The selected consolidated income statement data for the years ended December 31, 2010, 2009 and 2008, and the balance sheet data as of December 31, 2010 and 2009 are derived from our audited financial statements included elsewhere in this document, which have been prepared in accordance with GAAP. You should read the following selected consolidated financial information along with the information contained in this document, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes included elsewhere in this Form 10-K.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated audited financial statements and accompanying notes which appear elsewhere in this Form 10-K. It contains forward-looking statements that involve risks and uncertainties. See “Business-Note on Forward-Looking Statements” for more information. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Form 10-K, particularly under the headings “Business-Risk Factors” and “Business-Note on Forward-Looking Statements.”
Our consolidated results of operations reflect significant changes in 2010 as a result of acquisitions completed in the current and prior years. On July 1, 2010, we closed on the acquisition of OBPL and we closed on AequiCap II in the fourth quarter of 2010. In the first quarter of 2009, we closed on the acquisitions of CastlePoint and Hermitage. In the fourth quarter of 2009, we closed on the acquisitions of AequiCap I and SUA. Our consolidated revenues and expenses reflect the results of these acquired companies from their respective acquisition dates. This affects the comparability of our results between years.
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, personal automobile and umbrella policies.
On July 1, 2010, Tower completed the OBPL acquisition pursuant to a definitive agreement (the “Agreement”) dated February 2, 2010 by and among the Company and OneBeacon Insurance Group, LLC (“OneBeacon”). This acquisition expanded Tower’s suite of personal lines insurance products to include private passenger automobile, homeowners, umbrella, and the signature package product, OneChoice CustomPac, which provides customers with one policy for all of their homeowners, automobile and umbrella needs.
On November 13, 2009, the Company completed the acquisition of SUA, a specialty property and casualty insurance company. SUA offers specialty commercial property and casualty insurance products through independent program underwriting agents that serve niche groups of insureds. The acquisition of SUA expands the Company’s Commercial Insurance segment and its regional presence in the Midwest.
On October 14, 2009, the Company completed the acquisition of the renewal rights to the workers’ compensation business of AequiCap Program Administrators Inc. (“AequiCap I”), an underwriting agency based in Fort Lauderdale, Florida. The acquired business primarily consists of small, low to moderate hazard workers’ compensation policies in Florida. Most of the employees of AequiCap I involved in the servicing of the workers’ compensation business became employees of the Company. The acquisition of this business expands the Company’s regional presence in the Southeast.
On February 27, 2009, the Company completed the acquisition of Hermitage, a property and casualty insurance holding company. Hermitage offers both admitted and “E&S” products. This transaction further expands the Company’s wholesale distribution system nationally and establishes a network of retail agents in the Southeast.
On February 5, 2009, the Company completed the acquisition of 100% of the issued and outstanding common stock of CastlePoint, a Bermuda exempted corporation, pursuant to an Agreement and Plan of Merger, dated as of August 4, 2008, between the Company and CastlePoint. CastlePoint was a Bermuda holding company organized to provide property and casualty insurance and reinsurance business solutions, products and services primarily to small insurance companies and program underwriting managers in the United States.
Operating expenses. In our Commercial Insurance and Personal Insurance segments, we refer to the operating expenses that we incur to underwrite risks as underwriting expenses. These include direct and ceding commission expenses (payments to our producers for the premiums that they generate for us) and other underwriting expenses. In our Insurance Services segment, operating expenses consist of costs incurred to manage the Reciprocal Exchanges, direct commissions paid to producers and other insurance service expenses.
We use various measures to analyze the growth and profitability of our business segments. In our Commercial Insurance and Personal Insurance segments, 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 fee income generated from the Reciprocal Exchanges, premiums produced by TRM, CPM and CPRMFL on behalf of other insurance companies and, to a lesser extent, fee and commission revenue received. 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 attributable to Tower Group, Inc. and return on average equity.
Management fee income earned by the attorneys-in-fact. Our management companies provide various underwriting, claims, investment management and other services to the Reciprocal Exchanges. We earn a percentage of the written premiums issued by
the Reciprocal Exchanges. GAAP requires the consolidation of the Reciprocal Exchanges within our financial statements; however their results are excluded in deriving net income attributable to Tower stockholders and earnings per share calculations.
Loss and LAE reserves. The reserving process for loss and LAE reserves provides 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 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. There are various actuarial methods that are appropriate for the different lines of business, and our actuaries’ use of a particular method or weighting of methods depends in part on the maturity of each accident year by line of business, the limits of liability covered under the policies, the presence or absence of large claims in the experience, and other considerations. In general, the various actuarial methods can be grouped into three categories: loss ratio projection, loss development methods, and the Bornhuetter-Ferguson (“B-F”) method. For the most recent accident year and especially for liability lines of business the actuarial method given the most weight is usually the loss ratio method, since the percentage of ultimate claims reported to date is expected to be low and the immature reported claims experience is not a reliable indicator of ultimate losses for that accident year. For property lines of business for the most recent accident year the B-F method is usually given the most weight, because experience typically shows that there is a small percentage of claims reported in the subsequent period due to normal lags in reporting and processing of claims in these lines of business that can be relatively
We segregate our data for estimating loss reserves. The property lines include Fire, Homeowners, Commercial Multi-peril Property, Multi-Family Dwellings and Automobile Physical Damage. The casualty lines include Commercial Multi-peril Liability, Other Liability, Workers’ Compensation, Commercial Automobile Liability, and Personal Automobile Liability. Commercial Insurance segment reserves are estimated separately from Personal Insurance segment reserves. For the Commercial Insurance segment we analyze reserves by line of business and, where appropriate, we further segregate the data for analysis purposes between small, middle and large policies sizes and by state or region. We also analyze various producers’ business separately where the volume of business from those producers is considered significant and the characteristics of the business from those particular producers are perceived to be different. Within the Personal Insurance segment, we estimate loss and loss expenses reserves separately for the Reciprocal Exchanges which we manage and for our owned companies. We utilize line of business breakdowns and, where appropriate, analyze results separately by state.
For LAE stemming from defense by other attorneys who are not our employees, we utilize automated legal fee auditing that we believe has become relatively common in the insurance industry and has been shown to reduce external attorneys’ bills by 5% to 10%.
ULAE for claims that are handled in-house by our claims adjusters utilize a similar process to that described above for ALAE. We determine fixed fees per claim by line of business, and assign these costs to line of business and accident year, with 50% of
the fixed fee attributed to claims when a claim is opened and 50% attributed to claims when they are closed. The IBNR portion of ULAE for these claims is based upon 50% of the fixed fee per claims for in-house ULAE multiplied by the number of claims open and by 100% of the fixed fee multiplied by the estimated number of claims to be reported for prior accident dates.
For some types of claims and for some programs where we utilize third-party administrators (“TPA”) to adjust claims, we pay them fees which are included in ULAE. In some cases, we arrange for fixed percentages of premiums earned to be the fee for claims administration, and in other cases we arrange for fixed fees per claim or hourly charges for ULAE services. The reserves for ULAE for these situations is estimated based upon the particular arrangement for these types of claims by product or program.
Deferred acquisition costs, net. We defer certain expenses and commission revenues that vary with and are directly related to the successful acquisition of new and renewal 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, deferred acquisition costs, net, 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, net, 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. The value of business acquired (“VOBA”) is an intangible asset relating
If an other-than-temporary-impairment (“OTTI”) loss is determined for a fixed-maturity security (for which we do not have the intent to sell or more likely than not would be required to sell), the credit portion is recorded in the income statement as net realized losses on investments and the non-credit portion is recorded in accumulated other comprehensive income. The credit portion results in a permanent reduction in the cost basis of the underlying investment. For all other fixed-maturity security and equity security impairments, the entire impairment is reflected as a realized loss and reduces the cost basis of the security. The determination of OTTI is a subjective process and different judgments and assumptions could affect the timing of loss realization. We recorded OTTI losses in our fixed maturity and equity securities in the amounts of $16.1 million, $44.2 million and $22.7 million in 2010, 2009, and 2008, respectively, of which $4.2 million, $23.5 million and $22.7 million were recorded in earnings in 2010, 2009, and 2008, respectively.
See “Business-Investments” and “Note 5 - Investments” in the notes to consolidated financial statements for additional detail regarding our investment portfolio at December 31, 2010, including disclosures regarding other than temporary declines in investment value.
Identifiable intangible assets with a finite useful life are amortized over the period in which the asset is expected to contribute directly or indirectly to our future cash flows. Identifiable intangible assets with finite useful lives are tested for recoverability whenever events or changes in circumstances indicate that a carrying amount may not be recoverable. Identifiable intangible assets with indefinite useful lives and goodwill are not amortized. Rather, they are tested for recoverability at least annually or whenever events or changes in circumstances indicate that a carrying amount may not be recoverable.
Our results of operations are discussed below in two parts, consolidated results of operations and the results of each of our three segments. The comparison between quarters is affected by the acquisitions described above.
Personal Insurance segment underwriting profit includes underwriting results of the Reciprocal Exchanges for the year ended December 31, 2010.
The gross and net underwriting expense ratios include fees paid by the Reciprocal Exchanges to Tower in excess of Tower’s direct costs to service the management services agreement. These fees increased the gross and net expense ratios by 0.9% and 1.0%, respectively, for the year ended December 31, 2010.
For the year ended December 31, 2010, the after-tax impact of acquisition-related transaction costs, offset by net realized investment gains, increased return on average equity by 0.6% and lowered return on equity by 1.3% for the year ended December 31, 2009.
Total revenues. Total revenues increased by 48.4% for the year ended December 31, 2010 as compared to 2009, primarily due to increased net premiums earned and net investment income resulting from the acquisition of OBPL at the beginning of the third quarter of 2010. The following table shows the effects of the various acquisitions on our gross premiums written in 2010:
Premiums earned. Gross premiums earned in the year ended December 31, 2010 increased 45.2% compared to the prior year, primarily as a result of the aforementioned acquisition. Ceded premiums earned increased by a lower percentage than the gross growth percentage as we retained a larger percentage of our gross premiums because of our increased capital base. Accordingly, net premiums earned in the year ended December 31, 2010 increased by $438.0 million as compared to 2009.
Commission and fee income. Commission and fee income decreased by $5.5 million in the year ended December 31, 2010. This decrease is attributed to our decision to use less quota share reinsurance in 2010 as compared to 2009 leading to reduced ceding commission revenue. Insurance services revenue declined for the year ended December 31, 2010 as compared to 2009 caused by TRM ceasing to produce business on behalf of CPIC subsequent to the CastlePoint acquisition in 2009. Partially offsetting these decreases was a $3.3 million increase in policy billing fees generated in connection with the OBPL business for the last six months of 2010.
Premiums earned. Gross premiums earned increased significantly due to the CastlePoint and Hermitage acquisitions. Net premiums earned by CastlePoint and Hermitage since the respective acquisition dates were $351.2 million and $56.0 million, respectively, for the year ended December 31, 2009. Net premiums earned also increased relative to gross premiums earned, because, as a result of the additional capital obtained via the CastlePoint acquisition, as well as increased retained earnings, we did not cede as much premiums for year ended December 31, 2009 compared to the same period of December 31, 2008. Ceded premiums earned reflect runoff of quota share ceded premiums written in 2008, excess of loss and property catastrophe ceded premiums and a quota share reinsurance contract ceding our Commercial Insurance segment’s liability business to Swiss Re and Allianz entered into in the fourth quarter of 2009. Under this quota share agreement, we ceded 50% of earned premiums and incurred losses on Commercial Insurance segment liability lines that are part of Commercial Multi-Peril policies and Other Liability policies. We did not have any other quota share treaties in force in 2009.
Net investment income and net realized gains (losses). Net investment income was $74.9 million for 2009 compared to $34.6 million in 2008. The increase in net investment income resulted from an increase in cash and invested assets to $2.1 billion as of December 31, 2009 compared to $677 million as of December 31, 2008. The increase in cash and invested assets resulted primarily from the acquisitions of CastlePoint, Hermitage, SUA, and from cash provided from operations of $214.7 million in 2009, partially offset by $130.1 million of cash used to acquire Hermitage in the first quarter of 2009. The positive cash flow from operations was the result of the aforementioned acquisitions and an increase in premiums resulting from the growth of our book of business. Net investment income attributable to CastlePoint, Hermitage and SUA was $33.8 million, $7.5 million, and $1.5 million, respectively for 2009. The tax equivalent investment yield, including cash, was 5.5% at December 31, 2009 compared with 4.6% at December 31, 2008. The higher yield is generally due to the acquisition of CastlePoint, whose investment portfolio had a market yield, excluding cash, on the date of acquisition of 7.0%. CastlePoint’s investment portfolio’s market yield became Tower’s book yield due to business combination accounting rules. Book yields on the Tower portfolios, excluding the
Net realized investment gains were $1.5 million for 2009 compared to losses of $14.4 million in 2008. Included in the 2009 realized investment gains are $23.5 million of credit-related OTTI losses. The $23.5 million of OTTI losses are comprised of $21.6 million related to certain structured securities and $1.9 million related to the impairment of our bond holdings of CIT Group, Inc.
Loss and loss adjustment expenses. The gross and net loss ratio increased for 2009 compared to 2008, since 2008 reflected a greater degree of favorable reserve development and because the business acquired from CastlePoint and SUA in 2009 had a higher loss ratio. For 2009 we had favorable prior year reserve development of $2.3 million, compared to favorable prior year reserve development of $8.9 million in 2008.
The net accident year loss ratio increased over the prior period by 1.4 percentage points, which was comprised of 1.4 percentage points increase due to the soft market conditions, 0.6 percentage points due to the business mix acquired from CastlePoint and SUA, offset by a favorable impact of 0.6 percentage points due to the amortization of the reserve risk premium on loss reserves in accordance with GAAP for the business combinations occurring during 2009.
Operating expenses. Operating expenses in 2009 increased compared to 2008 primarily resulting from increased underwriting expenses due to the growth in premiums earned, primarily relating to the CastlePoint and Hermitage acquisitions and additional depreciation costs related to our increased investment in technology.
Interest expense. Interest expense increased by $9.7 million in 2009 compared to 2008. The increase was mainly due to $10.6 million of interest expense on $130 million of subordinated debentures which were assumed as a result of our 2009 acquisitions.
The decrease in the effective tax rate for the year ended December 31, 2009 primarily relates to the gain on bargain purchase of SUA of $13.2 million, which is not subject to tax, an increase in our tax exempt municipal investments, and, to a lesser extent, lower state and local income taxes because of the decline in pre-tax earnings in the Insurance Services segment. The reduction in the effective tax rate was partially offset by the limited amount of acquisition-related transaction costs that are tax deductible.
Ceding commission revenue. Ceding commission revenue decreased for the year ended December 31, 2010 by $7.4 million compared to 2009. The decrease was a result of a lower ceded commission rate on our liability quota share for in-force and new and renewal basis, effective October 1, 2009 and which, was earned in 2010 compared to the ceded commission rate on our multi-line quota share which was earned in 2009. Ceding commission revenue decreased by $2.3 million for the year ended December 31, 2010 as a result of increases in ceded loss ratios on prior year’s quota share treaties compared to a decrease of $1.8 million for 2009.
The other underwriting expense (“OUE”) ratio, including boards, bureaus and taxes (“BB&T”), was 12.8% for the year ended December 31, 2010 compared to 11.0% for 2009. Our investment in technology and overall integration efforts have increased due to the previously mentioned acquisitions over the past eighteen months that were mainly commercial lines focused.
Compensation-related costs of $2.9 million were incurred in connection with staff reductions related to ongoing restructuring and closing of certain offices associated with acquired businesses.
The commission portion of the gross underwriting expense ratio, which is expressed as a percentage of gross premiums earned, was 17.5% for the year ended December 31, 2010 compared to 19.6% for 2009. The decrease in commission rate for 2010 resulted from significantly higher amortization costs in 2009 for the value of business acquired (“VOBA”) of CastlePoint.
Gross premiums. Commercial Insurance gross premium written increased by $345.5 million for the year ended December 31, 2009 compared to 2008. The increase was primarily due to the acquisitions of CastlePoint and Hermitage in February 2009 and of SUA in November 2009. Our acquisition of Hermitage added to our retail distribution particularly in the Southeast and to our non-admitted wholesale capabilities. The acquisition of CastlePoint broadened our program business. Our organic growth was primarily from territorial expansion.
OUE including BB&T was 11.0% for 2009 compared to 11.1% for 2008. We continue to focus on improving cost efficiencies, particularly through our continuing investments in technology and reducing expenses of acquired companies. The acquisitions in 2009 provided increased economies of scale and the additional amount of premiums contributed to a lower OUE ratio. Within our program business, we recorded additional OUE in 2009 resulting from absorbing the CastlePoint staff costs. Prior to the acquisition, CastlePoint managed all program business and the staff costs were recorded by them, and we recorded a higher commission expense to reflect these costs. Additionally, in our non-program business, we recorded $2.2 million of New York State workers’ compensation assessments that exceeded amounts we were originally permitted to assess policyholders based on statutorily enacted rates in 2009 compared to $0 in 2008.
Gross premiums. Gross written premiums for the year ended December 31, 2010 was $412.5 million, an increase of $226.5 million over the prior year. The acquisition of OBPL accounted for $224.3 million of the increase. The remaining growth from the existing business was predominately from our California homeowners book. The full year premium from the OBPL book was $437.4 million which was down compared to prior year. Immediately following the acquisition, actions were taken to shed unprofitable business and to reduce coastal exposures.
Ceded premiums. Ceded premiums written and earned premiums for the year were $85.7 million and $71.3 million, respectively. The increase in ceded premium is principally due to the acquisition of OBPL which generated $44.0 million in ceded premium. Following the acquisition of OBPL, we decided to retain a homeowners quota share program which ceded 30% of all premium. This treaty generated $26.5 million in ceded premium in 2010. The ceded premium for the existing Tower personal lines business was $29.5 million, an increase of $8.4 million over prior year.
Catastrophe ceded premiums written were $20.3 million for the year compared to $9.5 million for the prior period. The increase in catastrophe ceded premiums includes $8.1 million for OBPL and $2.7 million for the existing Tower business.
Ceding commission revenue. Ceding commission revenue for 2010 was $6.1 million, an increase of $1.5 million over 2009. The increase was primarily attributable to the commission revenue associated with the previously mentioned homeowner quota share treaty. In recording the fair value adjustments on acquisition, the Company’s VOBA was established as the value of business acquired, offset by embedded ceding commissions, as of July 1, 2010. Accordingly, the fair value of deferred ceding commissions was recorded at zero. VOBA is being amortized into commission expense in proportion to the earnings of the business acquired. Ceding commission revenue as a percentage of ceded premiums written and earned is expected to increase over the next few quarters as we earn the ceded commission revenue for business written in the second half of 2010.
Loss and loss adjustment expenses. Our gross and net loss ratios for 2010 decreased by 0.8 and of 3.6 percentage points, respectively, compared to 2009. The net loss ratio excluding the Reciprocal Exchanges was 51.4%. The improvement in loss ratio resulted from lower than expected losses in 2010 and favorable reserve development, which was offset in part by winter storm losses that occurred in March 2010. Winter storm losses were $15.5 million in 2010, which represented 4.4 loss ratio points overall. Third and fourth quarter 2010 homeowners losses were better than expected for the current accident year due to relatively mild winter weather even considering the snow storm that occurred in the Northeast on December 26, 2010.
Underwriting expenses and underwriting expense ratio. The gross underwriting expense ratio for the year was 31.3%, 1.3 percentage points lower than prior year. The net underwriting expense ratio was 35.9%, 4.7 points better than the prior year.
The commission portion of the gross underwriting expense ratio was 17.7%, compared to 18.1% for the prior year. The improvement in the commission ratio reflects the impact of lower commission rates in the Reciprocal Exchanges. The gross OUE ratio including BB&T, was 13.6% compared with 14.5% in 2009. The decrease in the OUE expense ratio resulted from the Company deferring acquisition costs relating to OBPL with no offsetting expense as VOBA associated with the acquired business was amortized in commission expense.
Ceded premiums. Ceded premiums written and earned were $30.7 million and $42.3 million, respectively, for the year ended December 31, 2009 and were $38.2 million and $40.5 million, respectively, for 2008. The decrease in ceded premiums written for the year ended December 31, 2009 as compared to 2008 is primarily attributed to our decision to retain most of our business following the increase in our capital after the CastlePoint acquisition which more than offset an increase in the amount of catastrophe and excess of loss premiums. In 2009, the entire ceded written premium was either catastrophe or excess of loss protection, whereas 2008 ceded written premium included $24.0 million in quota share reinsurance placed with CastlePoint and $14.0 million in catastrophe and excess of loss protection. Catastrophe and excess of loss ceded premiums written increased by $16.0 million in 2009 as compared to 2008, due to the increase in gross business written.
Loss and loss adjustment expenses. The gross loss ratio increased by 10.5 percentage points in 2009 as compared to 2008, primarily due to increased frequency of incurred losses. There were no catastrophe losses incurred in either 2008 or in 2009. The net loss ratio increased by 14.2 percentage points for the year ended December 31, 2009 compared to 2008, and the 3.7 percentage point increase in net incurred loss ratio as compared to gross incurred loss ratio is due to the increased ceded catastrophe premiums in 2009.
Underwriting expenses and underwriting expense ratio. The increase in underwriting expenses results from the increase in gross premiums earned, primarily related to the CastlePoint acquisition. The gross underwriting expense ratio of 32.6% for the year ended December 31, 2009 decreased from the gross expense ratio of 34.4%, as the increase in gross earned premiums outpaced the growth in underwriting expenses. The net expense ratio in 2009 was 40.6% as compared to 39.6% in 2008, and the increase in the net expense ratio is due to lower ceding commission revenues from the reduced quota share business in 2009.
The commission portion of the gross underwriting expense ratio was 18.1% for the year ended December 31, 2009 compared to 17.2% for 2008. The OUE ratio including BB&T, was 14.5% for the year ended December 31, 2009 compared to 17.3% for 2008. The decrease in the OUE expense ratio resulted from the growth in personal lines premiums outpacing the costs of operating the segment.
Total revenue. The increase in total revenue for the year ended December 31, 2010 compared to 2009 was primarily due to the management fee income earned by Tower for underwriting, claims, investment management and other services provided to the Reciprocal Exchanges pursuant to a management services agreement with the Reciprocal Exchanges. The management fee income is calculated as a percentage of the Reciprocal Exchanges’ gross written premiums of $126.8 million in 2010. The increase in management fee income was offset by modest declines in revenue generated from our managing general agencies: TRM, CPM and CPRMFL. The Company had no premiums managed by our general agencies in 2010 whereas they managed $10.7 million in 2009.
Total expenses. The increase in total expenses for the year ended December 31, 2010 compared to 2009 was primarily due to the costs incurred under the management services agreement between Tower and the Reciprocal Exchanges.
The following table presents a breakdown of the amortized cost, aggregate fair value and unrealized gains and losses by investment type as of December 31, 2010 and December 31, 2009:
The average credit rating of our fixed-maturity securities, using ratings assigned to securities by Standard & Poor’s, was AA- at December 31, 2010 and December 31, 2009. The following table shows the ratings distribution of our fixed-maturity portfolio:
At December 31, 2010, $219.7 million of our municipal bonds, at fair value, were guaranteed by third parties from a total of $2.0 billion, at fair value, of all fixed-maturity securities held by us. The amount of securities guaranteed by third parties along with the credit rating with and without the guarantee is as follows:
A number of our Level 3 investments have also been written down as a result of our impairment analysis. At December 31, 2010, there were 7 securities that were priced in Level 3 with a fair value of $2.1 million and an unrealized gain of $0.9 million.
As more fully described in Note 5 to our consolidated financial statements, “Investments-Impairment Review,” we completed a detailed review of all our securities in a continuous loss position, including but not limited to residential and commercial mortgage-backed securities, and concluded that the unrealized losses in these asset classes are the result of a decrease in value due to technical spread widening and broader market sentiment, and in some instances include fundamental collateral deterioration, and are temporary in nature.
Refer to “Note 6 - Fair Value Measurements” to the consolidated financial statements for a description of the valuation methodology utilized to value Level 3 assets, how the valuation methodology is validated and an analysis of the change in fair value of Level 3 assets. As of December 31, 2010, the fair value of Tower Level 3 assets as a percentage of Tower’s total assets carried at fair value was as follows (the Reciprocal Exchanges had no Level 3 assets):
The fair value of our fixed maturity portfolio is directly affected by changes in interest rates and credit spreads. We 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.
The following tables show the fair value and unrealized loss by sector and credit quality rating of our corporate and other bonds in an unrealized loss position at December 31, 2010:
The majority of our corporate bonds that are in an unrealized loss position are rated below AA. Based on our analysis of these securities and current market conditions, we expect price recovery on these over time, and we have determined that these securities are temporarily impaired as of December 31, 2010.
Tower is organized as a holding company (the “Holding Company”) with multiple intermediate holding companies, 13 Insurance Subsidiaries and several management companies. The Holding Company’s principal liquidity needs include interest on debt, stockholder dividends and share repurchases under its share repurchase program. The Holding Company’s principal sources of liquidity include dividends and other permitted payments from our subsidiaries, as well as financing through borrowings and sales of securities.
Under New York law, TICNY is limited to paying dividends to the Holding Company only from statutory earned surplus. In addition, the New York Insurance Department must approve any dividend declared or paid by TICNY that, together with all dividends declared or distributed by TICNY during the preceding twelve months, exceeds the lesser of (1) 10% of TICNY’s policyholders’ surplus as shown on its latest statutory financial statement filed with the New York State Insurance Department or (2) 100% of adjusted net investment income during the preceding twelve months. TICNY declared $4.7 million, $2.0 million and $5.2 million in dividends to the Holding Company in 2010, 2009 and 2008, respectively.
The other Insurance Subsidiaries are subject to similar restrictions, usually related to policyholders’ surplus, unassigned surplus or net income and notice requirements of their domiciliary state. As of December 31, 2010, the amount of distributions that our Insurance Subsidiaries could pay to Tower without approval of their domiciliary Insurance Departments was $30.8 million. In addition, we can return capital of $39.3 million from CastlePoint Re without permission from the Bermuda Monetary Authority.
We may seek to raise additional capital or may seek to return additional capital to our stockholders through share repurchases, cash dividends or other methods (or a combination of such methods). Any such determination will be at the discretion of our Board of Directors and will be dependent upon our profits, financial requirements and other factors, including legal restrictions, rating agency requirements, credit facility limitations and such other factors as our board of directors deems relevant.
For the year ended December 31, 2010, net cash provided by operating activities was $170.0 million as compared to $214.7 million for 2009. The decrease in cash flow for the year ended December 31, 2010 primarily resulted from increased claims payments offset by reductions in cash paid for income taxes attributed to 2009 tax overpayments and increased tax deductions in 2010 relating to capital losses from the sale of certain fixed income securities.
The increase in operating cash flow in 2009 was primarily a result of additional cash flows provided through the acquisition of CastlePoint and Hermitage and in increase in premiums collected, which was partially offset by increased claims and tax payments.
Net cash flows used in financing activities related primarily to the payment of dividends to stockholders of $10.7 million in 2009, compared to $4.6 million in 2008.
Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2010, 2009, and 2008
To the Board of Directors and Stockholders of Tower Group, Inc.:
In our opinion, the consolidated balance sheet as of December 31, 2010 and the related consolidated statements of income and comprehensive income, changes in stockholders’ equity, and cash flows for the year then ended present fairly, in all material respects, the financial position of Tower Group, Inc. and its subsidiaries at December 31, 2010, and the results of their operations and their cash flows for the year ended December 31, 2010 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index on page S-1 present fairly, in all material respects, the information set forth therein at December 31, 2010 and for the year then ended when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
We have audited the accompanying consolidated balance sheet of Tower Group, Inc. (“the Company”) as of December 31, 2009, and the related consolidated statements of income and comprehensive income, shareholders’ equity, and cash flows for the years ended December 31, 2009 and 2008. Our audits also included the financial statement schedules for the years ended December 31, 2009 and 2008 listed in the Index at Item 15. These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Tower Group, Inc. at December 31, 2009 and the consolidated results of its operations and its cash flows for the years ended December 31, 2009 and 2008, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedules for the years ended December 31, 2009 and 2008, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
March 1, 2010, except for Note 21, as to which the date is March 1, 2011
Tower Group, Inc. (the “Company” or “Tower”) offers a broad range of commercial, personal and specialty property and casualty insurance products and services through its subsidiaries to businesses in various industries and to individuals. The Company’s common stock is publicly traded on the NASDAQ Global Select Market under the symbol “TWGP”.
On July 1, 2010, the Company completed its acquisition of the Personal Lines Division of OneBeacon Insurance Group, Ltd. (“OBPL”). Subsequent to this acquisition, the Company changed the presentation of its business results, beginning July 1, 2010, by allocating the personal insurance business previously reported in the Brokerage Insurance segment along with the newly acquired OBPL business to a new Personal Insurance segment and merged the commercial business previously reported in the Brokerage Insurance and Specialty Business segments in a new Commercial Insurance segment. The Company’s Insurance Services segment will also include fees earned by the management companies acquired as a part of the OBPL transaction. This change in presentation reflects the way management organizes the Company for making operating decisions and assessing profitability subsequent to the OBPL acquisition. This will result in the reporting of three operating segments. The prior period segment disclosures have been restated to conform to the current presentation.
As a result of the changes described above, the Company now operates three business segments: Commercial Insurance, Personal Insurance and Insurance Services:
The accompanying consolidated financial statements include the accounts of Tower and its insurance subsidiaries: Tower Insurance Company of New York (“TICNY”), Tower National Insurance Company (“TNIC”), Preserver Insurance Company (“PIC”), North East Insurance Company (“NEIC”), Mountain Valley Indemnity Company (“MVIC”), CastlePoint Insurance Company (“CPIC”), CastlePoint Reinsurance Company, Ltd. (“CastlePoint Re”), CastlePoint Florida Insurance Company (“CPFL”), Hermitage Insurance Company (“HIC”), Kodiak Insurance Company (“KIC”), SUA Insurance Company (“SUA”) (renamed CastlePoint National Insurance Company (“CPNIC”)), Massachusetts Homeland Insurance Company (“MHIC”) and York Insurance Company of Maine (“York”) (collectively the “Insurance Subsidiaries”); its managing general agencies: Tower Risk Management Corp. (“TRM”), CastlePoint Management Corp. (“CPM”) and AequiCap CP Services Group, Inc. (renamed CastlePoint Risk Management of Florida, Inc. (“CPRMFL”)); and its management companies: Adirondack AIF, LLC (“ADAIF”) and New Jersey Skylands Management Company LLC (“NJSM”). The Company also consolidates Preserver Group, Inc. (“PGI”), CastlePoint Bermuda Holdings (“CBH”) and HIG, Inc. (“Hermitage”) which are intermediate holding companies. The consolidated financial statements include the accounts of Adirondack Insurance Exchange, a New York reciprocal insurer, and New Jersey Skylands Insurance Association, a New Jersey reciprocal insurer and its wholly owned insurance subsidiary, New Jersey Skylands Insurance Company (together, the “Reciprocal Exchanges”). The Company does not own the Reciprocal Exchanges but manages them through ADAIF and NJSM.
Direct commission revenue from the Company’s managing general underwriting services is recognized and earned as insurance policies are placed with the issuing companies of TRM, CPM, and CPRMFL. Fees relating to the provision of reinsurance intermediary services are earned when the Company’s Insurance Subsidiaries or the issuing companies of TRM, CPM, and CPRMFL cede premiums to reinsurers. Claims administration fees and other administration revenues are earned as services are performed. Management fees earned by the management companies, ADAIF and NJSM, for services provided to the Reciprocal Exchanges are reported as management fee income within the segment but are eliminated in consolidation.
Tower estimates reserves separately for losses, allocated loss adjustment expenses, and unallocated loss adjustment expenses. Allocated loss adjustment expenses (“ALAE”) refers to costs of attorneys as well as miscellaneous costs such as investigators, witness fees and court costs attributable to specific claims that generally are in various stages of litigation. Unallocated loss adjustment expenses (“ULAE”) refers to costs for administering claims that are not related to attorney fees and miscellaneous costs associated with litigated claims. Tower estimates the ALAE liability separately for claims that are defended by in-house
The Company uses reinsurance to limit its exposure to certain risks. Management has evaluated its reinsurance arrangements and determined that significant insurance risk is transferred to the reinsurers. Reinsurance agreements have been determined to be short-duration prospective contracts and, accordingly, the costs of reinsurance are recognized over the life of the contracts in a manner consistent with the earning of premiums on the underlying policies subject to the reinsurance contract.
Premiums receivable represent amounts due from insureds and reinsureds for insurance coverage and are presented net of an allowance for doubtful accounts of $2.1 million and $1.3 million at December 31, 2010 and 2009, respectively. The allowance for uncollectible amounts is based on an analysis of amounts receivable giving consideration to historical loss experience and current economic conditions and reflects an amount that, in management’s judgment, is adequate. Uncollectible agent’s premiums receivable of $1.8 million, $0.9 million and $0.4 million were written off in 2010, 2009 and 2008, respectively.
tested for recoverability whenever events or changes in circumstances indicate that a carrying amount may not be recoverable. No impairment losses were recognized in 2010, 2009 or 2008.
Pursuant to a written tax agreement (the “Tax Sharing Agreement”), each of the entities in the group is required to make payments to Tower for federal income tax imposed on its taxable income in a manner consistent with filing a separate federal income tax return (but subject to certain limitations that are applied to the Tower consolidated group as a whole). The Reciprocal Exchanges are not subject to the Tax Sharing Agreement but file separate tax returns annually.
The Company accounts for the treasury stock at the repurchase price as a reduction to stockholders’ equity as it does not currently intend to retire the treasury stock held at December 31, 2010.
Insurance related assessments are accrued in the period in which they have been incurred. The Company is subject to a variety of assessments. Among such assessments are state guaranty funds and workers’ compensation second injury funds. State guaranty fund 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.
The Company measures earnings per share at two levels: basic earnings per share and diluted earnings per share. Basic earnings per share is calculated by dividing net income attributable to Tower common stockholders by the weighted average number of common shares outstanding during the year. This weighted average number of shares includes unvested share-based awards that contain nonforfeitable rights to dividends or dividend equivalents whether paid or unpaid (“participating securities”). Diluted
In June 2009, the Financial Accounting Standards Board (“FASB”) issued new guidance which requires more information about transfers of financial assets, including securitization transactions, where entities have continuing exposure to the risks related to the transferred financial assets. This guidance eliminates the concept of a “qualifying special-purpose entity,” changes the requirements for derecognizing financial assets, and requires additional disclosures. The new guidance enhances information reported to users of financial statements by providing greater transparency about transfers of financial assets and an entity’s continuing involvement in transferred financial assets. The Company adopted this new guidance on January 1, 2010, with no material effects on its financial statements as of December 31, 2010.
hierarchy within GAAP. The Company adopted this guidance on January 1, 2010, with the required disclosure included in “Note 6 - Fair Value Measurements”.
In December 2010, the FASB issued new guidance on disclosure requirements for business combinations. This guidance requires disclosure of revenue and earnings of the combined entity as though the business combinations that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. Additionally, this guidance requires a description of the nature and amount of material non-recurring pro forma adjustments directly attributable to the business combination included in the pro forma revenue and earnings. The Company early adopted this guidance as of January 1, 2010. The disclosures in “Note 3 - Acquisitions” have been conformed to this new guidance.
In October 2010, the FASB issued new guidance concerning the accounting for costs associated with acquiring or renewing insurance contracts. This guidance generally follows the model of that for loan origination costs. Under the new guidance, only direct incremental costs associated with successful insurance contract acquisitions or renewals would be deferrable. The guidance also states that advertising costs and indirect costs should be expensed as incurred. Although this guidance states that certain advertising costs that meet current accounting guidance could be deferred and treated as deferred acquisition costs (“DAC”), the Company does not currently record any advertising costs in DAC. The following categories of acquisitions costs are included within the December 31, 2010 caption “Deferred acquisition costs, net”:
Effective July 1, 2010, Tower entered into transition service agreements with OneBeacon whereby OneBeacon will provide certain information technology and operational support to Tower until such time that these processes are migrated to Tower. Expenses incurred under such transition service agreements were $13.3 million for the year ended December 31, 2010.
Direct costs of the acquisition are accounted for separately from the business combination and are expensed as incurred. As the values of certain assets and liabilities are preliminary in nature, they are subject to adjustment as additional information is obtained, including, but not limited to, valuation of separately identifiable intangibles, fixed assets, deferred taxes and loss reserves. The valuations will be finalized within 12 months of the close of the acquisition. When the valuations are finalized, any changes to the preliminary valuation of assets acquired or liabilities assumed may result in adjustments to separately identifiable intangible assets and goodwill.
From July 1, 2010, the date of acquisition, through December 31, 2010, OBPL contributed revenue and earnings to the Company from its acquisition date as follows:
On October 14, 2009, the acquisition of the renewal rights to the workers’ compensation business of AequiCap was completed (“AequiCap I”). These renewal rights were purchased for $5.5 million in cash. The acquired business primarily consists of small, low to moderate hazard workers’ compensation policies in Florida. Most of the employees of AequiCap I involved in the servicing of the workers’ compensation business became employees of the Company. The acquisition of this business strengthened the regional presence in the Southeast.
The Company began consolidating the Hermitage financial statements as of the closing date. The purchase consideration has been allocated to the assets acquired and liabilities assumed, including separately identified intangible assets, based on their fair values as of the close of the acquisition, with the amounts exceeding the fair value recorded as goodwill. The goodwill consists largely of the synergies and economies of scale expected from combining the operations of the Company and Hermitage.
The following table presents assets acquired and liabilities assumed with the acquisition of Hermitage, based on their fair values and the fair value hierarchy level under GAAP as of February 27, 2009, the closing date of this acquisition:
Also, the fair value of the CastlePoint acquisition included the fair value of the Company’s previously held interest in CastlePoint and is presented as follows:
The Company began consolidating CastlePoint’s financial statements as of the closing date. The purchase consideration has been allocated to the assets acquired and liabilities assumed, including separately identified intangible assets, based on their fair values
The Reciprocal Exchanges are policyholder-owned insurance carriers organized as unincorporated associations. Each policyholder insured by the Reciprocal Exchanges shares risk with the other policyholders. In the event of dissolution, policyholders would share any residual unassigned surplus in the same proportion as the amount of insurance purchased but are not subject to assessment for any deficit in unassigned surplus of the Reciprocal Exchanges. Through its management companies, Tower is the attorney-in-fact for the Reciprocal Exchanges and has the ability to direct their activities. Tower receives management fee income for the services provided to the Reciprocal Exchanges. The assets of the Reciprocal Exchanges can be used only to settle the obligations of the Reciprocal Exchanges and general creditors to their liabilities have no recourse with Tower as the primary beneficiary.
The Reciprocal Exchanges were originally capitalized by issuing surplus notes. The obligation to repay principal on the surplus notes is subordinated to all other liabilities including obligations to policyholders and claimants for benefits under insurance policies. Principal and interest on the surplus notes are repayable only with regulatory approval. New Jersey Skylands Insurance Association was capitalized with a $31.3 million surplus note issued in 2002. Adirondack Insurance Exchange was capitalized with a $70.7 million surplus note issued in 2006. As discussed in “Note 3 - Acquisitions” above, on July 1, 2010, the Company completed the acquisition of OBPL and acquired the surplus notes of the Reciprocal Exchanges. The Company has no ownership interest in the Reciprocal Exchanges.
The Company determined that each of the Reciprocal Exchanges qualifies as a VIE and that the Company is the primary beneficiary as it has both the power to direct the activities of the Reciprocal Exchanges that most significantly impact their
For the year ended December 31, 2010, the Reciprocal Exchanges recognized total revenues and total expenses of $101.0 million and $95.3 million, respectively, and had net income of $4.0 million.
The cost or amortized cost and fair value of the Company’s invested assets, gross unrealized gains and losses, and other-than-temporary impairment losses as of December 31, 2010 and December 31, 2009 are summarized as follows:
At December 31, 2010 and 2009, U.S. Treasury Notes and other securities with carrying values of $188.5 million and $113.1 million, respectively, were on deposit with various states to comply with the insurance laws of the states in which the Company is licensed.
Proceeds from the sale and maturity of fixed-maturity securities were $1,427.5 million, $936.0 million and $356.0 million for the year ended December 31, 2010, 2009 and 2008, respectively. Proceeds from the sale of equity securities were $80.7 million, $50.6 million and $6.5 million for the year ended December 31, 2010, 2009 and 2008, respectively.
Management, in conjunction with its outside portfolio managers, analyzes its non-agency RMBS using default loss models based on the performance of the underlying loans. Performance metrics include delinquencies, defaults, foreclosures, prepayment speeds and cumulative losses incurred. The expected losses for a mortgage pool are compared to the break-even loss, which represents the point at which the Company’s tranche begins to experience losses.
The non-structured fixed-maturity securities (U.S. Treasury securities, obligations of U.S. Government and government agencies and authorities, obligations of states, municipalities and political subdivisions, and certain corporate debt) unrealized loss is reviewed to determine whether full recovery of principal and interest will be received. The estimate of expected cash flows is determined by projecting a recovery value and a recovery time frame and assessing whether further principal and interest will be received. The determination of recovery value incorporates an issuer valuation assumption utilizing one or a combination of valuation methods as deemed appropriate by management. The present value of the cash flows is determined by applying the effective yield of the security at the date of acquisition (or the most recent implied rate used to accrete the security if the implied rate has changed as a result of a previous impairment) and an estimated recovery time frame. For securities for which the issuer is financially troubled but not in bankruptcy, that time frame is generally longer. Included in the present value calculation are expected principal and interest payments; however, for securities for which the issuer is classified as bankrupt or in default, the present value calculation assumes no interest payments and a single recovery amount. In situations for which a present value of cash flows cannot be estimated, a write down to fair value is recorded.
The following table shows the amount of fixed-maturity and equity securities that were OTTI for the years ended December 31, 2010, 2009 and 2008. This resulted in recording impairment write-downs included in net realized investment gains (losses), and reduced the unrealized loss in other comprehensive net income:
The following table provides a rollforward of the cumulative amount of OTTI for securities still held showing the amounts that have been included in earnings on a pretax basis for the years ended 2010 and 2009 (none of such OTTI was included within the Reciprocal Exchanges):
For all fixed-maturity securities in an unrealized loss position at December 31, 2010, the Company has received the contractual interest payments (and principal if applicable). Based on the continuing receipt of cash flow and the foregoing analyses, management expects continued timely payments of principal and interest and considers the losses to be temporary.
As of December 31, 2010 and 2009, there were a total of 793 and 525 securities, respectively, in an unrealized loss position. The unrealized loss position associated with the fixed-maturity portfolio was $14.7 million as of December 31, 2010, consisting primarily of mortgage-backed and asset-backed securities representing 34.9% of the gross unrealized loss related to fixed-maturity securities. The total fixed-maturity portfolio of gross unrealized losses included 718 securities which were, in aggregate, 2.2% below amortized cost. Of the 718 fixed maturity investments identified, 24 have been in an unrealized loss position for more than 12 months. The total unrealized loss on these investments at December 31, 2010 was $1.2 million. Management does not consider these investments to be other-than-temporarily impaired.
The unrealized loss for the corporate and other bonds was $4.8 million with 2 securities in an unrealized loss position over 12 months. These investments are not considered to be other-than-temporarily impaired.
The following table shows the composition of the fixed-maturity portfolio by remaining time to maturity at December 31, 2010 and 2009. 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.
The fair values of the fixed-maturity, equity investments and short-term investments are determined by management after taking into consideration available sources of data. Various factors are considered that may indicate an inactive market, including levels of activity, source and timeliness of quotes, abnormal liquidity risk premiums, unusually wide bid-ask spreads, and lack of correlation between fair value of assets and relevant indices. If management believes that the price provided from the pricing source is distressed, management will use a valuation method that reflects an orderly transaction between market participants, generally a discounted cash flow method that incorporates relevant interest rate, risk and liquidity factors.
Substantially all of the portfolio valuations at December 31, 2010 classified as Level 1 or Level 2 in the above table is priced by utilizing the services of several independent pricing services that provide the Company with a price quote for each security. The remainder of the Level 1 and Level 2 portfolio valuations represents non-binding broker quotes. There were no adjustments made to the prices obtained from the independent pricing sources and dealers on securities classified as Level 1 or Level 2.
The Level 3 classified securities in the investment portfolio consist of primarily non-agency mortgage-backed and asset-backed securities that were either not traded or very thinly traded. Management, in conjunction with its outside portfolio managers, has considered the various factors that may indicate an inactive market and has concluded that prices provided by the pricing sources represent an inactive or distressed market. As a result, prices from independent third party pricing services, broker quotes or other observable inputs were not always available or were deemed unrealistic, or, in the case of certain broker quotes, were non-binding. Therefore, the fair values of these securities were determined 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, non-binding broker quotes were available and these were also considered in determining the appropriateness of the security price.
The following table summarizes changes in Level 3 assets measured at fair value for the year ended December 31, 2010 and 2009 for Tower (the Reciprocal Exchanges have no Level 3 assets):
Primarily relates to the acquisitions of CastlePoint and Hermitage in 2009 and OBPL and AequiCap II in 2010.
The Company does not expect any of the goodwill related to the acquisition of OBPL to be deductible for tax purposes.
The Company performs an analysis annually to identify potential goodwill impairment and measures the amount of any goodwill impairment loss that may need to be recognized. Goodwill impairment testing requires an evaluation of 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. No impairments have been identified to date.
Intangible assets consist of finite and indefinite life assets. Finite life intangible assets include customer relationships and trademarks. Insurance company licenses and management contracts are considered indefinite life intangible assets subject to annual impairment testing. The weighted average amortization period of identified intangible assets with a finite life is 6.1 years as of December 31, 2010.
The Company recorded amortization expense related to intangibles of $6.6 million, $3.2 million and $1.2 million in the years ended December 31, 2010, 2009 and 2008, respectively. The estimated amortization expense for each of the next five years is:
Acquisition costs incurred and policy-related ceding commission revenue are deferred and amortized to income on property and casualty business for the year ended December 31, 2010 and 2009 as follows:
As disclosed in “Note 2 - Accounting Policies and Basis of Presentation”, management expects to adopt new accounting guidance related to DAC on January 1, 2011 and believes this will reduce the December 31, 2010 DAC balance by $71.0 million to $75.0 million.
The Company has automatic treaty capacity of $30.0 million for property risks, $50.0 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. In addition, the Company has clash coverage in effect for 2010 for a limit of $5.0 million in excess of $5.0 million which applies to the aggregate liability of losses from multiple insureds involved in the same occurrence.
The Reciprocal Exchanges participate in a shared property catastrophe reinsurance cover placed on an excess of loss basis. At July 1, 2010 this property catastrophe coverage was for 100% of $150 million in excess of a $10 million retention.Certain of the Company’s reinsurance agreements contain provisions for loss ratio caps to provide the reinsurers with some limit on the amount of potential loss being assumed, while maintaining the transfer of significant insurance risk with the possibility of a significant loss to the reinsurer. Loss ratio caps cut off the reinsurers’ liability for losses above a specified loss ratio. The loss ratio cap in the 2008 Swiss Re quota share agreement was 120%. The loss ratio cap for the liability quota share agreements effective October 1, 2009 and January 1, 2010 is 110%. There was no loss ratio cap in 2007 and 2006.
The structure of the Company’s reinsurance program enables the Company to reflect significant reductions in premiums written and earned and also provides income as a result of ceding commissions earned pursuant to reinsurance contracts. This structure has enabled the Company to significantly grow its premium volume while maintaining regulatory capital and other financial ratios within expected ranges used for regulatory oversight purposes. The Company’s participation in reinsurance arrangements does not relieve the Company from its obligations to policyholders.
The Company is obliged under the quota share reinsurance agreements, effective October 1, 2003, January 1, 2004, January 1, 2005, October 1, 2009 and January 1, 2010 to credit reinsurers with an annual effective yield of 2.5%, 2.5%, 3.0%, 4.0% and 4.0%, respectively, on the monthly balance in the funds held under reinsurance agreements liability accounts. The amounts credited for 2010, 2009 and 2008 were $2.7 million, $0.7 million and $0.6 million, respectively, and have been recorded as interest expense.
The Company earns ceding commissions under certain quota share reinsurance agreements based on a sliding scale of commission rates and ultimate treaty year loss ratios on the policies reinsured under each of these agreements. The sliding scale includes minimum and maximum commission rates in relation to specified ultimate loss ratios. The commission rate and ceding commissions earned increase when the estimated ultimate loss ratio decreases, and conversely, the commission rate and ceding commissions earned decrease when the estimated ultimate loss ratio increases.
As of December 31, 2010, the Company’s estimated ultimate loss ratios attributable to these contracts are lower than the contractual ultimate loss ratios at which the minimum amount of ceding commissions can be earned. Accordingly, the Company has recorded ceding commissions earned that are greater than the minimum commissions. The relevant estimated ultimate loss ratios and commissions as of December 31, 2010 are set forth below for treaties that remain in effect as of December 31, 2010 ($ in millions):
The estimated ultimate loss ratios are the Company’s best estimate based on facts and circumstances known at the end of each period that losses are estimated. The estimation process is complex and involves the use of informed estimates, judgments and actuarial methodologies relative to future claims severity and frequency, the length of time for losses to develop to their ultimate level, possible changes in law and other external factors. The same uncertainties associated with estimating loss adjustment
expense reserves affect the estimates of ceding commissions earned. The Company monitors and adjusts the ultimate loss ratio on a quarterly basis to determine the effect on the commission rate and ceding commissions earned. The increase (decrease) in estimated ceding commission income relating to prior years recorded in 2010, 2009 and 2008 was ($2.7) million , ($2.2) million and ($1.8) million, respectively.
The components of the liability for loss and LAE expenses and related reinsurance recoverables for the years ended December 31, 2010 and 2009 are as follows:
Included in the reserves for the loss and LAE reserves at December 31, 2010 and 2009 is $3.7 million and $4.5 million, respectively, of tabular reserve discount for workers’ compensation and excess workers’ compensation claims. Most of these claims pertain to the SUA transaction.
The Company has implemented a number of changes during the past several years that have favorably impacted LAE expenses and LAE reserves. For ALAE, the changes reflect a shift of defending third-party liability claims by the Company’s attorneys rather than by attorneys that are not employees of the Company. For ULAE the changes reflect a revised study of the cost of settling claims.
Because of the cost advantage for ALAE utilizing attorneys who are employees of the Company, we had been increasing the number of employed attorneys, and as part of the OBPL acquisition we significantly increased the number of these employed attorneys. We shifted these employed attorneys to defend commercial lines third-party liability claims. Also, our increased capabilities enabled us to defend in-house third-party liability claims throughout the Northeast. Currently, we are handling over 85% of new litigated third-party commercial claims in the Northeast utilizing attorneys who are employees of the Company, and due to the shift to handling claims by employed attorneys we reduced the ALAE expenses in 2010 in the Commercial Insurance segment by approximately $10 million on a net basis as a result.
Due to the inherent uncertainty associated with the reserving process, the ultimate liability may differ, perhaps substantially, from the original estimate. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current year’s results. Reserves are closely monitored and are recomputed periodically using the most recent information on reported claims and a variety of statistical techniques. Specifically, on at least a quarterly basis, the Company reviews, by line of business, existing reserves, new claims, changes to existing case reserves and paid losses with respect to the current and prior years.
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. As the current year matures the estimated loss and LAE is determined with more weight given to reported experience during the year by utilizing the B-F method or potentially for relatively fast developing lines of business giving more weight to loss development methods.
The incurred method relies on historical development factors derived from changes in the Company’s incurred estimates of claims paid and case reserves over time. The paid method relies on the Company’s claim payment patterns and ultimate claim costs. The incurred method is sensitive to changes in case reserving practices over time. Thus, if case reserving practices change over time, the incurred method may produce significant variation in estimates of ultimate losses. The paid method relies on actual claim payments and therefore is not sensitive to changes in case reserve estimates.
However, there are no assurances that future loss development and trends will be consistent with its past loss development history, and so adverse loss reserves development remains a risk factor to the Company’s business.
The Company’s borrowings consisted of the following at December 31, 2010 and 2009:
Amount reflected in balance sheet for convertible senior notes is net of unamortized original issue discount of $10,792.
On May 14, 2010, the Company entered into a $125 million credit facility agreement. The credit facility will be used for general corporate purposes and expires on May 14, 2013.
The Company may request that the facility be increased by an amount not to exceed $50 million. The credit facility contains customary covenants for facilities of this type, including restrictions on indebtedness and liens, limitations on mergers, dividends and the sale of assets, and requirements to maintain certain consolidated net worth, debt to capitalization ratios, minimum risk-based capital and minimum statutory surplus. The credit facility also provides for customary events of default, including failure to pay principal when due, failure to pay interest or fees within three days after becoming due, failure to comply with covenants, any representation or warranty made by the Company being false in any material respect, default under certain other indebtedness, certain insolvency or receivership events affecting the Company and its material subsidiaries, the occurrence of certain material judgments, or a change in control of the Company, and upon an event of default the administrative agent (subject to the consent of the requisite percentage of the lenders) may immediately terminate the obligations to make loans and to issue letters of credit, declare the Company’s obligations under the credit facility to become immediately due and payable, and require the Company to deposit in a collateral account cash collateral with a value equal to the then outstanding amount of the aggregate face amount of any outstanding letters of credit. The Company was in compliance with all covenants under the credit facility at December 31, 2010.
The Company has no balance outstanding as of December 31, 2010.
The proceeds from the issuance of the Notes were allocated to the liability component and the embedded conversion option, or equity component. The equity component was reported as an adjustment to paid-in-capital, net of tax, and is reflected as an original issue discount (“OID”). The OID of $11.5 million and deferred origination costs relating to the liability component of
$5.0 million will be amortized into interest expense over the term of the Notes. After considering the contractual interest payments and amortization of the original issue discount, the Notes’ effective interest rate is 7.2%. Transaction costs of $0.4 million associated with the equity component were netted with the equity component in paid-in-capital. Interest expense, including amortization of deferred origination costs, recognized on the Notes was $3.1 million for the year ended December 31, 2010. The Notes’ fair value was $168.4 million at December 31, 2010.
In connection with the offering of the Notes, the Company also entered into convertible senior notes hedge transactions (the “Note Hedges” or “purchased call options”) and warrant transactions (the “Warrants”) with respect to its common stock with financial institutions. The Note Hedges and Warrants are intended generally to reduce the potential dilution of the Company’s common stock and to offset potential cash payments in excess of the principal of the Notes upon conversion. The Note Hedges and Warrants are separate transactions, entered into by the Company with the financial institutions, and are not part of the terms of the Notes.
The Company received $3.8 million for Warrants sold to the financial institutions. The Warrants provide for the acquisition of 5.5 million shares of common stock at a strike price of $33.42 per share, subject to anti-dilution adjustments. The Warrants have been accounted for as an adjustment to the Company’s paid-in-capital.
The Board of Directors of Tower approved a $100 million share repurchase program on February 26, 2010. Purchases can be made from time to time in the open market or in privately negotiated transactions in accordance with applicable laws and regulations. The share repurchase program has no expiration date. In the year ended December 31, 2010, 4.0 million shares of common stock were purchased under this program at an aggregate consideration of $88.0 million. As the share repurchase program began in 2010, there were no purchases in the prior years.
Dividends on common stock of $16.6 million $10.7 million and $4.6 million for the years ended December 31, 2010, 2009 and 2008, respectively, were declared.
The following table provides information with respect to the stock options and shares of the Company’s common stock issued (i) to the Company’s employees under the Plan and (ii) to employees and directors of companies acquired by the Company in exchange for the options and shares owned by such employees and directors in such companies at the time of acquisition.
The following table provides an analysis of restricted stock activity for the years ended December 31, 2010, 2009 and 2008:
The following table provides an analysis of stock option activity for the years ended December 31, 2010, 2009 and 2008:
The fair value of the options granted to replace the SUA options was estimated using the Black-Scholes pricing model as of November 13, 2009, the date of conversion from SUA stock options to the Company’s stock options, with the following weighted average assumptions: risk free interest rate of 1.66%, dividend yield of 1.2%, volatility factors of the expected market price of the Company’s common stock of 43.8%, and a weighted-average expected life of the options of 1.4 years.
The total remaining compensation cost related to non-vested stock options and restricted stock awards not yet recognized in the income statement was $9.6 million of which $0.2 million was for stock options and $9.4 million was for restricted stock as of December 31, 2010. The weighted average period over which this compensation cost is expected to be recognized is 3.1 years.
In assessing the valuation of deferred tax assets, the Company considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible.
The Internal Revenue Service is currently performing an audit of The Company’s 2006 tax year. The audit has been extended to September 30, 2011. Additionally, in 2011 the IRS will begin an audit of CastlePoint Management and Subsidiary’s federal income tax return for the period ended February 2009. CastlePoint Re’s federal excise tax and protective income tax returns for the 2008 tax year and SUA’s federal income tax return for the 2007 tax year are still under IRS audit. However, the Company does not anticipate any material adjustments from these audits.
The SERP is a non-qualified defined contribution plan effective as of January 1, 2009 that is intended to enhance retirement benefits for the Company’s most senior executives and certain other key employees. Eligibility to participate in the SERP generally requires three years of prior employment with the Company for Senior Vice Presidents and between five and 10 years of prior employment with the Company for other key employees. In 2011, it is expected that all of the Named Executive Officers other than the Chief Financial Officer (who is not yet eligible), as well as certain other key executives selected at the discretion of the Compensation Committee, will be eligible to participate in the SERP. Subject to the approval of the Compensation Committee, the Company may make annual contributions to the SERP on behalf of each participant. For the Chief Executive Officer, the current annual contribution level is intended to provide him with a target annual benefit equal to 60% of his annual
cash compensation upon retirement after 30 years of service. The SERP is not a defined benefit plan and such target benefit level cannot be guaranteed. For other participants, the amount of the annual contribution is equal to 5.0% of their annual cash compensation. Company contributions for each participant remain unvested until such participant has completed 10 years of service with the Company, and vest in full upon completion of 10 years of service. The Compensation Committee has discretion to terminate the SERP at any time or to adjust upward or downward the level of the Company’s contribution each year.
On May 12, 2010, Mirabilis Ventures, Inc. (“Mirabilis”) commenced an action against Specialty Underwriters’ Alliance Insurance Co. (“SUA”, now known as CastlePoint National Insurance Company (“CNIC”), a subsidiary of Tower Group, Inc.) and Universal Reinsurance Co., Ltd., an unrelated entity, in the United States District Court for the Middle District of Florida. The Complaint is based upon a Workers’ Compensation/Employer’s Liability policy issued by SUA to AEM, Inc. (“AEM”), to whose legal rights Mirabilis is alleged to have succeeded as a result of the Chapter 11 bankruptcy of AEM. The Complaint, which includes claims against SUA for breach of contract and breach of the duty of good faith, alleges that SUA failed to properly audit AEM’s operations to determine AEM’s Workers’ Compensation exposure for two policy years, in order to compute the premium owed by AEM, such that SUA owes Mirabilis the principal sum of $3.4 million for one policy year and $0.6 million for the other policy year, plus interest and costs. On July 30, 2010, CNIC filed its answer in which it asserted nine separate counterclaims, to which Mirabilis responded on September 3, 2010. Mirabilis amended its complaint on February 21, 2011. The litigation is only in its preliminary stage, and the Company is therefore unable to assess the likelihood of any particular outcome.
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 Company’s future minimum lease payments are as follows:
Total rental expense charged to operations was $10.0 million, $7.9 million and $3.8 million in 2010, 2009 and 2008, respectively.
CastlePoint Re is registered as a Class 3 reinsurer under The Insurance Act 1978 (Bermuda), amendments thereto and related regulations (the “Insurance Act”). Under the Insurance Act, CastlePoint Re is required to prepare Statutory Financial Statements and to file a Statutory Financial Return. The Insurance Act also requires CastlePoint Re to maintain minimum share capital and surplus, and it has met these requirements as of December 31, 2010.
For the year ended December 31, 2010, CastlePoint Re had statutory net income of $29.4 million and at December 31, 2010, had statutory surplus of $269.9 million.
GAAP guidance requires all entities to disclose the fair value of financial instruments, both assets and liabilities recognized and not recognized in the balance sheet, for which it is practicable to estimate fair value. See “Note 3-Acquisitions” for further information about the fair value of assets and liabilities of CastlePoint, Hermitage and SUA acquired upon acquisition. The Company uses the following methods and assumptions in estimating its fair value disclosures for financial instruments:
Common trust securities-statutory business trusts: The carrying values for the common trust securities are considered to approximate their fair values.
Convertible Senior Notes. The Notes’ fair value was $168.4 million at December 31, 2010..
Subordinated debentures: Fair value disclosures for the subordinated debt carried on the balance sheet for these financial statements are included in “Note 12 - Debt.”
As disclosed in “Note 1 - Nature of Business”, the Company revised its business segments to present Commercial Insurance, Personal Insurance and Insurance Services segments. The Company has restated prior period segments to be consistent with the current presentation.
The following table reconciles the results of the Company’s individual segments to consolidated income before income taxes:
Since the weighted-average shares for the quarters are calculated independently of the weighted-average shares for the year, quarterly earnings per share may not total to annual earnings per share.