We lease approximately 118,500 square feet of space at 120 Broadway, New York, New York, which consists of the 30th and 31st floors and part of the 29th floor. The lease will end on December 31, 2021. See Note 17-“Commitments and Contingencies” in the notes to our audited consolidated financial statements included elsewhere in this report.
We also lease office space in Paramus, New Jersey; Melville, New York; Buffalo, New York; Quincy, Massachusetts; Scarborough, Maine; Bedford, New Hampshire; Maitland, Florida; Irving, Texas; Lisle, Illinois; White Plains, New York; Mobile, Alabama; Irvine, California; Palm Springs, California; Glastonbury, Connecticut; Atlanta, Georgia; Chicago, Illinois; and Hamilton, Bermuda.
The gross underwriting expense ratio is calculated by dividing gross underwriting expenses (consisting of direct commission expenses and other underwriting expenses net of policy billing fees) by gross premiums earned.
Book value per share is based on total common stockholders’ equity divided by common shares outstanding at year end.
Tower, through its subsidiaries, offers a broad range of commercial, personal and specialty property and casualty insurance products and services to businesses in various industries and to individuals. We provide coverage for many different market segments, including non-standard risks that do not fit the underwriting criteria of standard risk carriers due to factors such as type of business, location and premium per policy. We provide these products on both an admitted and excess and surplus (“E&S”) basis.
Our consolidated results of operations reflect significant changes in 2009 as a result of acquisitions completed in the year. During the first quarter of 2009, we closed on the acquisitions of CastlePoint and Hermitage on February 5, 2009 and February 27, 2009, respectively. During the fourth quarter of 2009, we closed on the renewal rights acquisition of AequiCap’s workers’ compensation business and the acquisition of SUA. The acquisitions completed in 2009, expanded our distribution platform. As a result of the acquisitions of CastlePoint and SUA, we have expanded our commercial product offerings to target narrowly defined homogeneous classes of business that we refer to as specialty business through our Specialty Business segment. We have expanded our excess and surplus lines distribution through Hermitage in our Brokerage segment.
In our Insurance Services segment, we generate management fees and commission income from our managing general agencies by producing premiums on behalf of issuing companies, and we generate fees by providing claims administration and reinsurance intermediary services.
On October 14, 2009, the Company completed the acquisition of the renewal rights to the workers’ compensation business of AequiCap Program Administrators Inc. (“AequiCap”), an underwriting agency based in Fort Lauderdale, Florida. The acquired business primarily consists of small, low to moderate hazard workers compensation policies in Florida. During 2009, we entered into an agreement with AequiCap to provide claims handling services for workers’ compensation claims. Most of the employees of AequiCap 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 excess and surplus lines (“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 Holdings, Ltd. (“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.
Ceding commission revenue. We earn ceding commission revenue (generally a percentage of the premiums ceded) on the gross premiums written that we cede to reinsurers under quota share reinsurance agreements.
Insurance Service revenue. We earn fee income in the form of commissions generated by TRM, CPM and CPRMFL on premiums produced by their managing general agencies and fees earned from their claims administration, other administration services and reinsurance intermediary services. We also earn fee income in the form of policy billing fees arising in the course of collecting premiums from our policyholders.
Operating expenses. In our Brokerage Insurance and Specialty Business 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 direct commissions paid to producers and other insurance service expenses.
Loss ratio. The loss ratio is the ratio of losses and LAE 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 premiums) for our Brokerage Insurance and Specialty Business segments. 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 business 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 is considered in determining 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 particular accident 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 and LAE reserves from prior accident years as a percentage of premiums earned during that particular calendar year.
Underwriting expense ratio. The gross underwriting expense ratio is the ratio of direct commission expenses and other underwriting expenses less policy billing fees to gross premiums earned. The gross underwriting expense ratio measures a company’s operational efficiency in producing, underwriting and administering its insurance business. Due to our historically high levels of reinsurance, we also calculate our underwriting expense ratio after the effect of ceded reinsurance. Ceding commission revenue is applied to reduce our underwriting expenses in our insurance company operation. Because the ceding commission rate we earn on our premiums ceded has historically been higher than our underwriting expense ratio on those premiums, our extensive use of quota share reinsurance has, in certain periods, caused our net underwriting expense ratio in certain periods to be lower than our gross expense ratio.
Net income and return on average equity. We use net income to measure our profits and return on average equity to measure our effectiveness in utilizing our stockholders’ equity to generate net income on a consolidated basis. In determining return on average equity for a given year, net income is divided by the average of stockholders’ equity for that year.
This process helps management set carried loss reserves based upon the actuaries’ best estimates, using estimates made by segment, product or line of business, territory, and accident year. The actuaries also separately estimate loss reserves from LAE reserves and within LAE reserves estimates are made for defense and cost containment expenses or Allocated Loss Adjustment Expenses (“ALAE”) and for other claims adjusting expenses or Unallocated Loss Adjustment Expenses (“ULAE”). 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
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 and price changes, trend, mix of business, and other factors.
In most cases, our data is sufficiently credible to determine loss development factors utilizing our own data. In some cases, we supplement our own loss development experience with industry data and utilizing historical loss development experience for particular books of business, programs or treaties obtained from our sources. The loss development factors are reviewed at least annually, and whenever there is a significant change in the underlying business. Each quarter we test the loss development by analyzing actual emerging claims compared to expected development.
We estimate ALAE reserves separately for claims that are defended by in-house attorneys, claims that are handled by other attorneys that are not employees, and miscellaneous ALAE costs such as witness fees and court costs.
For claims that are defended by in-house attorneys, we estimate the defense cost per claim, and we attribute to each of these claims a fixed fee for defense work. We allocate 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 our in-house attorneys, and these amounts are calibrated each quarter to reimburse our in-house legal department for all of their costs.
Deferred acquisition costs, net. We defer certain expenses and commission revenues that vary with and are directly related to the 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
Goodwill and intangible assets and potential impairment. The costs associated with a group of assets acquired in a transaction are allocated to the individual assets, including identifiable intangible assets, based on their relative fair values. Purchase consideration in excess of the fair value of tangible and intangible assets is recorded as goodwill.
As noted in the Overview section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, we completed the acquisitions of CastlePoint on February 5, 2009, Hermitage on February 27, 2009, AequiCap on October 14, 2009 and SUA on November 13, 2009.
Total revenues. Total revenues increased due to significant increases in net premiums earned and net investment income stemming primarily from the acquisitions of CastlePoint and Hermitage that occurred in the first quarter of 2009. Net premiums earned also increased due to the inclusion of Brokerage Insurance premiums managed by Tower but previously placed with CastlePoint Insurance Company. These sources of growth in total revenues were partially offset by reductions in commission and fee income due to lower ceding quota share reinsurance in 2009 as compared to prior years. Taken together, these changes caused net premiums earned to be a significantly higher percentage of total revenues in 2009 as compared to 2008. This is discussed more fully under “Brokerage Insurance Segment Results of Operations” and “Specialty Business Segment Results of Operations” below. The following table shows the effects of the various acquisitions on our gross premiums written in 2009:
Multi year quota share reinsurance agreements with CastlePoint Reinsurance began April 6, 2006.
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 renewal premiums written in the third quarter of 2008.
Commission and fee income. Commission and fee income decreased primarily due to our decision to not cede as much brokerage premiums in 2009 as discussed above. Ceding commission revenue in 2009 represents commissions on ceded premiums earned from quota share reinsurance contracts written in 2008 and continuing to earn in 2009, as well as ceding commission earned on the brokerage liability quota share agreement described above, effective October 1, 2009. TRM also ceased producing business on behalf of CPIC subsequent to the CastlePoint acquisition date. Commission and fee income during 2008 included $55.4 million in fee income earned from CPIC and $71.2 million earned on quota share ceded premiums from CastlePoint Re (“CPRe”). In 2009, the effects of transactions between Tower and CastlePoint are eliminated in consolidation.
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 approximately $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 businesses acquired, were higher by 5.2 basis points in 2009 as compared to 2008 primarily due to the reinvestment of cash in the Tower portfolios in the fourth quarter of 2009.
For 2009 we had favorable prior year reserve development of $2.3 million, comprised of $4.8 million of favorable development in the Brokerage Insurance segment offset by $2.5 million of unfavorable development in the Specialty Business segment compared to favorable prior year reserve development of $8.9 million in the Brokerage Insurance segment in 2008. See “Brokerage Insurance Segment Results of Operations” and “Specialty Business Segment Results of Operations”.
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. See “Brokerage Insurance Segment Results of Operations” and “Specialty Business Segment Results of Operations” for further discussion.
Acquisition-related transaction costs. Acquisition-related transaction costs in 2009 relate to the acquisition of CastlePoint and, to a lesser extent, the acquisitions of Hermitage and SUA.
Total revenues. The increase is primarily due to the increase in net premiums earned and insurance services revenue. Net premiums earned increased 9.9% as compared to 2007. Net premiums earned decreased as a percentage of revenue due to the significant increase in commission and fee income. This was the result of an increase in direct commission revenue on premiums produced by TRM on behalf of CPIC. Net premiums earned increased principally due to reducing the quota share cession to CPRe on brokerage business. Neither CPIC nor CPRe were wholly owned and consolidated subsidiaries in 2008 or 2007. Net investment income decreased in 2008 primarily due to lower investment yields. Net realized investment losses were $14.4 million in 2008 compared to $17.5 million in 2007. Net realized investment losses in 2008 and 2007 included OTTI losses of $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.
Premiums earned. The 9.9% increase in net premiums earned in 2008 as compared to 2007 was due to the effect of the 10.8% increase in gross premiums earned, offset in part by an 11.9% increase in ceded premiums earned for 2008 compared to 2007. Other items affecting the year to year comparison are shown below:
Commission and fee income. Ceding commission revenue earned increased as a result of the overall increase in ceded premiums earned as discussed above as well as an increase in the ceding commission rate on business ceded to Swiss Re America. Also, as discussed above, in 2008 and 2007 our managing general agency subsidiary, TRM, produced premiums of $171.7 million and $84.2 million, respectively, on behalf of CPIC and earned $55.4 million and $27.0 million, respectively, in direct commission revenue.
Net realized investment losses were $14.4 million and $17.5 million in 2008 and 2007, respectively. Net realized investment gains and (losses), excluding OTTI, were $8.3 million and ($7.4) million in 2008 and 2007, respectively. The realized loss in 2007 was primarily related to the sale of a closed-end investment fund that invested in mortgage-backed and asset-backed securities. In addition we recognized $22.7 million and $10.1 million of OTTI losses in 2008 and 2007, respectively. The OTTI losses in 2008 related principally to lower rated residential mortgage-backed securities with projected adverse cash flows as well as the impairment of three Lehman Brothers fixed maturity securities and the impairment of an asset backed security which held collateralized bank debt. The OTTI losses in 2007 included all of our equity investments in REITs, as well as certain asset-backed sub-prime securities.
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 average equity for 2008 and 2007 would have increased 2.9% and 4.6%, respectively. For 2008, the return on average equity was calculated by dividing net income of $57.5 million by average stockholders’ equity of $323.5 million. For 2007, the return on average equity 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.
Net premiums. As a result of the increase in gross premiums and the decrease in ceded premiums described above, net premiums earned increased $328.3 million in 2009 compared to 2008. The increase in net premiums earned was consistent with the increase in net premiums written.
Loss and loss adjustment expenses and loss ratio. We had favorable prior year reserve development that lowered our loss ratio on both a gross and net basis in 2009 amounting to $4.8 million as compared to favorable prior year development experienced in 2008 of $8.9 million, thus the benefit in the loss ratio from prior year reserves development was less than in 2008. The favorable development that we experienced in 2009 was largely due to savings in loss adjustment expenses from shifting our in house attorneys from hourly billing to fixed fee per claim billing for CastlePoint and Hermitage, which did not utilize this practice prior to our acquisition. We also implemented legal fee auditing of external attorneys bills for these newly acquired companies. Fixed fee billing limits both the overall amounts that can be billed on any one claim and the amount of development for ALAE.
Underwriting expenses and underwriting expense ratio. Underwriting expenses include direct commissions and other underwriting expenses. The increase in underwriting expenses was due to the increase in gross premiums earned, which was primarily due to the CastlePoint and Hermitage acquisitions. Our gross underwriting expense ratio was 31.4% for 2009 as compared to 30.3% for 2008.
Underwriting profits increased 40.7% for the year ended December 31, 2009 compared to the prior year. This increase was driven by the increase in net premiums earned, but was partially offset by the increase in the combined ratio described above.
Net premiums. Net premiums written increased 23.8% in 2008 as compared to 2007, primarily as a result of the decrease in ceded premiums written. Net premiums earned increased by 4.4% in 2008 as compared to 2007, and this increase was less than for net premiums written due to timing differences as the change to the ceding percentages occurred in the last half of 2008.
Ceding commission revenue. The decrease in ceding commission revenue in 2008 as compared to 2007 was due to the reduction in quota share premiums ceded in 2008 as described above
Loss and loss adjustment expenses and loss ratio. The decrease in the gross and net loss ratios for 2008 compared to 2007 was primarily due to lower than expected loss emergence for workers’ compensation, general liability, and homeowners’ lines of business. The decrease also was affected by the decrease in loss adjustment expenses as a result of changing to fixed fee billing for our in-house attorneys. Fixed fee billing both limits the overall amounts that can be billed on any one claim, and also limits the amount of development for ALAE. The prior year reserves developed favorably by $8.9 million, of which $4.0 million was attributable to the improvement in loss adjustment expense reserves.
Underwriting expenses and underwriting expense ratio. Underwriting expenses include direct commissions and other underwriting expenses. Direct commissions increased to 16.9% for 2008 compared to 16.4% for 2007, while other underwriting expenses increased to 13.4% for 2008 compared to 12.9% for 2007, respectively.
The net underwriting expense ratio increased to 30.5% in 2008 compared to 28.5% in 2007, although this increase was offset by increases in management fee income in the Insurance Services segment from increasing the amount of brokerage business placed into CastlePoint Insurance Company, particularly during the latter half of 2008.
Gross premiums. Total Specialty Business gross premiums written increased in 2009 as compared to the prior year primarily as a result of our acquisitions of CastlePoint and SUA. Also, during 2009 we began to write new programs focusing on workers’ compensation for extended living facilities workers, auto dealerships, and specialty auto trucking liability. On an adjusted basis including CastlePoint gross premiums written, but excluding SUA gross premiums written, our gross premiums written grew by 25.6% in 2009. Growth in program business in the U.S. was offset by a reduction in assumed reinsurance business in CPRe, as we shifted capital from CPRe to support primary specialty business.
Loss and loss adjustment expenses. The loss ratio increased on both a gross and net basis for 2009 compared to last year. We had unfavorable development of approximately $2.5 million stemming from the runoff of specialty business in CastlePoint Re. On an accident year basis the gross and net loss ratios increased due to the inclusion of reinsurance business and other programs underwritten by CastlePoint and SUA that impacted the business mix in the current period. In addition, the net accident year loss ratio was favorably impacted by 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.
The OUE portion of the gross underwriting expense ratio was 7.4% for 2009 compared to 4.2% in 2008. The increase in the OUE ratio resulted from absorbing the CastlePoint staff costs. Prior to the acquisition, CastlePoint managed all specialty business and the staff costs were recorded by them, and we recorded a higher commission expense to reflect these costs.
Underwriting profit and combined ratio. The increase in underwriting profit for the year ended December 31, 2009 primarily resulted from the acquisition of CastlePoint in the first quarter of 2009 which increased net premiums earned significantly. Our net combined ratio improved by 2.3 points reflecting improved expense ratios that more than offset the 1.8 point increase in our loss ratio.
Ceded premiums. The increase in ceded premiums written was due to our agreements with CastlePoint to cede significant portions of the specialty and traditional programs that CastlePoint managed and underwrote utilizing our insurance subsidiaries’ paper. The increase in ceded premiums from $21.8 million in 2007 to $96.4 million in 2008 was commensurate with the growth in gross premiums written.
Total revenues. The decrease in total revenues, of which direct commission revenue is the principal component, for 2009 compared to 2008 was primarily due to the acquisition of CastlePoint in February 2009. Premiums produced and managed by TRM on behalf of CPIC decreased to $10.7 million in 2009 compared to $85.1 million for 2008. As a result of the decrease in premiums produced, revenues declined to $5.1 million in 2009 compared to $68.5 million in 2008. Claims administration and other administration revenues earned in 2008 were primarily earned from CPIC managed business and declined in 2009 as intercompany transactions between us and CPIC were eliminated. The decline in both claims and other administration revenues was partially offset as a result of entering into two new agreements in 2009. During 2009 we recorded $0.4 million of claims administration revenues as a result of entering into an agreement with AequiCap to provide claims handling services for workers’ compensation claims. The decline in other administration revenue was also offset as a result of the Hermitage acquisition. Hermitage provides administrative services to an insurance company and earned $0.3 million in 2009.
Other insurance services expenses. The decrease in other insurance expenses resulted from the decline in premium produced. The amount of reimbursement for underwriting expenses by TRM to TICNY for the year ended December 31, 2009 was $1.4 million as compared to $12.3 million for 2008.
Total revenues. The increase in 2008 revenues resulted from business produced by TRM on behalf of CPIC of $171.7 million for 2008 compared to $84.2 million for the same period last year. As a result of the increase in premiums produced, direct commission revenue increased to $58.2 million for the year ended December 31, 2008 as compared to $28.8 million for the prior year. Direct commission revenue also benefitted from favorable loss development on premiums produced in prior years of $1.9 million for 2008 compared to $1.8 million for the same period last year. Claims administration revenues increased to $5.4 million for 2008 compared to $2.3 million in 2007 as a result of the increased volume of claims handled on behalf of issuing carriers. Policies in-force for our brokerage business managed by us and produced on behalf of CPIC increased 221.4% as of December 31, 2008 compared to December 31, 2007. During 2008, premiums on renewed business increased 3.4%.
Other insurance services expenses. The amount of reimbursement for underwriting expenses by TRM to TICNY for 2008 was $12.3 million compared to $5.8 million for the same period in 2007. The increase resulted from the increase in premiums produced.
The following table presents a breakdown of the cost or amortized cost, gross unrealized gains and losses and aggregate fair value by investment type as of December 31, 2009 and 2008:
As of December 31, 2009, 99% of the investment portfolio recorded at fair value was priced based upon quoted market prices or other observable inputs. For investments in active markets, we used the quoted market prices provided by the outside pricing services to determine fair value. In circumstances where quoted market prices were unavailable, we used fair value estimates based upon other observable inputs including matrix pricing, benchmark interest rates, market comparables and other relevant inputs. When observable inputs were adjusted to reflect management’s best estimate of fair value, such fair value measurements are considered a lower level measurement in the GAAP fair value hierarchy.
Our process to validate the market prices obtained from the outside pricing sources includes, but is not limited to, periodic evaluation of model pricing methodologies and analytical reviews of certain prices. We also periodically perform testing of the market to determine trading activity, or lack of trading activity, as well as evaluating the variability of market prices. Securities sold during the quarter are also “back-tested” (i.e., the sales price is compared to the previous month end reported market price to determine reasonableness of the reported market price).
As more fully described in Note 4 - Investments - Impairment Review in the notes to the consolidated financial statements, 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 decline in estimated cash flows resulting generally from weakened economic conditions. Specifically, Residential Mortgage-backed Securities (“RMBS”) cash flows are negatively impacted by a decline in home prices and a high unemployment rate while Commercial Mortgage-backed Securities (“CMBS”) cash flows are negatively impacted by higher projected delinquencies. These unrealized losses are deemed to be temporary in nature.
Refer to Note 5 - Fair Value Measurement in the notes 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, 2009, the fair value of Level 3 assets as a percentage of our total assets carried at fair value was as follows:
In 2009, U.S. Government and Agency securities underperformed against other fixed income classes, a reversal of the trend in 2008. One of the major themes for 2009 was the reversal of the flight-to-quality trend seen in 2008. As such, high yielding bonds were the strongest performing sector in 2009. Corporate bonds, especially in the financial institution sector, extended gains throughout 2009. CMBS garnered solid returns, fueled by strong demand resulting from the TALF program and from investors in search for yield. The continued strong rally had a pronounced effect on Tower’s investment portfolio as net unrealized losses were $53.2 million at December 31, 2008 and improved to net unrealized gains of $52.4 million at December 31, 2009.
Changes in interest rates directly impact the fair value of our fixed maturity portfolio. 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 table presents information regarding our invested assets that were in an unrealized loss position at December 31, 2009 and December 31, 2008 by amount of time in a continuous unrealized loss position:
At December 31, 2009, the unrealized losses for fixed-maturity securities were primarily in our investments in mortgage and asset-backed securities.
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, 2009:
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, 2009.
For those fixed-maturity investments deemed not to be in an OTTI position, we believe that the gross unrealized investment loss was primarily caused by a lack of liquidity in the capital markets. We expect cash flows from operations to be sufficient to meet our liquidity requirements and, therefore, we do not intend
See Note 4 - “Investments” in the consolidated financial statement for further information about impairment testing and other-than-temporary impairments.
Under New York law, TICNY is limited to paying dividends to Tower 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 $2.0 million, $5.2 million and $8.5 million in dividends to Tower in 2009, 2008 and 2007, respectively.
On January 22, 2007, we sold 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 February 5, 2007, the underwriters exercised their over-allotment option with respect to 340,600 shares of common stock. We received aggregate net proceeds of approximately $89.4 million from the offering and over-allotment option, after underwriting discounts and expenses.
On November 13, 2006, we entered into the Stock Purchase Agreement with a subsidiary of CastlePoint pursuant to which we agreed to issue and sell 40,000 shares of perpetual preferred stock to the subsidiary for aggregate consideration of $40 million. The transaction closed on December 4, 2006. On January 26, 2007, we fully redeemed all 40,000 shares of the preferred stock for $40.0 million using $20.0 million of the net proceeds from our trust preferred securities issued on January 25, 2007 and $20.0 million of the net proceeds from our common stock offering.
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, partially offset by increased claims and tax payments.
The following table summarizes information about contractual obligations and commercial commitments. The minimum payments under these agreements as of December 31, 2009 were as follows:
At various times over the past five years we have issued trust preferred securities through wholly-owned Delaware statutory business trusts. The trusts use the proceeds of the sale of the trust preferred securities and common securities that we acquire from the trust to purchase junior subordinated debentures from us with terms that match the terms of the trust preferred securities. Interest on the junior subordinated debentures and the trust preferred securities is payable quarterly. In some cases, the interest rate is fixed for an initial period of five years after issuance and then floats with changes in the London Interbank Offered Rate (“LIBOR”). In other cases the interest rate floats with LIBOR without any initial fixed-rate period. The principal terms of the outstanding trust preferred securities are summarized in the following table:
7.5% until September 30, 2008; three-month LIBOR plus 400 basis points thereafter
7.4% until December 7, 2009; three-month LIBOR plus 340 basis points thereafter
8.5551% until December 14, 2011; three-month LIBOR plus 330 basis points thereafter
8.66% until December 1, 2011; three-month LIBOR plus 350 basis points thereafter
8.39% until September 27, 2012; three-month LIBOR plus 350 basis points thereafter
our failure to comply with the covenants or other provisions of the indentures or the trust preferred securities; or
In the last three decades, there have been three hard markets in which industry-wide inflation-adjusted premiums grew. Each of these periods was followed by an increase in capacity, price competition and the aggressive terms and conditions that are typical of a soft market. According to A.M. Best a prolonged period of competitive conditions drove industry net premiums written down by 4.2% to $426.8 billion in 2009 and, for the first time in A.M. Best’s recorded history, net premiums written have declined in three consecutive years.
The outlook for 2010 suggests that the economy, although sluggish, is showing signs of recovery as banks lessen restrictions on lending, the housing sector seems to be bottoming out and consumer and business debt loads are shrinking. These factors suggest a modest organic premium growth from new business and renewal retention. The degree of growth will be influenced by a slowly improving job sector and general uncertainty of the direction of key economic indicators. Production pressures in the P&C industry continue as evidenced by ongoing rate decreases, reductions in exposure units such as payroll, sales, new housing starts and limited new business creation. A. M. Best projects a 1.6% decrease in net premiums written in 2010. With rates flat to slightly down, there are no signs of a meaningful market hardening and, barring a major catastrophe, a turn in the cycle may be delayed until 2011 at the earliest. Overall industry combined ratio estimates project the greatest negative impact to be seen in Workers Compensation, Commercial Multi-Peril, Other Liability, Fire & Allied Lines and Medical Professional Liability. These will be driven by accident year loss development, escalating medical costs and an anticipated return to a normal weather-related catastrophe results. The Private Passenger Auto line, with selected rate increases making an impact coupled with a stable loss frequency, projects a combined ratio improvement for 2010. While overall results of the industry are expected to continue to deteriorate until a general market improvement, those companies that manage the cycle effectively will be well-positioned to take advantage of the current adverse conditions and substantially outperform their peers.
Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2009, 2008, and 2007
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Tower Group, Inc. as of December 31, 2009 and 2008, and the results of its consolidated operations and its cash flows for each of the years in the three-year period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements as a whole, present fairly, in all material respects, the information set forth therein. Also in our opinion, Tower Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Brokerage Insurance (“Brokerage”) Segment offers a broad range of commercial lines and personal lines property and casualty insurance products to small to mid-sized businesses and individuals distributed through a network of retail and wholesale agents on both an admitted and non-admitted basis;
On February 5, 2009, the Company completed the acquisition of 100% of the issued and outstanding common stock of CastlePoint Holdings, Ltd. (“CastlePoint”), a Bermuda exempted corporation. 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.
On February 27, 2009, the Company and its subsidiary, CastlePoint, completed the acquisition of HIG, Inc. (“Hermitage”), a property and casualty insurance holding company. Hermitage offers both admitted and excess and surplus lines (“E&S”) products. This transaction further expanded the Company’s wholesale distribution system nationally and established a network of retail agents in the Southeast.
On October 14, 2009, the Company completed the acquisition of the renewal rights to the workers compensation business of AequiCap Program Administrators, Inc. (“AequiCap”), an underwriting agency based in Fort Lauderdale, Florida.
On November 13, 2009, the Company completed the acquisition of 100% of the issued and outstanding common stock of Specialty Underwriters’ Alliance, Inc. (“SUA”). SUA offers specialty commercial property and casualty insurance products through program underwriting managers that serve niche groups of insureds.
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”), North East Insurance Company (“NEIC”), Mountain Valley Indemnity Company (“MVIC”), CastlePoint Insurance Company (“CPIC”), CastlePoint Reinsurance Company, Ltd. (“CPRe”), CastlePoint Florida Insurance Company (“CPFL”), Hermitage Insurance Company (“HIC”), Kodiak Insurance Company (“KIC”), and SUA Insurance Company (“SUA”) (renamed CastlePoint National Insurance Company (“CPNIC”)) (collectively the “Insurance Subsidiaries”), and 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”)). The Company has four intermediate holding companies, Preserver Group, Inc. (“PGI”), Ocean I Corporation, CastlePoint Bermuda Holdings, Ltd. (“CBH”), and HIG, Inc. (“Hermitage”). 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 accounts and transactions have been eliminated in consolidation.
Insurance policies issued or reinsured by the Company are short-duration contracts. Accordingly, premium revenue, including direct writings and reinsurance assumed, net of premiums ceded to reinsurers, is recognized on a pro-rata basis over the terms of the underlying policies. Unearned premiums represent premium applicable to the unexpired risk of in-force insurance contracts at each balance sheet date. Prepaid reinsurance premiums represent the unexpired portion of reinsurance premiums on risks ceded and are earned consistent with premiums.
Commissions on reinsurance premiums ceded are earned in a manner consistent with the recognition of the costs to acquire the underlying policies, 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 of the policies covered by the agreements. The Company records ceding commission revenue based on its current estimate of losses on the reinsured policies subject to variable commission rates. 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 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.
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. ULAE includes overhead costs attributable to the claims function. Tower estimates the ALAE liability separately for claims that are defended by in-house attorneys, claims that are handled by other attorneys that are not employees, and miscellaneous ALAE costs such as witness fees and court costs.
For ULAE the Company determines a standard cost per claim for each line of business that represents the ultimate average cost to administer that claim. 50% of this standard cost is recorded as paid ULAE when a claim is opened, and 50% of this standard cost is recorded as paid ULAE when a claim is closed. The standard costs are determined actuarially and subject to adjustment each quarter such that the total calendar period costs for the claims function is recorded as paid ULAE each quarter.
The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. Cash and cash equivalents are presented at cost, which approximates fair value.
Fair value for fixed-maturity securities and equity securities is based on quoted market prices or a recognized pricing service, with limited exceptions as discussed in “Note 5 - Fair Value Measurements”. Changes in unrealized gains and losses, net of tax effects, are reported as a separate component of other comprehensive income while cumulative unrealized gains and losses are reported in stockholders’ equity as a separate component. Realized gains and losses are determined on the specific identification method. Investment income is recorded when earned and includes the amortization of premium and discount on investments.
Premiums receivable represent amounts due from insureds and reinsureds for insurance coverage and are presented net of an allowance for doubtful accounts of $1.3 million and $0.6 million at December 31, 2009 and 2008, 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 $0.9 million, $0.4 million, and $0.2 million were written off in 2009, 2008 and 2007, respectively.
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 costs). Policy acquisition costs are deferred and recognized as expense as related premiums are earned. Deferred acquisition costs (“DAC”) presented in the balance sheet are net of deferred ceding commission revenue. The value of business acquired (“VOBA”) is an intangible asset relating to the estimated fair value of the unexpired insurance policies acquired in a business combination. VOBA is determined at the time of a business combination and is reported on the consolidated balance sheet with DAC and is amortized in proportion to the timing of the estimated underwriting profit associated with the in force policies acquired. The cash flow or interest component of VOBA is amortized in proportion to the expected pattern of future cash flows. The Company considers anticipated investment income in determining the recoverability of these costs and believes they are fully recoverable.
assets with an indefinite life and goodwill are not amortized and are subject to annual impairment testing. The Company conducted the required annual goodwill and intangible asset impairment testing as of September 30 for 2009 whereas it had performed this testing as of December 31 in prior years. All identifiable intangible assets and goodwill are tested for recoverability whenever events or changes in circumstances indicate that a carrying amount may not be recoverable. No impairment losses were recognized in 2009, 2008 and 2007.
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. The premiums receivable balances are generally diversified due to the number of entities comprising the Company’s distribution force and its customer base, which is largely concentrated in the Northeast (primarily New York), Florida, Texas and California. To reduce credit risk, the Company performs ongoing evaluations of its distribution force’s and 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 and, in certain cases, requires collateral from 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.
In April 2008, the FASB issued new guidance in determining the useful life of a recognized intangible asset. The purpose of this guidance is to improve consistency between the useful life of an intangible asset and the period of expected cash flows used to measure the fair value of the asset for purposes of determining possible impairments. This guidance requires an entity to disclose information related to the extent the expected future cash flows associated with the asset are affected by the entity’s intent and/or ability to renew or extend the arrangement. This guidance is required to be applied prospectively to all new intangible assets acquired after January 1, 2009. The Company adopted the new guidance on January 1, 2009, with no material effects on the financial statements.
In May 2009, the FASB issued new guidance requiring entities to disclose the date through which they have evaluated subsequent events and whether the date corresponds with the release of their financial statements. The Company implemented this guidance as of April 1, 2009. As this guidance relates to disclosure rather than measurement of assets and liabilities, there will be no effect on the financial results or position of the Company.
In June 2009, the FASB issued guidance establishing a new hierarchy of generally accepted accounting principles called “FASB Accounting Standards Codification”. The new hierarchy is the new single source of authoritative nongovernmental U.S. generally accepted accounting principles. The codification reorganizes the thousands of GAAP pronouncements into roughly 90 accounting topics and displays them using a consistent structure. Also included is relevant Securities and Exchange Commission guidance organized using the same topical structure in separate sections. Effective for interim and annual periods that end after September 15, 2009, the Company implemented this guidance as of July 1, 2009 and has removed all references to prior authoritative literature.
In June 2009, the FASB issued new guidance which requires more information about transfers of financial assets, including securitization transactions, and where entities have continuing exposure to the risks related to 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. This guidance will be effective for annual reporting periods beginning on or after January 1, 2010. Early application is not permitted. The Company is currently analyzing the effect this guidance may have on its financial statements.
In June 2009, the FASB issued new guidance which concerns the consolidation of variable interest entities and changes how a reporting entity determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a reporting entity is required to consolidate another entity is based on, among other things, the other entity’s purpose and design and the reporting entity’s ability to direct the activities of the other entity that most significantly affect the other entity’s economic performance. The new guidance will require a reporting entity to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement. A reporting entity will be required to disclose how its involvement with a variable interest entity affects the reporting entity’s financial statements. This guidance will be effective for annual reporting periods beginning on or after January 1, 2010. Early application is not permitted. The Company is currently analyzing the effect this guidance may have on its financial statements.
In January 2010, the FASB issued new guidance that requires additional disclosure of the fair value of assets and liabilities. This guidance calls for additional disclosures to be made about significant transfers in and out of Levels 1 and 2 of the fair value hierarchy within GAAP. This requirement will be effective for annual and interim periods beginning after December 15, 2009. This guidance also calls for additional disclosure about the gross activity within Level 3 of the fair value hierarchy within GAAP as opposed to the net disclosure currently required. This disclosure will be effective for annual and interim periods beginning after December 15, 2010. As this guidance relates to disclosure rather than measurement of assets and liabilities, there will be no effect on the financial results or position of the Company. The Company will comply with the disclosure requirements as they become effective.
The Company began consolidating the financial results of SUA as of the date of acquisition. As the fair value of net assets acquired was in excess of the total purchase consideration, the gain on bargain purchase of $13.2 million shown in the schedule above has been recognized in other income. The assets and liabilities were adjusted to fair value as of the acquisition date, and as a part of these adjustments the nominal value of the loss and loss adjustment expense reserves was increased by $25.7 million. The valuation model then used an estimate of net nominal future cash flows related to the loss and loss adjustment expense reserves which were adjusted for the time value of money at a risk free rate and a risk margin to compensate Tower for bearing the risk associated with the liabilities. The adjustment for the time value of money and a risk margin amounted to $1.9 million. The total fair value adjustment impacting loss and loss adjustment expense reserves totaled $27.6 million. This adjustment is based upon our actuaries’ best estimate of SUA’s reserves using loss reserving techniques consistent with those utilized by Tower for lines of business that have relatively long reporting and settlement claims patterns. The Company incurred approximately $2.3 million of transaction costs, including legal, accounting, investment advisory and other costs directly related to the acquisition which were expensed in 2009.
The acquisition was accounted for using the purchase method in accordance with recently issued GAAP guidance on business combinations. Under the terms of the Agreement, the Company acquired AequiCap for $5.5 million in cash. The distribution network was the only identifiable intangible asset acquired. The fair value of this asset was $5.3 million and the fair value of miscellaneous assets acquired was $0.1 million resulting in $0.1 million of goodwill.
The following presents assets acquired and liabilities assumed with the acquisition of CastlePoint, based on their fair values and the fair value hierarchy level under GAAP as of February 5, 2009:
On February 27, 2009, the Company completed the acquisition of Hermitage, a property and casualty insurance holding company, from a subsidiary of Brookfield Asset Management Inc. for $130.1 million. Hermitage offers both admitted and Excess & Surplus (“E&S”) lines products. This transaction further expanded the Company’s wholesale distribution system nationally and establishes a network of retail agents in the Southeast.
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 Company recorded goodwill from the acquisitions of CastlePoint, Hermitage and AequiCap in the amount of $184.3 million, $35.3 million and $0.1 million, respectively. The acquisition of SUA resulted in negative goodwill which was recorded as a gain on bargain purchase in the income statement in 2009. The Company estimated that $17.0 million of goodwill related to the Hermitage acquisition is deductible for tax purposes. The Company has determined that none of the goodwill related to the CastlePoint acquisition may be deductible for tax purposes. See “Note 6 - Goodwill and Intangible Assets” for the allocation of goodwill to segments as required by GAAP.
The amounts in the table above include revenues and net income for CastlePoint, Hermitage and SUA based on each company’s net premiums earned prior to pooling. Revenues and net income for CastlePoint Re include the assumed business, on a quota share basis, from the Tower insurance subsidiaries. Net losses incurred and net underwriting expenses incurred are based on the related net ratio of the pool. Net investment income represents actual net investment income earned.
The fair value of intangible assets represents acquired customer relationships, insurance licenses and trademarks. The fair value of customer relationships and trademarks was estimated based upon an income approach methodology. The fair value of insurance licenses was based upon a market approach methodology. Critical inputs into the valuation model for customer relationships included estimations of expected premium and attrition rates, expected operating margins and capital requirements.
(1) The Company excluded certain one-time charges from the pro forma results for the year ended December 31, 2009 and 2008 including, (i) transaction costs of $14.1 million, and $9.4 million, respectively related to the acquisitions of CastlePoint, Hermitage and SUA, (ii) CastlePoint’s severance expenses of $2.0 million for the year ended
December 31, 2009, (iii) Tower’s gain of $7.4 million related to the acquisition of CastlePoint for the year ended December 31, 2009 and (iv) Tower’s gain on bargain purchase of $13.2 million related to the acquisition of SUA for the year ended December 31, 2009.
The cost or amortized cost and fair value of investments in fixed-maturity securities, equities and short-term investments and gross unrealized gains, losses and other-than-temporary impairment losses as of December 31, 2009 and 2008 are summarized as follows:
Proceeds from the sale and maturity of fixed-maturity securities were $936.6 million, $356.0 million and $199.6 million in 2009, 2008 and 2007, respectively. Proceeds from the sale of equity securities were $50.6 million, $6.5 million and $24.8 million in 2009, 2008 and 2007, respectively.
The Company’s gross realized gains, losses and impairment write-downs on investments are summarized as follows:
The Company may dispose of a particular security due to significant changes in economic facts and circumstances related to an invested asset that have arisen since the Company’s last analysis of the facts supporting the Company’s intent and ability to retain the investment in the security for a period of time sufficient to recover the amortized cost or cost basis as of the prior reporting period.
The Company’s commercial mortgage-backed securities (“CMBS”), non-agency residential mortgage-backed securities (“RMBS”) and corporate bonds represent our largest unrealized loss positions as of December 31, 2009.
For certain 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, debt securities issued by foreign governments, and certain corporate debt), 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 the Company. 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. Generally, that time frame for securities for which the issuer is in bankruptcy is 12 months. 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.
In estimating the recovery value, significant judgment is involved in the development of assumptions relating to a myriad of factors related to the issuer including, but not limited to, revenue, margin and earnings projections, the likely market or liquidation values of assets, potential additional debt to be incurred pre- or post- bankruptcy/ restructuring, the ability to shift existing or new debt to different priority layers, the amount of restructuring/bankruptcy expenses, the size and priority of unfunded pension obligations, litigation or other contingent claims, the treatment of intercompany claims and the likely outcome with respect to inter-creditor conflicts.
There are 525 investment positions at December 31, 2009 that account for the gross unrealized loss, none of which is deemed by the Company to be OTTI. Temporary losses on investments resulted primarily from purchases made in a lower interest rate environment or lower yield spread environment as opposed to market illiquidity and market dislocation that existed during 2008. There have been some ratings downgrades within the corporate sector due to the weak, but improving, economic environment. However, after analyzing the credit quality, balance sheet strength and company outlook, management believes these securities will recover in value as liquidity and the economy continue to improve. The structured securities that had significant unrealized losses resulted from continuing declines in both residential and commercial real estate prices. However, declines in home and commercial property prices have not adversely affected projected cash flows on these securities. To the extent projected cash flows on structured securities change adversely, they would be considered OTTI and an impairment loss would be recognized. The Company considered all relevant factors, including expected recoverability of cash flows, in assessing whether the loss was other than temporary. The Company does not intend to sell these fixed maturity securities and it is not more likely than not that we will be required to sell these securities before recovering their cost basis.
For all securities in an unrealized loss position at December 31, 2009, the Company has received all contractual interest payments (and principal if applicable). Based on the continuing receipt of cash flow and the foregoing analyses, the Company expects continued timely payments of principal and interest and considers the losses to be temporary.
The following table presents information regarding the Company’s invested assets that were in an unrealized loss position at December 31, 2009 and December 31, 2008 by amount of time in a continuous unrealized loss position:
The unrealized losses on the Company’s investments in preferred securities were primarily due to purchases made during the third quarter of 2009 where pricing was adversely affected after the ex-dividend date was declared. The Company evaluated preferred securities that were in an unrealized loss position as of December 31, 2009. The evaluation consisted of a detailed review including but not limited to some or all of the following factors for each security: the current S&P rating, analysts’ reports, past earnings trends and analysts’ earnings expectations for the next 12 months, liquidity, near term financing risk, and
whether the company was currently paying dividends on its equity securities. We believe the decline in value to be temporary in nature and we do not consider these investments to be other-than-temporarily impaired.
The following tables stratify, by securitized assets and all other assets, the gross unrealized losses in the Company’s portfolio at December 31, 2009, by duration in a loss position and magnitude of the loss as a percentage of the cost of the security:
The following table shows the composition of our fixed-maturity portfolio by remaining time to maturity at December 31, 2009 and December 31, 2008. 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.
GAAP establishes a three-level hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the
The availability of observable inputs varies and is affected by a wide variety of factors. When the valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires significantly more judgment. The degree of judgment exercised by management in determining fair value is greatest for investments categorized as Level 3. For investments in this category, the Company considers prices and inputs that are current as of the measurement date. In periods of market dislocation, as characterized by current market conditions, the ability to observe stable prices and inputs may be reduced for many instruments. This condition could cause a security to be reclassified between levels.
The fair values of the Company’s fixed-maturity and equity investments are determined by management after taking into consideration available sources of data. Management believes that pricing sources, at times, use unrealistically low prices based on trades in inactive or distressed markets. The Company considers various factors 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 based on the Company’s evaluation of market activity, the Company 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.
The Company’s use of Level 3 (the unobservable inputs) included 66 and 60 securities and accounted for approximately 0.7% and 3.3% of total investments at December 31, 2009 and 2008, respectively.
The following table summarizes changes in Level 3 assets measured at fair value at December 31, 2009 and 2008:
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. This test is performed during the fourth quarter of each year or more frequently if events or circumstances change in a way that requires the Company to perform the impairment analysis on an interim basis. 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.
The activity in the components of intangible assets for the year ended December 31, 2009 consisted of intangible assets acquired from business combinations and amortization expense as shown in the table below:
The Company’s Insurance Subsidiaries were parties to three multi-year quota share reinsurance agreements with CastlePoint Reinsurance Company, Ltd. (“CastlePoint Reinsurance”) covering brokerage business, traditional program business and specialty program business. These agreements were terminated on December 31, 2008 on a run-off basis.
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 participated 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 the date the Company acquired it on February 5, 2009, and from 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.
At December 31, 2008, the Company’s receivables and payables with CastlePoint arising in the normal course of business were as follows:
Note 8 - Deferred Acquisition Costs and Deferred Ceding Commission Revenue
Included in software are internally developed applications. The Company accounts for costs incurred to develop computer software for internal use in accordance with applicable GAAP guidance. The Company capitalizes the costs incurred during the application development stage, which include costs to design the software configuration and interfaces, coding, installation, and testing. Costs incurred during the preliminary project along with post-implementation stages of internal use computer software are expensed as incurred. Capitalized development costs are amortized over various periods up to three years. Costs incurred to maintain existing product offerings are expensed as incurred. The capitalization and ongoing assessment of recoverability of development costs requires considerable judgment by management with respect to certain external factors, including, but not limited to, technological and economic feasibility, and estimated economic life. For the years ended December 31, 2009 and 2008, the Company capitalized software development costs of $13 million and $6.0 million, respectively. As of December 31, 2009 and 2008, net capitalized software costs totaled $29.5 million and $7.8 million, respectively.
The following collateral is available to the Company for amounts recoverable from reinsurers as of December 31, 2009 and 2008:
As of December 31, 2009, the Company’s estimated ultimate loss ratios attributable to these contracts are lower than the contractual ultimate loss ratios at which the minimum amount of ceding commissions can be earned. Accordingly, the Company has recorded ceding commissions earned that are greater than the minimum commissions. The relevant estimated ultimate loss ratios and commissions as of December 31, 2009 are set forth below for treaties that remain in effect as of December 31, 2009 ($ 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 2009, 2008 and 2007 was ($2.2) million, ($1.8) million and ($0.5) million, respectively.
The following table provides a reconciliation of the beginning and ending balances for unpaid losses and LAE for the year ended December 31, 2009:
Incurred losses and LAE of $483.8 million were reduced by $5.0 million pertaining to the amortization of the reserve risk premium on loss reserves in accordance with GAAP for the business combinations occurring during 2009.
Incurred losses and LAE are net of amounts ceded under reinsurance contracts of $91.3 million, $125.6 million and $106.8 million in 2009, 2008 and 2007, respectively.
Loss and loss adjustment expense reserves. The reserving process for loss and LAE reserves provides for the Company’s 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 liability for loss and LAE also includes the fair value adjustment related to the acquisitions of CastlePoint, Hermitage and SUA 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 the Company’s control. The methods used to select the estimated loss reserves include the loss ratio projection, loss development projection, and the Bornhuetter-Ferguson (B-F) method. The process produces carried reserves set by management based upon the actuaries’ best estimate and is the result of numerous best 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 insurance as adjusted to current conditions. Since our process produces loss and LAE reserves set by management based upon the actuaries’ best estimate, there is no explicit or implicit risk premium provision for uncertainty in the carried loss and LAE reserves, excluding the loss and LAE reserves assumed through business combinations in 2009.
The Company has implemented two changes in estimating LAE reserves. These two changes impacted costs to handle litigation for claims handled by the Company’s attorneys and costs to handle litigation for claims handled by attorneys who are not employed by the Company.
The Company segregates 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 Company also analyzes and records reserves separately for Specialty Business programs and treaties and for Brokerage Insurance.
In most cases, the Company’s data have sufficient credibility and historical experience to base development factors on its own data. Where necessary, we supplement our own data with historical experience for the business that is available from the previous insurance carrier, and we may utilize industry loss development factors, where appropriate. 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 the Company expects 50%, 90% and 99% of losses to be reported for a given accident year, although for some classes of business the development patterns may be significantly longer:
The Company is not aware of any claims trends that have emerged or that would cause future adverse development that have not already been considered in existing case reserves and in its current loss development factors.
In New York State, lawsuits for negligence, subject to certain limitations, must be commenced within three years from the date of the accident or are otherwise barred. Accordingly, the Company’s exposure to IBNR is relatively limited, although there remains a possibility of adverse development on reported claims. This is reflected by the loss development for our Brokerage Insurance segment for which New York State comprises a significant proportion of the business, particularly for older accident years. 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.
At our option at par on or after December 1, 2011
The carrying amount reported for the subordinated debentures was $235.1 million and $101.0 million at December 31, 2009 and 2008, respectively. Based upon models using the spreads between the interest rates on the subordinated debt and 30 year Treasury Notes, management has estimated the fair value of the subordinated debt to be $248.4 million at December 31, 2009.
Aggregate scheduled maturities of the subordinated debentures at December 31, 2009 are:
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.
The plan provides for the granting of non-qualified stock options, incentive stock options (within the meaning of Section 422 of the Code), stock appreciation rights (“SARs”), restricted stock and restricted stock unit awards, performance shares and other cash or share-based awards. The maximum amount of share-based awards authorized is 2,325,446 of which 239,166 are available for future grants as of December 31, 2009.
A summary of the status of the SUA non-vested restricted stock awards, after conversion of the awards to the Company’s common stock on the date of acquisition on November 13, 2009, as of December 31, 2009 and changes during the period from the acquisition to December 31, 2009 is presented in the following table:
The fair value measurement objective of the relevant GAAP guidance is achieved using the Black-Scholes model as the model (a) is applied in a manner consistent with the fair value measurement objective and other requirements of GAAP, (b) is based on established principles of financial economic theory and generally applied in that field and (c) reflects all substantive characteristics of the instrument.
The Company files a consolidated Federal income tax return. The provision for Federal, state and local income taxes consists of the following components:
Section 382 imposes limitations on a corporation’s ability to utilize its net operating loss carry forwards (“NOL”) if it experiences an “ownership change.” As a result of the acquisitions, Preserver, CastlePoint and SUA underwent ownership changes as defined in the IRC. Use of the NOL from Preserver, CastlePoint and SUA of $36.2 million, $15.0 million and $2.7 million, respectively, or $53.9 million in total, are subject to an annual limitation under Section 382 determined by multiplying the purchase price of Preserver, CastlePoint and SUA by the applicable long-term tax free rate resulting in an annual limitation amount of approximately $2.8 million, $11.1 million and $4.6 million, respectively. Any unused annual limitation may be carried over to later years. Preserver’s NOL balance has been adjusted to reflect the finalization of Preserver’s income tax returns with the IRS. The $53.8 million of NOL will expire if unused in 2011-2027.
The Company made elections under IRC § 338(g) for CPBH and CPRe, both of which are Bermuda entities. The effect of these elections is to treat CPBH and CPRe as new corporations, effective as of the day of the closing, with a fair market value basis in their assets for US tax purposes and a new taxable year beginning the day after the closing. The Company also made a “check-the-box” election to treat CPBH as a disregarded entity for US tax purposes. Furthermore, the Company made an IRC § 953(d) election with regards to CPRe for the taxable year beginning after the date of acquisition. The 953(d) election will cause CPRe to be treated as a domestic corporation for US income tax purposes.
The Company has also made elections under IRC §338(h) (10) with regards to its purchase of Hermitage. The effect of these elections is to treat Hermitage as a new corporation, effective as of the day of the closing, with a fair market value basis in their assets for US tax purposes and a new taxable year beginning the day after the closing.
The Company adopted the relevant provisions of GAAP concerning uncertainties in income taxes on January 1, 2007. At the adoption date and as of December 31, 2009, the Company had no material unrecognized tax benefits and no adjustments to liabilities or operations were required.
Investments in fixed-maturity securities are valued at NAIC value for statutory financial purposes, which is primarily amortized cost. GAAP requires certain investments in fixed-maturity securities classified as available for sale, to be reported at fair value.
For the years ended December 31, 2009, 2008 and 2007, the Company’s Insurance Subsidiaries had SAP net income of $32.8 million, $30.2 million and $43.6 million, respectively. At December 31, 2009 and 2008 the Company’s Insurance Subsidiaries had reported SAP surplus as regards policyholders of $593.9 million and $305.2 million, respectively, as filed with the insurance regulators.
The Company’s Insurance Subsidiaries paid approximately $15.0 million, $5.2 million and $8.5 million in dividends and or return of capital to Tower in 2009, 2008 and 2007, respectively. As of December 31, 2009, the maximum distribution that Tower’s Insurance Subsidiaries could pay without prior regulatory approval was approximately $52.8 million.
CP 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, CP Re is required to prepare Statutory Financial Statements and to file a Statutory Financial Return. The Insurance Act also requires CP Re to maintain minimum share capital and surplus, and it has met these requirements as of December 31, 2009.
For the year ended December 31, 2009, CP Re had statutory net income of $19.1 million and at December 31, 2009, had statutory surplus of $255.0 million.
Equity and fixed income investments: Fair value disclosures for investments are included in “Note 4-Investments.”
Common trust securities-statutory business trusts: Common trust securities are investments in related parties; as such it is not practical to estimate the fair value of these instruments. Accordingly, these amounts are reported using the equity method.
Subordinated debentures: Fair value disclosures for the subordinated debt carried on the balance sheet for these financial statements are included in
Effective January 1, 2009, the Company adopted relevant new GAAP guidance, which requires that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) be considered participating securities and included in the computation of earnings per share pursuant to the two-class method. This guidance became effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years.
In accordance with the two-class method, the Company allocates its undistributed net earnings (net income less dividends declared during the period) to both its common stock and unvested share-based payment awards (“unvested restricted stock”). Because the common shareholders and share-based payment award holders share in dividends on a 1:1 basis, the earnings per share on undistributed earnings is equivalent. Undistributed earnings are allocated to all outstanding share-based payment awards, including those for which the requisite service period is not expected to be rendered.
All prior-period earnings per share data have been adjusted retrospectively to conform to the provisions of this new guidance. As a result, weighted average common shares outstanding for the years ended December 31, 2008 and 2007 increased by 250,010 and 212,424 shares to 23,290,506 and 22,927,087 shares, respectively. Basic and diluted earnings per share for the years ended December 31, 2008 and 2007 decreased by $0.02 and $0.01, respectively.
The following table shows the computation of the Company’s earnings per share pursuant to the two-class method:
For the year ended December 31, 2009, 401,659 options to purchase Tower shares were not included in the computation of diluted earnings per share because the exercise price of the options was greater than the average market price.
The Company has changed the presentation of its business results by allocating its previously reported insurance segment into brokerage insurance and specialty business, based on the way management organizes the segments, for making operating decisions and assessing profitability. This change results in reporting three segments: brokerage (commercial and personal lines underwriting), specialty, which includes third party reinsurance assumed by CPRe, and insurance services (underwriting, claims and reinsurance services). The prior period segment disclosures have been restated to conform to the current presentation. The Company considers many factors in determining reportable segments including economic characteristics, production sources, products or services offered and the regulatory environment.
The Company evaluates segment performance based on segment profit, which excludes investment income, realized gains and losses, interest expense, income taxes and incidental corporate expenses. The Company does not allocate assets to segments because assets, which consist primarily of investments and fixed assets, other than intangibles and goodwill, are considered in total by management for decision-making purposes. Intangibles and goodwill are allocated for purposes of impairment testing as more fully described in Note 6 -“Goodwill and Intangible Assets.”
On February 2, 2010 the Company announced the signing of a definitive agreement to acquire the Personal Lines Division of OneBeacon, subject to customary closing conditions and regulatory approvals. For the purchase price of $32.5 million plus book value, Tower will acquire Massachusetts Homeland Insurance Company, York Insurance Company of Maine and two management companies. The management companies are the attorneys-in-fact for Adirondack Insurance Exchange, a New York reciprocal insurer, and New Jersey Skylands Insurance Association, a New Jersey reciprocal insurer, and its New Jersey domiciled stock insurance subsidiary, New Jersey Skylands Insurance Company. Tower will also purchase the surplus notes issued by the two reciprocal insurers for an amount equal to the statutory surplus in the exchanges (approximately $103 million at December 31, 2009). This transaction is subject to approvals by the appropriate regulatory agencies and is expected to close at the end of the second quarter of 2010. Tower will write and manage the private passenger automobile, homeowners and package policies through the companies currently issuing these policies and combine its existing personal lines operations, which is currently reflected in our Brokerage Insurance segment, with the business being acquired. Excluded from this transaction are AutoOne, specialty collector car and boat businesses, and Houston General companies. The Personal Lines Division writes business in the Northeastern United States with offices in: Canton, Massachusetts; South Portland, Maine; and Williamsville, New York.
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. In addition, preferred dividends are excluded from the quarterly calculations of earnings per share in 2007 since they are anti-dilutive, but are included in the year end calculations.