(6) 2007 net income attributable to Tower Group, Inc. is adjusted for dividends and excess consideration pertaining to Series A perpetual preferred stockholders.
Deferred acquisition costs, net. We have retrospectively adopted updated guidance issued by the Financial Accounting Standards Board (“FASB”) on the accounting for deferred acquisition costs (“DAC”) effective January 1, 2011. Our prior period results have been restated for the impact of this accounting change. We defer certain expenses that vary with and are directly related to the successful acquisition of new and renewal insurance business, including commission expense on gross premiums written, premium taxes and certain other costs related to the acquisition of insurance contracts. These costs are capitalized and the resulting asset, DAC, is amortized and charged to expense or income in future periods as gross and ceded premiums written are earned. The method followed in computing deferred acquisition costs, net, limits the amount of such deferred amounts to its estimated realizable value. The ultimate recoverability of deferred acquisition costs is dependent on the continued profitability of our insurance underwriting. We also consider anticipated invested income in determining the recoverability of these costs. If our insurance underwriting becomes unprofitable, we may have to write off a portion of our deferred acquisition costs, resulting in a further charge to income in the period in which the underwriting losses are recognized. The value of business acquired (“VOBA”) is an intangible asset relating to the estimated fair value of the unexpired insurance policies acquired in a business combination. VOBA is determined at the time of a business combination and is reported on the consolidated balance sheet with DAC and is amortized in proportion to the timing of the estimated underwriting profit associated with the in force policies acquired. The cash flow or interest component of VOBA is amortized in proportion to the expected pattern of future cash flows. The Company considers anticipated investment income in determining the recoverability of these costs and believes they are fully recoverable.
Net premiums written for the year ended December 31, 2010 was $326.8 million, an increase of $171.5 million over 2009. The acquisition of OBPL accounted for $167.8 million of the increase.
As more fully described in Note 5 to our consolidated financial statements, “Investments-Impairment Review,” we completed a detailed review of all our securities in a continuous loss position, including but not limited to residential and commercial mortgage-backed securities, and concluded that the unrealized losses in these asset classes are the result of a decrease in value due to technical spread widening and broader market sentiment.
The insurance subsidiaries are required by law to maintain a certain minimum level of policyholders’ surplus on a statutory basis. Policyholders’ surplus is calculated by subtracting total liabilities from total assets. The NAIC maintains risk-based capital (“RBC”) requirements for property and casualty insurance companies. RBC is a formula that attempts to evaluate the adequacy of statutory capital and surplus in relation to investments and insurance risks. The formula is designed to allow the state Insurance Departments to identify potential weakly capitalized companies. Under the formula, a company determines its risk-based capital by taking into account certain risks related to the insurer’s assets (including risks related to its investment portfolio and ceded reinsurance) and the insurer’s liabilities (including underwriting risks related to the nature and experience of its insurance business). Applying the RBC requirements as of December 31, 2011, the insurance subsidiaries’ risk-based capital exceeded the minimum level that would trigger regulatory attention.
CastlePoint, a Bermuda exempted corporation, was acquired in 2009. The consideration for this acquisition was $491.4 million consisting of 16.9 million shares of Tower common stock with an aggregate value of $421.7 million, $4.4 million related to the fair value of unexercised warrants, and $65.3 million of cash. The Company issued 1.1 million employee stock options to replace the CastlePoint employee and director stock options as of the acquisition date. The value of the Company’s stock options attributed to the services rendered by the CastlePoint employees as of the acquisition date totaled $9.1 million and was included in the purchase consideration. This transaction has expanded and diversified revenues by accessing CastlePoint’s programs and risk sharing businesses.
Through its management companies, Tower is the attorney-in-fact for the Reciprocal Exchanges and has the ability to direct their activities. The Reciprocal Exchanges are policyholder-owned insurance carriers organized as unincorporated associations. Each policyholder insured by the Reciprocal Exchanges shares risk with the other policyholders.
Proceeds from the sale of fixed-maturity securities were $2.0 billion, $1.4 billion and $936.0 million for the year ended December 31, 2011, 2010 and 2009, respectively. Proceeds from the sale of equity securities were $793.9 million, $80.7 million and $50.6 million for the year ended December 31, 2011, 2010 and 2009, respectively.
As disclosed in “Note 2 - Accounting Policies and Basis of Presentation”, the Company adopted new guidance concerning the accounting for the costs associated with acquiring or renewing insurance contracts. This guidance was adopted retrospectively effective January 1, 2011 and the Company has adjusted its previously issued financial information.
Loss and loss adjustment expense reserves. The reserving process for loss and LAE reserves provides for the Company’s best estimate at a particular point in time of the ultimate unpaid cost of all losses and LAE incurred, including settlement and administration of losses, and is based on facts and circumstances then known and including losses that have been incurred but not yet been reported. The process includes using actuarial methodologies to assist in establishing these estimates, judgments relative to estimates of future claims severity and frequency, the length of time before losses will develop to their ultimate level and the changes in the law and other external factors that are often beyond the Company’s control. The methods used to select the estimated loss reserves include loss ratio projections, loss development projections, and Bornhuetter-Ferguson (“B-F”) method projections. The actuaries’ best estimates are the result of numerous analyses made by line of business, accident year, and for loss, ALAE and ULAE, and the actuarial analyses also consider input from underwriting and claims managements about the nature of the underlying risks, claims and other trends in the business
The proceeds from the issuance of the Notes were allocated to the liability component and the embedded conversion option, or equity component. The equity component was reported as an adjustment to paid-in-capital, net of tax, and is reflected as an original issue discount (“OID”). The OID of $11.5 million and $5.0 million of deferred origination costs relating to the liability component are being amortized into interest expense over the term of the Notes. After considering the contractual interest payments and amortization of the original issue discount, the Notes’ effective interest rate is 7.2%. Transaction costs of $0.4 million associated with the equity component were netted with the equity component in paid-in-capital. Interest expense, including amortization of deferred origination costs, recognized on the Notes was $11.3 million for the year ended December 31, 2011.
In September 2010, the Company received $3.8 million for Warrants sold to the financial institutions. The Warrants provide for the acquisition of 5.5 million shares of common stock at a strike price of $33.14 per share at December 31, 2011, subject to anti-dilution adjustments. The Warrants have been accounted for as an adjustment to the Company’s paid-in-capital.
On May 12, 2010, Mirabilis Ventures, Inc. (“Mirabilis”) commenced an action against Specialty Underwriters’ Alliance Insurance Co. (“SUA”, now known as CastlePoint National Insurance Company (“CNIC”), a subsidiary of Tower Group, Inc.) and Universal Reinsurance Co., Ltd., an unrelated entity, in the United States District Court for the Middle District of Florida. The Complaint is based upon a Worker’s Compensation/Employer’s Liability policy issued by SUA to AEM, Inc. (“AEM”), to whose legal rights Mirabilis is alleged to have succeeded as a result of the Chapter 11 bankruptcy of AEM. The Complaint, which includes claims against SUA for breach of contract and breach of the duty of good faith, alleges that SUA failed to properly audit AEM’s operations to determine AEM’s worker’s compensation exposure for two policy years, in order to compute the premium owed by AEM, such that SUA owes Mirabilis the principal sum of $3.4 million for one policy year and $0.6 million for the other policy year, plus interest and costs. On July 30, 2010, CNIC answered the Complaint and asserted nine separate counterclaims, to which Mirabilis responded on September 3, 2010. Since that time, Mirabilis has filed an amended complaint that failed to add any defenses against Mirabilis. While the parties are engaging in discovery, CNIC has filed a motion for summary judgment on all of Mirabilis’ claims. However, the court has yet to rule on the motion. The Company is unable to estimate a possible loss or range of loss.
Total rental expense was $11.1 million, $10.0 million and $7.9 million in 2011, 2010 and 2009, respectively.
Premiums receivable and reinsurance recoverable: The carrying values reported in the accompanying balance sheets for these financial instruments approximate their fair values.