We also lease office space in Paramus, New Jersey; Melville, New York; Buffalo, New York; Quincy, Massachusetts; Scarborough, Maine; and Bedford, New Hampshire.
We changed our presentation of our business results in the first quarter of 2008 by combining our previously reported insurance segment with our reinsurance segment based on the way management organizes the segments for making operating decisions and assessing profitability. This change in presentation results in the reporting of two operating segments. The prior period segment disclosures have been restated to conform to the current presentation.
We provide a broad range of property and casualty insurance products as well as reinsurance through our Insurance Subsidiaries, TICNY, TNIC, PIC, NEIC and MVIC. We also provide managing general underwriting, claims and other administration and reinsurance intermediary services through TRM, our insurance services subsidiary. We manage these operations through two business segments: insurance (commercial, personal lines underwriting and reinsurance), and insurance services (managing general agency, claims and other administration and reinsurance intermediary operations).
In our insurance segment, our Insurance Subsidiaries provide commercial and personal lines insurance policies to businesses and individuals. Our 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. Our personal lines products consist of homeowners, dwelling, personal automobile and other liability policies. With regard to our reinsurance activities, TICNY assumes reinsurance directly from the insurance companies for which TRM produces insurance premiums (which we refer to as TRM’s “issuing companies”), except CPIC, or indirectly from reinsurers that provide reinsurance coverage directly to these issuing companies.
Our insurance segment reports premiums that we produce as part of our brokerage business. In addition, the insurance segment includes premiums from the traditional and specialty pools that CPM manages for our Insurance Subsidiaries. Our insurance services segment records management fee income that we earn as a result of managing the brokerage business on behalf of CastlePoint. When shown in the consolidated results, this amount is included in total revenues. See “Business-Strategic Relationship and Agreements with CastlePoint and Reinsurance-CastlePoint” for a description of the various agreements between the Company and CastlePoint.
The premium-to-surplus ratio has increased from 0.85:1 to 0.94:1 at year end 2008. Projections for 2009 indicate that while premium-to-surplus ratios have increased; sufficient capacity remains, assuming there are no continued investment losses and failures. We believe that reduced capitalization, decreased new business ventures, increased business declines, as well as negligible new home ownership will reduce the demand for small commercial and personal lines policies. As a result premium growth from mature market segments will likely slow and reduce slightly. We believe that new business and renewal retention will be influenced by economic factors as opposed to competitive forces within the insurance market. However, entry into new territories and business segments will promote growth for us in the transactional small and lower middle market commercial segments. We will continue to be less interested in the higher premium levels of the upper middle market which we believe will be challenged to maintain adequate pricing and produce a profitable result. We expect to continue to maintain underwriting discipline and selectivity in low to medium hazard classes of business, as well as to focus on premium adequacy and appropriate coverage terms. Our broad product line platform continues to allow us the opportunity to adjust our business mix in response to varying market conditions.
We derive our revenue from the premiums earned, ceding commissions, direct commission revenue, and fees and net investment income and net realized gains from investments.
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 and assumed premiums from our insurance segment. Throughout this Form 10-K, direct and assumed premiums (written or earned), separately or together, are also referred to as gross premiums.
Insurance services revenue. Insurance service revenue consists of direct commission revenues and fees that include commissions earned by TRM on premiums produced by its managing general agency and fees earned from its claims administration, other administration services and reinsurance intermediary services. It also includes policy billing fees that we earn in the course of collecting premiums from our policyholders. This fee is charged primarily on policies written through our insurance segment.
Losses and loss adjustment expenses. We establish loss and loss adjustment expense (“LAE”) reserves in an amount equal to our estimate of the ultimate liability for claims under our insurance policies and the cost of adjusting and settling those claims. Our provision for loss and LAE reserves in any period, which is the expense recorded, includes estimates for losses incurred during the period and changes in estimates for prior periods.
Operating expenses. In our insurance segment, we refer to the operating expenses that we incur to underwrite risks as underwriting expenses. Underwriting expenses consist of direct and ceding commission expenses and other underwriting expenses. In our insurance services segment, we refer to our operating expenses as insurance services expenses, which consist of direct commission expense and other insurance services expenses. On a consolidated basis, operating expenses for our two business segments are divided into direct and ceding commission expenses and other operating expenses as explained below:
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 insurance segment. Ceding commission is typically paid on quota share reinsurance agreements, but not on excess of loss reinsurance agreements.
Other operating expenses. Other operating expenses consist of other underwriting expenses related to our Insurance Subsidiaries’ underwriting operations in our insurance segment and other insurance services expenses related to our managing general agency and reinsurance intermediary operations conducted through TRM in our insurance services segment. Other underwriting expenses consist of general administrative expenses such as salaries, rent, office supplies, depreciation and all other operating expenses not otherwise classified separately and boards, bureaus and taxes, which are the assessments of statistical agencies for items such as rating manuals, rating plans and experience data, as well as state and local taxes based on premiums, licenses and fees, assessments for fire patrol and contributions to workers’ compensation and state and local security funds. Other insurance services expenses include general administrative expenses, principally reimbursements to TICNY for underwriting services, and exclude expenses that are incurred by TRM’s issuing companies such as boards, bureau and taxes. General administrative expenses related to claims administration services, which are billed on an hourly basis to TRM’s issuing companies, are also excluded.
We use various measures to analyze the growth and profitability of our business segments. In the insurance segment, we measure growth in terms of gross, ceded and net premiums written and we measure underwriting profitability by examining our loss, expense and combined ratios. We also measure our gross and net written premiums to surplus ratios to measure the adequacy of capital in relation to premiums written. In the insurance services segment, we measure growth in terms of premiums produced by TRM on behalf of other insurance companies as well as fee and commission revenue received, and we analyze profitability by evaluating income before taxes and the size of such income relative to our Insurance Subsidiaries’ net premiums earned. On a consolidated basis, we measure profitability in terms of net income and return on average equity.
Loss ratio. The loss ratio is the ratio of losses and LAE 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 (after reinsurance) basis. We also measure the loss ratio on the ceded portion (the difference between gross and net premium) for our insurance segment. We use the gross loss ratio as a measure of the overall underwriting profitability of the insurance business we write and to assess the adequacy of our pricing. We use the loss ratio on the ceded portion of our insurance segment to measure the experience on the premiums that we cede to reinsurers, including the premiums ceded under our quota share treaties. Since 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 LAE for insured events occurring in a particular year, regardless of when they are reported, as a percentage of premiums earned during that year. A calendar year loss ratio measures losses and LAE for insured events occurring during a particular year and the changes in estimates in loss reserves from prior accident years as a percentage of premiums earned during that year.
Premiums 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 have historically utilized TRM’s access to its issuing companies as a means to expand our ability to generate premiums in states where our Insurance Subsidiaries were not yet licensed. As part of our strategic relationship with CastlePoint, we entered into a management agreement on July 1, 2007 with CPIC to produce and manage brokerage business on behalf of CPIC. 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 and generate fees.
Loss and LAE reserves. The reserving process for loss and LAE reserves provides for our best estimate at a particular point in time of the ultimate unpaid cost of all losses and LAE incurred, including settlement and administration of losses, and is based on facts and circumstances then known and including losses that have been incurred but not yet been reported. The process includes using actuarial methodologies to assist in establishing these estimates, judgments relative to estimates of future claims severity and frequency, the length of time before losses will develop to their ultimate level and the possible changes in the law and other external factors that are often beyond our control. The methods used to select the estimated loss reserves include the loss ratio projection, incurred loss projection, and the Bornhuetter-Ferguson (B-F) method. These methods are described in “Business-Loss and Loss Adjustment Expense Reserves.” This process helps management to set carried loss reserves based upon the actuaries’ best estimate, using estimates made by line of business, accident year, and loss and LAE. The amount of loss and LAE 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 LAE reserves for unreported claims are determined using historical information by line of business as adjusted to current conditions. Since our process produces loss reserves set by management based upon the actuaries’ best estimate, there is no explicit or implicit provision for uncertainty in the carried loss reserves.
We segregate our data for estimating loss reserves. Property lines include Fire, Homeowners, CMP Property, Multi-Family Dwellings and Auto Physical Damage. Casualty lines include CMP Liability, Other Liability, Workers’ Compensation, Commercial Auto Liability, and Personal Auto Liability. The actuarial methods used by property line have been consistent since the 2003 year-end review. During the year-end review, the accident years are split into most recent, first prior and all other accident years. For the 2008 review, the most recent accident year is 2008, the first prior is 2007, and all other accident years are 2006 and prior. The table below shows the method used by product line and accident year to select the estimated year-ending loss reserves:
Our data have sufficient credibility to base development factors on our own data. The loss development factors are reviewed annually. There have only been minor changes in selected loss development factors since 2003, and only minor changes to the key assumptions used during the last three annual reserve estimates.
The chart below shows the number of years by product line when we expect 50%, 90% and 99% of losses to be reported for a given accident year:
We estimate LAE reserves separately for claims that are defended by in-house attorneys, claims that are handled by other attorneys that are not employees, and miscellaneous LAE costs such as witness fees and court costs.
We implemented two improvements in estimating LAE reserves. These two changes impacted costs to handle litigation for claims handled by our attorneys and costs to handle litigation for claims handled by attorneys who are not employed by us.
For LAE stemming from defense by other attorneys who are not our employees, we implemented automated legal fee auditing in the forth quarter of 2008 that we believe has become relatively common in the insurance industry and has been shown to reduce external attorneys bills by 5% to 10%.
increases, the commission rate decreases, which reduces ceding commissions earned. As a result, the same uncertainties associated with estimating loss and LAE reserves affect the estimates of ceding commissions earned. We monitor the ceded ultimate loss ratio on a quarterly basis to determine the effect on the commission rate of the ceded premiums earned that we accrued during prior accounting periods. The estimated ceding commission income relating to prior years recorded in 2008, 2007 and 2006 was a decrease of $1.8 million, a decrease of $0.5 million and an increase of $1.1 million, respectively.
Insurance Services Revenue. Direct commission revenue from our managing general underwriting services is recognized and earned as insurance policies are placed with TRM’s issuing companies. Fees from reinsurance intermediary services are earned when our Insurance Subsidiaries or TRM’s issuing companies cede premiums to reinsurers. Claims administration fees and other administration revenues are earned as services are performed.
Reinsurance recoverables. Reinsurance recoverable balances are established for the portion of paid and unpaid loss and LAE that is assumed by such reinsurers. Prepaid reinsurance premiums represent unearned premiums that are ceded to reinsurers. Reinsurance recoverables and prepaid reinsurance premiums are reported on our balance sheet separately as assets, instead of 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 LAE reserves affect the estimates of the amount of ceded reinsurance recoverables. We continually monitor the financial condition and rating agency ratings of our reinsurers. Non-admitted reinsurers are required to collateralize their share of unearned premium and loss reserves either by placing funds in a trust account meeting the requirements of New York Regulation 114 or by providing a letter of credit. In addition, from October 2003 to December 31, 2005, we placed our new quota share treaties on a “funds withheld” basis, under which TICNY retained the ceded premiums written and placed that amount in segregated trust accounts from which TICNY may withdraw amounts due to it from the reinsurers. In 2008 and 2007, CastlePoint Reinsurance collateralized its net exposure with a New York Regulation 114 compliant trust account.
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 and ceded 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. We also consider anticipated invested income in determining the recoverability of these costs. 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.
Investments. In accordance with our investment guidelines, our investments consist largely of high-grade marketable fixed maturity securities. Investments are carried at estimated fair value as determined by quoted market prices or recognized pricing services at the reporting date for those or similar investments. Changes in unrealized gains and losses on our investments, net of any deferred tax effect, are included as an element of other comprehensive income, and cumulative unrealized gains and losses are included as a separate component of stockholders’ equity. Realized gains and losses on sales of investments are determined on a specific identification basis. In addition, unrealized depreciation in the value of individual securities that management considers to be other than temporary is charged to income in the period it is determined. Investment income is recorded when earned and includes the amortization of premium and discounts on investments.
Impairment of invested assets. Impairment of investment securities results in a charge to operations when a market decline below cost is deemed to be other-than-temporary. We regularly review our fixed-maturity and
equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. In general, we focus our attention on those securities whose fair value was less than their amortized cost or cost, as appropriate, for six or more consecutive months. In evaluating potential impairment, we consider, 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; our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in fair value to cost or amortized cost; specific credit issues related to the issuer; industry outlook, specific cash flow estimations for mortgage-backed securities and macro-economic changes, including government policy initiatives. In addition, while evaluating the asset and mortgaged back securities portfolios, management follows the guidance of (FSP) EITF 99-20-1, “Amendments to the Impairment Guidance of EITF Issue No. 99-20.” (“FSP EITF 99-20-1”).
The unprecedented events in the capital and credit markets have resulted in extreme volatility and disruption to the financial markets. Several factors contributed to the decrease in fair values of our investment portfolio as of December 31, 2008 including the tightening/freezing of credit markets, significant failures of large financial institutions, uncertainty regarding the effectiveness of governmental solutions, as well as the current recession. Unrealized losses on fixed maturity securities at December 31, 2008 are principally attributable to widening credit spreads between U.S. Government and investment grade corporate securities as a result of significant illiquidity in the CMBS and non-agency RMBS markets. 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 if future events, information and the passage of time cause us to determine that a decline in value is other-than-temporary.
We conduct our business in two distinct segments: insurance and insurance services. Because we do not manage our assets by segments, our investment income is not allocated among our segments. Operating expenses incurred by each segment are recorded in each segment directly. General corporate overhead not incurred by an individual segment is allocated based upon a combination of employee head count, policy count or premiums written, as appropriate.
Our results of operations are discussed below in two parts. The first part discusses the consolidated results of operations. The second part discusses the results of operations of our insurance segment followed by the results of operations of our insurance services segment.
$22.7 million and $10.1 million, respectively. In 2008, we also had realized gains on sales of securities of $8.3 million, while in 2007 we had losses on sales of securities of $7.4 million.
During 2008 we ceded $201.9 million of our premiums earned to CastlePoint, compared to $189.8 million in 2007. In 2008, we also ceded $9.3 million of ceded premiums earned to Swiss Re America. The quota share ceding percentages on our policies were as follows:
On July 1, 2008, we reduced the ceding percentage under our brokerage business quota share reinsurance agreement with CastlePoint Reinsurance to 25% applicable to both the ceded unearned premium reserve as of July 1, 2008 and new and new and renewal premiums written in the third quarter of 2008.
Operating expenses. Operating expenses increased by 25.6% to $223.9 million for 2008 from $178.3 million for 2007. The increase was due primarily to the increase in underwriting expenses resulting from the growth in premiums earned, increased commission expense on traditional and specialty program business and depreciation expense of $10.5 million related to our increased investment in technology assets.
Other income. Our equity in net income of CastlePoint decreased $2.2 million due to a decrease in CastlePoint’s operating income, combined with $15.1 million of OTTI losses, of which our share is approximately $1.0 million, recorded in 2008.
Net income and return on average equity. Our net income and return on average equity were $57.5 million and 17.8%, respectively, for 2008 compared to $45.1 million and 18.0%, respectively, for 2007. Excluding net realized investment losses, our return on equity for 2008 and 2007 would have increased 2.9% and 4.6%, respectively. For 2008, the return was calculated by dividing net income of $57.5 million by average stockholders’ equity of $323.5 million. For 2007, the return was calculated by dividing net income, after deducting $0.7 million of preferred stock dividends and excess consideration paid for the redemption of preferred stock in January 2007, of $44.4 million, by average stockholders’ equity of $246.9 million.
Premiums earned. Net premiums earned increased by 27.7% to $286.1 million for 2007 compared to $224.0 million for 2006. The increase in net premiums earned was due to the 21.1% increase in gross
premiums written for 2007 compared to 2006, offset in part by a 69.1% increase in ceded premiums earned for 2007 compared to 2006. Other items affecting the year to year comparison are shown below:
During 2007 we ceded $189.8 million of our premiums earned to CastlePoint, compared to $75.5 million in 2006. We did not place quota share reinsurance for policies written during the first quarter of 2006 in expectation that CastlePoint Reinsurance, post formation, would agree to enter into a multi-year quota share reinsurance agreement with us. We entered into three multi-year quota share reinsurance agreements with CastlePoint Reinsurance on April 6, 2006. In order to achieve our targeted net retention consistent with our hybrid business model, the quota share ceding percentages on our policies were as follows:
Policies in-force, before the effect of the Preserver acquisition, increased by 16.8% as of December 31, 2007 compared to December 31, 2006. During 2007, premium increases on renewed business averaged 9.3% in personal lines and 0.3% in commercial lines. The retention rate was 75% for personal lines and 72% for commercial lines. The retention rate on both personal and commercial lines declined in 2007 as compared to 2006 as brokerage business was renewed through TRM on behalf of CPIC. The retention rate including brokerage business renewed by TRM on behalf of CPIC was 85% for personal lines and 79% for commercial lines. Gross premiums written and produced increased 44.4% to $608.4 million compared to $421.3 million in 2006.
Commission and fee income. Total commission and fee income increased by 103.6% to $106.3 million for 2007 compared to $52.2 million in 2006. Ceding commission revenue earned increased as a result of the overall increase in ceded premiums earned as discussed above. Also, as discussed above, in 2007 our managing general agency subsidiary, TRM, produced $83.7 million in premium on behalf of CPIC and earned $26.8 million in fee income. Preserver’s inclusion in the CastlePoint quota share agreement added $4.0 million in commission and fee income for 2007. In addition, commission and fee income included other administration revenue of $1.4 million from services provided to and reimbursed by CastlePoint. For 2007 the change in estimated sliding scale commission rate for commissions earned in prior periods in both the insurance segment and the insurance services segment resulted in a net increase of $1.3 million compared to a net increase of $1.9 million in 2006.
Net investment income and realized gains (losses). Net investment income increased by 59.6% to $36.7 million for 2007 compared to $23.0 for 2006. The increase in net investment income resulted from an increase in cash and invested assets to $696.8 million as of December 31, 2007 compared to $564.6 million as of December 31, 2006. Net cash flows provided by operations of $74.1 million contributed to the increase in invested assets during 2008. The increase in invested assets was also due to cash flow provided by financing activities of $67.5 million as a result of our net proceeds from the issuance of subordinated debentures on January 25, 2007, an equity offering on January 26, 2007 and the exercise of the underwriters’ over-allotment option on February 5, 2007, partially offset by $40 million of funds used to redeem our preferred stock. The acquisition of Preserver added $4.8 million of net investment income in 2007. The net cash flow used in
Net realized investment losses were $17.5 million for 2007 compared to net realized investment gains of $12,000 for 2006. The net realized investment losses were related to the sale of a closed-end investment fund, Hyperion Brookfield Collateralized Securities Fund (“HCS Fund”), which was sold in December 2007. The HCS Fund invested in various investments grade mortgage-backed and asset-backed securities. In addition we recognized $10.1 million of OTTI in 2007. The OTTI included all of our equity investments in REITs, as well as all of our sub-prime exposures within our residential mortgage-backed securities.
Net income and return on average equity. Our net income and return on average equity were $45.1 million and 18.0%, respectively, for 2007 compared to $36.8 million and 22.2%, respectively, for 2006. Excluding net realized losses on investments, return on equity for 2007 would have increased 4.6%. For 2007, the return was calculated by dividing net income, after deducting $0.7 million of preferred stock dividends and excess consideration paid for the redemption of preferred stock in January, 2007 of $44.4 million, by average stockholders’ equity of $246.9 million. In 2006, the return was calculated by dividing net income of $36.6 million, excluding preferred stock dividends of $0.2 million, by average stockholders’ equity of $164.6 million.
The increase in brokerage business premiums resulted from various initiatives including our appointment of wholesale and other agents outside of the Northeast region. We write excess and surplus lines business in Florida and Texas, and began writing on an admitted basis in California in 2008. New business written from wholesale agents with binding authority for 2008 was approximately $86.5 million compared to $29.0 million for the same period in 2007. Our brokerage business written outside of the state of New York, including premiums produced by TRM on behalf of CastlePoint, increased from 22.6% of all brokerage premium for
2007 to 29.9% for 2008. In 2009 we expect to increase premiums through the acquisition of the Hermitage Insurance Group which is expected to close during the first quarter of 2009. Policies in force for our brokerage business increased by 7.8% as of December 31, 2008 compared to December 31, 2007.
Ceded premiums. Ceded premiums written for the year ended December 31, 2008 increased by $25.9 million or 9.8% to $290.8 million from $264.8 million in the prior year. The increase in ceded premiums written resulted primarily from the increase in gross premiums written in our traditional and specialty program business which are ceded to CastlePoint Reinsurance and have ceded quota share percentages of 50% and 85%, respectively. The overall increase in ceded premiums written was partially offset as a result of a reduction in the ceding percentage under our brokerage business quota share agreement with CastlePoint Reinsurance. Effective July 1, 2008, the ceding percentage applicable to both the ceded unearned premium reserve and new and renewal premiums under our brokerage business quota share agreement was reduced to 25%. In addition, ceded premiums written was also reduced as a result of a reduction in gross premiums written due to more of our brokerage business having been placed with CPIC through TRM, which is included in our Insurance Services segment results and for which TRM receives commission revenue.
Separately, under our excess of loss and catastrophe reinsurance programs, $4.6 million and $4.4 million of premiums were ceded to CastlePoint for 2008 and 2007, respectively. As part of the brokerage business quota share agreement, CastlePoint paid us $7.3 million and $2.3 million in 2008 and 2007, respectively, which represented a 30% share of our catastrophe reinsurance costs. We recorded $2.7 million in net loss recoveries from the two aggregate stop loss reinsurance agreements with CPIC for 2008. Overall, our net catastrophe ceded premiums increased to $16.9 million for 2008 as compared to $14.8 million in 2007, net of reimbursements for catastrophe reinsurance premiums from CastlePoint.
Underwriting expenses and underwriting expense ratio. Underwriting expenses, which include direct commissions and other underwriting expenses, increased $23.1 million in 2008 compared to 2007. Our gross expense ratio for 2008 was 30.4% as compared to 29.2% in the prior year. The increase in underwriting expenses is due to the increase in gross premiums earned and the acquisition of Preserver on April 10, 2007.
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 18.3% for 2008 compared to 16.7% for the prior year. The increase was due to increased program business premiums which carry higher commission rates. However, 50% of the traditional program business premiums and approximately 85% of the specialty program business premiums are ceded to CastlePoint for which we receive a ceding commission that offsets a significant portion of the higher commission expense on program business.
The underwriting expense portion of the gross expense ratio declined to 12.1% for 2008 as compared to 12.6% in the prior year. The decrease in this ratio resulted from continuing to focus on achieving economies of scale and efficient business processes. Additionally, this ratio declined due to increased program business premiums for which underwriting expenses paid by us to CastlePoint for managing program business are included in the commissions paid. The net underwriting expense ratio, which reflects the benefits of ceding commission revenue that lowers the gross expense ratio, was 30.7% for 2008 as compared to 28.5% for the prior year. The net underwriting expense ratio for 2008 was higher than the gross underwriting expense ratio as a result of the increase in the amount of catastrophe reinsurance premiums ceded, which reduced net earned premiums thereby increasing the net loss ratio.
Underwriting profit and combined ratio. The underwriting profit, which reflects our underwriting results on a net basis after the effects of reinsurance, was $55.2 million and $46.6 million for 2008 and 2007, respectively. The gross combined ratio was 80.3% and 79.9% for 2008 and 2007, respectively. The slightly higher gross combined ratio resulted from an increase in the underwriting expense ratio which was partially offset by a decrease in the gross loss ratio. The net combined ratio was 82.4% for 2008 as compared to 83.7% for the prior year. The decrease in the net combined ratio resulted from a lower net loss ratio offset by a higher underwriting expense ratio compared to the same period in 2007.
Gross premiums. Gross premiums written increased by 21.1% to $524.0 million for 2007 compared to $432.7 million for 2006. Gross premiums earned increased by 43.6% to $521.9 million for 2007 compared to $363.4 million for 2006. The lesser increase in gross premiums written than gross premium earned resulted from the implementation of insurance risk sharing with CastlePoint by placing premiums with CPIC through TRM, which generated a significant increase in commission and fee income in our insurance services segment. Other items affecting gross premiums included the acquisition of Preserver on April 10, 2007 that added $63.7 million and $63.6 million in gross premiums written and earned, respectively, for 2007 and growth in specialty program business premium, managed by CastlePoint, which increased to $24.5 million in 2007, compared to $11.1 million in 2006. Also, in 2007 we initiated a wholesale producer program which will allow us to strategically expand our core brokerage book of business locally and geographically into larger insurance markets. We started writing excess and surplus lines business in Florida and Texas in 2007, and will start writing on an admitted basis in California in 2008. Additionally, as part of the wholesale producer program, we will appoint producers with binding authority to write new program business which is separate and distinct from our core book of brokerage business. New business written in 2007 from wholesale agents with binding authority amounted to approximately $29.0 million, of which approximately $7.0 million was written in Florida. In 2006, we entered into novation agreements with PXRE which increased gross premiums written and earned by $11.4 million.
Effective in the fourth quarter of 2007, New York enacted a law to reform the workers’ compensation system. This law included provisions which instituted a cap on certain benefits, implemented several medical discount
Ceded premiums. Ceded premiums written increased by 41.2% to $264.8 million for 2007 compared to $187.6 million for 2006. The greater increase in ceded premiums written than in gross premiums written was due to the increase in the quota share ceding percentages to CastlePoint Reinsurance in 2007 compared to 2006. We entered into three multi-year quota share reinsurance agreements with CastlePoint Reinsurance on April 6, 2006. We ceded $221.1 million of premiums written to CastlePoint Reinsurance in 2007 and $155.2 million in 2006. Separately, under our excess of loss and property catastrophe reinsurance programs, $4.4 million and $2.6 million of premiums were ceded to CastlePoint for 2007 and 2006, respectively. Additionally, effective April 1, 2007, under the brokerage business quota share agreement, CastlePoint paid us $2.3 million, which represented a 30% share of our catastrophe reinsurance costs. Overall, catastrophe ceded premiums were $14.8 million for 2007 as compared to $13.1 million in 2006, net of reimbursements for catastrophe reinsurance premiums from CastlePoint.
Ceded premiums earned increased 69.1% during 2007 as compared to 2006. This was due primarily to the 41.2% increase in ceded premiums written in 2007 and slightly lower ceded premiums earned in 2006. We did not cede any premiums in the first quarter of 2006 and the quota share ceding percentage was 30% for the three months ending June 30, 2006 and 40% thereafter.
Ceding commission revenue. Ceding commission revenue increased by 64.6% to $71.0 million for 2007 compared to $43.1 million for 2006 largely due to the 69.2% increase in ceded premiums earned. Also, as a result of the commutation agreements with PXRE, we recorded a charge of $3.2 million to ceding commission revenue in 2006. During 2007, ceding commission revenue decreased by $0.5 million as a result of an increase in the ceded loss ratios on prior years’ quota share treaties while in 2006 ceding commission revenue increased $1.1 million as a result of an improvement in the ceded loss ratios on prior years’ quota share treaties.
Loss and loss adjustment expenses. Gross loss and loss adjustment expenses and the gross loss ratio for the insurance and reinsurance segments combined for 2007 were $264.7 million and 50.7%, respectively, compared to $199.9 million and 55.0%, respectively, for 2006. The net loss ratio for the combined segments was 55.2% for 2007 as compared to 60.3% in 2006. The net loss ratio in 2006 included a $1.6 million charge resulting from the commutation agreement with PXRE which was a present value discount on the reserves commuted. In addition to the commutation agreement with PXRE, we executed novation agreements with PXRE relating to other reinsurance agreements covering business written in 2001, 2002 and 2003. These agreements were written by other insurance companies with respect to business managed on their behalf by TRM. Under the novation agreements we assumed loss liabilities of $12.2 million and received consideration of $11.4 million. Since novation transactions are recorded by including the consideration received as premiums written and earned and the liabilities assumed as losses incurred, the gross and net loss ratios were also affected. The PXRE commutation and novation transactions added 1.7 and 3.2 percentage points to the gross and net loss ratios, respectively, in 2006.
years in 2007 compared to 2006. During 2007, prior accident years’ loss reserves developed favorably to the extent of $0.4 million, whereas during 2006, prior accident years’ loss reserves developed favorably to the extent of $2.6 million excluding the $1.6 million loss related to the commutation with PXRE, resulting in net favorable development of $1.0 million.
Underwriting expenses. Underwriting expenses, which include direct commission expenses and other underwriting expenses, were $154.6 million for 2007 as compared with $105.4 million for 2006. Our gross expense ratio was 29.2% for 2007 as compared with 28.7% for 2006. Preserver’s gross expense ratio for the portion of 2007 subsequent to the acquisition declined to 33.6% and 31.2% in the fourth quarter of 2007.
The underwriting expense portion of the gross expense ratio was 12.6% for 2007 as compared to 12.5% for 2006. The gross expense ratio would have declined, but was affected by the acquisition of Preserver which had higher underwriting expenses during the second and third quarters of 2007. Overall underwriting expenses increased due to the growth in premium volume.
The net underwriting expense ratio was 28.5% for 2007 as compared to 27.3% in 2006. The net expense ratio in 2007 was also affected by the acquisition of Preserver in 2007. The net expense ratio did benefit from both a higher ceding commission rate and favorable increases in ceding commission revenue which resulted from improvement in the ceded loss ratio on prior year quota share treaties.
Pre-tax income. As a result of the factors discussed above, pre-tax income increased to $24.0 million for 2008 compared to $11.2 million for 2007.
Claims expense reimbursement. The amount of reimbursement by TRM for claims administration pursuant to the terms of the expense sharing agreement with TICNY was $2.3 million in 2007 as compared to $3.2 million in 2006 due to a decrease in the number of claims handled.
Pre-tax income. Pre-tax income in 2007 increased to $11.2 million as compared to $1.3 million in 2006. The increase was primarily due to the increase in premiums produced and the resulting direct commission revenue and, to a lesser extent, additional commissions from the favorable loss development on premiums produced in prior years as compared to 2006.
The following table provides a breakdown of the amortized cost, aggregate fair value and unrealized gains and losses by investment type as of December 31, 2008 and December 31, 2007:
The average credit rating of our fixed maturity securities, using ratings assigned to securities by Standard & Poor’s, was AA- at December 31, 2008 and AA at December 31, 2007. The following table shows the ratings distribution of our fixed maturity portfolio at December 31, 2008 and 2007.
The following table shows the composition of our fixed maturity portfolio by remaining time to maturity at December 31, 2008 and 2007. For securities that are redeemable at the option of the issuer and have a market price that is greater than par value, the maturity used for the table below is the earliest redemption date. For
securities that are redeemable at the option of the issuer and have a market price that is less than par value, the maturity used for the table below is the final maturity date.
As of December 31, 2008, approximately 97% 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 are unavailable, we utilize fair value estimates based upon other observable inputs including matrix pricing, benchmark interest rates, market comparables and other relevant inputs. When observable inputs are adjusted to reflect management’s best estimate of fair value, such fair value measurements are considered a lower level measurement in the SFAS 157 fair value hierarchy.
As more fully described in Note 4 of 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, rather than fundamental collateral deterioration, and are temporary in nature.
At December 31, 2008, the unrealized losses for fixed-maturity securities were primarily in our investments in corporate and other bonds, commercial and residential mortgage-backed securities and asset-backed securities and certain equity securities.
The majority of our corporate bonds that are in an unrealized loss position are investment grade quality. Based on our analysis of these and current market conditions, we expect price recovery on these over time, and we have determined that these securities are temporarily impaired as of December 31, 2008.
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 $7.2 million, $0 million and $0.7 million in 2008, 2007, and 2006, 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 Tower its share of the Federal income tax liability primarily based on separate return calculations. The tax allocation agreement allows Tower 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. During 2008, Tower received $27.1 million in tax payments from its subsidiaries under this agreement.
During 2008, yield spreads continued to widen resulting from continued lack of liquidity in the market, increasing the gross unrealized investment loss significantly. The increase in the unrealized investment loss was in corporate bond securities, residential and commercial mortgage-backed securities and our asset-backed securities. Our policy is to regularly review both our fixed-maturity and equity portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. Throughout 2008, following our normal review procedures, we recorded OTTI on our equity and fixed maturity securities totaling $22.7 million. Some of our equity securities were invested in REITs and the OTTI for these securities was $2.4 million in 2008 recorded in the first quarter of 2008. These securities were sold in April 2008 and we recorded a gain of $70,000, after considering the OTTI adjustment recorded as of
March 31, 2008. The OTTI losses on fixed maturity securities included $3.3 million of corporate bonds and $2.4 million related to an asset-backed security which held collaterized bank debt. As a result of performing cash flow testing in accordance with Emerging Issues Task Force Number 99-20-1, we determined that additional OTTI related to other fixed maturity securities was $14.6 million, which consisted of $14.0 million of residential mortgage-backed securities, $0.2 million of asset-backed securities and $0.4 million of commercial mortgage-backed securities.
We have determined that we do not hold any remaining investments, after recording the charge for OTTI, that would have been considered other than temporarily impaired, and that the recent increase in the gross unrealized investment loss was caused by the lack of liquidity in the capital markets. We expect cash flows from operations to be sufficient to meet our liquidity requirements. We have the ability and intent to hold these investments, excluding the investments we determined were OTTI, until a recovery of fair value to our cost or amortized cost basis, which may be at maturity for fixed maturity securities.
The net cash flows used by financing activities for 2008 related primarily to the payment of dividends.
The cash equivalents at December 2006 were higher than they were historically as a result of raising $48 million through the issuance of $40 million of perpetual preferred stock and $8 million from the sale of Tower Indemnity Company of America near the end of 2006. At the time we raised these funds the yield curve was relatively flat. At December 31, 2006, we had $65 million of cash equivalents invested in agency-backed discount notes and commercial paper that had interest yields between 5.14% and 5.25%. Our belief then was that longer term interest rates would rise in 2007.
For 2007 and 2006, net cash provided by operating activities was $74.1 million and $134.1 million, respectively. The decrease in cash flow for 2007 was a result of Federal income tax payments of $27.6 million for 2007, compared to $15.3 million for 2006, as well as increased reinsurance costs. In addition, net cash provided by operating activities in 2006 included $37 million received from PXRE, which resulted from the commutation and novation transactions.
The net cash flows provided by financing activities for 2007 and 2006 were $67.5 million and $59.7 million, respectively. The 2007 amount included the net proceeds from the issuance of $20.6 million in subordinated debentures on January 25, 2007, the $89.4 million of net proceeds from the January 26, 2007 equity offering and the related exercise of the underwriters’ over-allotment option, offset by $40.0 million used for the redemption of preferred stock. In 2006, net cash flows provide by financing activities included the net proceeds from the issuance of $20.6 million of subordinated debentures on March 31, 2006 and the issuance of the perpetual preferred stock in December 2006, net of issuance costs.
we sold two corporate bonds and recorded OTTI related to these bonds as of December 31, 2007, because we no longer had the intent to hold them to maturity.
Our insurance companies are subject to significant regulatory restrictions limiting their ability to declare and pay dividends. As of December 31, 2007, the maximum amount of distributions that our insurance companies could pay to us without approval of their domiciliary Insurance Department was approximately $17.1 million. Cash flow needs at the holding company level were primarily for dividends to our stockholders and interest payments on our $101.0 million of subordinated debentures.
holdings of short-term investments and cash and cash equivalents to provide sufficient liquidity to respond to changes in the anticipated pattern of claims payments. See “Business-Investments.”
For a discussion of our loss and LAE reserving process, see “Critical Accounting Policies-Loss and LAE Reserves.” Actual payments of losses and loss adjustment expenses by period will vary, perhaps materially, from the above table to the extent that current estimates of loss reserves vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns. See “Risk Factors-Risks Related to Our Business. If our actual loss and loss adjustment expenses exceed our loss reserves, our financial condition and results of operations could be adversely affected,” for a discussion of the uncertainties associated with estimating loss and LAE expense reserves. The ceded reserves recoverable referred to above also assumes timely reimbursement from our reinsurers. If our reinsurers do not meet their contractual obligations on a timely basis, the payment assumptions presented above could vary materially.
We do not consolidate interest in our statutory business trusts for which we hold 100% of the common trust securities because we are not the primary beneficiary of the trusts. Our investments in common trust securities of the statutory business trusts are reported in investments as equity securities. We report as a liability the outstanding subordinated debentures owed to the statutory business trusts.
non-payment of interest on the trust preferred securities, unless such non-payment is due to a valid extension of an interest payment period;
Pursuant to the terms of our subordinated debentures, we and our subsidiaries cannot declare or pay any dividends if we are in default or have elected to defer payments of interest on the subordinated debentures.
Property and casualty insurance premiums are established before we know the amount of losses and loss adjustment expenses or the extent to which inflation may affect such amounts. We attempt to anticipate the potential impact of inflation in establishing our loss and LAE reserves. Inflation in excess of the levels we have assumed could cause loss and LAE expenses to be higher than we anticipated.
Consolidated Statements of Income and Comprehensive Net Income for the years ended December 31, 2008, 2007 and 2006
We have audited the accompanying consolidated balance sheets of Tower Group, Inc. (“the Company”) as of December 31, 2008 and 2007, and the related consolidated statements of income and comprehensive net income, changes in stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2008. Our audits also included the financial statement schedules listed in Item 15. We also have audited the Company’s internal control over financial reporting as of December 31, 2008, 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 the 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 the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these financial statements and the financial statement schedules and an opinion on the Company’s internal control over financial reporting based on our audits.
The Insurance Services Segment provides insurance brokering, claim administration, reinsurance intermediary services and other administrative services.
The consolidated financial statements include the accounts of Tower Group, Inc. (“Tower”) and its insurance subsidiaries, Tower Insurance Company of New York (“TICNY”), Tower National Insurance Company (“TNIC”), Preserver Insurance Company (“PIC”), Northeast Insurance Company (“NEIC”), Mountain Valley Indemnity Company (“MVIC”) (collectively the “Insurance Subsidiaries”), Preserver Group, Inc. (“PGI”) and Tower Risk Management Corporation (“TRM”), its managing general agency. The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant inter-company transactions have been eliminated in consolidation.
Commissions on reinsurance premiums ceded are earned in a manner consistent with the recognition of the costs of the reinsurance, generally on a pro-rata basis over the terms of the policies reinsured. Certain reinsurance agreements contain provisions whereby the ceding commission rates vary based on the loss experience under the agreements. The Company records ceding commission revenue based on its current estimate of subject losses. The Company records adjustments to the ceding commission revenue in the period that changes in the estimated losses are determined.
Direct commission revenue from the Company’s managing general underwriting services is recognized and earned as insurance policies are placed with TRM’s issuing companies. Fees from reinsurance intermediary
Tower estimates LAE reserves separately for claims that are defended by in-house attorneys, claims that are handled by other attorneys that are not employees, and miscellaneous LAE costs such as witness fees and court costs.
For LAE stemming from defense by in-house attorney’s the Company determines a fixed fee per in-house litigated claim, and allocates to each of these litigated claims 50% of this fixed fee when litigation on a particular claim begins and 50% of the fee when the litigation is closed. The fee is determined actuarially based upon the projected number of litigated claims and expected closing patterns at the beginning of each year as well as the projected budget for the Company’s in-house attorneys, and these amounts are subject to adjustment each quarter based upon actual experience.
In preparing financial statements, management estimates uncollectible amounts receivable from reinsurers 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, 2008 and 2007 and did not expense any uncollectible reinsurance during 2008, 2007 and 2006. 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 the Company’s Insurance Subsidiaries’ ability to meet their regulatory capital and surplus requirements.
The Company maintains its cash balances at several financial institutions. The Federal Deposit Insurance Corporation (“FDIC”) secures accounts up to $250,000 at these institutions through December 31, 2009 at which time the insured limit is scheduled to revert back to $100,000. Management monitors balances in excess of insured limits and believes they do not represent a significant credit risk to the Company.
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 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 fair value to cost or amortized cost; specific credit issues related to the issuer; specific cash flow estimations for mortgage-backed securities and current economic conditions. In addition, while evaluating the asset and mortgage-back securities portfolios, management followed the guidance of FSP EITF 99-20-1. Other-than-temporary impairment (“OTTI”) losses result in a permanent reduction of the cost basis of the underlying investment. During 2008 and 2007, the Company recorded impairment write-downs in the amount of $22.7 million and $10.1 million, respectively, after determining that certain of its investments were OTTI. During 2006, the Company did not record any OTTI.
The Company uses brokers and outside pricing services to assist in determining fair values. For investments in active markets, the Company uses the quoted market prices provided by the outside pricing services to determine fair value. The outside pricing services used by the Company have indicated that they will only provide prices where observable inputs are available. In circumstances where quoted market prices are unavailable, the Company utilizes fair value estimates based upon other observable inputs including matrix pricing, benchmark interest rates, market comparables and other relevant inputs.
Acquisition costs represent the costs of writing business that vary with, and are primarily related to, the production of insurance business (principally commissions, premium taxes and certain underwriting salaries). 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.
Furniture, leasehold improvements, computer equipment, and software are reported at cost less accumulated depreciation and amortization. Depreciation and amortization is provided using the straight-line method over the estimated useful lives of the assets. The Company estimates the useful life for computer equipment is three years, computer software three to seven years, furniture and other equipment is seven years and leasehold improvements is the term of the lease.
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 in accordance with FIN No. 46(R), “Consolidation of Variable Interest Entities”. See “Note 15-Debt.” The Company’s investment in common trust securities of the statutory business trust are reported in balance sheet at equity. The Company reports as a liability the outstanding subordinated debentures owed to the statutory business trusts.
The Company accounts for the treasury stock at the repurchase price as a reduction to stockholders’ equity as it does not intend to retire the treasury stock held at December 31, 2008.
The Company adopted the provision of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment” (SFAS No. 123(R)) effective January 1, 2006 and has elected the modified prospective application method. All unvested stock options outstanding as of January 1, 2006 are being expensed over the requisite service period that has not been rendered, based upon the original grant date fair value of the award as calculated for recognition of the pro forma disclosure under SFAS No. 123(R).
Insurance related assessments are accrued in the period in which they have been incurred. A typical obligating event would be the issuance of an insurance policy or the occurrence of a claim. The Company is subject to a variety of assessments. Among such assessments are state guaranty funds as well as workers’ compensation second injury funds. State guaranty funds assessments are used by state insurance oversight boards to cover losses of policyholders of insolvent insurance companies and for the operating expenses of such agencies. The Company uses estimates derived from state regulators and/or NAIC Tax and Assessments Guidelines.
Financial instruments that potentially subject the Company to concentration of credit risk are primarily cash and cash equivalents, investments and accounts receivable. Investments are diversified through many industries and geographic regions through the use of money managers who employ different investment strategies. The Company limits the amount of credit exposure with any one financial institution and believes that no significant concentration of credit risk exists with respect to cash and investments. At December 31, 2008 and 2007, the outstanding premiums receivable balance is generally diversified due to the number of entities composing the Company’s customer base, which is largely concentrated in the Northeast. To reduce credit risk, the Company performs ongoing evaluations of its customers’ financial condition. The Company also has receivables from its reinsurers. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company periodically evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. Management’s policy is to review all outstanding receivables at period end as well as the bad debt write-offs experienced in the past and establish an allowance for doubtful accounts, if deemed necessary.
Lines of business that subject the Company to concentration risk are primarily commercial multiple-peril. For the years ended December 31, 2008, 2007 and 2006, 42%, 42% and 44%, respectively, of gross premiums earned were for commercial multiple-peril.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-Including an Amendment of SFAS No. 115” (“SFAS No. 159”). This standard permits an entity to choose to measure many financial instruments and certain other items at fair value. Most of the provisions in SFAS No. 159 are elective; however, the amendment to SFAS No. 115 applies to all entities with available-for-sale and trading securities. The FASB’s stated objective in issuing this standard is as follows: “to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions.” The fair value option established by SFAS No. 159 permits all entities to choose to measure eligible items at fair value at specified election dates. A business entity will report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option: (a) may be applied instrument by instrument, with a few exceptions, such as investments otherwise accounted for by the equity method; (b) is irrevocable (unless a new election date occurs); and (c) is applied only to entire instruments and not to portions of instruments. SFAS No. 159 is effective as of the beginning of the entity’s first fiscal year that begins after November 15, 2007. The Company did not elect to implement the fair value option for eligible financial assets and liabilities as of January 1, 2008 or during the year ending December 31, 2008.
In June 2007, the FASB issued Emerging Issues Task Force (“EITF”) No. 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards” (“EITF Issue No. 06-11”). EITF Issue No. 06-11
In February 2008, the FASB issued FSP No. FAS 157-1, “Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13” (“FSP FAS 157-1”). FSP FAS 157-1 provides a scope exception from SFAS 157 for the evaluation criteria on lease classification and capital lease measurement under SFAS No. 13, “Accounting for Leases” and other related accounting pronouncements. Accordingly, the Company did not apply the provisions of SFAS 157 in determining the classification of and accounting for leases and the adoption of FSP FAS 157-1 did not have an impact on the Company’s consolidated financial statements.
Reporting units measured at fair value in the goodwill impairment test as described in SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), and nonfinancial assets and nonfinancial liabilities measured at fair value in the SFAS 142 goodwill impairment test, if applicable; and
Nonfinancial long-lived assets measured at fair value for impairment assessment under SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”
In January 2009, the FASB has issued FASB Staff Position (FSP) EITF 99-20-1, “Amendments to the Impairment Guidance of EITF Issue No. 99-20.” This FSP amends the impairment guidance in EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets.” The FASB believes this guidance will achieve a more consistent determination of whether an other-than-temporary impairment has occurred. The FSP also retains and emphasizes the objective of an other-than-temporary impairment assessment and the related disclosure requirements in FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities”, and other related guidance. The Company applied the guidance set forth in this FSP in determining both the fair value and OTTI of certain of its investments at December 31, 2008.
In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS No. 141(R)”). This standard establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. SFAS No. 141(R) also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The guidance will become effective as of the beginning of the Company’s fiscal year beginning after December 15, 2008. The Company will evaluate the effect that the adoption of SFAS No. 141(R) will have on its consolidated financial condition and results of operations on a transaction by transaction basis as the effect is fact specific.
In June 2008, the FASB issued FSP No. EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities” (“FSP EITF 03-6-1”). The FSP addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing earnings per share (“EPS”) under the two-class method described in SFAS No. 128, “Earnings per Share” (“SFAS 128”). The FSP requires that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS pursuant to the two-class method. FSP EITF 03-6-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years. All prior-period EPS data presented shall be adjusted retrospectively (including interim financial statements, summaries of earnings, and selected financial data) to conform to the provisions of this FSP. Early application is not permitted. The Company expects to adopt FSP EITF 03-6-1 on January 1, 2009, and does not expect the adoption to have a material effect on the Company’s earnings per share.
In April 2008, the FASB issued FSP No. FAS 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS 142. FSP FAS 142-3 amends paragraph 11(d) of SFAS 142 to require an entity to use its own assumptions about renewal or extension of an arrangement, adjusted for the entity-specific factors in paragraph 11 of SFAS 142, even when there is likely to be substantial cost or material modifications. FSP FAS 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years, with early adoption prohibited. The provisions of FSP FAS 142-3 are to be applied prospectively to intangible assets acquired after January 1, 2009 for the Company, although the disclosure provisions are required for all intangible assets recognized as of or subsequent to January 1, 2009. The Company expects to adopt FSP FAS 142-3 on January 1, 2009, and does not expect the adoption to have a material effect on the Company’s consolidated financial condition and results of operations.
The purchase price allocation of fair value to the acquired assets and liabilities was adjusted in December 2007 and March 2008 in finalizing the allocation of the purchase price. The December 2007 adjustment related to an adjustment to Preserver’s proportionate share of assets and liabilities relating to involuntary residual market plans. The March 2008 adjustment resulted from recording a deferred tax liability related to
A summary of the amortized cost and fair value of the Company’s investments in fixed-maturity securities at December 31, 2008 by contractual maturity is shown below:
Includes a gain of $1.8 million for the year ended December 31, 2008, on the sale of the Company’s investment in AgencyPort Insurance Services, Inc., a privately held company that provides web-based solutions for the Company and other property and casualty insurers. At December 31, 2008, the Company had a receivable of $1.4 million related to this transaction, payable over eight semi-annual periods beginning March, 2009.
There were 417 securities at December 31, 2008 that accounted for the gross unrealized losses, none of which is deemed by the Company to be OTTI. Significant factors influencing the Company’s determination that unrealized losses were temporary included the magnitude of the unrealized losses in relation to each securities’ cost, the nature of the investment and management’s intent and ability to retain the investment for a period of time sufficient to allow for anticipated recovery of fair value to the Company’s cost basis.
The Company evaluated the severity of the impairment in relation to the carrying amount for the securities referred to above and found it to be between 0.01% and 82%. The Company considered all relevant factors particularly the length of time the fair value has been below cost, and specific credit issues related to the issuer or collateral, in assessing whether the loss was other-than-temporary. The Company also considered its ability and intent to hold these investments until there is a recovery of fair value to the Company’s original cost basis, which may be at maturity. As a result, the Company does not consider these investments to be other-than-temporarily impaired.
SFAS No. 157 establishes a three-level hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the assets or liabilities fall within different levels of the hierarchy, the classification is based on the lowest level input that is significant to the fair value measurement of the asset or liability. Classification of assets and liabilities within the hierarchy considers the markets in which the assets and liabilities are traded, including during period of market disruption, and the reliability and transparency of the assumptions used to
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 securities and obligations of U.S. government agencies, together with municipal bonds, corporate debt securities, commercial mortgage and asset-backed securities, certain residential mortgage-backed securities that are generally investment grade and certain equity securities.
During most of 2008, certain securities, primarily non-agency mortgage-backed and asset-backed securities, were either not traded or very thinly traded due to concerns in the securities market. As a result, prices from independent third party pricing services, broker quotes or other observable inputs were not always available, or, in the case of certain broker quotes, were non-binding. Therefore, the fair values of these securities were estimated using a model to develop a security price using future cash flow expectations that were developed based on collateral composition and performance and discounted at an estimated market rate (including estimated risk and liquidity premiums) taking into account estimates of the rate of future prepayments, current credit spreads, credit subordination protection, mortgage origination year, default rates, benchmark yields and time to maturity. For certain securities, broker quotes were available and these were also considered in determining the appropriateness of the developed security price.
The Company’s use of Level 3 “unobservable inputs” included 60 securities and accounted for approximately 3.3% of total investments and 1.2% of total assets at December 31, 2008.
The Company has automatic treaty capacity of $30.0 million for property risks, $1.0 million/ $2.0 million for liability coverages, $30.0 million for workers’ compensation, $5.0 million for umbrella liability and $100.0 million for equipment breakdown. The Company may offer higher limits through its use of facultative reinsurance. 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:
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 placed 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 adjustment expense payments and commission adjustments. Segregated assets in trust accounts amounted to $20.9 and $40.4 million at December 31, 2008 and 2007 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 3.0% in 2008, 3.0% in 2007 and 3.0% in 2006. The amounts credited for 2008, 2007 and 2006 were $0.6 million, $1.2 million and $1.6 million respectively, and have been recorded as interest expense. The quota share agreement effective January 1, 2006 is collateralized in a New York Regulation 114 compliant trust account. The Company has reinsurance recoverables from Swiss Reinsurance America of $47.4 million, offset by $27.3 million of ceded balances payable and $14.0 million of deferred ceding commission.
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 $33.5 million for all treaties for all five years. The ceded premiums for the 2003, 2004, 2005, 2006 and 2007 treaty years have been fully earned as of December 31, 2008. As of December 31, 2008, the ceded premium earned and prepaid reinsurance premiums for the 2008 treaty year were $77.6 million and $97.3 million, respectively.
Intangible assets consist of finite and indefinite life assets. Finite life intangible assets include both renewal rights and the agency force book of business. Insurance company licenses are considered indefinite life intangible assets subject to annual impairment testing. The weighted average amortization period of identified intangible assets of finite useful life is 16.6 years as of December 31, 2008.
In 2005, the Company closed on its purchase of the outstanding common stock of a shell property casualty insurance company, North American Lumber Insurance Company (“NALIC”), subsequently renamed Tower National Insurance Company. Prior to the closing, all assets and liabilities (other than insurance licenses) of Tower National Insurance Company were transferred to a liquidating trust. The Company capitalized the purchase as an intangible asset related to state licenses with an indefinite life subject to annual impairment testing. The amount capitalized was $1.2 million and included the purchase price, legal fees and a broker’s fee.
Goodwill is calculated as the excess of purchase price over the net fair value of assets acquired. In acquiring Preserver, the Company entered into an agreement that provided for a base purchase price of approximately $68.3 million, subject to certain purchase price adjustments. The agreement provided for using a portion of the purchase price to pay off certain debt owed to Preserver’s stockholders and to settle Preserver’s direct transaction costs. The purchase price, net of Preserver’s direct transaction costs, was approximately $64.7 million plus approximately $1.3 million of transaction costs incurred by Tower. Approximately $30.8 million of the purchase price was used to pay off certain debt owed to Preserver’s stockholders.
the estimated fair value of each reporting unit to its carrying value, including the goodwill. An impairment charge is recorded if the estimated fair value is less than the carrying amount of the reporting unit.
These transactions met the requirements to be accounted for as an operating lease.
and December 31, 2007, the Company capitalized software development costs of $6.0 million and $1.4 million, respectively. As of December 31, 2008, and December 31, 2007, net capitalized software costs totaled $7.8 million and $2.0 million, respectively.
During the third quarter of 2006, the Company relocated its New York City corporate headquarters within the same building. The landlord provided a $4.5 million build-out that partially financed the cost of the leasehold improvements. In 2006 the Company capitalized $22.9 million for the purchase of fixed assets, including $10.4 million for leasehold improvements, $6.1 million for furniture and equipment and $6.4 million for computer hardware and software. The Company also entered into a sale and leaseback of certain furniture and equipment in the amount of $5.2 million on December 29, 2006. The transaction met the requirements to be accounted for as an operating lease.
Depreciation expense for 2008, 2007 and 2006 was $10.5 million, $7.7 million and $4.8 million, respectively.
The Company has determined that CastlePoint qualifies as a variable interest entity (“VIE”) under the provisions of Financial Accounting Standards Board Interpretation (“FIN”) 46(R). The Company has determined that its investment in CastlePoint does not meet the requirements for consolidation because the Company is not the primary beneficiary of the VIE as defined in FIN 46(R). However, the Company has recorded its investment in CastlePoint using the equity method of accounting as the Company exercises significant influence over CastlePoint. The Company and CastlePoint have the same Chief Executive Officer, Michael H. Lee.
On March 23, 2007, CastlePoint raised $114.8 million net of expenses in an initial public offering which reduced the Company’s investment ownership from 8.6% to 6.7%. As a result of the initial public offering, the book value of CastlePoint increased from $279.7 million as of December 31, 2006 to $401.3 million as of March 31, 2007. Accordingly, in the three months ended March 31, 2007, the Company recorded a gain of $2.7 million in income before taxes on its common stock investment in CastlePoint in accordance with SAB No. 51.
The Company has recorded $830,000 of CastlePoint dividends received or accrued since inception as a reduction to its investment in CastlePoint.
As of December 31, 2008, the aggregate fair value of the Company’s investment in its 2,555,000 shares of CastlePoint common stock listed on the NASDAQ Global Market under the symbol “CPHL” was $34.6 million.
As more fully described in Note 25-Subsequent Events, the Company acquired CastlePoint on February 5, 2009, at which time it became a wholly-owned subsidiary.
The following table provides an analysis of the reinsurance activity between the Company and CastlePoint Reinsurance for the years ended December 31, 2008, 2007 and 2006, respectively:
Under the brokerage business quota share reinsurance agreement, which covers business that the Company has historically written through its retail and wholesale agents, the Company’s insurance subsidiaries cede between 17.5% and 50% of premiums and losses, such ceding percentage being subject to periodic adjustment by the Company. The ceding percentages for the brokerage business since April 2006 are included in the following table:
Effective April 1, 2007, under the brokerage business quota share reinsurance agreement, CastlePoint agreed to pay 30% of the Company’s property catastrophe reinsurance premiums relating to the brokerage business pool managed by the Company and 30% of the Company’s net retained property catastrophe losses. CastlePoint and the Company will participate proportionately in catastrophe reinsurance on the underlying brokerage business pool. The premium payment was $7.3 million and $2.3 million in 2008 and 2007, respectively. CastlePoint Reinsurance also participated as a reinsurer on the Company’s overall property catastrophe reinsurance program from July 1, 2008 to June 30, 2009 and July 1, 2006 to June 30, 2007, and the Company’s excess of loss reinsurance program, effective May 1, 2006 through December 31, 2008. Under the catastrophe and excess reinsurance programs, the Company ceded premiums of $4.5 million and $4.4 million to CastlePoint Reinsurance in 2008 and 2007, respectively.
The traditional program business quota share reinsurance agreement covers program business historically written by the Company. Under this agreement, the Company’s insurance subsidiaries cede 50% of the Company’s traditional program business to CastlePoint Reinsurance and share premium revenue and losses in
proportion to the parties’ respective quota share participation. Ceding commissions are intended to approximate actual expenses.
Under the specialty program business and insurance risk-sharing business quota share reinsurance agreement, which covers business not historically written by the Company, the Company’s insurance subsidiaries cede 85% of the Company’s net retention on specialty program business to CastlePoint Reinsurance and receive a ceding commission which approximates actual expenses.
At December 31, 2008 and 2007, the Company’s receivables and payables with CastlePoint arising in the normal course of business were as follows:
Under the program management agreement, CastlePoint Management Corp. (“CPM”) was appointed by TICNY to perform certain underwriting and claims services, effective January 1, 2007, with respect to the traditional and specialty program business and insurance risk-sharing business, such as soliciting, underwriting, quoting, binding, issuing and servicing of insurance policies. In circumstances where CPM cannot fully perform these functions on its own, CPM plans to delegate authority to the program underwriting agents or to purchase services from the Company under the service and expense sharing agreement. The Company reimburses CPM for expenses it incurs under this agreement. All expenses paid by the Company were included as direct commission expenses to CPM in the insurance segment. The total direct commission expenses paid in 2008 and 2007 by the Company was $32.1 million and $6.3 million, respectively.
TRM entered into a management agreement with CPIC effective July 1, 2007 to produce and manage brokerage business on behalf of CPIC. Under this agreement, TRM receives a provisional management fee equal to 34.0% of the subject premium of the business produced by TRM. The amount of the fee is adjusted between 31.0% and 36.0% based on the loss ratio of the business produced. During 2008 and 2007, TRM produced $171.7 million and $84.2 million of premiums, respectively, and earned $55.4 million $27.0 million, respectively, in direct commission revenue from CPIC. The maximum potential reduction to direct commission revenue is $12.8 million.
Under the service and expense sharing agreements, CPM can purchase from TICNY, and TICNY can purchase from CPM, certain insurance company services, such as claims adjustment, policy administration, technology solutions, underwriting, and risk management services, at cost and market these services to program underwriting agents on an unbundled basis. The reimbursements for these charges have been recorded as “Other administration revenues” in the Company’s insurance services segment. CPM shares with the Company
50% of the profits and losses generated from marketed services. The Company charged CastlePoint $3.6 million and $1.4 million for such services in 2008 and 2007, respectively.
Effective May 2007, TRM entered into a service agreement with CPM pursuant to which TRM provides to CPM and CPM may provide to TRM insurance company services such as claim adjustment, policy administration, technology solutions, underwriting and risk management services. Under this agreement TRM agreed to produce and manage, on behalf of CPM, CPIC’s share of the Company’s brokerage business. During 2007, TRM produced $0.5 million of premium and earned $0.2 million in management fees from CPIC pursuant to this agreement. CastlePoint paid $4.3 million and $0.3 million, respectively, for the years ended December 31, 2008 and 2007, respectively, for claims adjustment services pursuant to this agreement. As more fully described under “Management Agreement” above, effective July 1, 2007, TRM entered into a new agreement to produce and manage CPIC business.
The components of the liability for loss and LAE expenses (“LAE”) and related reinsurance recoverables are as follows:
Incurred loss and LAE attributable to insured events of prior years decreased by $8.9 million, $1.6 million, and $0.7 million in 2008, 2007 and 2006, respectively. The 2006 decrease of $0.7 million is net of the $1.6 million loss due to the PXRE commutation. Prior year development is based upon numerous estimates by line of business and accident year. During calendar 2008, fire, homeowners, commercial multi peril property, commercial multi peril liability, workers’ compensation, and other liability had favorable prior year development that was partially offset by unfavorable development in auto lines. During calendar 2007, fire, homeowners, commercial multi peril property, workers’ compensation, and other liability had favorable prior year development that was partially offset by unfavorable development in other lines. No additional premiums or return premiums have been accrued as a result of the prior year effects; however, these charges in estimated losses impact the Company’s sliding scale commission income estimates. 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 6-Reinsurance-Commutation and Novation with PXRE Reinsurance Company.”
Beginning in the fourth quarter of 2008, LAE stemming from defense by in-house attorneys’ is attributed to claims based upon a determined fixed fee per in-house litigated claim. The Company allocates to each of these litigated claims 50% of the fixed fee when litigation on a particular claim begins and 50% of the fee when the litigation is closed. The fee is determined actuarially based upon the projected number of litigated claims and expected closing patterns at the beginning of each year, as well as the projected budget for the Company’s in-house attorneys, and these amounts are subject to adjustment each quarter based upon actual experience.
table below shows the method used by product line and accident year to select the estimated year-ending loss reserves:
Two key assumptions that materially impact the estimate of loss reserves are the loss ratio estimate for the current accident year and the loss development factor selections for all accident years. The loss ratio estimate for the current accident year is selected after reviewing historical accident year loss ratios adjusted for rate changes, trend, and mix of business.
Our data have sufficient credibility to base development factors on our own data. The loss development factors are reviewed annually. There have only been minor changes in selected loss development factors since 2003. The chart below shows the number of years by product line when we expect 50%, 90% and 99% of losses to be reported for a given accident year:
The Company has made only minor changes to the key assumptions used during the last three annual reserve estimates. In 2006 the Company had favorable development in its net losses from prior accident years of $0.7 million and excluding the PXRE commutation the Company had favorable development of $2.3 million. In 2007 and 2008, the Company had favorable development in its net losses from prior accident years of $1.6 million and $8.9 million, respectively.
Three-month LIBOR plus 425 basis points (capped at 12.5% until May 24, 2009)
Total interest expense incurred for all subordinated debentures, including amortization of deferred origination costs, was $7.9 million, $8.2 million and $5.3 million, respectively, for the years ended December 31, 2008, 2007 and 2006.
Aggregate scheduled maturities of the subordinated debentures at December 31, 2008 are:
On January 22, 2007, the Company signed an underwriting agreement providing for the issuance and sale of 2,704,000 shares of common stock at a price of $31.25 per share, less underwriting discounts, and granted to the underwriters an option to purchase up to 405,600 additional shares of common stock at the same price to cover over-allotments. On January 26, 2007, the Company closed on its sale of 2,704,000 shares of common stock. On February 5, 2007, the underwriters exercised their over-allotment option with respect to 340,600 shares of common stock. The Company received aggregate net proceeds of approximately $89.4 million from the offering and over-allotment option, after underwriting discounts and expenses.
For the year ended December 31, 2008, the Company issued 23,366 new common shares as the result of employee stock option exercises and issued 159,740 new common shares as the result of restricted stock grants. For the year ended December 31, 2007, the Company issued 81,100 new common shares as the result of employee stock option exercises and issued 93,581 new common shares as the result of restricted stock grants. For the year ended December 31, 2006, the Company issued 58,067 new common shares as the result of employee stock option exercises and issued 75,019 new common shares as the result of restricted stock grants.
For the years ended December 31, 2008 and 2007, the Company purchased 24,615 and 14,022 shares, respectively of its common stock from employees in connection with the vesting of restricted stock issued in conjunction with its 2004 Long Term Equity Compensation Plan (the “Plan”). The shares were withheld at the direction of employee as permitted under the Plan in order to pay the minimum amount of tax liability owed by the employee from the vesting of those shares. In addition, for the year ended December 31, 2008 and 2007, 14,889 and 10,292 shares, respectively, of common stock were surrendered to the Company as a result of restricted stock forfeitures.
As part of the IPO in October 2004, the Company issued to Friedman, Billings, Ramsey & Co., Inc. (“FBR”), the lead underwriter, warrants to purchase 189,000 shares of the Company’s common 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 was issued 10,567 shares by the Company from treasury shares. 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. During 2008, FBR assigned the then outstanding warrants to six of its employees. An employee of FBR exercised 1,333 warrants on November 25, 2008 via a cashless exercise which resulted in the issuance of 797 shares by the Company from treasury shares. An employee of FBR exercised warrants and paid the Company the warrant exercise price of $8.50 per share or $84,150 and was issued 9,900 shares by the Company from treasury shares. As of December 31, 2008 and 2007, there were 25,000 and 36,233 warrants outstanding that are included in the calculation of diluted EPS.
Includes restricted stock and restricted stock unit awards, performance shares and other cash or share-based awards.
In December 2000, the Board of Directors adopted a long-term incentive plan (the “2001 Stock Award Plan”). The plan provided for a variety of awards, including incentive or non-qualified stock options, performance shares, SARs or any combination of the foregoing.
As of December 31, 2008, there are 137,030 shares of common stock options outstanding that are fully vested. With the adoption of the 2004 Long-Term Incentive Compensation Plan, no further awards may be granted under the 2001 Stock Award Plan.
The total intrinsic value of restricted stock vesting during the years ended December 31, 2008, 2007 and 2006 was $2.0 million, $2.1 million and $1.8 million, respectively. The intrinsic value of unvested restricted stock outstanding as of December 31, 2008 is $7.3 million.
The fair value of the 2001 options granted was estimated using the Black-Scholes pricing model as of January 1, 2001, the date of the initial grant, with the following weighted average assumptions: risk free interest rate of 4.97%, dividend yield of 1.75%, volatility factors of the expected market price of the Company’s common stock of 35%, and a weighted-average expected life of the options of 7 years.
rendered and is based upon the original grant date fair value of the award as calculated for recognition of the pro forma disclosure under SFAS No. 123(R).
The total intrinsic value of stock options exercised during the years ended December 31, 2008, 2007 and 2006 was $0.4 million, $2.4 million and $1.4 million, respectively. The intrinsic value of stock options outstanding as of December 31, 2008 is $5.9 million of which $5.4 million is related to vested options.
The total remaining compensation cost related to non-vested stock options and restricted stock awards not yet recognized in the income statement was $5.3 million of which a de minimus amount was for stock options and $5.3 million was for restricted stock as of December 31, 2008. The weighted average period over which this compensation cost is expected to be recognized is 2.9 years.
purposes and income tax purposes, tax effected at a 35% rate. Significant components of the Company’s deferred tax assets and liabilities are as follows:
At December 31, 2008, the Company had $38.9 million of net operating loss carryforwards that will expire if unused in 2009-2027 and $8.1 million of capital loss carryforwards that will expire if unused in 2012-2013.
The Company recognizes interest and penalties related to uncertain tax positions in income tax expense which were zero for the years ended 2008, 2007 and 2006.
The Company has various lease agreements for office space furniture and equipment. The terms of the office space lease agreements provide for annual rental increases and certain lease incentives including initial free rent periods and cash allowances for leasehold improvements. The Company amortizes scheduled annual rental increases and lease incentives ratably over the term of the lease. The difference between rent cash
payments and recognized rent expense is recorded as deferred rent. The Company’s future minimum lease payments are as follows:
Tower’s Insurance Subsidiaries are also required to participate in various mandatory insurance facilities or in funding mandatory pools, which are generally designed to provide insurance coverage for consumers who are unable to obtain insurance in the voluntary insurance market. The Insurance Subsidiaries are subject to assessments in New York, New Jersey and other states for various purposes, including the provision of funds necessary to fund the operations of the New York Insurance Department and the New York Property/Casualty Insurance Security Fund, which pays covered claims under certain policies provided by impaired, insolvent or failed insurance companies and various funds administered by the New York Workers’ Compensation Board, which pays covered claims under certain policies provided by impaired, insolvent or failed insurance companies. The Company was assessed approximately $0, $624,000 and $2,042,000 in 2008, 2007 and 2006, respectively, for its proportional share of the total assessment for the Property/Casualty Security Fund and approximately $2,013,000, $1,409,000, and $1,470,000 in 2008, 2007 and 2006, respectively, for its proportional share of the operating expenses of the New York Insurance Department. Property casualty insurance company insolvencies or failures may result in additional security fund assessments to the Company at some future date. At this time the Company is unable to estimate the possible amounts, if any, of such assessments. Accordingly, the Company is unable to determine the impact, if any; such assessments may have on financial position or results of operations of the Company. The Company is permitted to assess premium surcharges on workers’ compensation policies that are based on statutorily enacted rates. Actual assessments have resulted in differences to the original estimates based on permitted surcharges of $0, ($2,156,000) and ($127,000) in 2008, 2007 and 2006, respectively. The Company estimates its liability for future assessments based on actual written premiums and historical rates and available information. As of December 31, 2008 the liability for the various workers’ compensation funds, which includes amounts assessed on workers’ compensation policies was $1,009,000. This amount is expected to be paid over an eighteen month period ending June 30, 2010. As of December 31, 2008, the liability for the various workers’ compensation funds was $433,000.
The New York City Fire Patrol (“Fire Patrol”), which is governed by the New York Board of Fire Underwriters (“NYBFU”), was created to improve fire safety in New York City and was responsible for the salvage and dewatering operations at the scene of fires and water leaks for the purpose of protecting property from loss due to these perils. Fire Patrol’s operations were supported by assessments made by the NYBFU on the insurance company members of the NYBFU and, in some instances, other writers of fire insurance in New York City who had elected not to become members. The NYBFU’s membership voted to discontinue the Fire Patrol on January 31, 2006. Subsequently, the Company received a $506,000 assessment from the Fire Patrol for the 2006 year. The Company does not believe that it is a proper assessment and it has requested additional information from the NYBFU on the Fire Patrol assessment. The Company has not recorded any liability for this assessment as of December 31, 2008 and 2007. The NYBFU has informed the Company that the Fire Patrol ceased operations on October 15, 2006. The Company cannot predict what action, if any, the NYBFU
will take in this matter and whether the Company may ultimately be liable for some amount of the assessment.
The Company’s Insurance Subsidiaries declared approximately $5.2 million, $8.5 million, and $4.6 million in dividends to Tower in 2008, 2007, and 2006, respectively. As of December 31, 2008, the maximum distribution that Tower’s Insurance Subsidiaries could pay without prior regulatory approval was approximately $17.1 million.
Equity and fixed income investments: Fair value disclosures for investments are included in “Note 2-Investments.”
In the insurance segment, the Insurance Subsidiaries provide commercial and personal lines insurance policies to businesses and individuals. The Insurance Subsidiaries commercial lines products include commercial
Underwriting expenses in the insurance segment are net of expense reimbursements that are made by the insurance services segment pursuant to an expense sharing agreement between TRM and TICNY. In accordance with terms of this agreement, TRM reimburses TICNY for a portion of TICNY’s underwriting and other expenses resulting from TRM’s use of TICNY’s personnel, facilities and equipment in underwriting insurance on behalf of TRM’s issuing companies. The reimbursement for underwriting and other expenses is calculated as a minimum reimbursement of 5% of the premiums produced by TRM, and is adjustable according to the terms of the agreement based on the number of policies in force and additional expenses that may be incurred by TRM. The amount of this reimbursement was $12.3 million, $5.8 million and $1.6 million in 2008, 2007 and 2006, respectively. TRM also reimburses TICNY, at cost, for claims administration expenses pursuant to the terms of this expense sharing agreement. Claims expenses reimbursed by TRM were $5.4 million, $2.3 million and $3.2 million in 2008, 2007 and 2006, respectively. TICNY is also reimbursed, at cost, for other administrative services provided to CastlePoint, pursuant to the terms of the service and expense sharing agreement which were $3.6 million, $1.4 million and $0.7 million in 2008, 2007 and 2006, respectively.
On February 27, 2009, the Company and its subsidiary, CastlePoint, completed the acquisition of HIG, Inc (“Hermitage”), a specialty property and casualty insurance holding company, from a subsidiary of Brookfield Asset Management Inc. for $130 million. This transaction was previously announced on August 27, 2008. Hermitage offers both admitted and E&S lines products and wrote more than $100 million of premiums in 2008. This transaction further expands the Company’s wholesale distribution system nationally and establishes a network of retail agents in the Southeast.
Tower Group, Inc.’s Board of Directors approved a quarterly dividend on February 27, 2009 of $0.05 per share payable March 27, 2009 to stockholders of record as of March 16, 2009.
On January 28, 2009 an amendment to increase the number of authorized shares of common stock, par value $0.01 per share from 40,000,000 shares to 100,000,000 shares was approved at a special meeting of stockholders. The amendment was filed with the Secretary of the State of Delaware on February 4, 2009.