constraints.**

Tower is a holding company and, as such, has no directoperations of its own. Tower does not expect to have any significant operationsor assets other than its ownership of the shares of its operating subsidiaries.Dividends and other permitted payments from our operating subsidiaries areexpected to be our primary source of funds to meet ongoing cash requirements,including any future debt service payments and other expenses, and to paydividends, if any, to our stockholders. TICNY is subject to significantregulatory restrictions limiting its ability to declare and pay dividends. Asof December 31, 2006, the maximum amount of distributions that TICNY couldpay to Tower without approval of the New York Insurance Department was $10.5million. The inability of TICNY to pay dividends and other permitted paymentsin an amount sufficient to enable us to meet our cash requirements at theholding company level would have a material adverse effect on our operationsand our ability to pay dividends to our stockholders. As of December 31,2006, the maximum amount of distributions that TNIC could pay to its parentwithout approval of the Massachusetts Division of Insurance was approximately$89,000. Accordingly, if you require dividend income you should carefullyconsider these risks before making an investment in our company.

**Although we havepaid cash dividends in the past, we may 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 2007. However, future cashdividends will depend upon our results of operations, financial condition, cashrequirements and other factors, including the ability of our subsidiaries tomake distributions to us, which ability is restricted in the manner previouslydiscussed in this section. Also, there can be no assurance that we willcontinue to pay dividends even if the necessary financial conditions are metand if sufficient cash is available for distribution.

**Risks Related toour Acquisition of Preserver Group, Inc.**

**We must obtainseveral governmental consents to complete the acquisition, which, if delayed,not granted or granted with unacceptable conditions may jeopardize or delay theacquisition, result in additional expense or reduce the anticipated benefits ofthe transaction.**

We must obtain specified approvals and consents in atimely manner from state governmental authorities prior to the completion ofthe acquisition of Preserver. State insurance laws generally require that,prior to the acquisition of an insurance company, the acquiring party mustobtain approval from the insurance commissioner of the insurance company’sstate of domicile or, in certain cases, the state where such insurance companyis commercially domiciled. If we do not receive these approvals on terms thatsatisfy the purchase agreement, then we will not be obligated to complete theacquisition. The governmental authorities from which we seek approvals havebroad discretion in administering relevant laws and regulations. As a conditionto the approval of the acquisition, governmental authorities may imposerequirements, limitations or costs that could negatively affect the way thecombined companies conduct business. We are not obligated to complete theacquisition if a governmental authority, in connection with the grant of itsapproval or consent, imposes a condition or restriction which could reasonablybe expected to have a material adverse effect on the business, assets,liabilities, financial condition or results of operations of us or Preserver.If we agree to any material conditions or restrictions in order to obtain anyapprovals required to complete the acquisition, these conditions orrestrictions could adversely affect our ability to integrate the business ofTower and Preserver or reduce the anticipated benefits of the acquisition.

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**Whether or not theacquisition is completed, the announcement and pendency of the acquisitioncould cause disruptions in the businesses of Tower and Preserver, which couldhave an adverse effect on their business and financial results**

Whether or not the acquisition is completed, theannouncement and pendency of the acquisition could cause disruptions in thebusinesses of Tower and Preserver. Specifically:

·       currentand prospective employees and agents may experience uncertainty about theirfuture roles with Tower, which might adversely affect Tower’s ability to retainkey managers and other employees and agents; and

·       theattention of management of each of Tower and Preserver may be directed towardthe completion of the acquisition and not their ongoing businesses.

**The acquisition issubject to certain closing conditions that, if not satisfied or waived, willresult in the acquisition not being completed, which may cause the market priceof Tower common stock to decline.**

The acquisition is subject to customary conditions toclosing. If any condition to the acquisition is not satisfied or waived, theacquisition will not be completed. In addition, we and the current owners ofPreserver may terminate the purchase agreement under certain circumstances. Ifwe and Preserver do not complete the acquisition, the market price of ourcommon stock may fluctuate to the extent that the current market prices ofthose shares reflect a market assumption that the acquisition will becompleted. Further, whether or not the acquisition is completed, we will alsobe obligated to pay certain financing, legal and accounting fees and relatedexpenses in connection with the acquisition, which could negatively impactresults of operations when incurred. In addition, we would not realize any ofthe expected benefits of having completed the acquisition. If the acquisitionis not completed, we cannot assure our stockholders that additional risks willnot materialize or not materially adversely affect its business, financialresults, financial condition and stock prices.

**We may experiencedifficulties in integrating our business with the business of Preserver, whichcould cause us to fail to realize many of the anticipated potential benefits ofthe acquisition.**

We have entered into the purchase agreement withPreserver because we believe that the acquisition will be beneficial to us andour stockholders. Achieving the anticipated benefits of the acquisition willdepend in part upon whether we are able to integrate our businesses in anefficient and effective manner. We may not be able to accomplish thisintegration process smoothly or successfully. The necessity of coordinatinggeographically separated organizations and addressing possible differences incorporate cultures and management philosophies may increase the difficulties ofintegration. The integration of certain operations following the merger mayrequire the dedication of significant management resources, which maytemporarily distract management’s attention from the day-to-day business of thecombined company. Employee uncertainty and lack of focus during the integrationprocess may also disrupt our business. Any inability of our management tointegrate successfully the operations of Tower and Preserver could have amaterial adverse effect on our business and results of operations. An inabilityto realize the full extent of, or any of, the anticipated benefits of theacquisition, as well as any delays encountered in the transition process, couldhave an adverse effect upon our revenues, level of expenses and operatingresults, which may affect the value of our common stock.

After the acquisition, wemay seek to combine certain operations and functions using common informationand communication systems, operating procedures, financial controls and humanresource practices, including training, professional development and benefitprograms. We may be unsuccessful or delayed in implementing the integration ofthese systems and processes.

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**Risks Related toOur Industry**

**The threat ofterrorism and military and other actions may adversely affect our investmentportfolio and may result in decreases in our net income, revenue and assetsunder management.**

The threat of terrorism, both within the United Statesand abroad, and military and other actions and heightened security measures inresponse to these types of threats, may cause significant volatility anddeclines in the equity markets in the United States, Europe and elsewhere, aswell as loss of life, property damage, additional disruptions to commerce andreduced economic activity. Some of the assets in our investment portfolio maybe adversely affected by declines in the equity markets and economic activitycaused by the continued threat of terrorism, ongoing military and other actionsand 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 of operationsand revenues may fluctuate as a result of many factors, including cyclicalchanges in the insurance industry, which may cause the price of our securitiesto be volatile.**

The results of operations of companies in the propertyand casualty insurance industry historically have been. subject to significantfluctuations and uncertainties. Our profitability can be affected significantlyby:

·       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 reinsuranceindustry. As a result, the insurance business historically has been a cyclicalindustry characterized by periods of intense price competition due to excessiveunderwriting capacity alternating with periods when shortages of capacitypermitted favorable premium levels. Premium levels for many products haveincreased in recent years and significant amounts of new capital have flowedinto the insurance and reinsurance sectors. These factors could lead to asignificant reduction in premium rates, less favorable policy terms and fewersubmissions for our underwriting services. In addition to these considerations,changes in the frequency and severity of losses suffered by insureds andinsurers may affect the cycles of the insurance business significantly, and weexpect to experience the effects of such cyclicality. 

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Thiscyclicality could have a material adverse effect on our results of operationsand revenues, which may cause the price of our securities to be volatile.

**Item 1B.**               UnresolvedStaff Comments

The Company has nounresolved staff comment as of December 31, 2006.

**Item 2.**                        PROPERTIES

We lease approximately 118,500 square feet of space at120 Broadway, New York, New York, which consists of 30th and 31st floors and part ofthe 29th floor. The lease commencement date is January 1,2006 and will end on December 31, 2021. See Note 14—“Commitments andContingencies” in the notes to our audited consolidated financial statementsincluded elsewhere in this report.

We also lease office spacein Melville, New York, Buffalo, New York and Quincy, Massachusetts.

**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 treatment or improper termination. There are no suits of a materialnature 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 2006.

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

**Shareholders**

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

In December 2006, we issued 40,000 shares of aperpetual preferred stock for $40.0 million less $0.4 million of issuance costs.On January 26, 2007 the perpetual preferred stock was redeemed in full.

As of March 5, 2007,there were 23,101,108 common shares issued and outstanding that were held by121 shareholders of record.

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**Price Range ofCommon Stock**

Thehigh and low sales prices for quarterly periods from January 1, 2005through December 31, 2006 as reported by the Nasdaq were as follows:

| ** **     | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $        | 24.46      |     | $          | 16.80 |   | $ | 14.27 |   | $ | 10.56 |   |
| Second Quarter |       | $        | 32.00      |     | $          | 22.50 |   | $ | 15.75 |   | $ | 10.05 |   |
| Third Quarter  |       | $        | 34.47      |     | $          | 25.87 |   | $ | 17.14 |   | $ | 13.75 |   |
| Fourth Quarter |       | $        | 36.49      |     | $          | 29.18 |   | $ | 23.45 |   | $ | 14.30 |   |

 

**Dividend Policy**

Our Board of Directors has historically declared thepayment of quarterly dividends 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 regulatoryrestrictions limiting their ability to declare and pay dividends. See “Item 1.—Regulation”and “Item 7.—Management’s Discussion and Analysis of Financial Condition andResults of Operations.”

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.

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

| ** **                          | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------|------------|----------|------------|----------|------------|
| Common stock  dividends declared    |       | $        | 1,976      |     | $          | 1,959 |   |
| Preferred stock  dividends declared |       | 212      |       | —   |       |
| Total dividends declared            |       | $        | 2,188      |     | $          | 1,959 |   |

 

TheCompany declared dividends per share on common stock as follows:

| ** **   | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------|------------|----------|------------|----------|------------|
| Common Stock |       | $        | 0.10       |     | $          | 0.10 |   |
|              |            |          |            |          |            |  |  |

 

Perpetual preferred stock was issued inDecember 2006 that is not cumulative and not mandatorily redeemable, andits dividends are recorded as a reduction to stockholders’ equity. Theperpetual preferred stock dividend for 2006 was $212,000. The perpetualpreferred stock was redeemed in full on January 26, 2007.

 

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**Item 6.**                        SELECTEDCONSOLIDATED FINANCIAL INFORMATION

The selectedconsolidated income statement data for the years ended December 31, 2006,2005 and 2004 and the balance sheet data as of December 31, 2006 and 2005are derived from our audited financial statements included elsewhere in thisdocument, which have been prepared in accordance with GAAP and have beenaudited by Johnson Lambert & Co., our independent registered publicaccounting firm. You should read the following selected consolidated financialinformation along with the information contained in this document, including “Item7.—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,**                                     | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| ** **                                                      | ** ** | **2006**                                                                                         | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                      | ** ** | **($ in thousands, except share and per share amounts)** | ** ** |
| **Income Statement Data**                                       |       |                                                                                             |       |   |   |   |   |   |   |   |   |
| Gross premiums  written                                         |       | $                                                                                                | 432,663    |   | $ | 300,107 |   | $ | 177,766 |   | $ | 134,482 |   | $ | 106,740 |   |
| Ceded premiums  written                                         |       | 187,593                                                                                          |       | 88,325 |   | 79,691 |   | 105,532 |   | 79,411 |   |
| Net premiums  written                                           |       | $                                                                                                | 245,070    |   | $ | 211,782 |   | $ | 98,075 |   | $ | 28,950 |   | $ | 27,329 |   |
| Net premiums  earned                                            |       | $                                                                                                | 223,988    |   | $ | 164,436 |   | $ | 45,564 |   | $ | 22,941 |   | $ | 26,008 |   |
| Ceding commission  revenue                                      |       | 43,130                                                                                           |       | 25,218 |   | 39,983 |   | 35,605 |   | 21,872 |   |
| Insurance services  revenue                                     |       | 7,973                                                                                            |       | 14,103 |   | 16,381 |   | 12,830 |   | 12,428 |   |
| Net investment  income                                          |       | 23,026                                                                                           |       | 14,983 |   | 5,070 |   | 2,268 |   | 1,933 |   |
| Net realized gains  (loss) on investments                       |       | 12                                                                                               |       | 122 |   | 13 |   | 493 |   | 95 |   |
| Policy billing  fees                                            |       | 1,134                                                                                            |       | 892 |   | 679 |   | 545 |   | 376 |   |
| Total revenues                                                  |       | 299,263                                                                                          |       | 219,754 |   | 107,690 |   | 74,682 |   | 62,712 |   |
| Losses and loss  adjustment expenses                            |       | 135,125                                                                                          |       | 96,614 |   | 27,060 |   | 15,071 |   | 16,356 |   |
| Operating expenses:                                             |       |                                                                                             |       |   |   |   |   |   |   |   |   |
| Direct and ceding  commission expenses                          |       | 60,558                                                                                           |       | 43,839 |   | 32,825 |   | 26,158 |   | 19,187 |   |
| Other operating  expenses(1)                                    |       | 53,675                                                                                           |       | 42,632 |   | 29,954 |   | 22,337 |   | 17,279 |   |
| Interest expense                                                |       | 6,870                                                                                            |       | 4,853 |   | 3,128 |   | 1,462 |   | 122 |   |
| Total expenses                                                  |       | 256,228                                                                                          |       | 187,938 |   | 92,967 |   | 65,028 |   | 52,944 |   |
| Other Income                                                    |       |                                                                                             |       |   |   |   |   |   |   |   |   |
| Equity in  unconsolidated affiliate                             |       | 914                                                                                              |       | — |   | — |   | — |   | — |   |
| Gain from issuance  of common stock by unconsolidated affiliate |       | 7,883                                                                                            |       | — |   | — |   | — |   | — |   |
| Warrant received  from unconsolidated affiliate                 |       | 4,605                                                                                            |       | — |   | — |   | — |   | — |   |
| Income (loss)  before income taxes                              |       | 56,437                                                                                           |       | 31,816 |   | 14,723 |   | 9,654 |   | 9,768 |   |
| Income tax expense  (benefit)                                   |       | 19,673                                                                                           |       | 11,062 |   | 5,694 |   | 3,374 |   | 4,135 |   |
| Net income (loss)                                               |       | $                                                                                                | 36,764     |   | $ | 20,754 |   | $ | 9,029 |   | $ | 6,280 |   | $ | 5,633 |   |
| Net income (loss)  available to common stockholders             |       | $                                                                                                | 36,553     |   | $ | 20,754 |   | $ | 9,029 |   | $ | 6,122 |   | $ | 5,318 |   |
| **Per Share Data**                                              |       |                                                                                             |       |   |   |   |   |   |   |   |   |
| Basic earnings  (loss) per share                                |       | $                                                                                                | 1.85       |   | $ | 1.06 |   | $ | 1.23 |   | $ | 1.37 |   | $ | 1.18 |   |
| Diluted earnings  (loss) per share                              |       | $                                                                                                | 1.82       |   | $ | 1.03 |   | $ | 1.06 |   | $ | 1.09 |   | $ | 0.94 |   |
| Basic weighted  average outstanding                             |       | 19,750,309                                                                                       |       | 19,571,081 |   | 7,335,286 |   | 4,453,717 |   | 4,500,000 |   |
| Diluted weighted  average per shares outstanding                |       | 20,147,318                                                                                       |       | 20,147,073 |   | 8,565,815 |   | 5,708,016 |   | 5,761,949 |   |
| **Selected Insurance Ratios**                                   |       |                                                                                             |       |   |   |   |   |   |   |   |   |
| Gross loss  ratio(2)                                            |       | 55.0                                                                                             | %          | 56.8 | % | 55.2 | % | 60.8 | % | 63.8 | % |
| Gross underwriting  expense ratio(3)                            |       | 28.7                                                                                             | %          | 30.8 | % | 31.1 | % | 30.0 | % | 31.0 | % |
| Gross combined  ratio(4)                                        |       | 83.7                                                                                             | %          | 87.6 | % | 86.3 | % | 90.8 | % | 94.8 | % |
| Net loss ratio(5)                                               |       | 60.3                                                                                             | %          | 58.8 | % | 59.4 | % | 65.7 | % | 62.9 | % |
| Net underwriting  expense ratio(6)                              |       | 27.3                                                                                             | %          | 29.3 | % | 16.2 | % | 4.4 | % | 18.5 | % |
| Net combined  ratio(7)                                          |       | 87.6                                                                                             | %          | 88.1 | % | 75.6 | % | 70.1 | % | 81.4 | % |

 

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| ** **                                      | ** ** | **As of December 31,**                                                            | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                                                                         | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                      | ** ** | **($ in thousands, except share and per share amounts)** | ** ** |
| **Summary  Balance Sheet Data**                 |       |                                                                                             |       |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                       |       | $                                                                                                | 100,598    |   | $ | 38,760 |   | $ | 55,201 |   | $ | 30,339 |   | $ | 3,399 |   |
| Investments at fair market value                |       | 464,020                                                                                          |       | 357,173 |   | 228,434 |   | 57,349 |   | 39,618 |   |
| Reinsurance recoverable                         |       | 118,003                                                                                          |       | 104,811 |   | 101,173 |   | 84,760 |   | 55,110 |   |
| Deferred acquisition costs, net                 |       | 35,811                                                                                           |       | 29,192 |   | 18,740 |   | 573 |   | — |   |
| Total assets                                    |       | 954,082                                                                                          |       | 657,457 |   | 494,147 |   | 286,592 |   | 186,116 |   |
| Reserve for losses and loss adjustment expenses |       | 302,541                                                                                          |       | 198,724 |   | 128,722 |   | 99,475 |   | 65,688 |   |
| Unearned premium                                |       | 227,017                                                                                          |       | 157,779 |   | 95,505 |   | 70,248 |   | 57,012 |   |
| Long-term debt and redeemable preferred stock   |       | 68,045                                                                                           |       | 47,426 |   | 47,426 |   | 29,208 |   | 3,000 |   |
| Deferred ceding commission revenue, net         |       | —                                                                                           |       | — |   | — |   | — |   | 3,494 |   |
| Total stockholders’ equity                 |       | 223,920                                                                                          |       | 144,822 |   | 129,447 |   | 13,061 |   | 9,067 |   |
| **Per Share Data:**                             |       |                                                                                             |       |   |   |   |   |   |   |   |   |
| Book value per share(8)                         |       | $                                                                                                | 9.23       |   | $ | 7.29 |   | $ | 6.56 |   | $ | 2.96 |   | $ | 2.01 |   |
| Diluted book value per share(9)                 |       | $                                                                                                | 9.07       |   | $ | 7.16 |   | $ | 6.45 |   | $ | 2.38 |   | $ | 1.62 |   |
| Dividends declared  per share                   |       |                                                                                             |       |   |   |   |   |   |   |   |   |
| Common Stock                                    |       | $                                                                                                | 0.10       |   | $ | 0.10 |   | $ | 0.0250 |   | $ | — |   | $ | 0.1048 |   |
| 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 commonstockholders’ equity divided by common shares outstanding at year end.

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

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

The following discussion and analysis of our financialcondition and results of operations should be read in conjunction with ourconsolidated financial statements and accompanying notes which appear elsewherein this Form 10-K. It contains forward-looking statements thatinvolve 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.—RiskFactors” 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, claims andother administration and reinsurance intermediary services through TRM, ourinsurance services subsidiary. We manage these operations through threebusiness segments: insurance (commercial and personal lines underwriting),reinsurance, and insurance services (managing general agency, claims and otheradministration and reinsurance intermediary operations).

In our insurance segment,TICNY and TNIC provide commercial and personal lines insurance policies tobusinesses and individuals. TICNY and TNIC’s commercial lines products includecommercial multiple-peril (provides both property and liability insurance),monoline general liability (insures bodily injury or property damageliability), commercial umbrella, monoline property (insures buildings, contentsor business income), workers’ compensation and commercial automobile policies. Itspersonal lines products consist of homeowners, dwelling and other liabilitypolicies. In our reinsurance segment, TICNY assumes reinsurance directly fromthe insurance companies for which TRM produces insurance premiums (which werefer to as TRM’s “issuing companies”) or indirectly from reinsurers thatprovide reinsurance coverage directly to these issuing companies. In ourinsurance services segment, TRM generates commission income from its managinggeneral agency by producing premiums on behalf of its issuing companies andgenerates fees by providing claims administration and reinsurance intermediaryservices. The insurance services segment also generates other administrationrevenue from services provided to CastlePoint Reinsurance and will earnmanagement fees in 2007   from poolingbusiness with CastlePoint. See “Item 1.—Reinsurance—CastlePoint Reinsurance andPooling” and “Item 1.—Strategic Relationship and Agreements with CastlePoint.”

**Purchase of ShellCompanies**

On March 25, 2005, we closed on our purchase ofthe outstanding common stock of a shell insurance Company, North AmericanLumber Insurance Company (“NALIC”), that was renamed Tower National InsuranceCompany (“TNIC”). The purchase price was $1,050,000 and included nine activestate licenses and two inactive state licenses. The nine active states licenseswere for New Jersey, Connecticut, Massachusetts, Rhode Island, Vermont,Maryland, Delaware, South Carolina and Wisconsin. The two inactive states werePennsylvania and Maine. The inactive state licenses have an additionalcontingent purchase price of $75,000 per state payable upon licensereactivation within one year of the closing. These licenses were activated in2005. Prior to the closing, all liabilities and assets (other than insurancelicenses) of TNIC 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.  The total amount capitalized as of December 31,2005, was $1,303,000 and included the purchase price, legal fees and a broker’sfee. As of December 31, 2006, TNIC was authorized to write business intwenty-five states.

On June 28, 2006, weclosed on our purchase of 100% of the outstanding common stock of a shellinsurance company, MIIX Insurance Company of New York, which was renamed TowerIndemnity 

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Companyof America (“TICA”). We acquired TICA for the value of its statutory surplus atclosing plus $225,000. In October 2006, we entered into an agreement tosell all of the issued and outstanding capital stock of TICA to CastlePoint fora cash purchase price of $350,000 plus an amount equal to the value of thestatutory surplus of TICA at closing. The $125,000 difference in the pricereflects the legal and brokerage fees paid by us in connection with ouracquisition of the company. Following the closing of the TICA transaction whichoccurred on December 4, 2006, CastlePoint intended to rename TICA “CastlePointInsurance Company.”  We have agreed toenter into various pooling agreements with CastlePoint Insurance Company, whichwill be effective January 1, 2007 pending regulatory approval from theState of New York Insurance Department

**Commutation andNovation with PXRE Reinsurance Company**

On June 29, 2006, toeliminate our exposure to uncollateralized reinsurance recoverables from PXREReinsurance Company (“PXRE”), which had requested the withdrawal of itsfinancial strength and issuer rating from A.M. Best, we concluded, throughcommutation agreements, PXRE’s participation under various reinsuranceagreements with TICNY covering the 2001, 2002 and a portion of the 2003 policyperiods. Ceded loss and loss adjustment expense recoverables of $20.5 million,ceded paid losses of $2.4 million and ceding commissions receivable of $8.7million, totaling $31.6 million of unsecured recoverables were settled with apayment from PXRE of $26.7 million, which represents an estimate of the presentvalue of these recoverables. This resulted in a $4.8 million pre-tax charge, ofwhich $1.6 million was recognized in loss and loss adjustment expenses and $3.2million was recognized as a reduction to ceding commission income in the secondquarter of 2006. In addition, on the same date, novation agreements wereexecuted with PXRE relating to other reinsurance agreements covering businesswritten in 2001, 2002 and 2003 by other insurance companies and managed ontheir behalf by TRM, our risk management subsidiary. As a result of thenovation, TICNY assumed loss reserves of $12.2 million for which it received asconsideration $11.4 million in cash and other assets and TRM recorded areduction in commission liabilities for $0.2 million, the total of whichresulted in a $0.6 million pre-tax charge. As a result of the commutation andnovation agreements, which are effective as of June 29, 2006, PXRE isdischarged from future obligations under the reinsurance agreements. There areno other agreements outstanding with PXRE.

**Transactions WithCastlePoint**

We have invested in CastlePoint, an unconsolidatedBermuda holding company, which we organized and sponsored with an initialinvestment of $15.0 million on February 6, 2006. We consolidated theactivities of CastlePoint as a wholly owned subsidiary during the first quarterof 2006 and recognized approximately $0.5 million of non-recurring start-upcosts. On April 4, 2006, CastlePoint raised $249.9 million, net ofexpenses, in a private placement offering of unissued shares, which reduced ourinvestment ownership from 100% to 8.6%. The book value per share of our2,555,000 shares of CastlePoint common stock increased from $5.87 per share to$8.96 per share as a result of this offering. The carrying value of ourinvestment in CastlePoint increased from $15.0 million to $22.9 million. Wehave recorded this gain of $7.9 million in income before taxes in accordancewith the SEC’s Staff Accounting Bulletin (“SAB”) No. 51—“Accounting forSales of Stock by a Subsidiary” in the twelve months ended December 31,2006.

On April 6, 2006, we received a warrant fromCastlePoint to purchase an additional 3.7% or 1,127,000 shares of common stockwith a fair value of approximately $4.6 million using a Black-Scholes optionpricing model. The warrant is exercisable in whole or in part at any time up toApril 6, 2016, and the exercise price is $10 per share. Shares acquiredthrough the exercise of the warrant may not be sold prior to April 9,2009. The warrant was received in exchange for sponsorship services, whichincluded management, operational and industry expertise to establish theCastlePoint organization and prepare for a private placement offering. Accordingly,we recognized $4.6 million in income before taxes in the twelve 

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months ending December 31,2006 relating to non-recurring sponsorship services. The warrant has beenrecorded as an equity instrument at cost, which was determined to be the fairvalue of the warrant on the date it was received and will be subject toimpairment testing.

We have determined that our ownership in CastlePointqualifies as a variable interest entity (“VIE”) under the provisions of FIN 46-(R).We determined that our investment in CastlePoint does not meet the requirementsfor consolidation because we are not the primary beneficiary of the VIE asdefined in FIN 46-(R). However, we have recorded our 8.6% investment inCastlePoint using the equity method of accounting as we exercise significantinfluence over CastlePoint. We have the same CEO as CastlePoint. Through ourtwo insurance subsidiaries, TICNY and TNIC, we entered into three, multi-yearquota share reinsurance agreements with CastlePoint Reinsurance, which wereeffective April 4, 2006, and a service and expense sharing agreementwhereby our staff provides CastlePoint administrative and underwriting servicesat cost. In connection with the sale of perpetual preferred stock toCastlePoint in December 2006, the brokerage insurance business quota shareagreement with CastlePoint was extended for an additional year beyond theoriginal three year term. Through our strategic relationship with CastlePoint in 2006, wehave reduced the risk of relying on other reinsurance and issuing companies andwill be able to maintain and strengthen our business model as well as pursueour growth plans. Through reinsurance and pooling, we plan to transferapproximately 49% of our total premiums written and produced to CastlePoint’sreinsurance and insurance company subsidiaries in order to generate commissionand fee income. We will continue to maintain the operational infrastructurethat will market, originate, underwrite and service the total premiums writtenand produced.

CastlePoint Reinsurance entered into three multi-yearquota share reinsurance agreements with our insurance subsidiaries that cede toCastlePoint Reinsurance between 25% and 45%, subject to a periodic adjustmentby us, of premiums and losses on our brokerage insurance business that we havehistorically written through our retail and wholesale agents. These agreementshave been extended for an additional year. The ceding commission for thebrokerage business is fixed at 34% of ceded written premium for the period April 1,2006 to March 31, 2007 and it then reverts to a sliding scale commissionon April 1, 2007. During the second quarter of 2006, we ceded 30% of ourin force, new and renewal brokerage insurance business to CastlePointReinsurance and ceded 40% of our new and renewal brokerage insurance businesswritten in the third and fourth quarters of 2006 to CastlePoint Reinsurance. Weceded 50% of our traditional program business and 85% of our specialty programbusiness written during 2006 to CastlePoint Reinsurance. Traditional programbusiness written through program underwriting agencies is comprised of classesof business that we have historically written. The specialty program businesscovers business not historically written by us. The ceding commission rate forthe traditional and specialty program business is 30%. During 2006, we ceded$40.9 million of unearned premiums as of April 1, 2006, which consisted of$19.2 million and $21.7 million of unearned premiums retained by us on policieswritten in 2006 and 2005, respectively, and $114.2 million on premiums writtenduring the nine months ended December 31, 2006. In addition, CastlePointReinsurance participates as a reinsurer on our excess of loss reinsuranceprogram, effective May 1, 2006 and our catastrophe reinsurance program,effective July 1, 2006. We ceded excess of loss reinsurance andcatastrophe premiums to CastlePoint Reinsurance of $1.6 million and $1.0million, respectively for the nine months ended December 31, 2006. Recoverablesand prepaid reinsurance totaling $115.2 million from CastlePoint Reinsurance,which is an unauthorized reinsurer and are collateralized in a New York StateRegulation 114 compliant trust account for our benefit with a balance of $95.3million as of December 31, 2006 with the remaining amount offset by cededbalances payable.

Our pooling agreements with CastlePoint InsuranceCompany will impact the reporting of our business segments beginning in 2007.Our insurance segment will report premiums that we produce as part of ourbrokerage pool and our insurance services segment will record management feeincome that we will earn as a result of managing the brokerage pool on behalfof CastlePoint. In addition, the insurance segment will include premiums fromthe traditional and specialty pools that CastlePoint Management 

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manages for TICNY and TNIC.Our brokerage business will also be written through CastlePoint InsuranceCompany or other insurance companies that CastlePoint may acquire in the future.When shown in the consolidated results, this amount will be included in totalrevenues and will have the effect of reducing the net underwriting expenseratio in the same manner as policy billing fees and ceding commission revenue. Inaddition, we plan to assume through a pooling agreement a certain percentage ofthe business written by us or CastlePoint utilizing CastlePoint InsuranceCompany. This business will be reported in our assumed reinsurance segment. See“Item 1.—Recent Developments and Reinsurance—CastlePoint Reinsurance andPooling.”

Our insurance companies entered into a service andexpense sharing agreement with CastlePoint, pursuant to which they will provideinsurance company services now offered by us, such as claims adjustment, policyadministration, technology solutions, underwriting, and risk managementservices, to the U.S. domiciled insurance subsidiaries of CastlePoint, as wellas to companies appointed as managing general underwriters by those companies. Wecharged CastlePoint $0.7 million for such services for the nine months ended December 31,2006, which have been recorded as other administration revenue in our insuranceservices segment.

Effective April 4, 2006, we novated businessassumed from the Accident Insurance Company by TICNY to CastlePoint Reinsurance.TICNY recorded $0.1 million as ceded premiums written and earned and eliminatedliabilities of $0.1 million, which was recorded as a reduction to lossesincurred during the three months ending June 30, 2006.

On November 13, 2006,we entered into the Preferred Stock Purchase Agreement with a subsidiary ofCastlePoint pursuant to which we agreed to issue and sell 40,000 shares ofperpetual preferred stock to the subsidiary for aggregate consideration of $40million. The transaction closed on December 4, 2006. See “Item 1.—StrategicRelationship and Agreements with CastlePoint.” The perpetual preferred stock was redeemed in full on January 26,2007.

**Acquisition ofPreserver**

On November 13, 2006,we signed an agreement to acquire Preserver Group, Inc. (“Preserver”) fora base purchase price of $68.3 million (approximately $64.8 million afterdeduction for expenses incurred by Preserver, net of tax). A portion of thepurchase price paid will be used to redeem $30.8 million of debt to Preserver’sshareholders at closing. In addition, $12 million of Preserver’s trustpreferred securities will remain outstanding. Preserver is a privately-heldcompany that offers products similar to ours in the Northeast, particularly inNew Jersey, Maine and Massachusetts. Preserver’s gross written premiums were$88.6 million in 2005 and $86.4 million for 2006. Preserver is rated “B++”(Good) by A.M. Best. On December 7, 2006, A.M. Best placed theratings of Preserver under review with positive implications. We believe thistransaction will accelerate our regional expansion by allowing us to accessPreserver’s approximately 300 agents that produce business in variousNortheastern states. The acquisition is subject to regulatory approvals and isexpected to close in the second quarter of 2007. See “Item 1. - Acquisition ofPreserver.”

**MarketplaceConditions and Trends**

The property and casualty insurance industry isaffected by naturally occurring industry cycles known as “hard” and “soft”markets. For the first ten years after our company began, we operated in a softmarket cycle, generallyconsidered an adverse industry cycle in the property and casualty insuranceindustry. A soft market cycle is characterized by intense competition thatresults in inadequate pricing, expanded coverage terms and increasedcommissions paid to distribution sources in order to compete for business. Webelieve that a hard market began sometime in late 2000. Ahard market, generally considered a beneficial industry 

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trend, is characterized byreduced competition that results in higher pricing, reduced coverage terms andlower commissions paid to acquire business.

In the last three decades, there have been three hardmarkets in which industry-wide inflation-adjusted premiums grew. Each of theseperiods was followed by an increase in capacity, price competition and theaggressive terms and conditions that are typical of a soft market.

Beginning in late2004 and in the first half of 2005, segments of both the reinsurance andcommercial lines market started to exhibit signs of a softening market. Themarket softening was slowed by the effects of hurricanes Katrina, Rita andWilma. According to A.M. Best, these catastrophic hurricanes in the GulfStates caused an estimated $60 billion of insured losses for the insurance andreinsurance industries and triggered the raising of an estimated $20 billion ofnew reinsurance capital or capacity in 2005.

A.M. Best believes that in 2006 the insurance industrywill post record earnings due, in part, to modest catastrophic activity andfavorable frequency and severity trends. Although soft market conditionsprevailed in some lines and segments, underwriting remained generally prudentwith personal lines experiencing strong overall results.

A.M. Best has stated that it expects rates forcatastrophe-prone areas will remain elevated in 2007, a function of moreconservative selection and pricing, reduced market capacity for certainsegments and substantially higher reinsurance costs on these risks. Soft marketconditions will prevail in most other lines and segments, with a gradualrelease of previously favorable terms and conditions for the industry. Overallpersonal lines pricing continues to be impacted by increased competition,predominantly in the personal auto line and soft market conditions are expectedto continue in selected commercial lines. In 2007, A.M. Best believes thatprofit margins will likely be eroded to a certain extent as a result ofstronger balance sheets encouraging increased competition for market share in specifiedsegments. However; A.M. Best projects that financial results for the U.S.property/casualty industry as a whole in 2007 will be generally favorableespecially if catastrophic losses remain modest.

The competition referred to above has affected non-catastrophemiddle market and larger package policies, commercial automobile, workers’compensation and umbrella policies. In the urban and metropolitan segmentswhich we participate in, in particular, homeowners, smaller commercial accountsand the lower end of the middle market, increased competition and pricesoftening has not been as evident as in the larger commercial account segment.

Our gross premiums written in 2006, 2005 and 2004 were$432.6 million, $300.1 million and $177.8 million, respectively. Premiumsproduced by TRM in 2006, 2005 and 2004 were $12.9 million, $35.2 million and$53.4 million, respectively.

A.M. Best estimates thatthe industry-wide change in net premiums written in the property and casualtyindustry was 2.6% in 2006 compared to -0.2% in 2005 and is estimated tobe 0.1% in 2007. The change in industry policyholders’ surplus as estimatedby A.M. Best was 13.5% in 2006 compared to 9.1% in 2005 and is estimatedto be 7.4% in 2007. In addition, the new capacity that has entered the markethas placed more demand on production and profitability targets. We expect thatpremium levels will remain relatively attractive in the business segments wehave targeted. These include small, commercial lines of business and modestlyvalued homeowners and dwelling policies. Management of our mix of business isexpected to produce selective growth in the lower premium segment of the middlemarket. Generally, we will be less interested at the higher premium levels ofthe middle market in which we see continuing evidence that competitive forceswill reduce potential for profitable growth. We expect to continue to maintainunderwriting discipline and selectivity in low hazard classes of business, aswell as focusing on premium adequacy and appropriate coverage terms. Our broadproduct line platform continues to allow us the opportunity to adjust ourbusiness mix in response to varying market conditions.

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**Principal Revenueand 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 relied on other reinsurance companies and cededpremiums to them to generate ceding commissions in TICNY and we producedpremiums for TRM’s issuing companies to generate non-risk bearing revenues inour insurance services operation. Consistent with this strategy, during thefive years ended December 31, 2004, we derived 34.6% and 36.9% of ourtotal revenues from net premiums earned and ceding commissions, respectivelyfrom TICNY and 24.8% of our total revenue from direct commission and fees fromour insurance services operation. Our investment income and realized gains frominvestments comprised 3.7% of our total revenues during this period. Immediatelyafter the IPO we contributed $98 million of the proceeds from the IPO and theconcurrent private placement to TICNY, which increased its statutory surplus. Additionally,TICNY received a rating upgrade from A.M. Best to “A-” (Excellent) in October 2004.With the higher rating we were able to more fully deploy the additional capital.

*Netpremiums earned.*   Premiums written include allpremiums received by an insurance company during a specified accounting period,even if the policy provides coverage beyond the end of the year. Premiums areearned over the term of the related policies. At the end of each accountingperiod, the portion of the premiums that are not yet earned are included in theunearned premium reserve and are realized as income in subsequent periods overthe remaining term of the policy. Our policies typically have a term of 12months. Thus, for example, for a policy that is written on July 1, 2006,one-half of the premiums would be earned in 2006 and the other half would beearned in 2007.

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.*   Direct commissionrevenues and fees consist of commissions earned by TRM on premiums produced byits managing general agency and fees earned from its claims administration,other administration services and reinsurance intermediary services. It alsoincludes policy billing fees that we earn in the course of collecting premiumsfrom our policyholders. This fee is charged primarily on small policies writtenthrough our 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 

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of adjusting and settlingthose claims. Our provision for loss and loss adjustment expense reserves inany period, which is the expense recorded, includes estimates for lossesincurred during the period and changes in estimates 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 expenses consistof other underwriting expenses related to TICNY and TNIC’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, bureaus and taxes, which arethe 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. Inaddition, interest expense includes amortization of any debt issuance costsover the remaining term of our subordinated debentures.

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

**Measurement ofResults**

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 and TNIC’s net premiums earned. Ona consolidated basis, we measure profitability in terms of net income andreturn on average equity.

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*Premiumswritten.*   We use gross premiums written tomeasure our sales of insurance products and, in turn, our ability to generateceding commission revenues from premiums that we cede to reinsurers. Grosspremiums written also correlates to our ability to generate net premiumsearned.

*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 a measure 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 changesin estimates in loss reserves from prior accident years as a percentage ofpremiums earned during that year.

*Underwritingexpense ratios.**  *Theunderwriting expense ratio is the ratio of direct and ceding commissionexpenses and other underwriting expenses less policy billing fees and otheradministration revenue to premiums earned. The underwriting expense ratiomeasures a company’s operational efficiency in producing, underwriting andadministering its insurance business. Due to our historically high levels ofreinsurance, we calculate our underwriting expense ratios on a gross basis(before the effect of ceded reinsurance) and net basis (after the effect ofceded reinsurance). Ceding commission revenue is applied to reduce ourunderwriting expenses in our insurance company operation. Because the cedingcommission rate we earn on our premiums ceded has historically been higher thanour underwriting expense ratio on those premiums, our extensive use of quotashare reinsurance has caused our net underwriting expense ratio generally 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 in states where TICNY and TNIC are not yetlicensed. For this reason, we use written premiums produced by TRM on behalf ofits issuing companies as well as TRM’s commission revenue to evaluate ourability to achieve growth.

*Net income and return onaverage common equity.**  *Weuse net income to measure our profits and return on average common equity andto measure our effectiveness in utilizing our shareholders’ equity to generatenet income on a consolidated basis. In determining return on average commonequity for a given year, net income is divided by the average of shareholders’equity for that year. As a result of the preferred stock raised in the fourthquarter of 2006, the 2006 full year return on common equity was calculated bydividing net income less preferred stock dividends by an average stockholder’sequity for the year which was calculated using an ending total stockholders’equity excluding the preferred stock.

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**Critical AccountingPolicies**

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.**  *The reservingprocess for loss adjustment expense reserves provides for our best estimate ata particular point in time of the ultimate unpaid cost of all losses and lossadjustment expenses incurred, including settlement and administration oflosses, and is based on facts and circumstances then known and including lossesthat have been incurred but not yet been reported. The process includes usingactuarial methodologies to assist in establishing these estimates, judgmentsrelative to estimates of future claims severity and frequency, the length oftime before losses will develop to their ultimate level and the possiblechanges in the law and other external factors that are often beyond our control.The methods used to select the estimated loss reserves include the loss ratio projection,incurred loss projection, and the Bornhuetter-Ferguson (B-F) method. Themethods are described in “Business—Loss and Loss Adjustment Expense Reserves.”  The process produces carried reserves set bymanagement based upon the actuaries’ best estimate and is the result ofnumerous best estimates made by line of business, accident year, and loss andloss adjustment expense. The amount of loss and loss adjustment expensereserves for reported claims is based primarily upon a case-by-case evaluationof coverage, liability, injury severity, and any other information consideredpertinent to estimating the exposure presented by the claim. The amounts ofloss and loss adjustment expense reserves for unreported claims are determinedusing historical information by line of insurance as adjusted to currentconditions. Since our process produces loss reserves set by management basedupon the actuaries’ best estimate, there is no explicit or implicit provisionfor uncertainty in the carried loss reserves.

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 “Business—Loss and Loss AdjustmentExpense Reserves” for additional information regarding our loss reserves.

 

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Wesegregate our data for estimating loss reserves. Property lines include Fire,Homeowners, CMP Property, Multi-Family Dwellings and Auto Physical Damage.Casualty lines include CMP Liability, Other Liability, Workers’ compensationand Auto Liability. The actuarial methods used by segment have been consistentsince the 2003 year-end review. During the year-end review the accident yearsare split into most recent, first prior and all other accident years. For the2006 review the most recent accident year is 2006, the first prior is 2005, andall other accident years are 2004 and prior. The table below shows the methodused by segment and accident year to select the estimated year-ending lossreserves:

| ** **                           | ** ** | **Accident Year** | ** ** |
|--------------------------------------|------------|------------------------|------------|
| **Segment**                          | ** ** | ** **             | ** ** | **Most Recent** | ** ** | **1**st Prior | ** ** | **All Other** | ** ** |
| Fire                                 |       | Loss  Ratio            |       | Loss  Development |   | Loss  Development |   |
| Homeowners                           |       | Loss  Ratio            |       | Loss  Development |   | Loss  Development |   |
| Multi-Family                         |       | Loss  Ratio            |       | Loss  Development |   | Loss  Development |   |
| Commercial  multiple-peril property  |       | Loss  Ratio            |       | Loss  Development |   | Loss  Development |   |
| Commercial  multiple-peril liability |       | Loss  Ratio            |       | B-F |   | Loss  Development |   |
| Workers’  Compensation          |       | Loss  Ratio            |       | B-F |   | Loss  Development |   |
| Other Liability                      |       | Loss  Ratio            |       | B-F |   | Loss  Development |   |
| Auto Liability                       |       | Loss  Ratio            |       | B-F |   | Loss  Development |   |
| Auto Physical Damage                 |       | Loss Ratio             |       | Loss Development |   | Loss Development |   |
|                                      |            |                        |            |  |  |  |  |  |  |

 

Two key assumptions that materially impact theestimate of loss reserves are the loss ratio estimate for the current accidentyear and the loss development factor selections for all accident years. Theloss ratio estimate for the current accident year is selected after reviewinghistorical accident year loss ratios adjusted for rate changes, trend, and mixof business.

Ourdata has sufficient credibility to base development factors on our own data. Theloss development factors are reviewed annually. There have only been minorchanges in selected loss development factors since 2003. The chart below showsthe number of years by segment when we expect 50%, 90% and 99% of losses to be reportedfor a given accident year: 

| ** **                           | ** ** | **Number of years** | ** ** |
|--------------------------------------|------------|-------------------------------|------------|
| **Segment**                          | ** ** | ** **                    | ** ** | **50%** | ** ** | **90%** | ** ** | **99%** | ** ** |
| Fire                                 |       | < 1 year                   |       | < 1 year |   | 2  years |   |
| Homeowners                           |       | < 1 year                   |       | < 2 years |   | 3  years |   |
| Multi-Family                         |       | < 2 years                  |       | < 2 years |   | 5  years |   |
| Commercial  multiple-peril property  |       | < 1 year                   |       | 1 year |   | 2  years |   |
| Commercial  multiple-peril liability |       | < 2 years                  |       | 5 years |   | 9  years |   |
| Workers’  Compensation          |       | < 1 year                   |       | 2 years |   | 5  years |   |
| Other Liability                      |       | 3 years                       |       | 4 years |   | 9  years |   |
| Auto Liability                       |       | < 1 year                   |       | 3 years |   | 4  years |   |
| Auto Physical  Damage                |       | < 1 year                   |       | < 1 year |   | 1  year |   |
|                                      |            |                               |            |  |  |  |  |  |  |

 

The Company has made only minor changes to the keyassumptions used during the last three annual reserve estimates*.*

*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 reinsurers inorder 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 

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income as ceded premiumswritten are earned. Since 2001, the ultimate commission rate earned on ourquota share reinsurance contracts has been determined by the loss ratio on theceded premiums earned. If the estimated loss ratio decreases from the levelcurrently in effect, the commission rate increases and additional ceding commissionsare earned in the period in which the decrease is recognized. If the estimatedloss ratio increases, the commission rate decreases, which reduces cedingcommissions earned. As a result, the same uncertainties associated withestimating loss and loss adjustment expense reserves affect the estimates ofceding commissions earned. We monitor the ceded ultimate loss ratio on aquarterly basis to determine the effect on the commission rate of the cededpremiums earned that we accrued during prior accounting periods. The estimatedceding commission income relating to prior years recorded in 2006, 2005 and2004 was an increase of $1.1 million, and a decrease of $1.2 million and anincrease of $1.7 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. Reinsurance recoverables and prepaidreinsurance premiums are reported on our balance sheet separately as assets,instead of being netted against the related liabilities, since reinsurance doesnot relieve us of our legal liability to policyholders and ceding companies. Weare required to pay losses even if a reinsurer fails to meet its obligationsunder the applicable reinsurance agreement. Consequently, we bear credit riskwith respect to our individual reinsurers and may be required to make judgmentsas to the ultimate recoverability of our reinsurance recoverables. Additionally,the same uncertainties associated with estimating loss and loss adjustmentexpense reserves affect the estimates of the amount of ceded reinsurancerecoverables. We continually monitor the financial condition and rating agencyratings of our reinsurers. Non-admitted reinsurers are required tocollateralize their share of unearned premium and loss reserves either byplacing funds in a trust account meeting the requirements of New YorkRegulation 114 or by providing a letter of credit. In addition, from October 2003to December 31, 2005, we placed our new quota share treaties on a “fundswithheld” basis, under which TICNY retained the ceded premiums written andplaced that amount in segregated trust accounts from which TICNY may withdrawamounts due to it from the reinsurers. In 2006, CastlePoint Reinsurancecollateralized its net exposure with a New York Regulation 114 compliant trustaccount.

*Deferredacquisition costs/commission revenues.**  *Wedefer certain expenses and commission revenues related to producing andreinsuring insurance business, including commission expense on gross premiumswritten, commission income on ceded premiums written, premium taxes and certainother costs related to the acquisition of insurance contracts. These costs andrevenues are capitalized and the resulting asset or liability, deferredacquisition costs/revenues, is amortized and charged to expense or income infuture periods as gross premiums written are earned. The method followed incomputing deferred acquisition costs/income limits the amount of such deferredamounts to its estimated realizable value. The ultimate recoverability ofdeferred acquisition costs is dependent on the continued profitability of ourinsurance underwriting. We also consider anticipated invested income indetermining the recoverability of these costs. 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.**  *Inaccordance with our investment guidelines, our investments consist largely ofhigh-grade marketable fixed maturity securities. Investments are carried atestimated fair value as determined by quoted market prices or recognizedpricing services at the reporting date for those or similar investments. Changesin unrealized gains and losses on our investments, net of any deferred taxeffect, are included as an element of other comprehensive income, andcumulative unrealized 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 

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in the period it isdetermined. Investment income is recorded when earned and includes theamortization of premium and discounts on investments.

*Impairmentof invested assets.**  *Impairment of investmentsecurities results in a charge to income when a market decline below cost isdeemed to be other than temporary. We regularly review our fixed maturity andequity securities portfolios to evaluate the necessity of recording impairmentlosses for other than temporary declines in the fair value of investments. Ingeneral, we focus our attention 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, we consider, amongother criteria: the current fair value compared to amortized cost or cost, asappropriate; the length of time the security’s fair value has been belowamortized cost or cost; our intent and ability to retain the investment for aperiod of time sufficient to allow for any anticipated recovery in value;specific credit issues related to the issuer; and current economic conditions.Other than temporary impairment losses result in a permanent reduction of thecost basis of the underlying investment. Only temporary declines in the fairvalue of our fixed maturity and equity securities were recorded during 2006,2005 and 2004. Significant changes in the factors we consider when evaluatinginvestments for impairment losses could result in a significant change inimpairment losses reported in our consolidated financial statements. See “Business-Investments”and “Note 2. Investments” in the notes to our audited consolidated financialstatements for additional detail regarding our investment portfolio at December 31,2006, including disclosures regarding other than temporary declines ininvestment value.

*Intangible assets andpotential impairment.*   The costs associated witha group of assets acquired in a transaction are allocated to the individualassets, including identifiable intangible assets based on their relative fairvalues. Identifiable intangible assets with a finite useful life are amortizedover the period which the asset is expected to contribute directly orindirectly to our future cash flows. Identifiable intangible assets with finiteuseful lives are tested for recoverability whenever events or changes incircumstances indicate that a carrying amount may not be recoverable. Animpairment loss is recognized if the carrying value of an intangible asset isnot recoverable and its carrying amount exceeds its fair value. No impairmentlosses were recognized in 2006, 2005 and 2004. Significant changes in thefactors we consider when evaluating our intangible assets for impairment lossescould result in a significant change in impairment losses reported in ourconsolidated financial statements. See “Note 7. Intangible Assets” in the notesto our audited consolidated financial statements.

**Results ofOperations**

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 and reinsurance segments, followed by theresults of operations of our insurance services segment.

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***Consolidated Resultsof Operations***

| ** **                                                   | ** ** | **For the year ended December 31,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                   | ** ** | **($ in thousands)**                               | ** ** |
| **Revenues**                                                 |       |                                                         |       |   |   |   |   |
| Premiums earned                                              |       |                                                         |       |   |   |   |   |
| Gross premiums earned                                        |       | $                                                            | 363,425    |   | $ | 237,833 |   | $ | 152,509 |   |
| Less: Ceded premiums earned                                  |       | (139,437                                                     | )          | (73,397 | ) | (106,945 | ) |
| Net premiums earned                                          |       | 223,988                                                      |       | 164,436 |   | 45,564 |   |
| Total commission  and fee income                             |       | 52,237                                                       |       | 40,213 |   | 57,043 |   |
| Net investment  income                                       |       | 23,026                                                       |       | 14,983 |   | 5,070 |   |
| Net realized  investment gains                               |       | 12                                                           |       | 122 |   | 13 |   |
| Total revenues                                               |       | 299,263                                                      |       | 219,754 |   | 107,690 |   |
| **Expenses**                                                 |       |                                                         |       |   |   |   |   |
| Net loss and loss adjustment expenses                        |       | 135,125                                                      |       | 96,614 |   | 27,060 |   |
| Operating expenses                                           |       | 114,233                                                      |       | 86,471 |   | 62,779 |   |
| Interest expense                                             |       | 6,870                                                        |       | 4,853 |   | 3,128 |   |
| Total expenses                                               |       | 256,228                                                      |       | 187,938 |   | 92,967 |   |
| **Other Income**                                             |       |                                                         |       |   |   |   |   |
| Equity income in unconsolidated affiliate                    |       | 914                                                          | ** ** | — | ** ** | — | ** ** |
| Gain from issuance common stock by unconsolidated  affiliate |       | 7,883                                                        | ** ** | — | ** ** | — | ** ** |
| Warrant received from unconsolidated affiliate               |       | 4,605                                                        | ** ** | — | ** ** | — | ** ** |
| **Income before Income Taxes**                               |       | 56,437                                                       |       | 31,816 |   | 14,723 |   |
| Federal and state income taxes                               |       | 19,673                                                       |       | 11,062 |   | 5,694 |   |
| **Net Income**                                               | ** ** | **$**                                                        | **36,764** | ** ** | **$** | **20,754** | ** ** | **$** | **9,029** | ** ** |
| **Key Measures**                                             | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Return on average common  equity                             |       | 22.2                                                         | %          | 15.1 | % | 23.7 | % |

 

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Thefollowing table reconciles the results of our individual segments toconsolidated income before income taxes:

| ** **                                                      | ** ** | **For the year ended December 31,** | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                      | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                      | ** ** | **($ in thousands)**                               | ** ** |
| Insurance segment  underwriting profit                          |       | $                                                            | 29,255     |   | $ | 19,262 |   | $ | 9,524 |   |
| Reinsurance  segment underwriting (loss) profit                 |       | (1,504                                                       | )          | 422 |   | 1,582 |   |
| Total  underwriting profit                                      |       | 27,751                                                       |       | 19,684 |   | 11,106 |   |
| Insurance  services segment income before income taxes          |       | 1,299                                                        |       | 2,840 |   | 1,951 |   |
| Net investment  income                                          |       | 23,026                                                       |       | 14,983 |   | 5,070 |   |
| Net realized  investment gains                                  |       | 12                                                           |       | 122 |   | 13 |   |
| Corporate  expenses                                             |       | (2,183                                                       | )          | (960 | ) | (289 | ) |
| Interest expense                                                |       | (6,870                                                       | )          | (4,853 | ) | (3,128 | ) |
| Equity income in  unconsolidated affiliate                      |       | 914                                                          |       | — |   | — |   |
| Gain from  issuance of common stock by unconsolidated affiliate |       | 7,883                                                        | ** ** | — | ** ** | — | ** ** |
| Warrant received  from unconsolidated affiliate                 |       | 4,605                                                        | ** ** | — | ** ** | — | ** ** |
| **Income before income taxes**                                  | ** ** | **$**                                                        | **56,437** | ** ** | **$** | **31,816** | ** ** | **$** | **14,723** | ** ** |

 

***Consolidated Results of Operations 2006 Compared to2005***

During 2006 a number of significant events affectedthe consolidated results of operations. We executed commutation and novationagreements between us and PXRE in order to eliminate our exposure touncollateralized reinsurance recoverables from PXRE. We recorded a net chargeas a result of these agreements of $5.5 million. In addition, we realized gainson our investment in CastlePoint as result of CastlePoint’s sale of unissuedCastlePoint shares in a private offering, which resulted in a $7.9 million gain.We also received a warrant to purchase additional CastlePoint shares which wasvalued at $4.6 million resulting in additional income in that amount, inexchange for sponsorship services, which included management, organizationaland industry expertise. Lastly, we entered into three multi-year quota sharereinsurance agreements and a service and expense agreement with CastlePoint.Since we did not place quota share reinsurance in the first quarter of 2006,pending the formation of CastlePoint Reinsurance, we ceded $40.9 million ofunearned premiums to CastlePoint Reinsurance as of April 1, 2006. Inaddition we completed our acquisition of MIIX Insurance Company of New Yorkwhich we renamed Tower Indemnity Company of America. In October 2006, theCompany entered into an agreement to sell all of the issued and outstandingcapital stock of TICA to Castle Point for a cash purchase price of $350,000plus an amount equal to the value of the statutory surplus of TICA at closing.Following the closing of the TICA transaction which occurred on December 4,2006 CastlePoint renamed TICA “CastlePoint Insurance Company.”  In December 2006, we issued 40,000shares of perpetual preferred stock for $40.0 million less $0.4 million ofissuance costs. On January 26, 2007 the perpetual preferred stock wasredeemed in full.

*Totalrevenues.*   Total revenues increased by 36.2% to$299.3 million for 2006 compared to $219.8 million in 2005. The increase isprimarily due to the increase in net premiums earned, total commission and feeincome and net investment income. Net premiums earned represented 74.8% oftotal revenues in both 2006 and 2005. Net investment income, excluding realizedcapital losses, represented 7.7% and 6.8% of total revenues, 2006 and 2005,respectively. In addition, total commission and fee income increased to $52.2million, or 17.5% of total revenue for 2006 compared to $40.2 million, or 18.3%of total revenue, for 2005.

*Premiumsearned.*   Net premiums earned increased by 36.2%to $224.0 million for 2006 compared to $164.4 million for the 2005. Theincrease in net premiums earned was due to the overall increase in gross 

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premiums written through December 31,2006 especially in our other liability, homeowners and commercial multi perillines and the novation agreements with PXRE. The novation agreements added$11.4 million to gross and net premiums earned in 2006. Since we did not placequota share reinsurance in the first quarter of 2006, pending the formation ofCastlePoint Reinsurance, we ceded $40.9 million of unearned premiums as of April 1,2006 and $114.2 million of premiums on policies written in 2006. The second,third and fourth quarter cessions to CastlePoint reflected a 30%, 40% and 40%quota share ceding percentage for the brokerage business, respectively,resulting in a total quota share ceded premium earned to CastlePoint in 2006 of$75.5 million. The total quota share ceded premium earned in 2006, includingpremiums ceded to other reinsurers under the 2005 quota share agreements, was$115.1 million. This represents a 91.5% increase in comparison to $60.1 millionin 2005 quota share ceding percentage was 25%. The traditional program businessand specialty program business quota share ceding percentages ceded 50% and85%, respectively, in 2006. In 2006, we ceded $2.2 million to CastlePoint forthe traditional and specialty programs business.

*Commissionand fee income.**  *Totalcommission and fee income increased by 29.9% to $52.2 million in 2006 comparedto $40.2 million in 2005. This was due to the increase in the ceding commissionrevenue earned as a result of the overall increase in ceded premiums earned asdiscussed above. In addition commission and fee income includes other administrationrevenue of $0.7 million from services provided to and reimbursed byCastlePoint. This increase was offset in part by a reduction in fee income inour insurance services segment as more policies previously produced in thatsegment were written in our insurance segment. Additionally, as a result of thecommutation agreements with PXRE, we recorded a charge (reduction) of $3.2million to ceding commissions representing the difference between the carriedamount of commissions due from PXRE and the amount received at an estimatedpresent value. For 2006 the change in estimated sliding scale commission ratefor commissions earned in prior periods in both the insurance segment and theinsurance services segment resulted in a net increase of $1.9 million ofcommission and fee income compared to a reduction of $1.2 million in 2005.

*Netinvestment income and realized gains.*   Netinvestment income increased by 53.7% to $23.0 million for 2006 compared to$15.0 million in 2005. This resulted from an increase in invested assets andcash and cash equivalents to $564.6 million as of December 31, 2006compared to $395.9 million as of December 31, 2005. Net cash flow providedby operations, including $37.0 million of cash received from PXRE resultingfrom the commutation and novation transactions, contributed to the $168.7million increase in invested assets and cash and cash equivalents for 2006. Ona tax equivalent basis, the yield was 5.7% as of December 31, 2006 and5.2% as of December 31, 2005.

Net realized capital gains were $12,000 in 2006compared to net realized capital gains of $122,000 for the same period in 2005.There was no impact on net realized gains attributable to adjustments for otherthan temporary impairment of securities held during 2006 or in 2005.

*Lossand loss adjustment expenses.**  *Grossloss and loss adjustment expenses and the gross loss ratio for the insuranceand reinsurance segments combined for 2006 were $199.9 million and 55.0%,respectively, compared to $135.2 million and 56.8%, respectively, for the sameperiod in 2005. The net loss ratio for the combined segments was 60.3% for the2006 as compared to 58.8% in 2005. The net loss ratio for 2006 reflected a $1.6million charge resulting from the commutation agreement with PXRE which was apresent value discount on the reserves commuted. In addition to the commutationagreement with PXRE, we executed novation agreements with PXRE relating toother reinsurance agreements covering business written in 2001, 2002 and 2003. Theseagreements were written by other insurance companies with respect to businessmanaged on their behalf by TRM. Under the novation agreements the Companyassumed loss liabilities of $12.2 million and received consideration of $11.4million. Since novation transactions are recorded by including theconsideration received as premiums written and earned and the liabilitiesassumed as losses incurred, the gross and net loss ratios were also affected.The PXRE 

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commutation and novationtransactions added 1.7 and 3.2 percentage points to the gross and net lossratios, respectively, in 2006

The decrease in the gross and net loss ratios,excluding the effect of the PXRE transactions, for 2006 compared to 2005 wasprimarily due to lower than expected loss emergence for the property lines forthe 2005 and 2006 accident years. However the decrease in the net loss ratio,excluding the effect of PXRE, was offset, in part, by the increase in thecatastrophe reinsurance premiums ceded. Also, during 2006, prior accident years’net loss reserves developed favorably to the extent of $2.3 million. The $1.6million charge related to the PXRE commutation affected prior accident years’reserves. Accordingly the net favorable development on prior year’s reserveswas $0.7 million. There was favorable development from prior years’ loss reserveson a net basis of approximately $0.4 million in 2005. See “Item 7.—InsuranceService Segment Results of Operations” and “Item 7.—Reinsurance Segment Resultsif Operations” for further discussion.

*Operatingexpenses.*   Operating expenses increased by 32.1%to $114.2 million for 2006 from $86.5 million in 2005. The increase was dueprimarily to the increase in underwriting expenses resulting from the growth inpremiums earned. Operating expenses for 2006 also includes organizational andstart up costs of approximately $0.5 million related to our sponsorship ofCastlePoint which was a wholly owned subsidiary during the first quarter of2006.

*Interestexpense.**  *Ourinterest expense increased for 2006 to $6.9 million compared to $4.9 million in2005. The increase resulted from $1.3 million of interest expense from the$20.6 million of subordinated debentures issued on March 31, 2006, $0.4million resulting from an increase in interest rates on the floating rateportions of our subordinated debentures and $0.3 million as a result ofcrediting reinsurers on funds withheld in segregated trusts as collateral forreinsurance recoverables.

*OtherIncome.**  *In 2006we recorded a gain of $7.9 million resulting from the sale of CastlePoint’sunissued shares and other income of $4.6 million from a warrant that wereceived from CastlePoint for our sponsorship and formation activities. We alsorecorded $0.9 million income representing our 8.6% equity in CastlePoint’s netincome for the nine months ended December 31, 2006. See  “Note 3.—Investments in UnconsolidatedAffiliate—CastlePoint” elsewhere in this report for further details regardinggains and losses recorded on these transactions.

*Incometax expense.**  *Ourincome tax expense was $19.7 million for 2006 compared to $11.1 million in 2005.The increased income tax expense was due primarily to the increase in incomebefore income taxes. The effective income tax rate was 34.9% for 2006 comparedto 34.8% in 2005.

*Net income and return onaverage common equity.**  *Ournet income and return on average common equity was $36.8 million and 22.2%,respectively, in 2006 compared to $20.8 million and 15.1%, respectively, in2005. For 2006, the return was calculated by dividing net income of $36.6million excluding preferred stock dividends by an average common stockholders’equity of $164.6 million. The net effects of the PXRE commutation and novationtransactions, and the gains recorded on the CastlePoint investment and warrant,reduced by $0.5 million of start-up expenses for CastlePoint, added $4.1million to our net income and 2.2 percentage points to our return on averagecommon equity for 2006. For 2005, the return was calculated by dividing netincome of $20.8 million by an average stockholders’ equity of $137.1 million.

***Consolidated Results of Operations 2005 Compared to2004***

*Totalrevenues.**  *Totalrevenues increased by 104.1% to $219.8 million for 2005 compared to $107.7million in 2004. The increase is primarily due to the increase in net premiumsearned and net investment income. Net premiums earned represented 74.8% oftotal revenues for 2005 compared to 42.3% for the same period in 2004. Netinvestment income, excluding realized capital gains, represented 6.8% and 4.7%of total revenues for 2005 and, 2004, respectively. These increases werepartially offset by lower total 

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commission and fee incomefor 2005 of $40.2 million, or 18.3% of total revenue, compared to $57.0million, or 53.0% of total 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 reinsurance agreement from 60% to 25% beginning October 1, 2004which was maintained throughout 2005. In addition, the net premiums earned in2005 included all of the $13.1 million of unearned premiums as of December 31,2004 that would have been ceded to Converium Reinsurance (North America) Inc.absent a novation of our reinsurance agreement in 2004. See “Item 7.—InsuranceSegment Results of Operations” and “Item 7.—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.

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*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, in 2004. Thenet loss ratio for the combined segments was 58.8% for 2005 and 59.4% for thesame period in 2004. The improvement in the net loss ratio in 2005 compared tothe same period in 2004 was due primarily to the increase in net premiumsearned that reduced the effect of catastrophe reinsurance premiums on the netloss ratio and to favorable development from prior years’ reserves of $392,000in 2005 compared to $199,000 in the same period in 2004. See “Item 7—InsuranceSegment Results of Operations” and “Reinsurance Segment Results of Operations”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 December 2004 and $0.3 million credited toreinsurers on funds withheld in segregated trusts as collateral for reinsurancerecoverables. This increase was offset by reductions of $0.6 million ofinterest expense on other borrowings and preferred stock repaid in the fourthquarter 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 common equity.*   Our net income and returnon average common equity was $20.8 million and 15.1%, respectively, for 2005compared to $9.0 million and 23.7%, respectively, in 2004. Although net incomeincreased 129.9% in 2005 compared to 2004, the lower return on average equityresulted from the significant increase in average stockholders’ equity as ourIPO and concurrent private placement were completed in the fourth quarter of2004. For 2005, the return was calculated by dividing net income of $20.8million by an average stockholders’ equity of $137.1 million. For 2004, thereturn was calculated by dividing net income of $9.0 million by an averagestockholders’ equity of $38.1 million.

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***Insurance SegmentResults of Operations***

| ** **                                    | ** ** | **For the year ended December 31,** | ** **  |
|-----------------------------------------------|------------|--------------------------------------------------------------|-------------|
| ** **                                    | ** ** | **2006**                                                     | ** **  | **2005** | ** ** | **2004** | ** ** |
| ** **                                    | ** ** | **($ in thousands)**                               | ** **  |
| **Revenues**                                  |       |                                                         |        |   |   |   |   |
| Premiums earned                               |       |                                                         |        |   |   |   |   |
| Gross premiums earned                         |       | $                                                            | 344,015     |   | $ | 236,174 |   | $ | 151,210 |   |
| Less: Ceded premiums earned                   |       | (139,336                                                     | )           | (73,263 | ) | (106,783 | ) |
| Net premiums  earned                          |       | 204,679                                                      |        | 162,911 |   | 44,427 |   |
| Ceding commission  revenue                    |       | 43,130                                                       |        | 25,218 |   | 39,983 |   |
| Policy billing  fees                          |       | 1,129                                                        |        | 868 |   | 671 |   |
| **Total**                                     | ** ** | **248,938**                                                  | ** **  | **188,997** | ** ** | **85,081** | ** ** |
| **Expenses**                                  |       |                                                         |        |   |   |   |   |
| Loss and loss adjustment  expenses            |       |                                                         |        |   |   |   |   |
| Gross loss and loss adjustment expenses       |       | 182,911                                                      |        | 134,788 |   | 84,840 |   |
| Less: Ceded loss and loss adjustment expenses |       | (64,929                                                      | )           | (39,088 | ) | (57,087 | ) |
| Net loss and loss adjustment expenses         |       | 117,982                                                      |        | 95,700 |   | 27,753 |   |
| Underwriting expenses                         |       |                                                         |        |   |   |   |   |
| Direct commissions expense                    |       | 56,021                                                       |        | 38,772 |   | 25,349 |   |
| Other underwriting expenses                   |       | 45,680                                                       |        | 35,263 |   | 22,455 |   |
| Total  underwriting expenses                  |       | 101,701                                                      |        | 74,035 |   | 47,804 |   |
| **Underwriting  Profit**                      | ** ** | **$**                                                        | **29,255**  | ** ** | **$** | **19,262** | ** ** | **$** | **9,524** | ** ** |
| **Key Measures**                              |       |                                                         |        |   |   |   |   |
| **Premiums Written**                          |       |                                                         |        |   |   |   |   |
| Gross premiums written                        |       | $                                                            | 408,334     |   | $ | 298,643 |   | $ | 176,166 |   |
| Less: Ceded premiums written                  |       | (187,509                                                     | )           | (88,200 | ) | (79,571 | ) |
| Net premiums written                          | ** ** | **$**                                                        | **220,825** | ** ** | **$** | **210,443** | ** ** | **$** | **96,595** | ** ** |
| **Loss Ratio**                                |       |                                                         |        |   |   |   |   |
| Gross                                         |       | 53.2                                                         | %           | 57.1 | % | 56.1 | % |
| Net                                           |       | 57.6                                                         | %           | 58.7 | % | 62.5 | % |
| **Accident Year Loss Ratio**                  |       |                                                         |        |   |   |   |   |
| Gross                                         |       | 54.1                                                         | %           | 57.3 | % | 56.6 | % |
| Net                                           |       | 58.2                                                         | %           | 59.0 | % | 61.2 | % |
| **Underwriting Expense Ratio**                |       |                                                         |        |   |   |   |   |
| Gross                                         |       | 29.2                                                         | %           | 31.0 | % | 31.2 | % |
| Net                                           |       | 28.1                                                         | %           | 29.4 | % | 16.1 | % |
| **Combined Ratio**                            |       |                                                         |        |   |   |   |   |
| Gross                                         |       | 82.4                                                         | %           | 88.1 | % | 87.3 | % |
| Net                                           |       | 85.7                                                         | %           | 88.1 | % | 78.6 | % |

 

***Insurance Segment Results of Operations 2006 Comparedto 2005***

*Grosspremiums.*   Gross premiums written increased by36.7% to $408.3 million for 2006 compared to $298.6 million in 2005. Grosspremiums earned increased by 45.7% to $344.0 million for 2006 compared to$236.2 million for the same period in 2005. Gross premiums earned was alsoaffected by the significant increase in gross premiums written in 2005 and theoverall increase in gross premiums written through December 31, 2006especially in our homeowners and commercial multi peril and other liabilitylines. The number of policies in force increased by 18.8% as of December 31,2006 compared to December 31, 2005. 

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Additionally, during 2006,premium increases on renewed business averaged 9.3% in personal lines and 3.3%in commercial lines. The retention rate was 87% for personal lines and 80% forcommercial lines during 2006. New business written during 2006 through formerOneBeacon producers that we appointed in connection with the 2004 renewalrights transaction amounted to $21.5 million compared to $17.3 million in 2005.

*Cededpremiums.*   Ceded premiums written increased by112.6% to $187.5 million for 2006 compared to $88.2 million for 2005. Thisincrease was greater than the increase in gross premiums written for thefollowing reasons. In April 2006, we entered into three multi-year quotashare reinsurance agreements with CastlePoint Reinsurance. Since we did notplace quota share reinsurance in the first quarter of 2006, we ceded toCastlePoint Reinsurance $40.9 million of unearned premiums as of April 1,2006. In addition, we ceded $114.2 million of premiums written on policies thatbegan on April 1, 2006 through the period ending December 31, 2006. Consistentwith our business plans and targeted net premiums written levels, the second,third and fourth quarter cessions to CastlePoint Reinsurance reflected a 30%,40%  and 40% quota share cedingpercentage, respectively,  for thebrokerage business resulting in a total quota share ceded premium earned toCastlePoint in 2006 of $75.5 million. The total quota share ceded premiumearned in 2006 including premiums ceded to other reinsurers under the 2005quota share agreements, was $115.1 million. This represents a  91.5% increase in comparison to $60.1 millionin 2005 quota share ceding percentage was 25%. The traditional program businessand specialty program business quota share ceding percentages were 50% and 85%,respectively, in 2006. In 2006, we ceded $2.2 million to CastlePoint for thetraditional and specialty program business.

Ceded premiums earned increased 90.2% during 2006 ascompared to 2005 as a result of the increase in gross premiums earned and theaforementioned changes in quota share ceding percentages, as well as anadditional $19.2 million of ceded premiums earned included in the $40.9 millionportfolio of unearned premiums that was ceded to CastlePoint Reinsurance as of April 1,2006 which related to business written in 2005 that we had previously retained.

*Netpremiums.*   Net premiums written increased by 4.9%to $220.8 million for, 2006 compared to $210.4 million for 2005 notwithstandingthe 36.7% increase in gross premiums written. This was due to the increasedceded premiums written as described above.

Net premiums earned increased by 25.6% to $204.7million in 2006 compared to $162.9 million in 2005 as a result of the 45.7%increase in gross premiums earned offset by the 90.2% increase in cededpremiums earned discussed above.

*Cedingcommission revenue.*   Ceding commission revenueincreased by 71.0% to $43.1 million for 2006 compared to $25.2 million for 2005due to the 90.2% increase in ceded premiums earned offset, in part, by a lowerquota share ceding commission rate of 34% as compared to a ceding commissionrate of 41% in 2005. Also, as a result of the commutation agreements with PXRE,we recorded a charge of $3.2 million to ceding commission revenue in 2006. Cedingcommission revenue increased by $1.1 million in 2006 as a result of animprovement in the ceded loss ratios on prior years’ quota share treatiescompared to a decrease of $0.8 as a result of deterioration in the ceded lossratios on prior years’ quota share treaties in 2005.

*Lossand loss adjustment expenses and loss ratio.**  *Gross and net losses and loss adjustment expenseswere $182.9 million and $118.0 million, respectively, for 2006 compared with$134.8 million and $95.7 million, respectively, for 2005. Our gross loss ratiowas 53.2% for 2006 as compared with 57.1% for 2005. The net loss ratio was57.6% for the 2006 and reflected the $1.6 million charge resulting from thecommutation agreement with PXRE referred to previously. The effect of thecommutation added 0.7% percentage point to the net loss ratio in 2006. The netloss ratio was 58.7% in the same period of 2005. The decrease in the gross andnet loss ratios, excluding the impact of PXRE, for 2006 compared to 2005 was 

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primarily due to lowerthan expected loss emergence for the property lines for the 2006 accident yearcompared to 2005. However the decrease in the net loss ratio, excluding theimpact of PXRE, was offset, in part, by the significant increase in the amountof catastrophe reinsurance premiums ceded which reduced net earned premiumsthereby increasing the net loss ratio. We ceded catastrophe reinsurancepremiums equal to 5.0% of net premiums earned during 2006 as compared to 2.5%in 2005. During 2006, prior accident years’ loss reserves developed favorablyto the extent of $2.3 million excluding the $1.6 million loss related to thecommutation with PXRE, resulting in net favorable development of $1.0 million. Therewas favorable development from prior years’ loss reserves on a net basis ofapproximately $0.4 million in 2005.

Loss and loss adjustment expenses are net ofreimbursements for loss and loss adjustment expenses made by TRM pursuant tothe expense sharing arrangement between TICNY and TRM. See “Item 7.—InsuranceService Segment Results of Operations” for the amounts of loss and lossadjustment expense reimbursements.

*Underwritingexpenses and underwriting expense ratio.*   Underwritingexpenses, which include direct commission expenses and other underwritingexpenses, were $101.7 million for 2006 as compared with $74.0 million for 2005.Our gross expense ratio was 29.2% for 2006 as compared with 31.0% for 2005.

The commission portion of the gross expense ratio,which expresses direct commission expense paid to our producers as a percentageof gross premiums earned, was 16.3% for 2006, compared to 16.4% for 2005.

The underwriting expense portion of the gross expenseratio was 13.0% for 2006 as compared to 14.6% for 2005. Although underwritingexpenses increased due to the growth in premium volume, the gross ratiodeclined as gross premiums earned increased more rapidly than underwritingexpenses.

The net underwriting expense ratio was 28.1% for 2006as compared to 29.4% for 2005. The net expense ratio, which reflects cedingcommission revenue, was affected by the reduction in ceding commissions of $3.2million resulting from the commutations with PXRE which added 1.6 percentagepoints to the net expense ratio. The net expense ratio for 2006 also includedthe benefit of additional ceding commission revenue due to the additional cededpremiums to CastlePoint Reinsurance as of April 1, 2006.

*Underwriting profit andcombined ratio.*   The underwriting profit, whichreflects our underwriting results on a net basis after the effects ofreinsurance, was $29.3 million in 2006 and $19.3 million in 2005. The grosscombined ratio was 82.4% for 2006 as compared with 88.1% for 2005. The decreasein the gross combined ratio in 2006 resulted primarily from a decrease in boththe gross loss ratio and gross underwriting expense ratio. The net combinedratio was 85.7% for 2006 as compared to 88.1% in 2005. The decrease in the netcombined ratio resulted from a decrease in both the net loss ratio and the netunderwriting expense ratio as described above. The effects of the commutationreduced underwriting profits by $4.8 million and added 2.3 percentage points tothe net combined ratio.

***Insurance Segment Results of Operations 2005 Comparedto 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, 

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amounted to $31.4 millionduring 2005 compared to $2.4 million in 2004. New business written during 2005through former OneBeacon producers that we appointed in connection with therenewal rights transaction amounted to $17.3 million compared to $2.6 millionin 2004. Also, due to the upgrade in TICNY’s rating from A.M. Best to “A-”(Excellent) from “B++” (Good), certain policies in the more rating sensitivelarge lines and middle market programs in our Insurance Services Segment wererenewed in 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. Notwithstandingthe lower ceding percentage in 2005, ceded premiums written in 2005 decreasedonly 10.8% as a result of the increase in the gross written 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 than the percentage increase in grosspremiums written and earned due to the decrease in the ceding percentage from60% in the first nine months of 2004 to 25% beginning October 1, 2004 andcontinuing 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 catastrophereinsurance premiums on the net loss ratio. We ceded catastrophe reinsurancepremiums equal to 2.5% of net premiums earned during 2005 compared to 8.6%during the same period in 2004. There was favorable development from prioryears’ loss reserves on both a gross and net basis of approximately $461,000 and$392,000, respectively, in 2005. There was $568,000 adverse development fromprior years’ loss reserves on a net basis in 2004. Loss and loss adjustment expenses are net of reimbursements for lossadjustment expenses made by TRM pursuant to the expense sharing arrangement betweenTICNY and TRM. See “Item 7.—Insurance Services Segment Results of Operations”for the amounts of loss and loss adjustment expense reimbursements.

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*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 in 2004. Ourgross 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, which reflectsour underwriting results on a net basis after the effects of reinsurance, was$19.3 million in 2005 and $9.5 million in 2004. The gross combined ratio was88.1% in 2005 as compared with 87.3% in 2004. The increase in the grosscombined ratio in 2005 resulted from an increase in the gross loss ratio. Thenet combined ratio was 88.1% in 2005 as compared to 78.6% in 2004. The increasein the net combined ratio resulted from an increase in the net expense ratioprimarily 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.

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***Reinsurance SegmentResults of Operations***

| ** **                                    | ** ** | **For the year ended December 31, ** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                    | ** ** | **($ in thousands)**                                     | ** ** |
| **Revenues**                                  |       |                                                               |       |   |   |   |   |
| Premiums earned                               |       |                                                               |       |   |   |   |   |
| Gross premiums earned                         |       | $                                                                  | 19,410     |   | $ | 1,659 |   | $ | 1,299 |   |
| Less: Ceded premiums earned                   |       | (101                                                               | )          | (134 | ) | (162 | ) |
| Net premiums earned                           |       | 19,309                                                             |       | 1,525 |   | 1,137 |   |
| Ceding commission  revenue                    |       | —                                                             |       | — |   | — |   |
| **Total**                                     | ** ** | **19,309**                                                         | ** ** | **1,525** | ** ** | **1,137** | ** ** |
| **Expenses**                                  |       |                                                               |       |   |   |   |   |
| Loss and loss adjustment  expenses            |       |                                                               |       |   |   |   |   |
| Gross loss and loss adjustment expenses       |       | 16,952                                                             |       | 410 |   | (676 | ) |
| Less: Ceded loss and loss adjustment expenses |       | 191                                                                |       | 504 |   | (17 | ) |
| Net loss and loss adjustment expenses         |       | 17,143                                                             |       | 914 |   | (693 | ) |
| Underwriting expenses                         |       |                                                               |       |   |   |   |   |
| Ceding commissions expense                    |       | 2,612                                                              |       | 16 |   | 44 |   |
| Other underwriting expenses                   |       | 1,058                                                              |       | 173 |   | 204 |   |
| Total  underwriting expenses                  |       | 3,670                                                              |       | 189 |   | 248 |   |
| **Underwriting  (Loss) Profit**               | ** ** | **$**                                                              | **(1,504** | **)** | **$** | **422** | ** ** | **$** | **1,582** | ** ** |
| **Key Measures**                              |       |                                                               |       |   |   |   |   |
| **Premiums Written**                          |       |                                                               |       |   |   |   |   |
| Gross premiums written                        |       | $                                                                  | 24,329     |   | $ | 1,464 |   | $ | 1,600 |   |
| Less: Ceded premiums written                  |       | (84                                                                | )          | (125 | ) | (120 | ) |
| **Net premiums written**                      | ** ** | **$**                                                              | **24,245** | ** ** | **$** | **1,339** | ** ** | **$** | **1,480** | ** ** |
| **Loss Ratio**                                |       |                                                               |       |   |   |   |   |
| Gross                                         |       | 87.3                                                               | %          | 24.7 | % | -52.0 | % |
| Net                                           |       | 88.8                                                               | %          | 59.9 | % | -60.9 | % |
| **Accident Year Loss Ratio**                  |       |                                                               |       |   |   |   |   |
| Gross                                         |       | 86.8                                                               | %          | 55.2 | % | 5.7 | % |
| Net                                           |       | 87.3                                                               | %          | 60.0 | % | 6.5 | % |
| **Underwriting Expense Ratio**                |       |                                                               |       |   |   |   |   |
| Gross                                         |       | 18.9                                                               | %          | 11.4 | % | 19.1 | % |
| Net                                           |       | 19.0                                                               | %          | 12.4 | % | 21.8 | % |
| **Combined Ratio**                            |       |                                                               |       |   |   |   |   |
| Gross                                         |       | 106.2                                                              | %          | 36.1 | % | -33.0 | % |
| Net                                           |       | 107.8                                                              | %          | 72.3 | % | -39.1 | % |

 

***Reinsurance Segment Results of Operations 2006Compared to 2005***

*Grosspremiums.*   Gross premiums written increased to$24.3 million for, 2006 as compared to $1.5 million for 2005. This increase wasdue to our having entered into novation agreements with PXRE in June 2006which increased assumed premiums written by $11.4 million and our decision toassume substantially all of the premiums placed through the insurance servicessegment. Gross premiums earned increased to $19.4 million for 2006 from $1.7million in 2005 due to the significant increase in gross premiums written andthe novation agreements with PXRE. The increase in gross premium written andearned in 2006, excluding the novation from PXRE, resulted from businessproduced by TRM on behalf of 

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Virginia Surety and StateNational where TICNY and TNIC were not yet licensed. In 2005, the majority ofthis business was reinsured by other reinsurers.

*Netpremiums.*   Net premiums written increased to$24.2 million for the twelve months ended December 31, 2006 as compared to$1.3 million in 2005. The increase in net premiums written was due to anincrease in gross premiums as discussed above. Net premiums earned increased to$19.3 million for 2006 as compared to $1.5 million in 2005 as a result of theincrease in gross premiums earned, which included the premiums arising from thenovation agreements with PXRE.

*Lossand loss adjustment expenses and loss ratio.**  *Gross loss and loss adjustmentexpenses were $17.0 million for 2006 as compared to $0.4 million for 2005. Netlosses were $17.1 million for 2006 as compared to $0.9 million in 2005. Bothgross and net losses for 2006 were increased by $12.2 million as a result ofthe novation agreements with PXRE. The gross and net loss ratios were 87.3% and88.8%, respectively, in 2006 as compared to 24.7% and 59.9%, respectively, in2005. There was unfavorable developmentfrom prior years’ loss reserves on a net basis of approximately $0.3 million in2006, compared to favorable development from prior years’ loss reserves on anet basis of approximately, $0.5 million in 2005. The effect of the PXREnovation agreements added 27.9 percentage points and 26.1 percentage points tothe gross and net loss ratio, respectively, for 2006.

*Underwritingexpenses and underwriting expense ratio.*   Grossunderwriting expenses increased for 2006 to $3.7 million as compared to $0.2million in 2005. Our net underwriting expense ratio increased to 19.0% for 2006from 12.4% in 2005. These increases resulted from approximately a 34% to 35%ceding commission paid to issuing carriers. In 2005, this segment assumedpremiums on an excess of loss basis which did not result in a ceding commissionpayment. Additionally, the increase in gross premiums written resulted in anincrease in the allocated share of other underwriting expenses to this segment.The gross and net underwriting expense ratios were 18.9% and 19.0%,respectively, for 2006 compared to 11.4% and 12.4%, respectively, in 2005. ThePXRE novation added $11.4 million of additional gross and net premiums earnedbut did not include any commission expense and thus lowered the gross and netexpense ratios. The effects of the PXRE novation reduced the gross and netunderwriting expense ratios by 27.1 percentage points and 27.6 percentagepoints, respectively, for 2006.

*Underwriting(loss) profit and combined ratio.*   Theunderwriting loss from assumed reinsurance for 2006 was $1.5 million comparedto underwriting profit of $0.4 million in 2005 and includes the charge of $0.8million resulting from the novation agreements with PXRE. The net combinedratio was 107.8% for 2006 compared to 72.3% in 2005. The higher net combinedratio for 2006 was the result of the increased net loss ratio as explainedabove.

The gross combined ratio increased to 106.2% for 2006compared to 36.1% in 2005 due to the increase in the gross loss ratio and theother underwriting expense ratio. The effects of the PXRE novation agreementsadded 0.7 percentage points to the gross combined ratio and reduced the netcombined ratio by 1.5 percentage points for 2006.

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***Reinsurance Segment Results of Operations 2005Compared 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 premiums earned resulted from an increase in premiums written in thelater 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.

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***Insurance ServicesSegment Results of Operations***

| ** **                                               | ** ** | **For the year ended December 31,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                               | ** ** | **($ in thousands)**                               | ** ** |
| **Revenue**                                              |       |                                                         |       |   |   |   |   |
| Direct commission  revenue from managing general agency  |       | $                                                            | 3,466      |   | $ | 9,148 |   | $ | 11,546 |   |
| Claims  administration revenue                           |       | 3,193                                                        |       | 4,268 |   | 4,105 |   |
| Other  administration revenue(1)                         |       | 737                                                          |       | — |   | — |   |
| Reinsurance  intermediary fees(2)                        |       | 577                                                          |       | 688 |   | 730 |   |
| Policy billing  fees                                     |       | 5                                                            |       | 23 |   | 8 |   |
| **Total  Revenues**                                      |       | 7,978                                                        |       | 14,127 |   | 16,389 |   |
| **Expenses**                                             |       |                                                         |       |   |   |   |   |
| Direct  commissions expense paid to producers            |       | 1,925                                                        |       | 5,051 |   | 7,432 |   |
| Other insurance  services expenses(3)                    |       | 1,578                                                        |       | 1,981 |   | 2,987 |   |
| Claims expense  reimbursement to TICNY                   |       | 3,176                                                        |       | 4,255 |   | 4,019 |   |
| **Total  Expenses**                                      |       | 6,679                                                        |       | 11,287 |   | 14,438 |   |
| **Insurance  Services Pre-tax Income**                   | ** ** | **$**                                                        | **1,299**  | ** ** | **$** | **2,840** | ** ** | **$** | **1,951** | ** ** |
| Premiums produced by TRM  on behalf of issuing companies | ** ** | **$**                                                        | **12,926** | ** ** | **$** | **35,177** | ** ** | **$** | **53,445** | ** ** |

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(1)          Theother administration revenue includes amounts reimbursed by CastlePointReinsurance for services rendered pursuant to a service and expense sharingagreement.

(2)          Thereinsurance intermediary fees include commissions earned for placement ofreinsurance on behalf of TICNY and TNIC.

(3)          Consistsof underwriting expenses reimbursed to TICNY pursuant to an expense sharingagreement and to CastlePoint Reinsurance pursuant to a service and expensesharing agreement.

***Insurance Services Segment Results of Operations 2006Compared to 2005***

*Totalrevenues.*   Total revenues for the insuranceservices segment were $8.0 million for 2006 as compared with $14.1 million for2005. The decrease in total revenues was due to direct commission revenue thatdecreased 62.1% to $3.5 million for 2006 compared to $9.1 million for 2005.Reinsurance intermediary fees decreased to $0.6 million in 2006 compared to$0.7 million in 2005 in which reinsurance intermediary fees were increased as aresult of an adjustment to a prior year reinsurance contract. Claimsadministration revenue decreased by 25.2% to $3.2 million for 2006 as comparedto $4.3 million in 2005 as a result of fewer hours associated with claimshandled for issuing carriers. These amounts were partially offset by $0.7million of other administration revenue reimbursements from CastlePoint for thenine months ended December 31, 2006. In 2006 we entered into a service andexpense sharing agreement with CastlePoint to provide underwriting, claims,legal and other corporate services, such as human resources and informationtechnology to CastlePoint.

For the twelve months of 2006, direct commissionrevenues decreased as compared to last year as a result of the 63.3% decreasein premiums produced by TRM to $12.9 million from $35.2 million as morepolicies previously produced in insurance services segment were renewed in theinsurance segment. In addition there was an increase in commission revenue of$0.8 million in 2006 as a result of favorable loss development on the premiumsproduced in prior years, compared to a reduction of commission income of $0.4million in 2005 resulting from unfavorable loss development on premiumsproduced in periods prior to 2005. As a result of the PXRE novation, TRMrecognized $0.2 million of direct commission revenue.

*Directcommission expense.*   TRM’s direct commissionexpense rate was 14.9% for 2006 compared to 14.4% for 2005 as the majority ofpremiums in 2006 are on smaller policies that typically carry a higher 

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commission rate ascompared to 2005 when there was a larger proportion of policies with largerpremiums and lower commission rates.

*Otherinsurance services expenses.*   The amount ofreimbursement for underwriting expenses by TRM to TICNY in 2006 was $1.6million as compared to $2.0 million in 2005, as a result of the decrease inpremiums produced. The amount of reimbursement for underwriting expenses in2006 includes the underlying expenses relating to the service and expensesharing agreement with CastlePoint, which have been billed and included inother administration revenue as described above.

*Claimsexpense reimbursement.*   The amount ofreimbursement by TRM for claims administration pursuant to the terms of theexpense sharing agreement with TICNY in 2006 was $3.2 million as compared to$4.3 million in 2005 due to a decrease in the number of claims handled.

*Pre-tax income.*   Pre-taxincome in 2006 decreased by 54.3% to $1.3 million as compared to $2.8 millionin 2005. The decrease was due to the decrease in premiums produced offsetpartially by a favorable adjustment in direct commission revenue of $0.8million in 2006 as compared to an unfavorable adjustment in direct commissionincome of $0.4 million resulting from unfavorable loss development on premiumsproduced in periods prior to 2005.

***Insurance Services Segment Results of Operations 2005Compared 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 5.8% decrease in reinsurance intermediary fees to $688,000 in2005, compared to $730,000 in 2004 due to the reduction in the quota sharetreaty ceding percentages. Claims administration revenue increased by 4.0% to$4.3 million in 2005 as compared to $4.1 million in 2004. Premiums producedduring 2005 on business subject to the renewal rights agreement with OneBeaconamounted to $5.1 million compared to $0.8 million in 2004. New businessproduced through former OneBeacon producers that we appointed in connectionwith the renewal rights transaction amounted to $1.5 million in 2005 comparedto $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.

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

**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 value of our invested assets as of December 31,2006 was $ 464.0 million. Our fixed maturity securities as of this date had afair value of $414.6 million and an amortized cost of $416.6 million. Theequity securities carried at fair value were $49.5 million with a cost of $48.0million as of December 31, 2006. Equity securities carried at cost werereclassified to equity securities at fair value as of September 30, 2006in accordance with GAAP for insurance companies.

On November 3, 2005, the FASB issued FSP FAS 115-1and FAS 124-1, “Other-Than-Temporary Impairment and Its Application toCertain Investments.”  The guidance inthis FSP addresses the determination of when an investment is consideredimpaired, whether that impairment is other-than-temporary, and the measurementof an impairment loss. The FSP also includes accounting considerationssubsequent to the recognition of other than temporary impairment and requirescertain disclosures about unrealized losses that have not been recognized asother-than-temporary impairments. The guidance in this FSP applies to reportingperiods beginning after December 15, 2005.

Impairment of investment securities results in acharge to operations when a market decline below cost is deemed to beother-than-temporary. As of December 31, 2006, we reviewed ourfixed-maturity and equity securities portfolios to evaluate the necessity ofrecording impairment losses for other-than-temporary declines in the fair valueof investments in accordance with the provisions of this FSP. We determinedthat we did not hold any investments were considered other than temporarilyimpaired.

Thefollowing table provides a breakdown of the amortized cost, aggregate fairvalue and unrealized gains and losses by investment type as of December 31,2006 and December 31, 2005.

| ** **                              | ** ** | **As of December 31,** | ** **  |
|-----------------------------------------|------------|---------------------------------------|-------------|
| ** **                              | ** ** | **2006**                              | ** **  | **2005** | ** ** |
| **Category**                            | ** ** | ** **                            | ** **  | **Cost or   Amortized**Cost | ** ** | **Aggregate  Fair  Value** | ** ** | **Unrealized  Gains/  (Losses)** | ** ** | **Cost or   Amortized**  Cost | ** ** | **Aggregate  Fair  Value** | ** ** | **Unrealized  Gains/  (Losses)** | ** ** |
| ** **                              | ** ** | **($ in thousands)**        | ** **  |
| U.S. Treasury securities                |       | $                                     | 14,594      |   | $ | 14,459 |   |   | $ | (135 | ) |   | $ | 7,224 |   | $ | 7,132 |   |   | $ | (92 | ) |   |   |
| U.S. Agency securities                  |       | 30,699                                |        | 30,674 |   |   | (25 | ) |   | 31,937 |   | 31,623 |   |   | (314 | ) |   |   |
| Corporate fixed maturity securities     |       | 122,868                               |        | 122,685 |   |   | (183 | ) |   | 77,852 |   | 76,488 |   |   | (1,364 | ) |   |   |
| Mortgage-backed securities              |       | 130,373                               |        | 129,257 |   |   | (1,116 | ) |   | 98,786 |   | 96,922 |   |   | (1,864 | ) |   |   |
| Asset-backed securities                 |       | 17,165                                |        | 16,917 |   |   | (248 | ) |   | 15,431 |   | 15,188 |   |   | (243 | ) |   |   |
| Other taxable fixed maturity securities |       | —                                |        | — |   |   | — |   |   | 250 |   | 244 |   |   | (6 | ) |   |   |
| Municipal securities                    |       | 100,943                               |        | 100,575 |   |   | (368 | ) |   | 99,643 |   | 99,084 |   |   | (559 | ) |   |   |
| Preferred stocks                        |       | 5,627                                 |        | 5,672 |   |   | 45 |   |   | 113 |   | 115 |   |   | 2 |   |   |   |
| Common stocks                           |       | 42,344                                |        | 43,781 |   |   | 1,437 |   |   | 31,126 |   | 29,872 |   |   | (1,254 | ) |   |   |
| **Total**                               | ** ** | **$**                                 | **464,613** |   | **$** | **464,020** |   | ** ** | **$** | **(593** | **)** | ** ** | **$** | **362,362** |   | **$** | **356,668** |   | ** ** | **$** | **(5,694** | **)** | ** ** |   |
|                                         |            |                                       |             |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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Thefollowing table presents information regarding our invested assets that were inan unrealized loss position at December 31, 2006 by amount of time in acontinuous 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                  |       | $                              | 4,095       |                    |       | $                    | (10        | ) |   | $ | 5,801 |   |   | $ | (151 | ) |   | $ | 9,896 |   |   | $ | (161 | ) |   |
| U.S. Agency  securities                    |       | 6,525                          |        |                    | (21        | )                    |       | 12,151 |   |   | (118 | ) |   | 18,676 |   |   | (139 | ) |   |
| Corporate fixed  maturity securities       |       | 25,550                         |        |                    | (237       | )                    |       | 42,748 |   |   | (1,052 | ) |   | 68,298 |   |   | (1,289 | ) |   |
| Mortgage-backed  securities                |       | 28,669                         |        |                    | (213       | )                    |       | 59,868 |   |   | (1,566 | ) |   | 88,537 |   |   | (1,779 | ) |   |
| Asset-backed  securities                   |       | 995                            |        |                    | (3         | )                    |       | 14,180 |   |   | (282 | ) |   | 15,175 |   |   | (285 | ) |   |
| Municipal  securities                      |       | 20,213                         |        |                    | (94        | )                    |       | 45,390 |   |   | (613 | ) |   | 65,603 |   |   | (707 | ) |   |
| Equities                                   |       | 25,960                         |        |                    | (275       | )                    |       | 2,816 |   |   | (463 | ) |   | 28,776 |   |   | (738 | ) |   |
| **Total temporarily impaired  securities** | ** ** | **$**                          | **112,007** | ** **              | ** ** | **$**                | **(853**   | **)** | ** ** | **$** | **182,954** | ** ** | ** ** | **$** | **(4,245** | **)** | ** ** | **$** | **294,961** | ** ** | ** ** | **$** | **(5,098** | **)** | ** ** |
|                                            |            |                                |             |                         |            |                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Liquidity andCapital 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.

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 $4,600,000,$2,050,000, and $850,000 in dividends to Tower in 2006, 2005, and 2004,respectively. As of December 31, 2006, the maximum amount of distributionsthat TICNY could pay to its parent without approval of the New York StateInsurance Department was $10.5 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$700,000 in 2006, $2,550,000 in 2005 and none in 2004.

TNIC may 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 Massachusetts Commissionerof Insurance has received notice of the intended dividend and not objected insuch time. As of December 31, 2006, the maximum amount of distributionsthat TNIC could pay to its parent without approval of the MassachusettsCommissioner of Insurance was $89,000.

Pursuant to a TaxAllocation Agreement, by and among Tower, TICNY, TNIC, TICA and TRM, we computeand pay Federal income taxes on a consolidated basis. TICA will file a shortyear tax return in 

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2006. Atthe end of each consolidated return year, each entity must compute and pay toTower its share of the Federal income tax liability primarily based on separatereturn calculations. The tax allocation agreement allows Tower to make certainCode elections in the consolidated Federal tax return. In the event such Codeelections are made, any benefit or liability is accrued or paid by each entity.If a unitary or combined state income tax return is filed, each entity’s shareof the liability is based on the methodology required or established by stateincome tax law or, if none, the percentage of each entity’s separate income ortax divided by the total separate income or tax reported on the return. During2006, TICNY paid $14.7 million, TRM paid $0.1 million, and TNIC paid $0.1million to Tower 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 $107.8 million from the offeringand concurrent private placement after the underwriting discounts, commissionsand offering expenses. The total costs of the IPO and private placement were$12.3 million of which $8.4 million was for the underwriting discount, and $3.8million 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.

On October 26, 2004 we contributed $98.0 millionin paid in capital to TICNY, which in turn invested this cash in itsfixed-income portfolio.

On June 8, 2005 theCompany contributed $10.0 million in capital and surplus to TNIC. In 2006, wecontributed $49.6 million in capital and surplus to TICNY.

***Cash Flows from Issuance of Subordinated Debenturesand Perpetual Preferred Stock***

In March 2006, we issued $20 million ofsubordinated debentures and in December 2006, we issued 40,000 shares ofperpetual preferred stock for $39.6 million, net of issuance costs.

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***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 31,2006, 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 capital contributions toTICNY of $49.6 in 2006 and none in 2005. In June 2005, we contributed$10.0 million in cash to TNIC and an additional $1.3 million for the stateinsurance licenses we acquired as part of the 2005 purchase of a shellinsurance 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 insurance regulators.Statutory surplus requirements are greater for net premiums earned and retainedthan 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 and TNIC aregross premiums written, ceding commissions from our quota share reinsurers,loss payments by our reinsurers, investment income and proceeds from the saleor maturity of investments. Funds are used by TICNY and TNIC for ceded premiumpayments to reinsurers, which are paid on a net basis after subtracting lossespaid on reinsured claims and reinsurance commissions. TICNY and TNIC also usefunds for loss payments and loss adjustment expenses on our net business,commissions to producers, salaries and other underwriting expenses as well asto purchase investments and to pay dividends to Tower. TRM’s primary sources ofcash are commission and fee income. TRM’s primary uses of cash are commissionsto producers and expenses reimbursed to TICNY under an expense sharingagreement.

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 Years Ended December 31, 2006 and2005***

For 2006 net cash provided by operating activities was$134.0 million compared to $128.5 million for 2005. The increase in net cashprovided by operations for 2006 resulted primarily from an increase incollected premiums as a result of the growth in gross premiums written and thePXRE commutation and novation agreements executed during the second quarter of2006, offset by the increase in payments to our reinsurers which resulted froman increase in the quota share premiums ceded to CastlePoint and from theincrease in catastrophe costs in 2006.

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For 2006 we had $131.8 million of net cash flows usedin investing activities that were funded from operating cash flow compared to$143.3 million in 2005. During 2006, the Company capitalized $22.9 million forthe purchase of fixed assets and entered into a sale leaseback on $5.2 millionof these assets. The Company relocated its New York City corporate headquarterswithin the same building during 2006. The Company capitalized $10.4 million forleasehold improvements, $6.1 million for furniture & equipment and $6.4million for computer hardware and software in 2006. The landlord provided a$4.8 million build-out allowance which partly financed the $10.4 million ofleasehold improvements. In addition, we had net purchases in our fixed-maturitysecurities for $83.4 million and net purchases in our equity investments for$16.6 million in 2006. In addition, during 2006 we invested $14.4 million tostart up CastlePoint.

Net cash flows provided byfinancing activities for the twelve months ended December 31, 2006 were$59.7 million compared to $1.6 million used in financing activities in 2005. The2006 amount included the net proceeds from the issuance of $20.0 million insubordinated debentures on March 31, 2006 and the issuance of perpetualpreferred stock in December 2006, net of issuance costs, for $39.6 million.The Company paid common stockholder dividends of $2.0 million in each of 2006and 2005.

***Comparison of Years Ended December 31, 2005 and2004***

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 investments in securities with cash provided by operations.

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 million in2005 and 2004, respectively.

***Liquidity***

We maintain sufficient liquidity to pay claims,operating expenses and meet our other obligations. We held $100.6 million and$38.8 million of cash and cash equivalents at December 31, 2006 and 2005,respectively, which included $20.0 and $26.1 million, respectively, which wereof short-term duration of less than ninety days and were recorded as cashequivalents on the balance sheet. We monitor our expected claims payment needsand maintain a sufficient portion of our invested assets in cash and cashequivalents to enable us to fund our claims payments without having to selllonger-duration investments. As of December 31, 2006, cash and cashequivalents greatly exceeded the estimated $45.2 million of net loss reservesas of that date that we expected to pay within the next year. The $61.8 millionincrease in cash and cash equivalents as of December 31, 2006 compared to December 31,2005 was due to the relatively flat yield curve and management’s decision toinvest new funds short term and not taking on additional interest rate riskassociated with longer term investments as well as the $39.6 million of newcash from the perpetual preferred stock offering. These funds will bereinvested longer term by our investment manager as we see advantages in thefixed maturity market. As necessary, we adjust our holdings of short-term 

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investments and cash andcash equivalents to provide sufficient liquidity to respond to changes in theanticipated pattern of claims payments. See “Item 1.—Investments.”

On January 26, 2007 we closed on our sale of2,704,000 shares of common stock at an offering price of $31.25 per share. Ourgross proceeds of $84.5 million were reduced by $4.2 million for theunderwriters discount and $1.0 million for other offering expenses which leftus approximately $79.3 million of new proceeds. We used $20.0 million of thesenet proceeds to redeem our remaining $20.0 million of perpetual preferred stock.As of January 26, 2007 all of our perpetual preferred stock was fullyredeemed.

On February 5, 2007the underwriters exercised their 340,600 shares of common stock available undertheir 30-day over-allotment option at the offering price of $31.25 pershares. We received gross proceeds of $10.6 million from this over-allotmentoption and net proceeds of $10.1 million after the underwriting discount. Theexercise of the over-allotment option brings our aggregate net proceeds fromthe offering and follow-on offering, after underwriting discounts, commissionsand expenses, to approximately $89.4 million.

***Commitments***

Thefollowing table summarizes information about contractual obligations andcommercial commitments. The minimum payments under these agreements as of December 31,2006 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             |       | $                              | 88,664      |   |   | $ | — |   |   | $ | — |   | $ | — |   | $ | 88,664 |   |
| Interest on  subordinated debentures |       | 208,310                        |        |   | 7,363 |   |   | 14,726 |   | 14,726 |   | 171,495 |   |
| Operating lease  obligations         |       | 59,851                         |        |   | 5,118 |   |   | 10,371 |   | 10,403 |   | 33,959 |   |
| Gross loss  reserves                 |       | 302,541                        |        |   | 70,989 |   |   | 117,048 |   | 70,008 |   | 44,496 |   |
| **Total contractual obligations**    | ** ** | **$**                          | **659,366** | ** ** | ** ** | **$** | **83,470** |   | ** ** | **$** | **142,145** | ** ** | **$** | **95,137** | ** ** | **$** | **338,614** | ** ** |

 

The gross loss reserves payments due by period in thetable above are based upon the loss and loss expense reserves estimates as of December 31,2006 and actuarial estimates of expected payout patterns by line of business.As a result, our calculation of loss reserve payments due by period is subject tothe same uncertainties associated with determining the level of reserves and tothe additional uncertainties arising from the difficulty of predicting whenclaims (including claims that have not yet been reported to us) will be paid.The projected gross loss payments presented do not include the estimated cededreserves recoverable from reinsurers that amounted to $110.0 million which areestimated to be recovered as follows: less than one year, $25.8 million; one tothree years, $42.6 million; four to five years, $25.5 million; and after fiveyears, $16.2 million. The interest on the subordinated debentures is calculatedusing interest rates in effect at December 31, 2006 for variable ratedebentures.

For a discussion of ourreserving process, see “Item 7.—Critical Accounting Policies—Loss and LossAdjustment Expense Reserves.” Actual payments of losses and loss adjustmentexpenses by period will vary, perhaps materially, from the above table to theextent that current estimates of loss reserves vary from actual ultimate claimsamounts and as a result of variations between expected and actual payoutpatterns. See “Item 1A. - Risk Factors-Risks Related to Our Business-If ouractual loss and loss adjustment expenses exceed our loss reserves, ourfinancial condition and results of operations could be significantly affected,”for a discussion of the uncertainties associated with estimating loss and lossadjustment expense reserves. The ceded reserves recoverable referred to abovealso assumes timely reimbursement from our reinsurers. If our reinsurers do notmeet their contractual obligations on a timely basis, the payment assumptionspresented above could vary materially.

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***Capital Resources***

On March 31, 2006, we participated in a privateplacement of $20.0 million of fixed /floating rate capital securities (the “TrustPreferred Securities”) issued by Tower Group Statutory Trust V (the “Trust”),an affiliated Delaware trust formed on March 29, 2006. The Trust PreferredSecurities mature in April 2036, are redeemable at our option at parbeginning April 7, 2011, and require quarterly distributions of interestby the Trust to the holder of the Trust Preferred Securities. Interestdistributions are initially at a fixed rate of 8.5625% for the first five yearsand will then reset quarterly for changes in the three-month London InterbankOffered Rate (“LIBOR”) plus 330 basis points. The Trust simultaneously issued619 of the Trust’s common securities to us for a purchase price of $0.6million, which constitutes all of the issued and outstanding common securitiesto purchase for $20.6 million a junior subordinated debt security due 2036issued by the Company.

We do not consolidate interest in its statutorybusiness trusts for which we hold 100% of the common trust securities becausewe are not the primary beneficiary of the trusts. The Company’s investment incommon trust securities of the statutory business trust are reported ininvestments as equity securities. We report as a liability the outstandingsubordinated debentures owed to the statutory business trusts.

On January 25, 2007, we participated in a privateplacement of $20.0 million of fixed/floating rate capital securities (the “TrustPreferred Securities”) issued by Tower Group Statutory Trust VI (the “Trust”),an affiliated Delaware trust formed on January 11, 2007. The TrustPreferred Securities mature in April 2036, are redeemable at our option atpar beginning April 7, 2011, and require quarterly distributions ofinterest by the Trust to the holder of the Trust Preferred Securities. Interestdistributions are initially at a fixed rate of 8.155% for the first five yearsand will then reset quarterly for changes in the three-month London InterbankOffered Rate (“LIBOR”) plus 300 basis points. The Trust simultaneously issued619 of the Trust’s common securities to us for a purchase price of $0.6million, which constitutes all of the issued and outstanding common securitiesof the Trust. The Trust used the proceeds from the sale of the Trust PreferredSecurities and common securities to purchase for $20.6 million a JuniorSubordinated Debt Security due 2037 issued by the Company.

In 2003, we formed two statutory business trusts andwe own all of the common trust securities of each trust. The trusts issued$20.0 million of trust preferred securities in private placements and investedthe proceeds thereof and the proceeds from the sale of common trust securitiesin exchange for $20.6 million of junior subordinated debentures issued by ourholding company. In December 2004, we formed two additional statutorybusiness trusts and we own all of the common securities of each of thosetrusts. The trusts issued $26 million of trust preferred securities in aprivate placement and invested the proceeds thereof and the proceeds from thesale of common trust securities in exchange for $26.8 million of juniorsubordinated debentures issued by our holding company. All of the debentureshave stated maturities of thirty years. We have the option to call any or allof the securities at par beginning five years from the date of issuance. Theinterest rate on $10.3 million of the subordinated debentures issued in May 2003will float quarterly for changes in the three month LIBOR plus 4.1% and may notexceed 12.5% prior to the first call date of May 15, 2008. The interestrate on $10.3 million of subordinated debentures issued in September 2003is a combination fixed and floating rate with a fixed rate of 7.5% during theno call 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 the interest rate will floatquarterly for changes in the three month LIBOR interest rate plus 3.4%. Theinterest rate on $13.4 million of subordinated debentures issued on December 21,2004 will float based on the three month LIBOR interest rate plus 3.4%.

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Under the terms forall of the trust preferred securities, 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 default occurs and is continuing, theentire principal and the interest accrued thereon may be declared to be due andpayable 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 Sheet Arrangements***

We have posted anirrevocable letter of credit for $2.0 million for the benefit of OneBeacon InsuranceGroup LLC (“OneBeacon”) representing the estimated commissions due to OneBeaconfor the first year of the Commercial Renewal Rights Agreement dated September 13,2004. We paid the second fiscal year commission in February 2007 and weare in the process of reducing the letter of credit to $1.0 million.

***Inflation***

Property and casualty insurance premiums areestablished before we know the amount of losses and loss adjustment expenses orthe extent to which inflation may affect such amounts. We attempt to anticipatethe potential impact of inflation in establishing our reserves. Inflation inexcess of the levels we have assumed could cause loss and loss adjustmentexpenses 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.

**Item 7A.    QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

Market risk is the riskthat we will incur losses in our investments due to adverse changes in marketrates and prices. Market risk is directly influenced by the volatility andliquidity in the market in which the related underlying assets are invested. Webelieve that we are principally exposed to three types of market risk: changesin interest rates, changes in credit quality of issuers of investmentsecurities and reinsurers, and changes in 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.

We also bear credit risk on our reinsurancerecoverables and premiums ceded to reinsurers. As of December 31, 2006, wehad unsecured reinsurance recoverables of $17.6 million owed by Munich 

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Reinsurance America Inc.,$8.2 million owed by Platinum Underwriters Reinsurance Inc., $5.1 owed byHannover Rueckversicherung AG, $3.6 million owed by Endurance Reinsurance Corp.of America and other reinsurers owing $6.2 million. If any of these reinsurersfails to pay its 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.”

On February 16, 2006, A.M. Best downgradedto “B++” (Good) its former “A-” (Excellent) financial strength rating on PXREand issued a negative outlook. On February 24, 2006 A.M. Bestdowngraded PXRE to “B+ (Good) with a negative outlook. In 2006, we concluded acommutation with PXRE. See “Item 1.—Reinsurance” and Note 5—“Reinsurance.”

We also bear credit riskfor premiums produced by TRM and a limited portion, generally a deposit amount,of the direct premiums written by TICNY. Producers collect such premiums andremit them to us within prescribed periods. After receiving a deposit, theTICNY premiums are directly billed to insureds. In New York State and otherjurisdictions, premiums paid to producers by an insured may be considered tohave been paid under applicable insurance laws and regulations and the insuredwill no longer be liable to us for those amounts, whether or not we haveactually received the premium payment from the producer. Consequently, weassume a degree of credit risk associated with producers. Due to the unsettledand fact specific nature of the law, we are unable to quantify our exposure tothis risk.

***Equity Risk***

Equity risk is the riskthat we may incur economic losses due to adverse changes in equity prices. Ourexposure to changes in equity prices primarily results from our holdings ofcommon stocks, mutual funds and other equities. Our portfolio of equitysecurities available for sale are carried on the balance sheet at fair value. Sinceonly a small percentage of our assets are invested in equity securities, we donot believe that our exposure to equity price risk is significant.

***Interest Rate Risk***

Interest rate risk is the risk that we may incureconomic losses due to adverse changes in interest rates. The primary marketrisk to the investment portfolio is interest rate risk associated withinvestments in fixed maturity securities. Fluctuations in interest rates have adirect impact on the market valuation of these securities. The fair value ofour fixed maturity securities as of December 31, 2006 was $414.6 million.

For fixed maturity securities, short-term liquidity needsand the potential liquidity needs for the business are key factors in managingour portfolio. We use modified duration analysis to measure the sensitivity ofthe fixed income portfolio to changes in interest rates.

As of December 31,2006, we had a total of $23.7 million of outstanding floating rate debt all ofwhich is outstanding subordinated debentures underlying our trust securitiesissued by our wholly owned statutory business trusts and carrying an interestrate that is determined by reference to market interest rates. If interestrates increase, the amount of interest payable by us would also increase.

***Sensitivity Analysis***

Sensitivity analysis is a measurement of potentialloss in future earnings, fair values or cash flows of market sensitive instrumentsresulting from one or more selected hypothetical changes in interest rates andother market rates or prices over a selected time. In our sensitivity analysismodel, we select a hypothetical change in market rates that reflects what webelieve are reasonably possible near-term changes in those 

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rates. The term “near-term”means a period of time going forward up to one year from the date of theconsolidated financial statements. Actual results may differ from thehypothetical change in market rates assumed in this disclosure, especiallysince this sensitivity analysis does not reflect the results of any action thatwe may take to mitigate such hypothetical losses in fair value.

In this sensitivity analysis model, we use fair valuesto measure our potential loss. The sensitivity analysis model includes fixedmaturities and short-term investments.

For invested assets, we use modified duration modelingto calculate changes in fair values. Durations on invested assets are adjustedfor call, put and interest rate reset features. Durations on tax-exemptsecurities are adjusted for the fact that the yield on such securities is lesssensitive to changes in interest rates compared to Treasury securities. Investedasset portfolio durations are calculated on a market value weighted basis,including accrued investment income, using holdings as of December 31,2006.

Thefollowing table summarizes the estimated change in fair value on our fixedmaturity portfolio including short-term investments based on specific changesin interest rates as of December 31, 2006:

| **Change in Interest Rate** | ** ** | ** ** | ** ** | **Estimated Increase   (Decrease) in Fair Value  ($ in thousands)** | ** ** | **Estimated Percentage   Increase (Decrease)   in Fair Value** | ** ** |
|--------------------------------------------|------------|------------|------------|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| 300 basis point  rise                      |       |       | (53,056    | )                                                                                                      |       |                                                                                         | (12.8      | %) |   |
| 200 basis rise                             |       |       | (35,886    | )                                                                                                      |       |                                                                                         | (8.7       | %) |   |
| 100 basis rise                             |       |       | (18,078    | )                                                                                                      |       |                                                                                         | (4.4       | %) |   |
| As of  December 31, 2006              |       |       | 0          |                                                                                                   |       |                                                                                         | 0.0        | % |   |
| 50 basis point  decline                    |       |       | 8,851      |                                                                                                   |       |                                                                                         | 2.1        | % |   |
| 100 basis point decline                    |       |       | 17,378     |                                                                                                   |       |                                                                                         | 4.2        | % |   |

 

The sensitivity analysis model used by us produces apredicted pre-tax loss in fair value of market-sensitive instruments of $18.1million or 4.4% based on a 100 basis point increase in interest rates as of December 31,2006. This loss amount only reflects the impact of an interest rate increase onthe fair value of our fixed maturities investments which constitutedapproximately 89% of our total invested assets excluding cash and cashequivalents as of December 31, 2006.

Interest expense would also be affected by ahypothetical change in interest rates. As of December 31, 2006 we had$23.7 million of floating rate debt obligations. Assuming this amount remainsconstant, a hypothetical 100 basis point increase in interest rates wouldincrease annual interest expense by $237,000, a 200 basis point increase wouldincrease interest expense by $474,000 and a 300 basis point increase wouldincrease interest expense by $711,000.

With respect to investment income, the mostsignificant assessment of the effects of hypothetical changes in interest rateson investment income would be based on Statement of Financial AccountingStandards No. 91, Accounting for Nonrefundable Fees and Costs Associatedwith Originating or Acquiring Loans and Initial Direct Costs of Leases (“FAS 91”),issued by the Financial Accounting Standards Board (“FASB”), which requiresamortization adjustments for mortgage backed securities. The rates at which themortgages underlying mortgage backed securities are prepaid, and therefore theaverage life of mortgage backed securities, can vary depending on changes ininterest rates (for example, mortgages are prepaid faster and the average lifeof mortgage backed securities falls when interest rates decline). Theadjustments for changes in amortization, which are based on revised averagelife assumptions, would have an impact on investment income if a significantportion of our mortgage backed securities holdings had been purchased atsignificant discounts or premiums to par value. As of December 31, 2006,the par value of our mortgage backed securities holdings was $134.7 million andthe book value of our mortgage backed securities holdings was $130.4 million. Thisequates to an average price of 96.8% of par. Since few of our mortgage 

98

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backed securities werepurchased at more than three points (below 97% and above 103%) from par, a FAS91 adjustment would not have a significant effect on investment income.

Furthermore, significant hypothetical changes ininterest rates in either direction would not have a significant effect onprincipal redemptions, and therefore investment income, because of theprepayment protected mortgage securities in the portfolio. The mortgage backedsecurities portion of the portfolio totaled 23.9% as of December 31, 2006.Of this total, only 1.0% was in agency pass through securities, which have thehighest amount of prepayment risk from declining rates. The remainder of ourmortgage backed securities portfolio is invested in agency planned amortizationclass collateralized mortgage obligations, non-agency residentialnon-accelerating securities, and commercial mortgage backed securities.

The planned amortization class collateralized mortgageobligation securities maintain their average life over a wide range ofprepayment assumptions, while the non-agency residential non-acceleratingsecurities have five years of principal lock-out protection and the commercialmortgage backed securities have very onerous prepayment and yield maintenanceprovisions that greatly reduce the exposure of these securities to prepayments.

99

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**ITEM 8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

**Index toConsolidated Financial Statements**

|                                                                                                                           | ** ** | **Page** |
|---------------------------------------------------------------------------------------------------------------------------|------------|----------|
| Management Report on Internal Control Over Financial  Reporting                                                           |       | F-1      |
| Report of Independent Registered Public Accounting  Firm—Internal Control Over Financial Reporting                   |       | F-2      |
| Report of Independent Registered Public Accounting  Firm—Consolidated Financial Statements                           |       | F-4      |
| Consolidated  Balance Sheets at December 31, 2006 and 2005                                                           |       | F-5      |
| Consolidated Statements of Income and Comprehensive  Net Income for the years ended December 31, 2006, 2005 and 2004 |       | F-7      |
| Consolidated Statements of Stockholders’ Equity for  the years ended December 31, 2006, 2005 and 2004           |       | F-8      |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2006, 2005 and 2004                          |       | F-9      |
| Notes to Consolidated Financial Statements                                                                                |       | F-11     |

vh

100

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**CONSOLIDATEDFINANCIAL STATEMENTS**

**Management’s AnnualReport on Internal Control Over Financial 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, 2006, 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 that framework, management concluded thatthe Company’s internal control over financial reporting was effective as of December 31,2006.

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, 2006 has been audited by Johnson Lambert & Co.LLP an independent registered accounting firm, as stated in their reportincluded herein, which expresses unqualified opinions on management’sassessment and on the effectiveness of the Company’s internal control overfinancial reporting as of December 31, 2006.

**March 5, 2007**

F-1

----

**Reportof Independent Registered Public Accounting Firm**

Tothe Board of Directors

Tower Group, Inc.

We have audited management’s assessment, included inthe accompanying Management’s Annual Report on Internal Control Over FinancialReporting, that Tower Group, Inc and subsidiaries (the “Company”) maintainedeffective internal control over financial reporting as of December 31,2006, 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 effectiveinternal control over financial reporting and for its assessment of theeffectiveness of internal control over financial reporting. Our responsibilityis to express an opinion on management’s assessment and an opinion on theeffectiveness of the company’s internal control over financial reporting basedon our audit.

We conducted our audit 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 effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining an understandingof internal control over financial reporting, evaluating management’sassessment, testing and evaluating the design and operating effectiveness ofinternal control, and performing such other procedures as we considerednecessary in the circumstances. We believe that our audit provides a reasonablebasis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, in reasonabledetail, accurately and fairly reflect the transactions and dispositions of theassets of the company; (2) provide reasonable assurance that transactionsare recorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that theCompany maintained effective internal control over financial reporting as of December 31,2006, is fairly stated, in all material respects, based on criteria establishedin Internal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). Also, in our opinion, theCompany maintained, in all material respects, effective internal control overfinancial reporting as of December 31, 2006, based on criteria establishedin Internal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).

F-2

----

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 31,2006 and 2005, 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, 2006 and ourreport dated March 5, 2007 expressed an unqualified opinion thereon.

|                        | /s/ JOHNSON  LAMBERT & CO. LLP |
|------------------------|-----------------------------------------|
|                   |                                    |
|                   |
| Falls Church, Virginia |
| March 5, 2007     |

 

F-3

----

**Reportof Independent Registered Public Accounting Firm**

Tothe Board of Directors

Tower Group, Inc.

We have audited the accompanying consolidated balancesheets of Tower Group, Inc. and subsidiaries (the “Company”) as of December 31,2006 and 2005 and the related statements of income and comprehensive netincome, changes in stockholders’ equity and cash flows for each of the threeyears in the period ended December 31, 2006. These financial statementsare the responsibility of the Company’s management. Our responsibility is toexpress an opinion on these financial statements based on our 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, 2006 and 2005, and the results of its operations andits cash flows for the three years in the period ended December 31, 2006in 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, 2006 based on criteria establishedin Internal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO) and our report dated March 5,2007 expressed an unqualified opinion thereon.

|                        | /s/ JOHNSON LAMBERT & CO. LLP |
|------------------------|----------------------------------------|
| Falls Church, Virginia |
| March 5,  2007    |

 

F-4

----

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

| ** **                                                                                                            | ** ** | **December 31,**          | ** **  |
|-----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|-------------|
| ** **                                                                                                            | ** ** | **2006**                       | ** **  | **2005** | ** ** |
| ** **                                                                                                            | ** ** | **($ in thousands)** | ** **  |
| **Assets**                                                                                                            | ** ** | ** **                     | ** **  | ** ** | ** ** |
| Fixed-maturity  securities, available-for-sale, at fair value (amortized cost $416,642 in  2006 and $331,123 in 2005) |       | $                              | 414,567     |   | $ | 326,681 |   |
| Equity  securities, available-for-sale, at fair value (cost $47,971 in 2006 and  $31,239 in 2005)                     |       | 49,453                         |        | 30,492 |   |
| **Total investments**                                                                                                 |       | 464,020                        |        | 357,173 |   |
| Cash and cash  equivalents                                                                                            |       | 100,598                        |        | 38,760 |   |
| Investment income  receivable                                                                                         |       | 4,767                          |        | 3,337 |   |
| Agents’ balances  receivable                                                                                     |       | 65,578                         |        | 46,004 |   |
| Assumed premiums  receivable                                                                                          |       | 77                             |        | 1,076 |   |
| Ceding commission  receivable                                                                                         |       | 3,237                          |        | 8,727 |   |
| Reinsurance  recoverable                                                                                              |       | 118,003                        |        | 104,811 |   |
| Receivable—claims  paid by agency                                                                                |       | 5,186                          |        | 2,309 |   |
| Prepaid  reinsurance premiums                                                                                         |       | 94,063                         |        | 43,319 |   |
| Deferred  acquisition costs net of deferred ceding commission revenue                                                 |       | 35,811                         |        | 29,192 |   |
| State income tax  recoverable                                                                                         |       | —                         |        | 365 |   |
| Deferred income  taxes                                                                                                |       | —                         |        | 3,204 |   |
| Intangible assets                                                                                                     |       | 5,423                          |        | 5,835 |   |
| Fixed assets, net of accumulated depreciation                                                                         |       | 20,563                         |        | 7,920 |   |
| Investment in  unconsolidated affiliate                                                                               |       | 27,944                         |        | — |   |
| Investment in  statutory business trusts, equity method                                                               |       | 2,045                          |        | 1,426 |   |
| Other assets                                                                                                          |       | 6,767                          |        | 3,999 |   |
| **Total Assets**                                                                                                      | ** ** | **$**                          | **954,082** | ** ** | **$** | **657,457** | ** ** |

 

*(Continued)*

See accompanying notes to the consolidated financial statements.

F-5

----

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

| ** **                                                                                                                                                                                                                                    | ** ** | **December 31,**                                           | ** **  |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------|-------------|
| ** **                                                                                                                                                                                                                                    | ** ** | **2006**                                                        | ** **  | **2005** | ** ** |
| ** **                                                                                                                                                                                                                                    | ** ** | **($ in thousands,  except par value and  share amounts)** | ** **  |
| **Liabilities**                                                                                                                                                                                                                               |       |                                                            |        |   |   |
| Loss and loss  adjustment expenses                                                                                                                                                                                                            |       | $                                                               | 302,541     |   | $ | 198,724 |   |
| Unearned premium                                                                                                                                                                                                                              |       | 227,017                                                         |        | 157,779 |   |
| Reinsurance  balances payable                                                                                                                                                                                                                 |       | 38,560                                                          |        | 19,200 |   |
| Payable to  issuing carriers                                                                                                                                                                                                                  |       | 662                                                             |        | 5,252 |   |
| Funds held as  agent                                                                                                                                                                                                                          |       | 8,181                                                           |        | 8,191 |   |
| Funds held under  reinsurance agreements                                                                                                                                                                                                      |       | 51,527                                                          |        | 59,042 |   |
| Accounts payable  and accrued expenses                                                                                                                                                                                                        |       | 18,267                                                          |        | 13,694 |   |
| Deferred rent  liability                                                                                                                                                                                                                      |       | 6,295                                                           |        | — |   |
| Payable for  securities                                                                                                                                                                                                                       |       | 2,922                                                           |        | — |   |
| Other liabilities                                                                                                                                                                                                                             |       | 3,515                                                           |        | 2,867 |   |
| Federal and state  income taxes payable                                                                                                                                                                                                       |       | 1,163                                                           |        | 460 |   |
| Deferred income  taxes                                                                                                                                                                                                                        |       | 1,255                                                           |        | — |   |
| Dividends payable                                                                                                                                                                                                                             |       | 212                                                             |        | — |   |
| Subordinated  debentures                                                                                                                                                                                                                      |       | 68,045                                                          |        | 47,426 |   |
| **Total Liabilities**                                                                                                                                                                                                                         | ** ** | **730,162**                                                     | ** **  | **512,635** | ** ** |
| **Stockholders’  Equity**                                                                                                                                                                                                                |       |                                                            |        |   |   |
| Series A  perpetual preferred stock ($0.01 par value per share; 2,000,000 shares  authorized; 40,000 shares issued and outstanding in 2006; liquidation  preference of $1,000 per share, net of $0.4 million of issuance costs |       | 39,600                                                          |        | — |   |
| Common stock  ($0.01 par value per share; 40,000,000 shares authorized, 20,005,758 and  19,872,672 shares issued in 2006 and 2005 and 19,980,306 and 19,854,791  outstanding in 2006 and 2005)                                                |       | 200                                                             |        | 199 |   |
| Paid-in-capital                                                                                                                                                                                                                               |       | 113,168                                                         |        | 111,066 |   |
| Accumulated other  comprehensive net loss                                                                                                                                                                                                     |       | (437                                                            | )           | (3,352 | ) |
| Retained earnings                                                                                                                                                                                                                             |       | 71,596                                                          |        | 37,019 |   |
| Treasury stock  (25,452 shares in 2006 and 17,881 in 2005)                                                                                                                                                                               |       | (207                                                            | )           | (110 | ) |
| **Total Stockholders’ Equity**                                                                                                                                                                                                           | ** ** | **223,920**                                                     | ** **  | **144,822** | ** ** |
| **Total  Liabilities and Stockholders’ Equity**                                                                                                                                                                                          | ** ** | **$**                                                           | **954,082** | ** ** | **$** | **657,457** | ** ** |

 

See accompanying notes to the consolidated financial statements.

F-6

----

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

| ** **                                                                                            | ** ** | **Year Ended December 31,**                                                   | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| ** **                                                                                            | ** ** | **2006**                                                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                            | ** ** | **($ in thousands, except per share  and share amounts)** | ** ** |
| **Revenues**                                                                                          | ** ** | ** **                                                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net premiums earned                                                                                   |       | $                                                                                            | 223,988    |   | $ | 164,436 |   | $ | 45,564 |   |
| Ceding commission revenue                                                                             |       | 43,130                                                                                       |       | 25,218 |   | 39,983 |   |
| Insurance services revenue                                                                            |       | 7,973                                                                                        |       | 14,103 |   | 16,381 |   |
| Net investment income                                                                                 |       | 23,026                                                                                       |       | 14,983 |   | 5,070 |   |
| Net realized gains on investments                                                                     |       | 12                                                                                           |       | 122 |   | 13 |   |
| Policy billing fees                                                                                   |       | 1,134                                                                                        |       | 892 |   | 679 |   |
| Total revenues                                                                                        |       | 299,263                                                                                      |       | 219,754 |   | 107,690 |   |
| **Expenses**                                                                                          |       |                                                                                         |       |   |   |   |   |
| Loss and loss adjustment expenses                                                                     |       | 135,125                                                                                      |       | 96,614 |   | 27,060 |   |
| Direct commission expense                                                                             |       | 60,558                                                                                       |       | 43,839 |   | 32,825 |   |
| Other operating expenses                                                                              |       | 53,675                                                                                       |       | 42,632 |   | 29,954 |   |
| Interest expense                                                                                      |       | 6,870                                                                                        |       | 4,853 |   | 3,128 |   |
| Total expenses                                                                                        |       | 256,228                                                                                      |       | 187,938 |   | 92,967 |   |
| **Other Income**                                                                                      |       |                                                                                         |       |   |   |   |   |
| Equity income in unconsolidated affiliate                                                             |       | 914                                                                                          |       | — |   | — |   |
| Gain from issuance of common stock by unconsolidated  affiliate                                       |       | 7,883                                                                                        |       | — |   | — |   |
| Warrant received from unconsolidated affiliate                                                        |       | 4,605                                                                                        |       | — |   | — |   |
| Income before income taxes                                                                            |       | 56,437                                                                                       |       | 31,816 |   | 14,723 |   |
| Income tax expense                                                                                    |       | 19,673                                                                                       |       | 11,062 |   | 5,694 |   |
| **Net income**                                                                                        | ** ** | **$**                                                                                        | **36,764** | ** ** | **$** | **20,754** | ** ** | **$** | **9,029** | ** ** |
| **Comprehensive Net Income**                                                                          |       |                                                                                         |       |   |   |   |   |
| Net income                                                                                            |       | $                                                                                            | 36,764     |   | $ | 20,754 |   | $ | 9,029 |   |
| Other  comprehensive income:                                                                          |       |                                                                                         |       |   |   |   |   |
| Gross unrealized investment holding gains (losses)  arising during period                             |       | 4,443                                                                                        |       | (6,664 | ) | 44 |   |
| Equity in net unrealized gains in investment in  unconsolidated affiliate’s investment portfolio |       | 143                                                                                          |       | — |   | — |   |
| Less: reclassification adjustment for net realized  gains included in net income                      |       | (12                                                                                          | )          | (122 | ) | (13 | ) |
|                                                                                                  |       | 4,574                                                                                        |       | (6,786 | ) | 31 |   |
| Income tax (expense) benefit related to items of  other comprehensive income                          |       | (1,659                                                                                       | )          | 2,382 |   | (27 | ) |
| Total other comprehensive net income (losses)                                                         |       | 2,915                                                                                        |       | (4,404 | ) | 4 |   |
| **Comprehensive Net Income**                                                                          | ** ** | **$**                                                                                        | **39,679** | ** ** | **$** | **16,350** | ** ** | **$** | **9,033** | ** ** |
| **Earnings Per Share**                                                                                |       |                                                                                         |       |   |   |   |   |
| Basic earnings per common share                                                                       |       | $                                                                                            | 1.85       |   | $ | 1.06 |   | $ | 1.23 |   |
| Diluted earnings per common share                                                                     |       | $                                                                                            | 1.82       |   | $ | 1.03 |   | $ | 1.06 |   |
| **Weighted Average Common Shares  Outstanding:**                                                      |       |                                                                                         |       |   |   |   |   |
| Basic                                                                                                 |       | 19,750,309                                                                                   |       | 19,571,081 |   | 7,335,286 |   |
| Diluted                                                                                               |       | 20,147,318                                                                                   |       | 20,147,073 |   | 8,565,815 |   |
| **Dividends declared and paid per  common share:**                                                    |       |                                                                                         |       |   |   |   |   |
| Common stock                                                                                          |       | $                                                                                            | 0.10       |   | $ | 0.10 |   | $ | 0.0250 |   |
| Class A stock                                                                                    |       | N/A                                                                                          |       | N/A |   | $ | 0.1137 |   |
| Class B stock                                                                                    |       | N/A                                                                                          |       | N/A |   | $ | 0.1142 |   |

 

See accompanying notes to the consolidated financial statements.

F-7

----

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

| ** **                                                                       | ** ** | **Preferred  Stock**      | ** ** | **Common  Stock** | ** ** | **Class A  Common Stock** | ** ** | **Class B  Common Stock** | ** ** | **Paid-in  Capital** | ** ** | **Accumulated  Other  Comprehensive  Net Income** | ** ** | **Retained  Earnings** | ** ** | **Treasury  Stock** | ** ** | **Total  Stockholders’  Equity** | ** ** |       |
|----------------------------------------------------------------------------------|------------|---------------------------|------------|-------------------|------------|-------------------------------------|------------|-------------------------------------|------------|----------------------|------------|--------------------------------------------------------|------------|------------------------|------------|---------------------|------------|---------------------------------------|------------|------------|
| ** **                                                                       | ** ** | **($ in thousands)** | ** ** |              |
| **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          | ** **                          |       |                 | —     |                                                   |       |                   | —     |                |       | 487                                   |       |       | — |   |   | — |   |   | 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**    | ** **                          |       |                 | —     |                                                   |       |                   | —     | ** **          |       | **110,467**                           | ** ** |       | **1,052** | ** ** |   | **18,224** |   |   | **(494** | **)** |   |   | **129,447** | ** ** |   |
| Dividends  declared                                                              |       |                      | —     | ** **        |       |                                | —     | ** **                          |       |                 | —     |                                                   |       |                   | —     |                |       | —                                |       |       | — |   |   | (1,959 | ) |   | — |   |   |   | (1,959 | ) |   |
| Stock based  compensation                                                        |       |                      | —     | ** **        |       |                                | 1          | ** **                          |       |                 | —     |                                                   |       |                   | —     |                |       | 925                                   |       |       | — |   |   | — |   |   | (32 | ) |   |   | 894 |   |   |
| Warrant exercise                                                                 |       |                      | —     | ** **        |       |                                | —     | ** **                          |       |                 | —     |                                                   |       |                   | —     |                |       | (326                                  | )          |       | — |   |   | — |   |   | 416 |   |   |   | 90 |   |   |
| Net income                                                                       |       |                      | —     | ** **        |       |                                | —     | ** **                          |       |                 | —     |                                                   |       |                   | —     |                |       | —                                |       |       | — |   |   | 20,754 |   |   | — |   |   |   | 20,754 |   |   |
| Net unrealized  appreciation on securities available for sale, net of income tax |       |                      | —     | ** **        |       |                                | —     | ** **                          |       |                 | —     |                                                   |       |                   | —     |                |       | —                                |       |       | (4,404 | ) |   | — |   |   | — |   |   |   | (4,404 | ) |   |
| **Balance  at December 31, 2005**                                           | ** ** |                      | **—** | ** **        |       |                                | **199**    | ** **                          |       |                 | **—** | ** **                                             |       |                   | **—** | ** **          |       | **111,066**                           | ** ** |       | **(3,352** | **)** |   | **37,019** |   |   | **(110** | **)** |   |   | **144,822** | ** ** |   |
| Dividends  declared                                                              |       |                      | —     | ** **        |       |                                | —     | ** **                          |       |                 | —     |                                                   |       |                   | —     |                |       | —                                |       |       | — |   |   | (1,975 | ) |   | — |   |   |   | (1,975 | ) |   |
| Dividends  declared on preferred stock                                           |       |                      | —     | ** **        |       |                                | —     | ** **                          |       |                 | —     |                                                   |       |                   | —     |                |       | —                                |       |       | — |   |   | (212 | ) |   | — |   |   |   | (212 | ) |   |
| Stock based  compensation                                                        |       |                      | —     | ** **        |       |                                | 1          | ** **                          |       |                 | —     |                                                   |       |                   | —     |                |       | 2,102                                 |       |       | — |   |   | — |   |   | (97 | ) |   |   | 2,006 |   |   |
| Issuance of  preferred stock, net of issuance costs of $0.4 million              |       |                      | 39,600     | ** **        |       |                                | —     | ** **                          |       |                 | —     |                                                   |       |                   | —     |                |       | —                                |       |       | — |   |   | — |   |   | — |   |   |   | 39,600 |   |   |
| Net income                                                                       |       |                      | —     | ** **        |       |                                | —     | ** **                          |       |                 | —     |                                                   |       |                   | —     |                |       | —                                |       |       | — |   |   | 36,764 |   |   | — |   |   |   | 36,764 |   |   |
| Net unrealized  appreciation on securities available for sale, net of income tax |       |                      | —     | ** **        |       |                                | —     | ** **                          |       |                 | —     |                                                   |       |                   | —     |                |       | —                                |       |       | 2,915 |   |   | — |   |   | — |   |   |   | 2,915 |   |   |
| **Balance  at December  31, 2006**                                          | ** ** |                      | **$**      | **39,600**        | ** ** |                                |       | **$**                               | **200**    | ** **           |       |                                                   | **$**      | **—**             | ** ** |                |       | **$**                                 | **—** | ** ** |   | **$** | **113,168** | ** ** |   | **$** | **(437** | **)** |   | **$** | **71,596** |   |   | **$** | **(207** | **)** |   |   | **$** | **223,920** | ** ** |   |
|                                                                                  |            |                           |            |                   |            |                                     |            |                                     |            |                      |            |                                                        |            |                        |            |                     |            |                                       |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

See accompanyingnotes to the consolidated financial statements.

F-8

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**TOWER GROUP, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

| ** **                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                         | ** ** | **($ in thousands)**             | ** ** |
| **Cash flows from operating activities:**                                          | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                                          | 36,764     |   | $ | 20,754 |   | $ | 9,029 |   |
| Adjustments to reconcile net income to net cash  provided by (used in) operations: |       |                                       |       |   |   |   |   |
| Gain on issuance of  common shares by unconsolidated affiliate                     |       | (7,883                                     | )          | — |   | — |   |
| Gain on sale of furniture                                                          |       | (58                                        | )          | — |   | — |   |
| Warrant received from  unconsolidated affiliate                                    |       | (4,605                                     | )          | — |   | — |   |
| Gain on sale of investments                                                        |       | (12                                        | )          | (122 | ) | (13 | ) |
| Depreciation                                                                       |       | 4,800                                      |       | 2,870 |   | 1,984 |   |
| Amortization of  intangible assets                                                 |       | 412                                        |       | 446 |   | 22 |   |
| Amortization of bond  premium or discount                                          |       | 564                                        |       | 948 |   | 365 |   |
| Amortization of debt  issuance costs                                               |       | 52                                         |       | 39 |   | 178 |   |
| Amortization of  restricted stock                                                  |       | 860                                        |       | 618 |   | 310 |   |
| Deferred income taxes                                                              |       | 2,801                                      |       | (2,409 | ) | 3,595 |   |
| (Increase) decrease in assets:                                                     |       |                                       |       |   |   |   |   |
| Investment income  receivable                                                      |       | (1,430                                     | )          | (1,362 | ) | (1,423 | ) |
| Agents’ balances  receivable                                                  |       | (19,574                                    | )          | (12,531 | ) | (11,521 | ) |
| Assumed premiums  receivable                                                       |       | 999                                        |       | 121 |   | (200 | ) |
| Receivable for cancelled  reinsurance                                              |       | —                                     |       | — |   | 15,748 |   |
| Ceding commissions  receivable                                                     |       | 5,490                                      |       | (398 | ) | (346 | ) |
| Reinsurance recoverable                                                            |       | (13,192                                    | )          | (4,325 | ) | (16,223 | ) |
| Receivable—claims paid by  agency                                             |       | (2,877                                     | )          | — |   | — |   |
| Prepaid reinsurance  premiums                                                      |       | (50,744                                    | )          | (14,928 | ) | 27,254 |   |
| Deferred acquisition  costs, net                                                   |       | (6,619                                     | )          | (10,452 | ) | (18,168 | ) |
| Federal and state income  taxes recoverable                                        |       | 1,068                                      |       | 2,070 |   | (2,102 | ) |
| Intangible assets                                                                  |       | —                                     |       | (1,302 | ) | (5,000 | ) |
| Equity income in  unconsolidated affiliate                                         |       | (914                                       | )          | — |   | — |   |
| Excess tax benefits from  share-based payment arrangements                         |       | (891                                       | )          | — |   | — |   |
| Other assets                                                                       |       | (2,820                                     | )          | (600 | ) | (2,029 | ) |
| Increase (decrease) in liabilities:                                                |       |                                       |       |   |   |   |   |
| Loss and loss adjustment  expenses                                                 |       | 103,817                                    |       | 70,002 |   | 29,247 |   |
| Unearned premium                                                                   |       | 69,238                                     |       | 62,274 |   | 25,257 |   |
| Reinsurance balances  payable                                                      |       | 19,360                                     |       | 16,465 |   | (18,053 | ) |
| Payable to issuing  carriers                                                       |       | (4,590                                     | )          | (13,400 | ) | 5,926 |   |
| Accounts payable and  accrued expenses                                             |       | 4,573                                      |       | 1,425 |   | 5,266 |   |
| Other liabilities                                                                  |       | 648                                        |       | — |   | — |   |
| Deferred rent                                                                      |       | 6,295                                      |       | — |   | — |   |
| Federal and state income  taxes payable                                            |       | —                                     |       | — |   | (892 | ) |
| Funds held under  reinsurance agreements                                           |       | (7,525                                     | )          | 12,296 |   | 29,198 |   |
| Deferred compensation  liability                                                   |       | —                                     |       | — |   | (1,294 | ) |
| Net cash flows  provided by operations                                             |       | 134,007                                    |       | 128,499 |   | 76,115 |   |
| **Cash flows from investing activities:**                                          | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Purchase of fixed  assets                                                          |       | (22,818                                    | )          | (5,370 | ) | (3,364 | ) |
| Disposal of fixed  assets                                                          |       | 5,433                                      |       |   |   |   |   |
| Investment in  unconsolidated affiliate                                            |       | (14,400                                    | )          | — |   | — |   |
| Purchases of investments:                                                          |       |                                       |       |   |   |   |   |
| Fixed-maturity securities                                                          |       | (154,917                                   | )          | (147,149 | ) | (197,129 | ) |
| Equity securities                                                                  |       | (17,804                                    | )          | (31,126 | ) | — |   |
| Sale of investments:                                                               |       |                                       |       |   |   |   |   |
| Fixed-maturity securities                                                          |       | 71,672                                     |       | 38,325 |   | 23,474 |   |
| Equity securities                                                                  |       | 1,003                                      |       | 1,972 |   | 50 |   |
| Net cash flows used in investing activities                                        |       | (131,831                                   | )          | (143,348 | ) | (176,969 | ) |
|                                                                                    |            |                                            |            |  |  |  |  |  |  |  |

 

*(Continued)*

See accompanying notes to the consolidated financial statements.

F-9

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**TOWER GROUP, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS—(Continued)**
|                                                                     | ** ** | **Year Ended December 31,** | ** **  |
|---------------------------------------------------------------------|------------|--------------------------------------------|-------------|
| ** **                                                          | ** ** | **2006**                                   | ** **  | **2005** | ** ** | **2004** | ** ** |
| ** **                                                          | ** ** | **($ in thousands)**             | ** **  |
| **Cash  flows from financing activities:**                          | ** ** | ** **                                 | ** **  | ** ** | ** ** | ** ** | ** ** |
| Repayment of redeemable preferred stock                             |       | —                                     |        | — |   | (3,000 | ) |
| Proceeds from issuance of subordinated debentures                   |       | 20,619                                     |        | — |   | 26,806 |   |
| Purchase of common trust securities—statutory  business trusts |       | (619                                       | )           | — |   | (806 | ) |
| Repayment of long-term debt- CIT                                    |       | —                                     |        |   |   | (5,588 | ) |
| Decrease (increase) in notes receivables from related  parties      |       |                                       |        |   |   | 1,421 |   |
| Stock repurchase                                                    |       | (97                                        | )           | — |   | — |   |
| Exercise of stock options                                           |       | 1,243                                      |        |   |   |   |   |
| Excess tax benefits from share-based payment  arrangements          |       | 891                                        |        | 277 |   | 200 |   |
| Exercise of warrants                                                |       | —                                     |        | 90 |   | — |   |
| Issuance of perpetual preferred stock, net of  issuance costs       |       | 39,600                                     |        | — |   | — |   |
| IPO and private placement, net proceeds                             |       | 107,845                                    |        |   |   |   |   |
| Dividends paid                                                      |       | (1,975                                     | )           | (1,959 | ) | (1,162 | ) |
| Net cash flows provided/(used in) by financing  activities          |       | 59,662                                     |        | (1,592 | ) | 125,716 |   |
| Increase (decrease) in cash and cash equivalents                    |       | 61,838                                     |        | (16,441 | ) | 24,862 |   |
| Cash and cash equivalents, beginning of period                      |       | 38,760                                     |        | 55,201 |   | 30,339 |   |
| **Cash and cash equivalents, end of year**                          | ** ** | **$**                                      | **100,598** | ** ** | **$** | **38,760** | ** ** | **$** | **55,201** | ** ** |
| **Supplemental disclosures of cash flow  information:**             |       |                                       |        |   |   |   |   |
| Cash paid for income taxes                                          |       | $                                          | 15,344      |   | $ | 11,479 |   | $ | 5,114 |   |
| Cashpaid for  interest                                              |       | $                                          | 6,432       |   | $ | 3,445 |   | $ | 2,261 |   |

 

See accompanying notes to the consolidated financial statements.

F-10

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

**Note 1—Summary ofSignificant Accounting Policies**

*Background*

The consolidated financial statements include theaccounts of Tower Group, Inc. (“Tower”) and its wholly-owned subsidiaries,Tower Insurance Company of New York (“TICNY”), Tower National Insurance Company(“TNIC”), Tower Indemnity Company of America (“TICA”) and Tower Risk ManagementCorporation (“TRM”) (collectively “the Company”). The Company’s stock is tradedon the NASDAQ National Market under the symbol “TWGP.”

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’sIPO, at the 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 underwriters’discount, 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. closedon its purchase of the outstanding common stock of a shell insurance Company,North American Lumber Insurance Company (“NALIC”), that was renamed TowerNational Insurance Company. As of December 31, 2006, Tower NationalInsurance Company was authorized to write business in twenty-five states and issubject to comprehensive regulation and supervision, including limitationsrelating to reserves and statutory surplus, in Massachusetts, its state ofdomicile.

On June 28, 2006, the Company closed on itspurchase of 100% of the outstanding common stock of a shell insurance company,MIIX Insurance Company of New York, which was renamed Tower Indemnity Companyof America (“TICA”). The Company acquired TICA for the value of its statutorysurplus at closing plus $225,000. In October 2006, the company enteredinto an agreement to sell all of the issued and outstanding capital stock ofTICA to CastlePoint for a cash purchase price of $350,000 plus an amount equalto the value of the statutory surplus of TICA at closing. The $125,000difference in the price reflects the legal and brokerage fees paid by Tower inconnection with its acquisition of the company. CastlePoint will rename TICA “CastlePointInsurance Company.”  The Company hasagreed to enter into various pooling agreements with CastlePoint InsuranceCompany, subject to its obtaining regulatory approval from the State InsuranceDepartment of New York, which agreements will be effective January 1, 2007pending the approval of the New York State Department of Insurance.

The Company has invested in an unconsolidated Bermudaholding company, CastlePoint Holdings, Ltd. (“CastlePoint”), which the Companyorganized and sponsored with an initial investment of $15.0 million on February 6,2006. The Company consolidated the activities of CastlePoint as a wholly ownedsubsidiary during the first quarter of 2006 and recognized approximately $0.5million of non-recurring start-up costs. On April 4, 2006, CastlePointraised $249.9 million, net of expenses, in a private placement 

F-11

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offering of 27,025,000unissued shares at $10.00 per share, which reduced the Company’s investmentownership from 100% to 8.6%. The book value per share of the Company’s2,555,000 shares of CastlePoint common stock increased from $5.87 per share to$8.96 per share as a result of this offering. The carrying value of the Company’sinvestment in CastlePoint increased from $15.0 million to $22.9 million. TheCompany has recorded this gain of $7.9 million in income before taxes inaccordance with the Securities and Exchange Commission’s Staff AccountingBulletin (“SAB”) No. 51—Accounting for Sales of Stock by a Subsidiary. TheCompany recorded a deferred income tax provision of $2.8 million on thistransaction.

As previously announced, Michael H. Lee serves aschairman and chief executive officer of CastlePoint Holdings, Ltd. and TowerGroup, Inc.

On April 6, 2006, the Company received a warrantfrom CastlePoint to purchase an additional 3.7% or 1,127,000 shares of commonstock with a fair value of approximately $4.6 million using a Black-Scholesoption pricing model. The warrant is exercisable in whole or in part at anytime up to April 6, 2016, and the exercise price is $10 per share. Sharesacquired through the exercise of the warrant may not be sold prior to April 9,2009. The warrant was received in exchange for sponsorship services, whichincluded management, operational and industry expertise to establish theCastlePoint organization and prepare for a private placement offering.Accordingly, the Company recognized $4.6 million in income before taxes in the yearending December 31, 2006 relating to non-recurring sponsorship services.The warrant has been recorded as an equity instrument at cost, which wasdetermined to be the fair value of the warrant on the date it was received andwill be subject to impairment testing. The Company recorded a deferred incometax provision of $1.6 million on this transaction.

The Company issued 40,000perpetual series A preferred shares to a subsidiary of CastlePoint on December 4,2006 with a $0.01 par value per share and a $1,000 liquidation preference pershare. The carrying value of this stock is $40 million less issuing cost of$0.4 million or $39.6 million and pays a fixed 8.66% annual dividend which isnot cumulative.

*Description ofBusiness*

TICNY is a property and 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. As of December 31, 2006, TICNYwas authorized to write business in thirty-six states and has direct premium writtenin New York, Pennsylvania, New Jersey, Illinois, Maryland, Massachusetts andTennessee in 2006.

TNIC is a property and casualty insurance companyincorporated in the Commonwealth of Massachusetts in December 1983. TNICprovides coverage for preferred risks and offers commercial multiple-peril,monoline general liability, commercial umbrella, monoline property, workers’compensation and commercial automobile policies as well as personal linesproducts such as homeowners, dwelling and other liability policies. As of December 31,2006 TNIC was authorized to write business in twenty-five 

F-12

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states and has directpremium written in New Jersey, New York, Pennsylvania, Illinois andMassachusetts in 2006.

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. In 2006, TRMcontinued to produce business on behalf of Virginia Surety Company Inc. from January 1,2006 to August 31, 2006 and State National Insurance Company Inc.beginning on November 1, 2006 primarily to maintain business in stateswhere TNIC and TICNY were not yet licensed. In 2006, TICNY directly reinsured100% of the TRM business produced by Virginia Surety and State National. TheCompany uses these non-risk-bearing insurance services operations to generatecommission income on premiums produced for other insurance companies. In 2006and 2005, two companies accounted for 100% of the managing general agencycommissions of TRM.

Certain activities of theCompany are provided by TICNY, DBA the Law Office of Steven Fauth. Theseactivities primarily consist of claims management activities of TICNY andclaims management services provided by TRM to other issuing carriers. Mr. Fauthis an officer and director of the Company.

*Basis ofPresentation*

The accompanyingconsolidated financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America (“GAAP”).All significant inter-company transactions have been eliminated inconsolidation. The Company has reclassified certain amounts in its 2005consolidated balance sheet to conform to the 2006 presentation. None of thesereclassifications had an effect on the Company’s consolidated net earnings,total shareholders’ equity or cash flows.

*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 of insuranceprotection provided, on a pro-rata basis over the terms of the underlyingpolicies. Unearned premiums represent premium applicable to the unexpiredportions of in-force insurance contracts at the end of each year. Prepaidreinsurance premiums represent the unexpired portion of reinsurance premiumsceded.

*Policy Billing Fees*

Policy billing fees areearned as they are collected. These fees include installment and other feesrelated to billing and collections.

F-13

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*Liability for Lossand Loss Adjustment Expense*

The liability for loss andloss adjustment expenses represents management’s best estimate of the ultimatecost of all reported and unreported losses that are unpaid as of the balancesheet date. The liability for loss and loss adjustment expenses is estimated onan undiscounted basis, using individual case-basis valuations, statisticalanalyses, and various actuarial procedures. The projection of future claimpayment and reporting is based on an analysis of the Company’s historicalexperience, supplemented by analyses of industry loss data. Management believesthat the reserves for loss and loss adjustment expenses are adequate to coverthe ultimate cost of losses and claims to date; however, because of theuncertainty 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 indetermining the estimated amounts for such liability at the balance sheet date.As adjustments to these estimates become necessary, such adjustments arereflected in current operations. Because of the nature of the businesshistorically written, the Company’s management believes that the Company haslimited exposure 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 the reinsurancecontract.

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 amounts; however, as changes inthe estimated ultimate liability for loss and loss adjustment expenses aredetermined, the estimated ultimate amount recoverable from the reinsurer willalso change. Accordingly, the ultimate recoverable could be significantly inexcess of or less than the amount indicated in the consolidated financial statements.As adjustments to these estimates become necessary, such adjustments arereflected in current operations. Loss and loss adjustment expenses incurred aspresented in the consolidated statement of income and comprehensive net incomeare 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 31,2006 and 2005 and did not expense any uncollectible reinsurance during 2006,2005 and 2004. 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. 

F-14

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Certainreinsurance agreements contain provisions whereby the ceding commission ratesvary based on the loss experience under the agreements. The Company recordsceding commission revenue based on its current estimate of subject losses. TheCompany records adjustments to the ceding commission revenue in the period thatchanges in the estimated losses are determined.

*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 and otheradministration revenues are earned as services are performed.

*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 thatthey present insignificant risk of changes in value due to changing interestrates.

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.

*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.

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  In evaluating potential impairment,management considers, among other criteria: the current fair value compared toamortized cost or cost, as appropriate; the length of time the security’s fairvalue has been below amortized cost or cost; management’s intent and ability toretain the investment for a period of time sufficient to allow for anyanticipated recovery in value; specific credit issues related to the issuer;and current economic conditions. Other-than-temporary impairment losses resultin a permanent reduction of the cost basis of the underlying investment. During2006, 2005 and 2004, the Company did not record any other-than-temporaryimpairments.

F-15

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At December 31, 2006and 2005, U.S. Treasury Notes with fair values of approximately $8,681,000 and$6,597,000, respectively, were on deposit with various states to comply withthe insurance laws of the states in which the Company is licensed.

*Agents’ Balances*

Agents’ balances receivable are presented net of anallowance for doubtful accounts of $248,000, $170,000 and $123,000 at December 31,2006, 2005 and 2004, respectively. The allowance for uncollectible amounts isbased on an analysis of amounts receivable giving consideration to historicalloss experience and current economic conditions and reflects an amount that, inmanagement’s judgment, is adequate. Uncollectible agent’s balances of $139,000,$26,000 and $27,000 were written off in 2006, 2005, and 2004 respectively. Oneagent accounted for approximately 9%, 10% and 12%, respectively, of TICNY’s andTRM’s agents’ balances at December 31, 2006, 2005 and 2004. The same agentaccounted for 11%, 11% and 14% of TICNY’s direct premiums written and TRM’spremiums produced in 2006, 2005 and 2004, respectively.

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 2006,2005 and 2004 for this activity.

*Receivable—ClaimsPaid by Agency*

Receivable—claims paid byagency represent claim payments due from issuing carriers to reimburse claimspaid by TRM on their behalf in conjunction with claims administration services.The receivables are partially secured by funds held totaling $8,181,000 and$8,191,000 as of December 31, 2006 and 2005, respectively. As of December 31,2005 and 2004, no reserve for uncollectible recoverables was recorded. During2006, 2005 and 2004, no amounts relating to these receivables were written-off.

*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 acquired identifiableintangible assets. In accounting for such assets, the Company follows “Statementof Financial Accounting Standard No. 142, “Goodwill and Other IntangibleAssets” (“SFAS 142”). The cost of a group of assets acquired in a transactionis allocated to the individual assets including identifiable intangible assetsbased on their relative fair values. Identifiable intangible assets with afinite useful life are amortized over the period that the asset is expected tocontribute directly or indirectly to the future cash flows of the Company. Indefinitelived intangible assets are not amortized. All identifiable intangible assetsare tested for recoverability whenever events or changes in circumstancesindicate that a carrying amount may not be recoverable and are subject to annualimpairment testing as well. An impairment loss is recognized if the carryingvalue of an intangible asset is not recoverable and its carrying amount exceedsits fair value. No impairment losses were recognized in 2006, 2005 and 2004.

F-16

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*Fixed Assets*

Furniture, equipment,leasehold improvements and software are reported at cost less accumulateddepreciation and amortization. Depreciation and amortization is provided usingthe straight-line method over the estimated useful lives of the assets. TheCompany estimates the useful life for computer equipment and software is threeyears, furniture and other equipment is seven years and leasehold improvementsis the term of the lease.

*Statutory BusinessTrusts*

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 in accordance with FIN 46 (R). See “Note 8. Debt.”  The Company’s investment in common trustsecurities of the statutory business trust are reported in investments atequity. The Company reports as a liability the outstanding subordinateddebentures owed to the statutory business trusts.

*Income Taxes*

Pursuant to a TaxAllocation Agreement, Tower, TICNY, TNIC, TRM and TICA compute and pay Federalincome taxes on a consolidated basis. TICA will file a short-period tax returnfor 2006. Deferred tax assets and liabilities are recognized for the future taxconsequences attributable to differences between the financial statementcarrying amounts of existing assets and liabilities and their respective taxbasis and for operating loss and tax credit carry forwards. Deferred tax assetsand liabilities are measured using enacted tax rates expected to apply totaxable income in the years in which those temporary differences are expectedto be recovered or settled. The effect on deferred tax assets and liabilitiesof a change in tax rates is recognized in income in the period that includesthe enactment date.

*Treasury Stock*

The Company accounts forthe treasury stock at the repurchase price as a reduction to stockholders’equity as it does not intend to retire the treasury stock held atDecember 31, 2006.

*Equity CompensationPlans*

The Company adopted the provision of SFAS 123-Reffective January 1, 2006 and has elected the modified prospectiveapplication method. All unvested stock options outstanding as ofJanuary 1, 2006 are being expensed over the requisite service period thathas not been rendered and is based upon the original grant date fair value ofthe award as calculated for recognition of the pro forma disclosure under SFAS 123-R.

The Company accounts forrestricted stock shares awarded at fair value at the date awarded andcompensation expense is recorded over the requisite service period that has notbeen rendered. An award is subject to graded vesting if it vests periodically.The Company recognizes compensation expense on a graded vesting award for theentire award on a straight-line basis over the requisite service period for theentire award.

*Segment Reporting*

The Company manages its operations through threereportable segments: insurance (commercial and personal lines underwriting),reinsurance, and insurance services (managing general agency, claimsadministration and reinsurance intermediary operations). See “Note 18. SegmentInformation.”

F-17

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*Earnings Per Share*

In accordance withStatement of Financial Accounting Standards (SFAS) No. 128, “Earnings PerShare,” the Company measures earnings per share at two levels: basic earningsper share and diluted earnings per share. Basic earnings per share iscalculated by dividing income (loss) allocable to common stockholders by theweighted average number of common shares outstanding during the year excludingissued but unvested restricted stock shares. Diluted earnings per share iscalculated by dividing income (loss) allocable to common stockholders by theweighted average number of common shares outstanding during the year, asadjusted for the potentially dilutive effects of stock options, warrants,unvested restricted stock and/or preferred stock, unless common equivalentshares are antidilutive.

*Recent AccountingDevelopment*

In June, 2006 FASB Interpretation No. 48, “Accountingfor Uncertainty in Income Taxes.” This interpretation clarifies the accountingfor uncertainty in income taxes recognized in an enterprise’s financialstatements in accordance with SFAS No. 109, Accounting for Income Taxes.This interpretation prescribes a recognition threshold and measurementattribute for the financial statement recognition and measurement of a taxposition taken or expected to be taken in a tax return. This interpretationalso provided guidance on derecognition, classification, interest andpenalties, accounting in interim periods, disclosure and transition. Thisinterpretation is effective for fiscal years beginning after December 15,2006. The Company reviewed whether it is more likely than not that its taxpositions will be sustained upon examination and concluded that it has nouncertain tax positions as of December 31, 2006.

In September, 2006 the FASB issued SFAS No. 157, “FairValue Measurements.”  This new standardprovides guidance for using fair value to measure assets and liabilities. UnderSFAS 157, fair value refers to the price that would be received to sell anasset or paid to transfer a liability in an orderly transaction between marketparticipants in the market in which the reporting entity transacts. In thisstandard, the FASB clarifies the principle that fair value should be based onthe assumptions market participants would use when pricing the asset orliability. In support of this principle, SFAS 157 establishes a fair valuehierarchy that prioritizes the information used to develop those assumptions. Thefair value hierarchy gives the highest priority to quoted prices in activemarkets and the lowest priority to unobservable data such as the reportingentity’s own data. Under the standard, fair value measurements would beseparately disclosed by level within the fair value hierarchy. The provisionsof SFAS 157 are effective for financial statements issued beginning November 15,2007. SFAS 157 is not expected to have a material impact on our results ofoperations or financial position.

In September, 2006 theFASB issued SFAS No. 158, “Employers’ Accounting for Defined BenefitPension and other Postretirement Plans.” The Company has no defined benefit pension plan or other post retirementplans and therefore, SFAS 158 will have no effect on the Company’s results ofoperations or financial position.

F-18

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**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,  2006:** |       |                |        |                         |       |                          |       |            |       |   |   |   |   |
| U.S. Government bonds        | ** ** | $                   | 45,294      |                         |       | $                             | 139        |            |       |   | $ | (300 | ) |   | $ | 45,133 |   |
| Municipal bonds              |       | 100,943             |        |                         | 339        |                          |       |            | (707       | ) |   | 100,575 |   |
| Corporate and other bonds    |       | 140,032             |        |                         | 1,144      |                          |       |            | (1,574     | ) |   | 139,602 |   |
| Mortgage-backed securities   |       | 130,373             |        |                         | 663        |                          |       |            | (1,779     | ) |   | 129,257 |   |
| **Total**                    | ** ** | **$**               | **416,642** | ** **                   | ** ** | **$**                         | **2,285**  |            | ** ** | ** ** | **$** | **(4,360** | **)** | ** ** | **$** | **414,567** | ** ** |
| **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** | ** ** |

 

Asummary of the amortized cost and fair value of the Company’s investments infixed-maturity securities at December 31, 2006 by contractual maturity isshown below (in 000’s):

| ** **                 | ** ** | **Amortized  Cost** | ** **  | **Fair  Value** | ** ** |
|----------------------------|------------|---------------------|-------------|-----------------|------------|
| **Years to Maturity:**     |       |                |        |            |       |
| One or less                |       | $                   | 12,577      |            | $          | 12,525 |   |
| After one through five     |       | 122,815             |        | 121,698         |       |
| After five through ten     |       | 124,681             |        | 125,058         |       |
| After ten                  |       | 26,196              |        | 26,029          |       |
| Mortgage-backed securities |       | 130,373             |        | 129,257         |       |
| **Total**                  | ** ** | **$**               | **416,642** | ** **      | **$**      | **414,567** | ** ** |

 

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

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,  2006** |       |     |       |                               |       |                          |       |            |       |   |   |   |   |
| Preferred stocks            |       | $        | 5,627      |                               |       | $                             | 45         |            |       |   | $ | — |   |   | $ | 5,672 |   |
| Common stocks               |       | 42,344   |       |                               | 2,175      |                          |       |            | (738       | ) |   | 43,781 |   |
| **Total**                   | ** ** | **$**    | **47,971** | ** **                         | ** ** | **$**                         | **2,220**  |            | ** ** | ** ** | **$** | **(738** | **)** | ** ** | **$** | **49,453** | ** ** |
| **December 31, 2005:** |       |     |       |                               |       |                          |       |            |       |   |   |   |   |
| Preferred stocks            |       | $        | 113        |                               |       | $                             | 2          |            |       |   | $ | — |   |   | $ | 115 |   |
| Common stocks               |       | 31,126   |       |                               | 568        |                          |       |            | (1,822     | ) |   | 29,872 |   |
| **Total**                   | ** ** | **$**    | **31,239** | ** **                         | ** ** | **$**                         | **570**    |            | ** ** | ** ** | **$** | **(1,822** | **)** | ** ** | **$** | **29,987** | ** ** |

 

F-19

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

| ** **                                         | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|----------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Income:                                            |       |       |       |       |       |       |       |
| Fixed-maturity  securities                         |       | $          | 18,568     |       | $          | 12,406     |       | $ | 4,868 |   |
| Equity securities                                  |       | 3,104      |       | 2,290      |       | 48         |       |
| Cash and cash  equivalents                         |       | 1,892      |       | 718        |       | 294        |       |
| Interest on notes  receivable from related parties |       | —     |       | —     |       | 46         |       |
| Dividends on  common trust securities              |       | 157        |       | 104        |       | 52         |       |
| **Total**                                          | ** ** | **23,721** | ** ** | **15,518** | ** ** | **5,308**  | ** ** |
| Expenses:                                          |       |       |       |       |       |       |       |
| Investment  expenses                               |       | 695        |       | 535        |       | 238        |       |
| **Net  investment income**                         | ** ** | **$**      | **23,026** | ** ** | **$**      | **14,983** | ** ** | **$** | **5,070** | ** ** |

 

Proceedsfrom the sale and maturity of fixed-maturity securities were $71,672,000,$38,325,000 and $23,474,000 in 2006, 2005 and 2004, respectively. Proceeds fromthe sale of equity securities were $1,003,000, $1,972,000, and $50,000 and in2006, 2005 and 2004, respectively. The Company’s gross realized gains andlosses on investments are summarized as follows (in 000’s):

| ** **                 | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|----------------------------|------------|------------|------------|------------|------------|------------|------------|
| Income:                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Fixed maturity  securities |       |       |       |       |       |       |       |
| Gross realized gains       |       | $          | 368        |       | $          | 67         |       | $ | 137 |   |
| Gross realized losses      |       | (452       | )          | (203       | )          | (124       | )          |
|                       | ** ** | **(84**    | **)**      | **(136**   | **)**      | **13**     | ** ** |
| Equity securities:         |       |       |       |       |       |       |       |
| Gross realized gains       |       | 96         |       | 258        |       | —     |       |
| Gross realized losses      |       | —     |       | —     |       | —     |       |
|                       |       | 96         |       | 258        |       | —     |       |
| **Net  realized gains**    | ** ** | **$**      | **12**     | ** ** | **$**      | **122**    | ** ** | **$** | **13** | ** ** |

 

Thefollowing table presents information regarding the Company’s invested assetsthat were in an unrealized loss position at December 31, 2006 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       |       | $                                      | 10,620      |                                   |       | $         | (31        | ) |   | $ | 17,952 |   |   | $ | (269 | ) |   | $ | 28,572 |   |   | $ | (300 | ) |   |
| Municipal bonds             |       | 20,213                                 |        |                                   | (94        | )         |       | 45,390 |   |   | (613 | ) |   | 65,603 |   |   | (707 | ) |   |
| Corp. and other  bonds      |       | 26,545                                 |        |                                   | (240       | )         |       | 56,928 |   |   | (1,334 | ) |   | 83,473 |   |   | (1,574 | ) |   |
| Mortgage-backed  securities |       | 28,669                                 |        |                                   | (213       | )         |       | 59,868 |   |   | (1,566 | ) |   | 88,537 |   |   | (1,779 | ) |   |
| Total fixed  maturities     |       | 86,047                                 |        |                                   | (578       | )         |       | 180,138 |   |   | (3,782 | ) |   | 266,185 |   |   | (4,360 | ) |   |
| Equities                    |       | 25,960                                 |        |                                   | (275       | )         |       | 2,816 |   |   | (463 | ) |   | 28,776 |   |   | (738 | ) |   |
| **Total**                   | ** ** | **$**                                  | **112,007** | ** **                             | ** ** | **$**     | **(853**   | **)** | ** ** | **$** | **182,954** | ** ** | ** ** | **$** | **(4,245** | **)** | ** ** | **$** | **294,961** | ** ** | ** ** | **$** | **(5,098** | **)** | ** ** |

 

As of December 31, 2006, 199 securities accountedfor the gross unrealized losses, all of which are not deemed to beother-than-temporarily impaired. Significant factors influencing management’sdetermination that unrealized losses were temporary included the mild severityof the unrealized losses in 

F-20

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relation to eachsecurities 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.

The unrealized loss position for Equity securitieswere primarily due to the Company’s investment in four Real Estate Investmenttrusts (“REITs”) as of December 31, 2006. Three of the REITs were publiclytraded and all four consist of real estate related mortgage backed securities. Theseverity of the impairment for three out of the four REIT investments inrelation to their carrying amounts is between 1.03% and 9.7%. The severity ofthe impairment for one of the equity investments in relation to its carryingamount was 27.8% as of December 31, 2006 and it has been in an unrealizedloss position for more than one year. Publicly traded mortgage REIT stockprices as a sector did not perform well in 2005. The dividends paid on thesefunds were reduced 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. Thequarterly dividend for the one investment which was impaired 27.8% hasincreased for four consecutive quarters and the stock price has rebounded from$10.94 per share at December 31, 2005 to $13.91 per share at December 31,2006. The Company’s cost basis of this investment is $19.28 per share. TheCompany considered the financial condition and positive outlook for thisinvestment, as well as its ability and intent to hold the investment for a longenough period to recover the unrealized loss which was $350,000 as of December 31,2006. The Company has the ability and the intent to hold these equityinvestments until a recovery of fair value and therefore, the Company does notconsider these investments to be other-than-temporarily impaired.

The unrealized losses onthe Company’s investments in fixed maturity securities were caused by interestrate changes. The Company evaluated 191 investments, which were in anunrealized loss position as of December 31, 2006, of which 129 have beenin an unrealized loss position for more than 12 months. Of these 191 securitiesthe severity of the impairment in relation to the carrying amount of theindividual investment for 186 of these investments was between 0.01% and 4.8%. Fourof the remaining five investments were impaired between 5.6% and 8.9% of theircarrying value and one investment was impaired by 11.5%. The unrealized loss onthese five investments was $252,000 and accounted for 4.9% of the unrealizedloss as of December 31, 2006. These investments are extremely sensitive tointerest rate changes as they do not mature until at least 15 years from December 31,2006. The Company has the ability and the intent to hold these investmentsuntil a recovery of fair value, which may be maturity. The Company does notconsider these investments to be other-than-temporarily impaired.

**Note 3—Investmentin Unconsolidated Affiliate—CastlePoint**

At December 31, 2006, the Company’s maximumexposure to a loss from its investment in CastlePoint was approximately $27.9million, which consists of its equity ownership interest of approximately $23.3million (after deducting dividends received in the third quarter of 2006) andthe fair value of the warrant the Company received from CastlePoint of $4.6million.

The carrying valueof the Company’s equity investment in CastlePoint as of December 31, 2006is as follows in millions:

| Initial  investment in CastlePoint                                                    |   | $15.0 |   |
|---------------------------------------------------------------------------------------|--------|-------|--------|
| Consolidated net  loss for the three months ended March 31, 2006                 |   | (0.5  | )      |
| Equity in net  income of CastlePoint for the nine months ended December 31, 2006 |   | 0.9   |   |
| Gain from  issuance of common stock by CastlePoint                                    |   | 7.9   |   |
| Equity in net  unrealized gains of the CastlePoint investment portfolio               |   | 0.1   |   |
| Dividends  received from CastlePoint.                                                 |   | (0.1  | )      |
| Value of warrant  received                                                            |   | 4.6   |   |
| Carrying value of equity  investment in CastlePoint                                   |   | $27.9 |   |

 

F-21

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A general dividend and a special dividend of $0.025per share each were declared and paid by CastlePoint in September 2006.The Company recorded its $128,000 of CastlePoint dividends as a reduction toits investment in CastlePoint.

TICNY and TNIC entered intoa service and expense sharing agreement with CastlePoint, pursuant to whichthey will provide services, such as claims adjustment, policy administration,technology solutions, underwriting, and risk management services, to the U.S.domiciled insurance subsidiaries of CastlePoint, as well as to companiesappointed as managing general underwriters by the CastlePoint companies. TheCompany charged CastlePoint $0.7 million in 2006 for these services.

**Note 4—Property andCasualty Insurance Activity**

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

| ** **                   | ** ** | **Direct** | ** **  | **Assumed** | ** ** | **Ceded**  | ** ** | **Net**    | ** **   |
|------------------------------|------------|------------|-------------|-------------|------------|------------|------------|------------|--------------|
| **2006**                     | ** ** | ** ** | ** **  | ** **  | ** ** | ** ** | ** ** | ** ** | ** **   |
| Premiums written             |       | $          | 408,352     |        | $          | 24,311     |       | $          | (187,593     | ) | $ | 245,070 |   |
| Change in  unearned premiums |       | (64,362    | )           | (4,876      | )          | 48,156     |       | (21,082    | )            |
| **Premiums  earned**         | ** ** | **$**      | **343,990** | ** **  | **$**      | **19,435** | ** ** | **$**      | **(139,437** | **)** | **$** | **223,988** | ** ** |
| **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** | ** ** |

 

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, 2006**  |       |                     |       |                          |       |   |   |   |   |
| Case-basis  reserves        |       |                     | $          | 151,169                       |       |   |   | $ | 52,563 |   |   |
| IBNR reserves               |       |                     | 151,372    |                          |       |   | 57,479 |   |   |
| Recoverable on  paid losses |       |                     | —     |                          |       |   | 7,961 |   |   |
| **Total**                   | ** ** | ** **               | **$**      | **302,541**                   |       | ** ** | ** ** | **$** | **118,003** |   |   |
| **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** |   |   |

 

F-22

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

| ** **                        | ** ** | **2006**    | ** **  | **2005**   | ** ** | **2004**    | ** ** |
|-----------------------------------|------------|-------------|-------------|------------|------------|-------------|------------|
| Balance at  January 1,       |       | $           | 198,724     |       | $          | 128,722     |       | $ | 99,475 |   |
| Less reinsurance recoverables     |       | (96,978     | )           | (91,773    | )          | (75,114     | )          |
|                              |       | 101,746     |        | 36,949     |       | 24,361      |       |
| Incurred related  to:             |       |        |        |       |       |        |       |
| Current year                      |       | 135,863     |        | 97,006     |       | 27,259      |       |
| Prior years                       |       | (2,340      | )           | (392       | )          | (199        | )          |
| PXRE commutation                  |       | 1,602       |        | —     |       | —      |       |
| **Total incurred**                | ** ** | **135,125** | ** **  | **96,614** | ** ** | **27,060**  | ** ** |
| Paid related to:                  |       |        |        |       |       |        |       |
| Current year                      |       | 30,605      |        | 20,891     |       | 6,991       |       |
| Prior years                       |       | 13,767      |        | 10,926     |       | 7,481       |       |
| **Total paid**                    | ** ** | **44,372**  | ** **  | **31,817** | ** ** | **14,472**  | ** ** |
| Net balance at  December 31, |       | 192,499     |        | 101,746    |       | 36,949      |       |
| Add reinsurance recoverables      |       | 110,042     |        | 96,978     |       | 91,773      |       |
| **Balance  at December 31,** | ** ** | **$**       | **302,541** | ** ** | **$**      | **198,724** | ** ** | **$** | **128,722** | ** ** |

 

Incurred losses and loss adjustment expenses are netof reinsurance recoveries under reinsurance contracts of $64,738,000,$38,584,000, and $57,104,000 in 2006, 2005 and 2004, respectively.

Incurred loss and loss adjustment expensesattributable to insured events of prior years excluding the PXRE commutationloss of $1,602,000, decreased by $2,341,000, $392,000 and $199,000 in 2006,2005 and 2004, respectively. Prior year development is based upon numerousestimates by line of business and accident year. During calendar year 2006,fire, homeowners, commercial multi peril liability, workers’ compensation, andauto liability had favorable prior year development that was partially offsetby unfavorable development in other lines. During calendar year 2005 commercialmulti peril liability, workers’ compensation, and auto liability had favorableprior year development that was partially offset by unfavorable development inother lines. During 2004 the reinsurance operations had favorable prior yeardevelopment that offset any unfavorable development in the insurance operations.No additional premiums or return premiums have been accrued as a result ofthese prior 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 6—Reinsurace—Commutationand Novation with PXRE Reinsurance Company.”

*Lossand loss adjustment expense reserves.**  *The reserving process for loss adjustment expensereserves provides for the Company’s best estimate at a particular point in timeof the ultimate unpaid cost of all losses and loss adjustment expensesincurred, including settlement and administration of losses, and is based onfacts and circumstances then known and including losses that have been incurredbut not yet been reported. The process includes using actuarial methodologiesto assist in establishing these estimates, judgments relative to estimates offuture claims severity and frequency, the length of time before losses willdevelop to their ultimate level and the possible changes in the law and otherexternal factors that are often beyond the Company’s control. The methods usedto select the estimated loss reserves include the loss ratio projection,incurred loss projection, and the Bornhuetter-Ferguson (B-F) method. Theprocess produces carried reserves set by management based upon the actuaries’best estimate and is the result of numerous best estimates made by line ofbusiness, accident year, and loss and loss adjustment expense. The amount ofloss and loss adjustment expense reserves for reported claims is basedprimarily upon a case-by-case evaluation of coverage, liability, injuryseverity, and any other information considered pertinent to estimating theexposure presented by the claim. The amounts of loss and loss adjustmentexpense reserves for unreported claims are determined using historicalinformation by line of insurance as 

F-23

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adjusted to currentconditions. Since the Company’s process produces loss reserves set bymanagement based upon the actuaries’ best estimate, there is no explicit orimplicit provision for uncertainty in the carried loss reserves.

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, the Company reviews by line of business existingreserves, new claims, changes to existing case reserves and paid losses withrespect to the current and prior years.

TheCompany segregates its data for estimating loss reserves. Property linesinclude Fire, Homeowners, CMP Property, Multi-Family Dwellings and AutoPhysical Damage. Casualty lines include CMP Liability, Other Liability, Workers’compensation and Auto Liability. The actuarial methods used by segment havebeen consistent since the 2003 year-end review. During the year-end review theaccident years are split into most recent, first prior and all other accidentyears. For the 2003 year-end review the most recent accident year is 2003, thefirst prior is 2002, and all other accident years are 2001 and prior. Similarlyfor the 2006 review the most recent accident year is 2006, the first prior is2005, and all other accident years are 2004 and prior. The table below showsthe method used by segment and accident year to select the estimatedyear-ending loss reserves:
|                                      | ** ** | ** **  | ** ** | **Accident Year** | ** ** | ** **         |
|--------------------------------------|------------|-------------|------------|-------------------|------------|--------------------|
| **Segment**                          | ** ** | ** **  | ** ** | **Most Recent**   | ** ** | **1**st Prior | ** ** | **All Other** |
| Fire                                 |       | Loss  Ratio |       | Loss Development  |       | Loss Development   |
| Homeowners                           |       | Loss  Ratio |       | Loss Development  |       | Loss Development   |
| Multi-Family                         |       | Loss  Ratio |       | Loss Development  |       | Loss Development   |
| Commercial  multiple-peril property  |       | Loss  Ratio |       | Loss Development  |       | Loss Development   |
| Commercial  multiple-peril liability |       | Loss  Ratio |       | B-F               |       | Loss Development   |
| Workers’ Compensation           |       | Loss  Ratio |       | B-F               |       | Loss Development   |
| Other Liability                      |       | Loss  Ratio |       | B-F               |       | Loss Development   |
| Auto Liability                       |       | Loss  Ratio |       | B-F               |       | Loss Development   |
| Auto Physical Damage                 |       | Loss Ratio  |       | Loss Development  |       | Loss Development   |
|                                      |            |             |            |                   |            |                    |  |  |

 

Two key assumptions that materially impact theestimate of loss reserves are the loss ratio estimate for the current accidentyear and the loss development factor selections for all accident years. The lossratio estimate for the current accident year is selected after reviewinghistorical accident year loss ratios adjusted for rate changes, trend, and mixof business.

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TheCompany’s data has sufficient credibility to base development factors on ourown data. The loss development factors are reviewed annually. There have onlybeen minor changes in selected loss development factors since 2003. The chartbelow shows the number of years by segment when the Company expects 50%, 90%and 99% of losses to be reported for a given accident year:
|                                      | ** ** | ** **   | ** ** | **Number of years** | ** ** | ** ** |
|--------------------------------------|------------|--------------|------------|---------------------|------------|------------|
| **Segment**                          | ** ** | ** **   | ** ** | **50%**             | ** ** | **90%**    | ** ** | **99%** |
| Fire                                 |       | <1  year  |       | <1  year         |       | 2  years   |
| Homeowners                           |       | <1  year  |       | <2  years        |       | 3  years   |
| Multi-Family                         |       | <2  years |       | <2  years        |       | 5  years   |
| Commercial  multiple-peril property  |       | <1  year  |       | 1  year             |       | 2  years   |
| Commercial  multiple-peril liability |       | <2  years |       | 5  years            |       | 9  years   |
| Workers’  Compensation          |       | <1  year  |       | 2  years            |       | 5  years   |
| Other Liability                      |       | 3  years     |       | 4  years            |       | 9  years   |
| Auto Liability                       |       | <1  year  |       | 3  years            |       | 4  years   |
| Auto Physical  Damage                |       | <1 year   |       | <1 year          |       | 1 year     |
|                                      |            |              |            |                     |            |            |  |  |

 

The Company has made only minor changes to the keyassumptions used during the last three annual reserve estimates. In 2004 and2005 the Company had favorable development in its net losses from prioraccident years of $0.2 million and $0.4 million respectively. In 2006 theCompany had favorable development in its net losses from prior accident yearsof $0.7 million. Excluding the PXRE commutation for 2006 the Company hadfavorable development of $2.3 million.

The paid development, incurred development, theBornhuetter Ferguson (B-F) method, and loss ratio projections are thepredominate methodologies the Companies actuaries utilize to project losses andcorresponding reserves. Based upon these methods the Company’s actuariesdetermine a best estimate of the loss reserves. All of these methods arestandard actuarial approaches and have been utilized consistently since 2003. Theselected development factors within the paid and incurred development methodsare derived from the Company’s data while the loss ratio method is used for themost recent accident year when there is high volatility in the developmentpatterns. The B-F method combines the loss ratio method and the lossdevelopment method to determine loss reserves by adding an expected development(loss ratio times premium times percent unreported) to the case reserves.

The incurred method relies on historical developmentfactors derived from changes in the Company’s incurred estimates of claims paidand case reserves over time. The paid method relies on the Company’s claimpayment patterns and ultimate claim costs. The incurred method is sensitive tochanges in case reserving practices over time thus if case reserving practiceschange over time the incurred method may produce significant variation inestimates of ultimate losses. The paid method relies on actual claim paymentsand therefore is not sensitive to changes in case reserve estimates.

The Company is not aware of any claims trends thathave emerged or that would cause future adverse development that have notalready been considered in existing case reserves and in its current lossdevelopment factors.

Also, in New York State,lawsuits for negligence, subject to certain limitations, must be commencedwithin three years from the date of the accident or are otherwise barred. Accordingly,the Company’s exposure to IBNR for accident years 2003 and prior is limitedalthough there remains the possibility of adverse development on reportedclaims. Due to the reserve strengthening in 2002 and close monitoring andanalysis of reserves, the Company believes its loss reserves are adequate. Thisis reflected by the loss development as of December 31, 2006 showingdeveloped redundancies since 2003. However, there are no assurances that futureloss development and trends will be consistent with its past loss developmenthistory, and so adverse loss reserves development remains a risk factor to theCompany’s business.

F-25

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**Note 5—DeferredAcquisition 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):

| ** **                                                                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net deferred  acquisition costs net of ceding commission revenue, January 1,   |       | $        | 29,192     |     | $          | 18,740   |       | $ | 573 |   |
| Costs incurred  and deferred during years:                                          |       |     |       |     |       |     |       |
| Commissions and  brokerage                                                          |       | 71,364   |       | 49,458   |       | 29,732   |       |
| Other  underwriting and acquisition costs                                           |       | 50,188   |       | 36,978   |       | 24,482   |       |
| Ceding commission  revenue                                                          |       | (56,586  | )          | (30,337  | )          | (10,379  | )          |
| Net acquisition  costs net of ceding commission revenue deferred during year        |       | 64,966   |       | 56,099   |       | 43,835   |       |
| Amortization                                                                        |       | (58,347  | )          | (45,647  | )          | (25,668  | )          |
| Net deferred acquisition  costs net of ceding commission revenue, December 31, |       | $        | 35,811     |     | $          | 29,192   |       | $ | 18,740 |   |

 

**Note 6—Reinsurance**

The Company has automatic treaty capacity of$10,000,000 for property risks, $1,000,000/$2,000,000 for liability coverages, $10,000,000for workers’ compensation, $5,000,000 for umbrella liability and $35,000,000for equipment breakdown. The Company may offer higher limits through its use offacultative reinsurance. Through various quota share, excess of loss andcatastrophe reinsurance agreements, as described further below, the Companylimits its exposure to a maximum loss on any one risk of $600,000 for theperiod July 1, 2006 through December 31, 2006, $700,000 for theperiod April 1, 2006 to June 30, 2006, $1,000,000 during the period January 1,2006 to March 31, 2006, $750,000 during the period January 1, throughDecember 31, 2005,  $400,000 duringthe period January 1 through September 30, 2004, $750,000 during theperiod October 1, through December 31, 2004, $450,000 during theperiod January 1, through September 30, 2003 (after commutation—seediscussion 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 provide the reinsurers with somelimit on the amount of potential loss being assumed, while maintaining thetransfer of significant insurance risk with the possibility of a significantloss to the reinsurer, and thereby to reduce the cost of reinsurance. Lossratio caps cut off the reinsurers’ liability for losses above a specified lossratio. The loss ratio caps in the 2005, 2004 and 2003 quota share agreementswere 95.0%, 95.0% and 92.0%, respectively, and there was no loss ratio cap for2006.

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.

F-26

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

| ** **                                  | ** ** | **Unpaid  Losses** | ** **  | **Paid  Losses** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|--------------------|-------------|------------------|------------|-----------|------------|
| **December 31, 2006:**                 |       |               |        |             |       |      |       |
| CastlePoint  Reinsurance Company, Ltd.      |       | $                  | 31,660      |             | $          | 2,493     |       | $ | 34,153 |   |
| Munich  Reinsurance America Inc.            |       | 15,318             |        | 2,706            |       | 18,024    |       |
| Tokio Millennium  Re Ltd.                   |       | 31,796             |        | 1,634            |       | 33,430    |       |
| Hannover  Reinsurance (Ireland) Ltd.        |       | 14,429             |        | 836              |       | 15,265    |       |
| E+S Reinsurance  (Ireland) Ltd.             |       | 3,603              |        | 209              |       | 3,812     |       |
| Hannover  Rueckversicherung AG              |       | 3,220              |        | (5               | )          | 3,215     |       |
| Platinum  Underwriters Reinsurance Company  |       | 6,121              |        | (5               | )          | 6,116     |       |
| Endurance  Reinsurance Corp of America      |       | 2,138              |        | —           |       | 2,138     |       |
| QBE Reinsurance  Corp.                      |       | 350                |        | —           |       | 350       |       |
| Axis Reinsurance  Company                   |       | 854                |        | —           |       | 854       |       |
| NGM Insurance  Company                      |       | 427                |        | —           |       | 427       |       |
| Others                                      |       | 126                |        | 93               |       | 219       |       |
| **Total**                                   | ** ** | **$**              | **110,042** | ** **       | **$**      | **7,961** | ** ** | **$** | **118,003** | ** ** |
| **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** | ** ** |

 

The Companyrecorded prepaid reinsurance premiums as follows (in 000’s):

| ** **                                 | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|
| ** **                                 | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Munich  Reinsurance America Inc.           |       | $                     | —     |   | $ | 1,252 |   |
| Tokio Millennium  Re Ltd.                  |       | —                |       | 18,934 |   |
| Hannover  Reinsurance (Ireland Ltd.)       |       | 2,242                 |       | 15,147 |   |
| E+S Reinsurance  (Ireland) Ltd.            |       | —                |       | 3,787 |   |
| Hannover  Rueckversicherung AG             |       | —                |       | 1,551 |   |
| Platinum  Underwriters Reinsurance Company |       | 2,609                 |       | 1,645 |   |
| Axis Reinsurance  Company                  |       | 1,245                 |       | — |   |
| CastlePoint  Reinsurance Company, Ltd.     |       | 81,000                |       | — |   |
| Endurance  Reinsurance Corp of America     |       | 2,325                 |       | — |   |
| General  Reinsurance Corp.                 |       | 830                   |       | — |   |
| Hartford  Steamboiler Group                |       | 408                   |       | — |   |
| Lloyds of London                           |       | 1,276                 |       | — |   |
| NGM Insurance  Company                     |       | 446                   |       | — |   |
| QBE Reinsurance  Corp.                     |       | 270                   |       | — |   |
| Others                                     |       | 1,412                 |       | 1,003 |   |
| **Total**                                  | ** ** | **$**                 | **94,063** | ** ** | **$** | **43,319** | ** ** |

 

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Thefollowing collateral is available to the Company for amounts recoverable fromreinsurers (in 000’s) as of December 31, 2006 and 2005:

| ** **                           | ** ** | **Regulation  114 Trust** | ** ** | **Letters of  Credit** | ** ** | **Funds Held** | ** ** | **Total**  | ** ** |
|--------------------------------------|------------|--------------------------------|------------|-----------------------------|------------|---------------------|------------|------------|------------|
| **December 31,  2006**          | ** ** |                           | ** ** | ** **                  |       |                | ** ** | ** ** |       |   | ** ** | ** ** |   | ** ** | ** ** |
| CastlePoint Reinsurance Company Ltd. |       |                           | $          | 95,308                      | ** ** |                |       | $          | —     | ** ** |   |   | $ | — | ** ** |   | $ | 95,308 |   |
| Tokio Millennium Re Ltd.             |       |                           | 5,644      | ** **                  |       |                | —     | ** ** |       |   | 30,540 | ** ** |   | 36,184 |   |
| Hannover Reinsurance (Ireland) Ltd.  |       |                           | —     | ** **                  |       |                | 3,050      | ** ** |       |   | 16,789 | ** ** |   | 19,839 |   |
| E+S Reinsurance (Ireland) Ltd.       |       |                           | —     | ** **                  |       |                | 763        | ** ** |       |   | 4,197 | ** ** |   | 4,960 |   |
| Others                               |       |                           | —     | ** **                  |       |                | 796        | ** ** |       |   | — | ** ** |   | 796 |   |
| Total                                |       |                           | $          | 100,952                     | ** ** |                |       | $          | 4,609      | ** ** |   |   | $ | 51,526 | ** ** |   | $ | 157,087 |   |
| **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 |   |

 

To reduce TICNY’s creditexposure to reinsurance, quota share reinsurance agreements effective October 1,2003, January 1, 2004 and January 1, 2005 were placed on a “fundswithheld” basis. Under these agreements TICNY placed the collected cededpremiums written, net of commissions and the reinsurers margin, in segregatedtrusts for the benefit of TICNY and the reinsurers. TICNY may withdraw fundsfor loss and loss adjustment expense payments and commission adjustments. Segregatedassets in trust accounts amounted to $54,425,000 and $60,047,000 at December 31,2006 and 2005 and are included in invested assets. The Company is obliged underthe reinsurance agreements to credit reinsurers with an annual effective yieldon the monthly balance in the funds held under reinsurance agreements liabilityaccounts of 3% in 2006 3% in 2005 and 2.5% in 2004. The amounts credited for2006, 2005 and 2004 were $1,599,000 and $1,339,000, and $1,069,000respectively, and have been recorded as interest expense. The quota shareagreement effective January 1, 2006 is collateralized in a New YorkRegulation 114 compliant trust account

*Commutation andNovation with PXRE Reinsurance Company*

On June 29, 2006, toeliminate its exposure to uncollateralized reinsurance recoverables from PXREReinsurance Company (“PXRE”) which had requested the withdrawal of itsfinancial strength and issuer rating from A.M. Best, the Companyconcluded, through commutation agreements PXRE’s participation under variousreinsurance agreements with TICNY covering the 2001, 2002 and a portion of the2003 policy periods. Ceded loss and loss adjustment expense recoverables of$20.5 million, ceded paid losses of $2.4 million and ceding commissionsreceivable of $8.7 million, totaling $31.6 million of unsecured recoverableswere settled with a payment from PXRE of $26.7 million, which represents anestimate of the present value of these recoverables. These transactionsresulted in a $4.8 million pre-tax charge, of which $1.6 million was recognizedin loss and loss adjustment expenses and $3.2 million was recognized as areduction to ceding commission income in the second quarter of 2006. Inaddition, on the same date, novation agreements were executed with PXRErelating to other reinsurance agreements covering business written in 2001,2002 and 2003 by other insurance companies and managed on their behalf by TRM,the Company’s risk management subsidiary. As a result of the novation, TICNYassumed loss reserves of $12.2 million for which it received as consideration$11.4 million in cash and other assets and TRM recorded a reduction incommission liabilities for $0.2 million, the total of which resulted in a $0.6million pre-tax charge. As a result of the commutation and novation agreements,which were effective as of 

F-28

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June 29,2006, PXRE is discharged from future obligations under the reinsuranceagreements. There are no other agreements outstanding with PXRE.

*ReinsuranceAgreement with CastlePoint*

The Company’s insurance subsidiaries entered intothree multi-year quota share reinsurance agreements with CastlePointReinsurance that will cede to CastlePoint Reinsurance between 25% and 45%, subjectto a periodic adjustment by the Company, of premiums and losses on theirbrokerage insurance business that the Company has historically written throughits retail and wholesale agents. During 2006, the Company ceded $40.9 millionof unearned premiums as of April 1, 2006, which consisted of $19.2 millionand $21.7 million of unearned premiums retained by the Company on policieswritten in 2006 and 2005, respectively. The Company ceded and $114.2 million onpremiums written during the nine months ended December 31, 2006. Inaddition, CastlePoint Reinsurance participates as a reinsurer on the Company’scatastrophe reinsurance program, effective July 1, 2006, and excess ofloss reinsurance program effective, May 1, 2006. The Company ceded excessof loss reinsurance and catastrophe premiums to CastlePoint Reinsurance of $2.6million for the nine months ended December 31, 2006. Recoverables andprepaid reinsurance totaling $115.2 million from CastlePoint Reinsurance, whichis an unauthorized reinsurer, are collateralized in a New York State Regulation114 compliant trust account for the benefit of the Company with a balance of$95.3 million as of December 31, 2006 with the remaining amount offset byceded balances payable.

Effective April 4,2006, the Company novated business assumed from the Accident Insurance Company(“AIC”) by TICNY to CastlePoint Reinsurance. TICNY recorded $0.1 million asceded premiums written and earned and eliminated liabilities of $0.1 million.

*Ceding Commissions*

The Company earns ceding commissions under quota sharereinsurance agreements for 2005 and 2004 based on a sliding scale of commissionrates and ultimate treaty year loss ratios on the policies reinsured under eachof these agreements. The sliding scale includes minimum and maximum commissionrates in relation to specified ultimate loss ratios. The commission rate andceding commissions earned increase when the estimated ultimate loss ratiodecreases and, conversely, the commission rate and ceding commissions earneddecrease when the estimated ultimate loss ratio increases.

On December 31, 2006 the ceding commissionreceivable was $3,237,000 compared to $8,727,000 on December 31, 2005. Thedecrease was primarily due to the commutation with PXRE on June 27, 2006.

As of December 31,2006, 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 31,2006 are set forth below (dollars in 000’s) for treaties that remain in effectas of December 31, 2006:

| **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** | ** ** |
|----------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|---------------------------------|------------|-------------------------|------------|--------------------------------------------------------------------------------|------------|
| 2003                 |       | 65.6%                                                                                                       |       |                                     | 61.3       | %                               |       |                    | $          | 23.3                                                                           |       |   |   | $ | 20.6 |   |   |   | $ | 2.7 |   |   |
| 2004                 |       | 68.0%                                                                                                       |       |                                     | 51.2       | %                               |       |                    | $          | 31.2                                                                           |       |   |   | $ | 20.6 |   |   |   | $ | 10.6 |   |   |
| 2005                 |       | 68.0%                                                                                                       |       |                                     | 50.7       | %                               |       |                    | $          | 31.9                                                                           |       |   |   | $ | 20.8 |   |   |   | $ | 11.1 |   |   |

 

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 $24.4 million 

F-29

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for all treaties for allthree years. The ceded premiums for the 2003, 2004 and 2005 treaty years havebeen fully earned as of December 31, 2006.

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 increase (decrease) in estimated cedingcommission income relating to prior years recorded in 2006, 2005 and 2004 was$1,138,000, ($810,000) and $1,663,000, respectively.

**Note 7—IntangibleAssets**

The Company entered into a Commercial Renewal Rights Agreementwith OneBeacon Insurance Group, LLC (“OneBeacon”) on September 13, 2004under which it has acquired OneBeacon’s rights to seek to renew a block ofcommercial lines insurance policies in New York State consisting of commercialmultiple-peril, worker’s compensation, commercial umbrella, commercial inlandmarine, commercial auto, fire and allied lines and general liability coverages.Under the terms of the agreement, the Company did not acquire any in-forcebusiness or historical liabilities associated with the policies. Pursuant tothe agreement, the Company also obtained the rights to establish contractualrelationships with certain OneBeacon agents. The Company agreed to payOneBeacon an amount equal to 5% of the direct premiums written resulting fromthe Company’s renewal of any subject policies in the first year, 4% in thesecond year and 1% in the third year, with no payments due after the thirdyear, subject to the Company’s obligation to pay a minimum of $5,000,000 in theaggregate over the three year period. The Company has recorded this transactionas $5,000,000 of intangible assets. Shortly after signing this agreement theCompany provided an irrevocable letter of credit for the benefit of OneBeaconin the amount of $2,000,000 representing the estimated payments for the firstyear of the agreement.

TheCompany has determined that two intangible assets were acquired in thistransaction: renewal rights and new agent contractual relationships, both ofwhich were determined to be intangible assets with a finite useful life. Therenewal rights were recorded at $1,250,000 and will be amortized over ten yearsin proportion 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. During2006 and 2005, the Company recorded amortization expense of $412,000 and$446,000, respectively, on the intangible assets. The weighted averageamortization period of identified intangible assets of finite useful life is16.5 years. The estimated aggregate amortization expense for each of the nextfive years is (in 000’s):

| 2007 |   | $ | 367 |   |
|------|--------|---|-----|--------|
| 2008 |   | $ | 331 |   |
| 2009 |   | $ | 302 |   |
| 2010 |   | $ | 279 |   |
| 2011 |   | $ | 261 |   |

 

In 2005, Tower Group, Inc. closed on its purchaseof the outstanding common stock of a shell property casualty insurance company,North American Lumber Insurance Company (“NALIC”), subsequently renamed TowerNational Insurance Company. Prior to the closing, all liabilities and assets(other than insurance licenses) of Tower National Insurance Company weretransferred to a liquidating trust. The Company capitalized these purchases asan intangible asset related to state licenses with an 

F-30

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indefinite life subject toannual impairment testing. The total amount capitalized as of December 31,2006 and 2005, was $1,303,000 and included the purchase price, legal fees and abroker’s fee.

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

| ** **                  | ** ** | **Initial Balance** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|-----------------------------|------------|--------------------------|------------|-------------------------------|------------|---------|------------|
| **December 31,  2006** |       |                     |       |                          |       |    |       |   |   |   |   |
| Renewal rights              |       |                     | $          | 1,250                         |       |    |       | $ | (505 | ) |   | $ | 745 |   |
| Agency force                |       |                     | 3,750      |                          |       |    | (375       | ) |   | 3,375 |   |
| Insurance  Licenses         |       |                     | 1,303      |                          |       |    | —     |   |   | 1,303 |   |
| **Total**                   |       |                     | $          | 6,303                         |       |    |       | $ | (880 | ) |   | $ | 5,423 |   |
| **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 |   |

 

As of December 31,2006 there was no impairment on any of the intangible assets as per the Company’sannual impairment testing.

**Note 8—Fixed Assets**

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

| ** **                   | ** ** | **Cost** | ** ** | **Accumulated  Depreciation** | ** ** | **Net** | ** ** |
|------------------------------|------------|----------|------------|-------------------------------|------------|---------|------------|
| **December 31,  2006:** |       |     |       |                          |       |    |       |   |   |
| Furniture                    |       | $        | 1,511      |                          |       | $       | (191       | ) |   | $ | 1,320 |   |
| Leasehold  improvements      |       | 10,781   |       |                          | (272       | )       |       | 10,509 |   |
| Computer  equipment          |       | 7,954    |       |                          | (5,700     | )       |       | 2,254 |   |
| Software                     |       | 13,367   |       |                          | (6,947     | )       |       | 6,420 |   |
| Artwork                      |       | 60       |       |                          | —     |    |       | 60 |   |
| Total fixed assets           |       | $        | 33,673     |                          |       | $       | (13,110    | ) |   | $ | 20,563 |   |
| **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 |   |

 

During the third quarterof 2006, the Company relocated its New York City corporate headquarters withinthe same building. The landlord provided a $4.5 million build-out allowancewhich partially financed the cost of the leasehold improvements. In 2006 theCompany capitalized $22.9 million for the purchase of fixed assets, including$10.4 million for leasehold improvements, $6.1 million for furniture andequipment and $6.4 million for computer hardware and software. The Company alsoentered into a sale and leaseback of certain furniture and equipment in theamount of $5.2 million on December 29, 2006. The transaction met therequirements to be accounted for as an operating lease.

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**Note 9—Debt**

**SubordinatedDebentures**

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, 2006 this interest rate was 9.47% compared to 8.40% in2005. The Trust II floating rate preferred securities bear interest at a fixedrate of 7.5% until September 30, 2008 and at a variable rate, resetquarterly, equal to the 3-month LIBOR, plus 4.00%, thereafter. The finalmaturity on the subordinated debentures is May 15, 2033 and September 30,2033 for Trust I and Trust II, respectively, with prepayment at the option ofthe Company available beginning in 2008. Issuance costs, primarily legal fees,of $301,000 and $338,000 for the Trust I and Trust II offerings, respectively,were deferred and are being amortized over the term of the subordinateddebentures 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 LIBORrate plus 3.4%. The Trust IV preferred securities bear interest that will floatbased on the 3-month LIBOR interest rate plus 3.4% and their rate as of December 31,2006 was 8.76% compared to 7.89% in 2005. The final maturity on thesubordinated debentures is December 15, 2034 and March 15, 2035 forTrust III and Trust IV, respectively, with prepayment at the option of theCompany available beginning in 2009. Issuance costs, primarily legal fees, of$262,000 and $252,000 for the Trust III and Trust IV offerings, respectively,were deferred and are being amortized over the term of the subordinated debenturesusing the effective interest method.

In March 2006, Tower formed a statutory businesstrusts (“Trust V”), of which the Company owns all of the common trustsecurities. On March 31, 2006, Trust V issued $20,000,000 floating ratetrust preferred securities to investment pools. The trust invested the proceedsthereof and the proceeds received from the issuance of the common trustsecurities to Tower in exchange for $20,619,000 of floating rate juniorsubordinated debentures (“subordinated debentures”) issued by Tower. Thesubordinated debentures are unsecured obligations of Tower and are subordinatedand junior in right of payment to all present and future senior indebtedness ofTower. Tower has entered into guarantee agreements, which provide for full andunconditional guarantee of the trust securities. The Trust V preferredsecurities bear interest that is fixed at 8.5625% until March 31, 2011 andthe coupon will float quarterly thereafter at the three months LIBOR rate plus3.4%. The final maturity on the subordinated debentures is April 7, 2036with prepayment at the option of the Company available beginning in 2011. Issuancecosts, primarily legal fees, 

F-32

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of $505,100 were deferredand are being amortized over the term of the subordinated debentures using theeffective interest method.

Total interest expense incurred for all subordinateddebentures, including amortization of deferred origination costs, was $5,271,000, $3,514,000 and $1,461,000, respectively for the years ended December 31,2006, 2005 and 2004.

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

| **2033**  |       | $      | 20,620     |       |
|-----------|------------|--------|------------|------------|
| **2034**  |       | 13,403 |       |
| **2035**  |       | 13,403 |       |
| **2036**  |       | 20,619 |       |
| **Total** | ** ** | **$**  | **68,045** | ** ** |

 

**Note 10—CapitalStock**

Theroll-forward of shares of common stock is as follows (in 000’s):

| ** **                                       | ** ** | **Shares Issued** | ** ** | ** **                                     | ** ** |
|--------------------------------------------------|------------|------------------------|------------|------------------------------------------------|------------|
| **Increase (decrease)**                     | ** ** | ** **             | ** ** | **Series A  Perpetual  Preferred  Stock** | ** ** | **Common  Stocks** | ** ** | **Class A  Common  Stock** | ** ** | **Class B  Common  Stock** | ** ** | **Treasury  Stock** | ** ** |
| **Balance  at January 1, 2004**             |       |                   | —     |                                           |       |   | — |   |   |   | 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 | ) |   |
| Restricted stock issued to employees             |       |                   | —     |                                           |       |   | 72 |   |   |   | — |   |   |   | — |   |   |   |   |   |   |
| Common shares  repurchased by Company            |       |                   | —     |                                           |       |   | — |   |   |   | — |   |   |   | — |   |   |   | (1 | ) |   |
| Stock options exercised                          |       |                   | —     |                                           |       |   | 58 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Restricted stock issued to directors             |       |                   | —     |                                           |       |   | 3 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Restricted stock forfeited                       |       |                   | —     |                                           |       |   | — |   |   |   | — |   |   |   | — |   |   |   | (6 | ) |   |
| Issuance of preferred shares                     |       |                   | 40         |                                           |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| **Balance at December 31,  2006**           |       |                   | 40         |                                           |       |   | 20,006 |   |   |   | — |   |   |   | — |   |   |   | (25 | ) |   |
|                                                  |            |                        |            |                                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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As part of the IPO in October 2004, the Companyissued to Friedman Billings Ramsey (FBR), the lead underwriter, warrants topurchase 189,000 shares of the Company’s common 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. OnOctober 28, 2005, FBR exercised warrants and paid the Company the warrantexercise price of $8.50 per share or $89,820 and were issued 10,567 shares bythe Company from treasury shares. In addition, FBR exercised 132,300 warrantson October 28, 2005 via a cashless exercise which resulted in the issuanceof 64,244 shares by the Company from treasury shares. As of December 31,2006, FBR has 46,133 warrants outstanding which are included in the calculationof diluted EPS.

On November 8, 2005, the Securities and ExchangeCommission declared Tower Group, Inc.’s Post-Effective AmendmentNo. 2 to Form S-1 on Form S-3 Registration Statementeffective. This registration covers the resale of up to 500,000 shares of TowerGroup, Inc.’s common stock from time to time by an affiliate of Friedman,Billings, Ramsey & Co., Inc., the lead underwriter for theCompany’s IPO. The Company will not receive any of the proceeds from the saleof these shares.

The Company issued 40,000 perpetual series A preferredshares on December 4, 2006 with a $0.01 par value per share and a $1,000liquidation preference per share to CastlePoint Reinsurance Company, Ltd. whichare potentially convertible into common stock upon a public offering of commonshares by the Company. The carrying value of this stock is $40 million lessissuing cost of $0.4 million or $39.6 million and pays a fixed 8.66% annualdividend that is not cumulative. As more fully described in Note 20, theCompany redeemed the 40,000 shares of perpetual preferred stock inJanuary 2007.

For the twelve months ended December 31, 2006,the Company issued 58,067 new common shares as the result of employee stockoption exercises and issued 75,019 new common shares as the result ofrestricted stock grants. For the year ended December 31, 2005, the Companyissued 32,705 new common shares as the result of employee stock optionexercises and issued 13,832 new common shares as the result of restricted stockgrants.

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

| ** **                                    | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Common stock  dividends declared              |       | $        | 1,976      |     | $          | 1,959    |       | $ | 493 |   |
| Class A  common stock dividends declared |       | —   |       | —   |       | 228      |       |
| Class B  common stock dividends declared |       | —   |       | —   |       | 281      |       |
| Total common stock dividends declared         |       | 1,976    |       | 1,959    |       | 1,002    |       |
| Preferred stock dividends declared            |       | 212      |       | —   |       | —   |       |
| Total dividends  declared                     |       | $        | 2,188      |     | $          | 1,959    |       | $ | 1,002 |   |

 

**Note 11—EquityCompensation Plans**

**2004 Long-TermEquity 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 874,883, of which 717,271 may be issued under awardsother than stock options or SARs. As of December 31, 2006, awards inrespect of 287,840 shares have been made under the plan.

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**2001 Stock AwardPlan**

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.

As of December 31,2006, there are 225,680 shares of common stock options outstanding that arefully vested. With the adoption of the 2004 Long-Term Incentive CompensationPlan, no further awards may be granted under the 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 continuous employment with the Company fromthe date of grant through the vesting date. During the vesting period, therecipients have voting rights and will receive dividends but the shares may notbe sold, assigned, transferred, exchanged, pledged or otherwise encumbered. Thefair value of the restricted shares was $1,563,000 on the grant date. Theserestricted shares were authorized and issued prior to the adoption and approvalof the 2004 Long-Term Equity Compensation Plan.

For the years ended December 31, 2006, 2005 and2004, the Company incurred restricted stock expense of $559,000, $402,000 and$201,000, respectively, net of tax that was included in net income.

The total intrinsic value of restricted stock vestingduring the years ended December 31, 2006, 2005 and 2004 was $1,759,000,$701,000 and $0, respectively. The intrinsic value of unvested restricted stockoutstanding as of December 31, 2006 is $5,674,000.

***Changes in restricted stock for the three years ended December 31,2006 were as follows:***

| ** **                            | ** ** | **Number  of Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|---------------------------------------|------------|----------------------------|------------|---------------------------------------------------------|------------|
| **OUTSTANDING  AT DECEMBER 31, 2003** | ** ** | **0**                      | ** ** |                                                    | **$**      | **0.00** | ** ** |   |
| Granted                               |       | 216,585                    |       |                                                    | 10.24      | ** ** |   |
| Vested                                |       | 0                          |       |                                                    | 0.00       | ** ** |   |
| Forfeited                             |       | 0                          |       |                                                    | 0.00       | ** ** |   |
| **OUTSTANDING  AT DECEMBER 31, 2004** | ** ** | **216,585**                |       |                                                    | **$**      | **10.24** | ** ** |   |
| Granted                               |       | 13,832                     |       |                                                    | 14.89      | ** ** |   |
| Vested                                |       | (55,504                    | )          |                                                    | 10.33      | ** ** |   |
| Forfeited                             |       | (3,725                     | )          |                                                    | 8.50       | ** ** |   |
| **OUTSTANDING  AT DECEMBER 31, 2005** | ** ** | **171,188**                | ** ** |                                                    | **$**      | **10.63** | ** ** |   |
| Granted                               |       | 75,019                     |       |                                                    | 27.08      | ** ** |   |
| Vested                                |       | (59,182                    | )          |                                                    | 10.94      | ** ** |   |
| Forfeited                             |       | (6,259                     | )          |                                                    | 10.52      | ** ** |   |
| **OUTSTANDING AT DECEMBER 31,  2006** | ** ** | **180,766**                |       |                                                    | **$**      | **17.35** | ** ** |   |

 

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**Stock Options**

Thefollowing table provides an analysis of stock option activity during the threeyears ended December 31, 2006.

| ** **                      | ** ** | **2006**                   | ** **  | **2005**                     | ** ** | **2004**                   | ** ** |
|---------------------------------|------------|----------------------------|-------------|------------------------------|------------|----------------------------|------------|
| ** **                      | ** ** | **Number of  Shares** | ** **  | **Average  Exercise  Price** | ** ** | **Number of  Shares** | ** ** | **Average  Exercise  Price** | ** ** | **Number of  Shares** | ** ** | **Average  Exercise  Price** | ** ** |
| Outstanding,  beginning of year |       |                       | 431,000     |                         |       |                       | $          | 4.80 |   |   |   | 472,777 |   |   |   | $ | 4.73 |   |   |   | 358,200 |   |   |   | $ | 2.78 |   |   |
| Granted at market  value        |       |                       | —      |                         |       |                       | —     |   |   |   | — |   |   |   | — |   |   |   | 161,077 |   |   |   | 8.50 |   |   |
| Forfeitures and  expirations    |       |                       | (9,937      | )                            |       |                       | 8.50       |   |   |   | (9,072 | ) |   |   | 8.50 |   |   |   | (9,000 | ) |   |   | 2.78 |   |   |
| Exercised                       |       |                       | (58,067     | )                            |       |                       | 3.25       |   |   |   | (32,705 | ) |   |   | 2.78 |   |   |   | (37,500 | ) |   |   | 2.78 |   |   |
| **Outstanding,  end of year**   | ** ** | ** **                 | **362,996** |                         |       |                       | $          | 4.94 |   | ** ** | ** ** | **431,000** |   | ** ** | ** ** | **$** | **4.80** |   | ** ** | ** ** | **472,777** |   |   |   | $ | 4.73 |   |   |
| **Exercisable, end of year**    | ** ** | ** **                 | **280,607** |                         |       |                       | $          | 3.90 |   | ** ** | ** ** | **305,450** |   | ** ** | ** ** | **$** | **3.38** |   | ** ** | ** ** | **295,320** |   | ** ** | ** ** | **$** | **2.78** |   |   |

 

Optionsoutstanding and exercisable as of December 31, 2006 are shown on thefollowing 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                                 |       |                         | 225,680     |                         |       |   | 4.0 years |   |   |   | 2.78 |   |   |   | 225,680 |   |   |   | 2,78 |   |   |
| $5.00 - $10.00                              |       |                         | 137,316     |                         |       |   | 7.8 years |   |   |   | 8.50 |   |   |   | 54,927 |   |   |   | 8.50 |   |   |
| **Total Options**                           | ** ** | ** **                   | **362,996** |                         | ** ** | ** ** | **5.9 years** |   | ** ** | ** ** | **$** | **4.94** |   | ** ** | ** ** | **280,607** |   | ** ** | ** ** | **$** | **4.94** |   |   |
|                                             |            |                              |             |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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.

The Company adopted the provision of SFAS 123-Reffective January 1, 2006 and has elected the modified prospectiveapplication method and is expensing all unvested stock options outstanding asof January 1, 2006. The compensation expense is recognized over therequisite service period that has not been rendered and is based upon theoriginal grant date fair value of the award as calculated for recognition ofthe pro forma disclosure under SFAS 123 R.

Compensation expense net of tax recorded related tostock options was $62,808 for 2006 and has been included in net income.

The total intrinsic value of stock options exercisedduring the years ended December 31, 2006, 2005 and 2004 was $1,434,000,$404,000 and $282,000, respectively. The intrinsic value of stock optionsoutstanding as of December 31, 2006 is $9,600,000 of which $7,714,000 is relatedto vested options.

Priorto the adoption of SFAS 123-R, the Company followed the intrinsic valuemethod in accordance with APB 25 to account for employee stock options andaccordingly recognized no compensation expense for the stock option grants. Inaccordance with SFAS 123-R, the Company adopted the provisions of thestatement on January 1, 2006 using the modified prospective applicationmethod. Under this method, prior periods are not restated. Had compensationcost for share-based plans been determined consistent with 

F-36

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SFAS 123-R, the Company’s net earnings andearnings per share for the twelve months ended December 31, 2005 and 2004would have been the following pro-forma amounts:

| ** **                                                                                                                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Net income as  reported                                                                                                                      |       | $        | 20,754     |     | $          | 9,029 |   |
| 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 |   |
| Earnings per  share                                                                                                                          |       |     |       |     |       |
| Basic—as reported                                                                                                                       |       | $        | 1.06       |     | $          | 1.23 |   |
| Basic—pro forma                                                                                                                         |       | $        | 1.06       |     | $          | 1.23 |   |
| Fully diluted—as reported                                                                                                               |       | $        | 1.03       |     | $          | 1.06 |   |
| Fully diluted—pro  forma                                                                                                                |       | $        | 1.03       |     | $          | 1.06 |   |

 

**Total EquityCompensation Not Yet Recognized**

The total remainingcompensation cost related to non vested stock option and restricted stockawards not yet recognized in the income statement was $2,808,000 of which$238,000 was for stock options and $2,570,000 was for restricted stock as of December 31,2006. The weighted average period over which this compensation cost is expectedto be recognized is 3.4 years.

**Note 12—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):

| ** **                                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current Federal  income tax expense                      |       | $        | 15,294     |     | $          | 11,864   |       | $ | 1,462 |   |
| Current state  income tax expense                        |       | 1,578    |       | 1,607    |       | 638      |       |
| Deferred Federal  and State income tax (benefit) expense |       | 2,801    |       | (2,409   | )          | 3,594    |       |
| Provision for income  taxes                              |       | $        | 19,673     |     | $          | 11,062   |       | $ | 5,694 |   |

 

F-37

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Deferredtax assets and liabilities are determined using the enacted tax ratesapplicable to the period the temporary differences are expected to be recovered.Accordingly, the current period income tax provision can be affected by theenactment of new tax rates. The net deferred income taxes on the balance sheetreflect temporary differences between the carrying amounts of the assets andliabilities for financial reporting purposes and income tax purposes, taxeffected at a 35% rate. Significant components of the Company’s deferred taxassets and liabilities are as follows (in 000’s):

| ** **                                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax asset:                                                   |       |     |       |     |       |
| Claims reserve discount                                               |       | $        | 6,839      |     | $          | 4,109 |   |
| Unearned premium                                                      |       | 9,488    |       | 8,012    |       |
| Allowance for doubtful accounts                                       |       | 87       |       | 60       |       |
| Deferred rent                                                         |       | 351      |       | —   |       |
| Equity compensation plans                                             |       | 232      |       | 124      |       |
| Net unrealized depreciation of securities                             |       | 157      |       | 1,816    |       |
| Other                                                                 |       | 33       |       | 33       |       |
| Total deferred tax asset                                              |       | 17,187   |       | 14,154   |       |
| Deferred tax liability:                                               |       |     |       |     |       |
| Deferred acquisition costs net of deferred ceding  commission revenue |       | 12,482   |       | 10,217   |       |
| Depreciation and Amortization                                         |       | 597      |       | 453      |       |
| Warrant received from unconsolidated affiliate                        |       | 1,612    |       |     |       |
| Gain from issuance of common stock by unconsolidated  affiliate       |       | 2,759    |       | —   |       |
| Equity income in unconsolidated affiliate                             |       | 320      |       | —   |       |
| Accrual of bond discount                                              |       | 672      |       |     |       |
| Other                                                                 |       | —   |       | 280      |       |
| Total deferred tax liabilities                                        |       | 18,442   |       | 10,950   |       |
| Net deferred  income tax (liability)/asset                            |       | $        | (1,255     | )        | $          | 3,204 |   |

 

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):

| ** **                                                                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Theoretical  Federal income tax expense at U.S. statutory rate (35%, 35%, 34%) |       | $        | 19,753     |     | $          | 11,136   |       | $ | 5,006 |   |
| Tax advantaged investments                                                          |       | (1,073   | )          | (928     | )          | (210     | )          |
| State income taxes net of Federal benefit                                           |       | 1,025    |       | 1,044    |       | 385      |       |
| Other                                                                               |       | (32      | )          | (190     | )          | 513      |       |
| Provision for income  taxes                                                         |       | $        | 19,673     |     | $          | 11,062   |       | $ | 5,694 |   |

 

F-38

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**Note 13—EmployeeBenefit Plans**

The Company maintains adefined contribution Employee Pretax Savings Plan (401(k) Plan) for itsemployees. The Company matches 50% of each participant’s contribution up to 8%of the participant’s compensation. The Company incurred approximately $789,000,$649,000 and $461,000 of expense in 2006, 2005 and 2004, respectively, relatedto this plan.

**Note 14—Commitmentsand Contingencies**

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 various lease agreements for office space and equipment. The termsof the office space lease agreements provide for annual rental increase andcertain lease incentives including initial free rent periods and cashallowances for leasehold improvements. The Company amortizes scheduled annualrental increases and lease incentives ratably over the term of the lease. Thedifference between rent cash payments and recognized rent expense is recordedas deferred rent. The Company’s future minimum lease payments are as follows ($’sin 000’s): 

| **Year**   | ** ** | ** ** | ** ** | **Amount** | ** ** |
|------------|------------|------------|------------|------------|------------|
| 2007       |       | $          | 5,118      |       |
| 2008       |       | 5,232      |       |
| 2009       |       | 5,138      |       |
| 2010       |       | 5,101      |       |
| 2011       |       | 5,303      |       |
| Thereafter |       | 33,958     |       |
| Total      |       | $          | 59,850     |       |

 

Total rental expense charged to operations wasapproximately $3,779,000, $2,333,000, and $1,536,000 in 2006, 2005 and 2004,respectively.

TICNY and TNIC are subjectto assessments in New York for various purposes, including the provision offunds necessary to fund the operations of the New York Insurance Department andthe New York Property/Casualty Insurance Security Fund, which pays coveredclaims under certain policies provided by impaired, insolvent or failedinsurance companies and various funds administered by the New York Workers’Compensation Board, which pays covered claims under certain policies providedby impaired, insolvent or failed insurance companies  The Company was assessed approximately$2,042,000, $941,000 and $435,000 in 2006, 2005 and 2004, respectively, for itsproportional share of the total assessment for the Property/Casualty SecurityFund and approximately $1,470,000, $589,000 and $556,000 in 2006, 2005 and2004, respectively, for its proportional share of the operating expenses of theNew York Insurance Department. Property casualty insurance company insolvenciesor failures may result in additional security fund assessments to the Companyat some future date. At this time the Company is unable to estimate thepossible amounts, if any, of such assessments. Accordingly, the Company isunable to determine the impact, if any, such assessments may have on financialposition or results of operations of the Company. The Company is permitted toassess premium surcharges on workers’ compensation policies that are based onstatutorily enacted rates. Actual assessments have resulted in differences tothe original estimates based on permitted surcharges of $(127,000), $0 and$1,143,000 in 2006, 2005 and 2004, 

F-39

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respectively.The Company estimates its liability for future assessments based on actualwritten premiums and historical rates and available information. As of December 31,2006 the liability for the various workers’ compensation funds, which includesamounts assessed on workers’ compensation policies was $4,463,000. This amountis expected to be paid over an eighteen month period ending June 30, 2008.As of December 31, 2005, the liability for the various workers’compensation funds was $2,276,000.

*ContingenciesSurrounding the 2006 New York Board of Fire Underwriters Assessment*

The New York City FirePatrol (“Fire Patrol”) which is governed by the New York Board of FireUnderwriters (“NYBFU”) was created to improve fire safety in the New York Cityand was responsible for the salvage and dewatering operations at the scene offires and water leaks for the purpose of protecting property from loss due tothese perils. Fire Patrol’s operations were supported by assessments made bythe NYBFU upon the insurance company members of the NYBFU and, in someinstances, other writers of fire insurance in New York City who had elected notto become members. The NYBFU’s membership voted to discontinue the Fire Patrolon January 31, 2006. Subsequently, the Company received a $505,748assessment from the Fire Patrol for the 2006 year. The Company does not believethat it is a proper assessment and it has requested additional information fromthe NYFBU on the Fire Patrol assessment. The Company has not recorded anyliability for this assessment as of December 31, 2006. The NYBFU hasinformed the Company that the Fire Patrol ceased operations on October 15,2006. The Company cannot predict what action, if any, the NYBFU will take inthis matter and whether the Company may ultimately be liable for some amount ofthe assessment.

**Note 15—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.

F-40

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For the years endedDecember 31, 2006, 2005 and 2004, TICNY reported statutory basis netincome/ (loss) of $21,136,000, $6,249,000 and ($5,705,000), and respectively.At December 31, 2006 and 2005 TICNY reported statutory basis surplus asregards policyholders of $200,650,000, and $132,409,000, respectively as filedwith the insurance regulators. As of December 31, 2006 TICNY is requiredto maintain $7,900,000 of minimum capital and surplus in accordance with NewYork Insurance Law.

For the years ended December 31,2006 and 2005, TNIC reported statutory basis net income/ (loss) of $(596,000)and $116,000, respectively. Reported statutory basis surplus as regardspolicyholders as December 31, 2006 and 2005 was $9,714,000 and$10,116,000, respectively. As of December 31, 2006 TNIC is required tomaintain $6,350,000 of minimum of capital and surplus in accordance with theCommonwealth of Massachusetts Insurance Law.

Under New York law, TICNYis limited in the amount of dividends it can pay to Tower. Under New York law,TICNY may pay dividends to Tower only out of statutory earned surplus. Inaddition, the New York Insurance Department must approve any dividend declaredor paid by TICNY that, together with all dividends declared or distributed byTICNY during the preceding twelve months, exceeds the lesser of (1) 10% ofTICNY’s policyholders’ surplus as shown on its latest statutory financialstatement filed with the New York State Insurance Department or (2) 100%of adjusted net investment income during the preceding twelve monthsimmediately preceding the declaration or distribution of the current dividendincreased by the excess, if any, of net investment income over dividendsdeclared or distributed during the period commencing thirty-six months prior tothe declaration or distribution of the current dividend and ending twelvemonths prior thereto. TICNY declared approximately $4,600,000, $2,050,000, and$850,000 in dividends to Tower in 2006, 2005, and 2004, respectively. As ofDecember 31, 2006, the maximum distribution that TICNY could pay withoutprior regulatory approval was approximately $10,477,000.

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 theMassachusetts Commissioner of Insurance has received notice of the intendeddividend and not objected in such time. In addition, dividends may only be paidout of unassigned funds. As of December 31, 2006, TNIC’s maximum dividendit could pay without the approval of the Massachusetts Commissioner ofInsurance was $89,000.

**Note 16—Fair Value of Financial Instruments**

Statement of FinancialAccounting Standards No. 107, “Disclosures about Fair Value of FinancialInstruments” (“SFAS 107”) requires all entities to disclose the fair value offinancial instruments, both assets and liabilities recognized and notrecognized in the balance sheet, for which it is practicable to estimate fairvalue. The company uses the following methods and assumptions in estimating itsfair value disclosures for financial instruments:

***Equity and fixed income investments:****  *Fair value disclosures for investments are includedin “Note 2. Investments.”

***Investment in unconsolidated affiliate—******Investments***inunconsolidated affiliates are investments in related parties; as such it is notpractical to estimate the fair value of these instruments. Accordingly, theseamounts are reported using the equity method.

***Common trust securities—statutory business trusts:***   Commontrust securities are investments in related parties; as such it is notpractical to estimate the fair value of these instruments. Accordingly, theseamounts are reported using the equity method.

F-41

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***Agents’ balances receivable, assumed premiumsreceivable, receivable-claims paid by agency:***   Thecarrying values reported in the accompanying balance sheets for these financialinstruments approximate their fair values.

***Reinsurance balances payable, payable to issuingcarrier and funds held:****  *Thecarrying value reported in the balance sheet for these financial instrumentsapproximates 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.

**Note 17—EarningsPer Share**

The followingtable shows the computation of the company’s earnings per share (in 000’s,except shares and per share amounts):

| ** **                       | ** ** | **Income**      | ** ** | **Shares**        | ** ** | **Per Share** | ** ** |
|----------------------------------|------------|-----------------|------------|-------------------|------------|--------------------|------------|
| ** **                       | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount**         | ** ** |
| **2006**                         |       |            |       |              |       |               |       |   |   |   |   |   |   |
| Net income                       |       |            | $          | 36,764            |       |               |       | — |   |   |   | — |   |   |
| Less: preferred stock  dividends |       |            | (212       | )                 |       |               |       |   |   |   |   |   |   |
| Basic EPS                        |       |            | $          | 36,552            |       |               |       | 19,750,309 |   |   |   | $ | 1.85 |   |   |
| Effect of dilutive securities:   |       |            |       |              |       |               |       |   |   |   |   |   |   |
| Stock options                    |       |            | —     |              |       |               | 203,222    |   |   |   |   |   |   |
| Unvested restricted  stock       |       |            | —     |              |       |               | 64,888     |   |   |   |   |   |   |
| Warrants                         |       |            | —     |              |       |               | 31,997     |   |   |   |   |   |   |
| Preferred shares                 |       |            | —     |              |       |               | 96,902     |   |   |   |   |   |   |
| Preferred stock  dividends       |       |            | 212        |              |       |               | —     |   |   |   |   |   |   |
| Diluted EPS                      |       |            | $          | 36,764            |       |               |       | 20,147,318 |   |   |   | $ | 1.82 |   |   |
| **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 |   |   |

 

PXRE had an optionagreement to purchase 599,400 common shares of the Company for $16.67 per sharethat it would terminate if certain conditions were met. These options were notincluded in the computation of diluted EPS in 2004 because their effect wouldbe antidilutive. On June 8, 2005 the Company was notified that allconditions were met and that PXRE’s right to purchase 599,400 common shares ofthe Company was terminated.

F-42

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**Note 18—Segment Information**

The Company manages itsoperations through three business segments: insurance (commercial and personallines underwriting), reinsurance, and insurance services (managing generalagency, claims administration and reinsurance intermediary operations). TheCompany considers many factors in determining reportable segments includingeconomic characteristics, production sources, products or services offered andregulatory environment.

In the insurance segment,TICNY provides commercial and personal lines insurance policies to businessesand individuals. TICNY’s commercial lines products include commercialmultiple-peril, monoline general liability, commercial umbrella, monolineproperty, workers’ compensation and commercial automobile policies. Itspersonal lines products consist of homeowners, dwelling and other liabilitypolicies.

In the reinsurancesegment, TICNY assumes reinsurance directly from TRM’s issuing companies orindirectly from reinsurers that provide reinsurance coverage directly to theissuing companies. TICNY assumes, as a reinsurer, a modest amount of the riskon the premiums that TRM’s managing general agency produces.

In the insurance servicessegment, TRM generates commission revenue from its managing general agency byproducing premiums on behalf of its issuing companies and generates fees byproviding claims administration and reinsurance intermediary services. Theinsurance services segment also includes other administration services providedby TICNY to CastlePoint. Prior to 2006, placing risks through TRM’s issuingcompanies allowed the Company to underwrite larger policies and gain exposureto market segments that were unavailable to TICNY due to its rating, financialsize and geographical licensing limitations. In 2006, TRM allowed the Companyto write business through issuing carriers in states in which it was notlicensed. TRM does not assume any risk on business produced by it. All of therisk is ceded by the issuing companies to a variety of reinsurers pursuant toreinsurance programs arranged by TRM’s reinsurance intermediary working withoutside reinsurance intermediaries. Through its issuing companies, TRM’smanaging general agency offers commercial package, monoline general liability,monoline property, commercial automobile and commercial umbrella products.

The insurance servicessegments direct commission revenue is from two issuing carriers. Each issuingcarrier provides less than 10% of the Company’s consolidated total revenues. Althoughthis segment is dependent upon two issuing carriers, it is management’s opinionthat the loss of one or both can be remedied by replacement issuing carriers. Thereis no intercompany 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.

F-43

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Businesssegment results are as follows (in 000’s):

| ** **                                              | ** ** | **2006**    | ** ** | **2005**    | ** ** | **2004**   | ** ** |
|---------------------------------------------------------|------------|-------------|------------|-------------|------------|------------|------------|
| **Insurance Segment**                                   |       |        |       |        |       |       |       |
| Revenues                                                |       |        |       |        |       |       |       |
| Net premiums earned                                     |       | $           | 204,679    |        | $          | 162,911    |       | $ | 44,427 |   |
| Ceding commission  revenue                              |       | 43,130      |       | 25,218      |       | 39,983     |       |
| Policy billing fees                                     |       | 1,129       |       | 868         |       | 671        |       |
| **Total  Revenues**                                     | ** ** | **248,938** | ** ** | **188,997** | ** ** | **85,081** | ** ** |
| Expenses                                                |       |        |       |        |       |       |       |
| Net loss and loss  adjustment expenses                  |       | 117,982     |       | 95,700      |       | 27,753     |       |
| Underwriting expenses                                   |       | 101,701     |       | 74,035      |       | 47,804     |       |
| **Total  Expenses**                                     | ** ** | **219,683** | ** ** | **169,735** | ** ** | **75,557** | ** ** |
| Underwriting Profit                                     | ** ** | **$**       | **29,255** | ** **  | **$**      | **19,262** | ** ** | **$** | **9,524** | ** ** |
| **Reinsurance Segment**                                 |       |        |       |        |       |       |       |
| Revenues                                                |       |        |       |        |       |       |       |
| Net premiums earned                                     |       | $           | 19,309     |        | $          | 1,525      |       | $ | 1,137 |   |
| Ceding commission  revenue                              |       | —      |       | —      |       | —     |       |
| **Total  Revenues**                                     | ** ** | **19,309**  | ** ** | **1,525**   | ** ** | **1,137**  | ** ** |
| Expenses                                                |       |        |       |        |       |       |       |
| Net loss and loss  adjustment expenses                  |       | 17,143      |       | 914         |       | (693       | )          |
| Underwriting expenses                                   |       | 3,670       |       | 189         |       | 248        |       |
| Total Expenses                                          | ** ** | **20,813**  | ** ** | **1,103**   | ** ** | **(445**   | **)**      |
| Underwriting (Loss)  Profit                             | ** ** | **$**       | **(1,504** | **)**       | **$**      | **422**    | ** ** | **$** | **1,582** | ** ** |
| **Insurance Services Segment**                          |       |        |       |        |       |       |       |
| Revenues                                                |       |        |       |        |       |       |       |
| Direct commission  revenue from managing general agency |       | $           | 3,466      |        | $          | 9,148      |       | $ | 11,546 |   |
| Claims administration  revenue                          |       | 3,193       |       | 4,268       |       | 4,105      |       |
| Other administrative  revenue                           |       | 737         |       | —      |       | —     |       |
| Reinsurance intermediary  fees                          |       | 577         |       | 688         |       | 730        |       |
| Policy billing fees                                     |       | 5           |       | 23          |       | 8          |       |
| **Total  Revenues**                                     | ** ** | **7,978**   | ** ** | **14,127**  | ** ** | **16,389** | ** ** |
| Expenses                                                |       |        |       |        |       |       |       |
| Direct commissions  expense paid to producers           |       | 1,925       |       | 5,051       |       | 7,432      |       |
| Other insurance services  expenses                      |       |        |       |        |       |       |       |
| Underwriting expenses  reimbursed to TICNY              |       | 1,578       |       | 1,981       |       | 2,987      |       |
| Claims expense  reimbursement to TICNY                  |       | 3,176       |       | 4,255       |       | 4,019      |       |
| **Total  Expenses**                                     | ** ** | **6,679**   | ** ** | **11,287**  | ** ** | **14,438** | ** ** |
| Insurance Services Pretax Income                        |       | $           | 1,299      |        | $          | 2,840      |       | $ | 1,951 |   |

 

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 $1,578,000 in 2006, $1,981,000 in 2005 and $2,987,000 in 2004. TRM also reimburses TICNY, at cost, for claims administrationexpenses pursuant to the terms of this expense sharing agreement. Claimsexpenses reimbursed by TRM were $3,176,000 in 2006, $4,255,000 in 2005 and$4,019,000 in 2004. TICNY is also 

F-44

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reimbursed, at cost, forother administrative services provided to CastlePoint, pursuant to the terms ofthe service and expense sharing agreement which were $737,000 in 2006.

The following tablereconciles revenues by segment to consolidated revenue (in 000’s):

| ** **                  | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|----------|------------|
| Revenue                     |       |     |       |     |       |     |       |
| Insurance segment           |       | $        | 248,938    |     | $          | 188,997  |       | $ | 85,081 |   |
| Reinsurance segment         |       | 19,309   |       | 1,525    |       | 1,137    |       |
| Insurance services  segment |       | 7,978    |       | 14,127   |       | 16,389   |       |
| Total segment revenues      |       | 276,225  |       | 204,649  |       | 102,607  |       |
| Investment income           |       | 23,026   |       | 14,983   |       | 5,070    |       |
| Realized capital gains      |       | 12       |       | 122      |       | 13       |       |
| Consolidated revenues       |       | $        | 299,263    |     | $          | 219,754  |       | $ | 107,690 |   |

 

The following table reconciles the results of ourindividual segments to consolidated income before taxes (in 000’s):

| ** **                                      | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Insurance segment  underwriting profit          |       | $        | 29,255     |     | $          | 19,262   |       | $ | 9,524 |   |
| Reinsurance segment  underwriting (loss) profit |       | (1,504   | )          | 422      |       | 1,582    |       |
| Total underwriting  profit                      |       | 27,751   |       | 19,684   |       | 11,106   |       |
| Insurance services  segment pretax income       |       | 1,299    |       | 2,840    |       | 1,951    |       |
| Net investment income                           |       | 23,026   |       | 14,983   |       | 5,070    |       |
| Net realized investment  gains                  |       | 12       |       | 122      |       | 13       |       |
| Corporate expenses                              |       | (2,183   | )          | (960     | )          | (289     | )          |
| Interest expense                                |       | (6,870   | )          | (4,853   | )          | (3,128   | )          |
| Other income                                    |       | 13,402   |       | —   |       | —   |       |
| Income before taxes                             |       | $        | 56,437     |     | $          | 31,816   |       | $ | 14,723 |   |

 

**Note 19—Capitalized Acquisition Costs for Preserver**

On November 13,2006, the Company signed an agreement to acquire Preserver Group, Inc. (“Preserver”)for a base purchase price of $68.3 million (approximately $64.8 million afterdeduction for expenses incurred by Preserver, net of tax). Preserver is aprivately-held company that offers products similar to the Company’s in theNortheast, particularly in New Jersey, Maine and Massachusetts. Preserver israted “B++” (Good) by A.M. Best. On December 7, 2006, A.M. Bestplaced the ratings of Preserver under review with positive implications. Theacquisition is subject to regulatory approvals and is expected to close in thesecond quarter of 2007. The Company incurred $0.6 million of acquisition costsfor legal, accounting and other expenses that has been capitalized and isrecorded as other assets as of December 31, 2006.

**Note 20—Subsequent Events**

On January 22, 2007,the Securities and Exchange Commission declared Tower Group, Inc.’sregistration statement effective on Form S-3 relating to $84,500,000of the Company’s common stock, par value $.01 per share, of the Company (“commonstock”). On January 22, 2007, the Company signed an underwriting agreementproviding for the issuance and sale by the Company of 2,704,000 shares ofcommon stock at a price of $31.25 per share, less underwriting discounts, andthe grant to the underwriters of an option to purchase up to 405,600 additionalshares of common stock at the same price to cover over-allotments.

On January 25, 2007,the Company participated in a private placement of $20.0 million offixed/floating rate capital securities (the “Trust Preferred Securities”)issued by Tower Group Statutory Trust VI (the “Trust”), an affiliated Delawaretrust formed on January 11, 2007. The Trust Preferred Securities mature inApril 2036, are redeemable at the Company’s option at par beginning April 7,2011, 

F-45

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andrequire quarterly distributions of interest by the Trust to the holder of theTrust Preferred Securities. Interest distributions are initially at a fixedrate of 8.155% for the first five years and will then reset quarterly forchanges in the three-month London Interbank Offered Rate (“LIBOR”) plus 300basis points. The Trust simultaneously issued 619 of the Trust’s commonsecurities to the Company for a purchase price of $0.6 million, whichconstitutes all of the issued and outstanding common securities of the Trust.The Trust used the proceeds from the sale of the Trust Preferred Securities andcommon securities to purchase for $20.6 million a junior subordinated debtsecurity due 2037 issued by the Company. The Company does not consolidateinterest in its statutory business trusts for which the Company holds 100% ofthe common trust securities because the Company is not the primary beneficiaryof the trusts. The Company’s investment in common trust securities of thestatutory business trust are reported in investments as equity securities. TheCompany reports as a liability the outstanding subordinated debentures owed tothe statutory business trusts.

On January 26, 2007,the Company closed on its sale of 2,704,000 shares of common stock. The Company’snet proceeds were approximately $79.3 million.

On January 10, 2007,the Company converted its perpetual preferred series A stock into preferredseries A-1 stock. On January 26, 2007, the company fully redeemedall 40,000 shares for $40.0 million using $20.0 million of the net proceedsfrom its trust preferred securities issued on January 25, 2007 and $20.0million of the net proceeds from its common stock offering on January 26,2007.

On February 5, 2007the underwriters exercised their over-allotment option with respect to 340,600shares of common stock at the offering price of $31.25 per shares, lessunderwriting discounts. The Company received $10.6 million net proceeds fromthis exercise $10.1 million after the underwriting discount. The exercise ofthe over-allotment option brings the Company’s aggregate net proceeds from theoffering and over-allotment option, after underwriting discounts, and expenses,to approximately $89.4 million.

Tower Group, Inc’s Boardof Directors approved a quarterly dividend on February 22, 2007 of $0.025per share payable March 27, 2007 to stockholders of record as of March 15,2007.

**Note 21—Unaudited Quarterly Financial Information**

| ** **            | ** ** | **2006**                                                              | ** ** |
|-----------------------|------------|-----------------------------------------------------------------------|------------|
| ** **            | ** ** | **First**                                                             | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Total** | ** ** |
| ** **            | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Revenues              |       | $                                                                     | 71,172     |   | $ | 77,160 |   | $ | 73,021 |   | $ | 77,910 |   | $ | 299,263 |   |
| Net Income            |       | 6,510                                                                 |       | 12,285 |   | 8,456 |   | 9,513 |   | 36,764 |   |
| Net income per share: |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Basic                 |       | 0.33                                                                  |       | 0.62 |   | 0.43 |   | 0.47 |   | 1.85 |   |
| Diluted               |       | 0.32                                                                  |       | 0.61 |   | 0.42 |   | 0.46 |   | 1.82 |   |
|                       |            |                                                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **            | ** ** | **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 |   |
|                       |            |                                                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-46

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**ITEM9.**                CHANGES IN ANDDISAGREEMENTS 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 anychanges in our internal control over financial reporting during the periodcovered by this report that have materially affected, or are reasonably likelyto materially affect, our internal control over financial reporting.

**ITEM 9B.**       OTHERINFORMATION

Not applicable.

**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, 2006, and such information is incorporated hereinby reference.

The Company has adopted a Code of Business Conduct andEthics and posted it on its website http://www.twrgrp.com/ under InvestorInformation and then under Corporate Governance.

 

101

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**ITEM11.**         EXECUTIVE COMPENSATION

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, 2006, and such information is incorporated hereinby reference.

**ITEM12.**         SECURITY OWNERSHIP OFCERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information called forby the Item and not provided herein will be contained in the Company’s ProxyStatement, which the Company intends to file within 120 days after the end ofthe Company’s fiscal year ended December 31, 2006, and such information isincorporated herein by reference.

**ITEM13.**         CERTAIN RELATIONSHIPS ANDRELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information called forby the Item and not provided herein will be contained in the Company’s ProxyStatement, which the Company intends to file within 120 days after the end ofthe Company’s fiscal year ended December 31, 2006, and such information isincorporated herein by reference.

**ITEM14.**         PRINCIPAL ACCOUNTANT FEESAND SERVICES

The information called forby the Item and not provided herein will be contained in the Company’s ProxyStatement, which the Company intends to file within 120 days after the end ofthe Company’s fiscal year ended December 31, 2006, and such information isincorporated herein by reference.

**PART IV.**

**ITEM15. EXHIBITS, FINANCIAL STATEMENT 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        Subsidiariesof Tower Group, Inc.

Exhibit 23.1        Consentof Johnson Lambert & Co. LLP

Exhibit 31.1        Certificationof CEO to Section 302(a)

Exhibit 31.2        Certificationof CFO to Section 302(a)

Exhibit 32           Certification of CEO & CFOto 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 5, 2007 | **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 on behalf of the registrant and in the capacitiesindicated.
|                          | **Signature** | ** **                                       | ** ** | ** **         | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|--------------------------|---------------|--------------------------------------------------|------------|--------------------|-----------|------------|------------|------------|----------|------------|
| /s/ Michael H. Lee       |          | Chairman of the  Board, President and Chief      |       | March 8, 2007 |
| Michael H. Lee           |          | Executive Officer  (Principal Executive Officer) |       |               |
| /s/ Francis M. Colalucci |          | Senior Vice  President, Chief Financial Officer  |       | March 8, 2007 |
| Francis M. Colalucci     |          | and Treasurer, Director  (Principal Financial    |       |               |
|                     |          | Officer, Principal  Accounting Officer)          |       |               |
| /s/ Steven G. Fauth      |          | Senior Vice  President, and Secretary, Director  |       | March 8, 2007 |
| Steven G. Fauth          |          |                                             |       |               |
| /s/ Steven W. Schuster   |          | Director                                         |       | March 8, 2007 |
| Steven W. Schuster       |          |                                             |       |               |
| /s/ Charles A. Bryan     |          | Director                                         |       | March 8, 2007 |
| Charles A. Bryan         |          |                                             |       |               |
| /s/ William W. Fox Jr.   |          | Director                                         |       | March 8, 2007 |
| William W. Fox Jr.       |          |                                             |       |               |
| /s/ Austin P. Young III  |          | Director                                         |       | March 8, 2007 |
| Austin P. Young III      |          |                                             |       |               |

 

 

103

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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                    |       |   | 105 |   |   |
| ** ** | **I**      |       |       | Summary of Investments—other than investments in  related parties                                                 |       |   | S-1 |   |   |
| ** ** | **II**     |       |       | Condensed Financial Information of the Registrant as  of and for the years ended December 31, 2006, 2005 and 2004 |       |   | S-2 |   |   |
| ** ** | **III**    |       |       | Supplementary Insurance Information for the years  ended December 31, 2006, 2005 and 2004                    |       |   | S-6 |   |   |
| ** ** | **IV**     |       |       | Reinsurance for the years ended December 31,  2006, 2005 and 2004                                                 |       |   | S-7 |   |   |
| ** ** | **V**      |       |       | Valuation and Qualifying Accounts for the years ended  December 31, 2006, 2005 and 2004       |       |   | S-8 |   |   |
| ** ** | **VI**     |       |       | Supplemental Information Concerning Insurance  Operations for the years ended December 31, 2006, 2005 and 2004    |       |   | S-9 |   |   |

 

104

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ONFINANCIAL STATEMENT SCHEDULES**

To the Board of DirectorsTower Group, Inc.

We have audited theconsolidated financial statements of Tower Group, Inc. and subsidiaries(the “Company”) as of December 31, 2006 and 2005, and for each of thethree years in the period ended December 31, 2006, management’s assessmentof the effectiveness of the Company’s internal control over financial reportingas of December 31, 2006, and the effectiveness of the Company’s internalcontrol over financial reporting as of December 31, 2006, and have issuedour report thereon dated March 5, 2007 listed in the accompanying index atItem 15. These financial statement schedules are the responsibility of theCompany’s management. Our responsibility is to express an opinion based on ouraudits. In our opinion, such financial statement schedules, when considered inrelation to the basic consolidated financial statements taken as a whole,present fairly, in all material respects, the information set forth therein.

/s/ JOHNSON LAMBERT & CO. LLP

Falls Church, VirginiaMarch 5, 2007

105

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**TOWER GROUP, INC.**

**SCHEDULE I—SUMMARYOF INVESTMENTS—OTHER THAN INVESTMENTS IN RELATED PARTIES**($ in thousands)

| ** **                                                                  | ** ** | **December 31, 2006** | ** **  |
|-----------------------------------------------------------------------------|------------|---------------------------------|-------------|
| ** **                                                                  | ** ** | **Cost**                        | ** **  | **Fair  Value** | ** ** | **Amount  Reflected on   Balance Sheet** | ** ** |
| Fixed maturities:                                                           |       |                            |        |   |   |   |   |   |   |
| Available for sale:                                                         |       |                            |        |   |   |   |   |   |   |
| U.S. Treasury  securities and obligations  of U.S. Government agencies |       | $                               | 45,294      |   | $ | 45,133 |   |   | $ | 45,133 |   |   |
| Corporate  securities                                                       |       | 122,867                         |        | 122,685 |   |   | 122,685 |   |   |
| Mortgage-backed  securities                                                 |       | 130,373                         |        | 129,257 |   |   | 129,257 |   |   |
| Asset-backed  securities                                                    |       | 17,165                          |        | 16,917 |   |   | 16,917 |   |   |
| Municipal  securities                                                       |       | 100,943                         |        | 100,575 |   |   | 100,575 |   |   |
| **Total  fixed maturities**                                                 | ** ** | **416,642**                     | ** **  | **414,567** | ** ** | ** ** | **414,567** |   |   |
| Preferred Stocks                                                            |       | 5,627                           |        | 5,672 |   |   | 5,672 |   |   |
| Common Stock                                                                |       | 42,344                          |        | 43,781 |   |   | 43,781 |   |   |
| **Total investments**                                                       | ** ** | **$**                           | **464,613** | ** ** | **$** | **464,020** | ** ** | ** ** | **$** | **464,020** |   |   |

 

S-1

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**TOWER GROUP, INC.SCHEDULE II—CONDENSED FINANCIAL INFORMATON OF THE REGISTRANTCONDENSED BALANCE SHEETS**($ in thousands)
|                                                                                                               | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                                    | ** ** | **2006**              | ** ** | **2005**              | ** ** |
| **Assets**                                                                                                    | ** ** |                  | ** ** | ** **            |       |   | ** ** | ** ** |   |
| Fixed-maturity securities, available for sale, at  fair value (amortized cost $0 in 2006, and $5,203 in 2005) |       |                  | $          | —                | ** ** |   |   | $ | 5,139 | ** ** |   |
| Equity securities, available for sale , at cost                                                               |       |                  | —     | ** **            |       |   | 7,064 | ** ** |   |
| **Total investments**                                                                                         |       |                  | —     | ** **            |       |   | 12,203 | ** ** |   |
| Cash and cash equivalents                                                                                     |       |                  | 5,089      | ** **            |       |   | 2,651 | ** ** |   |
| Investment in subsidiaries                                                                                    |       |                  | 253,141    | ** **            |       |   | 173,236 | ** ** |   |
| Common trust securities—statutory business trusts,  equity method                                        |       |                  | 2,045      | ** **            |       |   | 1,426 | ** ** |   |
| Federal and state tax recoverable                                                                             |       |                  | 2,295      | ** **            |       |   | 105 | ** ** |   |
| Deferred income tax                                                                                           |       |                  | —     | ** **            |       |   | 38 | ** ** |   |
| Intangible assets                                                                                             |       |                  | 1,000      | ** **            |       |   | 2,940 | ** ** |   |
| Fixed assets, net of accumulated depreciation                                                                 |       |                  | 10,294     | ** **            |       |   | — | ** ** |   |
| Due from parent and affiliate                                                                                 |       |                  | 382        | ** **            |       |   | 672 | ** ** |   |
| Investment in unconsolidated affiliate                                                                        |       |                  | 27,944     | ** **            |       |   | — | ** ** |   |
| Other assets                                                                                                  |       |                  | 4,056      | ** **            |       |   | 2,758 | ** ** |   |
| **Total Assets**                                                                                              | ** ** |                  | **$**      | **306,246**           | ** ** |   |   | **$** | **196,029** | ** ** |   |
| **Liabilities**                                                                                               | ** ** |                  | ** ** | ** **            |       |   | ** ** | ** ** |   |
| Accounts payable and accrued expenses                                                                         |       |                  | 3,318      | ** **            |       |   | 3,781 | ** ** |   |
| Deferred rent liability                                                                                       |       |                  | 5,959      | ** **            |       |   | — | ** ** |   |
| Dividends payable to stockholders                                                                             |       |                  | 212        | ** **            |       |   | — | ** ** |   |
| Deferred tax liability                                                                                        |       |                  | 4,792      | ** **            |       |   | — | ** ** |   |
| Subordinated debentures                                                                                       |       |                  | 68,045     | ** **            |       |   | 47,426 | ** ** |   |
| **Total Liabilities**                                                                                         |       |                  | 82,326     | ** **            |       |   | 51,207 | ** ** |   |
| **Stockholders’ Equity**                                                                                 |       |                  | 223,920    | ** **            |       |   | 144,822 | ** ** |   |
| **Total Liabilities and  Stockholders’ Equity**                                                          | ** ** |                  | **$**      | **306,246**           | ** ** |   |   | **$** | **196,029** | ** ** |   |

 

S-2

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**TOWER GROUP, INC.SCHEDULE II—CONDENSED FINANCIAL INFORMATON OF THE REGISTRANTCONDENSED STATEMENTS OF CASH FLOWS**($ in thousands)
|                                                                                    | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Cash flows from operating activities:**                                          | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                                          | 36,764     |   | $ | 20,754 |   | $ | 9,029 |   |
| Adjustments to reconcile  net income to net cash (used in) provided by operations: |       |                                       |       |   |   |   |   |
| Gain on issuance  of common shares of unconsolidated affiliate                     |       | (7,883                                     | )          | — |   | — |   |
| Dividends received  from consolidated subsidiaries                                 |       | 5,300                                      |       | 3,800 |   | 850 |   |
| Equity in  undistributed net income of subsidiaries                                |       | (33,175                                    | )          | (22,963 | ) | (10,544 | ) |
| Warrant received  from unconsolidated affiliate                                    |       | (4,605                                     | )          |   |   |   |   |
| Unrealized  portfolio in unconsolidated affiliate                                  |       | (50                                        | )          | — |   | — |   |
| Amortization of  debt issuance costs                                               |       | 52                                         |       | 39 |   | 178 |   |
| Amortization of  restricted stock                                                  |       | 860                                        |       | 618 |   | 310 |   |
| (Increase) decrease in  assets:                                                    |       |                                       |       |   |   |   |   |
| Federal and state  income tax recoverable                                          |       | (2,190                                     | )          | (270 | ) | 1,006 |   |
| Equity pick-up in  unconsolidated affiliate                                        |       | (914                                       | )          | — |   | — |   |
| Intangible asset                                                                   |       | 1,940                                      |       | 1,948 |   | (4,888 | ) |
| Excess tax  benefits from share-based payment arrangements                         |       | (891                                       | )          | — |   |   |   |
| Receivables from  subsidiaries                                                     |       | 290                                        |       | — |   | — |   |
| Other assets                                                                       |       | (1,350                                     | )          | (409 | ) | (804 | ) |
| (Increase) decrease in  liabilities:                                               |       |                                       |       |   |   |   |   |
| Accounts payable  and accrued expenses                                             |       | (463                                       | )          | (1,805 | ) | 5,523 |   |
| Deferred rent                                                                      |       | 5,959                                      |       | — |   | — |   |
| Payable to  subsidiaries                                                           |       | —                                     |       | (572 | ) | (4,400 | ) |
| Deferred income  tax                                                               |       | 4,830                                      |       | — |   |   |   |
| Dividends payable                                                                  |       | 212                                        |       | — |   | (160 | ) |
| Net cash flows  provided (used) by operations                                      |       | 4,686                                      |       | 1,140 |   | (3,900 | ) |
| **Cash flows from investing activities:**                                          | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Purchase of fixed  assets                                                          |       | (10,294                                    | )          | — |   | — |   |
| Investments in  unconsolidated affiliate                                           |       | (14,400                                    | )          | — |   | — |   |
| Purchase of investments:                                                           |       |                                       |       |   |   |   |   |
| Fixed-maturity  securities                                                         |       | —                                     |       | (20,921 | ) | — |   |
| Equity securities                                                                  |       | —                                     |       | (7,064 | ) | — |   |
| Sale of investments:                                                               |       |                                       |       |   |   |   |   |
| Fixed-maturity  securities                                                         |       | 6,513                                      |       | 15,658 |   | — |   |
| Equity securities                                                                  |       | 8,513                                      |       |   |   |   |   |
| Investment in  subsidiary                                                          |       | (52,030                                    | )          | (11,480 | ) | (98,096 | ) |
| Net cash flows  used in investing activities                                       |       | (61,698                                    | )          | (23,807 | ) | (98,096 | ) |
| **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                                 |       | —                                     |       | — |   | 1,421 |   |
| Proceeds from  issuance of subordinated debentures                                 |       | 20,619                                     |       | — |   | 26,806 |   |
| Purchase of common  trust securities—statutory business trusts                |       | (619                                       | )          | — |   | (806 | ) |
| Stock repurchase                                                                   |       | (97                                        | )          | — |   | — |   |
| Excess tax  benefits form share-based payment arrangements                         |       | 891                                        |       | — |   | — |   |
| Exercise of warrants                                                               |       | —                                     |       | 277 |   | — |   |
| Issuance of  preferred stock                                                       |       | 39,600                                     |       |   |   |   |   |
| Exercise of stock  options                                                         |       | 1,243                                      |       | 90 |   | 200 |   |
| IPO and private  placement, net proceeds                                           |       |                                       |       | — |   | 107,845 |   |
| Dividends declared                                                                 |       | (2,187                                     | )          | (1,959 | ) | (1,162 | ) |
| Net cash flows  provided by (used in) financing activities                         |       | 59,450                                     |       | (1,592 | ) | 125,716 |   |
| **Increase  in cash and cash equivalents**                                         |       | 2,438                                      |       | (24,259 | ) | 22,343 |   |
| Cash and cash  equivalents, beginning of year                                      |       | 2,651                                      |       | 26,910 |   | 4,567 |   |
| **Cash and  cash equivalents, end of year**                                        |       | $                                          | 5,089      |   | $ | 2,651 |   | $ | 26,910 |   |

 

S-3

----

**TOWER GROUP, INC.**

**SCHEDULE II—CONDENSEDFINANCIAL INFORMATONOF THE REGISTRANT**

**CONDENSEDSTATEMENTS OF INCOME ANDCOMPREHENSIVE INCOME**

| ** **                                                                                             | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                             | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                             | ** ** | **($ in  thousands)**                 | ** ** |
| **Revenues**                                                                                           |       |                                       |       |   |   |   |   |
| Net investment  income                                                                                 |       | $                                          | —     |   | $ | 1,147 |   | $ | 75 |   |
| Net realized  investment loss                                                                          |       | —                                     |       | (63 | ) | — |   |
| Total Revenue                                                                                          |       | —                                     |       | 1,084 |   | 75 |   |
| **Equity in net earnings of subsidiaries**                                                             |       | 33,175                                     |       | 22,963 |   | 10,544 |   |
| **Expenses**                                                                                           |       |                                       |       |   |   |   |   |
| Other operating  expenses                                                                              |       | 2,182                                      |       | 959 |   | 289 |   |
| Interest expense                                                                                       |       | 5,271                                      |       | 3,513 |   | 2,015 |   |
| **Other Income**                                                                                       |       |                                       |       |   |   |   |   |
| Equity in income  of unconsolidated affiliate                                                          |       | 914                                        |       | — |   | — |   |
| Gain from  issuance of common stock byunconsolidated affiliate                                         |       | 7,883                                      |       | — |   | — |   |
| Warrant received  from unconsolidated affiliate                                                        |       | 4,605                                      |       | — |   | — |   |
| **Income  Before Income Taxes**                                                                        |       | 39,124                                     |       | 19,575 |   | 8,315 |   |
| Provision/(benefit) for income taxes                                                                   |       | 2,360                                      |       | (1,179 | ) | (714 | ) |
| **Net Income**                                                                                         |       | $                                          | 36,764     |   | $ | 20,754 |   | $ | 9,029 |   |
| **Comprehensive  Net Income**                                                                          | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                                             |       | 36,764                                     |       | 20,754 |   | 9,029 |   |
| Other  comprehensive income:                                                                           |       |                                       |       |   |   |   |   |
| Gross unrealized investmentholding gains arising  during period                                        |       | 4,443                                      |       | (6,664 | ) | 44 |   |
| Equity in net unrealized gains in investments in  unconsolidated affiliate’s investment portfolio |       | 143                                        |       | — |   | — |   |
| Less: reclassification adjustment for gains included  in net income                                    |       | (12                                        | )          | (122 | ) | (13 | ) |
|                                                                                                   |       | 4,574                                      |       | (6,786 | ) | 31 |   |
| Income tax (expense)/benefit related to items of  other comprehensive income                           |       | (1,659                                     | )          | 2,382 |   | (27 | ) |
| Total other comprehensive net income                                                                   |       | 2,915                                      |       | (4,404 | ) | 4 |   |
| **Comprehensive  Net Income**                                                                          | ** ** | **$**                                      | **39,679** | ** ** | **$** | **16,350** | ** ** | **$** | **9,033** | ** ** |

 

S-4

----

**TOWER GROUP, INC.**

**SCHEDULE II—CONDENSEDFINANCIAL INFORMATON OF THE REGISTRANT**

**CONDENSED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY**

**($in thousands)**

| ** **                                                                       | ** ** | **Preferred  Stock** | ** ** | **Common  Stock** | ** ** | **Class A  Common  Stock** | ** ** | **Class B  Common  Stock** | ** ** | **Paid-in  Capital** | ** ** | **Accumulated  Other  Comprehensive  Net Income** | ** ** | **Retained  Earnings** | ** ** | **Treasury  Stock** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------|------------|-------------------|------------|---------------------------------|------------|---------------------------------|------------|----------------------|------------|--------------------------------------------------------|------------|------------------------|------------|---------------------|------------|---------------------------------------|------------|
| **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          | ** **                      |       |                 | —     |                                                   |       |                   | —     |                |       | 487                                   |       |   | — |   |   |   | — |   |   |   | 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**    | ** **                      |       |                 | **—** | ** **                                             |       |                   | **—** | ** **          |       | **110,467**                           | ** ** |   | **1,052** | ** ** |   |   | **18,224** | ** ** |   |   | **(494** | **)** |   |   | **129,447** | ** ** |   |   |
| Dividends declared                                                               |       |                 | —     | ** **        |       |                            | —     | ** **                      |       |                 | —     |                                                   |       |                   | —     |                |       | —                                |       |   | — |   |   |   | (1,959 | ) |   |   | — |   |   |   | (1,959 | ) |   |   |
| Stock based compensation                                                         |       |                 | —     | ** **        |       |                            | 1          | ** **                      |       |                 | —     |                                                   |       |                   | —     |                |       | 925                                   |       |   | — |   |   |   | — |   |   |   | (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**    | ** **                      |       |                 | **—** | ** **                                             |       |                   | **—** | ** **          |       | **111,066**                           | ** ** |   | **(3,352** | **)** |   |   | **37,019** | ** ** |   |   | **(110** | **)** |   |   | **144,822** | ** ** |   |   |
| Dividends declared on common stock                                               | ** ** |                 | **—** | ** **        |       |                            | **—** | ** **                      |       |                 | **—** | ** **                                             |       |                   | **—** | ** **          |       | **—**                            | ** ** |   | **—** |   |   |   | (1,975 | ) |   |   | **—** |   |   |   | (1,975 | ) |   |   |
| Dividends declared on preferred stock                                            |       |                 | —     | ** **        |       |                            | —     | ** **                      |       |                 | —     |                                                   |       |                   | —     |                |       |                                  |       |   | — |   |   |   | (212 | ) |   |   | — |   |   |   | (212 | ) |   |   |
| Stock based compensation                                                         |       |                 | —     | ** **        |       |                            | 1          | ** **                      |       |                 | —     |                                                   |       |                   | —     |                |       | 2,102                                 |       |   | — |   |   |   | — |   |   |   | (97 | ) |   |   | 2,006 |   |   |   |
| Issuance of preferred stock, net of issuance costs of  $0.4 million              |       |                 | 39,600     | ** **        |       |                            | —     | ** **                      |       |                 | —     |                                                   |       |                   | —     |                |       | —                                |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 39,600 |   |   |   |
| Net income                                                                       |       |                 | —     | ** **        |       |                            | —     | ** **                      |       |                 | —     |                                                   |       |                   | —     |                |       | —                                |       |   | — |   |   |   | 36,764 |   |   |   | — |   |   |   | 36,764 |   |   |   |
| Net unrealized appreciation on securities available  for sale, net of Income tax |       |                 | —     | ** **        |       |                            | —     | ** **                      |       |                 | —     |                                                   |       |                   | —     |                |       | —                                |       |   | 2,915 |   |   |   | — |   |   |   |   |   |   |   | 2,915 |   |   |   |
| **Balance  at December 31, 2006**                                           | ** ** |                 | **$**      | **39,600**        | ** ** |                            |       | **$**                           | **200**    | ** **           |       |                                                   | **$**      | **—**             | ** ** |                |       | **$**                                 | **—** | ** ** |   | **$** | **113,168** | ** ** |   | **$** | **(437** | **)** |   |   | **$** | **71,596** | ** ** |   |   | **$** | **(207** | **)** |   |   | **$** | **223,920** | ** ** |   |   |

 

S-5

----

**TOWER GROUP, INC.SCHEDULE III—SUPPLEMENTARY INSURANCE INFORMATION**($ in thousands)
|           | ** ** | **Deferred  Acquisition  Cost, Net of  Deferred  Ceding  Commission  Revenue** | ** ** | **Gross  Future Policy  Benefits,  Losses and  Loss Expenses** | ** ** | **Gross  Unearned  Premiums** | ** ** | **Net Earned  Premiums** | ** ** | **Benefits,  Losses and  Loss Expenses** | ** ** | **Amortization  of DAC** | ** ** | **Operating  Expenses** | ** ** | **Net  Premiums  Written** | ** ** |
|-----------|------------|------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|-------------------------------|------------|-------------------------------|------------|----------------------------------------------------|------------|-------------------------------|------------|-------------------------|------------|----------------------------|------------|
| **2006**  | ** ** |                                                                                     | ** ** | ** **                                                                    |       |                          | ** ** | ** **                    |       |                                               | ** ** | ** **                    |       |                    | ** ** | ** **                 |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Segments: |       |                                                                                     |       | ** **                                                                    |       |                          |       | ** **                    |       |                                               |       | ** **                    |       |                    |       | ** **                 |       |   |   |   |   |   |   |   |   |   |   | ** ** |   |   |   | ** ** |   |
| Insurance   |       |   | $          | 33,633     | ** ** |   |       | $          | 284,389     | ** ** |       |       | $      | 221,337     | ** ** |       |   | $      | 204,679     | ** ** |   |   | $          | 117,982     |       |   |       | $          | (54,893     | )      |       |       | $      | 45,680     | ** ** |   |   | $     | 220,825     | ** ** |   |
|-------------|------------|--------|------------|------------|------------|--------|------------|------------|-------------|------------|------------|------------|--------|-------------|------------|------------|--------|--------|-------------|------------|--------|--------|------------|-------------|------------|--------|------------|------------|-------------|--------|------------|------------|--------|------------|------------|--------|--------|-------|-------------|------------|--------|
| Reinsurance |       |   | 2,178      | ** ** |       |   | 18,152     | ** ** |        |       | 5,680      | ** ** |   |        | 19,309     | ** ** |   |   | 17,143      |       |   |   | (3,454     | )           |       |   | 1,058      | ** ** |        |   | 24,245     | ** ** |   |
| **Total**   | ** ** |   | **$**      | **35,811** | ** ** |   |       | **$**      | **302,541** | ** ** |       |       | **$**  | **227,017** | ** ** |       |   | **$**  | **223,988** | ** ** |   |   | **$**      | **135,125** | ** ** |   |       | **$**      | **(58,347** | **)**  |       |       | **$**  | **46,738** | ** ** |   |   | **$** | **245,070** | ** ** |   |
| **2005**    | ** ** |   | ** ** | ** ** |       |   | ** ** | ** ** |        |       | ** ** | ** ** |   |        | ** ** | ** ** |   |   | ** **  | ** ** |   |   | ** ** | ** **  |       |   | ** ** | ** ** |        |   | ** ** | ** ** |   |
| Segments:   |       |   |       | ** ** |       |   |       | ** ** |        |       |       | ** ** |   |        |       | ** ** |   |   |        |       |   |   |       |        |       |   |       | ** ** |        |   |       | ** ** |   |
| Insurance   |       |   | $          | 29,184     | ** ** |   |       | $          | 196,737     | ** ** |       |       | $      | 156,201     | ** ** |       |   | $      | 162,911     | ** ** |   |   | $          | 95,700      |       |   |       | $          | (45,224     | )      |       |       | $      | 35,263     | ** ** |   |   | $     | 210,395     | ** ** |   |
| Reinsurance |       |   | 8          | ** ** |       |   | 1,987      | ** ** |        |       | 1,578      | ** ** |   |        | 1,525      | ** ** |   |   | 914         |       |   |   | (423       | )           |       |   | 173        | ** ** |        |   | 1,387      | ** ** |   |
| **Total**   | ** ** |   | **$**      | **29,192** | ** ** |   |       | **$**      | **198,724** | ** ** |       |       | **$**  | **157,779** | ** ** |       |   | **$**  | **164,436** | ** ** |   |   | **$**      | **96,614**  | ** ** |   |       | **$**      | **(45,647** | **)**  |       |       | **$**  | **35,436** | ** ** |   |   | **$** | **211,782** | ** ** |   |
| **2004**    | ** ** |   | ** ** | ** ** |       |   | ** ** | ** ** |        |       | ** ** | ** ** |   |        | ** ** | ** ** |   |   | ** **  | ** ** |   |   | ** ** | ** **  |       |   | ** ** | ** ** |        |   | ** ** | ** ** |   |
| Segments:   |       |   | ,          | ** ** |       |   |       | ** ** |        |       |       | ** ** |   |        |       | ** ** |   |   |        |       |   |   |       |        |       |   |       | ** ** |        |   |       | ** ** |   |
| Insurance   |       |   | $          | 18,718     | ** ** |   |       | $          | 127,435     | ** ** |       |       | $      | 66,226      | ** ** |       |   | $      | 44,427      | ** ** |   |   | $          | 27,753      |       |   |       | $          | (25,028     | )      |       |       | $      | 22,455     | ** ** |   |   | $     | 96,595      | ** ** |   |
| Reinsurance |       |   | 22         | ** ** |       |   | 1,287      | ** ** |        |       | 888        | ** ** |   |        | 1,137      | ** ** |   |   | (693        | )          |   |   | (640       | )           |       |   | 204        | ** ** |        |   | 1,480      | ** ** |   |
| **Total**   | ** ** |   | **$**      | **18,740** | ** ** |   |       | **$**      | **128,722** | ** ** |       |       | **$**  | **67,114**  | ** ** |       |   | **$**  | **45,564**  | ** ** |   |   | **$**      | **27,060**  | ** ** |   |       | **$**      | **(25,668** | **)**  |       |       | **$**  | **22,659** | ** ** |   |   | **$** | **98,075**  | ** ** |   |

 

S-6

----

**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,  2006** | ** ** | ** **         | ** **  |                                    | ** ** | ** **                                  |        |            | ** ** | ** **                                               |       | ** ** | ** ** |   | ** ** | ** ** |   |
| Premiums                               | ** ** | ** **         | ** **  |                                    | ** ** | ** **                                  |        |            |       | ** **                                               |       | ** ** | ** ** |   |   |   |   |
| Property and Casualty Insurance        |       | $                  | 408,352     | ** **                              |       | $                                           | 187,593     | ** **      |       |                                                     | $          | 24,311 | ** ** |   | $ | 245,070 | ** ** |   | 10.00 | % |   |
| Accident and Health Insurance          |       | —             | ** **  |                                    | —     | ** **                                  |        |            | —     | ** **                                               |       | — | ** ** |   | **0.00** | **%** |   |
| **Total Premiums**                     | ** ** | **$**              | **408,352** | ** **                              |       | **$**                                       | **187,593** | ** **      |       |                                                     | **$**      | **24,311** | ** ** |   | **$** | **245,070** | ** ** |   | **10.00** | **%** |   |
| **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** | **%** |   |

 

S-7

----

**TOWER GROUP, INC.SCHEDULE V—VALUATION AND QUALIFYING ACCOUNTSDecember 31, 2006, 2005 and 2004($ in thousands)**

| ** **                    | ** ** | **December 31,** | ** ** |
|-------------------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Balance,  January 1      |       | $                     | 170        |   | $ | 123 |   | $ | 123 |   |
| Additions                     |       | 115                   |       | 73 |   | 27 |   |
| Deletions                     |       | (37                   | )          | (26 | ) | (27 | ) |
| **Balance, December 31** | ** ** | **$**                 | **248**    | ** ** | **$** | **170** | ** ** | **$** | **123** | ** ** |

 

S-8

----

**TOWER GROUP, INC.SCHEDULE VI—SUPPLEMENTAL INFORMATION CONCERNING INSURANCE OPERATIONS**($ in thousands)

| ** ** | ** ** | ** **      | ** ** | **for Unpaid** | ** ** | ** **   | ** ** | ** **   | ** ** | ** **          | ** ** | ** **     | ** ** | **Claims and Claims  Adjustment Expenses  Incurred and Related** | ** ** | ** **           | ** ** | ** **       | ** ** | ** **           | ** ** |
|------------|------------|-----------------|------------|---------------------|------------|--------------|------------|--------------|------------|---------------------|------------|----------------|------------|-------------------------------------------------------------------------------------------|------------|----------------------|------------|------------------|------------|----------------------|------------|
| ** ** | ** ** | ** **      | ** ** | **Claims and** | ** ** | ** **   | ** ** | ** **   | ** ** | ** **          | ** ** | ** **     | ** ** | ** **                                                                                | ** ** | **Prior Year*** | ** ** | ** **       | ** ** | **Paid Claims** | ** ** | ** ** | ** ** |
| ** ** | ** ** | **Deferred**    | ** ** | **Claim**           | ** ** | ** **   | ** ** | **Gross**    | ** ** | ** **          | ** ** | **Net**        | ** ** | ** **                                                                                | ** ** | **Includes**         | ** ** | ** **       | ** ** | **and Claim**   | ** ** | **Net** | ** ** |
| ** ** | ** ** | **Acquisition** | ** ** | **Adjustment**      | ** ** | **Discount** | ** ** | **Unearned** | ** ** | **Net Earned** | ** ** | **Investment** | ** ** | **Current**                                                                               | ** ** | **PXRE**             | ** ** | **Amortization** | ** ** | **Adjustment**       | ** ** | **Premiums** | ** ** |
| ** ** | ** ** | **Cost**        | ** ** | **Expenses**        | ** ** | **Reserves** | ** ** | **Premium**  | ** ** | **Premium**         | ** ** | **Income**     | ** ** | **Year**                                                                                  | ** ** | **commutation**      | ** ** | **of DAC**  | ** ** | **Expenses**         | ** ** | **Written** | ** ** |

| **2006** |   |   | $ | 35,811 |   |   |   | $ | 302,541 |   |   |   | $ | — |   |   | $ | 227,017 |   |   | $ | 223,988 |   |   |   | $ | 23,026 |   |   | $ | 135,863 |   |   | $ | (738 | ) |   |   | $ | (58,347 | ) |   |   | $ | 44,372 |   |   | $ | 245,070 |   |
|----------|--------|--------|---|--------|--------|--------|--------|---|---------|--------|--------|--------|---|--------|--------|--------|---|---------|--------|--------|---|---------|--------|--------|--------|---|--------|--------|--------|---|---------|--------|--------|---|------|---|--------|--------|---|---------|---|--------|--------|---|--------|--------|--------|---|---------|--------|
| **2005** |   |   | $ | 29,192 |   |   |   | $ | 198,724 |   |   |   | $ | — |   |   | $ | 157,779 |   |   | $ | 164,436 |   |   |   | $ | 14,983 |   |   | $ | 97,006  |   |   | $ | (392 | ) |   |   | $ | (45,647 | ) |   |   | $ | 31,817 |   |   | $ | 211,782 |   |
| **2004** |   |   | $ | 18,740 |   |   |   | $ | 128,722 |   |   |   | $ | — |   |   | $ | 95,505  |   |   | $ | 45,564  |   |   |   | $ | 5,070  |   |   | $ | 27,259  |   |   | $ | (199 | ) |   |   | $ | (25,668 | ) |   |   | $ | 14,472 |   |   | $ | 98,075  |   |

 

F-9

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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 |       | Certificate of  Designations of Preferred Stock, incorporated by reference to the Company’s  Current Report on Form 8-K filed on December 8, 2006                                                                                                                                                    |
|     3.3 |       | Certificate of  Designations of Series A-1 Preferred Stock of Tower  Group, Inc. incorporated by reference to Exhibit 3.1 to the  Company’s Current Report on Form 8-K filed on January 12,  2007                                                                                     |
|     3.4 |       | 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 |       | 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            |       | 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                                                                              |
|   10.7            |       | 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                                                                                                                              |
|   10.8            |       | 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                                                                                      |

----

 

|   10.9 |   | 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                                                                                                                               |
|------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|  10.10      |   | 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                                                                                                                                                                                                |
|  10.11      |   | 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                                                                                                                                                                                      |
|  10.12      |   | 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 |
|  10.13      |   | 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                                                                                                                                                                                 |
|  10.14      |   | 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                                                                                                                                                                                           |
|  10.15      |   | 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                                                                                                                                                     |
|  10.16      |   | 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                                                                                                                                            |
|  10.16(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                                                                                                                                                                                                         |
|  10.17      |   | 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                                                                                                                       |
|  10.18      |   | 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                                                                                                                                                                                             |
|  10.19      |   | 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                                                                                                                                                   |

----

 

|  10.20 |   | 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                                                                                            |
|-------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|  10.21 |   | 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                                                                          |
|  10.22 |   | 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                   |
|  10.23 |   | 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                                                                                                                        |
|  10.24 |   | 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                                                            |
|  10.25 |   | 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                                                                                       |
|  10.26 |   | 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                                                           |
|  10.27 |   | 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                                                                     |
|  10.28 |   | 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 |
|  10.29 |   | 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                                               |

----

 

|  10.30 |   | 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        |
|-------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|  10.31 |   | 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                                                                                                      |
|  10.32 |   | 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                                                                                                                 |
|  10.33 |   | 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                                                                                              |
|  10.34 |   | 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                                                                                                                                               |
|  10.35 |   | 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                                                                                                                                                                       |
|  10.36 |   | 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                                                                                                |
|  10.37 |   | 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                                                                                                                                     |
|  10.38 |   | 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 |
|  10.39 |   | 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                                                                                                                                                                                                     |
|  10.40 |   | 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                                                                                                                                                                                                |

----

 

|  10.41 |   | 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 |
|-------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|  10.42 |   | 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                                                                                                                                                                                                                           |
|  10.43 |   | 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                                                                                                                                                                                                                     |
|  10.44 |   | Amended and Restated  Declaration of Trust, dated March 31, 2006, by and among Wells Fargo  Bank, National Association, as Institutional Trustee; Wells Fargo Delaware  Trust Company, as Delaware Trustee; Tower Group, Inc., as Sponsor; and  the Trust Administrators 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 April 6, 2006                                       |
|  10.45 |   | Indenture between Tower  Group, Inc. and Wells Fargo Bank, National Association, as Trustee,  dated March 31, 2006, incorporated by reference to Exhibit 10.03 to  the Company’s Current Report on Form 8-K filed on April 6,  2006                                                                                                                                                                                                                                     |
|  10.46 |   | Guarantee Agreement  dated March 31, 2006, by and between Tower Group, Inc. and Wells  Fargo Delaware Trust Company, incorporated by reference to Exhibit 10.02  to the Company’s Current Report on Form 8-K filed on April 6,  2006                                                                                                                                                                                                                                    |
|  10.47 |   | Employment Agreement  with Stephen L. Kibblehouse effective June 1, 2006 incorporated by  reference to the Company’s Current Report on Form 8-K filed on  June 26, 2006                                                                                                                                                                                                                                                                                                           |
|  10.48 |   | PXRE Commutation and  Novation Agreement executed June 29, 2006 incorporated by reference to  the Company’s Current Report on Form 8-K filed on July 7,  2006                                                                                                                                                                                                                                                                                                                     |
|  10.49 |   | Stock Purchase Agreement  by and among Tower Group, Inc. and Preserver Group, Inc. dated  November 13, 2006, incorporated by reference to Exhibit 10.1 to the  Company’s Current Report on Form 8-K filed on November 17,  2006                                                                                                                                                                                                                                    |
|  10.50 |   | Exchange Agreement by  and among Tower Group, Inc. and CastlePoint Management Corp. dated  January 11, 2007 incorporated by reference to Exhibit 10.1 to the  Company’s Current Report on Form 8-K filed on January 12,  2007                                                                                                                                                                                                                                           |
|  10.51 |   | Master Agreement dated  April 4, 2006 by and among Tower Group, Inc., Tower Insurance  Company of New York, Tower National Insurance Company, CastlePoint Holdings,  Ltd. and CastlePoint Management Corp. incorporated by reference to  Exhibit 10.1to the Company’s Current Report on Form 8-K filed  on January 22, 2007                                                                                                                                             |
|  10.52 |   | Addendum No. 1 to  the Master Agreement by and among Tower Group, Inc. and CastlePoint  Holdings, Ltd. incorporated by reference to Exhibit 10.2 to the  Company’s Current Report on Form 8-K filed on January 22,  2007                                                                                                                                                                                                                                                |
|  10.53 |   | Amended and Restated  Brokerage Business Quota Share Reinsurance Agreement, dated August 31,  2006 and effective as of April 1, 2006 by and among Tower  Group, Inc., Tower Insurance Company of New York. Tower National  Insurance Company and CastlePoint Reinsurance Company, Ltd. incorporated by  reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K  filed on January 22, 2007                                                           |

----

 

|  10.54 |   | Amended and Restated  Traditional Business Quota Share Reinsurance Agreement, dated August 31,  2006 and effective as of April 1, 2006 by and among Tower  Group, Inc., Tower Insurance Company of New York. Tower National  Insurance Company and CastlePoint Reinsurance Company, Ltd. incorporated by  reference to Exhibit 10.4 to the Company’s Current Report on Form 8-K  filed on January 22, 2007 |
|-------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|  10.55 |   | Amended and Restated  Specialty Business Quota Share Reinsurance Agreement, dated August 31,  2006 and effective as of April 1, 2006 by and among Tower  Group, Inc., Tower Insurance Company of New York. Tower National  Insurance Company and CastlePoint Reinsurance Company, Ltd. incorporated by  reference to Exhibit 10.5 to the Company’s Current Report on Form 8-K  filed on January 22, 2007   |
|  10.56 |   | Amendment No. 1 to  Amended and Restated Brokerage Business Quota Share Reinsurance Agreement,  dated January 11, 2007 by and among Tower Group, Inc., Tower  Insurance Company of New York and CastlePoint Reinsurance Company, Ltd.  incorporated by reference to Exhibit 10.6 to the Company’s Current  Report on Form 8-K filed on January 22, 2007                                                    |
|  10.57 |   | Amendment No. 1 to  Amended and Restated Traditional Business Quota Share Reinsurance Agreement,  dated January 11, 2007 by and among Tower Group, Inc., Tower  Insurance Company of New York and CastlePoint Reinsurance Company, Ltd.  incorporated by reference to Exhibit 10.7 to the Company’s Current  Report on Form 8-K filed on January 22, 2007                                                  |
|  10.58 |   | Amendment No. 1 to  Amended and Restated Specialty Business Quota Share Reinsurance Agreement,  dated January 11, 2007 by and among Tower Group, Inc., Tower  Insurance Company of New York and CastlePoint Reinsurance Company, Ltd.  incorporated by reference to Exhibit 10.8 to the Company’s Current  Report on Form 8-K filed on January 22, 2007                                                    |
|  10.59 |   | Brokerage Business  Pooling Agreement, effective January 1, 2007 by and among Tower  Insurance Company of New York and CastlePoint Insurance Company incorporated  by reference to Exhibit 10.9 to the Company’s Current Report on  Form 8-K filed on January 22, 2007                                                                                                                                               |
|  10.60 |   | Traditional Program  Business Pooling Agreement, effective January 1, 2007 by and among Tower  Insurance Company of New York and CastlePoint Insurance Company incorporated  by reference to Exhibit 10.10 to the Company’s Current Report on  Form 8-K filed on January 22, 2007                                                                                                                                    |
|  10.61 |   | Specialty Program  Business Pooling Agreement, effective January 1, 2007 by and among Tower  Insurance Company of New York and CastlePoint Insurance Company incorporated  by reference to Exhibit 10.11 to the Company’s Current Report on  Form 8-K filed on January 22, 2007                                                                                                                                      |
|  10.62 |   | Brokerage Business Pool  Management Agreement, effective January 1, 2007 by and among Tower  Insurance Company of New York and CastlePoint Insurance Company incorporated  by reference to Exhibit 10.12 to the Company’s Current Report on  Form 8-K filed on January 22, 2007                                                                                                                                      |
|  10.63 |   | Traditional Business  Pool Management Agreement, effective January 1, 2007 by and among Tower  Insurance Company of New York and CastlePoint Insurance Company incorporated  by reference to Exhibit 10.13 to the Company’s Current Report on  Form 8-K filed on January 22, 2007                                                                                                                                    |
|  10.64 |   | Specialty Program  Business Pool Management Agreement, effective January 1, 2007 by and  among Tower Insurance Company of New York and CastlePoint Insurance Company  incorporated by reference to Exhibit 10.14 to the Company’s Current  Report on Form 8-K filed on January 22, 2007                                                                                                                              |

----

 

|  10.65 |   | Amended and Restated  Declaration of Trust, dated January 25, 2007, by and among Wilmington  Trust, as Institutional Trustee and as Delaware Trustee; Tower  Group, Inc., as Sponsor; and the Trust Administrators Michael H. Lee,  Francis M. Colalucci and Stephen L. Kibblehouse, incorporated by reference to  Exhibit 10.02 to the Company’s Current Report on Form 8-K  filed on January 26, 2007 |
|-------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|  10.66 |   | Indenture between Tower  Group, Inc. and Wilmington Trust Company, as Trustee, dated  January 25, 2007, incorporated by reference to Exhibit 4.01 to the  Company’s Current Report on Form 8-K filed on January 26,  2007                                                                                                                                                                               |
|  10.67 |   | Guarantee Agreement  dated January 25, 2007, by and between Tower Group, Inc. and  Wilmington Trust Company, incorporated by reference to Exhibit 10.01 to  the Company’s Current Report on Form 8-K filed on January 26,  2007                                                                                                                                                                         |
|  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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