The net loss ratio is calculated by dividing net losses by net premiums earned.
The net underwriting expense ratio is calculated by dividing net underwriting expenses (consisting of direct commission expenses and other underwriting expenses net of policy billing fees and ceding commission revenue) by net premiums earned. Because the ceding commission revenue we earn on our ceded premiums has historically been higher than our expenses incurred to produce those premiums, our extensive use of quota share reinsurance has caused our net underwriting expense ratio to be lower than our gross underwriting expense ratio under GAAP.
Diluted book value per share is calculated based on total common stockholders’ equity divided by the sum of the number of shares of common stock outstanding plus the appropriate common stock equivalents for stock options, warrants and restricted stock using the treasury stock method.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated audited financial statements and accompanying notes which appear elsewhere in this Form 10-K. It contains forward-looking statements that involve risks and uncertainties.
We provide a broad range of property and casualty insurance products as well as reinsurance through our Insurance Subsidiaries, TICNY, TNIC, PIC, NEIC and MVIC. We also provide managing general underwriting, claims and other administration and reinsurance intermediary services through TRM, our insurance services subsidiary. We manage these operations through three business segments: insurance (commercial and personal lines underwriting), reinsurance, and insurance services (managing general agency, claims and other administration and reinsurance intermediary operations).
We have determined that our ownership in CastlePoint qualifies as a variable interest entity (“VIE”) under the provisions of FIN 46-(R). We determined that our investment in CastlePoint does not meet the requirements
for consolidation because we are not the primary beneficiary of the VIE as defined in FIN 46-(R). However, we have recorded our 6.7% investment in CastlePoint using the equity method of accounting as we exercise significant influence over CastlePoint.
The property and casualty insurance industry is affected by naturally occurring industry cycles known as “hard” and “soft” markets. For the first ten years after our company began, we operated in a soft market, generally considered an adverse industry condition in the property and casualty insurance industry. A soft market is characterized by intense competition that results in inadequate pricing, expanded coverage terms and increased commissions paid to distribution sources in order to compete for business. We believe that a hard market began sometime in late 2000. A hard market, generally considered a beneficial industry trend, is characterized by reduced competition that results in higher pricing, reduced coverage terms and lower commissions paid to acquire business.
A. M. Best and the Insurance Information Institute forecast that in 2007 the insurance industry is forecasted to have record earnings. Net income is projected to exceed $59 billion for the U.S. property & casualty industry. Despite continued price softening, an underwriting profit of $19.3 billion will be achieved. As in 2006, this was due, in part, to modest catastrophic activity, favorable loss reserve development and price monitoring. Analysts expect the industry’s profitability to continue in 2008, although market conditions should reduce the underwriting profit posted in 2007. A 2007 industry combined ratio is projected to be 93.8%; up only marginally from the 92.7% level in 2006.
A.M. Best Company estimates that the industry-wide change in net premiums written in the property and casualty industry was (1.2%) in 2007 compared to 3.9% in 2006 and is estimated to be (0.6%) in 2008. The change in industry policyholders’ surplus as estimated by A.M. Best Company was 9.0% in 2007 compared to 14.9% in 2006 and is estimated to be 4.6% in 2008. In addition, the new capacity that has entered the market has placed more pressure on production and profitability targets. We expect that premium levels will remain relatively attractive in the business segments we have targeted. These include small, commercial lines of business and modestly valued homeowners and dwelling policies. Management of our mix of business is expected to produce selective growth in the lower premium segment of the middle market. Generally, we will be less interested at the higher premium levels of the middle market in which we see continuing evidence that competitive forces will reduce potential for profitable growth. We expect to continue to maintain underwriting discipline and selectivity in low hazard classes of business, as well as focusing on premium adequacy and appropriate coverage terms. Our broad product line platform continues to allow us the opportunity to adjust our business mix in response to varying market conditions.
Net premiums earned. Premiums written include all premiums received by an insurance company during a specified accounting period, even if the policy provides coverage beyond the end of the year. Premiums are earned over the term of the related policies. At the end of each accounting period, the portion of the premiums that are not yet earned is included in the unearned premium reserve and is realized as income in subsequent periods over the remaining term of the policy. Our policies typically have a term of 12 months. Thus, for example, for a policy that is written on July 1, 2007, one-half of the premiums would be earned in 2007 and the other half would be earned in 2008.
We use various measures to analyze the growth and profitability of our three business segments. In the insurance and reinsurance segments, we measure growth in terms of gross, ceded and net premiums written and we measure underwriting profitability by examining our loss, expense and combined ratios. We also measure our gross and net written premiums to surplus ratios to measure the adequacy of capital in relation to premiums written. In the insurance services segment, we measure growth in terms of premiums produced by TRM on behalf of other insurance companies as well as fee and commission revenue received and we analyze profitability by evaluating income before taxes and the size of such income relative to our Insurance Subsidiaries’ net premiums earned. On a consolidated basis, we measure profitability in terms of net income and return on average equity.
In preparing our consolidated financial statements, management is required to make estimates and assumptions that affect reported assets, liabilities, revenues and expenses and the related disclosures as of the date of the
financial statements. Certain of these estimates result from judgments that can be subjective and complex. Consequently, actual results may differ, perhaps substantially, from the estimates.
Due to the inherent uncertainty associated with the reserving process, the ultimate liability may differ, perhaps substantially, from the original estimate. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current year’s results. Reserves are closely monitored and are recomputed periodically using the most recent information on reported claims and a variety of statistical techniques. Specifically, on at least a quarterly basis, we review, by line of business, existing reserves, new claims, changes to existing case reserves and paid losses with respect to the current and prior years. See “Business-Loss and Loss Adjustment Expense Reserves” for additional information regarding our loss reserves.
We segregate our data for estimating loss reserves. Property lines include Fire, Homeowners, CMP Property, Multi-Family Dwellings and Auto Physical Damage. Casualty lines include CMP Liability, Other Liability, Workers’ Compensation, Commercial Auto Liability, and Personal Auto Liability. The actuarial methods used by segment have been consistent since the 2003 year-end review. During the year-end review the accident years are split into most recent, first prior and all other accident years. For the 2007 review the most recent accident year is 2007, the first prior is 2006, and all other accident years are 2005 and prior. The table below shows the method used by product line and accident year to select the estimated year-ending loss reserves:
Ceding commission earned under a quota share reinsurance agreement is based on the agreed upon commission rate applied to the amount of ceded premiums written. Ceding commissions are realized as income as ceded premiums written are earned. Since 2001, the ultimate commission rate earned on our quota share reinsurance contracts has been determined by the loss ratio on the ceded premiums earned. If the estimated loss ratio decreases from the level currently in effect, the commission rate increases and additional ceding commissions are earned in the period in which the decrease is recognized. If the estimated loss ratio increases, the commission rate decreases, which reduces ceding commissions earned. As a result, the same uncertainties associated with estimating loss and LAE expense reserves affect the estimates of ceding commissions earned. We monitor the ceded ultimate loss ratio on a quarterly basis to determine the effect on the commission rate of the ceded premiums earned that we accrued during prior accounting periods. The estimated ceding commission income relating to prior years recorded in 2007, 2006 and 2005 was a decrease of $0.5 million, and an increase of $1.1 million and a decrease of $1.2 million, respectively.
Reinsurance recoverables. Reinsurance recoverable balances are established for the portion of paid and unpaid loss and LAE that is assumed by such reinsurers. Prepaid reinsurance premiums represent unearned premiums that are ceded to reinsurers. Reinsurance recoverables and prepaid reinsurance premiums are reported on our balance sheet separately as assets, instead of being netted against the related liabilities, since reinsurance does not relieve us of our legal liability to policyholders and ceding companies. We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. Consequently, we bear credit risk with respect to our individual reinsurers and may be required to make judgments as to the ultimate recoverability of our reinsurance recoverables. Additionally, the same uncertainties associated with estimating loss and LAE reserves affect the estimates of the amount of ceded reinsurance recoverables. We continually monitor the financial condition and rating agency ratings of our reinsurers. Non-admitted reinsurers are required to collateralize their share of unearned premium and loss reserves either by placing funds in a trust account meeting the requirements of New York Regulation 114 or by providing a letter of credit. In addition, from October 2003 to December 31, 2005, we placed our new quota share treaties on a “funds withheld” basis, under which TICNY retained the ceded premiums written and placed that amount in segregated trust accounts from which TICNY may withdraw amounts due to it from the reinsurers. In 2007 and 2006, CastlePoint Reinsurance collateralized its net exposure with a New York Regulation 114 compliant trust account.
Impairment of invested assets. Impairment of investment securities results in a charge to operations when a market decline below cost is deemed to be other-than-temporary. In accordance with FSP FAS 115-1 and FAS 124-1, “Other-Than-Temporary Impairment and Its Application to Certain Investments”, we regularly review our fixed-maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. In general, we focus our attention on those securities whose fair value was less than their amortized cost or cost, as appropriate, for six or more consecutive months. In evaluating potential impairment, we consider, among other criteria: the current fair value compared to amortized cost or cost, as appropriate; the length of time the security’s fair value has been below amortized cost or cost; our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in value; specific credit issues related to the issuer; specific cash flow estimations for mortgage-backed securities and current economic conditions. In addition, while evaluating the asset and mortgaged back securities portfolios, management follows the guidance of EITF 99-20 “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets” (“EITF 99-20”).
Other-than-temporary impairment losses result in a permanent reduction of the cost basis of the underlying investment. We recorded OTTI in our fixed maturity and equity securities in the amounts of $10.1 million, $0 and $0 in 2007, 2006 and 2005, respectively. Significant changes in the factors we consider when evaluating investments for impairment losses could result in a significant change in impairment losses reported in our consolidated financial statements. See “Business-Investments” and “Note 2. Investments” in the notes to our audited consolidated financial statements for additional detail regarding our investment portfolio at December 31, 2007, including disclosures regarding other than temporary declines in investment value.
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. Identifiable intangible assets with a finite useful life are amortized over the period that the asset is expected to contribute directly or indirectly to our future cash flows. Identifiable intangible assets with finite useful lives are tested for recoverability whenever events or changes in circumstances indicate that a carrying amount may not be recoverable. An impairment loss is recognized if the carrying value of an intangible asset is not recoverable and its carrying amount exceeds its fair value. No impairment losses were recognized in 2007, 2006 and 2005. Significant changes in the factors we consider when evaluating our intangible assets for impairment losses could result in a significant change in impairment losses reported in our consolidated financial statements. See “Note 7. Intangible Assets” in the notes to our audited consolidated financial statements.
Excluding net realized losses on investments, return on average equity would have increased 4.6%.
Total revenues. Total revenues increased by 37.6% to $411.6 million for 2007 compared to $299.3 million for 2006. The increase is primarily due to the increase in earned premiums, total commission and fee income and net investment income, offset by net realized investment losses. The acquisition of Preserver added $59.4 million to total revenues in 2007. Gross premiums earned increased by 43.6% to $521.9 million for 2007 compared to $363.4 million in 2006 partly due to the acquisition of Preserver, which added $63.6 million in gross premiums earned, and growth in our book of business. Total commission and fee income increased to
$106.3 million, in 2007 compared to $52.2 million, in 2006. An increase in both the quota share ceding percentage and commission on premiums produced by TRM contributed to this increase. Net investment income increased in 2007 primarily due to an increase in invested assets compared to 2006. Net realized investment losses were $17.5 million in 2007 compared to realized gains of $12,000 in 2006. The losses in 2007 are due to the sale of various residential mortgage-backed securities and recognition of $10.1 million in OTTI.
investing activities was $182.9 million for 2007 and includes $66.2 million for the purchase of Preserver. On a tax equivalent basis, the book yield was 5.6% as of December 31, 2007 and 5.7% as of December 31, 2006.
Net realized investment losses were $17.5 million for 2007 compared to net realized investment gains of $12,000 for 2006. The net realized investment losses were related to the sale of a closed-end investment fund, Hyperion Brookfield Collateralized Securities Fund (“HCS Fund”), which was sold in December 2007. The HCS Fund invested in various investment grade mortgage-backed and asset-backed securities. In addition we recognized $10.1 million of OTTI. The OTTI included all of our equity investments in “REITs, as well as all of our sub-prime exposures within our residential mortgage-backed securities.
Total revenues. Total revenues increased by 36.2% to $299.3 million in 2006 compared to $219.8 million in 2005. The increase is primarily due to the increase in net premiums earned, total commission and fee income and net investment income. Net premiums earned represented 74.8% of total revenues in both 2006 and 2005. Net investment income, excluding realized capital losses, represented 7.7% and 6.8% of total revenues, in 2006 and 2005, respectively. In addition, total commission and fee income increased to $52.2 million, or 17.5% of total revenue, in 2006 compared to $40.2 million, or 18.3% of total revenue, for 2005.
Net realized investment gains were $12,000 in 2006 compared to net realized investment gains of $122,000 for 2005. There was no impact on net realized gains attributable to adjustments for other than temporary impairment of securities held during 2006 or in 2005.
Loss and loss adjustment expenses. Gross loss and loss adjustment expenses and the gross loss ratio for the insurance and reinsurance segments combined in 2006 were $199.9 million and 55.0%, respectively, compared to $135.2 million and 56.8%, respectively, for 2005. The net loss ratio for the combined segments was 60.3% for the 2006 as compared to 58.8% in 2005. The net loss ratio in 2006 reflected a $1.6 million charge resulting from the commutation agreement with PXRE which was a present value discount on the reserves commuted. In addition to the commutation agreement with PXRE, we executed novation agreements with PXRE relating to other reinsurance agreements covering business written in 2001, 2002 and 2003. These agreements were written by other insurance companies with respect to business managed on their behalf by TRM. Under the novation agreements we assumed loss liabilities of $12.2 million and received consideration of $11.4 million. Since novation transactions are recorded by including the consideration received as premiums written and earned and the liabilities assumed as losses incurred, the gross and net loss ratios were also affected. The PXRE commutation and novation transactions added 1.7 and 3.2 percentage points to the gross and net loss ratios, respectively, in 2006
Net income and return on average common equity. Our net income and return on average common equity was $36.8 million and 22.2%, respectively, in 2006 compared to $20.8 million and 15.1%, respectively, in 2005. In 2006, the return was calculated by dividing net income of $36.6 million excluding preferred stock dividends by an average common stockholders’ equity of $164.6 million. The net effects of the PXRE commutation and novation transactions, and the gains recorded on the CastlePoint investment and warrant, reduced by $0.5 million of start-up expenses for CastlePoint, added $4.1 million to our net income and 2.2 percentage points to our return on average common equity in 2006. For 2005, the return was calculated by dividing net income of $20.8 million by an average stockholders’ equity of $137.1 million.
markets. We have started writing excess and surplus lines business in Florida and Texas, and will start writing on an admitted basis in California in 2008. Additionally, as part of the wholesale producer program we will appoint producers with binding authority to write new program business which is separate and distinct from our core book of brokerage business. New business written in 2007 from wholesale agents with binding authority amounted to approximately $29.0 million, of which approximately $7.0 million was written in Florida. In 2008 we expect to accelerate our new business growth through this initiative. Policies in-force, before the effect of the Preserver acquisition, increased by 16.8% as of December 31, 2007 compared to December 31, 2006. During 2007, premium increases on renewed business averaged 9.3% in personal lines and 0.3% in commercial lines. The retention rate was 75% for personal lines and 72% for commercial lines. The retention rate on both personal and commercial lines declined in 2007 as compared to 2006 as brokerage business was renewed through TRM on behalf of CPIC. The retention rate including brokerage business renewed by TRM on behalf of CPIC was 85% for personal lines and 79% for commercial lines.
Effective in the fourth quarter of 2007, New York enacted a law to reform the workers’ compensation system. This law included provisions that instituted a cap on certain benefits, implemented several medical discount programs, eliminated a special disability fund for new claims and imposed various administrative changes on the workers’ compensation system. As a result of this legislation, workers’ compensation rates in New York were decreased by approximately 16% on an overall basis in October 2007. The rate decrease for our core classes of business was approximately 25%. The legislation also required the rate decrease to take effect midterm on any policy with an effective date after October 1, 2007. We have taken steps to analyze our book of business and adjust our strategy and believe the impact in 2008 on our existing rate levels will be an overall rate reduction of 13%. Our premiums written in New York in 2007 totaled $30.6 million.
Ceded premiums earned increased 69.2% during 2007 as compared to 2006. This was due primarily to the 41.2% increase in ceded premiums written in 2007 and slightly lower ceded premiums earned in 2006. We did not cede any premiums in the first quarter of 2006 and the quota share ceding percentage was 30% for the three months ending June 30, 2006 and 40% thereafter.
Loss and loss adjustment expenses and loss ratio. Gross and net losses and loss adjustment expenses were $262.2 million and $155.4 million, respectively, for 2007 compared with $182.9 million and $118.0 million,
respectively in 2006. Our gross loss ratio was 50.8% for 2007 as compared with 53.2% in 2006. Our net loss ratio was 55.5% for 2007 as compared with 57.6% in 2006. The effect of the PXRE commutation added 0.7% of a percentage point to the net loss ratio in 2006. The decrease in the gross and net loss ratios, excluding the effect of the PXRE commutation, for 2007 compared to 2006 was primarily due to lower than expected loss emergence for workers’ compensation, commercial auto liability and the property lines. However the decrease in the net loss ratio, excluding the impact of PXRE, was offset, in part, by the difference in the amount of reserves released from prior accident years in 2007 compared to 2006. During 2007, prior accident years’ loss reserves developed favorably to the extent of $0.4 million, whereas during 2006, prior accident years’ loss reserves developed favorably to the extent of $2.6 million excluding the $1.6 million loss related to the commutation with PXRE, resulting in net favorable development of $1.0 million.
The underwriting expense portion of the gross expense ratio was 12.6% for 2007 as compared to 13.0% for 2006. Although underwriting expenses increased due to the growth in premium volume, the gross underwriting expense ratio declined as gross premiums earned increased more rapidly than underwriting expenses.
The net underwriting expense ratio was 28.2% for 2007 as compared to 28.1% in 2006. The net expense ratio in 2006 was affected by the reduction in ceding commissions of $3.2 million resulting from the commutations with PXRE which added 1.6 percentage points to the net expense ratio and benefited by both a higher ceding commission rate and a favorable increase in ceding commission revenue which resulted from improvement in the ceded loss ratio on prior year quota share treaties.
Underwriting profit and combined ratio. The underwriting profit, which reflects our underwriting results on a net basis after the effects of reinsurance, was $45.9 million in 2007 and $29.3 million in 2006.
Gross premiums. Gross premiums written increased by 36.7% to $408.3 million in 2006 compared to $298.6 million in 2005. Gross premiums earned increased by 45.7% to $344.0 million in 2006 compared to $236.2 million in 2005. Gross premiums earned in 2006 was affected by the significant increase in gross premiums written in 2005 and the overall increase in gross premiums written through December 31, 2006 especially in our homeowners and commercial multi peril and other liability lines. The number of policies in force increased by 18.8% as of December 31, 2006 compared to December 31, 2005. Additionally, during 2006, premium increases on renewed business averaged 9.3% in personal lines and 3.3% in commercial lines. The retention rate was 87% for personal lines and 80% for commercial lines during 2006. New business
Loss and LAE are net of reimbursements for loss and LAE expenses made by TRM pursuant to the expense sharing arrangement between TICNY and TRM. See “Insurance Services Segment Results of Operations” for the amounts of loss and LAE expense reimbursements.
Underwriting expenses. Underwriting expenses, which include direct commission expenses and other underwriting expenses, were $101.7 million in 2006 as compared with $74.0 million for 2005. Our gross expense ratio was 29.2% in 2006 as compared with 31.0% for 2005.
Underwriting profit and combined ratio. The underwriting profit, which reflects our underwriting results on a net basis after the effects of reinsurance, was $29.3 million in 2006 and $19.3 million in 2005. The gross combined ratio was 82.4% in 2006 as compared with 88.1% for 2005. The decrease in the gross combined ratio in 2006 resulted primarily from a decrease in both the gross loss ratio and gross underwriting expense ratio. The net combined ratio was 85.7% in 2006 as compared to 88.1% in 2005. The decrease in the net combined ratio resulted from a decrease in both the net loss ratio and the net underwriting expense ratio as described above. The effects of the commutation reduced underwriting profits by $4.8 million and added 2.3 percentage points to the net combined ratio.
Loss and loss adjustment expenses and loss ratio. Gross loss and loss adjustment expenses were $2.6 million for 2007 as compared to $17.0 million in 2006. Net losses were $2.5 million in 2007 as compared to $17.1 million in 2006. The gross and net loss ratios were 43.6% and 42.7%, respectively, in 2007 as compared
Underwriting expenses and underwriting expense ratio. Gross underwriting expenses decreased in 2007 to $2.6 million as compared to $3.7 million in 2006. The gross and net underwriting expense ratios were 44.2% and 44.6%, respectively, for 2007 compared to 18.9% and 19.0%, respectively, in 2006. The lower gross and net underwriting expense ratios in 2006 were the direct result of the $11.4 million of additional gross and net premiums earned from the PXRE novation which did not incur a commission expense. The effects of the PXRE novation reduced the gross and net underwriting expense ratios by 27.1 percentage points and 27.6 percentage points, respectively, in 2006.
Underwriting profit and combined ratio. The underwriting profit from assumed reinsurance for 2007 was $0.7 million compared to underwriting loss of $1.5 million for 2006 which includes the charge of $0.8 million resulting from the novation agreements with PXRE. The net combined ratio was 87.3% for 2007 compared to 107.8% for the same period of 2006. The lower net combined ratio for 2007 was the result of the decreased net loss ratio, offset in part by the increase in the net underwriting expense ratio as explained above.
The gross combined ratio decreased to 87.8% for 2007 compared to 106.2% for 2006 due to the decrease in the gross loss ratio, offset in part, by an increase in the gross underwriting expense ratio as explained above. The effects of the novation agreements added 0.7 percentage point and 1.5 percentage points to the gross and net combined ratios, respectively, in 2006.
Gross premiums. Gross premiums written increased to $24.3 million for, 2006 as compared to $1.5 million for 2005. This increase was due to our novation agreements with PXRE in June 2006 which increased assumed premiums written by $11.4 million and our decision to assume substantially all of the premiums placed through the insurance services segment. Gross premiums earned increased to $19.4 million in 2006 from $1.7 million in 2005 due to the novation agreements with PXRE. The increase in gross premium written and earned in 2006, excluding the novation from PXRE, resulted from business produced by TRM on behalf of Virginia Surety and State National in states where TICNY and TNIC were not yet licensed. In 2005, the majority of this business was reinsured by other reinsurers.
Loss and LAE expenses and loss ratio. Gross loss and LAE expenses were $17.0 million in 2006 as compared to $0.4 million for 2005. Net losses were $17.1 million in 2006 as compared to $0.9 million in 2005. Both gross and net losses in 2006 were increased by $12.2 million as a result of the novation agreements with PXRE. The gross and net loss ratios were 87.3% and 88.8%, respectively, in 2006 as compared to 24.7% and 59.9%, respectively, in 2005. There was unfavorable development from prior years’ loss reserves on a net basis of approximately $0.3 million in 2006, compared to favorable development from prior years’ loss reserves on a net basis of approximately, $0.5 million in 2005. The effect of the PXRE novation agreements added 27.9 percentage points and 26.1 percentage points to the gross and net loss ratio, respectively, in 2006.
The gross combined ratio increased to 106.2% in 2006 compared to 36.1% in 2005 due to the increase in the gross loss ratio and the other underwriting expense ratio. The effects of the PXRE novation agreements added 0.7 percentage point to the gross combined ratio and reduced the net combined ratio by 1.5 percentage points in 2006.
Consists of underwriting expenses reimbursed to TICNY pursuant to an expense sharing agreement and to CastlePoint Reinsurance pursuant to a service and expense sharing agreement.
Total revenues. Total revenues for the insurance services segment were $33.3 million for 2007 as compared with $8.0 million in 2006. The principal components of total revenues for our insurance services segment are direct commission revenue, claims administration revenue and other administration revenue. The increase in total revenues was primarily due to direct commission revenue increasing to $28.8 million for 2007 compared to $3.5 million in 2006 mainly as a result of business produced on behalf of CPIC which began in May 2007 but increased substantially beginning in July 2007. Overall, premiums produced by TRM increased from $12.9 million in 2006, to $85.1 million in 2007 of which $84.2 million was produced on behalf of CPIC. In addition, there was an increase in commission revenue of $1.8 million and $0.8 million in 2007 and 2006, respectively, as a result of favorable loss development on the premiums produced in prior years. Claims
administration revenues decreased to $2.3 million for 2007 compared to $3.2 million in 2006 as a result of fewer hours associated with claims handled on behalf of issuing carriers. Other administration revenue was $1.4 million for 2007 compared to $0.7 million in 2006 and consists primarily of reimbursements from CastlePoint under a service and expense sharing agreement.
Other insurance services expenses. The amount of reimbursement for underwriting expenses by TRM to TICNY in 2007 was $5.8 million as compared to $1.6 million in 2006. The increase in other insurance expenses resulted from the increase in premium produced.
Total revenues. Total revenues for the insurance services segment were $8.0 million in 2006 as compared with $14.1 million for 2005. The decrease in total revenues was due to direct commission revenue that decreased 62.1% to $3.5 million in 2006 compared to $9.1 million for 2005. Reinsurance intermediary fees decreased to $0.6 million in 2006 compared to $0.7 million in 2005 in which reinsurance intermediary fees were increased as a result of an adjustment to a prior year reinsurance contract. Claims administration revenue decreased by 25.2% to $3.2 million in 2006 as compared to $4.3 million in 2005 as a result of fewer hours associated with claims handled for issuing carriers. These amounts were partially offset by $0.7 million of other administration revenue reimbursements from CastlePoint for the nine months ended December 31, 2006. In 2006 we entered into a service and expense sharing agreement with CastlePoint to provide underwriting, claims, legal and other corporate services, such as human resources and information technology, to CastlePoint.
Other insurance services expenses. The amount of reimbursement for underwriting expenses by TRM to TICNY in 2006 was $1.6 million as compared to $2.0 million in 2005, as a result of the decrease in premiums produced. The amount of reimbursement for underwriting expenses in 2006 includes the underlying expenses relating to the service and expense sharing agreement with CastlePoint, which have been billed and included in other administration revenue as described above.
The aggregate fair value of our invested assets as of December 31, 2007 was $619.1 million. Our fixed maturity securities as of this date had a fair value of $606.5 million and an amortized cost of $616.8 million. Equity securities carried at fair value were $12.6 million with a cost of $14.4 million as of December 31, 2007.
TICNY is the only Insurance Subsidiary that has historically paid dividends. Under New York law, TICNY is limited to paying dividends to Tower only out of statutory earned surplus. In addition, the New York Insurance Department must approve any dividend declared or paid by TICNY that, together with all dividends declared or distributed by TICNY during the preceding twelve months, exceeds the lesser of (1) 10% of TICNY’s policyholders’ surplus as shown on its latest statutory financial statement filed with the New York State Insurance Department or (2) 100% of adjusted net investment income during the preceding twelve months. TICNY declared approximately $8.5 million, $5.5 million, and $4.6 million in dividends to Tower in 2007, 2006, and 2005, respectively. As of December 31, 2007, the maximum dividend distributions that TICNY could pay to its parent without approval of the New York State Insurance Department was $15.4 million.
On January 26, 2007, we closed on the sale of 2,704,000 shares of common stock. On February 5, 2007, the underwriters exercised their over-allotment option with respect to 340,600 shares of common stock. We received aggregate net proceeds of approximately $89.4 million from the offering and over-allotment option, after underwriting discounts and expenses.
Cash Flows from Issuance of Subordinated Debentures and Perpetual Preferred Stock
Tower’s Insurance Subsidiaries are required by law to maintain a certain minimum level of policyholders’ surplus on a statutory basis. Policyholders’ surplus is calculated by subtracting total liabilities from total assets. The NAIC maintains risk-based capital (“RBC”) requirements for property and casualty insurance companies. RBC is a formula that attempts to evaluate the adequacy of statutory capital and surplus in relation to investments and insurance risks. The formula is designed to allow the state Insurance Departments to identify potential weakly capitalized companies. Under the formula, a company determines its risk-based capital by taking into account certain risks related to the insurer’s assets (including risks related to its investment portfolio and ceded reinsurance) and the insurer’s liabilities (including underwriting risks related to the nature and experience of its insurance business). Applying the RBC requirements as of December 31, 2007, our Insurance Subsidiaries’ risk-based capital exceeded the minimum level that would trigger regulatory attention. In addition to monitoring RBC to ensure regulatory compliance, we monitor various financial ratios, including gross and net premiums written to surplus ratios. In 2007, we contributed $3.2 million to TICNY, $2.5 million to PIC and $2.5 million to NEIC. In 2006, we contributed $49.6 million in capital and surplus to TICNY. In 2005, Tower contributed $10.0 million in capital and surplus to TNIC.
Cash flows. Cash and cash equivalents at December 31, 2007 were $77.7 million as compared to $100.6 million at December 31, 2006. The cash equivalents at December 2006 were higher than what they were historically as a result of raising $48 million through the issuance of $40 million of perpetual preferred stock and $8 million from the sale of Tower Indemnity Company of America near the end of 2006. At the time we raised these funds the yield curve was relatively flat. At December 31, 2006, we had $65 million of cash equivalents invested in agency backed discount notes and commercial paper that had interest yields between 5.14% and 5.25%. Our belief then was that longer term interest rates would rise in 2007.
During 2007, yield spreads widened as a result of the lack of liquidity in the market, increasing the gross unrealized investment loss significantly. The increase in the unrealized investment loss was primarily in our residential and commercial mortgage-backed and asset-backed securities, as well as our corporate bond securities. Our policy has been to regularly review both our fixed-maturity and equity portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. At December 31, 2007, following our normal review, we recorded $10.1 million of OTTI on our equity and fixed maturity securities. Our equity securities are primarily invested in REITs and the OTTI for these securities was $5.2 million in 2007. The fixed maturity securities included sub-prime residential mortgage-backed securities and the OTTI for the sub-prime securities was $2.6 million in 2007. As a result of performing cash flow testing in accordance with Emerging Issues Task Force Number 99-20, we determined that additional OTTI related to other fixed maturity securities was $1.8 million. In January 2008, we sold two corporate bonds and have recorded an OTTI related to this bond as of December 31, 2007, because we no longer had the intent to hold them to maturity.
We have determined that we do not hold any remaining investments, after recording the charge for OTTI that would have been considered other than temporarily impaired and that the recent increase in the gross unrealized investment loss was caused by the lack of liquidity in the capital markets. We expect cash flows from operations to be sufficient to meet our liquidity requirements. We intend, and we believe we have the ability, to hold these investments, excluding the investments we determined were OTTI, until a recovery in value, which may be at maturity for fixed maturity securities.
In 2006 net cash provided by operating activities was $134.0 million compared to $128.5 million for 2005. The increase in net cash provided by operations in 2006 resulted primarily from an increase in collected premiums as a result of the growth in gross premiums written and the PXRE commutation and novation agreements executed during the second quarter of 2006, offset by the increase in payments to our reinsurers which resulted from an increase in the quota share premiums ceded to CastlePoint and from the increase in catastrophe costs in 2006.
Net cash flows provided by financing activities for the twelve months ended December 31, 2006 were $59.7 million compared to $1.6 million used in financing activities in 2005. The 2006 amount included the net proceeds from the issuance of $20.0 million in subordinated debentures on March 31, 2006 and the issuance of perpetual preferred stock in December 2006, net of issuance costs, for $39.6 million. The Company paid common stockholder dividends of $2.0 million in each of 2006 and 2005.
For a discussion of our loss and LAE reserving process, see “Critical Accounting Policies - Loss and LAE Reserves.” Actual payments of losses and loss adjustment expenses by period will vary, perhaps materially, from the above table to the extent that current estimates of loss reserves vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns. See “Risk Factors-Risks Related to Our Business-If our actual loss and loss adjustment expenses exceed our loss reserves, our financial condition and results of operations could be adversely affected,” for a discussion of the uncertainties associated with estimating loss and LAE reserves. The ceded reserves recoverable referred to above also assumes timely reimbursement from our reinsurers. If our reinsurers do not meet their contractual obligations on a timely basis, the payment assumptions presented above could vary materially.
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, then floats with changes in the London Interbank Offered Rate (“LIBOR”) and 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.
As described in Management’s Annual Report on Internal Control over Financial Reporting, the Company has excluded Preserver Group, Inc. from its assessment of internal control over financial reporting as of December 31, 2007 as Preserver Group, Inc. and its subsidiaries were acquired by the Company in a purchase business combination during 2007. We have also excluded Preserver Group, Inc. from our audit of internal control over financial reporting. The total assets and revenues of Preserver Group, Inc. represent 19% and 14%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2007.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Tower Group, Inc. (together with its consolidated subsidiaries, the “Company”) as of December 31, 2007 and 2006, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2007 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, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Insurance, which offers a broad range of specialized property and casualty insurance products and services to small to mid-sized businesses and to individuals primarily in the Northeast states;
Reinsurance, which assumes reinsurance directly from the insurance companies for which TRM produces insurance premiums or indirectly from reinsurers that provide reinsurance coverage directly to these issuing companies; and
Insurance Services, which provide insurance brokering, claim administration, reinsurance intermediary services and other administrative services.
Direct commission revenue from the Company’s managing general underwriting services is recognized and earned as insurance policies are placed with TRM’s issuing companies. Fees from reinsurance intermediary services are earned when the Company’s Insurance Subsidiaries or TRM’s issuing companies cede premiums
The Company accounts for reinsurance in accordance with Statement of Financial Accounting Standards No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts” (“SFAS No. 113”). Management has evaluated its reinsurance arrangements and determined that significant insurance risk is transferred to the reinsurers. Reinsurance agreements have been determined to be short-duration prospective contracts and, accordingly, the costs of the reinsurance are recognized over the life of the contract in a manner consistent with the earning of premiums on the underlying policies subject to the reinsurance contract.
Reinsurance recoverable represents management’s best estimate of paid and unpaid loss and LAE recoverable from reinsurers. Ceded losses recoverable are estimated using techniques and assumptions consistent with those used in estimating the liability for loss and LAE. Management believes that reinsurance recoverables as recorded represent its best estimate of such amounts; however, as changes in the estimated ultimate liability for loss and LAE are determined, the estimated ultimate amount recoverable from the reinsurers will also change. Accordingly, the ultimate recoverable could be significantly in excess of or less than the amount indicated in the consolidated financial statements. As adjustments to these estimates become necessary, such adjustments are reflected in current operations. Loss and LAE incurred as presented in the consolidated statement of income and comprehensive net income are net of reinsurance recoveries.
In preparing financial statements, management estimates uncollectible amounts receivable from reinsurers based on an assessment of factors including the creditworthiness of the reinsurers and the adequacy of collateral obtained, where applicable. The Company recorded no allowance for uncollectible reinsurance at December 31, 2007 and 2006 and did not expense any uncollectible reinsurance during 2007, 2006 and 2005. Significant uncertainties are inherent in the assessment of the creditworthiness of reinsurers and estimates of any uncollectible amounts due from reinsurers. Any change in the ability of the Company’s reinsurers to meet their contractual obligations could have a detrimental impact on the consolidated financial statements and the Company’s Insurance Subsidiaries’ ability to meet their regulatory capital and surplus requirements.
Impairment of investment securities results in a charge to operations when a market decline below cost is deemed to be other-than-temporary. In accordance with FSP FAS 115-1 and FAS 124-1, “Other-Than-Temporary Impairment and Its Application to Certain Investments.”, the Company regularly reviews its fixed-maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments In evaluating potential impairment, management considers, among other criteria: the current fair value compared to amortized cost or cost, as appropriate; the length of time the security’s fair value has been below amortized cost or cost; management’s intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in value to cost; specific credit issues related to the issuer; specific cash flow estimations for mortgage-backed securities and current economic conditions. In addition, while evaluating the asset and mortgaged back securities portfolios, management followed the guidance of EITF 99-20 “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets” (“EITF 99-20”). Other-than-temporary impairment (“OTTI”) losses result in a permanent reduction of the cost basis of the underlying investment. During 2007, the Company recorded an impairment write-down of $10.1 million after determining that certain of its investments were OTTI. During 2006 and 2005, the Company did not record any OTTI.
Agents’ balances receivable are presented net of an allowance for doubtful accounts of $204,000 and $248,000 at December 31, 2007 and 2006, 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 balances of $547,000, $139,000 and $26,000 were written off in 2007, 2006, and 2005 respectively. One agent accounted for approximately 12%, 9% and 10%, respectively, of the Insurance Subsidiaries and TRM’s agents’ balances at December 31, 2007, 2006 and 2005. The same agent accounted for 11%, 11% and 11% of the Insurance Subsidiaries’ direct premiums written and TRM’s premiums produced in 2007, 2006 and 2005, respectively.
Receivable-claims paid by agency represent claim payments due from issuing carriers to reimburse claims paid by TRM on their behalf in conjunction with claims administration services. The receivables are partially secured by funds held totaling $4.8 million and $8.2 million as of December 31, 2007 and 2006, respectively. As of December 31, 2007 and 2006, no reserve for uncollectible recoverables was recorded. During 2007, 2006 and 2005, no amounts relating to these receivables were written-off.
The Company has recorded acquired identifiable intangible assets. In accounting for such assets, the Company follows Statement of Financial Accounting Standard No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). The cost of a group of assets acquired in a transaction is allocated to the individual assets including identifiable intangible assets based on their relative fair values. Identifiable intangible assets with a finite useful life are amortized over the period that the asset is expected to contribute directly or indirectly to the future cash flows of the Company.
Intangible assets with an indefinite life and goodwill are not amortized. 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 and are also subject to annual impairment testing. An impairment loss is recognized if the carrying value of an intangible asset or goodwill is not recoverable and its carrying amount exceeds its fair value. If impairment exists, the impairment charge is recorded in income in the period in which it is determined. No impairment losses were recognized in 2007, 2006 and 2005.
Pursuant to a Tax Sharing Agreement, each of the entities in the group is required to make payments to the parent for Federal income tax imposed on its taxable income in a manner consistent with filing a separate federal income tax return (but subject to certain limitations that are applied to the Tower consolidated group as a whole) .
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax
basis and for operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
The Company accounts for restricted stock shares awarded at fair value at the date awarded and compensation expense is recorded over the requisite service period that has not been rendered. An award is subject to graded vesting if it vests periodically. The Company recognizes compensation expense on a graded vesting award for the entire award on a straight-line basis over the requisite service period.
Insurance related assessments are accrued in the period in which they have been incurred. A typical obligating event would be the issuance of an insurance policy or the occurrence of a claim. The Company is subject to a variety of assessments. Among such assessments are state guaranty fund’s as well workers’ compensation second injury funds. State guaranty funds assessments are used by state insurance oversight boards to cover losses of policyholders of insolvent insurance companies and for the operating expenses of such agencies. The Company uses estimates derived from state regulators and/or NAIC Tax and Assessments Guidelines.
Lines of business that subject the Company to concentration risk are primarily commercial multiple-peril. For the years ended December 31, 2007, 2006 and 2005, 42%, 44% and 50%, respectively, of gross premiums earned were for commercial multiple-peril.
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements,” (“SFAS No. 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosure about fair value measurements. It applies to other pronouncements that require or permit fair value but does not require any new fair value measurements. The statement defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” SFAS 157 establishes a fair value hierarchy to increase consistency and comparability in fair value measurements and disclosures. The hierarchy is based on the inputs used in valuation and gives the highest priority to quoted prices in active markets. The highest possible level should be used to measure fair value. SFAS 157 is effective for fiscal years beginning after November 15, 2007. The Company does not expect the provisions of SFAS 157 to have a material effect on its consolidated financial condition or results of operations.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-Including an Amendment of SFAS No. 115” (“SFAS No. 159”). This standard permits an entity to choose to measure many financial instruments and certain other items at fair value. Most of the provisions in SFAS No. 159 are elective; however, the amendment to SFAS No. 115 applies to all entities with available-for-sale and trading securities. The FASB’s stated objective in issuing this standard is as follows: “to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused
by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions.” The fair value option established by SFAS No. 159 permits all entities to choose to measure eligible items at fair value at specified election dates. A business entity will report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option: (a) may be applied instrument by instrument, with a few exceptions, such as investments otherwise accounted for by the equity method; (b) is irrevocable (unless a new election date occurs); and (c) is applied only to entire instruments and not to portions of instruments. SFAS No. 159 is effective as of the beginning of the entity’s first fiscal year that begins after November 15, 2007. The Company did not elect to implement the fair value option for eligible financial assets and liabilities as of January 1, 2008.
In June 2007, the FASB issued Emerging Issues Task Force (“EITF”) No. 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards” (“EITF Issue No. 06-11”). EITF Issue No. 06-11 requires that the tax benefit related to dividend equivalents paid on restricted stock, which are expected to vest, be recorded as an increase to additional paid-in capital. The Company currently accounts for this tax benefit as a reduction to income tax expense. EITF Issue No. 06-11 is to be applied prospectively for tax benefits on dividends declared in fiscal years beginning after December 15, 2007, and the Company expects to adopt the provisions of EITF Issue No. 06-11 beginning in the first quarter of 2008. EITF Issue No. 06-11 is not expected to have a material impact on the Company’s consolidated financial condition or results of operations.
The above pro forma results are presented for information purposes only and may not be indicative of the operating results that would have occurred had this acquisition been completed as of the beginning of 2006.
The following unaudited condensed balance sheet presents assets acquired and liabilities assumed with the acquisition of Preserver on April 10, 2007, based on their fair values:
Preserver’s stockholders’ equity on April 10, 2007 was $66.0 million, which includes the purchase price of $64.7 million plus an additional $1.3 million for Tower’s direct transaction costs.
Prior to closing the acquisition of Preserver on April 10, 2007, the Company formulated a plan to terminate a number of employees of Preserver primarily working in the underwriting, operations, and information technology areas and close down Preserver’s Albany branch office. The Company accrued a liability as of the closing date, in accordance with EITF No. 95-3 “Recognition of Liabilities in Connection with a Purchase Business Combination” in the amount of $650,000 representing severance costs, including employee benefits of the terminated employees and lease costs associated with early termination. The planned terminations were substantially completed by the end of 2007 and the accrued liability is $116,000 at December 31, 2007.
Residential mortgage-backed securities include agency and non-agency backed securities with fair values of $99.9 million and $40.0 million, respectively as of December 31, 2007.
Proceeds from the sale and maturity of fixed-maturity securities were $201.3 million, $71.7 million and $38.3 million in 2007, 2006 and 2005, respectively. Proceeds from the sale of equity securities were $24.8 million, $1.0 million, and $2.0 million and in 2007, 2006 and 2005, respectively. The Company’s gross realized gains and losses on investments are summarized as follows:
For 2007, the Company recorded $4.9 million and $5.2 million of impairment write-downs for fixed maturity and equity securities, respectively.
As of December 31, 2007, 221 securities accounted for the gross unrealized losses, none of which are deemed to be OTTI. Significant factors influencing management’s determination that unrealized losses were temporary included the mild severity of the unrealized losses in relation to each securities cost, the nature of the investments and management’s intent and ability to retain the investment for a period of time sufficient to allow for anticipated recovery of fair value to the Company’s cost basis.
The unrealized position associated with the fixed maturity portfolio included $15.1 million in gross unrealized losses, consisting of asset-backed and mortgage-backed securities which representing 72.9%, corporate bonds representing 26.5% and municipal bonds representing 0.6% of the total. The total fixed maturity portfolio gross unrealized losses included 216 securities which were, in aggregate, approximately 2.6% below amortized cost. Of the 216 investments evaluated, 67 have been in an unrealized loss position for more than 12 months. The total unrealized loss on these 67 investments at December 31, 2007 was $3.7 million. The Company evaluated the severity of the impairment in relation to the carrying amount for 182 of the 216 securities referred to above and found it to be between 0.01% and 14.6%. The corresponding unrealized loss was $4.8 million which accounted for 28.4% of the unrealized loss. The 34 remaining investments were impaired between 16.2% and 43.2% of their carrying value. The corresponding unrealized loss on these 34 investments was $10.3 million and accounted for 60.9% of the unrealized loss as of December 31, 2007. The Company considered all relevant factors, including a review of the sub-prime exposure and particularly the length of time the fair value has been below cost, in assessing whether the loss was other-than-temporary. The Company also considered its ability and intent to hold these investments until there is a recovery of fair value to the
Company’s original cost basis, which may be at maturity. As a result, the Company does not consider these investments to be other-than-temporarily impaired.
The carrying value of the Company’s equity investment in CastlePoint as of December 31, 2007 is as follows:
The Company organized and sponsored with an initial investment of $15.0 million on February 6, 2006. On April 4, 2006, CastlePoint raised $249.9 million, net of expenses, in a private placement offering of 27,025,000 unissued shares at $10.00 per share, which reduced the Company’s investment ownership from 100% to 8.6%. The book value per share of the Company’s 2,555,000 shares of CastlePoint common stock increased from $5.87 per share to $8.96 per share as a result of this offering. The carrying value of the Company’s investment in CastlePoint increased from $15.0 million to $22.9 million. The Company has recorded this gain of $7.9 million in income before taxes in accordance with the Securities and Exchange Commission’s Staff Accounting Bulletin (“SAB”) No. 51-Accounting for Sales of Stock by a Subsidiary. The Company recorded a deferred income tax provision of $2.8 million on this transaction.
On April 6, 2006, the Company received a warrant from CastlePoint to purchase an additional 3.7% or 1,127,000 shares of common stock with a fair value of approximately $4.6 million using a Black-Scholes option pricing model. The warrant is exercisable in whole or in part at any time up to April 6, 2016, and the exercise price is $10 per share. Shares acquired through the exercise of the warrant may not be sold prior to April 9, 2009. The warrant was received in exchange for sponsorship services, which included management, operational and industry expertise to establish the CastlePoint organization and prepare for a private placement offering. Accordingly, the Company recognized $4.6 million in income before taxes in the year ending December 31, 2006 relating to non-recurring sponsorship services. The warrant has been recorded as an equity instrument at cost, which was determined to be the fair value of the warrant on the date it was received and will be subject to impairment testing. The Company recorded a deferred income tax provision of $1.6 million on this transaction.
As of December 31, 2007, the aggregate fair value of the Company’s investment in its 2,555,000 shares of CastlePoint common stock listed on the NASDAQ Global Market under the symbol “CPHL” was $30,660,000.
The Company’s Insurance Subsidiaries are 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.
The following table provides an analysis of the reinsurance activity between the Company and CastlePoint Reinsurance for the years ended December 31, 2007 and 2006, respectively:
The traditional program business quota share reinsurance agreement covers program business historically written by the Company. Under this agreement, the Company’s Insurance Subsidiaries cede 50% of the Company’s traditional program business to CastlePoint Reinsurance and share premium revenue and losses in proportion to the parties’ respective quota share of participation. Ceding commissions, which are intended to approximate expenses, are deemed to be approximately 30% of business ceded.
and the Company. Under the first agreement, TICNY will reinsure approximately 85% (which percentage will be adjusted to equal Tower’s actual percentage of the total brokerage business written by the Company and CPIC) of CPIC’s brokerage business losses above a loss ratio of 52.5%. Under the second agreement, CPIC will reinsure approximately 15% (which percentage will be adjusted to equal CastlePoint’s actual percentage of the total brokerage business written by the Company and CPIC) of the Company’s brokerage business losses above a loss ratio 52.5%.The Company paid $0.8 million to CPIC for reinsurance brokerage business written by the Company and received $0.8 million from CPIC for business assumed that was produced by TRM as part of the brokerage business pool.
TRM entered into a management agreement with CPIC effective July 1, 2007 to produce and manage brokerage business on behalf of CPIC. Under this agreement, TRM receives a provisional management fee equal to 34.0% of the subject premium of the business produced by TRM. The amount of the fee is adjusted between 31.0% and 36.0% based on the loss ratio of the business produced. During 2007, TRM produced $83.7 million of premium and earned $26.8 million in direct commission revenue from CPIC. The maximum potential reduction to direct commission revenue is $4.1 million.
Under the service and expense sharing agreements, CPM can purchase from TICNY, and TICNY can purchase from CPM, certain insurance company services, such as claims adjustment, policy administration, technology solutions, underwriting, and risk management services, at cost, and market these services to program underwriting agents on an unbundled basis. The reimbursement for these charges have been recorded as “Other administration revenues” in the Company’s insurance services segment. CPM shares with the Company 50% of the profits and losses generated from marketed services. The Company charged CastlePoint $1.4 million and $0.7 million for such services in 2007 and 2006, respectively.
Effective May 2007, TRM entered into a service agreement with CPM pursuant to which TRM provides to CPM and CPM may provide to TRM insurance company services such as claim adjustment, policy administration, technologies solutions, underwriting and risk management services. Under this agreement
The components of the liability for loss and LAE and related reinsurance recoverables are as follows:
The following table provides a reconciliation of the beginning and ending balances for unpaid losses and LAE for the years ended 2007, 2006 and 2005:
Incurred losses and LAE are net of reinsurance recoveries under reinsurance contracts of $106.8 million, $64.7 million, and $38.6 million in 2007, 2006 and 2005, respectively.
Incurred loss and LAE attributable to insured events of prior years decreased by $1.6 million, $0.7 million and $0.4 million in 2007, 2006 and 2005, respectively. The 2006 decrease of $0.7 million is net of the $1.6 million loss due to the PXRE commutation. Prior year development is based upon numerous estimates by line of business and accident year. During calendar 2007, fire, homeowners, commercial multi peril property, workers’ compensation, and other liability had favorable prior year development that was partially offset by unfavorable development in other lines. During calendar year 2006, fire, homeowners, commercial multi peril liability, workers’ compensation, and auto liability had favorable prior year development that was partially offset by unfavorable development in other lines. No additional premiums or return premiums have been accrued as a result of the prior year effects; however, these charges in estimated losses impact the Company’s sliding scale commission income estimates. The Company’s management continually monitors claims activity to assess the appropriateness of carried case and IBNR reserves, giving consideration to Company and industry trends. See “Note 9-Reinsurance-Commutation and Novation with PXRE Reinsurance Company.”
Loss and loss adjustment expense reserves. The reserving process for loss and loss adjustment expense reserves provides for the Company’s best estimate at a particular point in time of the ultimate unpaid cost of all losses and loss adjustment expenses incurred, including settlement and administration of losses, and is based on facts and circumstances then known and including losses that have been incurred but not yet been reported. The process includes using actuarial methodologies to assist in establishing these estimates, judgments relative to estimates of future claims severity and frequency, the length of time before losses will develop to their ultimate level and the possible changes in the law and other external factors that are often beyond the Company’s control. The methods used to select the estimated loss reserves include the loss ratio projection, incurred loss projection, and the Bornhuetter-Ferguson (B-F) method. 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 loss adjustment expense. The amount of loss and loss adjustment expense reserves for reported claims is based primarily upon a case-by-case evaluation of coverage, liability, injury severity, and any other information considered pertinent to estimating the exposure presented by the claim. The amounts of loss and loss adjustment expense reserves for unreported claims are determined using historical information by line of insurance as adjusted to current conditions. Since our
process produces loss reserves set by management based upon the actuaries’ best estimate, there is no explicit or implicit provision for uncertainty in the carried loss reserves.
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 actuarial methods used by segment have been consistent since the 2003 year-end review. During the year-end review the accident years are split into most recent, first prior and all other accident years. For the 2007 review the most recent accident year is 2007, the first prior is 2006, and all other accident years are 2005 and prior. The table below shows the method used by product line and accident year to select the estimated year-ending loss reserves:
years of $0.4 million and $0.7 million respectively. Excluding the PXRE commutation in 2006 the Company had favorable development of $2.3 million. In 2007, the Company had favorable development in its net losses from prior accident years of $1.6 million.
The paid development, incurred development, the Bornhuetter-Ferguson (B-F) method, and loss ratio projections are the predominant methodologies the Companies actuaries use to project losses and corresponding reserves. Based on these methods the Company’s actuaries determine a best estimate of the loss reserves. All of these methods are standard actuarial approaches and have been used consistently since 2003. The selected development factors within the paid and incurred development methods are derived from the Company’s data while the loss ratio method is used for the most recent accident year when there is high volatility in the development patterns. The B-F method combines the loss ratio method and the loss development method to determine loss reserves by adding an expected development (loss ratio times premium times percent unreported) to the case reserves.
Also, 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 for accident years 2003 and prior is limited although there remains the possibility of adverse development on reported claims. Due to the reserve strengthening in 2002 and close monitoring and analysis of reserves, the Company believes its loss reserves are adequate. This is reflected by the loss development as of December 31, 2007 showing developed redundancies since 2003. However, there are no assurances that future loss development and trends will be consistent with its past loss development history, and so adverse loss reserves development remains a risk factor to the Company’s business.
The Company has automatic treaty capacity of $30.0 million for property risks, $1.0 million/ $2.0 million for liability coverages, $30.0 million for workers’ compensation, $5.0 million for umbrella liability and $100.0 million for equipment breakdown. The Company may offer higher limits through its use of facultative
The following collateral is available to the Company for amounts recoverable from reinsurers as of December 31, 2007 and 2006:
To reduce TICNY’s credit exposure to reinsurance, quota share reinsurance agreements effective October 1, 2003, January 1, 2004 and January 1, 2005 were placed on a “funds withheld” basis. Under these agreements TICNY placed the collected ceded premiums written, net of commissions and the reinsurers margin, in segregated trusts for the benefit of TICNY and the reinsurers. TICNY may withdraw funds for loss adjustment expense payments and commission adjustments. Segregated assets in trust accounts amounted to $40.4 and $54.4 million at December 31, 2007 and 2006 and are included in invested assets. The Company is obliged under the reinsurance agreements to credit reinsurers with an annual effective yield on the monthly balance in
On June 29, 2006, to eliminate its exposure to uncollateralized reinsurance recoverables from PXRE Reinsurance Company (“PXRE”) which had requested the withdrawal of its financial strength and issuer rating from A.M. Best Company, the Company concluded through commutation agreements PXRE’s participation under various reinsurance agreements with TICNY covering the 2001, 2002 and a portion of the 2003 policy periods. Ceded loss and LAE expense recoverables of $20.5 million, ceded paid losses of $2.4 million and ceding commissions receivable of $8.7 million, totaling $31.6 million of unsecured recoverables, were settled with a payment from PXRE of $26.7 million, which represents an estimate of the present value of these recoverables. These transactions resulted in a $4.8 million pre-tax charge, of which $1.6 million was recognized in loss adjustment expenses and $3.2 million was recognized as a reduction to ceding commission income in the second quarter of 2006. In addition, on the same date, novation agreements were executed with PXRE relating to other reinsurance agreements covering business written in 2001, 2002 and 2003 by other insurance companies and managed on their behalf by TRM, the Company’s risk management subsidiary. As a result of the novation, TICNY assumed loss reserves of $12.2 million for which it received as consideration $11.4 million in cash and other assets and TRM recorded a reduction in commission liabilities for $0.2 million, the total of which resulted in a $0.6 million pre-tax charge. As a result of the commutation and novation agreements, which were effective as of June 29, 2006, PXRE is discharged from future obligations under the reinsurance agreements. There are no other agreements outstanding with PXRE.
The Company earns ceding commissions under quota share reinsurance agreements for 2007, 2005 and 2004 based on a sliding scale of commission rates and ultimate treaty year loss ratios on the policies reinsured under each of these agreements. The sliding scale includes minimum and maximum commission rates in relation to specified ultimate loss ratios. The commission rate and ceding commissions earned increase when the estimated ultimate loss ratio decreases and, conversely, the commission rate and ceding commissions earned decrease when the estimated ultimate loss ratio increases.
Based on the amount of ceded premiums earned, the maximum potential reduction to ceding commissions earned related to an increase in the Company’s estimated ultimate loss ratios is $27.4 million for all treaties for all four years. The ceded premiums for the 2003, 2004, 2005 and 2006 treaty years have been fully earned
as of December 31, 2007. As of December 31, 2007, the ceded premium earned and ceded unearned premium reserve for the 2007 treaty year were $67.7 million and $97.5 million, respectively.
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 2007, 2006 and 2005 was ($0.5) million, $1.1 million and ($0.8) million, respectively.
Intangible assets consist of finite and indefinite life assets. Finite life intangible assets include both renewal rights and the agency force book of business. Insurance company licenses are considered indefinite life intangible assets subject to annual impairment testing. The weighted average amortization period of identified intangible assets of finite useful life is 17.6 years as of December 31, 2007.
In 2005, the Company closed on its purchase of the outstanding common stock of a shell property casualty insurance company, North American Lumber Insurance Company (“NALIC”), subsequently renamed Tower National Insurance Company. Prior to the closing, all assets and liabilities (other than insurance licenses) of Tower National Insurance Company were transferred to a liquidating trust. The Company capitalized these purchases as an intangible asset related to state licenses with an indefinite life subject to annual impairment testing. The amount capitalized as of December 31, 2007 and 2006 was $1.2 million and included the purchase price, legal fees and a broker’s fee.
With the acquisition of Preserver on April 10, 2007, the Company recognized $17.3 million of identifiable intangible assets including Preserver’s renewal rights of $1.9 million, its agency force book of business of $10.2 million and insurance company licenses of $5.2 million. The renewal rights and agency force book of business acquired are finite lived assets that will be amortized over ten and twenty years, respectively and are subject to annual impairment testing. The insurance company licenses are included as indefinite lived intangibles subject to annual impairment testing.
During 2007, 2006 and 2005, the Company recorded amortization expense, related to intangibles, of $1.0 million, $0.4 million and $0.4 million, respectively. The estimated aggregate amortization expense for each of the next five years is:
During the third quarter of 2006, the Company relocated its New York City corporate headquarters within the same building. The landlord provided a $4.5 million build-out allowance which partially financed the cost of the leasehold improvements. In 2006 the Company capitalized $22.9 million for the purchase of fixed assets, including $10.4 million for leasehold improvements, $6.1 million for furniture and equipment and $6.4 million for computer hardware and software. The Company also entered into a sale and leaseback of certain furniture and equipment in the amount of $5.2 million on December 29, 2006. The transaction met the requirements to be accounted for as an operating lease.
At our option at par on or after December 21, 2009
At our option at par on or after December 15, 2009
At our option at par on or after September 30, 2008
Total interest expense incurred for all subordinated debentures, including amortization of deferred origination costs, was $8.2 million, $5.3 million and $3.5 million, respectively for the years ended December 31, 2007, 2006 and 2005.
Aggregate scheduled maturities of the subordinated debentures at December 31, 2007 are:
For the year ended December 31, 2007, the Company issued 81,100 new common shares as the result of employee stock option exercises and issued 93,581 new common shares as the result of restricted stock grants. For the year ended December 31, 2006, the Company issued 58,067 new common shares as the result of employee stock option exercises and issued 75,019 new common shares as the result of restricted stock grants.
For the year ended December 31, 2005, the Company issued 32,705 new common shares as the result of employee stock option exercises and issued 13,832 new common shares as the result of restricted stock grants.
The Company declared dividends on common and preferred stock as follows:
As of December 31, 2007, there are 144,580 shares of common stock options outstanding that are fully vested. With the adoption of the 2004 Long-Term Incentive Compensation Plan, no further awards may be granted under the 2001 Stock Award Plan.
In May 2004, the Company’s Board of Directors authorized the issuance of 131,888 shares of restricted Common Stock to the President and Chief Executive Officer and 8,793 shares of restricted Common Stock to the Senior Vice President, Chief Financial Officer and Treasurer. The shares vest in installments over a varying period from one to four years from the date of grant contingent upon continuous employment with the Company from the date of grant through the vesting date. During the vesting period, the recipients have voting
The total intrinsic value of restricted stock vesting during the years ended December 31, 2007, 2006 and 2005 was $2.1 million, $1.8 million and $0.7 million, respectively. The intrinsic value of unvested restricted stock outstanding as of December 31, 2007 is $6.5 million.
Changes in restricted stock for the three years ended December 31, 2007 were as follows:
The following table provides an analysis of stock option activity during the three years ended December 31, 2007.
The Company adopted the provision of SFAS No. 123(R) effective January 1, 2006 and has elected the modified prospective application method and is expensing all unvested stock options outstanding as of January 1, 2006. The compensation expense is recognized over the requisite service period that has not been rendered and is based upon the original grant date fair value of the award as calculated for recognition of the pro forma disclosure under SFAS No. 123(R).
Compensation expense net of tax recorded related to stock options was $67,700 and $62,800 for 2007 and 2006, respectively, and has been included in net income.
The total intrinsic value of stock options exercised during the years ended December 31, 2007, 2006 and 2005 was $2.4 million, $1.4 million and $0.4 million, respectively. The intrinsic value of stock options outstanding as of December 31, 2007 is $7.2 million of which $6.0 million is related to vested options.
Prior to the adoption of SFAS No. 123(R), the Company followed the intrinsic value method in accordance with APB 25 to account for employee stock options and accordingly recognized no compensation expense for the stock option grants. In accordance with SFAS No. 123(R), the Company adopted the provisions of the statement on January 1, 2006 using the modified prospective application method. Under this method, prior periods are not restated. Had compensation cost for share-based plans been determined consistent with FAS No. 123(R), the Company’s net earnings and earnings per share for the year ended December 31, 2005 would have been the following pro-forma amounts:
The Company maintains a defined contribution Employee Pretax Savings Plan (401(k) Plan) for its employees. The Company matches 50% of each participant’s contribution up to 8% of the participant’s contribution. The Company incurred approximately $1.0 million, $0.8 million and $0.6 million of expense in 2007, 2006 and 2005, respectively, related to the 401(k) Plan.
The Company has various lease agreements for office space and equipment. The terms of the office space lease agreements provide for annual rental increases and certain lease incentives including initial free rent periods and cash allowances for leasehold improvements. The Company amortizes scheduled annual rental increases and lease incentives ratably over the term of the lease. The difference between rent cash payments and recognized rent expense is recorded as deferred rent. The Company’s future minimum lease payments are as follows:
Total rental expense charged to operations was approximately $4.3 million, $3.8 million, and $2.3 million in 2007, 2006 and 2005, respectively.
For regulatory purposes, the Company’s insurance company subsidiaries prepare their statutory basis financial statements in accordance with practices prescribed or permitted by the state they are domiciled in (“statutory basis” or “SAP”). The more significant SAP variances from GAAP are as follows:
State insurance laws restrict the ability of our insurance company subsidiaries to declare dividends. State insurance regulators require insurance companies to maintain specified levels of statutory capital and surplus. Generally, dividends may only be paid out of earned surplus, and the amount of an insurer’s surplus following payment of any dividends must be reasonable in relation to the insurer’s outstanding liabilities and adequate to meet its financial needs. Further, prior approval of the insurance department of its state of domicile is required before any of our insurance company subsidiaries can declare and pay an “extraordinary dividend” to the Company.
For the years ended December 31, 2007, 2006 and 2005, the Company’s insurance company subsidiaries had reported statutory basis net income/ (loss) of $43.6 million, $20.5 million and $6.4 million, respectively. At December 31, 2007 and 2006 the Company’s insurance company subsidiaries had reported statutory basis surplus as regards policyholders of $293.2 million, and $210.4 million, respectively, as filed with the insurance regulators.
not recognized in the balance sheet, for which it is practicable to estimate fair value. The company uses the following methods and assumptions in estimating its fair value disclosures for financial instruments:
Investment in unconsolidated affiliate-Investment in unconsolidated affiliates is an investment in related parties; and is reported using the equity method. As of December 31, 2007 the aggregate fair value of the Company’s investment in the common stock of CastlePoint Holdings Ltd. was $30.7 million.
In the insurance segment, the Insurance Subsidiaries provide commercial and personal lines insurance policies to businesses and individuals. The Insurance Subsidiaries commercial lines products include commercial multiple-peril, monoline general liability, commercial umbrella, monoline property, workers’ compensation and commercial automobile policies. Its personal lines products consist of homeowners, dwelling and other liability policies.
The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates segment performance based on segment profit, which excludes investment income, realized gains and losses, interest expenses, income taxes and incidental corporate expenses. The Company does not allocate assets to segments because assets, which consist primarily of investments and fixed assets, are considered in total by management for decision making purposes.