We lease approximately 54,000 square feet of space at 120 Broadway, New York, New York, which consists of the entire 14th floor and a portion of the 17th floor. In 2005 , we paid an annual rent of $1,336,000, which increased by the terms of the lease agreement on September 16, 2005 to $1,354,000. On September 1, 2005, we executed a Third Amendment to Lease for new premises (approximately 94,000 square feet) at 120 Broadway, New York, New York for the entire 31st floor and a portion of the 30th floor. The lease commencement date is January 1, 2006 and will end on June 30, 2021. We anticipate the surrender of our old premises on July 1, 2006. See Note 13-“Commitment and Contingencies”.
We provide a broad range of property and casualty insurance products as well as reinsurance through TICNY and TNIC, our insurance company subsidiaries We also provide managing general underwriting, claims administration and reinsurance intermediary services through TRM, our insurance services subsidiary. TNIC has not written or assumed any premiums in 2005.
In our insurance segment, TICNY provides commercial and personal lines insurance policies to businesses and individuals. TICNY’s commercial lines products include commercial multiple-peril (provides both property and liability insurance), monoline general liability (insures bodily injury or property damage liability), commercial umbrella, monoline property (insures buildings, contents or business income), workers’ compensation and commercial automobile policies. Its personal lines products consist of homeowners, dwelling and other liability policies. In our reinsurance segment, TICNY assumes reinsurance directly from the insurance companies for which TRM produces insurance premiums (which we refer to as TRM’s “issuing companies”) or indirectly from reinsurers that provide reinsurance coverage directly to these issuing companies. In our insurance services segment, TRM generates commission income from its managing general agency by producing premiums on behalf of its issuing companies and generates fees by providing claims administration and reinsurance intermediary services. As of December 31, 2005 TNIC has not commenced underwriting operations.
On June 22, 2004 our Board of Directors approved a 1.8:1 stock split, the maintaining of a par value of $0.01 after the split and the amendment and restatement of our Certificate of Incorporation which among other things combined the Class A and Class B common stock into one class of common stock and increased the authorized common stock to 40,000,000 shares. These actions became effective on October 20, 2004, which is the effective date of our IPO. All consolidated financial statements and per share amounts have been retroactively adjusted for the above stock split and maintaining the par value at $0.01 per share.
On October 20, 2004, we sold 13,000,000 shares in our IPO at $8.50 per share. On the same date, we also effected a concurrent private placement of 500,000 shares of our common stock to an affiliate of Friedman, Billings, Ramsey & Co., Inc., the lead underwriter for our IPO, at a price of $8.50 per share. On November 10, 2004 the underwriters exercised their 30-day over-allotment option after our IPO. Pursuant to this exercise, the underwriters purchased 629,007 additional shares of common stock from us and 1,320,993 shares of common stock from selling shareholders. We received net cash proceeds of $107,845,000 from the offering and concurrent private placement after the underwriting discounts, commissions and offering expenses. The total costs of the IPO and private placement were $12,252,000 of
which $8,407,000 was for the underwriters discount, and $3,845,000 was for all other costs. Costs of the IPO have been reflected as a reduction in Paid-in-Capital.
On August 8, 2005, following our shell acquisition strategy, we announced our execution of an agreement to acquire MIIX Insurance Company of New York (“MIIX”), an insurance company with licenses in New York and New Jersey. Closing of the transaction is expected to occur in early 2006 and is contingent upon a variety of conditions including approval of the transaction by the New York State Insurance Department. In the event of closing, we will pay $225,000 in cash at closing as well as an amount equal to MIIX’s statutory surplus which was approximately $7.8 million as of December 31, 2004. MIIX has no net liabilities for insurance losses. MIIX’s assets consist of U.S. Treasuries and cash.
A.M. Best expects that, although significant, the hurricanes of 2005 will only briefly offset industry-wide price softening in 2006. Price competition has become most apparent in the larger accounts for the commercial lines, especially the commercial property and general liability. The mid-sized and smaller
TICNY’s gross premiums written in 2005, 2004 and 2003 were $300.1 million, $177.8 million and $134.5 million, respectively. Premiums produced by TRM in 2005, 2004 and 2003 were $35.2 million, $53.4 million and $39.5 million, respectively.
We derive our revenue from the net premiums earned, ceding commissions, direct commission revenue and fees and net investment income and net realized gains from investments. The limited surplus in TICNY before our October 2004 IPO constrained our ability to write net premiums because we are required to maintain a minimum level of surplus to support premiums. As a result, we ceded premiums to generate ceding commissions in TICNY and we produced premiums for TRM’s issuing companies to generate non-risk bearing revenues in our insurance services operation. Consistent with this strategy, during the five years ended December 31, 2004, we derived 34.6% and 36.9% of our total revenues from net premiums earned and ceding commissions, respectively from TICNY and 24.8% of our total revenue from direct commission and fees from our insurance services operation. Our investment income and realized gains from investments comprised 3.7% of our total revenues during this period. Immediately after the IPO we contributed $98 million of the proceeds from the IPO and the concurrent private placement to TICNY, which increased its statutory surplus. Additionally, TICNY received a rating upgrade from A.M Best to “A-” (Excellent) in October 2004. With the higher rating we were able to more fully deploy the additional capital. In 2005, the first full calendar year since the IPO and concurrent private placement, TICNY increased its gross premiums written and maintained its reduced quota share ceding percentage at 25%. As a result, net premiums earned increased to 74.8% of total revenues, ceding commissions decreased to 11.9% of total revenues and direct commission and fees from our insurance services operation declined to 6.4% of total revenues. Our investment income and realized gains from investments increased to 6.9% of our total revenues in 2005.
Net premiums earned. Premiums written include all premiums received by an insurance company during a specified accounting period, even if the policy provides coverage beyond the end of the year. Premiums are earned over the term of the related policies. At the end of each accounting period, the portion of the premiums that are not yet earned are included in the unearned premium reserve and are realized as income in subsequent periods over the remaining term of the policy. Our policies typically have a term of 12 months. Thus, for example, for a policy that is written on July 1, 2005, one-half of the premiums would be earned in 2005 and the other half would be earned in 2006.
Net premiums earned are the earned portion of our net premiums written. Net premiums written are equal to the difference between gross premiums written and premiums ceded to reinsurers, or ceded premiums written. Our gross premiums (written and earned) are the sum of both direct premiums from our insurance segment and assumed premiums from our reinsurance segment. Throughout this Form 10-K, direct and assumed premiums (written or earned) separately or together are also referred to as gross premiums.
· Direct and ceding commission expenses. We pay direct commission expense to our producers in our insurance segment for the premiums that they generate for us. Our managing general agency also pays direct commission expense to our producers in our insurance services segment. In addition, TICNY also pays ceding commission expense to TRM’s issuing companies for the reinsurance premiums that we assume in our reinsurance segment. Ceding commission is typically paid on quota share reinsurance agreements, but not on excess of loss reinsurance agreements.
· Interest expense. We pay interest on our loans, on subordinated debentures and on segregated assets placed in trust accounts on a “funds withheld” basis in order to collateralize reinsurance recoverables.
· Income taxes. We pay Federal, state and local income taxes and other taxes.
Loss ratio. The loss ratio is the ratio of losses and loss adjustment expenses incurred to premiums earned and measures the underwriting profitability of a company’s insurance business. We measure our loss ratio on a gross (before reinsurance), and net basis (after reinsurance) as well as the loss ratio on the ceded portion (the difference between gross and net premium) for our insurance and reinsurance segments. We use the gross loss ratio as measures of the overall underwriting profitability of the insurance business we write and to assess the adequacy of our pricing. We use the ceded loss ratio to measure the experience on the premiums that we cede to reinsurers, including the premiums ceded under our quota share treaties. Beginning in 2001, the loss ratio on such ceded business has determined the ceding commission rate that we earn on ceded premiums. Our net loss ratio is meaningful in evaluating our financial results, which are net of ceded reinsurance, as reflected in our consolidated financial statements. In addition, we use accident year and calendar year loss ratios to measure our underwriting profitability. An accident year loss ratio measures losses and loss adjustment expenses for insured events occurring in a particular year, regardless of when they are reported, as a percentage of premium earned during that year. A calendar year loss ratio measures losses and loss adjustment expense for insured events occurring during a particular year and the change in loss reserves from prior accident years as a percentage of premiums earned during that year.
Underwriting expense ratios. The underwriting expense ratio is the ratio of direct and ceding commission expenses and other underwriting expenses less policy billing fees to premiums earned. The underwriting expense ratio measures a company’s operational efficiency in producing, underwriting and administering its insurance business. Due to our historically high levels of reinsurance, we calculate our underwriting expense ratios on a gross basis (before the effect of ceded reinsurance) and net basis (after the effect of ceded reinsurance). Ceding commission revenue is applied to reduce our underwriting expenses in our insurance company operation. Because the ceding commission rate we earn on our premiums ceded has historically been higher than our underwriting expense ratio on those premiums, our extensive use of quota share reinsurance has caused our net underwriting expense ratio to be lower than our gross expense ratio.
Premium produced by TRM. TRM operates a managing general agency that earns commissions on written premiums produced on behalf of its issuing companies. Although TRM is not an insurance company, we utilize TRM’s access to its issuing companies as a means to expand our ability to generate premiums beyond TICNY’s statutory surplus capacity. For this reason, we use written premiums produced by TRM on behalf of its issuing companies as well as TRM’s commission revenue to evaluate our ability to achieve growth.
Net income and return on average equity. We use net income to measure our profits and return on average equity and to measure our effectiveness in utilizing our shareholders’ equity to generate net income on a consolidated basis. In determining return on average equity for a given year, net income is divided by the average of shareholders’ equity for that year. As the IPO was completed in fourth quarter of 2004, the 2004 full year return on equity was calculated by dividing net income by an average shareholders’ equity for the year.
Loss and loss adjustment expense reserves. Loss and loss adjustment expense reserves represent our best estimate at a particular point in time of the ultimate unpaid cost of all losses and loss adjustment expenses incurred, including settlement and administration of losses, based on facts and circumstances then known and including losses that have been incurred but not yet been reported. The process of establishing the liability for unpaid losses and loss adjustment expenses is complex, requiring the use of informed estimates and judgments. Actuarial methodologies are employed to assist in establishing these estimates and include judgments relative to estimates of future claims severity and frequency, the length of time before losses will develop to their ultimate level, possible changes in the law and other external factors that are often beyond our control. The amount of loss and loss adjustment expense reserves for reported claims is based primarily upon a case-by-case evaluation of coverage, liability, injury severity, and
any other information considered pertinent to estimating the exposure presented by the claim. The amounts of loss and loss adjustment expense reserves for unreported claims are determined using historical information by line of insurance as adjusted to current conditions.
Due to the inherent uncertainty associated with the reserving process, the ultimate liability may differ, perhaps substantially, from the original estimate. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current year’s results. Reserves are closely monitored and are recomputed periodically using the most recent information on reported claims and a variety of statistical techniques. Specifically, on at least a quarterly basis, we review, by line of business, existing reserves, new claims, changes to existing case reserves and paid losses with respect to the current and prior years. See “Item 1.-Loss and Loss Adjustment Expense Reserves” and “Note 3. Property-Casualty Insurance” in the notes to our audited financial statements for additional information regarding our loss reserves.
In 2005 and 2004, we had favorable development in our net losses from prior years accident years of $392,000 and $199,000, respectively and unfavorable development in net losses from prior accident years of $75,000 in 2003.
Reinsurance recoverables. Reinsurance recoverable balances are established for the portion of the loss reserves that are ceded to reinsurers. Prepaid reinsurance premiums represent unearned premiums that are ceded to reinsurers. These are reported on our balance sheet separately as assets, instead of being netted against the related liabilities, since reinsurance does not relieve us of our legal liability to policyholders and ceding companies. We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. Consequently, we bear credit risk with respect to our individual reinsurers and may be required to make judgments as to the ultimate recoverability of our reinsurance recoverables. Additionally, the same uncertainties associated with estimating loss and loss adjustment expense reserves affect the estimates of the amount of ceded reinsurance recoverables. We continually monitor the financial condition and rating agency ratings of our reinsurers. 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’s Regulation 114 or by providing a letter of
Deferred acquisition costs/commission revenues. We defer certain expenses and commission revenues related to producing and reinsuring insurance business, including commission expense on gross premiums written, commission income on ceded premiums written, premium taxes and certain other costs related to the acquisition of insurance contracts. These costs and revenues are capitalized and the resulting asset or liability, deferred acquisition costs/revenues, is amortized and charged to expense or income in future periods as gross premiums written are earned. The method followed in computing deferred acquisition costs/income limits the amount of such deferred amounts to its estimated realizable value. The ultimate recoverability of deferred acquisition costs is dependent on the continued profitability of our insurance underwriting. If our insurance underwriting ceases to be profitable, we may have to write-off a portion of our deferred acquisition costs, resulting in a further charge to income in the period in which the underwriting losses are recognized.
of our fixed maturity and equity securities recorded during 2005, 2004 and 2003. Significant changes in the factors we consider when evaluating investments for impairment losses could result in a significant change in impairment losses reported in our consolidated financial statements. See “Item 1.-Investments” and “Note 2. Investments” for additional detail regarding our investment portfolio at December 31, 2005, including disclosures regarding other than temporary declines in investment value.
Total revenues. Total revenues increased by 104.1% to $219.8 million for 2005 compared to $107.7 million for the same period in 2004. The increase is primarily due to the increase in net premiums earned and net investment income. Net premiums earned represented 74.8% of total revenues for 2005 compared to 42.3% for the same period in 2004. Net investment income, excluding realized capital gains, represented 6.8% and 4.7% of total revenues for 2005 and December 31, 2004, respectively. These increases were partially offset by lower total commission and fee income for 2005 of $40.2 million, or 18.3% of total revenue, compared to $57.0 million, or 53.0% of total revenue, for the same period in 2004.
Interest expense. Our interest expense was $4.9 million in 2005 compared to $3.1 million in 2004. The increase resulted from an increase in interest expense of $2.0 million on subordinated debentures underlying our trust preferred securities of $47.4 million of which $26.8 million were issued in
Net income and return on average equity. Our net income and annualized return on average equity was $20.8 million and 15.1%, respectively, for 2005 compared to $9.0 million and 23.7%, respectively, for the same period in 2004. Although net income increased 129.9% in 2005 compared to 2004, the lower return on average equity resulted from the significant increase in average stockholders’ equity as our IPO and concurrent private placement were completed in the fourth quarter of 2004. For 2005, the return was calculated by dividing net income of $20.8 million by an average stockholders’ equity of $137.1 million. For 2004, the return was calculated by dividing net income of $9.0 million by an average stockholders’ equity of $38.1 million.
Losses and loss adjustment expenses. Gross loss and loss adjustment expenses and the gross loss ratio for both the insurance and reinsurance segments combined in 2004 were $84.2 million and 55.2%, respectively, compared to $74.2 million and 60.8%, respectively, in 2003. The net loss ratio for the combined segments was 59.4% in 2004 and 65.7% in 2003. The improvement in the net loss ratio in 2004 compared to 2003 was due primarily to an increase in net premiums earned that reduced the effect of excess and catastrophe reinsurance premiums on the net loss ratio and to favorable development from prior years’ reserves of $199,000. See “Item 7.-Insurance Segment Results of Operations” and “Reinsurance Segment Results of Operations.”
Operating expenses. Total operating expenses in 2004 increased by 29.5% to $62.8 million from $48.5 million in 2003. The increase was due primarily to the increase in underwriting expenses resulting from the growth in premiums earned in TICNY and produced by TRM, costs related to the OneBeacon transaction including establishing two new offices in Long Island and Western New York, additional staffing and other expenses in preparation for a public company environment, and an increase in regulatory assessments.
Net income and return on average equity. Net income and return on average equity in 2004 were $9.0 million and 23.7%, respectively, compared to $6.3 million and 56.8%, respectively, in 2003, which represents a 43.8% increase in net income. Although net income was significantly higher in 2004 than in 2003, the lower return on average equity resulted from the significant increase in average shareholders’ equity as the IPO was completed in the fourth quarter of 2004. For the year, the return was calculated by dividing net income of $9.0 million by an average shareholders’ equity of $38.1 million.
Gross premiums. Gross premiums written increased by 69.5% to $298.6 million for 2005 compared to $176.2 million in 2004. Gross premiums earned increased by 56.2% to $236.2 million for 2005 compared to $151.2 million in 2004. Factors contributing to these increases include a 29.2% increase in the number of policies in force as of December 31, 2005 compared to December 31, 2004 and premium increases on renewed business which averaged 7.6% in personal lines and 5.5% in commercial lines in 2005. The retention rate was 90% for personal lines and 84% for commercial lines. Additionally, premiums written on business subject to the OneBeacon renewal rights agreement, entered into in September 2004, amounted to $31.4 million during 2005 compared to $2.4 million in 2004. New business written during 2005 through former OneBeacon producers that we appointed in connection with the renewal rights transaction amounted to $17.3 million compared to $2.6 million in 2004. Also, due to the upgrade in TICNY’s rating from A.M. Best to “A-” (Excellent) from “B++” (Very Good), certain policies in the more rating sensitive large lines and middle market programs in our Insurance Services Segment were renewed in our Insurance Segment.
Ceded premiums. Ceded premiums written increased by 10.8% to $88.2 million in 2005 compared to $79.6 million in 2004 as a result of the increases in gross premiums written offset by a reduction in the percentage ceded under the quota share agreements. For the first nine months of 2004, the ceding percentage under our quota share reinsurance agreements was 60% and beginning October 1, 2004 was 25%. The 2005 quota share reinsurance agreements maintained the 25% ceding percentage throughout 2005. The effective quota share ceding percentage was 41.6% in 2004 that also included a $13.1 million reduction to ceded written premiums from the retention of the unearned premium at December 31, 2004 that would have been ceded to Converium. Following the downgrade of Converium ‘s rating and decision by its parent to place that company into runoff in September 2004, we terminated and novated Converium’s participation under its 2004 quota share treaty and decided to retain the ceded unearned premiums that would have been ceded to Converium absent the termination. Excluding the $13.1 million that we retained, the effective quota share ceding percentage would have been 49.1% in 2004 compared to 25% in 2005. See “Note 5. Reinsurance-Converium” in the notes to our audited financial statements and “Item 1.-Reinsurance-2004 Reinsurance Program” for a further discussion. Notwithstanding the lower ceding percentage in 2005, ceded premiums written in 2005 decreased only 10.8% as a result of the increase in the gross written premium by 69.5%
The commission portion of the gross expense ratio, which expresses direct commission expense paid to our producers as a percentage of gross premiums earned, was 16.4% in 2005, compared to 16.8% in 2004. This decrease was due primarily to the lower commission on large lines and middle market programs written in the Insurance Segment that were previously placed through the Insurance Services Segment. This decrease was offset in part by an increase in producer contingent commission expense.
Gross premiums. Gross premiums written in 2004 increased by 32.2% to $176.2 million from $133.3 million in 2003. Gross premiums earned increased similarly by 25.4% to $151.2 million in 2004 compared to $120.5 million in 2003. These increases are attributable to a 12.3% growth in policy count and to a 16.8% increase in average premium size resulting primarily from rate increases and other pricing actions.
Ceded premiums. Ceded premiums written in 2004 decreased by 24.4% to $79.6 million compared with $105.3 million in 2003. Although gross written premiums increased in 2004, ceded written premiums declined due to our decision to lower the ceding percentage under our quota share reinsurance agreements. For the first nine months of 2003, the ceding percentage under our quota share reinsurance agreement was 70% and beginning October 1, 2003 was 80%. The effective quota share ceding percentage was 77.2% for 2003. For the first nine months of 2004, the ceding percentage under our quota share reinsurance agreement was 60% and beginning October 1, 2004 was 25%. The effective quota share ceding
The commission portion of our underwriting expense ratio in 2004, which expresses direct commission expense paid to our producers as a percentage of gross premiums earned, was 16.8% compared to 17.2% in 2003. The commission ratio in 2003 was affected by the higher commissions paid to producers in 2002 and recognized as commission expense in 2003 as the related premium was earned.
The net underwriting expense ratio in 2004 was 16.1% compared to 4.9% in 2003 which reflects lower ceding commission revenue in 2004 due to the reduction in the effective quota share ceding percentage from 77.2% in 2003 to 41.6% in 2004. In addition, other underwriting expenses increased by 38.2% to $22.5 million in 2004 compared to $16.3 million in 2003 due principally to the increases mentioned above.
Gross premiums. Gross premiums written decreased by 8.5% to $1.5 million in 2005 as compared to $1.6 million in 2004. This was due to the decrease in the premiums produced by TRM for its issuing companies, primarily due to certain policies in the more rating sensitive middle market and large lines programs renewing in the Insurance Segment offset in part by higher premium rates.
5.8% decrease in reinsurance intermediary fees to $688,000 in 2005, compared to $730,000 in 2004 due to the reduction in the quota share treaty ceding percentages. Claims administration revenue increased by 4.0% to $4.3 million in 2005 as compared to $4.1 million in 2004. Premiums produced during 2005 on business subject to the renewal rights agreement with OneBeacon amounted to $5.1 million compared to $0.8 million in 2004. New business produced through former OneBeacon producers that we appointed in connection with the renewal rights transaction amounted to $1.5 million in 2005 compared to $0.7 million in 2004.
Direct commission expense. TRM’s direct commission expense rate was 14.4% in 2005 compared to 13.9% in 2004. This was due to the 4.9% increase in TRM’s small market program in 2005. The small market program carries a higher commission rate than the large market program.
Claims expense reimbursement. The amount of reimbursement by TRM for claims administration pursuant to the terms of the expense sharing agreement with TICNY in 2005 was $4.3 million as compared to $4.0 million in 2004 due to an increase in the number of claims handled.
Direct commission expense. TRM’s direct commission expense rate in 2004 was 13.9% compared to 13.7% in 2003. This was due to an increase in the small business overflow program to $9.9 million of premiums produced in 2004 from $6.7 million of premiums produced in 2003. The small business overflow program has a higher commission rate.
Other insurance services expense. The amount of reimbursement for underwriting expenses by TRM to TICNY in 2004 was $3.0 million as compared to $2.2 million in 2003. The increase resulted from the increase in premiums produced.
We classify our investments in fixed maturity securities as available for sale and report these securities at their estimated fair values based on quoted market prices or a recognized pricing service. Changes in unrealized gains and losses on these securities are reported as a separate component of comprehensive net income, and accumulated unrealized gains and losses are reported as a component of accumulated other comprehensive net income in stockholders’ equity. Realized gains and losses are charged or credited to income in the period in which they are realized.
The aggregate fair market value of our invested assets as of December 31, 2005 was $358.6 million. As of that date, our fixed maturity securities had a fair market value of $326.7 million and amortized cost of $331.1 million. Equity securities, available for sale, at fair value were $5.9 million as of December 31, 2005 and a cost of $6.7 million. Equity securities at cost were $24.6 million as of December 31, 2005. Our common trust securities-statutory business trusts had a fair value and equity value of $1.4 million.
The following table presents information regarding our invested assets that were in an unrealized loss position at December 31, 2005 by amount of time in a continuous unrealized loss position.
TRM is not subject to any limitations on its dividends to Tower, other than the basic requirement that dividends may be declared or paid if the net assets of TRM remaining after such declaration or payment will at least equal the amount of TRM’s stated capital. TRM declared dividends of $2,550,000 in 2005 and none in 2004 and 2003.
On October 20, 2004, we sold 13,000,000 shares in our IPO at $8.50 per share. On the same date, we also effected a concurrent private placement of 500,000 shares of our common stock to an affiliate of Friedman, Billings, Ramsey & Co., Inc., the lead underwriter for our IPO, at a price of $8.50 per share. On November 10, 2004 the underwriters exercised their 30-day over-allotment option after our IPO. Pursuant to this exercise, the underwriters purchased 629,007 additional shares of common stock from us and 1,320,993 shares of common stock from selling shareholders. We received net cash proceeds of $107,845,000 from the offering and concurrent private placement after the underwriting discounts, commissions and offering expenses. The total costs of the IPO and private placement were $12,252,000 of which $8,407,000 was for the underwriting discount, and $3,845,000 was for all other costs.
On June 8, 2005 the Company contributed $10,000,000 in capital and surplus to TNIC. The gross paid in and contributed surplus at December 31, 2005 for TNIC includes $1,303,000 of intangible assets contributed by us consisting of purchase price, legal fees and broker fees incurred to acquire TNIC.
TICNY and TNIC are required by law to maintain a certain minimum level of policyholders’ surplus on a statutory basis. Policyholders’ surplus is calculated by subtracting total liabilities from total assets. The NAIC maintains risk based capital (“RBC”) requirements for property and casualty insurance companies. RBC is a formula that attempts to evaluate the adequacy of statutory capital and surplus in relation to investments and insurance risks. The formula is designed to allow the state insurance departments to identify potential weakly capitalized companies. Under the formula, a Company determines its “risk-based capital” by taking into account certain risks related to the insurer’s assets (including risks related to its investment portfolio and ceded reinsurance) and the insurer’s liabilities (including underwriting risks related to the nature and experience of its insurance business). Applying the RBC requirements as of December 31, 2005, TICNY’s and TNIC’s risk-based capital exceeded the minimum level that would trigger regulatory attention. In addition to monitoring RBC to ensure regulatory compliance, we monitor various financial ratios, including gross and net premiums written to surplus ratios. There were no capital contributions to TICNY in 2005 and $98.0 million and $17.1 were contributed in 2004 and 2003, respectively. In June 2005, we contributed $10.0 million in cash to TNIC and an additional $1.3 million for the state insurance licenses we acquired as part of the 2005 purchase of a shell insurance company that was renamed TNIC.
Our 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 and issuing company settlements and the timing of our loss payments.
For 2005, net cash provided by operating activities was $128.5 million compared to operating cash flow of $76.1 in 2004. The increase in net cash provided by operations in 2005 resulted from an increase in collected premiums as a result of the growth in gross premiums and the reduction in the effective quota share reinsurance ceding percentage from 41.6% in 2004 to 25% in 2005.
December 31, 2005, cash and cash equivalents greatly exceeded the estimated $24.7 million of net loss reserves as of that date that we expected to pay within the next year. As necessary, we adjust our 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 “Item 1.-Investments”.
· non-payment of all or any part of the principal of the trust preferred securities;
Report of Independent Registered Public Accounting Firm-Internal Control Over Financial Reporting
Management of Tower Group, Inc. (together with its consolidated subsidiaries, the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting. Management conducted an assessment of the effectiveness, as of December 31, 2005, of the Company’s internal control over financial reporting, based on the framework established in Internal Control-Integrated Framework Issued by the Committee Sponsoring Organizations of the Treadway Commission (COSO). Based on our assessment under that framework, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2005.
Our internal control over financial reporting is a process designed by or under the supervision of our principal executive and principal financial officers to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes policies and procedures that(1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of management and the directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on our financial statements.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of December 31, 2005 and 2004, and the related consolidated statements of income and comprehensive net income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005 and our report dated February 17, 2006 expressed an unqualified opinion thereon.
In our opinion, the Company’s financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2005 and 2004, and the results of its operations and its cash flows for the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States.
The consolidated financial statements include the accounts of Tower Group, Inc. (“Tower”) and its wholly-owned subsidiaries, Tower Insurance Company of New York (“TICNY”), Tower National Insurance Company (“TNIC”) and Tower Risk Management Corporation (“TRM”) (collectively “the Company”). The Company’s stock is traded on the NASDAQ National Market under the symbol “TWGP”.
On October 20, 2004, the Securities and Exchange Commission declared Tower Group, Inc.’s registration statement effective. The Company’s IPO was for 13,000,000 shares and was priced at $8.50 per share. Also on October 20, 2004 Tower Group, Inc. offered a concurrent private placement of 500,000 shares of its common stock to an affiliate of Friedman, Billings, Ramsey & Co., Inc. the lead underwriter for the Company’s IPO, at the price of $8.50 per share. On November 10, 2004 the underwriters exercised their 30-day over-allotment option. Pursuant to this exercise, the underwriters purchased 629,007 additional shares of common stock from the Company and 1,320,993 shares of common stock from the selling stockholders at the IPO price of $8.50 per share, less the underwriting discount. The Company did not receive any proceeds from the sale of common stock by any selling stockholder. The Company received net cash proceeds of $107,845,000 from the offering and concurrent private placement after the underwriting discounts, commissions and offering expenses. The total costs of the IPO and private placement were $12,252,000 of which $8,407,000 was for the underwriters discount, and $3,845,000 was for all other costs. Costs of the IPO have been reflected as a reduction in Paid-in-Capital.
TICNY is a property-casualty insurance company incorporated in the State of New York in June 1989. TICNY obtained its license to operate in the State of New York in December 1990, at which time it commenced underwriting operations. TICNY provides coverage for many different market segments, including nonstandard risks that do not fit the underwriting criteria of standard carriers due to factors such as type of business, location and the relatively small amount of premium per policy. TICNY offers commercial multiple-peril, monoline general liability, commercial umbrella, monoline property, workers’ compensation and commercial automobile policies as well as personal lines products such as homeowners, dwelling and other liability policies. Generally, TICNY targets customers that have a reduced potential for loss severity and are not normally exposed to long-tailed, complex or contingent risks, such as products liability, asbestos or environmental claims. TICNY’s commercial lines products provide insurance coverages to businesses such as retail and wholesale stores, grocery stores, restaurants, artisan contractors and residential and commercial buildings. Personal lines products focus on modestly valued homes and dwellings. TICNY’s products are marketed through independent agents. All direct premiums are written in the State of New York. As of December 31, 2005, TICNY was authorized to write business in fourteen states.
TNIC is a property and casualty insurance company that did not write or assume any premiums in 2005.
TRM is a non-risk-bearing insurance services company that produces, through its managing general agency, business on behalf of other insurance companies (which are referred to as TRM’s issuing companies) and primarily focuses on commercial risks with higher per policy premium, including risks that TICNY historically had not been able to target due to surplus, rating and geographical license constraints. However, since Tower’s IPO and private placement in 2004, TICNY has increased its surplus and its A.M. Best rating was upgraded to A- from B++. These changes resulted in TICNY writing more of the risks previously placed by TRM.TICNY also reinsures a portion of the premiums written by TRM’s issuing companies. The Company uses these non-risk-bearing insurance services operations to generate commission income on premiums produced for other insurance companies. In addition, the insurance services operation earns fee revenues by providing claims administration and reinsurance intermediary services to TRM’s issuing companies and to other insurance companies. In 2005 and 2004, two companies accounted for 100% of the managing general agency commissions of TRM. See “Note 5. Reinsurance” for further description.
Additionally, during 2003 the Company engaged in significant reinsurance arrangements with American Re-Insurance Company (“Am Re”), which owned all of the Company’s outstanding shares of Series A Cumulative Redeemable Preferred Stock as of December 31, 2004. The Series A Cumulative Redeemable Preferred Stock was redeemed during 2004. Am Re also held warrants for the purchase of common stock that were exercised during 2004. See “Note 5. Reinsurance”, “Note 8. Debt”, and “Note 9. Capital Stock”.
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant intercompany transactions have been eliminated in consolidation.
The liability for loss and loss adjustment expenses represents management’s best estimate
of the ultimate cost of all reported and unreported losses that are unpaid as of the balance sheet date. The liability for loss and loss adjustment expenses is estimated on an undiscounted basis, using individual case-basis valuations, statistical analyses, and various actuarial procedures. The projection of future claim payment and reporting is based on an analysis of the Company’s historical experience, supplemented by analyses of industry loss data. Management believes that the reserves for loss and loss adjustment expenses are adequate to cover the ultimate cost of losses and claims to date; however, because of the uncertainty from various sources, including changes in reporting patterns, claims settlement patterns, judicial decisions, legislation, and economic conditions, actual loss experience may not conform to the assumptions used in determining the estimated amounts for such liability at the balance sheet date. As adjustments to these estimates become necessary, such adjustments are reflected in current operations. Because of the nature of the business historically written, the Company’s management believes that the Company has limited exposure to environmental claim liabilities.
The Company accounts for reinsurance in accordance with Statement of Financial Accounting Standards No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts” (“SFAS 113”). Management believes the Company’s reinsurance arrangements qualify for reinsurance accounting in accordance with SFAS 113. Management has evaluated its reinsurance arrangements and determined that insurance risk is transferred to the reinsurers. Reinsurance agreements have been determined to be short-duration prospective contracts and, accordingly, the costs of the reinsurance are recognized over the life of the contract in a manner consistent with the earning of premiums on the underlying policies subject to the reinsurance contract.
In preparing financial statements, management estimates the amounts receivable from reinsurers to be uncollectible based on an assessment of factors including the creditworthiness of the reinsurers and the adequacy of collateral obtained, where applicable. The Company recorded no allowance for uncollectible reinsurance at December 31, 2005 and 2004 and did not expense any uncollectible reinsurance during 2005, 2004 and 2003. Significant uncertainties are inherent in the assessment of the creditworthiness of reinsurers and estimates of any uncollectible amounts due from reinsurers. Any change in the ability of the Company’s reinsurers to meet their contractual obligations could have a detrimental impact on the consolidated financial statements and TICNY’s ability to meet its regulatory capital and surplus requirements.
Included in equity securities at cost as of December 31, 2005 are common shares of a closed-end management investment company investing predominately in asset-backed securities and mortgage-backed securities with a cost of $19,558,000. This investment is carried at cost on the balance sheet because there is no publicly traded price quote available. However, management estimated the fair value for this fund by taking the market prices for all the securities in the fund provided by an outside third party pricing service and then dividing by the number of shares outstanding to determine its price per share. Also included in equity securities at cost is an investment in a Real Estate Investment Trust (“REIT”) with a cost of $5,000,000 and an estimated fair value of $5,000,000. The estimated fair value for this security is determined based on recent trades and an expected early 2006 IPO price for this security. This single REIT investment has not been registered under the Securities Act of 1933 and no active market exists for this investment.
Impairment of investment securities results in a charge to operations when a market decline below cost is deemed to be other-than-temporary. The Company regularly reviews its fixed-maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. In general, attention is focused on those securities whose fair value was less than 80% of their amortized cost or cost, as appropriate, for six or more consecutive months. In evaluating potential impairment, management considers, among other criteria: the current fair value compared to amortized cost or cost, as appropriate; the length of time the security’s fair value has been below amortized cost or cost; management’s intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in value; specific credit issues related to the issuer; and current economic conditions. Other-than-temporary impairment losses result in a permanent reduction of the cost basis of the underlying investment. During 2005, 2004 and 2003, the Company did not record any other-than-temporary impairments.
and TRM’s agents’ balances at December 31, 2005, 2004 and 2003 and 11%, 14%and 17% of TICNY’s direct premiums written and TRM’s premiums produced in 2005, 2004and 2003, respectively.
Acquisition costs represent the costs of writing business that vary with, and are primarily related to, the production of insurance business. Policy acquisition costs are deferred and recognized as expense as related premiums are earned. Deferred acquisition costs presented in the balance sheet are net of deferred ceding commission revenue. The Company considers anticipated investment income in determining the recoverability of these costs and believes they are fully recoverable.
In December 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46(R), “Consolidation of Variable Interest Entities” (“FIN 46(R)”), which establishes accounting guidance for consolidation of variable interest entities (“VIE”) that function to support the activities of the primary beneficiary. The primary beneficiary of a VIE is the entity that absorbs a majority of the VIE’s expected losses, receives a majority of the VIE’s expected residual returns, or both, as a result of ownership, controlling interest, contractual relationship or other business relationship with a VIE. Prior to the implementation of FIN 46(R), VIE’s were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority of voting interest in the entity. As of December 31, 2004, the Company does not consolidate interest in its statutory business trusts for which the Company holds 100% of the common trust securities because Tower is not the primary beneficiary of the trusts. See “Note 8. Debt”. The Company’s investment in common trust securities of the statutory business trust are reported in investments at equity. The Company reports as a liability the outstanding subordinated debentures owed to the statutory business trusts.
Pursuant to a Tax Allocation Agreement, dated as of January 1, 2001, Tower, TICNY, TNIC and TRM compute and pay Federal income taxes on a consolidated basis. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and for operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
The Company manages its operations through three reportable segments: insurance (commercial and personal lines underwriting), reinsurance, and insurance services (managing general agency, claims administration and reinsurance intermediary operations). See “Note 17. Segment Information”.
In December 2004, the Financial Accounting Standards Board (“The FASB”) issued the revised Statement of Financial Accounting Standards SFAS No. 123-R, an amendment to SFAS 123, which suspends APB 25 and requires that the cost of share-based payment transactions be recognized in the financial statements after the fiscal quarter beginning after June 15, 2005. The intended adoption by the Company of SFAS 123-R has been postponed to January 2006 per the Securities and Exchange Commission’s rule amendment promulgated April 14, 2005, that allows calendar year-end companies to elect to implement SFAS 123-R at the start of their next fiscal year beginning after June 15, 2005. The implementation of SFAS 123-R is not expected to have a material effect on the Company’s financial position or results of operations.
In May 2005, The FASB issued statement SFAS No. 154, “Accounting Changes Error Correction,” that changes the requirements for the accounting and reporting of a change in accounting principle made in fiscal years beginning after December 15, 2005. This statement applies to all voluntary changes in accounting principle. The statement requires that the new accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings for that period rather than reported in the income statement. Management does not expect the adoption of this new accounting pronouncement to have any impact on the Company’s financial statements.
of December 31, 2005 the Company did not hold any investments that would have been considered other than temporarily impaired had the application of this accounting standard been required as of December 31, 2005.
Proceeds from the sale and maturity of fixed-maturity securities were $38,325,000, $23,474,000 and $8,992,000 in 2005, 2004 and 2003, respectively. Proceeds from the sale of equity securities were $1,972,000, $50,000 and $25,000 in 2005, 2004 and 2003, respectively. The Company’s gross realized gains and losses on investments are summarized as follows (in 000’s):
Incurred losses and loss adjustment expenses are net of reinsurance recoveries under reinsurance contracts of $38,584,000, $57,104,000, and $59,090,000 in 2005, 2004 and 2003, respectively.
Incurred loss and loss adjustment expenses attributable to insured events of prior years decreased by $392,000 and $199,000 in 2005 and 2004, respectively and increased by $75,000 in 2003. Prior year development is based upon numerous estimates by line of business and accident year. During calendar year 2005 commercial multi peril liability, workers’ compensation, and auto liability had favorable prior year development that was partially offset by unfavorable development in other lines. During 2004 the reinsurance operations had favorable prior year development that offset any unfavorable development in the insurance operations. No additional premiums or return premiums have been accrued as a result of these prior year effects. The Company’s management continually monitors claims activity to assess the appropriateness of carried case and IBNR reserves, giving consideration to Company and industry trends. See “Note 1-Summary of Significant Accounting Policies, Liability for Loss and Loss Adjustment Expense”.
The Company offers insurance coverage for limits up to $10,000,000 for property risks, $1,000,000/$2,000,000 for liability coverages and $10,000,000 for workers’ compensation. Through various quota share, excess of loss and catastrophe reinsurance agreements, as described further below, the Company limits its exposure to a maximum loss on any one risk of $750,000 during the period January 1, through December 31, 2005, $400,000 during the period January 1 through September 30, 2004, $750,000 during the period October 1, through December 31, 2004, $450,000 during the period January 1, through September 30, 2003 (after commutation-see discussion below) and $312,500 during the period October 1 through December 31, 2003.
The structure of the Company’s reinsurance program enables the Company to reflect significant reductions in premiums written and earned and also provides income as a result of ceding commissions earned pursuant to reinsurance contracts. This structure has enabled the Company to significantly grow its premium volume while maintaining regulatory capital and other financial ratios generally within expected ranges used for regulatory oversight purposes. The Company’s participation in reinsurance arrangements does not relieve the Company from its obligations to policyholders.
To reduce TICNY’s credit exposure to reinsurance, quota share reinsurance agreements effective October 1, 2003, January 1, 2004 and January 1, 2005 were placed on a “funds withheld” basis. Under these agreements TICNY places the collected ceded premiums written, net of commissions and the reinsurers margin, in segregated trusts for the benefit of TICNY and the reinsurers. TICNY may withdraw funds for loss and loss adjustment expense payments and commission adjustments. Segregated assets in trust accounts amounted to $60,047,000 and $53,888,000 at December 31, 2005 and 2004 and are included in invested assets. The Company is obliged under the reinsurance agreements to credit reinsurers with an annual effective yield on the monthly balance in the funds held under reinsurance agreements liability accounts of 3% in 2005 and 2.5% in 2004. The amounts credited for 2005 and 2004 were $1,339,000 and $1,069,000, respectively, and have been recorded as interest expense.
The Company earns ceding commissions under quota share reinsurance agreements for 2005, 2004 and 2003 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.
Based on the amount of ceded premiums earned, the maximum potential reduction to ceding commissions earned related to an increase in the Company’s estimated ultimate loss ratios is $25.0 million for all treaties for all four years. The maximum potential reduction for the 2005 treaty year may increase as
In 2001, the Company entered into quota share reinsurance and option agreements with PXRE. Under the option agreement, which was effective on June 30, 2001, PXRE was granted the right to purchase 599,400 shares of common stock of the Company for $16.67 per share. PXRE paid the Company $5,000,000 for this option, which becomes exercisable on June 30, 2006 and expires on July 31, 2006. The agreement provides that PXRE’s right to exercise the option terminates if the Company meets certain conditions. Those conditions included the Company granting to PXRE a right of first refusal with respect to all quota share reinsurance cessions made by the Company through December 31, 2005 and presenting reinsurance submissions to PXRE involving gross written premiums of at least $25,000,000 per year from 2001 through 2005. The terms and conditions of the 2001 quota share reinsurance treaty between PXRE and TICNY, including the commission rate, were amended to reflect the payment of the $5,000,000 under the option agreement. The Company classified the $5,000,000 proceeds for the stock options as commission income in 2001 and attributed no value to the options issued to PXRE due to the $16.67 per share exercise price. On June 8, 2005 the Company was notified that, all conditions were met and that PXRE’s right to purchase 599,400 common shares of the Company was terminated.
In September 2004, A.M. Best downgraded the rating of Converium Reinsurance (North America) Inc. (“Converium”) to “B-” (Fair) and Converium was placed into run-off by its parent Company. As a result, on September 2, 2004, the Company delivered notice to Converium under our quota share treaty of our intent to terminate Converium’s participation on a cut-off basis effective November 1, 2004. Subsequently the Company reached an agreement with Converium, Tokio Millenium Re Ltd. (“Tokio”) and Hannover Reinsurance (Ireland) Ltd. and E+S Reinsurance (Ireland) Ltd. (collectively “Hannover”) to effect a novation of Converium’s participation under the quota share treaty to those other reinsurers effective January 1, 2004, as a result of which Tokio and Hannover agreed to each take 50% of Converium’s share. In connection with the agreement, Tokio, Hannover and the Company agreed to fully release Converium for any liabilities under the quota share treaty. As a result of the novation, Tokio and Hannover assumed the earned premiums and related risks for the period from January 1, 2004 through December 31, 2004. In addition, the Company has retained the unearned premiums and related risks of as of December 31, 2004 that would have been ceded to Converium absent the novation. The unearned premiums of $13,090,000 were fully earned as of December 31, 2005.
The Company entered into a Commercial Renewal Rights Agreement with OneBeacon Insurance Group LLC on September 13, 2004 under which it has acquired OneBeacon’s rights to seek to renew a block of commercial lines insurance policies in New York State consisting of commercial multiple-peril, worker’s compensation, commercial umbrella, commercial inland marine, commercial auto, fire and allied lines and general liability coverages. Under the terms of the agreement, the Company did not acquire any in-force business or historical liabilities associated with the policies. Pursuant to the agreement, the Company also obtained the rights to establish contractual relationships with certain OneBeacon agents. The Company has agreed to pay OneBeacon an amount equal to 5% of the direct premiums written resulting from the Company’s renewal of any subject policies in the first year, 4% in the second year and
1% in the third year, with no payments due after the third year, subject to the Company’s obligation to pay a minimum of $5,000,000 in the aggregate over the three year period. The Company has recorded this transaction as $5,000,000 of intangible assets. Shortly after signing this agreement the Company provided an irrevocable letter of credit for the benefit of OneBeacon in the amount of $2,000,000 representing the estimated payments for the first year of the agreement.
The Company has determined that two intangible assets were acquired in this transaction: renewal rights and new agent contractual relationships, both of which were determined to be intangible assets with a finite useful life. The renewal rights were recorded at $1,250,000 and will be amortized over ten years in proportion to anticipated renewal premiums to be written during this time period. The new agent contractual relationships have been recorded at $3,750,000 and will be amortized over twenty years on a straight-line basis. During 2005 and 2004, the Company recorded amortization expense of $446,000 and $22,000, respectively, on the intangible assets. The weighted average amortization period of identified intangible assets of finite useful life is 17.5 years. The estimated aggregate amortization expense for each of the next five years is (in 000’s):
The components of intangible assets are summarized as follows (in 000’s):
As of December 31, 2005 there was no impairment on any of the intangible assets as per the Company’s annual impairment testing. See Note 1. “Summary of Significant Accounting Policies, Intangible Assets”.
Total interest expense incurred for all subordinated debentures, including amortization of deferred origination costs, was $3,514,000, $1,461,000 and $559,000, respectively for the years ended December 31, 2005, 2004 and 2003.
The roll forward of shares of common stock is as follows (in 000’s):
As part of the IPO in October 2004, the Company issued Friedman Billings Ramsey (FBR), the lead underwriter, warrants to purchase 189,000 shares of the Company’s commons stock at an exercise price of $8.50 per share. The warrants are exercisable for a term of four years beginning on October 20, 2004 and expire on October 20, 2009. On October 28, 2005, FBR exercised warrants and paid the Company the warrant exercise price of $8.50 per share or $89,820 and were issued 10,567 shares by the Company from treasury shares. In addition, FBR exercised 132,300 warrants on October 28, 2005 via a cashless exercise which resulted in the issuance of 64,244 shares by the Company from treasury shares. As of December 31, 2005, FBR has 46,133 warrants outstanding which are included in the calculation of diluted EPS.
The Company declared dividends per share on common stock as follows:
In 2005, the Company issued 33,000 new common shares as a result of employee stock option exercises and 14,000 new common shares for its restricted stock grants to certain employees and directors of the Company. During 2005, 3,725 restricted stock shares were forfeited due to employee terminations and have been recorded as additional treasury shares.
The Company incurred restricted stock amortization expense in 2005, and 2004 of $402,000 and $201,000, respectively, net of tax, which has been included in reported net income.
The Company issued 946,642 additional shares of common stock immediately prior to its IPO in October 2004 as a result of the exercise in full of Am Re’s warrant to purchase 1,049,999 shares of common stock at an exercise price of $0.76 per share, pursuant to a cashless exercise provision, and based upon the IPO price of $8.50 per share.
In 2004, the Company’s Board of Directors adopted and its shareholders approved a long-term incentive plan (the “2004 Long-Term Equity Compensation Plan”). With the adoption of the 2004 Long-Term Equity Compensation Plan, no further grants will be made under the 2001 Stock Award Plan.
The 2004 Long-Term Equity Compensation 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 current maximum number of shares of common stock that may be issued in connection with awards under the plan is 933,707, of which 786,031 may be issued under awards other than stock options or SARs. As of December 31, 2005, awards in respect of 250,813 shares have been made under the plan.
continuous employment with the Company from the date of grant through the vesting date. During the vesting period, the recipients have voting rights and will receive dividends but the shares may not be sold, assigned, transferred, exchanged, pledged or otherwise encumbered. The fair value of the restricted shares was $1,563,000 on the grant date. These restricted shares were authorized and issued prior to the adoption and approval of the 2004 Long-Term Equity Compensation Plan.
Options outstanding and exercisable as of December 31, 2005 are shown on the following schedule:
The Company has elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Based Compensation” and related interpretations in accounting for its employee stock options. Under APB 25, no compensation expense is recognized upon the granting of stock options because the exercise price is equal to the estimated market price at the date of the grant.
January 2006 per the Securities and Exchange Commission’s rule amendment promulgated April 14, 2005, that allows calendar year-end companies to elect to implement SFAS 123-R at the start of their next fiscal year beginning after June 15, 2005. The implementation of SFAS 123-R is not expected to have a material effect on the Company’s financial position or results of operations.
The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123, to stock-based employee compensation (in 000’s, except per share amounts).
The Company files a consolidated Federal income tax return. The provision for Federal, state and local income taxes consists of the following components (in 000’s):
Deferred tax assets and liabilities are determined using the enacted tax rates applicable to the period the temporary differences are expected to be recovered. Accordingly, the current period income tax provision can be affected by the enactment of new tax rates. The net deferred income taxes on the balance sheet reflect temporary differences between the carrying amounts of the assets and liabilities for financial reporting purposes and income tax purposes, tax effected at a 35% rate for 2005 and 2004 and 34% for 2003.
The Company maintains a defined contribution Employee Pretax Savings Plan (401(k) Plan) for its employees. The Company contributes 50% of each participant’s contribution up to 8% of the participant’s compensation. The Company incurred approximately $649,000, $461,000 and $332,000 of expense in 2005, 2004 and 2003, respectively, related to this plan.
From time to time, the Company is involved in various legal proceedings in the ordinary course of business. For example, to the extent a claim asserted by a third party in a law suit against one of the Company’s insureds covered by a particular policy, the Company may have a duty to defend the insured party against the claim. These claims may relate to bodily injury, property damage or other compensable injuries as set forth in the policy. Such proceedings are considered in estimating the liability for loss and loss adjustment expenses. The Company is not subject to any other pending legal proceedings that management believes are likely to have a material adverse effect in the financial statements.
The Company has lease agreements for office space and equipment. The Company’s future minimum lease payments are as follows ($’s in 000’s):
Total rental expense charged to operations was approximately $2,333,000, $1,536,000 and $1,336,000 in 2005, 2004 and 2003, respectively.
On September 1, 2005 the Company executed a Third Amendment to its lease for new premises at 120 Broadway, New York, N.Y., which consists of the entire 31st floor and a portion of the 30th floor (approximately 93,730 square feet). The Company will surrender its old premises at 120 Broadway, New York, N.Y., which consists of the entire 14th floor and a portion of the 17th floor (approximately 54,000 square feet) on the expected surrender date of July 1, 2006. The amended lease term is for fifteen years and six months effective on the new premises commencement date of January 1, 2006. The new premises commencement date was postponed from October 1, 2005 to January1, 2006 per the agreement’s postponement clause which gave additional time to the landlord to complete base building work. The effective date of the landlord’s completed base building work was December 31, 2005. The Company has agreed to pay the landlord $2,718,083 annually for the first five years, $2,905,537 annually for the next five years and for the last five and a half years the greater of $2,905,537 annually or the then prevailing fair market rent. The Company will receive free rent for the first nine month period commencing on the new premises commencement date and will receive $4,502,757 for leasehold improvement incentives. The anticipated net cash outflow for the above amounts, excluding the leasehold improvements incentives, increased the Company’s future minimum lease payments by $42,059,991.The Company will receive an additional $581,530 from the landlord ten days after the surrender date for the purchase of scheduled furniture, fixtures and equipment located in the surrendered premises. The Company intends to execute an operating lease in 2006 for the furniture, fixtures and leasehold improvements for the new premises.
· Certain amounts related to ceded reinsurance are reported on a net basis within the statutory basis financial statements. GAAP requires these amounts to be shown gross.
For the year ended December 31, 2005 TNIC reported statutory net income of $116,000 and reported statutory basis surplus as regards policyholders of $10,116,000. As of December 31, 2005 TNIC is required to maintain $6,350,000 of minimum of capital and surplus in accordance with the Commonwealth of Massachusetts’ Insurance Law.
Under New York law, TICNY is limited in the amount of dividends it can pay to Tower. Under New York law, TICNY may pay dividends to Tower only out of statutory earned surplus. In addition, the New
York Insurance Department must approve any dividend declared or paid by TICNY that, together with all dividends declared or distributed by TICNY during the preceding twelve months, exceeds the lesser of (1) 10% of TICNY’s policyholders’ surplus as shown on its latest statutory financial statement filed with the New York State Insurance Department or (2) 100% of adjusted net investment income during the preceding twelve months immediately preceding the declaration or distribution of the current dividend increased by the excess, if any, of net investment income over dividends declared or distributed during the period commencing thirty-six months prior to the declaration or distribution of the current dividend and ending twelve months prior thereto. TICNY declared approximately $2,050,000, $850,000, and $363,000 in dividends to Tower in 2005, 2004, and 2003, respectively. As of December 31, 2005, TICNY owed Tower $300,000 in dividends payable. As of December 31, 2005, the maximum distribution that TICNY could pay without prior regulatory approval was approximately $4,049,000.
TNIC may not pay any dividend that, together with all dividends declared or distributed by TNIC during the preceding twelve months, excluding pro rata distributions of any class of the TNIC’s own securities, exceeds the greater of (1) 10% of TNIC’s policyholders’ surplus as of the end of the preceding calendar year or (2) TNIC’s net income for the next preceding calendar year, until thirty days after the Commissioner has received notice of the intended dividend and not objected in such time. Because TNIC has not yet commenced insurance operations it has no positive unassigned surplus and, therefore, it may not pay dividends at this time without the approval of the Massachusetts Commissioner of Insurance.
Equity and fixed income investments: Fair value disclosures for investments are included in “Note 2. Investments”.
per share. See “Note 5. Reinsurance”. These options were not included in the computation of diluted EPS in 2004 because their effect would be antidilutive. On June 8, 2005 the Company was notified that all conditions were met and that PXRE’s right to purchase 599,400 common shares of the Company was terminated.
The Company manages its operations through three business segments: insurance (commercial and personal lines underwriting), reinsurance, and insurance services (managing general agency, claims
As of December 31, 2005, the Company had unsecured reinsurance recoverables and ceding commissions receivable totaling $33,228,000 owed by PXRE Reinsurance Company. On February 16, 2006, A.M. Best downgraded to “B++” (Very Good) its former “A-” (Excellent) financial strength rating on PXRE and issued a negative outlook. On February 24, 2006 A.M. Best downgraded PXRE to “B+” (Very Good) with a negative outlook. The Company believes that the unsecured reinsurance recoverables and ceding commissions receivable from PXRE, none of which are past due nor in dispute, are fully collectible. The Company’s judgment is primarily based on PXRE’s capital position as a result of its recent capital raising initiatives.