We had several leases that expired in 2012 that were not renewed. They were located in Glastonbury, Connecticut; Mobile, Alabama; Philadelphia, Pennsylvania; Canton, Massachusetts; Paramus, New Jersey; Shelton, Connecticut; and Marlborough, Massachusetts.
The selected consolidated income statement data for the years ended December 31, 2012, 2011 and 2010, and the balance sheet data as of December 31, 2012 and 2011 are derived from our audited financial statements included elsewhere in this document, which have been prepared in accordance with GAAP. You should read the following selected consolidated financial information along with the information contained in this document, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes included elsewhere in this Form 10-K.
(5) Book value per share is based on Tower Group, Inc. stockholders’ equity divided by common shares outstanding at year end.
business previously reported in either the Brokerage Insurance or Specialty Business segments in a new Commercial Insurance segment. The Company retained its Insurance Services segment which includes fees earned by the management companies. This change in presentation reflects the way management organizes the Company for making operating decisions and assessing profitability. In developing cost allocations between the Commercial and Personal Insurance segments, management has made significant assumptions regarding costs of reinsurance and internal services provided on behalf of such segments. As management receives additional facts which enhance its ability to apportion such costs, it may modify such allocation. If modifications are made, such adjustments will be made to all reporting periods disclosed.
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.
Interest expense. We pay interest on our subordinated debentures, convertible senior notes, credit facility and on segregated assets placed in trust accounts on a “funds withheld” basis in order to collateralize reinsurance recoverables. In addition, interest expense includes amortization of debt origination costs and original issue discounts over the remaining term of our debt instruments.
Combined ratio. We use the net combined ratio to measure our underwriting performance. The combined ratio is the sum of the loss ratio and the underwriting expense ratio. We analyze the combined ratio on a gross (before the effect of reinsurance) and net (after the effect of reinsurance) basis. If the combined ratio is at or above 100%, an insurance company is not underwriting profitably and may not be profitable unless investment income is sufficient to offset underwriting losses.
Tangible book value per share. Tangible book value per share is calculated as Tower Group, Inc, stockholders’ equity, less intangible assets and goodwill, divided by the number of shares outstanding. We use this as a measure of value per share of the Company independent from the market price per share.
We segregate our data for estimating loss reserves. The property lines include Fire and Allied Lines, Homeowners-property, Commercial Multi-peril Property, Multi-Family Dwellings, Inland Marine and Automobile Physical Damage. The casualty lines include Homeowners-liability, Commercial Multi-peril Liability, Other Liability, Workers’ Compensation, Commercial Automobile Liability, and Personal Automobile Liability. Commercial Insurance segment reserves are estimated separately from Personal Insurance segment reserves. For the Commercial Insurance segment we analyze reserves by line of business and, where appropriate, we further segregate the data for analysis purposes between small, middle and large policies sizes and by state or region. We also analyze various producers’ business separately where the volume of business from those producers is considered significant and the characteristics of the business from those particular producers are perceived to be different. Within the Personal Insurance segment, we estimate loss and loss expenses reserves separately for the Reciprocal Exchanges, which we manage, and for our owned companies. We utilize line of business breakdowns and, where appropriate, analyze results separately by state.
Establishing fair value of loss and LAE reserves for acquired companies. At acquisition date, accounting standards require that loss and LAE reserves must be set to fair value. As there are no readily observable markets for these liabilities, we use a valuation model that estimates net nominal future cash flows related to the loss and LAE reserve. This valuation is adjusted for the time value of money and a risk margin to compensate the Company for holding capital supporting the risk associated with the liabilities. This adjustment is referred to as the “reserve risk premium”, which is amortized over the expected payout pattern of the claims.
Ceding commissions earned. We have historically relied on quota share, excess of loss and catastrophe reinsurance to manage our regulatory capital requirements and limit our exposure to loss.
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
If an other-than-temporary-impairment (“OTTI”) loss is determined for a fixed-maturity security (for which we do not have the intent to sell or it is not more likely than not we would be required to sell), the credit portion is recorded in the income statement as realized investment losses and the non-credit portion is recorded in accumulated other comprehensive income. The credit portion results in a permanent reduction in the cost basis of the underlying investment. For all other fixed-maturity security and equity security impairments, the entire impairment is reflected as a realized investment loss and reduces the cost basis of the
security. The determination of OTTI is a subjective process and different judgments and assumptions could affect the timing of loss realization. We recorded OTTI losses on our fixed maturity and equity securities in the amounts of $9.9 million, $3.5 million and $14.9 million in 2012, 2011, and 2010, respectively, of which $9.6 million, $3.2 million and $3.0 million were recorded in Net realized investment gains (losses) in 2012, 2011, and 2010, respectively.
See “Business-Investments” and “Note 6 - Investments” in the notes to consolidated financial statements for additional detail regarding our investment portfolio at December 31, 2012, including disclosures regarding OTTI.
The Company completed its annual indefinite lived intangible asset assessment as of September 30, 2012. An impairment loss is recognized if the carrying value of an intangible asset is not recoverable and its carrying amount exceeds its fair value. Any amount of intangible assets determined to be impaired will be recorded as an expense in the period in which the impairment determination is made. No impairment losses were recognized on indefinite lived intangible assets in 2012, 2011 or 2010.
The first step of the Company’s analysis indicated that the Personal Insurance reporting unit’s fair value exceeded its carrying value by 9%. As such, the second step of the annual impairment assessment was not required. The first step of the Company’s analysis (“Step 1”) for Commercial Insurance indicated that its carrying value exceeded its fair value by 2%. Accordingly, management was required to perform the second step of the goodwill impairment test, which assumes the implied fair value from the Step 1 test is allocated to the fair value of each of the assets and liabilities in the Commercial Insurance reporting unit. In Step 2, the implied value of the Commercial Insurance reporting unit’s goodwill was greater than its goodwill carrying value by approximately $5 million considering an acquisition control premium of 42%; therefore, goodwill was not impaired and no write-down was required; however, the Step 1 comparison indicates a greater risk of future impairment for this reporting unit’s goodwill.
In November and December 2012, Tower’s market capitalization was negatively impacted by what management believes was the uncertainty about the results of Superstorm Sandy coupled with the uncertainty as to the timing of the merger with Canopius: therefore, despite a temporary decline in the Company’s share price, management determined that there were no events or material changes in circumstances that indicated that a material change in the fair value of the Company’s reporting units had occurred.
The following tables present the consolidating financial statements as of December 31, 2012 and 2011 and for the years ended December 31, 2012, 2011 and 2010:
Commission and fee income. Commission and fee income, comprised of ceding commission revenue, insurance services revenue and policy billing fees, increased by $2.3 million for the year ended December 31, 2012, compared to the same period in 2011. The increase is due to additional policy billing fees and an increase in fees earned by our managing general agencies.
The Company had net realized investment gains of $25.5 million for the year ended December 31, 2012 compared to gains of $9.4 million in 2011. OTTI losses recorded in earnings for the year ended December 31, 2012 were $9.6 million, an increase from $3.2 million of OTTI losses recorded for 2011. $8.3 million of the 2012 OTTI losses were in the equity portfolio and $1.3 million were in the bond portfolio. These gains and losses were a function of individual securities selected for sale when cash needs arose in the ordinary course of business or general duration management and portfolio rebalancing activity as dictated in our investment policy statement. The increase in gains in 2012 is primarily due to sales of fixed income and equity securities in the fourth quarter of 2012 to provide liquidity for claims payments associated with Superstorm Sandy.
Loss and loss adjustment expenses. The consolidated net loss ratio, which includes the Reciprocal Exchanges, was 72.8% and 66.2% for the years ended December 31, 2012 and 2011, respectively. Excluding the Reciprocal Exchanges, the net loss ratio was 73.5% and 67.6% for the years ended December 31, 2012 and 2011, respectively. Severe weather losses added 7.3 points and 5.3 points to the loss ratio excluding the Reciprocal Exchanges in 2012 and 2011, respectively.
Operating expenses. Operating expenses, which include direct and ceding commission expenses and other operating expenses, were $676.4 million for year ended December 31, 2012, compared to $590.3 million for the year ended December 31, 2011 representing an increase of 14.6%. This increase is primarily due to: (i) increased business production, including more assumed premiums written which have a higher commission rate compared to direct premiums written, (ii) the Company’s ongoing efforts to build-out our information technology infrastructure to support our policy administration and claims processing needs, and (iii) a $2.9 million after-tax charge attributable to a legal settlement with Munich Reinsurance America, Inc.(“Munich Re”).
Acquisition-related transaction costs. Acquisition-related transaction costs for the year ended 2012 were $9.2 million and relate primarily to the acquisition of our equity interest in Canopius Group and expenses associated with the proposed merger with Canopius Bermuda. These costs were negligible for 2011.
Net income (loss) and return on average equity. Net (loss) and annualized return on average equity attributable to Tower Group, Inc. were ($28.2) million and (2.7%) for the year ended December 31, 2012 compared to $60.5 million and 5.8% for the year ended December 31, 2011. The return on average equity is calculated by dividing net income (loss) by average stockholders’ equity. Average stockholders’ equity was $1,027.2 million and $1,041.1 million at December 31, 2012 and 2011, respectively.
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 adverse development in Commercial Insurance of $46.1 million.
The net adverse 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 mono line 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 adverse development of $4.2 million in discontinued personal lines business, $3.1 million in involuntary plans and $0.8 million in other lines.
Operating expenses. Operating expenses, which include direct and ceding commission expenses and other operating expenses, were $590.5 million for the year ended December 31, 2011, representing an increase of 18.2% over the prior year, primarily as a result of the OBPL acquisition, which was not included in the Company’s results for the first six months of 2010. In addition, the Company amortized the value of business acquired (“VOBA”) asset recorded on July 1, 2010 in connection with the OBPL purchase. This resulted in $10.2 million of expense recorded in 2011 and exceeded the amount of acquisition costs that were capitalized in 2011as DAC. The VOBA was fully amortized as of June 30, 2011. In addition, the Company incurred $23.9 million in 2011 compared to $13.3 million in 2010, under the transition services agreements with OneBeacon. The net underwriting expense ratio improved to 34.1% in 2011 from 35.7% in 2010.
The gross underwriting expense ratio improved slightly to 32.3% in 2011 from 32.9% in 2010. The commission portion of the gross underwriting expense ratio was 17.4% and 17.6% 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 other underwriting expense (“OUE”) ratio, which includes boards, bureaus and taxes (“BB&T”), improved to 14.9% in 2011 from 15.3% in 2010.
Income tax expense. Income tax expense decreased in 2011 compared to 2010 due to the decrease in pre-tax income. The effective income tax rate (including state and local taxes) was 25.2% for the year ended December 31, 2011, compared to 34.2% for the same period in 2010.
The decrease in the net income and annualized return on equity in 2011 is primarily due to an increase of $48.3 million in after-tax losses from severe weather related events in 2011. These losses were partially offset by increased net income attributed to the acquisition of OBPL.
Ceding commission revenue. Ceding commission revenue decreased for the year ended December 31, 2012 by $7.1 million compared to the same period in 2011. This was primarily due to a change in loss ratio on a prior year’s quota share treaty which reduced ceding commission revenue by $4.2 million during the year ended December 31, 2012 compared to the same period in 2011 and also as 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 $70.8 million, or 19.6%, for the year ended December 31, 2012, respectively, compared to the same period in 2011. The net underwriting expense ratio increased 2.8 percentage points for year ended December 31, 2012 compared to the same period 2011.
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. Ceded premiums earned were $90.7 million compared to $155.7 million for the year ended December 31, 2011 compared to the same period in 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.
Net premiums written and earned increased $165.0 million and $131.2 million, respectively, in 2011 as compared to 2010. These changes are attributed to the gross and ceded premium changes discussed above.
Renewal retention rate excluding programs was 77.1% for the year ended December 31, 2011 compared to 77.0% during the same period in 2010. Premiums on renewed commercial business, other than programs, increased 1.5%. Excluding programs, policies in-force for our commercial business remained flat as of December 31, 2011.
Net loss and loss adjustment expenses. The net calendar year loss ratios were 67.7% and 62.6% for the years ended December 31, 2011 and 2010, respectively. The accident year loss ratios for the years ended December 31, 2011 and 2010 were 63.5% and 60.5%, respectively.
For the year ended December 31, 2011, the Company incurred net losses of $31.5 million relating to Hurricane Irene and other severe weather events. Excluding the effects of these storms, the net loss ratio would have been 64.8% for the year ended December 31, 2011.
The gross underwriting expense ratio was 30.3% for the year ended December 31, 2011 as compared to 31.4% in 2010. The commission portion of the gross underwriting expense ratio, which is expressed as a percentage of gross premiums earned, was 17.7% for the year ended December 31, 2011 compared to 17.5% for the same periods in 2010. This increase is attributable to the assumed reinsurance which has a higher commission. The OUE ratio, including BB&T, was 12.6% for the year ended December 31, 2011 compared 13.9% for the same period in 2010. The improvement in OUE in 2011 resulted from of our continued efforts to reduce expenses through integration, with many functions consolidated into one office.
Ceded premiums written for the year ended December 31, 2012 were $ 129.4 million, an increase of $30.1 million as compared to $99.4 million in 2011. Ceded premiums earned were $124.4 million compared to $105.2 million for the year ended December 31, 2012 compared to the same period in 2011. 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 and to reinstatement premiums on our catastrophe reinsurance program as a result of Superstorm Sandy.
Net premiums written increased $27.5 million and net premiums earned decreased $8.7 million, respectively, in 2012 as compared to 2011. These changes are attributed to the gross and ceded premium changes discussed above.
Ceding commission revenue. Ceding commission revenue increased for the year ended December 31, 2012 by $5.5 million compared to the same period in 2011. The increase is attributable to the commission revenue earned on the previously mentioned homeowners and umbrella quota share treaties on the OBPL acquired business.
Underwriting profit and combined ratio. Underwriting profit decreased $46.3 million and the combined ratio increased 9.4 percentage points for the year ended December 31, 2012 compared to the year ended December 31, 2011. The increase in the combined ratio for the twelve months ended December 31, 2012 resulted primarily from Superstorm Sandy losses in the fourth quarter of 2012. Such losses aggregated $42.8 million and increased the calendar year loss ratio by 12.8 points. These losses were partially offset by favorable prior year loss development of $4.9 million in 2012. In the year ended December 31, 2011, the Company also recorded catastrophe and other severe storm losses. In 2011 such losses aggregated $42.8 million and increased the calendar year loss ratio by 13.4 points. In addition, as discussed above, the expense ratio increased by 1.8 percentage points from 2011 to 2012.
Premiums. Gross premiums written for the year ended December 31, 2011 were $585.6 million compared to $412.5 million in 2010, for an increase of $173.1 million. The increase is primarily attributable to 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. Excluding the effects of OBPL, Tower’s other personal lines gross premiums written increased $7.7 million from $201.0 million in 2010 to $208.7 million in 2011 due principally to organic growth in our homeowners business.
Net premiums written and earned increased $159.5 million and $154.2 million, respectively, in 2011 as compared to 2010. These changes are attributed to the gross and ceded premium changes discussed above.
Net loss and loss adjustment expenses. For Personal Insurance, the net calendar year loss ratios were 63.0% and 55.4% for the year ended December 31, 2011 and 2010, respectively. The accident year loss ratios for the year ended December 31, 2011 and 2010 were 76.2% and 64.5%, respectively. Estimates of prior accident year loss and loss expenses decreased by $66.9 million for the year ended December 31, 2011.
Underwriting expenses. Underwriting expenses, which include direct commissions and other underwriting expenses, increased by $67.4 million for the year ended December 31, 2011 as compared to the prior year. Nearly all of the increase is related to the OBPL acquisition. The net underwriting expense ratio improved 2.8 percentage points from 2010 to 2011.
Total expenses. The increase in total expenses for the year ended December 31, 2012 compared to 2011 was primarily attributable to a settlement with Munich Reinsurance America, Inc. (“Munich Re”) to resolve a legal action commenced by Munich Re in 2009.
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, 2012 and December 31, 2011:
At December 31, 2012, $189.5 million of our municipal bonds, at fair value, were guaranteed by third parties from a total of $2.3 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:
As of December 31, 2012, our municipal bonds consisted of state general obligations, municipal general obligations and special revenue bonds. Municipal bonds by state at December 31, 2012 are as follows:
No one jurisdiction within “Other” in the table above exceeded 4% of the total fair value of municipal bonds. As of December 31, 2012, the special revenue bonds are supported primarily by water and sewer utilities, electric utilities, college revenues and highway tolls.
As of December 31, 2012, substantially all of the investment portfolio recorded at fair value was priced based upon quoted market prices or other observable inputs. For investments in active markets, we used the quoted market prices provided by the outside pricing services to determine fair value. In circumstances where quoted market prices were unavailable, we used fair value estimates based upon other observable inputs including matrix pricing, benchmark interest rates, market comparables and other relevant inputs. When observable inputs were adjusted to reflect management’s best estimate of fair value, such fair value measurements are considered a lower level measurement in the GAAP fair value hierarchy.
In certain instances, we deemed it necessary to utilize Level 3 pricing over prices available through pricing services used throughout 2012 and 2011. 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.
As more fully described in Note 6 to our consolidated financial statements, “Investments-Impairment Review,” we completed a detailed review of all our securities in a continuous loss position, including but not limited to residential and commercial mortgage-backed securities, and concluded that the unrealized losses in these asset classes are the result of a decrease in value due to technical spread widening and broader market sentiment.
At December 31, 2012, the investments in an unrealized loss position for twelve months or greater were primarily in our corporate industrial bonds and preferred stocks.
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, 2012:
See “Note 6-Investments” in our consolidated financial statements for further information about impairment testing and other-than-temporary impairments.
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, 2012:
The majority of our corporate bonds that are in an unrealized loss position are rated below AA. Based on our analysis of these securities and current market conditions, we expect price recovery on these over time, and we have determined that these securities are not other than temporarily impaired as of December 31, 2012.
Tower is organized as a holding company (the “Holding Company”) with multiple intermediate holding companies, 12 insurance subsidiaries and several management companies. The Holding Company’s principal liquidity needs include interest on debt, stockholder dividends and share repurchases under its share repurchase program. The Holding Company’s principal sources of liquidity include dividends and other permitted payments from our subsidiaries, as well as financing through borrowings and sales of securities.
CastlePoint Re is another of Tower’s significant insurance subsidiaries. Under the Insurance Act 1978 of Bermuda, as amended (the “Insurance Act”), CastlePoint Re is required to maintain a specified solvency margin and a minimum liquidity ratio and is prohibited from declaring or paying any dividends if doing so would cause CastlePoint Re to fail to meet its solvency margin and its minimum liquidity ratio. Under the Insurance Act, CastlePoint Re is prohibited from declaring or paying dividends without the approval of the Bermuda Monetary Authority (“BMA”), if CastlePoint Re failed to meet its solvency margin and minimum liquidity ratio on the last day of the previous fiscal year. Under the Insurance Act, CastlePoint Re is prohibited, without the approval of the BMA, from reducing by 15% or more its total statutory capital as set forth on its audited statutory financial statements for the previous year.
The management companies are not subject to any statutory limitations on their dividends to the Holding Company. The management companies declared dividends of $6.5 million, $19.9 million and $ 7.5 million in 2012, 2011 and 2010, respectively.
Pursuant to a tax allocation agreement, we compute and pay Federal income taxes on a consolidated basis. At the end of each consolidated return year, each entity must compute and pay to the Holding Company its share of the Federal income tax liability primarily based on separate return calculations. The tax allocation agreement allows the Holding Company to make certain Code elections in the consolidated Federal tax return. In the event such Code elections are made, any benefit or liability is accrued or paid by each entity. If a unitary or combined state income tax return is filed, each entity’s share of the liability is based on the methodology required or established by state income tax law or, if none, the percentage equal to each entity’s separate income or tax divided by the total separate income or tax reported on the return.
We believe that the cash flow generated by the operating activities of our subsidiaries, combined with other available capital sources, will provide sufficient funds for us to meet our liquidity needs over the next twelve months. Beyond the next twelve months, cash flow available to us may be influenced by a variety of factors, including general economic conditions and conditions in the insurance and reinsurance markets, as well as fluctuations from year-to-year in claims experience.
We have the intent and ability to hold any temporarily impaired fixed maturity securities until the anticipated date that these temporary impairments are recovered.
Book value per common share represents Tower Group Inc. stockholders’ equity divided by the number of common shares outstanding. Management uses growth in book value per common share as a key measure of the value generated for our common
shareholders each period and believes that book value per common share is a key driver of TWGP’s share price over time. Book value per common share is impacted by, among other factors, our underwriting results, investment returns and share repurchase activity, which has an accretive or dilutive impact on book value per common share depending on the purchase price.
The following table summarizes information about contractual obligations and commercial commitments. The minimum payments under these agreements as of December 31, 2012 were as follows:
In September 2010, the Company issued $150 million principal amount of 5.0% convertible senior notes (the “Notes”) due September 2014. Interest is being paid semi-annually commencing March 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 Company has been adjusting the conversion rate quarterly as the Company pays its quarterly dividend. At December 31, 2012 the conversion rate is 37.1689 shares of common stock per $1,000 principal amount of the Notes (equivalent to a conversion price of $26.90 per share), subject to further adjustment upon the occurrence of certain events, including future dividend payments. In February 2013, the conversion rate was adjusted to 37.2895, equivalent to a conversion price of $26.82 per share. 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.
On February 15, 2012, the Company amended its $125.0 million credit facility by increasing borrowing capacity up to $150 million, extending the maturity out to February 2016, and resetting borrowing fees to more favorable current market terms.
The gross loss reserve payments due by period in the table above are based upon the loss and loss expense reserves estimates as of December 31, 2012 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. The projected gross loss payments presented do not include the estimated amounts recoverable from reinsurers that amounted to $319.7 million, which are estimated to be recovered as follows: less than one year, $130.2 million; one to three years, $115.2 million; four to five years, $47.4 million; and after five years, $26.9 million. The interest on the subordinated debentures is calculated using interest rates in effect at December 31, 2012 for variable rate debentures.
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, 2012, 1.1 million shares of common stock were purchased under this program at an aggregate consideration of $21.0 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, $26.4 million remained available for future share repurchases under the new program.
The actual restricted stock expense that the Company has incurred for the year ended December 31, 2012 and the future restricted stock expense that the Company expects to incur for grants made as of December 31, 2012 assuming no forfeitures is shown in the table below:
For the year ended December 31, 2012, net cash provided by operating activities was $107.2 million as compared to $82.8 million for 2011. The increase in operating cash flow in 2012 primarily resulted from the increase in premium earned and an increase in claims relating to Superstorm Sandy that will be paid in 2013.
$45.0 million and $53.6 million, respectively, primarily related to the build out of new systems. The remaining cash flows in 2011 relates to the Company’s purchases and sales of fixed-maturity and equity investments. The remaining net cash outflows in 2012 relate primarily to the Company’s $71.5 million investment in Canopius Group and a $35.0 million increase in restricted cash for collateral posted for assumed reinsurance business with Lloyd’s of London offset by securities sales to generate cash to pay Superstorm Sandy claims.
For the year ended December 31, 2011, net cash provided by operating activities was $82.8 million as compared to $197.0 million for 2010. The decrease in cash flow for the year ended December 31, 2011 primarily resulted from a $66.2 million cash transfer to provide collateral support for business written on our behalf, claims payments on third quarter 2011 catastrophes and severe storms, tornado losses in the second quarter of 2011 and winter storms in late December 2010. These were partially offset by the receipt of a $22.0 million Federal income tax refund in 2011.
In our opinion, the accompanying consolidated balance sheets as of December 31, 2012 and 2011 and the related consolidated statements of income and comprehensive income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2012 present fairly, in all material respects, the financial position of Tower Group, Inc. and its subsidiaries (the “Company”) at December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing on page S-1 present fairly, in all material respects, the information set forth therein at December 31, 2012 and 2011, and for each of the years in the three year period ended December 31, 2012 when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audits. 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 audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of the financial statements included 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, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
Personal Insurance (“Personal”) Segment offers a broad range of personal lines property and casualty insurance products to individuals distributed through a network of retail and wholesale agents; and
Certain reclassifications have been made to prior years’ financial information to conform to the current year presentation.
The Company determines a standard cost per claim for ULAE for each line of business that represents the ultimate average cost to administer that claim. For property lines, 50% of this standard cost is recorded as paid ULAE when a claim is opened, and 50% of this standard cost is recorded as paid ULAE when a claim is closed. For casualty lines, 75% of this standard cost is recorded as paid ULAE when a claim is opened, and 25% is recorded as paid ULAE when a claim is closed. The standard costs are determined actuarially and subject to adjustment each quarter. Calendar period costs for the claims function is recorded as paid ULAE each quarter.
Cash consists of cash in banks, generally in operating accounts. The Company maintains its cash balances at several financial institutions. Management monitors balances and believes they do not represent a significant credit risk to the Company.
The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. Cash and cash equivalents are presented at cost, which approximates fair value. Cash restricted as to use is included in Other Assets.
The Company’s other invested assets consist of investments in limited partnerships accounted for using the equity method of accounting, real estate and certain securities for which the Company has elected the fair value option. In accounting for the partnerships, management uses the financial information provided by the general partners, which is on a three-month lag. As of December 31, 2012, the Company had future funding commitments of $29.7 million to these limited partnerships. For securities in which the Company has elected the fair value option, interest and dividends are reported in net investment income with the remaining change in overall fair value reported in other net realized investment gains (losses).
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) followed by similar but not identical assets or liabilities (Level 2) 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.
Premiums receivable represent amounts due from insureds and reinsureds for insurance coverage and are presented net of an allowance for doubtful accounts of $5.5 million and $4.4 million at December 31, 2012 and 2011, respectively. 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 premiums receivable of $4.8 million, $5.2 million and $1.8 million were written off in 2012, 2011 and 2010, respectively.
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 9 - Deferred Acquisition Costs” for additional information regarding deferred acquisition costs.
To estimate the fair value of its reporting units, the Company may utilize a combination of widely accepted valuation techniques including a stock price and market capitalization analysis, discounted cash flow calculations and peer company price to earnings multiples analysis. The stock price and market capitalization analysis takes into consideration the quoted market price of the Company’s outstanding common stock and includes a control premium, derived from historical insurance industry acquisition activity, in determining the estimated fair value of the consolidated entity before allocating that fair value to individual reporting units. The discounted cash flow analysis utilizes long term assumptions for revenue growth, capital growth, earnings projections including those used in the Company’s strategic plan, and an appropriate discount rate. The peer company price to earnings multiples analysis takes into consideration the price earnings multiples of peer companies for each reporting unit and estimated income from the Company’s strategic plan.
The Company conducted the required annual goodwill and intangible asset impairment testing as of September 30 for 2012. Additionally, identifiable intangible assets and goodwill are tested for recoverability whenever events or changes in circumstances indicate that a carrying amount may not be recoverable. No impairment losses were recognized in 2012, 2011 or 2010.
Tower’s other assets balances are comprised primarily of fixed assets, capitalized software development costs, restricted cash, receivables for securities sold, receivables for the participation in involuntary pools and current tax receivables.
The Company consolidates the Reciprocal Exchanges as it has determined that these are variable interest entities and that the Company is the primary beneficiary. See “Note 5 - Variable Interest Entities” for more details.
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, 2012.
The Company’s reporting currency is the U.S. dollar. The Company holds an equity method investment in Canopius Group, Limited, which is denominated in British pounds sterling (“GBP”). The Company translates this investment to U.S. dollars at the exchange rate in effect at the balance sheet date. Tower’s portion of changes in translation adjustment, based on its percentage ownership in this investment, is included as a component of accumulated other comprehensive income.
Our largest agent accounted for 7.5%, 10% and 12%, respectively, of the insurance subsidiaries’ premiums receivable balances at December 31, 2012, 2011 and 2010. Our largest agent accounted for 7%, 7% and 4% of the insurance subsidiaries’ direct premiums written in 2012, 2011 and 2010, respectively.
Note 3-Investment in Canopius Group Limited and Exercise of Merger Option
Under the Merger Agreement, Tower stockholders will receive, in exchange for each share of Tower’s common stock, a certain number of Canopius Bermuda common shares equal to a Stock Conversion Number (defined below). Canopius Group intends to sell its shares in Canopius Bermuda prior to the consummation of the merger in a private placement of those shares (the “Canopius Secondary Offering”) to a group of yet-to-be-identified institutional third party investors (the “Third Party Investors”). The “Stock Conversion Number” will be equal the quotient obtained by dividing (x) the price per share of Tower common stock at the market close on the date of the pricing of the Canopius Secondary Offering by (y) the Adjusted Canopius Bermuda Price Per Share (defined below).
The “Adjusted Canopius Bermuda Price Per Share” will be equal to the quotient obtained by dividing (i) the sum of (a) the Target TNAV Amount, which is the amount that Tower specifies in a written notice delivered to Canopius Group prior to the signing date of the purchase and sale agreements for the Canopius Secondary Offering, as the target amount of the tangible net asset value of Canopius Bermuda as of the closing date of the Canopius Secondary Offering, (b) the value of the retained business of Canopius Bermuda following its restructuring, (c) the aggregate amount of the placement fees received by the placement agents in connection with the Canopius Secondary Offering and (d) the aggregate amount, expressed in dollars, equal to the absolute
value of the discount from the closing price of Tower’s common stock on the pricing date of the Canopius Secondary Offering, or on another reasonably current date (as agreed by Tower, Canopius Bermuda and the Third Party Investors), that Tower, Canopius Bermuda and the Third Party Investors have agreed is necessary in order to effect the Canopius Secondary Offering, by (ii) the aggregate number of Canopius Bermuda common shares sold in the Canopius Secondary Offering. Because neither the restructuring of Canopius Bermuda nor the Canopius Secondary Offering is likely to occur until the first quarter of 2013 at the earliest, no assurances can be given as to the Target TNAV Amount or the Adjusted Canopius Bermuda Price Per Share. In determining the Target TNAV Amount, Tower will principally consider the amount of capital that it believes will be required to maintain its ratings and to operate the combined business. Tower believes this capital amount to be between $150 million and $180 million.
Although the Merger Agreement contains no conditions precedent to Tower’s obligations to consummate the merger, Tower will not proceed with the merger in the event that (1) the Canopius Secondary Offering cannot be effected, or can only be effected on terms that would make the Stock Conversion Number, and therefore the merger, unattractive to Tower, (2) the Adjusted Canopius Bermuda Price Per Share declines to a point that the Third Party Investors would own 20% or less of the merged entity’s fully diluted capital stock immediately following the closing of the merger, (3) Tower stockholders and option holders, as well as holders of Tower’s convertible senior notes, would own less than 76% of the fully diluted capital stock of Tower Ltd. immediately following the closing of the merger, (4) the parties to the Merger Agreement fail to obtain the necessary regulatory approvals on terms acceptable to Tower, (5) Tower’s stockholders fail to adopt the Merger Agreement and approve the merger, (6) Tower’s Board of Directors determines that the transactions contemplated by the Merger Agreement are not favorable to Tower or its stockholders and (7) Tower has not received an opinion of a nationally recognized law firm, in form and substance satisfactory to Tower, to the effect that the merger should not cause Tower Ltd. to be treated as a domestic corporation under Section 7874(b) of the Internal Revenue Code of 1986, as amended.
The consideration paid by Tower was allocated as follows based upon each of the acquired assets’ estimated fair values:
The Merger Option and SPS Transaction Right and Acquisition Right are reported in “Other assets” in the accompanying balance sheet at December 31, 2012.
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. 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.
Under the terms of the Agreement, the Company acquired Massachusetts Homeland Insurance Company (“MHIC”), York Insurance Company of Maine (“York”) and two management companies (collectively the “Stock Companies”). The management companies are the attorneys-in-fact for the Reciprocal Exchanges. Tower purchased $102 million principal of surplus notes issued by the Reciprocal Exchanges (the “surplus notes”). In addition, Tower also reinsured the personal lines business written by other subsidiaries of OneBeacon not acquired by Tower. The total consideration paid for OBPL was $164.3 million.
For the year ended December 31, 2012, the Reciprocal Exchanges recognized total revenues, total expenses and net income of $204.7 million, $201.9 million and $2.8 million, respectively. For the year ended December 31, 2011, the Reciprocal Exchanges recognized total revenues, total expenses and net income of $209.8 million, $198.8 million and $11.0 million, respectively.
As at December 31, 2012 and 2011, U.S. Treasury Notes and other securities with carrying values of $351.1 million and $226.8 million, respectively, were on deposit with various states to comply with the insurance laws in which the Company is licensed.
In addition, the Company had $481.5 million and $340.8 million of investments as of December 31, 2012 and 2011, 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.
For the non-structured fixed-maturity securities (U.S. Treasury and Agency securities, municipal bonds, and certain corporate debt), unrealized losses are reviewed to determine whether full recovery of principal and interest will be received. The estimate of expected cash flows is determined by projecting a recovery value and a recovery time frame and assessing whether further principal and interest will be received. The determination of recovery value incorporates an issuer valuation assumption utilizing one or a combination of valuation methods as deemed appropriate by management. The present value of the cash flows is determined by applying the effective yield of the security at the date of acquisition (or the most recent implied rate used to accrete the security if the implied rate has changed as a result of a previous impairment) and an estimated recovery time frame. For securities for which the issuer is financially troubled but not in bankruptcy, that time frame is generally longer. Included in the present value calculation are expected principal and interest payments; however, for securities for which the issuer is classified as bankrupt or in default, the present value calculation assumes no interest payments and a single recovery amount. In situations for which a present value of cash flows cannot be estimated, a write-down to fair value is recorded.
The following table shows the amount of fixed-maturity and equity securities that were OTTI for the years ended December 31, 2012, 2011 and 2010. This resulted in recording impairment write-downs included in net realized investment gains (losses), and reduced the unrealized loss in other comprehensive net income:
The following table provides a rollforward of the cumulative amount of credit related OTTI for securities still held showing the amounts that have been included in earnings on a pretax basis for the years ended 2012 and 2011 (none of such OTTI was included within the Reciprocal Exchanges):
The unrealized loss position associated with the fixed-maturity portfolio was $1.9 million as of December 31, 2012, consisting primarily of corporate bonds and mortgage-backed securities of $1.6 million. The total fixed-maturity portfolio of gross unrealized losses included 182 securities which were, in aggregate, approximately 0.7% below amortized cost. Of the 182 fixed maturity investments identified, 31 have been in an unrealized loss position for more than 12 months. The total unrealized loss on these investments at December 31, 2012 was $0.3 million. Management does not consider these investments to be other-than-temporarily impaired.
For common stocks, there were 23 securities in a loss position at December 31, 2012 totaling $4.3 million. Management evaluated the financial condition of the common stock issuers, the severity and duration of the impairment, and our ability and intent to hold to recovery and determined these securities are not OTTI. The evaluation consisted of a detailed review, including but not limited to some or all of the following factors for each security: the current S&P rating, analysts’ reports, past earnings trends and analysts’ earnings expectations for the next 12 months, liquidity, near-term financing risk, and whether the company was currently paying dividends on its equity securities. Management does not consider these investments to be other-than-temporarily impaired.
Level 2 - Inputs to the valuation methodology include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability and market-corroborated inputs. Included are investments in U.S. Treasury and Agency securities and, together with municipal bonds, corporate debt securities, commercial mortgages, residential mortgage-backed securities and asset-backed securities. Additionally, interest-rate swap contracts utilize Level 2 inputs in deriving fair values.
The availability of observable inputs varies and is affected by a wide variety of factors. When the valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires significantly more judgment. The degree of judgment exercised by management in determining fair value is greatest for investments categorized as Level 3. For investments in this category, management considers prices and inputs that are current as of the measurement date. In periods of market dislocation, as characterized by current market conditions, the ability to observe stable prices and inputs may be reduced for many instruments. This condition could cause a security to be reclassified between levels.
The ability to observe stable prices and inputs may be reduced for highly-customized and illiquid instruments which had been the case for certain non-agency residential and commercial mortgage-backed securities and asset-backed securities in previous periods.
In 2012, there were no transfers of investments between Level 1 and Level 2 or between Level 2 and Level 3.
The fair values of the debt and equity securities sold, not yet purchased were derived by using quoted prices for similar securities in active markets. These instruments resulted in net realized gains (losses) of $(2.1) million for the year ended December 31, 2012.
There were no changes in Level 3 assets measured at fair value for the years ended December 31, 2012 and 2011.
For the Commercial Insurance reporting unit, the Company determined in Step 1 that the reporting unit’s fair value was less than its carrying value, primarily driven by the overall market capitalization. Accordingly, recoverability was evaluated assuming fair value was allocated to assets and liabilities as if the reporting unit had been acquired in a business combination. In Step 2, the implied value of the Commercial Insurance reporting unit’s goodwill was greater than its goodwill carrying value by $5 million considering an acquisition control premium of 42%; therefore, goodwill was not impaired and no write-down was required; however, the Step 1 comparison indicates a greater risk of future impairment for this reporting unit’s goodwill.
For the Personal Insurance reporting unit, management determined in Step 1 that the reporting unit’s fair value was in excess of its carrying value by 9% or $21 million considering an acquisition control premium of 42%; and therefore goodwill was not impaired.
Intangible assets consist of finite and indefinite life assets. Finite life intangible assets include customer relationships and trademarks. Insurance company licenses and management contracts are considered indefinite life intangible assets subject to annual impairment testing.
The components of intangible assets and their useful lives, accumulated amortization, and net carrying value as of December 31, 2012 and 2011 are as follows:
(b) In 2012, Tower transferred a licensed insurance subsidiary shell to the Reciprocal Exchanges, as discussed in Note 2-Accounting Policies and Basis of Presentation. This resulted in classifying $2.6 million insurance licenses out of Tower and into the Reciprocal Exchange.
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, 2012, 2011 and 2010 as follows:
Tower’s 2012 quota share reinsurance cedes 35.5% of the homeowners business written by the companies obtained in the OBPL transaction. This coverage has a $288 million per occurrence cap.
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, 2012 renewal of its property catastrophe program, the Company maintained a retention of $75 million per catastrophe, had 100% catastrophe protection for the next $75 million of loss above the $75 million, 70% catastrophe protection for the next $75 million of loss over $150 million and 100% catastrophe protection for the next $700 million of loss in excess of $225 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 2012, 2011 and 2010 were $3.9 million, $3.6 million and $2.7 million, respectively, and have been recorded as interest expense.
The table below shows direct, assumed and ceded premiums for the years ended December 31, 2012, 2011 and 2010:
As of December 31, 2012 and 2011, the Company had $532.6 million and $314.0 million, respectively, of reinsurance recoverables with reinsurers rated A- or higher by A.M. Best. These represented 92.2% and 91.0%, respectively, of the Company’s total reinsurance recoverables as of those dates. As of December 31, 2012 and 2011, the largest reinsurance recoverable balance with any one reinsurer was approximately 8.3% and 9.1% of the Company’s stockholders’ equity.
The Company earns ceding commission revenue under certain quota share reinsurance agreements. In addition, the commission revenue earned on prior reinsurance agreements continue to be adjusted based on a sliding scale of commission rates and ultimate treaty year loss ratios on the policies reinsured under each of these agreements. The sliding scale includes minimum and maximum commission rates in relation to specified ultimate loss ratios. The commission rate and ceding commissions earned increase when the estimated ultimate loss ratio decreases, and conversely, the commission rate and ceding commissions earned decrease when the estimated ultimate loss ratio increases.
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 decrease in estimated ceding commission income relating to prior years recorded in 2012, 2011 and 2010 was $4.5 million, $0.1 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, 2012 and 2011 are as follows:
The following tables provide a reconciliation of the beginning and ending consolidated balances for unpaid losses and LAE for the years ended December 31, 2012, 2011 and 2010:
Incurred losses and LAE for the year ended December 31, 2012 attributable to insured events of prior years increased by $69.3 million. Excluding the Reciprocal Exchanges the incurred losses and LAE increased by $78.2 million.
Excluding the Reciprocal Exchanges, there was net adverse loss development of $78.2 million for the year ended December 31, 2012 comprised of adverse development in Personal Insurance of $4.0 million and adverse development in Commercial Insurance of $74.2 million.
Incurred losses and LAE for the years ended December 31, 2012 and 2011 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 $7.2 million and $3.7 million, respectively, for 2012 and 2011. The Reciprocal Exchanges had reductions in loss reserves of $2.5 million and $1.2 million, respectively, for 2012 and 2011.
of business, the actuarial reserving method usually given the most weight shifts from the loss ratio projection to the B-F method to the incurred loss projection as each accident year matures. These methods are described in “Business-Loss and Loss Adjustment Expense Reserves.”
In most cases, our data are sufficiently credible to determine loss development factors utilizing our own data. In some cases, we supplement our own loss development experience with industry data and utilize historical loss development experience for particular books of business, programs or treaties obtained from our sources. The loss development factors are reviewed at least annually, and whenever there is a significant change in the underlying business. Each quarter we test the loss development by analyzing actual emerging claims compared to expected development.
For the years ended December 31, 2012 and 2011, 0 and 34,612 new common shares, respectively, were issued as the result of employee stock option exercises and 372,618 and 654,180 new common shares, for the same periods, respectively, were issued as the result of restricted stock grants.
For the years ended December 31, 2012 and 2011, 103,599 and 78,732 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, 2012 and 2011, 25,166 and 18,841 shares, respectively, of common stock were surrendered as a result of restricted stock forfeitures.
Dividends on common stock of $29.1 million, $27.9 million and $16.6 million for the years ended December 31, 2012, 2011 and 2010, respectively, were declared and paid.
The Company’s borrowings consisted of the following at December 31, 2012 and 2011:
Total interest expense incurred, including interest expense on the funds held liabilities disclosed in “Note 10 - Reinsurance”, was $32.6 million, $34.3 million and $24.2 million for the years ended December 31, 2012, 2011 and 2010, respectively.
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 to floating rates and convert the subordinated debentures to fixed rates ranging from 5.1% to 5.9%. As of December 31, 2012 and 2011, the Swaps had a fair value of $9.0 million and $7.4 million, respectively, in a liability position and are reported in Other Liabilities.
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 years ended December 31, 2012, 2011 and 2010, $1.6 million, $0.4 million and $18,000, respectively, was reclassified from AOCI to interest expense for the effects of the hedges. As of December 31, 2012 and 2011, the Company had collateral on deposit with the counterparty amounting to $9.1 million and $7.0 million, respectively, pursuant to its Credit Support Annex.
The Company had $70.0 million and $50.0 million outstanding as of December 31, 2012 and 2011, respectively. The weighted average interest rate on the amount outstanding as of December 31, 2012 and 2011 was 2.0% and 3.5%, respectively.
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 adjusted conversion rate at December 31, 2012 is 37.1689 shares of common stock per $1,000 principal amount of the Notes (equivalent to a conversion price of $26.90 per share), subject to further adjustment upon the occurrence of certain events,
including the following: if Tower issues shares of common stock as a dividend or distribution on shares of the common stock , or if Tower effects a share split or share combination; if Tower issues to all or substantially all holders of common stock any rights, options or warrants entitling them, for a period of not more than 45 calendar days after the announcement date of such issuance, to subscribe for or purchase shares of the common stock at a price per share that is less than the average of the last reported sales price of the common stock for the ten consecutive trading day period ending on the date of announcement of such issuance; if Tower distributes shares of its capital stock, other indebtedness, other assets or property of Tower or rights, options or warrants to acquire capital stock or other securities of Tower, to all or substantially all holders of capital stock; if any cash dividend or distribution is made to all or substantially all holders of the common stock, other than a regular quarterly cash dividend that does not exceed $0.125 per share; if Tower makes a payment in respect of a tender offer or exchange offer for common stock, and the cash and value of any other consideration included in the payment per share of common stock exceeds the last reported sale price of the common stock on the trading day next succeeding the last day on which the tenders or exchange may be made. In February 2013, the conversion rate was adjusted to 37.2895, equivalent to a conversion price of $26.82 per share.
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.
In September 2010, the Company received $3.8 million for Warrants sold to the financial institutions. The Warrants provide for the acquisition of 5.5 million shares of common stock at a strike price of $32.71 per share at December 31, 2012, subject to anti-dilution adjustments. The Warrants have been accounted for as an adjustment to the Company’s paid-in-capital.
To the extent the Company’s common stock price is above $26.90 but below the Warrant strike price of $32.71, 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 2008 LTEP 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 230,943 are available for future grants as of December 31, 2012.
The following table provides information with respect to the stock options and shares of the Company’s common stock issued (i) to the Company’s employees under the 2004 LTEP and (ii) to employees and directors of companies acquired by the Company in exchange for the options and shares owned by such employees and directors in such companies at the time of acquisition.
The following table provides an analysis of restricted stock activity for the years ended December 31, 2012, 2011 and 2010:
The following table provides an analysis of stock option activity for the years ended December 31, 2012, 2011 and 2010:
The fair value of the options granted to replace the CastlePoint options was estimated using the Black-Scholes pricing model as of February 5, 2009, the date of conversion from CastlePoint stock options to the Company’s stock options, with the following weighted average assumptions: risk free interest rate of 1.46% to 1.83%, dividend yield of 0.8%, volatility factors of the expected market price of the Company’s common stock of 43.8% to 45.3%, and a weighted-average expected life of the options of 3.3 to 5.3 years.
fixed assets placed in service after September 8, 2010 as allowed by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. This 100% acceleration provision expired on December 31, 2011, and the Company is back to a 50% acceleration of depreciation of fixed assets.
The Company maintains a defined contribution Employee Pretax Savings Plan (401(k) Plan) for its employees. The Company matches 50% of each participant’s contribution up to 8% of the participant’s eligible contribution. The Company incurred $3.5 million, $3.2 million, and $2.7 million of expense in 2012, 2011 and 2010, respectively, related to the 401(k) Plan.
The SERP is a non-qualified defined contribution plan effective as of January 1, 2009 that is intended to enhance retirement benefits for the Company’s most senior executives and certain other key employees. Eligibility to participate in the SERP generally requires three years of prior employment with the Company for Executive Vice Presidents and Senior Vice Presidents and between five and 10 years of prior employment with the Company for other key employees. In 2012, all of the Named Executive Officers, as well as certain other key executives selected at the discretion of the Compensation Committee, participated in the SERP. Subject to the approval of the Compensation Committee, the Company may make annual contributions to the SERP on behalf of each participant. The SERP is not a defined benefit plan and such target benefit level cannot be guaranteed. For all participants, the amount of the annual contribution is presently equal to 5.0% of their annual cash compensation. Company contributions for each participant remain unvested until such participant has completed 10 years of service with the Company, and vest in full upon completion of 10 years of service. The Compensation Committee has discretion to terminate the SERP at any time or to adjust upward or downward the level of the Company’s contribution each year.
The Company amortizes scheduled annual rental increases and lease incentives ratably over the term of the lease. The Company’s future minimum lease payments are as follows:
Total rental expense was $9.7 million, $11.1 million and $10.0 million in 2012, 2011 and 2010, respectively.
For regulatory purposes, the Company’s insurance subsidiaries, excluding CastlePoint Reinsurance Company, Ltd. (“CastlePoint Re”) which, as discussed below, is Bermuda domiciled, prepare their statutory basis financial statements in accordance with practices prescribed or permitted by the state they are domiciled in (“statutory basis” or “SAP”). The more significant SAP variances from GAAP are as follows:
State insurance laws restrict the ability of our insurance subsidiaries to declare dividends. State insurance regulators require insurance companies to maintain specified levels of statutory capital and surplus. Generally, dividends may only be paid out of earned surplus, and the amount of an insurer’s surplus following payment of any dividends must be reasonable in relation to the insurer’s outstanding liabilities and adequate to meet its financial needs. Further, prior approval of the insurance department of its state of domicile is required before any of our insurance subsidiaries can declare and pay an “extraordinary dividend” to the Company.
For the years ended December 31, 2012, 2011 and 2010, the Company’s insurance subsidiaries had SAP net income (loss) of $(29.6), $52.0 million and $76.0 million, respectively. At December 31, 2012 and 2011 the Company’s insurance subsidiaries had reported SAP surplus as regards policyholders of $619.9 million and $686.8 million, respectively, as filed with the insurance regulators.
For the year ended December 31, 2012, CastlePoint Re had statutory net income of $0.9 million and at December 31, 2012, had statutory surplus of $277.0 million.
Fixed maturity and equity securities: Fair value disclosures for investments are included in “Note 7-Fair Value Measurements.”
Reinsurance balances payable and funds held under reinsurance contracts: The carrying value reported in the balance sheet for these financial instruments approximates fair value.
Undistributed net earnings (loss) (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
The Personal Insurance segment includes revenues and expenses associated with the Reciprocal Exchanges, including fees paid to Tower for underwriting, claims, investment management and other services provided pursuant to management services agreements with the Reciprocal Exchanges. The Insurance Services segment reports revenues earned by Tower from the Reciprocal Exchanges as management fee income, which is calculated as a percentage of the Reciprocal Exchanges’ gross written premiums. The effects of these management services agreements between Tower and the Reciprocal Exchanges are eliminated in consolidation to derive consolidated net income. However, the management fee income is reported in net income attributable to Tower Group, Inc. and included in basic and diluted earnings per share.