During the fourth quarter of 2004, we established two branch offices. The first was set up in Melville, New York (Long Island Branch) for 17,127 square feet of space at 225 Broadhollow Road, Melville, New York. We entered into a sublease agreement for this property from April 15, 2005 until September 30, 2006 and entered into a lease agreement for the same property for the period commencing October 1, 2006 that will expire in 10 years and 8 months. The second branch was set up for 4,900 square feet of temporary space in Buffalo, New York (Buffalo Branch).
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and accompanying notes which appear elsewhere in this Form 10-K. It contains forward-looking statements that involve risks and uncertainties. See "Item 1.-Note on Forward-Looking Statements" for more information. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Form 10-K, particularly under the headings "Item 1.-Risk Factors" and "Item 1.-Note on Forward-Looking Statements."
INITIAL PUBLIC OFFERING On June 22, 2004 the Company's Board of Directors approved a 1.8:1 stock split, the maintaining of a par value of $0.01 after the split and the amendment and restatement of the Company's Certificate of Incorporation which among other things, combined the Class A and Class B common stock into one class of common stock and increased the authorized common stock to 40,000,000 shares. These actions became effective on October 20, 2004, which is the effective date of the Company's IPO. All consolidated financial statements and per share amounts have been retroactively adjusted for the above stock split and maintaining the par value at $0.01 per share.
SHELL ACQUISITION In January 2005, the Company announced that it entered into a stock purchase agreement to acquire North American Lumber Insurance Company ("NALIC"), a shell company with active licenses in the following nine states: New Jersey, Connecticut, Massachusetts, Rhode Island, Vermont, Maryland, Delaware, South Carolina and Wisconsin. Tower Group, Inc. will pay $1,050,000 in cash at closing. An additional $75,000 per state will be paid within one year of the closing date contingent upon license reactivation in each of Pennsylvania and Maine.
NALIC will be initially capitalized with part of the $26,000,000 raised by Tower Group, Inc. through two trust preferred securities offerings in December, 2004. According to the terms of the agreement, all liabilities and assets of NALIC (which will be renamed) will be transferred to a liquidating trust prior to closing with the exception of its charter and insurance licenses. The transaction has obtained court approval in Massachusetts and is expected to close in March or April of 2005.
Our perception of the shift in the property and casualty industry cycles led to a revision of our business model. Until 2001, we relied upon reinsurance and the capacity provided by TRM's issuing companies to support the expansion of the premium volume we produced. A soft reinsurance market during that period enabled us to secure favorable reinsurance terms and conditions for TICNY and for the issuing companies utilized by TRM.
Beginning in 2001, commission revenue generated by TRM's managing general agency began to decline, as we were unable to secure favorable reinsurance terms for the business produced for TRM's issuing companies due to the unfavorable loss experience on that business during the soft market. TICNY, however, was able to maintain favorable reinsurance terms due to the profitability of its business. As a result, we began to significantly increase TICNY's gross premiums written and de-emphasized producing premiums through TRM. We also began to reduce the percentage of premiums ceded by TICNY to our quota share reinsurers, increasing our net premiums written. On March 1, 2001, we entered into an agreement with one of our main regional insurance company competitors, Empire Insurance Group ("Empire"), to acquire the renewal rights for a significant portion of Empire's business. This transaction added gross premiums written of $41.1 million in TICNY and $426,000 in TRM's issuing companies during the first twelve months after we acquired the business.
Premium levels for many products have increased in recent years. However, beginning in 2004, rates for property and casualty insurance products began to moderate, and for certain products, began to decrease due to increased levels of competition. A. M. Best estimates that industry wide growth in net premiums written in the homeowner's line to be 7.9% in 2004, from 14.1% in 2003, and is expected to slow further to a projected 5.0% in 2005. A.M. Best also estimated that industry wide growth in net premiums written in commercial lines slowed significantly in 2004 to an estimated 4.8% from 12.3% in 2003 and that commercial lines net premium written in 2005 is projected to decline by 1.0%. The supply of insurance and reinsurance as measured by the amount of industry policyholders' surplus has increased and may continue to increase. Industry policyholders' surplus increased to record levels in 2004 to approximately $387.5 billion as projected by A.M. Best, a 9.5% increase over 2003. This additional underwriting capacity may result in increased competition from other insurers in order to generate an adequate return on capital or cause a shift in focus by some insurers to maintaining market share at the expense of underwriting discipline. These factors could lead to a significant reduction in premium rates and less favorable policy terms. However, we believe that premium levels remain relatively attractive in the sizeable underserved market segments where we can continue to maintain underwriting discipline and selectivity in low hazard classes of business, as well as adequate pricing and coverage terms. Additionally, our broad product line platform allows us to achieve an optimal business mix in response to varying market conditions.
PRINCIPAL REVENUE AND EXPENSE ITEMS We derive our revenue from the net premiums earned, ceding commissions, direct commission revenue and fees and net investment income and net realized gains from investments. The limited surplus in our insurance company before our October 2004 IPO constrained our ability to write net premiums because we are required to maintain a minimum level of surplus to support premiums. As a result, we ceded premiums to generate ceding commissions in our insurance company, and we produced premiums for TRM's issuing companies to generate non-risk bearing revenues in our insurance services operation. Consistent with this strategy, during the five years ended December 31, 2004, we derived 34.6% and 36.9% of our total revenues from net premiums earned and ceding commissions, respectively from our insurance company and 24.8% of our total revenue from direct commission and fees from our insurance services operation. Our investment income and realized gains from investments comprised 3.7% of our total revenues during this period. However, we contributed $98 million of the proceeds from the IPO and the concurrent offering to TICNY, which increased its statutory surplus. Additionally, TICNY received a rating upgrade from A.M Best to "A-" (Excellent). With the increased surplus and higher rating we plan to increase net premiums written. In order to more fully deploy the additional surplus capital, TICNY decreased its quota share ceding percentage to 25% from 60% beginning October 1, 2004. See "Item 7.-Outlook" for additional discussion of changes in the components of principal revenue items resulting from the IPO and concurrent private placement.
Net premiums earned. Premiums written include all premiums received by an insurance company during a specified accounting period, even if the policy provides coverage beyond the end of the year. Premiums are earned over the term of the related policies. At the end of each accounting period, the portion of the premiums that are not yet earned are included in the unearned premium reserve and are realized as income in subsequent periods over the remaining term of the policy. Our policies typically have a term of 12 months. Thus, for example, for a policy that is written on July 1, 2004, one-half of the premiums would be earned in 2004 and the other half would be earned in 2005.
Net investment income and realized gains and losses on investments. We invest our statutory surplus and the funds supporting our insurance reserves (including unearned premium reserve and the reserves established to pay for losses and loss adjustment expenses) in cash, cash equivalents and securities. Our investment income includes interest and dividends earned on our invested assets. Realized gains and losses on invested assets are reported separately from net investment income. We earn realized gains when invested assets are sold for an amount greater than their amortized cost in the case of fixed maturity securities and cost in the case of equities and recognize realized losses when invested assets are written down or sold for an amount less than their amortized cost or cost, as applicable.
Losses and loss adjustment expenses. We establish loss and loss adjustment expense reserves in an amount equal to our estimate of the ultimate liability for claims under our insurance policies and the cost of adjusting and settling those claims. Our provision for loss and loss adjustment expense reserves in any period, which is the expense recorded, includes estimates for losses incurred during the period and changes in estimates for prior periods.
o Direct and ceding commission expenses. We pay direct commission expense to our producers in our insurance segment for the premiums that they generate for us. Our managing general agency also pays direct commission expense to our producers in our insurance services segment. In addition, TICNY also pays ceding commission expense to TRM's issuing companies for the reinsurance premiums that we assume in our reinsurance segment. Ceding commission is typically paid on quota share reinsurance agreements, but not on excess of loss reinsurance agreements.
With the increased surplus in our insurance company, we plan to increase our net premiums written up to a level that will maximize the use of our capital while continuing to maintain a favorable rating from various rating agencies. In the event that we generate premiums in excess of this level, we plan to utilize quota share reinsurance and TRM's issuing companies to support this additional premium volume and generate ceding commission and fee income. In the latter half of 2004, increased competition began to become evident as premium rate increases moderated. See "Item 7.-Marketplace Conditions and Trends". (Our outlook for 2005 discussed below takes into account generally softer market conditions that we expect in 2005, but softening beyond our expectations could cause the actual results to differ from what we currently expect). With the increased capital from the IPO and the concurrent private placement, we anticipate the following changes to our current financial and business structure and certain ratios relative to periods prior to the IPO, including the nine months ended September 30, 2004 to the periods following the IPO:
o Reduced quota share reinsurance ceding. In 2003, our ceded leverage ratio was 2.97 as we ceded 72.4% of our gross premiums written totaling $97.4 million under our quota share treaties. For the first nine months of 2004, the ceded leverage ratio was 3.02 as we ceded 73.6% of our gross premium written. We reduced our ceded leverage ratio to 0.4 on an annualized basis in the fourth quarter of 2004 by reducing the percentage of our premiums ceded under our quota share treaty to 25% effective October 1, 2004. During 2005, we expect to maintain this quota share ceding percentage. In addition, we terminated Converium Reinsurance (North America) Inc.'s participation in our quota share treaty on a cut-off basis effective December 31, 2004. See "Item 1.--Reinsurance--2004 Reinsurance Program". In 2003 and for the first nine months of 2004 our net underwriting expenses were, respectively, $35.6 million and $30.3 million less than our gross underwriting expenses due to ceding commission revenue. Our ceding commission revenue from our quota share reinsurance treaties will be reduced as the volume of reinsurance ceded decreases, but the reduced ceding commission revenue will continue to lower our underwriting expenses and augment our return on equity. In 2003 and for the first nine months of 2004, our ceding commission revenue reduced our gross expense ratio by 25.6 and 17.3 percentage points, respectively. With the increased capitalization of our insurance company, we expect our ceding commission revenue to reduce our gross expense ratio by up to 3 percentage points depending upon the extent of our use of quota share reinsurance.
o Investment portfolio leverage. When we have fully deployed our capital, we plan to target an invested assets to equity ratio of between 2 to 1 and 3 to 1.
o Interest expense. With the increased capitalization of our insurance company, we expect our interest expense as a percentage of average stockholders' equity to decrease to approximately 2.0% to 2.5%.
Underwriting expense ratios. The underwriting expense ratio is the ratio of direct and ceding commission expenses and other underwriting expenses less policy billing fees to premiums earned. The underwriting expense ratio measures a company's operational efficiency in producing, underwriting and administering its insurance business. Due to our historically high levels of reinsurance, we calculate our underwriting expense ratios on a gross basis (before the effect of ceded reinsurance) and net basis (after the effect of ceded reinsurance). Ceding commission revenue is applied to reduce our underwriting expenses in our insurance company operation. Because the ceding commission rate we earn on our premiums ceded has historically been higher than our underwriting expense ratio on those premiums, our extensive use of quota share reinsurance has caused our net underwriting expense ratio to be lower than our gross expense ratio.
Premium produced by TRM. TRM operates a managing general agency that earns commissions on written premiums produced on behalf of its issuing companies. Although TRM is not an insurance company, we utilize TRM's access to its issuing companies as a means to expand our ability to generate premiums beyond TICNY's statutory surplus capacity. For this reason, we use written premiums produced by TRM on behalf of its issuing companies as well as TRM's commission revenue to evaluate our ability to achieve growth.
Due to the inherent uncertainty associated with the reserving process, the ultimate liability may differ, perhaps substantially, from the original estimate. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current year's results. Reserves are closely monitored and are recomputed periodically using the most recent information on reported claims and a variety of statistical techniques. Specifically, on at least a quarterly basis, we review, by line of business, existing reserves, new claims, changes to existing case reserves and paid losses with respect to the current and prior years. See "Item 1.-Loss and Loss Adjustment Expense Reserves" and "Note 3. Property-Casualty Insurance" for additional information regarding our loss reserves.
Prior to 2003 we had adverse loss development on our loss reserves. In 2001, the changes in reserves for prior accident years were $1.8 million and in 2002 the changes in reserves for prior accident years were $3.0 million. In 2003 there was minimal adverse loss development, amounting to $75,000. In 2004 we had favorable redundancy that developed in our reserves of $199,000.
The net loss reserves for the most recent accident years on a consolidated basis as of December 31, 2004 were $20.5 million for accident year 2004 and $8.7 million for accident year 2003. A 5% deficiency in net reserves for these years would impact our income before income taxes by $1.0 million and $435,000 for accident years 2004 and 2003, respectively.
Ceding commission earned under a quota share reinsurance agreement is based on the agreed upon commission rate applied to the amount of ceded premiums written. Ceding commissions are realized as income as ceded premiums written are earned. Since 2001, the ultimate commission rate earned on our quota share reinsurance contracts has been determined by the loss ratio on the ceded premiums earned. If the estimated loss ratio decreases from the level currently in effect, the commission rate increases and additional ceding commissions are earned in the period in which the decrease is recognized. If the estimated loss ratio increases, the commission rate decreases, which reduces ceding commissions earned. As a result, the same uncertainties associated with estimating loss and loss adjustment expense reserves affect the estimates of ceding commissions earned. We monitor the ceded ultimate loss ratio on a quarterly basis to determine the effect on the commission rate of the ceded premiums earned that we accrued during prior accounting periods. The increase in estimated ceding commission income relating to prior years recorded in 2004, 2003 and 2002 was $1.7 million, $1.3 million and $0, respectively.
Reinsurance recoverables. A reinsurance recoverable balance is established for the portion of the loss reserves and unearned premiums that are ceded to reinsurers. These are reported on our balance sheet separately as assets, instead of being netted against the related liabilities, since reinsurance does not relieve us of our legal liability to policyholders and ceding companies. We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. Consequently, we bear credit risk with respect to our individual reinsurers and may be required to make judgments as to the ultimate recoverability of our reinsurance recoverables. Additionally, the same uncertainties associated with estimating loss and loss adjustment expense reserves affect the estimates of the amount of ceded reinsurance recoverables. We continually monitor the financial condition and rating agency ratings of our reinsurers. Nonadmitted reinsurers are required to collateralize their share of unearned premium and loss reserves either by placing funds in a trust account meeting the requirements of New York's Regulation 114 or by providing a letter of credit. In addition, since October 2003, we have placed our new quota share treaties on a "funds withheld" basis, under which TICNY retains the ceded premiums written and places that amount in segregated trust accounts from which TICNY may withdraw amounts due to it from the reinsurers. Tokio Millennium Re Ltd., a reinsurer under the October 1, 2003 quota share treaty, posted a letter of credit at December 31, 2003 and replaced it with a Regulation 114 trust during the first quarter of 2004. At December 31, 2004 approximately 52% of our reinsurance recoverables were collateralized.
RESULTS OF OPERATIONS We conduct our business in three distinct segments: insurance, reinsurance and insurance services. Because we do not manage our assets by segments, our investment income is not allocated among our segments. Operating expenses incurred by each segment are recorded in each segment directly. General corporate overhead not incurred by the individual segments is allocated based upon a combination of employee head count, policy count or premiums written, whichever method is most appropriate.
Consolidated Results of Operations 2004 Compared to 2003 Total revenues. Total revenues increased by 44.2% in 2004 to $107.7 million compared to $74.7 million in 2003. The increases were primarily due to the increase in net earned premiums, ceding commission and fee income as well as investment income. Net earned premium represented 42.3% of total revenues for 2004 compared to 30.7% in 2003. Ceding commission and fee income represented 53.0% of total revenue in 2004 compared to 65.6% in 2003. Net investment income, excluding realized capital gains, represented 4.7% and 3.0% of total revenue for 2004 and 2003, respectively.
Net realized capital gains were $13,000 in 2004 compared to net realized capital gains of $493,000 in 2003. The 2003 capital gains were a result of our decision to reduce the weighted average duration of our fixed maturity securities portfolio to protect the portfolio from rising interest rates by selling certain securities.
There was no impact on net realized capital gains attributable to adjustments for other than temporary impairment of securities held during 2004 and 2003.
Premiums earned. Net premiums written increased by 5.9% to $28.9 million in 2003 compared with $27.3 million in 2002. Net premiums earned, however, decreased by 11.8% to $22.9 million in 2003 from $26.0 million in 2002. The decrease in net premiums earned in 2003 was due to our effort to control the amount of net premiums written in relation to our statutory surplus in 2003, which caused us to increase the percentage of premiums ceded to 81.2% from 70.0% in 2002. Net premiums earned from the insurance segment represented 97.5% of our total net premiums earned in both 2002 and 2003.
See "Item 7.-Insurance Segment Results of Operations" and "Item 7.-Reinsurance Segment Results of Operations" for a discussion of premiums and total commission and fee income.
Net investment income and realized gains. Net investment income increased by 17.0% in 2003 to $2.3 million compared to $1.9 million in 2002. The increases in each period were due to growth in our invested assets, offset in part by declines in the average yield on our invested assets as a result of the investment of new cash at lower rates.
We realized gains from the sale of securities of $493,000 in 2003 and $95,000 in 2002. In the first half of 2003, we reduced the weighted average duration of our fixed maturity securities portfolio to protect the portfolio from rising interest rates by selling certain securities. These sales resulted in a gross gain of $493,000. In 2002, we realized gross gains of $602,000 and gross losses of $128,000 from the sale of fixed maturity securities and net losses of $379,000 from the sale of equity securities.
Our invested assets were $57.3 million in 2003 compared to $39.6 million in 2002. The yield on our invested assets at the end of each year was 5.0% in 2003 and 5.8% in 2002. The increase in invested assets at December 31, 2003 from December 31, 2002 resulted from operating cash flows and $16.0 million in net proceeds from financing transactions after the repayment of a surplus note. Additionally, in October 2003 we commuted a reinsurance contract with one of our reinsurers, resulting in the return of $3.2 million representing ceded loss reserves. The increases in invested assets in 2002 resulted from an increase in operating cash flows and a decrease in cash and cash equivalents.
There was no impact on realized losses attributable to adjustments for other than temporary impairment of securities still held during these periods. As of December 31, 2003 and 2002, we had net unrealized gains of $1.3 million and $1.6 million on our investments.
Losses and loss adjustment expenses and loss ratio. Gross loss and loss adjustment expenses and the gross loss ratio for both the insurance and reinsurance segments combined were $74.1 million and 60.8% in 2003, $55.0 million and 63.8% in 2002, respectively. The net loss ratio for the combined segments was 65.7% in 2003 and 62.9% in 2002. The loss ratios for both years were affected by the higher loss ratio in the reinsurance segment and, in 2002, by adverse development of reserves for losses and loss adjustment expenses for business written in prior years.
Interest expense. Our interest expense increased in 2003 to $1.4 million, compared with $122,000 in 2002. The increase in 2003 resulted primarily from interest payments on $20.0 million of subordinated debentures we issued in May and September, 2003 in connection with issuances of trust preferred securities. Additionally, we borrowed $3.0 million in February, 2003 and an additional $3.0 million in December, 2003 under five year amortizing loans to increase the surplus of TICNY and retire $1.5 million of our Series A Preferred Stock (paid in January 2004). The proceeds from the subordinated debentures were used in part to retire a $10.0 million surplus note issued by TICNY in 2002 and to increase TICNY's surplus. Due to an accounting change as required by the implementation of FAS 150, which was effective for accounting periods after June 15, 2003 and which we implemented on July 1, 2003, the mandatorily redeemable Series A Preferred Stock of $3.0 million was required to be reported in our December 31, 2003 balance sheet as a liability, and dividends on the Series A Preferred Stock paid after July 1, 2003 amounting to $157,500 are required to be reported as interest expense in 2003 and charged to income rather than as a direct reduction to stockholders' equity.
Ceding commission revenue. Ceding commission revenue in 2004 increased by 13.2% to $40.0 million compared to $35.3 million in 2003. Despite the reduction in the quota share ceding percentage, ceding commission revenue increased as a result of an 8.8% increase in ceded premiums earned. Additionally, we experienced an improvement in the ceded loss ratios on prior years' quota share treaties, which increased ceding commission revenue by $1.7 million in 2004 and $1.3 million 2003.
Loss and loss adjustment expenses and loss ratio. Gross and net losses and loss adjustment expenses in 2004 were $84.8 million and $27.8 million, respectively, compared with $73.4 million and $14.7 million, respectively, in 2003. Our gross and net loss ratios were 56.1% and 62.5%, respectively, in 2004 as compared to 60.9% and 65.7%, respectively, in 2003. The decrease in the net loss ratio in 2004 as compared to 2003 was due primarily to an increase in net premiums earned that reduced the effect of excess and catastrophe reinsurance premiums on the net loss ratio. We ceded excess and catastrophe reinsurance premiums equal to 15.8% of net premiums earned during 2004 compared to 25.0% in 2003. There was $568,000 adverse development from prior years' reserves on a net basis in 2004 compared to $50,000 on a net basis in 2003 for the insurance segment. Loss and loss adjustment expenses are net of reimbursements for loss and loss adjustment expenses made by TRM pursuant to the expense sharing agreement between TICNY and TRM. See "Item 7.-Insurance Services Segment Results of Operations" for the amounts of claims reimbursements.
The portion of the underwriting expense ratio represented by other underwriting expenses was 14.4% in 2004 as compared with 13.0% in 2003. The increase in underwriting expenses was due to the growth in premiums earned in TICNY and premiums produced by TRM, costs related to the OneBeacon transaction including establishing two new offices in Long Island and Western New York, additional staffing of key positions in preparation for a public company environment, and an increase in regulatory assessments.
The gross combined ratio in 2004 was 87.3% compared with 91.1% in 2003. The lower gross combined ratio resulted from a lower gross loss ratio due to increased pricing in 2004.
Ceded premiums. As a result of the increase in gross premiums written in 2003, total ceded premiums written increased by 34.3% to $105.3 million from $78.4 million in 2002. Total ceded earned premiums increased by 65.9% to $98.2 million in 2003 from $59.2 million in 2002. The ceded earned premiums under our quota share treaty increased by 70.5% to $89.7 million from $52.6 million in 2002. The rate of increase for ceded premiums earned was higher than for ceded premiums written for the same reason mentioned above for gross premiums earned.
Ceding commission revenues. As a result of the increase in ceded premiums earned, ceding commission revenues from our quota share reinsurance treaty increased by 65.0% to $35.3 million in 2003 from $21.4 million in 2002. In 2003, the ceding commission revenue included $1.5 million that was received in connection with the commutation of TICNY's treaty with PXRE Barbados. This treaty inured to the benefit of PXRE New Jersey only. As a non-admitted reinsurer, PXRE Barbados was contractually required to provide collateral for unearned premium and, if a loss penetrated the layer, loss reserves and IBNR. During the course of the agreement, PXRE Barbados asked to be removed from the transaction and PXRE New Jersey, an admitted reinsurer, agreed to the removal of the inuring reinsurance and agreed to allow PXRE Barbados to pay us $1.5 million in consideration of our increased credit risk exposure to PXRE New Jersey, which does not provide collateral to us in the event of losses. The commutation did not increase our loss reserves or the risk exposure but required us to depend upon PXRE New Jersey as the sole reinsurer. See "Item 1.-Reinsurance" and "Note 5. Reinsurance". In 2003, we earned a commission rate of 36.3% on the 2003 quota share treaties based upon a 57.1% loss ratio for those treaties. Due to an improvement in the loss ratio on ceded premiums earned from 61.2% in 2002 to 57.9% in 2003 under the 2002 treaty, the commission rate on the 2002 quota share treaty increased from 34.5% to 37.8% in 2003. As a result, the commission rate applied in 2003 to premiums ceded under the 2002 treaty that were earned in 2003 increased to 40.8%, causing ceding commissions earned to increase by $1.3 million. The loss ratio for the 2001 quota share treaty remained at less than 70% in 2003, which resulted in no adjustment to the ceding commission rate for this treaty. After the adjustments to the prior quota share treaties, the commission rate that we earned in 2003 was 38.9% compared with 39.8% in 2002. No changes in estimates were required for ceding commissions earned in 2002 under the 2001 quota share treaty. The ceding commission rates are calculated under GAAP, which requires these commissions to be recognized when ceded premiums written are earned.
Results for 2002 were affected by additions to net loss reserves we made as a result of adverse development from prior years. After we experienced adverse reserve development in 2001, we retained a different independent actuarial firm to analyze our reserves in 2002, resulting in further reserve strengthening. See "Item 1.--Loss and Loss Adjustment Expense Reserves". On a net basis, reserve strengthening of $1.9 million in 2002 added 7.4 points to our net loss ratio for that year. In 2003, we had adverse reserve development on a net basis of $50,000 in our insurance segment, which, together with the reserve development of $25,000 in assumed reinsurance, resulted in a consolidated adverse reserve development of $75,000. See "Item 1.-Loss and Loss Adjustment Expense Reserves". The net loss ratio in 2003 was also affected by catastrophe reinsurance premium, which reduced earned premium by $2.7 million in 2003 compared with $1.7 million in 2002.
Our accident year gross and net loss ratios that exclude the effects of adverse development from prior years were 57.6% and 65.5%, respectively, in 2003, compared with 55.1% and 52.3%, respectively, in 2002. In 2002, we retained a higher proportion of our premiums in property lines, which represented 77.0% of our total net premiums written. Due to the absence of severe weather related losses that year, our greater retention in property lines resulted in a lower accident year net loss ratio of 52.3%.
Underwriting profits and combined ratio. The underwriting profit increased by 13.8% to $6.6 million in 2003 from $5.8 million in 2002. The net combined ratio was 70.6% in 2003 compared with 77.2% in 2002. The improvement in 2003 was primarily due to the increase in ceding commission revenue from increased ceded premiums and a lower ceded loss ratio, and from lower direct commission expense. These improvements were offset by an increase in losses incurred resulting from more severe winter weather in the Northeast region and slightly higher expenses incurred in anticipation of the IPO.
The gross combined ratio was 91.1% in 2003 compared with 93.0% in 2002. The improvement in the gross combined ratio in 2003 from 2002 reflects reductions in both the gross loss ratio and the gross underwriting expense ratio.
Loss and loss adjustment expenses and loss ratio. The gross and net loss and loss adjustment expenses in 2004 were a benefit of $0.7 million compared to a $0.8 million and $0.4 million expense, respectively, in 2003. Our gross and net loss ratios were negative 52.0% and negative 60.9%, respectively in 2004 compared to 52.8% and 64.7% in 2003. The improvement in the loss ratios in 2004 resulted from the full conversion of the current treaties to an aggregate excess of loss basis with improved pricing on the current treaties, improvement in the loss experience of the underlying business and favorable development of prior years' reserves of $0.7 million.
Reinsurance Segment Results of Operations 2003 Compared to 2002 Premiums. Gross premiums written decreased by 17.3% to $1.2 million from $1.5 million in 2002. Gross premiums earned decreased by 9.5% in 2003 to $1.5 million as compared with $1.6 million in 2002. We ceded 19.4% and 67.4% of the gross reinsurance premiums written in 2003 and 2002 to our quota share reinsurance treaty, which also reinsured our insurance segment. After the effects of reinsurance, net premiums written increased by 104.2% to $1.0 million in 2003 from $481,000 in 2002. Net premiums earned decreased by 11.7% to $576,000 in 2003 from $652,000 in 2002.
Loss and loss adjustment expenses and loss ratio. Gross and net losses and loss adjustment expenses were $782,000 and $372,000, respectively, in 2003, compared with $2.5 million and $1.6 million, respectively, in 2002. Our gross and net loss ratios were 52.8% and 64.7%, respectively, in 2003, compared with 155.2% and 239.9%, respectively, in 2002.
The gross and net loss ratios improved significantly in 2003 as a result of minimal adverse development ($25,000) and improvements in the underlying assumed business produced by TRM due to significant rate increases and re-underwriting that began in 2001. The gross and net loss ratios in 2002 were primarily affected by adverse loss development from accident years prior to 2001. The adverse loss reserve development was $1.1 million in 2002. Prior to 2001, 100% of the gross premiums were retained, whereas in 2002, 32.6% of the gross premiums were retained. For this reason, 100% of the adverse development from accident years prior to 2001 adversely affected our gross and net results. Due to the reduced net earned premium base resulting from ceding assumed premiums from 2002, however, our net results were affected more significantly due to this adverse loss development as indicated by the higher net loss ratios. The accident year gross and net loss ratios that exclude the effects of adverse development from prior years were 58.6% and 60.2%, respectively, for 2003 and 52.3% and 70.1%, respectively, for 2002.
Underwriting expenses and underwriting expense ratios. The ceding commission revenue earned on the assumed business reduced gross underwriting expenses. As a result, TICNY incurred gross and net underwriting expense ratios of 14.3% and negative 14.4%, respectively, in 2003 and 30.5% and 4.1% respectively in 2002. The negative underwriting expense ratios in 2003 resulted from ceding commission revenue earned in 2003 on premiums ceded under our 2002 quota share treaty, which exceeded the underwriting expenses incurred.
The gross combined ratio improved significantly to 67.1% in 2003 compared with 185.7% in 2002. The improvement in the gross combined ratio in 2003 was due to minimal adverse loss development, a favorable accident year loss ratio and minimal ceding commission expense. The gross combined ratio in 2002 was high primarily due to the effects of continued adverse development from prior accident years.
(2) Consists of underwriting expenses reimbursed to TICNY pursuant to an expense sharing agreement.
Insurance Services Segment Results of Operations 2004 Compared to 2003 Total Revenues. Total revenues in 2004 increased by 27.7% for the insurance services segment to $16.4 million compared to $12.8 million in 2003. The increase in total revenue was primarily due to direct commission revenue that increased by 44.6% to $11.5 million in 2004 as compared to $8.0 million in 2003 and claims administration revenue that increased by 9.6% to $4.1 million in 2004 from $3.7 million in 2003. The increase in revenue from direct commission revenue and claims administration revenue was offset by a reduction in reinsurance intermediary fees, which decreased by 33.6% to $0.7 million in 2004 as compared with $1.1 million in 2003. The reduction in reinsurance intermediary fees was primarily a result of lower ceded premiums in the insurance segment in 2004 and additional reinsurance intermediary fees recorded in 2003 pertaining to reinsurance arrangements in 2002.
Direct commission revenue is dependent upon the premiums and losses on business produced by TRM on behalf of its issuing companies. In 2004, direct commission revenues increased as a result of increases in premiums produced by TRM and in the commission rate. Premiums produced by TRM increased by 35.3% to $53.4 million in 2004 as compared to $39.5 million in 2003 resulting primarily from increases in premiums produced in the middle market and small business overflow programs. The composite commission revenue rate increased to 21.6% in 2004 from 20.2% in 2003 due to growth in the middle market program, which carries a higher commission rate, to $18.8 million of premiums produced in 2004 compared to $7.7 million in 2003. Additionally, due to a lower loss ratio on the business placed by TRM, additional commissions of $0.2 million were earned in 2004.
Direct commission expense. TRM's direct commission expense rate in 2004 was 13.9% compared to 13.7% in 2003. This was due to an increase in the small business overflow program to $9.9 million of premiums produced in 2004 from $6.7 million of premiums produced in 2003. The small business overflow program has a higher commission rate.
Pre-tax income. Pre-tax income in 2004 increased by 26.6% to $2.0 million as compared to $1.5 million in 2003. The increase was due to the 44.6% increase in direct commission revenue that was partially offset by a 27.9% increase in expenses for 2004 compared to 2003.
Direct commission revenue from TRM's operation in 2003 was $8.0 million, compared with $4.7 million in 2002. The composite commission revenue rate was 20.2% in 2003 compared to 19.3% in 2002 on premiums produced by TRM on behalf of its issuing companies of $39.5 million in 2003 and $24.3 million in 2002. The increase in direct commission revenue in 2003 reflects improved operating results due to increased profitability of the underlying business, improved reinsurance market conditions and the introduction of TRM's small business overflow program. See "Item 1.--Insurance Services Segment Products and Services".
TRM generated $1.1 million and $3.7 million in reinsurance intermediary and claims administration revenues, respectively, in 2003, compared with $3.2 million and $4.5 million, respectively, in 2002. TRM's reinsurance intermediary fees in 2002 were higher than 2003 due to an additional one-time intermediary fee in 2002. Claims administration revenue was mostly offset by an approximately equal amount of claims expense allocated to TRM in 2002 and 2003 under an expense sharing agreement with TICNY, with the exception of $259,000 that was earned in the aggregate in those years for arranging claims administration services for self-insureds and other work unrelated to the premiums underwritten for TRM's issuing companies.
TRM's average commission rate paid to its producers was 13.8% in 2002 and 13.7% in 2003. Commissions paid to producers were $5.4 million in 2003, compared with $3.4 million in 2002.
The following table presents information regarding our invested assets that were in an unrealized loss position at December 31, 2004 by amount of time in a continuous unrealized loss position.
Under New York law, TICNY is 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. In addition, the New York Insurance Department must approve any dividend declared or paid by TICNY that, together with all dividends declared or distributed by TICNY during the preceding twelve months, exceeds the lesser of (1) 10% of TICNY's policyholders' surplus as shown on its latest statutory financial statement filed with the New York State Insurance Department or (2) 100% of adjusted net investment income during the preceding twelve months. TICNY paid approximately $850,000, $364,000 and $1,555,000 in dividends to Tower in 2004, 2003, and 2002, respectively. As of December 31, 2004, the maximum distribution that TICNY could pay without prior regulatory approval was approximately $2.8 million.
TRM is not subject to any limitations on its dividends to Tower, other than the basic requirement that dividends may be declared or paid if the net assets of TRM remaining after such declaration or payment will at least equal the amount of TRM's stated capital. TRM paid a dividend of $860,000 to Tower in 2002 but did not pay any dividends to us in 2004 or 2003.
CASH FLOWS FROM IPO AND PRIVATE PLACEMENT On October 20, 2004, the Company sold 13,000,000 shares in its IPO at $8.50 per share. On the same date, the Company also effected a concurrent private placement of 500,000 shares of its common stock to an affiliate of Friedman, Billings, Ramsey & Co., Inc., the lead underwriter for the Company's IPO, at a price of $8.50 per share. On November 10, 2004 the underwriters exercised their 30-day over-allotment option after the Company's IPO. Pursuant to this exercise, the underwriters purchased 629,007 additional shares of common stock from the Company and 1,320,993 shares of common stock from selling shareholders. The Company received net cash proceeds of $107,845,000 from the offering and concurrent private placement after the underwriting discounts, commissions and offering expenses. The total costs of the IPO and private placement were $12,252,000 of which $8,407,000 was for the underwriting discount, and $3,845,000 was for all other costs.
Immediately before the closing of the IPO on October 26, 2004, we redeemed 30,000 shares of our Series A Cumulative Redeemable Preferred Shares for $1.5 million plus accrued interest. After the closing we utilized some of the cash proceeds to pay off a $5.0 million loan and accrued interest to CIT Group/Equipment Financing, Inc. We recognized a loss on early extinguishment of debt of $133,000 in the fourth quarter of 2004.
On October 26, 2004 we contributed $98,000,000 in Paid in Capital to our wholly owned affiliate TICNY, which in turn invested this cash in its fixed-income portfolio.
SURPLUS LEVELS TICNY is 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 New York Insurance Department 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, 2004, TICNY's risk-based capital exceeded the minimum level that would trigger regulatory attention. In addition to monitoring RBC to ensure regulatory compliance, we monitor various financial ratios, including gross and net premiums written to surplus ratios. Capital contributions to TICNY were $98.0 million and $17.1 in 2004 and 2003, respectively, and none in 2002.
CASH FLOWS The primary sources of cash flow in TICNY are gross premiums written, reinsurance commissions from our quota share reinsurers, loss payments by our reinsurers, investment income and proceeds from the sale or maturity of investments. Funds are used by TICNY for ceded premium payments, which are paid on a net basis after subtracting losses paid on reinsured claims and reinsurance commissions. TICNY also uses funds for loss payments and loss adjustment expenses on our net business, commissions to producers, salaries and other underwriting expenses as well as to purchase investments and to pay dividends to Tower. TRM's primary sources of cash are premiums produced on behalf of issuing companies and commission and fee income. TRM's primary uses of cash are premium payments and fees to issuing companies, net of paid losses and commission income, commissions to producers and expenses reimbursed to TICNY under an expense sharing agreement.
Comparison of Years Ended December 31, 2004 and 2003 For the year ended December 31, 2004 net cash provided by operating activities was $76.1 million compared to operating cash flow of $22.7 million in 2003. The increase in net cash provided by operations in 2004 resulted from an increase in collected premiums as a result of the growth in gross premiums and the reduction in the effective quota share reinsurance ceding percentage from 77.2% in 2003 to 41.6% in 2004, an increase of $29.2 million in funds withheld as collateral for reinsurance recoverable and a $15.7 million collection of a receivable for cancelled reinsurance.
Net cash used by investing activities was $177.0 million for the year ended December 31, 2004, compared to $19.0 million in 2003 due principally to the investment of $98.0 million of IPO proceeds contributed to and invested by TICNY and cash provided by operations.
The net loss reserves payments due by period in the table above are based upon the loss and loss expense reserves estimates as of December 31, 2004 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 to the same uncertainties associated with determining the level of reserves and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. For a discussion of our reserving process. See "Item 1.-Loss and Loss Adjustment Expense Reserves". Actual payments of loss and loss adjustment expenses by period will vary, perhaps materially, from the above table to the extent that current estimates of loss reserves vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns. See "Item 1.-Risks Related to Our Business-If our actual loss and loss adjustment expenses exceed our loss reserves, our financial condition and results of operations could be significantly affected", for a discussion of the uncertainties associated with estimating loss and loss adjustment expense reserves. This payment pattern also assumes timely reimbursement from our reinsurers. If our reinsurers do not meet their contractual obligations or a timely basis, the payment assumptions presented above could vary materially.
o bankruptcy or liquidation of us or of either of the financing trusts through which the trust preferred securities were issued.
Pursuant to the terms of our subordinated debentures, Tower and its subsidiaries cannot declare or pay any dividends if we are in default or have elected to defer payments of interest on the subordinated debentures.
OFF BALANCE SHEET ARRANGEMENTS We have posted an irrevocable letter of credit for $2.0 million for the benefit of OneBeacon Insurance Group LLC ("OneBeacon") representing the estimated commissions due to OneBeacon for the first year of the Commercial Renewal Rights Agreement dated September 13, 2004.
INFLATION Property and casualty insurance premiums are established before we know the amount of losses and loss adjustment expenses or the extent to which inflation may affect such amounts. We attempt to anticipate the potential impact of inflation in establishing our reserves. Inflation in excess of the levels we have assumed could cause loss and loss adjustment expenses to be higher than we anticipated.
Substantial future increases 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 the investment portfolio and cause unrealized losses or reductions in stockholders' equity.
Consolidated Statements of Income and Comprehensive Net Income for the years ended December 31, 2004, 2003 and 2002 83
Consolidated Statements of Stockholders' Equity for the years ended December 31, 2004, 2003 and 2002 84
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, 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 statements present fairly, in all material respects, the financial position of the Company as of December 31, 2004 and 2003, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States.
As discussed in Note 1, during 2003, the Company changed its method of accounting for its redeemable preferred stock to conform to Statement of Financial Accounting Standards No. 150.
TICNY is a property-casualty insurance company incorporated in the State of New York in June 1989. TICNY obtained its license to operate in the State of New York in December 1990, at which time it commenced underwriting operations. TICNY provides coverage for many different market segments, including nonstandard risks that do not fit the underwriting criteria of standard carriers due to factors such as type of business, location and the relatively small amount of premium per policy. TICNY offers commercial multiple-peril, monoline general liability, commercial umbrella, monoline property, workers' compensation and commercial automobile policies as well as personal lines products such as homeowners, dwelling and other liability policies. Generally, TICNY targets customers that have a reduced potential for loss severity and are not normally exposed to long-tailed, complex or contingent risks, such as products liability, asbestos or environmental claims. TICNY's commercial lines products provide insurance coverages to businesses such as retail and wholesale stores, grocery stores, restaurants, artisan contractors and residential and commercial buildings. Personal lines products focus on modestly valued homes and dwellings. TICNY's products are marketed through independent agents. All direct premiums are written in the State of New York.
TRM is a non-risk-bearing insurance services company that produces, through its managing general agency, business on behalf of other insurance companies (which are referred to as TRM's issuing companies) and primarily focuses on commercial risks with higher per policy premium, including risks that TICNY has not been able to target due to historical surplus, rating and geographical license constraints. TICNY also reinsures a portion of the premiums written by TRM's issuing companies. The Company utilizes these non-risk-bearing insurance services operations to generate commission income on premiums produced for other insurance companies. In addition, the insurance services operation earns fee revenues by providing claims administration and reinsurance intermediary services to TRM's issuing companies and to other insurance companies. In 2004 and 2003, two companies accounted for 100% of the managing general agency commissions of TRM. TRM generated 94% of its reinsurance intermediary commission income in 2002 from the placement of one reinsurance agreement. See "Note 5. Reinsurance" for further description.
Certain activities of the Company are provided by TICNY, DBA the Law Office of Steven Fauth. These activities primarily consist of claims management activities of TICNY and claims management services provided by TRM to other issuing carriers. Mr. Fauth is an officer and director of the Company.
During 2003 and 2002, the Company engaged in significant transactions with PXRE Reinsurance Company ("PXRE"), which had a significant impact on the operations and financial statements of the Company. Transactions between PXRE and the Company include reinsurance arrangements, debt financing and equity transactions. To reduce the credit risk associated with having a significant amount of reinsurance recoverable from PXRE the Company cancelled PXRE's participation in the 2003 quota share agreement as of September 30, 2003. See "Note 5. Reinsurance" and "Note 8. Debt".
Additionally, during 2003 and 2002 the Company engaged in significant reinsurance arrangements with American Re-Insurance Company ("Am Re"), which owned all of the Company's outstanding shares of Series A Cumulative Redeemable Preferred Stock as of December 31, 2003. The Series A Cumulative Redeemable Preferred Stock was redeemed during 2004. Am Re also held warrants for the purchase of common stock that were exercised during 2004. See "Note 5. Reinsurance", "Note 8. Debt", and "Note 9. Capital Stock".
Insurance policies issued or reinsured by the Company are short-duration contracts. Accordingly, premium revenue, including direct writings and reinsurance assumed, net of premiums ceded to reinsurers, is recognized as earned in proportion to the amount of insurance protection provided, on a pro-rata basis over the terms of the underlying policies. Unearned premiums represent premium applicable to the unexpired portions of in-force insurance contracts at the end of each year. Prepaid reinsurance premiums represent the unexpired portion of reinsurance premiums ceded.
The liability for loss and loss adjustment expenses represents management's best estimate of the ultimate cost of all reported and unreported losses that are unpaid as of the balance sheet date. The liability for loss and loss adjustment expenses is estimated on an undiscounted basis, using individual case-basis valuations, statistical analyses, and various actuarial procedures. The projection of future claim payment and reporting is based upon an analysis of the Company's historical experience, supplemented by analyses of industry loss data. Management believes that the reserves for loss and loss adjustment expenses are adequate to cover the ultimate cost of losses and claims to date; however, because of the uncertainty from various sources, including changes in reporting patterns, claims settlement patterns, judicial decisions, legislation, and economic conditions, actual loss experience may not conform to the assumptions used in determining the estimated amounts for such liability at the balance sheet date. As adjustments to these estimates become necessary, such adjustments are reflected in current operations. Because of the nature of the business historically written, the Company's management believes that the Company has limited exposure to environmental claim liabilities.
Reinsurance recoverable represents management's best estimate of unpaid loss and loss adjustment expenses recoverable from reinsurers. Ceded losses recoverable are estimated using techniques and assumptions consistent with those used in estimating the liability for loss and loss adjustment expenses. Management believes that reinsurance recoverables as recorded represent its best estimate of such amounts; however, as changes in the estimated ultimate liability for loss and loss adjustment expenses are determined, the estimated ultimate amount recoverable from the reinsurer will also change. Accordingly, the ultimate recoverable could be significantly in excess of or less than the amount indicated in the consolidated financial statements. As adjustments to these estimates become necessary, such adjustments are reflected in current operations. Loss and loss adjustment expenses incurred as presented in the consolidated statement of income and comprehensive net income are net of reinsurance recoveries.
Commissions on reinsurance premiums ceded are earned in a manner consistent with the recognition of the costs of the reinsurance, generally on a pro-rata basis over the terms of the policies reinsured. Certain reinsurance agreements contain provisions whereby the ceding commission rates vary based on the loss experience under the agreements. The Company records ceding commission revenue based on its current estimate of losses. The Company records adjustments to the ceding commission revenue in the period that changes in the estimated losses are determined. Ceding commissions receivable of $8,329,000 and $7,983,000 as of December 31, 2004 and 2003, respectively represent ceding commissions receivable from PXRE which are not due until final settlement of losses subject to the contracts or commutation of the agreements.
Cash and cash equivalents are presented at cost, which approximates fair value. The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. For the purpose of presentation in the Company's statements of cash flows, cash equivalents are short-term, highly liquid investments that are both (a) readily convertible to known amounts of cash, and (b) so near to maturity that they present insignificant risk of changes in value due to changing interest rates.
The Company maintains its cash balances at several financial institutions. The Federal Deposit Insurance Corporation secures accounts up to $100,000 at these institutions. Management monitors balances in excess of insured limits and believes they do not represent a significant credit risk to the Company.
The Company accounts for its investments in accordance with Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"), which requires that fixed-maturity and equity securities that have readily determined fair values be segregated into categories based upon the Company's intention for those securities. In accordance with SFAS 115, the Company has classified its fixed-maturity and equity securities as available-for-sale. The Company may sell its available-for-sale securities in response to changes in interest rates, risk/reward characteristics, liquidity needs or other factors.
Impairment of investment securities results in a charge to operations when a market decline below cost is deemed to be other-than-temporary. The Company regularly reviews its 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. In general, attention is focused on those securities whose fair value was less than 80% of their amortized cost or cost, as appropriate, for six or more consecutive months. In evaluating potential impairment, management considers, among other criteria: the current fair value compared to amortized cost or cost, as appropriate; the length of time the security's fair value has been below amortized cost or cost; management's intent and ability to retain the investment for a period 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 the cost basis of the underlying investment. During 2004, 2003 and 2002, the Company did not record any other-than-temporary impairments.
Agents' balances receivable are presented net of an allowance for doubtful accounts of $123,000 at December 31, 2004 and 2003. The allowance for uncollectible amounts is based on an analysis of amounts receivable giving consideration to historical loss experience and current economic conditions and reflects an amount that, in management's judgment, is adequate. Uncollectible agent's balances in 2004 were $27,000 and none in 2003 and 2002. One agent accounted for approximately 12% and 16%, respectively, of TICNY's and TRM's agents' balances at December 31, 2004 and 2003 and 14% and 17% of TICNY's direct premiums written and TRM's premiums produced in 2004 and 2003, respectively.
Receivable - claims paid by agency represent claim payments due from issuing carriers to reimburse claims paid by TRM on their behalf in conjunction with claims administration services. The receivables are partially secured by funds held totaling $785,000 and $796,000 as of December 31, 2004 and 2003, respectively. As of December 31, 2004 and 2003, no reserve for uncollectible recoverables was recorded. During 2004, 2003 and 2002, no amounts relating to these receivables were written-off.
With respect to the business produced by TRM for other issuing carriers, agents collect premiums from the policyholders and forward them to TRM. In certain jurisdictions, when the insured pays premium for these policies to agents for payment to TRM, the premium might be considered to have been paid and the insured will no longer be liable to TRM for those amounts, whether or not TRM has actually received the premiums from the agent. Consequently, TRM assumes a degree of credit risk associated with agents and brokers. The Company recorded no losses in 2004, 2003 and 2002 for this activity.
The Company received promissory notes from certain officers, directors, and employees in exchange for cash. The notes bear interest at 4% per year and maturity terms varied from 5 years to no stated maturity. Notes receivables as of December 31, 2003 from the Company's Chairman of the Board, President and Chief Executive Officer, totaled $1,338,000 and were repaid in 2004.
Acquisition costs represent the costs of writing business that vary with, and are primarily related to, the production of insurance business. Policy acquisition costs are deferred and recognized as expense as related premiums are earned. Deferred acquisitions costs as presented in the balance sheet are net of deferred ceding commission revenue. The Company considers anticipated investment income in determining the recoverability of these costs and believes they are fully recoverable.
Furniture, computer equipment, leasehold improvements and software are reported at cost less accumulated depreciation and amortization. Depreciation and amortization is provided using the straight-line method over the estimated useful lives of the assets.
In December 2003, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 46(R), "Consolidation of Variable Interest Entities" ("FIN 46(R)"), which establishes accounting guidance for consolidation of variable interest entities ("VIE") that function to support the activities of the primary beneficiary. The primary beneficiary of a VIE is the entity that absorbs a majority of the VIE's expected losses, receives a majority of the VIE's expected residual returns, or both, as a result of ownership, controlling interest, contractual relationship or other business relationship with a VIE. Prior to the implementation of FIN 46(R), VIE's were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority of voting interest in the entity. As of December 31, 2003, the Company does not consolidate interest in its statutory business trusts for which the Company holds 100% of the common trust securities because Tower is not the primary beneficiary of the trusts. See "Note 8. Debt". The Company's investment in common trust securities of the statutory business trust are reported in investments at equity. The Company reports as a liability the outstanding subordinated debentures owed to the statutory business trusts.
In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150"). SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. Due to the adoption by the Company of SFAS 150, Series A Cumulative Redeemable Preferred Stock was reclassified as debt as of July 1, 2003. Effective with adoption, dividends paid are reported as interest expense. See "Note 8. Debt" and "Note 9. Capital Stock".
Pursuant to a Tax Allocation Agreement, dated as of January 1, 2001, Tower, TICNY and TRM compute and pay Federal income taxes on a consolidated basis. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and for operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
The Company accounts for the treasury stock at the repurchase price as a reduction to stockholders' equity as it does not intend to retire the treasury stock held at December 31, 2004.
In December 2004, the Financial Accounting Standards Board issued the revised statement SFAS No. 123-R, an amendment to SFAS No. 123, "Accounting for Stock-Based Compensation" which suspends APB 25, requires that the cost of share-based payment transactions be recognized in the financial statements after the first fiscal quarter beginning after June 15, 2005. For calendar year companies, this means that pro-forma footnote disclosures, developed under the current SFAS 123 can continue to be provided in the first two quarters of 2005, with mandatory expensing of equity-based compensation beginning in the third quarter of 2005. The intended adoption by the Company of SFAS 123-R in June 2005 is not expected to have a material impact on the Company's financial position or results of operations.
The cost and estimated fair value of investments in equity securities are as follows (in 000's):
Major categories of the Company's net investment income are summarized as follows (in 000's):
Proceeds from the sale and maturity of fixed-maturity securities were $23,474,000, $8,992,000 and $19,717,000 in 2004, 2003 and 2002, respectively. Proceeds from the sale of equity securities were $50,000, $25,000 and $791,000 in 2004, 2003, and 2002, respectively. The Company's gross realized gains and losses on investments are summarized as follows (in 000's):
2004 2003 2002 ----- ----- ----- Fixed maturity securities: Gross realized gains $ 137 $ 493 $ 602 Gross realized losses (124) -- (128) ----- ----- ----- 13 493 474 Equity securities: Gross realized gains -- -- 50 Gross realized losses -- -- (429) ----- ----- ----- -- -- (379) ----- ----- ----- NET REALIZED GAINS $ 13 $ 493 $ 95 ===== ===== =====
The following table presents information regarding the Company's invested assets that were in an unrealized loss position at December 31, 2004 by amount of time in a continuous unrealized loss position (in 000's)
The components of the liability for loss and loss adjustment expenses and related reinsurance recoverables are as follows (in 000's):
Activity in the liability for loss and loss adjustment expenses is summarized as follows (in 000's):
Incurred losses and loss adjustment expenses are net of reinsurance recoveries under reinsurance contracts of $57,104,000, $59,090,000 and $38,609,000 in 2004, 2003 and 2002, respectively.
The increase in 2002 is the result of recent loss development trends in the reinsurance segment. The Company's management continually monitors claims activity to assess the appropriateness of carried case and IBNR reserves, giving consideration to Company and industry trends.
In an effort to manage the cost of quota share reinsurance in the time of rising cost and limited availability, the Company implemented provisions for loss ratio caps to its quota share reinsurance agreements. These provisions have been structured to provide the reinsurers with some limit on the amount of potential loss being assumed, while maintaining the transfer of significant insurance risk with the possibility of a significant loss to the reinsurer, and thereby to reduce the cost of reinsurance. Loss ratio caps cut off the reinsurers' liability for losses above a specified loss ratio. The loss ratio caps in the 2004, 2003 and 2002 quota share agreements were 95.0%, 92.0% and 97.5%, respectively.
DECEMBER 31, 2003: PXRE Reinsurance Company $ 51,697 $ 7,354 $ 59,051 American Re-Insurance Company 12,565 1,474 14,039 Tokio Millennium Re Ltd. 9,972 777 10,749 Others 880 41 921 -------- -------- -------- TOTAL $ 75,114 $ 9,646 $ 84,760 ======== ======== ========
DECEMBER 31, 2004 2003 ------- ------- PXRE Reinsurance Company $ -- $ 109 American Re-Insurance Company 1,376 1,760 Tokio Millennium Re Ltd. 13,093 52,389 Hannover Reinsurance (Ireland Ltd.) 10,474 -- E+S Reinsurance (Ireland) Ltd. 2,619 -- Others 829 1,387 ------- ------- TOTAL $28,391 $55,645 ======= =======
The following collateral is available to the Company for amounts receivable from reinsurers (in 000's) as of December 31, 2004 and 2003:
As of December 31, 2004, the Company's estimated ultimate loss ratios are lower than the contractual ultimate loss ratios at which the minimum amount of ceding commissions can be earned. Accordingly, the Company has recorded ceding commissions earned that are greater than the minimum commissions. The relevant estimated ultimate loss ratios and commissions as of December 31, 2004 are set forth below (dollars in 000's):
Based on the amount of ceded premiums earned, the maximum potential reduction to ceding commissions earned related to an increase in the Company's estimated ultimate loss ratios is $18.9 million for all treaties for all three years. The maximum potential reduction for the 2004 treaty year may increase as additional ceded premiums are earned in 2005 (assuming the estimated ultimate loss ratio remains the same). The ceded premiums for the 2002 and 2003 treaty years have been fully earned as of December 31, 2004.
The estimated ultimate loss ratios are the Company's best estimate based on facts and circumstances known at the end of each period that losses are estimated. The estimation process is complex and involves the use of informed estimates, judgments and actuarial methodologies relative to future claims severity and frequency, the length of time for losses to develop to their ultimate level, possible changes in law and other external factors. The same uncertainties associated with estimating loss and loss adjustment expense reserves affect the estimates of ceding commissions earned. The Company monitors and adjusts the ultimate loss ratio on a quarterly basis to determine the effect on the commission rate and ceding commissions earned. The increase in estimated ceding commission income relating to prior years recorded in 2004, 2003 and 2002 was $1,663,000, $1,326,000 and $0, respectively.
The Company has participated in various reinsurance agreements with Am Re. Ceded written premiums include $2,753,000, $3,811,000 and $3,154,000 ceded to Am Re in 2004, 2003 and 2002, respectively. Am Re had owned all outstanding shares of the Company's Series A Cumulative Redeemable Preferred Stock and held warrants for the purchase of common stock. See "Note 8. Debt" and "Note 9. Capital Stock". During 2004, all of the preferred stock was redeemed and the warrants were exercised.
The Company entered into a Commercial Renewal Rights Agreement with OneBeacon Insurance Group LLC on September 13, 2004 under which it has acquired OneBeacon's rights to seek to renew a block of commercial lines insurance policies in New York State consisting of commercial multiple-peril, workers compensation, commercial umbrella, commercial inland marine, commercial auto, fire and allied lines and general liability coverages. Under the terms of the agreement, the Company did not acquire any in-force business or historical liabilities associated with the policies. Pursuant to the agreement, the Company also obtained the rights to establish contractual relationships with certain OneBeacon agents. The Company has agreed to pay OneBeacon an amount equal to 5% of the direct premiums written resulting from the Company's renewal of any subject policies in the first year, 4% in the second year and 1% in the third year, with no payments due after the third year, subject to the Company's obligation to pay a minimum of $5,000,000 in the aggregate over the three year period. The Company has recorded this transaction as $5,000,000 of intangible assets and a corresponding $5,000,000 liability. Shortly after signing this agreement the Company provided an irrevocable letter of credit for the benefit of OneBeacon in the amount of $2,000,000 representing the estimated payments for the first year of the agreement.
The components of intangible assets are summarized as follows (in 000's):
The components of fixed assets are summarized as follows (in 000's):
During the second and third quarters of 2003, Tower formed two statutory business trusts ("Trust I" and "Trust II"), of which the Company 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 rate trust preferred securities totaling $20,000,000 to investment pools. The trusts invested the proceeds thereof and the proceeds received from the issuance of the common trust securities to Tower in exchange for $20,620,000 of floating rate junior subordinated debentures ("subordinated debentures") issued by Tower. The subordinated debentures are unsecured obligations of Tower and are subordinated and junior in right of payment to all present and future senior indebtedness of Tower. Tower has entered into guarantee agreements, which provide for full and unconditional guarantee of the trust securities. The subordinated debentures and the floating rate preferred securities issued by Trust I accrue and pay interest quarterly at 3 month LIBOR, plus 4.10%, which cannot exceed 12.50% prior to May 15, 2008. At December 31, 2004 this interest rate was 6.38%. The Trust II floating rate preferred securities bear interest at a fixed rate of 7.5% until September 30, 2008 and at a variable rate, reset quarterly, equal to the 3-month LIBOR, plus 4.00%, thereafter. The final maturity on the subordinated debentures is May 15, 2033 and September 30, 2033 for Trust I and Trust II, respectively, with prepayment at the option of the 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 subordinated debentures using the effective interest method.
In December, 2004, Tower formed two statutory business trusts ("Trust III" and "Trust IV"), of which the Company owns all of the common trust securities. On December 7, 2004 and December 17, 2004, Trust III and Trust IV, respectively, each issued $13,000,000 floating rate trust preferred securities totaling $26,000,000 to investment pools. The trusts invested the proceeds thereof and the proceeds received from the issuance of the common trust securities to Tower in exchange for $26,806,000 of floating rate junior subordinated debentures ("subordinated debentures") issued by Tower. The subordinated debentures are unsecured obligations of Tower and are subordinated and junior in right of payment to all present and future senior indebtedness of Tower. Tower has entered into guarantee agreements, which provide for full and unconditional guarantee of the trust securities. The Trust 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 LIBOR rate plus 3.4%. The Trust IV preferred securities bear interest that will float based on the three month LIBOR interest rate plus 3.4% and their rate as of December 31, 2004 was 5.92%. The final maturity on the subordinated debentures is December 15, 2034 and March 15, 2035 for Trust III and Trust IV, respectively, with prepayment at the option of the company 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 debentures using the effective interest method.
On February 21, 2003, Tower entered into a Credit Agreement with The CIT Group/Equipment Financing, Inc. ("CIT") for borrowings up to $6,000,000. Pursuant this agreement TOWER borrowed $3,000,000 ("First Advance") on February 25, 2003 and an additional $3,000,000 on December 31, 2003 ("Second Advance"). The Credit Agreement required that $1,800,000 of the First Advance be contributed to TICNY. The Credit Agreement included certain compliance requirements including certain financial requirements. Tower had pledged all of the outstanding common stock of TICNY and TRM as collateral for the borrowings pursuant to the Credit Agreement. TRM guaranteed Tower's obligations pursuant to the credit agreement and also granted CIT a security interest in all of TRM's assets. Interest is variable, adjusting each quarter, and is determined as LIBOR as of the first day of each quarter plus 4.50%. During 2003 interest rates pursuant to the credit agreement ranged from 5.62% to 5.88%. As of December 31, 2003, the interest rate was 5.66%. During 2004, interest rates pursuant to the credit agreement ranged from 5.61% to 6.11%. Origination fees, primarily legal fees, incurred with respect to the First and Second Advances totaling $175,000 were deferred amortized using the effective interest method and reported as an adjustment to interest expense. Interest expense incurred for the years ended December 31, 2004 and 2003, including amortization of origination costs, was $283,000 and $158,000, respectively. In October 2004, the remaining $5.0 million loan was repaid, the credit agreement was terminated and a loss of $133,000 was recorded reflecting unamortized origination fees.
On December 19, 2002, TICNY entered into a borrowing arrangement with PXRE Barbados for $10,000,000 ("Surplus Note"). The borrowings under this arrangement were not reflected in the December 31, 2002 consolidated GAAP basis financial statements as the Company received the proceeds from the Surplus Note on January 10, 2003. The Surplus Note accrued interest at the rate of 5.0% per annum, payable quarterly commencing April 1, 2003 upon prior approval of the State of New York Insurance Department's Superintendent ("the Superintendent"). TICNY issued the Surplus Note in conjunction with a financing agreement structured in accordance with the standards of Section 1307 of the New York Insurance Law in order to reflect the proceeds as surplus for statutory accounting purposes. The New York Insurance Law provides that notes of this nature have no due date and the Company cannot repay principal or interest to PXRE without the prior written approval of the Superintendent. On December 19, 2003, the Company repaid the balance owed under this agreement and terminated the borrowing agreement, having received approval for such repayment from the Superintendent. Interest expense incurred for 2003 pursuant to the Surplus Note was $500,000.
Due to the adoption by the Company of SFAS 150, the mandatorily redeemable Series A Cumulative Redeemable Preferred Stock of $3,000,000 was reclassified as a liability as of July 1, 2003. Preferred stock dividends of $130,000 for 2004 and $158,000 for the period from July 1, 2003 through December 31, 2003, are reported as interest expense. The dividends paid prior to the adoption of SFAS 150 were accounted for as a direct reduction to stockholders' equity.
As part of the IPO in October, 2004, the Company agreed to issue Friedman Billings Ramsey (FBR), the lead underwriter, warrants to purchase 189,000 shares of the Company's commons stock at the same price as the common stock sold in the offering, $8.50 per share. The warrants are exercisable for a term of four years beginning on the first anniversary of the date of the offering and expiring on the fifth anniversary of the date of the offering, and are restricted from sale, transfer, assignment or hypothecation for a period of 180-days from the effective date of the offering except to officers or partners of FBR and members of the selling group and their officers or partners. The Company granted FBR registration rights with respect to the shares issuable upon exercise of the warrants. Warrants to purchase 189,000 shares of the Company's common stock held by FBR are included in the calculation of diluted EPS.
The Company declared dividends on common and preferred stock as follows in (000's):
2004 2003 2002 ------ ------ ------ Common stock dividends declared $ 493 $ -- $ 473 Class A common stock dividends declared 228 293 -- Class B common stock dividends declared 281 1,403 -- ------ ------ ------ Total common stock dividends declared 1,002 1,696 473 Preferred stock dividends declared -- 158 315 ------ ------ ------ Total dividends declared $1,002 $1,854 $ 788 ====== ====== ======
2004 2003 2002 -------- -------- -------- Common Stock $ 0.0250 -- $ 0.1048 Class A Stock $ 0.1137 $ 0.1465 -- Class B Stock $ 0.1142 $ 0.5773 --
The Company's Series A Cumulative Preferred Stock was reclassified as debt as of July 1, 2003.
In 2004, the Company's Board of Directors adopted and its shareholders approved a long-term incentive plan (the "2004 Long-Term Equity Compensation Plan"). With the adoption of the 2004 Long-Term Equity Compensation Plan, no further grants will be made under the 2001 Stock Award Plan.
The 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 unit awards, performance shares and other cash or share-based awards. The maximum number of shares of common stock that may be issued in connection with awards under the plan is 1,162,723, of which 872,042 may be issued under awards other than stock options or SARs. As of December 31, 2004, awards in respect of 236,981 shares have been made under the plan.
In December 2000, the Board of Directors adopted a long-term incentive plan (the "2001 Stock Award Plan"). The plan provided for a variety of awards, including incentive or non-qualified stock options, performance shares, SARs or any combination of the foregoing.
Under the 2001 Stock Award Plan, 450,000 shares may be made the subject of awards granted under the plan. At December 31, 2004, 358,200 shares of common stock have been issued or are subject to issuance upon the exercise or payment of outstanding awards under the plan. The remaining 91,800 shares eligible for grants under the plan that have not been the subject of awards are now eligible under our 2004 Long-Term Incentive Compensation Plan, such that no further awards may be granted under the 2001 Stock Award Plan.
The restricted stock shares were recorded at fair value as a charge to Unearned Compensation - Restricted Stock in Stockholders' Equity and a credit to Common Stock and Paid-in-Capital. These shares will amortize ratably over their vesting period as a charge to compensation expense and a credit to Unearned Compensation - Restricted Stock in Stockholders' Equity on the balance sheet. In 2004, the Company amortized approximately $310,000 as a charge to compensation expense and a credit to Unearned Compensation - Restricted Stock.
The Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Based Compensation" and related interpretations in accounting for its employee stock options. Under APB 25, no compensation expense is recognized upon the granting of stock options because the exercise price is equal to the estimated market price at the date of the grant. In June 2005, the Company intends to adopt SFAS 123-R which calls for mandatory expensing of equity-based compensation beginning in the third quarter of 2005.
The fair value of the 2001 options granted was estimated using the Black-Scholes pricing model as of January 1, 2001, the date of the initial grant, with the following weighted average assumptions: risk free interest rate of 4.97%, dividend yield of 1.75%, volatility factors of the expected market price of the Company's common stock of 35%, and a weighted-average expected life of the options of 7 years.
The fair value of the 2004 options granted was estimated 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 of the expected market price of the Company's common stock of 30.6% and a weighted-average expected life of the options of 7 years.
The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123, to stock-based employee compensation (in 000's, except per share amounts).
The Company files a consolidated Federal income tax return. The provision for Federal, state and local income taxes consists of the following components (in 000's):
Deferred tax assets and liabilities are determined utilizing the enacted tax rates applicable to the period the temporary differences are expected to be recovered. Accordingly, the current period income tax provision can be affected by the enactment of new tax rates. The net deferred income taxes on the balance sheet reflect temporary differences between the carrying amounts of the assets and liabilities for financial reporting purposes and income tax purposes, tax effected at a 34% rate for 2003 and 2002 and 35% for 2004.
Significant components of the Company's deferred tax assets and liabilities are as follows (in 000's):
2004 2003 ------- ------- Deferred tax asset: Claims reserve discount $ 1,601 $ 1,126 Unearned premium 4,698 993 Deferred compensation -- 607 Allowance for doubtful accounts 43 42 Employee benefit plans 108 -- Other 157 -- ------- ------- Total deferred tax asset 6,607 2,768
The provision for Federal income taxes incurred is different from that which would be obtained by applying the Federal income tax rate to net income before income taxes. The items causing this difference are as follows (in 000's):
From time to time, the Company is involved in various legal proceedings in the ordinary course of business. For example, to the extent a claim asserted by a third party in a law suit against one of the Company's insureds covered by a particular policy, the Company may have a duty to defend the insured party against the claim. These claims may relate to bodily injury, property damage or other compensable injuries as set forth in the policy. Such proceedings are considered in estimating the liability for loss and loss adjustment expenses. The Company is not subject to any other pending legal proceedings that management believes are likely to have a material adverse effect in the financial statements.
Total rental expense charged to operations was approximately $1,536,000, $1,336,000 and $1,206,000 in 2004, 2003 and 2002, respectively.
For regulatory purposes, TICNY, domiciled in the State of New York, prepares its statutory basis financial statements in accordance with practices prescribed or permitted by the State of New York Insurance Department ("statutory basis" or "SAP"). The more significant SAP variances from GAAP are as follows:
o Certain assets including certain receivables, a portion of the net deferred tax asset, prepaid expenses and furniture and equipment are not admitted.
o Investments in fixed-maturity securities are valued at NAIC value for statutory financial purposes, which is primarily amortized cost. GAAP requires certain investments in fixed-maturity securities to be reported at fair value.
o Certain amounts related to ceded reinsurance are reported on a net basis within the statutory basis financial statements. GAAP requires these amounts to be shown gross.
o For SAP purposes, changes in deferred income taxes relating to temporary differences between net income for financial reporting purposes and taxable income are recognized as a separate component of gains and losses in surplus rather than included in income tax expense or benefit as required under GAAP.
For the years ended December 31, 2004, 2003 and 2002, TICNY reported statutory basis net (loss)/income of ($5,705,000), $2,782,000, and $2,612,000, respectively. At December 31, 2004 and 2003 TICNY reported statutory basis surplus as regards policyholders of $126,082,000 and $36,645,000, respectively. As of December 31, 2004 TICNY is required to maintain $4,900,000 of minimum capital and surplus in accordance with New York Insurance Law.
Under New York law, TICNY is 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. In addition, the New York Insurance Department must approve any dividend declared or paid by TICNY that, together with all dividends declared or distributed by TICNY during the preceding twelve months, exceeds the lesser of (1) 10% of TICNY's policyholders' surplus as shown on its latest statutory financial statement filed with the New York State Insurance Department or (2) 100% of adjusted net investment income during the preceding twelve months immediately preceding the declaration or distribution of the current dividend increased by the excess, if any, of net investment income over dividends declared or distributed during the period commencing thirty-six months prior to the declaration or distribution of the current dividend and ending twelve months prior thereto. TICNY paid approximately $850,000, $363,000 and $1,555,000 in dividends to Tower in 2004, 2003, and 2002, respectively. As of December 31, 2004, the maximum distribution that TICNY could pay without prior regulatory approval was approximately $2.8 million.
Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" ("SFAS 107") requires all entities to disclose the fair value of financial instruments, both assets and liabilities recognized and not recognized in the balance sheet, for which it is practicable to estimate fair value. The Company uses the following methods and assumptions in estimating its fair value disclosures for financial instruments:
COMMON TRUST SECURITIES - STATUTORY BUSINESS TRUSTS: Common trust securities are investments in related parties; as such it is not practical to estimate the fair value of these instruments. Accordingly, these amounts are reported using the equity method.
SHORT-TERM INVESTMENTS: The carrying values reported in the accompanying balance sheets for the financial instruments approximate their fair values.
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.
SUBORDINATED DEBENTURES: The carrying values reported in the accompanying balance sheets for these financial instruments approximate fair value. Fair value was estimated using projected cash flows, discounted at rates currently being offered for similar notes.
The following table shows the computation of the Company's earnings per share (in 000's, except shares and per share amounts):
PXRE holds an option agreement to purchase 599,400 common shares of the Company for $16.67 per share. See "Note 5. Reinsurance". These options are not included in the computation of diluted EPS because their effect would be antidilutive.
The insurance services segments direct commission revenue is from two issuing carriers. Each issuing carrier provides less than 10% of the Company's consolidated total revenues. Although this segment is dependent upon two issuing carriers, it is management's opinion that the loss of one or both can be remedied by replacement issuing carriers. There is no intercompany commission revenue in the insurance services segment.
Underwriting expenses in the insurance segment are net of expense reimbursements that are made by the insurance services segment pursuant to an expense sharing agreement between TRM and TICNY. In accordance with terms of this agreement, TRM reimburses TICNY for a portion of TICNY's underwriting and other expenses resulting from TRM's use of TICNY's personnel, facilities and equipment in underwriting insurance on behalf of TRM's issuing companies. The reimbursement for underwriting and other expenses is calculated as a minimum reimbursement of 5% of the premiums produced by TRM, and is adjustable according to the terms of the agreement based on the number of policies in force and additional expenses that may be incurred by TRM. The amount of this reimbursement was $2,876,000 in 2004, $2,247,000 in 2003 and $1,608,000 in 2002. TRM also reimburses TICNY, at cost, for claims administration expenses pursuant to the terms of this expense sharing agreement. Claims expenses reimbursed by TRM were $4,019,000 in 2004, $3,648,000 in 2003 and $4,399,000 in 2002.
The following table reconciles revenues by segment to consolidated revenue (in 000's):
On January 18, 2005 Tower Group, Inc. announced that it entered into a stock purchase agreement to acquire North American Lumber Insurance Company (NALIC), a shell company with active licenses in the following nine states: New Jersey, Connecticut, Massachusetts, Rhode Island, Vermont, Maryland, Delaware, South Carolina and Wisconsin. Tower Group, Inc. will pay $1,050,000 in cash at closing. An additional $75,000 per state will be paid within one year of the closing date contingent upon license reactivation in each of Pennsylvania and Maine.