We lease 118,500 square feet of space at 120 Broadway, New York, New York, which consists of the 30th and 31st floors and part of the 29th floor. While the lease for the majority of the space will expire in December, 2021, the lease for the 29th floor expires in 2012. We also lease space at 100 William Street, New York, New York. See “Note 16-Contingencies” in the notes to our audited consolidated financial statements included elsewhere in this report.
(2) The net loss ratio is calculated by dividing net losses and loss adjustment expenses by net premiums earned.
(4) The net combined ratio is the sum of the net loss ratio and the net underwriting expense ratio.
Tower, through its subsidiaries, offers a broad range of commercial, specialty and personal property and casualty insurance products and services to businesses in various industries and to individuals. We provide coverage for many different market sectors, including non-standard risks that do not fit the underwriting criteria of standard risk carriers due to factors such as type of business, location and premium per policy. We provide these products on both an admitted and excess and surplus (“E&S”) basis.
Subsequent to the acquisition of OBPL on July 1, 2010, the Company changed the presentation of its business results, by allocating the personal insurance business previously reported in the Brokerage Insurance segment along with the newly acquired
On November 2, 2010, Tower acquired the renewal rights to the commercial automobile liability and physical damage business of AequiCap (“AequiCap II”), an underwriting agency based in Fort Lauderdale, Florida. The business subject to the agreement covers both trucking and taxi risks that are consistent with Tower’s current underwriting guidelines. Most of the employees of AequiCap II involved in the servicing of this commercial liability and physical damage business became employees of the Company.
Net premiums earned. Premiums written include all policies produced in an accounting period. Premiums are earned over the term of the related policy. The portion of the premium that relates to the policy term that has not yet expired is included on the balance sheet as unearned premium to be earned in subsequent accounting periods. Premiums can be assumed from or ceded to reinsurers. Direct premiums combined with assumed premiums are referred to as gross premiums and subtracting premiums ceded to reinsurers results in net premiums.
Operating expenses. In our Commercial Insurance and Personal Insurance segments, we refer to the operating expenses that we incur to underwrite risks as underwriting expenses. These include direct and ceding commission expenses (payments to our producers for the premiums that they generate for us) and other underwriting expenses. In our Insurance Services segment, operating expenses consist of costs incurred to manage the Reciprocal Exchanges and other insurance service expenses.
Underwriting expense ratio. The gross underwriting expense ratio is the ratio of direct commission expenses and other underwriting expenses less policy billing fees to gross premiums earned. The gross 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 also calculate our underwriting expense ratio after the effect of ceded reinsurance. Ceding commission revenue is applied to reduce our underwriting expenses in our insurance company operation.
The following table provides a reconciliation of operating income to net income on a GAAP basis. The operating income is used to calculate operating earnings per share and operating return on average equity.
Our most critical accounting estimates involve the reporting of reserves for losses (including losses that have occurred but had not been reported by the financial statement date) and LAE, establishing fair value of losses and LAE for acquired businesses, net earned premiums, the reporting of ceding commissions earned, the amount and recoverability of reinsurance recoverable balances, deferred acquisition costs, investment impairments and potential impairments of goodwill and intangible assets.
This process helps management set carried loss reserves based upon the actuaries’ best estimates, using estimates made by segment, product or line of business, territory, and accident year. The actuaries also separately estimate loss reserves from LAE
Ceding commissions under a quota share reinsurance agreement are 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. The ultimate commission rate earned on our quota share reinsurance contracts is 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 LAE 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 estimated ceding commission income relating to prior years recorded in 2011, 2010, and 2009 was a decrease of $0.1 million, $2.7 million and $2.2 million, respectively. These decreases are attributed to prior year reserve development that was not initially anticipated.
Reinsurance recoverables. Reinsurance recoverable balances are established for the portion of paid and unpaid loss and LAE that is assumed by reinsurers. Prepaid reinsurance premiums represent unearned premiums that are ceded to reinsurers. Reinsurance recoverables and prepaid reinsurance premiums are reported on our balance sheet separately as assets, instead of 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 LAE reserves affect the estimates of the amount of ceded reinsurance recoverables. We continually monitor the financial condition and rating agency ratings of our reinsurers. Non-admitted 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 Regulation 114 or by providing a letter of credit. In addition, from October 2003 to December 31, 2005, we placed our quota share treaties on a “funds withheld” basis, under which we retained the ceded premiums written and placed that amount in segregated trust accounts from which we may withdraw amounts due to it from the reinsurers.
See “Business-Investments” and “Note 5 - Investments” in the notes to consolidated financial statements for additional detail regarding our investment portfolio at December 31, 2011, including disclosures regarding OTTI.
An impairment loss is recognized if the carrying value of an intangible asset or goodwill is not recoverable and its carrying amount exceeds its fair value. No impairment losses were recognized in 2011, 2010 and 2009. Significant changes in the factors we consider when evaluating our intangible assets and goodwill for impairment losses could result in a significant charge for impairment losses reported in our consolidated financial statements. See “Note 7 - Goodwill and Intangible Assets” in the notes to consolidated financial statements.
(1) Personal Insurance segment underwriting profit includes underwriting results of the Reciprocal Exchanges for the years ended December 31, 2011 and 2010.
(2) Insurance Services segment pretax income for the years ended December 31, 2011 and 2010 includes results related to Tower’s management services agreements with the Reciprocal Exchanges.
(4) The net underwriting expense ratios include fees paid by the Reciprocal Exchanges to Tower in excess of Tower’s direct costs to service the management services agreement. These fees increased the gross and net expense ratios by 0.6% and 1.0%, respectively, for the years ended December 31, 2011 and 2010.
(5) For the years ended December 31, 2011, 2010 and 2009, the after-tax impact of net realized investment gains offset by acquisition-related transaction costs, increased (lowered) return on average equity by 0.4%, 0.7% and (1.4)%, respectively.
Total revenues. Total revenues increased by 21.8% for the year ended December 31, 2011 as compared to 2010, primarily due to increased net premiums earned, net investment income and policy billing fees resulting from the acquisition of OBPL which was acquired on July 1, 2010 and was reflected in Tower’s consolidated results for twelve months in 2011 as compared to six months in 2010.
Premiums earned. Gross premiums earned for the years ended December 31, 2011 and 2010 were $1,789.8 million and $1,519.6 million, respectively, for an increase of 17.8%. This increase is primarily a result of OBPL and to a lesser extent the AequiCap II and Navigators renewal rights transactions and the customized solutions and assumed reinsurance initiatives. Ceded premiums earned declined $31.1 million to $195.9 million in 2011 from $227.0 million in 2010. Ceded premiums earned declined as Tower elected to cancel its liability quota share reinsurance treaty in 2011. This decrease was somewhat offset by the Company’s quota share reinsurance on the OBPL homeowners business, which was in effect for twelve months in 2011 as compared to six months in 2010.
Commission and fee income. Commission and fee income decreased by $0.4 million in the year ended December 31, 2011 as compared to the year ended December 31, 2010. This decrease is primarily attributed to the decline in ceding commission revenue on a liability quota share reinsurance treaty that was effective only in 2010, offset by an increase in policy billing fees and ceding commission revenues associated with the OBPL acquired business.
Net investment income and net realized gains (losses). Net investment income increased 20.3% in the year ended December 31, 2011 compared to 2010. The increase in net investment income resulted from an increase in average cash and invested assets for the year ended December 31, 2011 as compared to 2010. The increase in average cash and invested assets resulted primarily from $365.1 million of invested assets from the OBPL acquisition (reduced by cash to finance such acquisition) and from operating cash flows of $85.0 million generated in 2011. The positive cash flow from operations was the result of an increase in premiums collected from a growing book of business. The tax equivalent investment yield of our fixed maturity portfolio at amortized cost was 4.8 % and 4.7% at December 31, 2011 and 2010, respectively. Operating cash invested in fixed income securities in 2011 and in 2010 has been affected by a low yield environment. We increased investments in high-yield securities and dividend paying equity securities to reduce the impact of this low interest rate environment.
Excluding the Reciprocal Exchanges, the 2011 net loss and loss adjustment expenses included $74.3 million from claims related to severe weather related events, including first quarter of 2011 claims relating to heavy snow, Hurricane Irene in August 2011, and other severe winter storms and tornados that resulted in an unusual number of claims. Excluding these severe weather related events, the net loss ratio for Tower, excluding the Reciprocal Exchanges, would have been 62.3% for the year ended December 31, 2011.
Acquisition-related transaction costs. Acquisition-related transaction costs for the year ended December 31, 2010 were $2.4 million and relate to the acquisition of OBPL. These costs were negligible in 2011.
Interest expense. Interest expense increased by $9.9 million for the year ended December 31, 2011 compared to 2010. Interest expense increased mainly due to the issuance of $150 million of convertible senior notes in September 2010 and increased borrowings under the credit facility in 2011. Interest on funds withheld was $3.6 million in 2011 as compared to $2.7 million in 2010.
The decline in the effective tax rate from 2010 to 2011 is primarily attributed to (i) the increase in tax exempt interest income and dividend received deductions to $7.2 million in 2011 as compared to $4.9 million in 2010, and (ii) the decline in pre-tax income from 2010 to 2011. Also, the Company reduced the valuation allowance for the Reciprocal Exchanges in by $1.3 million in 2011, whereas no change to the valuation allowance was recorded in 2010.
Net investment income and net realized gains (losses). Net investment income increased 41.7% in the year ended December 31, 2010 compared to 2009. The increase in net investment income resulted from an increase in average cash and invested assets for the year ended December 31, 2010 that resulted primarily from invested assets acquired from OBPL and SUA. The tax equivalent investment yield at amortized cost was 4.7% at December 31, 2010 compared to 5.5% for 2009. Operating cash invested in 2009 and in 2010 has been affected by a low yield environment, as asset classes other than US Treasuries have experienced tightening spreads, the result of investors reaching for yield in a low interest rate environment. We have increased our investment in high-yield securities to partially reduce the impact of this low rate environment and in the fourth quarter of 2010. We made investments in dividend paying common equities starting in the fourth quarter of 2010, as a further strategy to mitigate the current low interest rate environment.
We had favorable loss development related to prior years of $12.3 million, comprised of unfavorable development of $19.8 million in the Commercial Insurance segment and favorable development of $32.1 million in the Personal Insurance segment, of which $9.9 million related to the Reciprocal Exchanges.
Operating expenses. Operating expenses were $497.7 million for the year ended December 31, 2010, an increase of 40.7% over the prior year, primarily as a result of the aforementioned acquisitions. Also contributing to the increase were investments in technology and restructuring, primarily in our Commercial Insurance segment, following the various acquisitions over the past eighteen months.
Acquisition-related transaction costs. Acquisition-related transaction costs for the year ended December 31, 2010 were $2.4 million and relate to the acquisition of OBPL. In the prior year, we recorded acquisition related transaction costs of $14.0 million, primarily related to the CastlePoint and SUA acquisitions.
Income tax expense. Income tax expense increased in 2010 compared to 2009. The increase in the income tax expense is attributable to the higher income before taxes in the current year, a higher effective tax rate in 2010 and an increase in state taxes from fee income associated with managing the Reciprocal Exchanges. The effective income tax rate (including state and local taxes) was 33.7% for the year ended December 31, 2010, compared to 31.6% for the same period in 2009. The gain on bargain purchase of SUA in 2009 decreased the effective tax rate in that year as this gain was not subject to tax.
Net income and return on average equity. Net income and annualized return on average equity were $ 103.9 million and 10.0% for the year ended December 31, 2010 compared to $96.8 million and 12.7% for the 2009. The decline in the annualized return on equity in 2010 is primarily due to the reduced earnings resulting from higher incurred loss and LAE, including the $17.5 million pre-tax charge for the northeast U.S. Storm occurring during March 13 to March 15, 2010. The return on average equity is calculated by dividing net income by average stockholders’ equity. Average stockholders’ equity was $1,039.1 million and $761.9 million at December 31, 2010 and 2009, respectively.
Premiums. Gross premiums written for the year ended December 31, 2011 were $1,225.3 million as compared to $1,083.9 million during the same period in 2010. The increase of $141.4 million is primarily attributed to our new initiatives with customized solutions and assumed reinsurance which accounted for growth of $85.7 million and $72.8 million in 2011 compared to 2010, respectively.
Ceded premiums written for the year ended December 31, 2011 were $73.0 million compared to $96.6 million for the year ended December 31, 2010. The decrease in ceded premiums written resulted from our decision to not renew our liability quota share reinsurance treaty which was in effect in 2010. In addition, we reduced the ceded premiums for our excess of loss reinsurance by raising our retention from $1.5 million to $5.0 million on all lines of business except workers’ compensation on which our retention was raised from $1.5 million to $2.5 million. The company also purchased catastrophe reinsurance for all property lines.
The increases in net premiums written and earned are attributed to both the increase in gross written premiums and decline in ceded written premiums, as discussed above.
Ceding commission revenue. Ceding commission revenue decreased for the year ended December 31, 2011 by $17.2 million compared to 2010. The decrease was a result of the non-renewal of our liability quota share contract.
Underwriting expenses and underwriting expense ratio. Underwriting expenses, which include direct commissions and other underwriting expenses, increased by $15.2 million, or 4.4%, for the year ended December 31, 2011 as compared to the 2010. The net underwriting expense ratio improved 1.6 percentage points from 2010 to 2011.
Premiums. Gross premium written for the year ended December 31, 2010 were $1,083.8 million compared to $884.7 million in 2009. The increase in gross premiums written was primarily the result of the acquisitions of CastlePoint and Hermitage in February 2009 and the acquisition of SUA in November 2009.
Ceded premiums written for the year ended December 31, 2010 were $96.6 million compared to $153.8 million for the year ended December 31, 2009. The decrease in ceded premiums written resulted from our decision to lower the ceded percentage on our liability quota share reinsurance treaty during 2010.
Catastrophe reinsurance ceded premiums were $11.4 million for the years ended December 31, 2010 and 2009. Catastrophe costs remained flat because there were no significant changes in commercial property exposure that we reinsure.
Loss and loss adjustment expenses and loss ratio. Our gross and net loss ratios increased by 6.7 points and 7.5 points, respectively, from 2009 to 2010. The loss ratios increased mostly as a result of more competitive market conditions and revised estimates of losses from prior years. These increases were partially offset by improvements in loss adjustment expenses impacting both ALAE and ULAE as well as by amortization of reserves risk premiums that were established in connection with fair value accounting for acquisitions made in 2009.
The other underwriting expense (“OUE”) ratio, including BB&T, was 13.9% for the year ended December 31, 2010 compared to 12.7% for 2009. This increase is attributed to: (i) the increase in gross premiums written which impact our BB&T; (ii) our investment in technology and overall integration efforts have increased due to the previously mentioned acquisitions over the past eighteen months that were mainly commercial lines focused; and (iii) compensation-related costs of $2.9 million were incurred in connection with staff reductions related to ongoing restructuring and closing of certain offices associated with acquired businesses.
Ceded premiums written for the year ended December 31, 2011 were $99.4 million, an increase of $13.7 million as compared to $85.7 million in 2010. The Company reinsures the homeowners and umbrella business obtained from OBPL through a quota share program. The Company also purchased catastrophe reinsurance for certain property business. The increase in ceded premiums written is due to the increase in gross premiums written associated with the OBPL acquisition
Net loss and loss adjustment expenses. Our net loss and loss adjustment expense ratio for 2011 compared to 2010 increased by 7.6 percentage points to 63.0% and, excluding the Reciprocal Exchanges, increased by 15.8 points to 67.2%.
The favorable development in Personal Insurance, excluding the Reciprocal Exchanges, of $29.1 million was comprised primarily of $22.2 million for private passenger automobile liability, $13.1 million for homeowners and $1.9 million for amortization of reserves risk premium, principally relating to reserves acquired in the OBPL transaction developing more favorably than anticipated at the time of the acquisition, offset by unfavorable development of $4.2 million in discontinued personal lines business, $3.1 million in involuntary plans and $0.8 million in other lines.
The Reciprocal Exchanges loss ratio included $6.5 million from winter storms and property catastrophes that amounted to 3.5 loss ratio percentage points. Excluding these storms the loss ratio would have been 52.3% in 2011.
The gross underwriting expense ratio improved to 36.0% in 2011 from 36.8% in 2010. The commission portion of the gross underwriting expense ratio was 16.6% and 17.7% for years ended December 31, 2011 and 2010, respectively. The improvement in the commission ratio reflects the impact of lower commission rates in the Reciprocal Exchanges. The gross OUE ratio, which includes BB&T, was 19.4% and 19.1% for the years ended December 31, 2011 and 2010, respectively. The costs of the transition services agreements with OneBeacon have the effect of increasing the gross OUE ratios.
Prior year losses developed favorably by $32.1 million, comprised of $22.3 million favorable development in our stock companies and $9.9 million favorable development in the Reciprocal Exchanges. For the OBPL business we recorded favorable development that we experienced relative to expected patterns only for the third and fourth quarters of 2010 after our acquisition of this business.
Underwriting expenses. Underwriting expenses increased by $102.4 million for the year ended December 31, 2010 as compared to 2009. This increase is related predominantly to the OBPL acquisition. The net underwriting expense ratio improved 1.6 percentage points from 44.1% in 2009 to 42.5% in 2010.
The gross underwriting expense ratio for 2010 was 36.8%, as compared to 35.3% in 2009. The commission portion of the gross underwriting expense ratio was 17.7%, compared to 18.1% for the prior year. The improvement in the commission ratio reflects the impact of lower commission rates in the Reciprocal Exchanges. The gross OUE ratio, including BB&T, was 19.1% compared with 17.2% in 2009. The increase in the OUE expense ratio relates primarily to increases in expenses attributed to OBPL, including the transition service agreements Tower entered into with OneBeacon whereby OneBeacon will provide certain information technology and operational support to Tower.
Underwriting profit and combined ratio. The net combined ratio for the Personal Insurance segment was 97.9% in 2010, 5.3 points better than prior year. Underwriting income of $7.5 million was $11.1 million better than 2009 and was largely driven by the addition of the OBPL business. Changes in combined ratio reflect the changes in the loss ratio and the expense ratio for reasons described above.
Total revenue. The increase in total revenue for the year ended December 31, 2010 compared to 2009 was primarily due to the management fee income earned by Tower for underwriting, claims, investment management and other services provided to the Reciprocal Exchanges pursuant to a management services agreement with the Reciprocal Exchanges. The management fee income is calculated as a percentage of the Reciprocal Exchanges’ gross written premiums of $126.8 million in 2010. The increase in management fee income was offset by modest declines in revenue generated from our managing general agencies.
Total expenses. The increase in total expenses for the year ended December 31, 2010 compared to 2009 was primarily due to the costs incurred under the management services agreements between Tower and the Reciprocal Exchanges.
The following table presents a breakdown of the amortized cost, aggregate fair value and unrealized gains and losses by investment type as of December 31, 2011 and December 31, 2010:
The average credit rating of our fixed-maturity securities, using ratings assigned to securities by Standard & Poor’s, was A+ at December 31, 2011 and December 31, 2010. The following table shows the ratings distribution of our fixed-maturity portfolio:
At December 31, 2011, $237.9 million of our municipal bonds, at fair value, were guaranteed by third parties from a total of $2.5 billion, at fair value, of all fixed-maturity securities held by us. The amount of securities guaranteed by third parties along with the credit rating with and without the guarantee is as follows:
Our process to validate the market prices obtained from the outside pricing sources includes, but is not limited to, periodic evaluation of model pricing methodologies and analytical reviews of certain prices. We also periodically perform testing of the market to determine trading activity, or lack of trading activity, as well as market prices. Several securities sold during the quarter were “back-tested” (i.e., the sales price is compared to the previous month end reported market price to determine reasonableness of the reported market price).
In certain instances, we deemed it necessary to utilize Level 3 pricing over prices available through pricing services used throughout 2011 and 2010. The ability to observe stable prices and inputs may be reduced for highly-customized an illiquid instruments as currently is the case for certain non-agency residential and commercial mortgage-backed securities and asset-backed securities.
The following table presents information regarding our invested assets that were in an unrealized loss position at December 31, 2011 and December 31, 2010 by amount of time in a continuous unrealized loss position:
The following table stratifies the gross unrealized losses in the portfolio at December 31, 2011, by duration in a loss position and magnitude of the loss as a percentage of the cost or amortized cost of the security:
The following table shows the number of securities, fair value, unrealized loss amount and percentage below amortized cost and the ratio of fair value by security rating as of December 31, 2011:
The following tables show the fair value and unrealized loss by sector and credit quality rating of our corporate and other bonds in an unrealized loss position at December 31, 2011:
The following tables show the fair value and unrealized loss by credit quality rating and deal origination year of our commercial mortgage-backed, non-agency residential mortgage-backed and asset-backed securities in an unrealized loss position at December 31, 2011:
Tower Insurance Company of New York (“TICNY”) is the Company’s largest insurance subsidiary. Under New York law, TICNY is limited to paying dividends to the Holding Company only from 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 annual 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 declared $15.0 million, $4.7 million and $2.0 million in dividends to the Holding Company in 2011, 2010 and 2009, respectively.
The other insurance subsidiaries are subject to similar restrictions, usually related to policyholders’ surplus, unassigned surplus or net income and notice requirements of their domiciliary state. As of December 31, 2011, the amount of distributions that our insurance subsidiaries could pay to Tower without approval of their domiciliary Insurance Departments was $29.3 million. In addition, we can return capital of $61.0 million from CastlePoint Re without permission from the Bermuda Monetary Authority.
The following table summarizes information about contractual obligations and commercial commitments. The minimum payments under these agreements as of December 31, 2011 were as follows:
We do not consolidate the statutory business trusts for which we hold 100% of the common trust securities because we are not the primary beneficiary of the trusts. Our investments in common trust securities of the statutory business trusts are reported in Other Assets. We report as a liability the outstanding subordinated debentures issued to the statutory business trusts.
In October 2010, the Company effected interest rate swap contracts with $190 million notional on the subordinated debentures. Certain of these subordinated debentures are currently paying a variable interest rate and other subordinated debentures will convert to variable rates over the next year. The interest rate swaps will fix the variable interest payments on the subordinated debentures to rates from 5.1% to 5.9%. The interest rate swaps mature in 2015.
For a discussion of our loss and LAE reserving process, see “Critical Accounting Policies-Loss and LAE Reserves.” Actual payments of losses 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 “Risk Factors-Risks Related to Our Business-If our actual loss and loss adjustment expense reserves exceed our loss and loss adjustment expense reserves, our financial condition and results of operations could be significantly adversely affected,” for a discussion of the uncertainties associated with estimating loss and LAE expense reserves. The estimated ceded reserves recoverable referred to above also assumes timely reimbursement from our reinsurers. If our reinsurers do not meet their contractual obligations on a timely basis, the payment assumptions presented above could vary materially.
As part of Tower’s capital management strategy, the Board of Directors of Tower approved a $100 million share repurchase program on March 3, 2011. This authorization is in addition to the $100 million share repurchase program approved on February 26, 2010. Purchases under both programs can be made from time to time in the open market or in privately negotiated transactions in accordance with applicable laws and regulations. The new share repurchase program will expire on March 4, 2013. The timing and amount of purchases under the programs depend on a variety of factors, including the trading price of the stock, market conditions and corporate and regulatory considerations. For the year ended December 31, 2011, 2.9 million shares of common stock were purchased under this program at an aggregate consideration of $64.6 million. In the year ended December 31, 2010, 4.0 million shares were purchased under this program at an aggregate consideration of $88.0 million. As of December 31, 2011, $47.4 million remained available for future share repurchases under the new program.
The reconciliation of net income to cash provided from operations is generally influenced by the collection of premiums in advance of paid losses, the timing of reinsurance, issuing company settlements and loss payments.
Net cash flows used in investing activities were $107.2 million for the year ended December 31, 2011 compared to $260.1 million used for the year ended December 31, 2010. The year ended December 31, 2011 and 2010 included an increase to fixed assets of $53.6 million and $36.9 million, respectively, primarily related to the build out of new systems. The additional cash outflows in 2010 related to the purchase of OBPL on July 1, 2010. The remaining cash flows in both years relates to purchases and sales of fixed-maturity and equity securities.
Cash flow needs at the holding company level are primarily for dividends to our stockholders, interest and principal payments on our outstanding debt and payments under the credit facility.
For the year ended December 31, 2010, net cash provided by operating activities was $197.0 million as compared to $214.7 million for 2009. The decrease in cash flow for the year ended December 31, 2010 primarily resulted from increased claims payments offset by reductions in cash paid for income taxes attributed to 2009 tax overpayments and increased tax deductions in 2010 relating to capital losses from the sale of certain fixed income securities.
The insurance subsidiaries maintain sufficient liquidity to pay claims, operating expenses and meet other obligations. We held $114.1 million and $140.2 million of cash and cash equivalents at December 31, 2011 and 2010, respectively. We monitor the expected claims payment needs and maintain a sufficient portion of our invested assets in cash and cash equivalents to enable us to fund the claims payments without having to sell longer-duration investments. As necessary, we adjust the holdings of short-term investments and cash and cash equivalents to provide sufficient liquidity to respond to changes in the anticipated pattern of claims payments. See “Business-Investments.”
Property and casualty loss and loss adjustment expense reserves 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 loss and LAE reserves. Inflation in excess of the levels we have assumed could cause loss and LAE expenses to be higher than we anticipated.
Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2011, 2010, and 2009
To the Board of Directors and Stockholders of Tower Group, Inc,
As discussed in Note 2 to the consolidated financial statements, the Company changed the manner in which it accounts for the costs associated with acquiring or renewing insurance contracts in 2011.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash flows for the year ended December 31, 2009 of Tower Group, Inc., in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedules for the year ended December 31, 2009, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
Tower Group, Inc. (the “Company” or “Tower”) offers a broad range of commercial, specialty and personal property and casualty insurance products and services through its subsidiaries to businesses in various industries and to individuals. The Company’s common stock is publicly traded on the NASDAQ Global Select Market under the symbol “TWGP”.
Commercial Insurance (“Commercial”) Segment offers a broad range of commercial lines property and casualty insurance products to businesses distributed through a network of retail and wholesale agents and program underwriting agents on both an admitted and non-admitted basis. This segment also includes assumed reinsurance;
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Cash amounts presented on the consolidated balance sheet at December 31, 2010 and the consolidated statements of cash flows for the year ended December 31, 2010 have been revised to present book overdrafts representing outstanding checks in excess of funds on deposit with individual financial institutions within other liabilities. These balances have previously been reported in cash and cash equivalents. This revision increased cash and cash equivalents and other liabilities by $37.3 million as of December 31, 2010 and net cash flows provided by operations by $27.0 million for the year ended December 31, 2010.
Management estimates uncollectible amounts receivable from reinsurers based on an assessment of a number of factors. The Company recorded no allowance for uncollectible reinsurance at December 31, 2011 or 2010. The Company did not write-off balances from reinsurers during the three year period ended December 31, 2011.
The Company primarily uses outside pricing services to assist in determining fair values. For investments in active markets, the Company uses the quoted market prices provided by the outside pricing services to determine fair value. In circumstances where quoted market prices are unavailable, the pricing services utilize fair value estimates based upon other observable inputs including matrix pricing, benchmark interest rates, market comparables and other relevant inputs.
The Company retrospectively adopted new accounting guidance for deferred acquisition costs effective January 1, 2011 as described in more detail under “Accounting Guidance Adopted in 2011” below. Acquisition costs represent the costs of writing business that vary with, and are primarily related to, the successful production of insurance business (principally commissions, premium taxes and certain underwriting costs). Policy acquisition costs are deferred and recognized as expense as related premiums are earned. Deferred acquisition costs (“DAC”) presented in the balance sheet are net of deferred ceding commission revenue.
The value of business acquired (“VOBA”) is an intangible asset relating to the estimated fair value of the unexpired insurance policies acquired in a business combination. VOBA is determined at the time of a business combination and is reported on the consolidated balance sheet with DAC and is amortized in proportion to the timing of the estimated underwriting profit associated with the in force policies acquired. The Company considers anticipated investment income in determining the recoverability of these costs and believes they are fully recoverable. See “Note 8 - Deferred Acquisition Costs” for additional information regarding deferred acquisition costs.
Furniture, leasehold improvements, computer equipment, and software, including internally developed software, are reported at cost less accumulated depreciation and amortization. Gross fixed assets were $176.4 million and $174.4 million as of December 31, 2011 and 2010, respectively. Capitalized leases of $41.0 million were included in this amount as at December 31, 2011. Accumulated depreciation and amortization of $56.5 million and $86.0 million were recorded as of December 31, 2011 and 2010, respectively. Depreciation and amortization is provided using the straight-line method over the estimated useful lives of the assets. The Company estimates the useful life for computer equipment to be three years, computer software, three to seven years, furniture and other equipment seven years and leasehold improvements is the term of the lease. Depreciation and amortization expense of $22.0 million, $15.0 million and $13.3 million were recorded for the years ended December 31, 2011, 2010 and 2009, respectively. Fixed assets are recorded in Other Assets on the balance sheet.
The Company accounts for the treasury stock at the repurchase price as a reduction to stockholders’ equity as it does not currently intend to retire the treasury stock held at December 31, 2011.
Our largest agent accounted for 10%, 12% and 4%, respectively, of the insurance subsidiaries’ premiums receivable balances at December 31, 2011, 2010 and 2009. Our largest agent accounted for 7%, 4% and 10% of the insurance subsidiaries’ direct premiums written in 2011, 2010 and 2009, respectively.
In June 2011 (and as amended in December 2011), the FASB issued new guidance concerning the presentation of comprehensive income. This guidance will be effective for annual and interim periods beginning after December 15, 2011. The Company is currently assessing how it will present comprehensive income under the new guidance.
In September 2011, the FASB issued amended guidance on testing goodwill for impairment. This guidance will be effective for annual periods beginning after December 15, 2011 and is intended to reduce the cost and complexity of the annual goodwill impairment test by allowing an entity to utilize more qualitative factors. This guidance will not affect the Company’s financial position, result of operations or cash flows.
On January 14, 2011, Tower obtained the renewal rights to the middle market commercial package and commercial automobile business underwritten through the NAV PAC division of Navigators Group, Inc. This business will allow us to continue to expand our middle market commercial product offering into certain niche classes of business. The underwriting personnel from Navigators became part of our recently formed Customized Solutions business unit focused on developing customized products for our key partner agents.
On November 2, 2010, Tower acquired the renewal rights to the commercial automobile liability and physical damage business of AequiCap for $12 million (“AequiCap II”). The business subject to the agreement covers both trucking and taxi risks that are consistent with Tower’s current underwriting guidelines. Most of the employees of AequiCap II involved in the servicing of this commercial liability and physical damage business became employees of the Company. The acquisition was accounted for as a business combination under GAAP. The distribution network was the only identifiable asset acquired and had a fair value of $11.3 million. No liabilities were assumed. $0.7 million of goodwill was recorded as a result of this transaction.
Direct costs of the acquisition are accounted for separately from the business combination and are expensed as incurred.
The acquisition was accounted for using the purchase method in accordance with GAAP guidance on business combinations. Under the terms of the Agreement, the Company acquired AequiCap I for $5.5 million in cash. The distribution network was the only identifiable intangible asset acquired. The fair value the distribution network was $5.3 million and the fair value of other assets acquired was $0.1 million resulting in $0.1 million of goodwill.
Hermitage, a property and casualty insurance holding company, was acquired in 2009 for $130.1 million in cash. This transaction further expanded the wholesale distribution system nationally and established a network of retail agents in the Southeast.
In addition, Tower holds the surplus notes issued by the Reciprocal Exchanges when they were originally capitalized. The obligation to repay principal and interest on the surplus notes is subordinated to the Reciprocal Exchanges’ other liabilities including obligations to policyholders and claimants for benefits under insurance policies. Principal and interest on the surplus notes are payable only with regulatory approval. The Company has no ownership interest in the Reciprocal Exchanges.
The cost or amortized cost and fair value of the Company’s investments in fixed maturity and equity securities, gross unrealized gains and losses, and other-than-temporary impairment losses as of December 31, 2011 and December 31, 2010 are summarized as follows:
In addition, the Company had $340.8 million and $261.1 million of investments as of December 31, 2011 and 2010, respectively, held by counterparties as collateral or in trusts to support letter of credit issued on Tower’s behalf, reinsurance liabilities on certain assumed reinsurance treaties, and collateral posted for certain leases.
Management, in conjunction with its outside portfolio managers, analyzes its non-agency residential mortgage-backed securities (“RMBS”) using default loss models based on the performance of the underlying loans. Performance metrics include delinquencies, defaults, foreclosures, anticipated cash flow prepayments and cumulative losses incurred. The expected losses for a mortgage pool are compared to the break-even loss, which represents the point at which the Company’s tranche begins to experience losses.
The commercial mortgage-backed securities (“CMBS”) holdings are evaluated using analytical techniques and various metrics including the level of subordination, debt-service-coverage ratios, loan-to-value ratios, delinquencies, defaults and foreclosures.
In estimating the recovery value, significant judgment is involved in the development of assumptions relating to a number of factors related to the issuer including, but not limited to, revenue, margin and earnings projections, the likely market or liquidation values of assets, potential additional debt to be incurred pre- or post- bankruptcy/restructuring, the ability to shift existing or new debt to different priority layers, the amount of restructuring/bankruptcy expenses, the size and priority of unfunded pension obligations, litigation or other contingent claims, the treatment of intercompany claims and the likely outcome with respect to inter-creditor conflicts.
For all fixed-maturity securities in an unrealized loss position at December 31, 2011, the Company has received all contractual interest payments (and principal if applicable). Based on the continuing receipt of cash flow and the foregoing analyses, management expects continued timely payments of principal and interest and considers the losses to be temporary.
The following table presents information regarding invested assets that were in an unrealized loss position at December 31, 2011 and December 31, 2010 by amount of time in a continuous unrealized loss position:
The following table shows the composition of the other invested assets as of December 31, 2011 (the Company had no other invested assets in 2010):
GAAP establishes a three-level hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the assets or liabilities fall within different levels of the hierarchy, the classification is based on the lowest level input that is significant to the fair value measurement of the asset or liability. Classification of assets and liabilities within the hierarchy considers the markets in which the assets and liabilities are traded, including during periods of market disruption, and the reliability and transparency of the assumptions used to determine fair value. The hierarchy requires the use of observable market data when available. The levels of the hierarchy are as follows:
Level 1 - Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities traded in active markets. Included are those equity securities that are traded on active exchanges, such as the NASDAQ Global Select Market.
As at December 31, 2011 and 2010, the Company’s financial instruments carried at fair value are allocated among levels as follows:
(1) $25,000 of the Other invested assets balance is reported at fair value. $19,347 of Other invested assets is reported under the equity method of accounting or at amortized cost.
Substantially all of the portfolio valuations at December 31, 2011 classified as Level 1 or Level 2 in the above table is priced by utilizing the services of several independent pricing services that provide the Company with a price quote for each security. There were no adjustments made to the prices obtained from the independent pricing sources and dealers on securities classified as Level 1 or Level 2.
In 2011, there were no transfers of investments between Level 1 and Level 2. Approximately $1.0 million of securities were transferred from Level 3 to Level 2 when quoted market prices for similar securities that were considered reliable and could be validated against an alternative source became available in 2011.
In December 2011, the Company purchased two securities, classified in other invested assets. For the fair value measurement, Management believes that its purchase price in December is a reasonable expectation of a price it would receive from a third-party market participant. Accordingly, this purchase price is used as the fair value estimate.
Goodwill is calculated as the excess of purchase price over the net fair value of assets acquired. See Note 3 - “Acquisitions” for information regarding the calculation of goodwill related to the recent acquisitions. The following is a summary of goodwill by reporting units:
The Company determined that none of the goodwill related to the acquisition of OBPL and AequiCap II is deductible for tax purposes.
The components of intangible assets and their useful lives, accumulated amortization, and net carrying value as of December 31, 2011 and 2010 are as follows:
Acquisition costs incurred and policy-related ceding commission revenue are deferred and amortized to income on property and casualty business for the year ended December 31, 2011, 2010 and 2009 as follows:
The Company also purchases property catastrophe reinsurance on an excess of loss basis above a specified retention to protect itself from an accumulation of losses resulting from a catastrophic event. At the July 1, 2011 renewal of its property catastrophe program, the Company maintained a retention of $75 million per catastrophe, had 60% catastrophe protection for the next $50 million of loss above the $75 million, and 100% percent catastrophe protection for the next $775 million of loss in excess of $125 million.
In 2010, Tower had reinsurance coverage, on a per policy basis, of $30 million for property risks, $5.0 million for liability coverage, $50 million for workers’ compensation risk, $5 million for umbrella coverage and $100 million for equipment breakdown. “Clash coverage” for 2010 was for coverage of $5 million in excess of $5 million. The 2010 quota share treaties included a liability quota share ceding certain liability coverage written by Tower and the homeowners quota share treaty ceding 30% of the homeowners business written by the companies obtained in the OBPL transaction. The property catastrophe program renewed on July 1, 2010 had a retention of $75 million per catastrophe, had 50% catastrophe protection for the next $50 million of loss above the $75 million, and 100% percent catastrophe protection for the next $650 million of loss in excess of $125 million.
The Company maintains funds held liabilities under the liability quota share reinsurance agreements written in 2010 and prior years and is required to credit interest to the reinsurers with annual effective yields ranging from 2.5% to 4.0% on the monthly balance in the funds held liability accounts. The amounts credited for 2011, 2010 and 2009 were $3.6 million, $2.7 million and $0.7 million, respectively, and have been recorded as interest expense.
The Reciprocal Exchanges are not party to the reinsurance agreements discussed above, except for the homeowners quota share treaty whereby they cede 30% of homeowners business written. The Reciprocal Exchanges were covered under this treaty in both 2011 and 2010. The Reciprocal Exchanges are also protected under a property catastrophe reinsurance cover placed on an excess of loss basis. In 2011 and 2010, this coverage was for 100% of $150 million in excess of a $10 million retention.
Under certain reinsurance agreements, collateral and letters of credit (“collateral”) are held to secure performance of reinsurers in meeting their obligations. The amount of such collateral was $161.9 million and $153.6 million at December 31, 2011 and 2010, respectively. The collateral we hold does not apply to our entire outstanding reinsurance recoverable. Rather, collateral is provided on an individual basis. For each individual reinsurer, the collateral held may exceed or fall below the total outstanding recoverable from that individual reinsurer.
As of December 31, 2011, the Company’s estimated ultimate loss ratios attributable to these contracts 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 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 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 (decrease) in estimated ceding commission income relating to prior years recorded in 2011, 2010 and 2009 was $(0.1) million, ($2.7) million and ($2.2) million, respectively.
The components of the liability for loss and LAE expenses and related reinsurance recoverables for the years ended December 31, 2011 and 2010 are as follows:
Incurred losses and LAE for the year ended December 31, 2011, attributable to insured events of prior years decreased by $20.8 million. Excluding the Reciprocal Exchanges the incurred losses and LAE increased by $17.0 million
The consolidated net loss ratio, which includes the Reciprocal Exchanges, was 66.2% and 60.7% for the years ended December 31, 2011 and 2010, respectively. Excluding the Reciprocal Exchanges, the net loss ratio was 67.6% and 60.2% for the years ended December 31, 2011 and 2010, respectively. The Reciprocal Exchanges’ net loss ratio was 55.8% and 66.3% for the years ended December 31, 2011 and 2010, respectively.
Excluding the Reciprocal Exchanges, the 2011 net loss and loss adjustment expenses included $74.3 million from claims related to severe weather related events, including first quarter 2011 claims relating to heavy snow, Hurricane Irene in August 2011, and other severe winter storms and tornados that resulted in an unusual number of claims.
Excluding the Reciprocal Exchanges, there was net adverse loss development of $17.0 million for the year ended December 31, 2011 comprised of favorable development in Personal Insurance of $29.1 million and unfavorable development in Commercial Insurance of $46.1 million.
The net unfavorable development in Commercial Insurance included $26.4 million for other liability, $30.5 million for workers compensation, and $7.9 million for commercial automobile. This was offset in part by favorable development on commercial packages and monoline property totaling $6.4 million, by favorable development in CPRE of $10.4 million, and $1.9 million for amortization of reserves risk premium that was established in 2009 as part of fair value accounting for the acquisitions made that year. The favorable development in Personal Insurance, was comprised primarily of $22.2 million for private passenger automobile liability, $13.1 million for homeowners and $1.9 million for amortization of reserves risk premium, principally relating to reserves acquired in the OBPL transaction developing more favorably than anticipated at the time of the acquisition, offset by unfavorable development of $4.2 million in discontinued personal lines business, $3.1 million in involuntary plans and $0.8 million in other lines.
For the Reciprocal Exchanges, the favorable development was $37.8 million, comprised of favorable development of $29.0 million for private passenger automobile liability, $7.6 million for homeowners and other lines, and $1.2 million for amortization of reserves risk premium.
Incurred losses and LAE for the years ended December 31, 2011 and 2010 included reductions in loss and loss expense reserves pertaining to the amortization of the reserve risk premium on loss reserves recorded in connection with the Company’s acquisitions in prior years. Excluding the Reciprocal Exchanges these reductions in loss reserves were $3.7 million and $4.3 million, respectively, for 2011 and 2010. The Reciprocal Exchanges had reductions in loss reserves of $1.2 million and $0.7 million, respectively, for 2011 and 2010.
Included in the reserves for the loss and LAE reserves at December 31, 2011 and 2010 is $3.7 million and $3.7 million, respectively, of tabular reserve discount for workers’ compensation and excess workers’ compensation claims.
As of December 31, 2011 and 2010, the Company had a remaining $9.7 million and $14.6 million, respectively, of reserve risk premium on loss reserves recorded in the purchase accounting for previous acquisitions. Excluding the Reciprocal Exchanges, the reserve risk premium was $7.2 million and $10.9 million at December 31, 2011 and 2010, respectively
In connection with the acquisition of CastlePoint in 2009, 16.9 million shares were issued to the shareholders of CastlePoint increasing Common Stock by $169,000 and Paid-in Capital by $421.5 million.
For the years ended December 31, 2011 and 2010, 34,612 and 242,169 new common shares, respectively, were issued as the result of employee stock option exercises and 654,180 and 355,539 new common shares, for the same periods, respectively, were issued as the result of restricted stock grants.
For the years ended December 31, 2011 and 2010, 78,732 and 77,670 shares, respectively, of common stock were purchased from employees in connection with the vesting of restricted stock issued under the 2004 Long Term Equity Compensation Plan (the “Plan”). The shares were withheld at the direction of employees as permitted under the Plan in order to pay the expected amount of tax liability owed by the employees from the vesting of those shares. In addition, for the years ended December 31, 2011 and 2010, 18,841 and 28,833 shares, respectively, of common stock were surrendered as a result of restricted stock forfeitures.
The Board of Directors of Tower approved a $100 million share repurchase program on March 3, 2011. This authorization is in addition to the $100 million share repurchase program approved on February 26, 2010. Purchases under both programs can be made from time to time in the open market or in privately negotiated transactions in accordance with applicable laws and regulations. The new share repurchase program will expire on March 4, 2013. In the year ended December 31, 2011, 2.9 million shares of common stock were purchased under these programs at an aggregate consideration of $64.6 million. In the year ended December 31, 2010, 4.0 million shares were purchased under these programs at an aggregate consideration of $88.0 million. As of December 31, 2011, the original $100 million share purchase program had been fully utilized and $47.4 million remained available for future share repurchases under the new program.
In October 2010, the Company entered into interest rate swap contracts (the “Swaps”) with $190 million notional value to manage interest costs and cash flows associated with the floating rate subordinated debentures. The Swaps have terms of five years. The majority of the Swaps is forward starting and become effective when the respective subordinated debentures change from fixed rates to floating rates and convert the subordinated debentures’ to rates ranging from 5.1% to 5.9%. As of December 31, 2011, the Swaps had a fair value of $7.4 million in a liability position and are reported in Other Liabilities. As of December 31, 2010, the Swaps had a fair value of $3.2 million in an asset position and are reported in Other Assets.
The Company has designated and accounts for the Swaps as cash flow hedges. The Swaps are considered to have no ineffectiveness and changes in their fair values will be recorded in Accumulated Other Comprehensive Income (“AOCI”), net of tax. For the year ended December 31, 2011 and 2010, $0.4 million and $18,000, respectively, was reclassified from AOCI to interest expense for the effects of the hedges. As of December 31, 2011, the Company had collateral on deposit with the counterparty amounting to $7.0 million pursuant to its Credit Support Annex.
The Company had $50.0 million outstanding as of December 31, 2011. The Company had no balance outstanding as of December 31, 2010. The weighted average interest rate on the amount outstanding as of December 31, 2011 was 3.5%.
In September 2010, the Company issued $150.0 million principal amount of 5.0% convertible senior notes (“the Notes”), which mature on September 15, 2014. Interest on the Notes is payable semi-annually in arrears on March 15 and September 15 of each year, commencing March 15, 2011. Holders may convert their Notes into cash or common shares, at the Company’s option, at any time on or after March 15, 2014 or earlier under certain circumstances determined by: (i) the market price of the Company’s stock, (ii) the trading price of the Notes, or (iii) the occurrence of specified corporate transactions. Upon conversion, the Company intends to settle its obligation either entirely or partially in cash. The conversion rate at December 31, 2011 is 36.6865 shares of common stock per $1,000 principal amount of the Notes (equivalent to a conversion price of $27.26 per share), subject to adjustment upon the occurrence of certain events. Additionally, in the event of a fundamental change, the holders may require the Company to repurchase the Notes for a cash price equal to 100% of the principal plus any accrued and unpaid interest.
The following table shows the amounts recorded for the Notes as of December 31, 2011:
financial institutions. The Note Hedges and Warrants are intended generally to reduce the potential dilution of the Company’s common stock and to offset potential cash payments in excess of the principal of the Notes upon conversion. The Note Hedges and Warrants are separate transactions, entered into by the Company with the financial institutions, and are not part of the terms of the Notes.
In September 2010, the Company paid $15.3 million for the Note Hedges which cover 5.5 million shares of common stock at a strike price of $27.26 per share at December 31, 2011, subject to anti-dilution provisions, and are exercisable upon conversion of the Notes. The Note Hedges have been accounted for as an adjustment to the Company’s paid-in-capital, net of deferred taxes.
To the extent the Company’s common stock price is above $27.26 but below the Warrant strike price of $33.14, there is no dilutive effect to common stockholders’ equity because the Note Hedge offsets any shares to be issued under the Notes. If the market value per share of the Company’s common stock exceeds the strike price of the Warrants, the Warrants will have a dilutive effect on the Company’s net income per share.
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 amount of share-based awards authorized is 2,325,446 of which 578,395 are available for future grants as of December 31, 2011.
The following table provides an analysis of restricted stock activity for the years ended December 31, 2011, 2010 and 2009:
The options granted for acquisitions in 2009 were originally issued to employees or directors of CastlePoint on four grant dates and were converted into options to acquire shares of the Company’s common stock upon the acquisition of CastlePoint. Also included in options granted for acquisition in 2009 were stock options that were originally issued to employees of SUA on seven grant dates and were converted into options to acquire shares of the Company’s common stock upon the acquisition of SUA.
The following table provides an analysis of stock based compensation expense for the years ended December 31, 2011, 2010 and 2009:
The Company’s current Federal income tax benefit for the year ended December 31, 2010 includes a refund from prior year overpayments and benefits from the acceleration of depreciation for fixed assets placed in service after September 8, 2010 as allowed by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.
Preserver Group, Inc. (“PGI”), acquired by the Company in 2007 and CastlePoint , acquired in 2009, have net operating tax loss carryforwards (“NOLs”) that the Company expects will be used in the future, subject to change of ownership limitations pursuant to Section 382 of the Internal Revenue Code (“Section 382”). As of December 31, 2011, the Tower NOL totaled $39.9 million related to PGI and CastlePoint as follows: $33.4 million and $6.5 million, respectively. In addition, the Reciprocal Exchanges have NOLs of $7.4 million.
As of December 31, 2011 and 2010, the Company had no material uncertain tax positions and no adjustments to liabilities or operations were required.
The Company paid $5.1 million, $4.8 million and $4.0 million in 2011, 2010 and 2009, respectively, for its proportional share of the operating expenses of the New York Insurance Department. Property casualty insurance company insolvencies or failures may result in additional security fund assessments to the Company at some future date. At this time the Company is unable to estimate the possible amounts, if any, of such assessments. Accordingly, the Company is unable to determine the impact, if any; such assessments may have on financial position or results of operations of the Company. The Company is permitted to assess premium surcharges on workers’ compensation policies that are based on statutorily enacted rates. Actual assessments have resulted in differences to the original estimates based on permitted surcharges of $1.1 million, $4.1 million and $2.2 million in 2011, 2010 and 2009, respectively. The Company estimates its liability for future assessments based on actual written premiums and historical rates and available information. As of December 31, 2011, the liability for the various workers’ compensation funds, which includes amounts assessed on workers’ compensation policies, was $8.2 million. This amount is expected to be paid over an eighteen month period ending June 30, 2013. As of December 31, 2010, the liability for the various workers’ compensation funds was $4.3 million.
Loss and LAE reserves are reported net of ceded reinsurance within the statutory basis financial statements. GAAP requires the reserve and reinsurance amounts to be shown gross.
For the years ended December 31, 2011, 2010 and 2009, the Company’s insurance subsidiaries had SAP net income of $46.7 million, $76.0 million and $30.6 million, respectively. At December 31, 2011 and 2010 the Company’s insurance subsidiaries had reported SAP surplus as regards policyholders of $686.8 million and $643.1 million, respectively, as filed with the insurance regulators.
GAAP guidance 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:
Debt: Fair value disclosures for debt are included in “Note 12-Debt.” The Company uses a discounted cash flow model to fair value the subordinated debentures. Market quotes are used to fair value the senior convertible notes.
In accordance with the two-class method, undistributed net earnings (net income less dividends declared during the period) are allocated to both common stock and unvested share-based payment awards (“unvested restricted stock”). Because the common shareholders and unvested restricted stock holders share in dividends on a 1:1 basis, the earnings per share on undistributed earnings is equivalent. Undistributed earnings are allocated to all outstanding share-based payment awards, including those for which the requisite service period is not expected to be rendered.
The computation of diluted earnings per share excludes outstanding options and other common stock equivalents in periods where inclusion of such potential common stock instruments would be anti-dilutive. For the years ended December 31, 2011, 2010 and 2009, 166,700, 193,000 and 401,700, respectively, options and other common stock equivalents to purchase Tower shares were excluded from the computation of diluted earnings per share because the exercise price of the options was greater than the average market price.
Segment performance is evaluated based on segment profit, which excludes investment income, realized gains and losses, interest expense, income taxes and incidental corporate expenses. Assets, other than intangibles and goodwill, are not allocated to segments because investments and assets other than intangibles and goodwill are considered in total by management for decision-making purposes.
(1) Since the weighted-average shares for the quarters are calculated independently of the weighted-average shares for the year, quarterly earnings per share may not total to annual earnings per share.