See “Footnote 3 - Acquisitions” for further details. Prior to the acquisition, we had an investment in CastlePoint which was revalued at acquisition resulting in a $7.4 million pre-tax gain in 2009.
Identifiable intangible assets with a finite useful life are amortized over the period in which the asset is expected to contribute directly or indirectly to our future cash flows. Identifiable intangible assets with finite useful lives are tested for recoverability whenever events or changes in circumstances indicate that a carrying amount may not be recoverable. Identifiable intangible assets with indefinite useful lives and goodwill are not amortized. Rather, they are tested for recoverability at least annually or whenever events or changes in circumstances indicate that a carrying amount may not be recoverable
Income tax expense. Income tax expense increased as a result of an increase in income before income taxes. The effective income tax rate (including state and local taxes) was 32.0% for 2009, compared to 35.8% for 2008.
Policies in-force for our brokerage business, including business managed by us and produced on behalf of CPIC, increased by 23.7% as of December 31, 2008 compared to December 31, 2007. During 2008, premiums on renewed business increased 3.4% in personal lines and decreased 2.0% in commercial lines. The retention rate including brokerage business renewed by TRM on behalf of CPIC was 86% for personal lines and 78% for commercial lines. Gross premiums written and produced increased 32.3% to $805.0 million in 2008 compared to $608.4 million in 2007.
Net investment income and realized gains (losses). Net investment income decreased from 2007 to 2008 due to a decrease in investment yields, particularly yields on mortgage-backed securities. Total invested assets, including cash and cash equivalents, were approximately the same at $677.2 million and $696.8 million for 2008 and 2007, respectively. Net cash flows provided by operations were $61.7 million in 2008. On a tax equivalent basis, the book yield
Excluding Hermitage, policies in force for our brokerage business increased by 19.3% in 2009 compared to 2008.
The other underwriting expense (“OUE”), which includes boards, bureaus and taxes, portion of the gross underwriting expense ratio was 13.0% for 2009 compared to 13.4% for the prior year. We continue to focus on improving cost efficiencies, particularly through our continuing investments in technology and reducing expenses of acquired companies. The acquisitions in 2009 provided increased economies of scale and the additional amount of premiums contributed to a lower OUE ratio. Offsetting the benefit of the additional premium volume, we recorded $2.2 million of New York State workers’ compensation assessments that exceeded amounts we were originally permitted to assess policyholders based on statutorily enacted rates in 2009 compared to $0 in 2008.
Underwriting profit and combined ratio. The net combined ratio was 87.9% for 2009, an increase of 6.0 percentage points compared to 2008. The increase in the combined ratio resulted from increases in the net loss ratio described above due to relatively less favorable development in the 2009 calendar year as compared to 2008 and softer market conditions, as well as increases in the net expense ratio due primarily to the change in ceding commission revenue described above.
Impairment of investment securities results in a charge to net income when a market decline below cost is deemed to be other-than-temporary. We review our fixed-maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. We recorded OTTI losses in our fixed maturity and equity securities in the amounts of $44.2 million and $22.7 million in 2009 and 2008, respectively.
The Company has changed the presentation of its business results, beginning January 1, 2009, by allocating its previously reported insurance segment into brokerage insurance and specialty business, based on the way management organizes the segments for making operating decisions and assessing profitability. The prior period segment disclosures have been restated to conform to the current presentation. We now report three operating segments as follows:
The Company uses reinsurance to limit its exposure to certain risks. Management has evaluated its reinsurance arrangements and determined that significant insurance risk is transferred to the reinsurers. Reinsurance agreements have been determined to be short-duration prospective contracts and, accordingly, the costs of the reinsurance are recognized over the life of the contracts in a manner consistent with the earning of premiums on the underlying policies subject to the reinsurance contract.
The Company measures earnings per share at two levels: basic earnings per share and diluted earnings per share. Basic earnings per share is calculated by dividing income (loss) allocable to common stockholders by the weighted average number of common shares outstanding during the year. This weighted average number of shares includes unvested share-based awards that contain nonforfeitable rights to dividends or dividend equivalents whether paid or unpaid (“participating securities”). Diluted earnings per share is calculated by dividing income (loss) allocable to common stockholders by the weighted average number of common shares outstanding during the year, as adjusted for the potentially dilutive effects of stock options, warrants, unvested restricted stock and/or preferred stock that are not participating securities, unless common equivalent shares are antidilutive.
Determine whether there are factors present that indicate that the market for the asset is not active at the measurement date; and
On February 5, 2009, the Company completed the acquisition of 100% of the issued and outstanding common stock of CastlePoint, a Bermuda exempted corporation. The acquisition was accounted for using the purchase method in accordance with GAAP guidance on business combinations effective in 2009. The Company acquired CastlePoint for $491.4 million consisting of 16,869,572 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 1,148,308 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 is included in the purchase consideration. Also, the fair value of the CastlePoint acquisition included the fair value of the Company’s previously held interest in CastlePoint and is presented as follows:
The Company regularly reviews its fixed-maturity and equity security portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. In evaluating potential impairment, management considers, among other criteria: (i) the overall financial condition of the issuer, (ii) the current fair value compared to amortized cost or cost, as appropriate; (iii) the length of time the security’s fair value has been below amortized cost or cost; (iv) specific credit issues related to the issuer such as changes in credit rating, reduction or elimination of dividends or non-payment of scheduled interest payments; (v) whether management intends to sell the security and, if not, whether it is not more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis; (vi) specific cash flow estimations for certain mortgage-backed and asset-backed securities and (vii) current economic conditions. If an other-than-temporary impairment loss is determined for a fixed-maturity security and management does not intend to sell and it is more likely than not that it will not be required to sell the security before recovery of cost or amortized cost, the credit portion is included in the statement of income in net realized investment gains (losses) and the non-credit portion is included in comprehensive net income. The credit portion results in a permanent reduction of the cost basis of the underlying investment. The determination of OTTI is a subjective process and different judgments and assumptions could affect the timing of loss realization.
The Company’s CMBS are also evaluated on a quarterly basis using analytical techniques and various metrics including the level of subordination, debt-service-coverage ratios, loan-to-value ratios, delinquencies, defaults and foreclosures. For certain of the CMBS holdings, the estimated cash flows have continued to decline throughout the year, similar to RMBS. The primary driver of this decline has been an increase of delinquencies from 1.5% at December 31, 2008 to 5.3% by the fourth quarter of 2009. Additionally, the weak economy is causing higher vacancies, negatively impacting income to support debt payments. Furthermore, a lack of financing in the CMBS market and a decline in real estate values is resulting in higher longer term projected losses due to the increase in refinancing risk of commercial loans upon the balloon dates. See the table below for a summary of OTTI losses recorded in 2009. The OTTI charges are recognized and recorded in the period when there are adverse changes in projected cash flows, which the Company tests on a quarterly basis.
The unrealized position associated with the fixed-maturity portfolio included $17.9 million in unrealized losses, consisting primarily of asset-backed and mortgage-backed securities representing 69% and corporate bonds representing 14% of the unrealized loss. The fixed-maturity portfolio unrealized losses included 428 securities which were, in aggregate, approximately 4.0% below amortized cost. Of the 428 investments, 127 have been in an unrealized loss position for more than 12 months. The total unrealized loss on these investments at December 31, 2009 was $14.1 million. The Company does not consider these investments to be other-than-temporarily impaired.
Goodwill is calculated as the excess of purchase price over the net fair value of assets acquired. See Note 3 - “Acquisitions” for information regarding the calculation of goodwill related to the acquisitions of CastlePoint, Hermitage and AequiCap. The acquisition of SUA resulted in negative goodwill which was recorded as a gain on bargain purchase in income in 2009. Under GAAP, the Company is required to allocate goodwill to its reportable segments. The following is a summary of goodwill by reporting units:
Intangible assets consist of finite and indefinite life assets. Finite life intangible assets include customer relationships and trademarks. Insurance company licenses are considered indefinite life intangible assets subject to annual impairment testing. The weighted average amortization period of identified intangible assets with a finite life is 7.1 years as of December 31, 2009.
As of December 31, 2009, the Company had recorded $14.1 million of reserve risk premium on loss reserves in accordance with GAAP for the business combinations occurring during 2009.
In connection with the acquisition of CastlePoint on February 5, 2009, the Company issued 16,869,572 shares to the shareholders of CastlePoint increasing Common Stock by $169,000 and Paid-in Capital by $421.5 million.
Preserver, which was acquired by the Company on April 10, 2007, CastlePoint, which was acquired by the Company on February 5, 2009, and SUA, which was acquired by the Company on November 13, 2009, have tax loss carryforwards and other tax assets that the Company believes will be used in the future, subject to change of ownership limitations pursuant to Section 382 of the Internal Revenue Code (“IRC”) and to the ability of the combined post-merger company to generate sufficient taxable income to use the benefits before the expiration of the applicable carryforward periods.
The Company maintains a defined contribution Employee Pretax Savings Plan (401(k) Plan) for its employees. The Company matches 50% of each participant’s contribution up to 8% of the participant’s eligible contribution. The Company incurred approximately $1.4 million, $1.3 million and $1.0 million of expense in 2009, 2008 and 2007, respectively, related to the 401(k) Plan.
Reinsurance balances payable, payable to issuing carrier and funds held: The carrying value reported in the balance sheet for these financial instruments approximates fair value.