The selected consolidated income statement data for the years ended December 31, 2006, 2005 and 2004 and the balance sheet data as of December 31, 2006 and 2005 are derived from our audited financial statements included elsewhere in this document, which have been prepared in accordance with GAAP and have been audited by Johnson Lambert & Co., our independent registered public accounting firm. You should read the following selected consolidated financial information along with the information contained in this document, including “
We provide a broad range of property and casualty insurance products as well as reinsurance through TICNY and TNIC, our insurance company subsidiaries. We also provide managing general underwriting, claims 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).
On June 28, 2006, we closed on our purchase of 100% of the outstanding common stock of a shell insurance company, MIIX Insurance Company of New York, which was renamed Tower Indemnity
On April 6, 2006, we 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, we recognized $4.6 million in income before taxes in the twelve
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 8.6% investment in CastlePoint using the equity method of accounting as we exercise significant influence over CastlePoint. We have the same CEO as CastlePoint. Through our two insurance subsidiaries, TICNY and TNIC, we entered into three, multi-year quota share reinsurance agreements with CastlePoint Reinsurance, which were effective April 4, 2006, and a service and expense sharing agreement whereby our staff provides CastlePoint administrative and underwriting services at cost. In connection with the sale of perpetual preferred stock to CastlePoint in December 2006, the brokerage insurance business quota share agreement with CastlePoint was extended for an additional year beyond the original three year term. Through our strategic relationship with CastlePoint in 2006, we have reduced the risk of relying on other reinsurance and issuing companies and will be able to maintain and strengthen our business model as well as pursue our growth plans. Through reinsurance and pooling, we plan to transfer approximately 49% of our total premiums written and produced to CastlePoint’s reinsurance and insurance company subsidiaries in order to generate commission and fee income. We will continue to maintain the operational infrastructure that will market, originate, underwrite and service the total premiums written and produced.
Our insurance companies entered into a service and expense sharing agreement with CastlePoint, pursuant to which they will provide insurance company services now offered by us, such as claims adjustment, policy administration, technology solutions, underwriting, and risk management services, to the U.S. domiciled insurance subsidiaries of CastlePoint, as well as to companies appointed as managing general underwriters by those companies. We charged CastlePoint $0.7 million for such services for the nine months ended December 31, 2006, which have been recorded as other administration revenue in our insurance services segment.
Effective April 4, 2006, we novated business assumed from the Accident Insurance Company by TICNY to CastlePoint Reinsurance. TICNY recorded $0.1 million as ceded premiums written and earned and eliminated liabilities of $0.1 million, which was recorded as a reduction to losses incurred during the three months ending June 30, 2006.
On November 13, 2006, we entered into the Preferred 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. See “Item 1.-Strategic Relationship and Agreements with CastlePoint.” The perpetual preferred stock was redeemed in full on January 26, 2007.
On November 13, 2006, we signed an agreement to acquire Preserver Group, Inc. (“Preserver”) for a base purchase price of $68.3 million (approximately $64.8 million after deduction for expenses incurred by Preserver, net of tax). A portion of the purchase price paid will be used to redeem $30.8 million of debt to Preserver’s shareholders at closing. In addition, $12 million of Preserver’s trust preferred securities will remain outstanding. Preserver is a privately-held company that offers products similar to ours in the Northeast, particularly in New Jersey, Maine and Massachusetts. Preserver’s gross written premiums were $88.6 million in 2005 and $86.4 million for 2006. Preserver is rated “B++” (Good) by A.M. Best. On December 7, 2006, A.M. Best placed the ratings of Preserver under review with positive implications. We believe this transaction will accelerate our regional expansion by allowing us to access Preserver’s approximately 300 agents that produce business in various Northeastern states. The acquisition is subject to regulatory approvals and is expected to close in the second quarter of 2007. See “Item 1. - Acquisition of Preserver.”
trend, is characterized by reduced competition that results in higher pricing, reduced coverage terms and lower commissions paid to acquire business.
Beginning in late 2004 and in the first half of 2005, segments of both the reinsurance and commercial lines market started to exhibit signs of a softening market. The market softening was slowed by the effects of hurricanes Katrina, Rita and Wilma. According to A.M. Best, these catastrophic hurricanes in the Gulf States caused an estimated $60 billion of insured losses for the insurance and reinsurance industries and triggered the raising of an estimated $20 billion of new reinsurance capital or capacity in 2005.
A.M. Best believes that in 2006 the insurance industry will post record earnings due, in part, to modest catastrophic activity and favorable frequency and severity trends. Although soft market conditions prevailed in some lines and segments, underwriting remained generally prudent with personal lines experiencing strong overall results.
Our gross premiums written in 2006, 2005 and 2004 were $432.6 million, $300.1 million and $177.8 million, respectively. Premiums produced by TRM in 2006, 2005 and 2004 were $12.9 million, $35.2 million and $53.4 million, respectively.
Direct commission revenues and fees. Direct commission revenues and fees consist of commissions earned by TRM on premiums produced by its managing general agency and fees earned from its claims administration, other administration services and reinsurance intermediary services. It also includes policy billing fees that we earn in the course of collecting premiums from our policyholders. This fee is charged primarily on small policies written through our insurance segment.
Losses and loss adjustment expenses. We establish loss and loss adjustment expense reserves in an amount equal to our estimate of the ultimate liability for claims under our insurance policies and the cost
· Interest expense. We pay interest on our loans, on subordinated debentures and on segregated assets placed in trust accounts on a “funds withheld” basis in order to collateralize reinsurance recoverables. In addition, interest expense includes amortization of any debt issuance costs over the remaining term of our subordinated debentures.
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 TICNY and TNIC’s net premiums earned. On a consolidated basis, we measure profitability in terms of net income and return on average equity.
Loss ratio. The loss ratio is the ratio of losses and loss adjustment expenses incurred to premiums earned and measures the underwriting profitability of a company’s insurance business. We measure our loss ratio on a gross (before reinsurance), and net basis (after reinsurance) as well as the loss ratio on the ceded portion (the difference between gross and net premium) for our insurance and reinsurance segments. We use the gross loss ratio as a measure of the overall underwriting profitability of the insurance business we write and to assess the adequacy of our pricing. We use the ceded loss ratio to measure the experience on the premiums that we cede to reinsurers, including the premiums ceded under our quota share treaties. Beginning in 2001, the loss ratio on such ceded business has determined the ceding commission rate that we earn on ceded premiums. Our net loss ratio is meaningful in evaluating our financial results, which are net of ceded reinsurance, as reflected in our consolidated financial statements. In addition, we use accident year and calendar year loss ratios to measure our underwriting profitability. An accident year loss ratio measures losses and loss adjustment expenses for insured events occurring in a particular year, regardless of when they are reported, as a percentage of premium earned during that year. A calendar year loss ratio measures losses and loss adjustment expense for insured events occurring during a particular year and the changes in estimates in loss reserves from prior accident years as a percentage of premiums earned during that year.
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.
Loss and loss adjustment expense reserves. The reserving process for loss adjustment expense reserves provides for our best estimate at a particular point in time of the ultimate unpaid cost of all losses and loss adjustment expenses incurred, including settlement and administration of losses, and is based on facts and circumstances then known and including losses that have been incurred but not yet been reported. The process includes using actuarial methodologies to assist in establishing these estimates, judgments relative to estimates of future claims severity and frequency, the length of time before losses will develop to their ultimate level and the possible changes in the law and other external factors that are often beyond our control. The methods used to select the estimated loss reserves include the loss ratio projection, incurred loss projection, and the Bornhuetter-Ferguson (B-F) method. The methods are described in “Business-Loss and Loss Adjustment Expense Reserves.” 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.
Our data has sufficient credibility to base development factors on our own data. The loss development factors are reviewed annually. There have only been minor changes in selected loss development factors since 2003. The chart below shows the number of years by segment when we expect 50%, 90% and 99% of losses to be reported for a given accident year:
The Company has made only minor changes to the key assumptions used during the last three annual reserve estimates.
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
Reinsurance recoverables. Reinsurance recoverable balances are established for the portion of the loss reserves that are ceded to reinsurers. Prepaid reinsurance premiums represent unearned premiums that are ceded to reinsurers. 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 loss adjustment expense reserves affect the estimates of the amount of ceded reinsurance recoverables. We continually monitor the financial condition and rating agency ratings of our reinsurers. Non-admitted reinsurers are required to collateralize their share of unearned premium and loss reserves either by placing funds in a trust account meeting the requirements of New York 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 2006, CastlePoint Reinsurance collateralized its net exposure with a New York Regulation 114 compliant trust account.
Deferred acquisition costs/commission revenues. We defer certain expenses and commission revenues related to producing and reinsuring insurance business, including commission expense on gross premiums written, commission income on ceded premiums written, premium taxes and certain other costs related to the acquisition of insurance contracts. These costs and revenues are capitalized and the resulting asset or liability, deferred acquisition costs/revenues, is amortized and charged to expense or income in future periods as gross premiums written are earned. The method followed in computing deferred acquisition costs/income limits the amount of such deferred amounts to its estimated realizable value. The ultimate recoverability of deferred acquisition costs is dependent on the continued profitability of our insurance underwriting. We also consider anticipated invested income in determining the recoverability of these costs. If our insurance underwriting ceases to be profitable, we may have to write-off a portion of our deferred acquisition costs, resulting in a further charge to income in the period in which the underwriting losses are recognized.
During 2006 a number of significant events affected the consolidated results of operations. We executed commutation and novation agreements between us and PXRE in order to eliminate our exposure to uncollateralized reinsurance recoverables from PXRE. We recorded a net charge as a result of these agreements of $5.5 million. In addition, we realized gains on our investment in CastlePoint as result of CastlePoint’s sale of unissued CastlePoint shares in a private offering, which resulted in a $7.9 million gain. We also received a warrant to purchase additional CastlePoint shares which was valued at $4.6 million resulting in additional income in that amount, in exchange for sponsorship services, which included management, organizational and industry expertise. Lastly, we entered into three multi-year quota share reinsurance agreements and a service and expense agreement with CastlePoint. Since we did not place quota share reinsurance in the first quarter of 2006, pending the formation of CastlePoint Reinsurance, we ceded $40.9 million of unearned premiums to CastlePoint Reinsurance as of April 1, 2006. In addition we completed our acquisition of MIIX Insurance Company of New York which we renamed Tower Indemnity Company of America. In October 2006, the Company entered into an agreement to sell all of the issued and outstanding capital stock of TICA to Castle Point for a cash purchase price of $350,000 plus an amount equal to the value of the statutory surplus of TICA at closing. Following the closing of the TICA transaction which occurred on December 4, 2006 CastlePoint renamed TICA “CastlePoint Insurance Company.” In December 2006, we issued 40,000 shares of perpetual preferred stock for $40.0 million less $0.4 million of issuance costs. On January 26, 2007 the perpetual preferred stock was redeemed in full.
Commission and fee income. Total commission and fee income increased by 29.9% to $52.2 million in 2006 compared to $40.2 million in 2005. This was due to the increase in the ceding commission revenue earned as a result of the overall increase in ceded premiums earned as discussed above. In addition commission and fee income includes other administration revenue of $0.7 million from services provided to and reimbursed by CastlePoint. This increase was offset in part by a reduction in fee income in our insurance services segment as more policies previously produced in that segment were written in our insurance segment. Additionally, as a result of the commutation agreements with PXRE, we recorded a charge (reduction) of $3.2 million to ceding commissions representing the difference between the carried amount of commissions due from PXRE and the amount received at an estimated present value. For 2006 the change in estimated sliding scale commission rate for commissions earned in prior periods in both the insurance segment and the insurance services segment resulted in a net increase of $1.9 million of commission and fee income compared to a reduction of $1.2 million in 2005.
The decrease in the gross and net loss ratios, excluding the effect of the PXRE transactions, for 2006 compared to 2005 was primarily due to lower than expected loss emergence for the property lines for the 2005 and 2006 accident years. However the decrease in the net loss ratio, excluding the effect of PXRE, was offset, in part, by the increase in the catastrophe reinsurance premiums ceded. Also, during 2006, prior accident years’ net loss reserves developed favorably to the extent of $2.3 million. The $1.6 million charge related to the PXRE commutation affected prior accident years’ reserves. Accordingly the net favorable development on prior year’s reserves was $0.7 million. There was favorable development from prior years’ loss reserves on a net basis of approximately $0.4 million in 2005. See “Item 7.-Insurance Service Segment Results of Operations” and “Item 7.-Reinsurance Segment Results if Operations” for further discussion.
Interest expense. Our interest expense increased for 2006 to $6.9 million compared to $4.9 million in 2005. The increase resulted from $1.3 million of interest expense from the $20.6 million of subordinated debentures issued on March 31, 2006, $0.4 million resulting from an increase in interest rates on the floating rate portions of our subordinated debentures and $0.3 million as a result of crediting reinsurers on funds withheld in segregated trusts as collateral for reinsurance recoverables.
Total revenues. Total revenues increased by 104.1% to $219.8 million for 2005 compared to $107.7 million in 2004. The increase is primarily due to the increase in net premiums earned and net investment income. Net premiums earned represented 74.8% of total revenues for 2005 compared to 42.3% for the same period in 2004. Net investment income, excluding realized capital gains, represented 6.8% and 4.7% of total revenues for 2005 and, 2004, respectively. These increases were partially offset by lower total
commission and fee income for 2005 of $40.2 million, or 18.3% of total revenue, compared to $57.0 million, or 53.0% of total revenue, for the same period in 2004.
Premiums earned. Net premiums earned increased by 260.9% to $164.4 million in 2005 compared to $45.6 million in 2004. The increase in net premiums earned was due to the overall increase in gross premiums written through December 31, 2005 and a reduced ceding percentage under our quota share reinsurance agreement from 60% to 25% beginning October 1, 2004 which was maintained throughout 2005. In addition, the net premiums earned in 2005 included all of the $13.1 million of unearned premiums as of December 31, 2004 that would have been ceded to Converium Reinsurance (North America) Inc. absent a novation of our reinsurance agreement in 2004. See “Item 7.-Insurance Segment Results of Operations” and “Item 7.-Reinsurance Segment Results of Operations” for further discussion of premiums.
Operating expenses. Operating expenses increased by 37.7% to $86.5 million in 2005 from $62.8 million in 2004. The increase was due primarily to the increase in underwriting expenses resulting from the growth in premiums earned in TICNY, costs related to the OneBeacon transaction, including establishing two new offices in Long Island and Western New York, additional staffing, compliance expenses incurred as a public company and an increase in insurance regulatory assessments.
Interest expense. Our interest expense was $4.9 million in 2005 compared to $3.1 million in 2004. The increase resulted from an increase in interest expense of $2.0 million on subordinated debentures underlying our trust preferred securities of $47.4 million of which $26.8 million were issued in December 2004 and $0.3 million credited to reinsurers on funds withheld in segregated trusts as collateral for reinsurance recoverables. This increase was offset by reductions of $0.6 million of interest expense on other borrowings and preferred stock repaid in the fourth quarter of 2004.
Net income and return on average common equity. Our net income and return on average common equity was $20.8 million and 15.1%, respectively, for 2005 compared to $9.0 million and 23.7%, respectively, in 2004. Although net income increased 129.9% in 2005 compared to 2004, the lower return on average equity resulted from the significant increase in average stockholders’ equity as our IPO and concurrent private placement were completed in the fourth quarter of 2004. For 2005, the return was calculated by dividing net income of $20.8 million by an average stockholders’ equity of $137.1 million. For 2004, the return was calculated by dividing net income of $9.0 million by an average stockholders’ equity of $38.1 million.
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 written during 2006 through former OneBeacon producers that we appointed in connection with the 2004 renewal rights transaction amounted to $21.5 million compared to $17.3 million in 2005.
Net premiums. Net premiums written increased by 4.9% to $220.8 million for, 2006 compared to $210.4 million for 2005 notwithstanding the 36.7% increase in gross premiums written. This was due to the increased ceded premiums written as described above.
Ceding commission revenue. Ceding commission revenue increased by 71.0% to $43.1 million for 2006 compared to $25.2 million for 2005 due to the 90.2% increase in ceded premiums earned offset, in part, by a lower quota share ceding commission rate of 34% as compared to a ceding commission rate of 41% in 2005. Also, as a result of the commutation agreements with PXRE, we recorded a charge of $3.2 million to ceding commission revenue in 2006. Ceding commission revenue increased by $1.1 million in 2006 as a result of an improvement in the ceded loss ratios on prior years’ quota share treaties compared to a decrease of $0.8 as a result of deterioration in the ceded loss ratios on prior years’ quota share treaties in 2005.
Loss and loss adjustment expenses and loss ratio. Gross and net losses and loss adjustment expenses were $182.9 million and $118.0 million, respectively, for 2006 compared with $134.8 million and $95.7 million, respectively, for 2005. Our gross loss ratio was 53.2% for 2006 as compared with 57.1% for 2005. The net loss ratio was 57.6% for the 2006 and reflected the $1.6 million charge resulting from the commutation agreement with PXRE referred to previously. The effect of the commutation added 0.7% percentage point to the net loss ratio in 2006. The net loss ratio was 58.7% in the same period of 2005. The decrease in the gross and net loss ratios, excluding the impact of PXRE, for 2006 compared to 2005 was
primarily due to lower than expected loss emergence for the property lines for the 2006 accident year compared to 2005. However the decrease in the net loss ratio, excluding the impact of PXRE, was offset, in part, by the significant increase in the amount of catastrophe reinsurance premiums ceded which reduced net earned premiums thereby increasing the net loss ratio. We ceded catastrophe reinsurance premiums equal to 5.0% of net premiums earned during 2006 as compared to 2.5% in 2005. During 2006, prior accident years’ loss reserves developed favorably to the extent of $2.3 million excluding the $1.6 million loss related to the commutation with PXRE, resulting in net favorable development of $1.0 million. There was favorable development from prior years’ loss reserves on a net basis of approximately $0.4 million in 2005.
The underwriting expense portion of the gross expense ratio was 13.0% for 2006 as compared to 14.6% for 2005. Although underwriting expenses increased due to the growth in premium volume, the gross ratio declined as gross premiums earned increased more rapidly than underwriting expenses.
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% for 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% for 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.
amounted to $31.4 million during 2005 compared to $2.4 million in 2004. New business written during 2005 through former OneBeacon producers that we appointed in connection with the renewal rights transaction amounted to $17.3 million compared to $2.6 million in 2004. Also, due to the upgrade in TICNY’s rating from A.M. Best to “A-” (Excellent) from “B++” (Good), certain policies in the more rating sensitive large lines and middle market programs in our Insurance Services Segment were renewed in our Insurance Segment.
Net premiums. Net premiums written increased by 117.9% to $210.4 million in 2005 compared to $96.6 million in 2004. Net premiums earned in 2005 increased by 266.7% to $162.9 million compared to $44.4 million in 2004. Net premiums earned in 2005 included the entire $13.1 million of retained unearned premiums as of December 31, 2004 that would have been ceded to Converium absent a novation of the reinsurance agreement in 2004. These percentage increases were greater than the percentage increase in gross premiums written and earned due to the decrease in the ceding percentage from 60% in the first nine months of 2004 to 25% beginning October 1, 2004 and continuing throughout 2005.
Loss and loss adjustment expenses and loss ratio. Gross and net losses and loss adjustment expenses were $134.8 million and $95.7 million, respectively, for 2005 compared with $84.8 million and $27.8 million, respectively, in 2004. Our gross and net loss ratios were 57.1% and 58.7%, respectively for 2005 as compared with 56.1% and 62.5%, respectively, in 2004. The decrease in the net loss ratio in 2005 compared to 2004 resulted from the increase in net premiums earned which reduced the effect of catastrophe reinsurance premiums on the net loss ratio. We ceded catastrophe reinsurance premiums equal to 2.5% of net premiums earned during 2005 compared to 8.6% during the same period in 2004. There was favorable development from prior years’ loss reserves on both a gross and net basis of approximately $461,000 and $392,000, respectively, in 2005. There was $568,000 adverse development from prior years’ loss reserves on a net basis in 2004. Loss and loss adjustment expenses are net of reimbursements for loss adjustment expenses made by TRM pursuant to the expense sharing arrangement between TICNY and TRM. See “Item 7.-Insurance Services Segment Results of Operations” for the amounts of loss and loss adjustment expense reimbursements.
The commission portion of the gross expense ratio, which expresses direct commission expense paid to our producers as a percentage of gross premiums earned, was 16.4% in 2005, compared to 16.8% in 2004. This decrease was due primarily to the lower commission on large lines and middle market programs written in the Insurance Segment that were previously placed through the insurance services segment. This decrease was offset in part by an increase in producer contingent commission expense.
Underwriting profit and combined ratio. The underwriting profit, which reflects our underwriting results on a net basis after the effects of reinsurance, was $19.3 million in 2005 and $9.5 million in 2004. The gross combined ratio was 88.1% in 2005 as compared with 87.3% in 2004. The increase in the gross combined ratio in 2005 resulted from an increase in the gross loss ratio. The net combined ratio was 88.1% in 2005 as compared to 78.6% in 2004. The increase in the net combined ratio resulted from an increase in the net expense ratio primarily due to the effects of reduced ceding commission revenue. Notwithstanding the increase in the net combined ratio in 2005, underwriting profit increased due to the overall increase in net premiums earned.
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 having entered into 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 for 2006 from $1.7 million in 2005 due to the significant increase in gross premiums written and 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
Underwriting expenses and underwriting expense ratio. Gross underwriting expenses increased for 2006 to $3.7 million as compared to $0.2 million in 2005. Our net underwriting expense ratio increased to 19.0% for 2006 from 12.4% in 2005. These increases resulted from approximately a 34% to 35% ceding commission paid to issuing carriers. In 2005, this segment assumed premiums on an excess of loss basis which did not result in a ceding commission payment. Additionally, the increase in gross premiums written resulted in an increase in the allocated share of other underwriting expenses to this segment. The gross and net underwriting expense ratios were 18.9% and 19.0%, respectively, for 2006 compared to 11.4% and 12.4%, respectively, in 2005. The PXRE novation added $11.4 million of additional gross and net premiums earned but did not include any commission expense and thus lowered the gross and net expense ratios. 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, for 2006.
Gross premiums. Gross premiums written decreased by 8.5% to $1.5 million in 2005 as compared to $1.6 million in 2004. This was due to the decrease in the premiums produced by TRM for its issuing companies, primarily due to certain policies in the more rating sensitive middle market and large lines programs renewing in the insurance segment offset in part by higher premium rates.
Loss and loss adjustment expenses and loss ratio. Gross loss and loss adjustment expenses were $0.4 million in 2005 as compared to benefit of $0.7 million in 2004. Net losses were $0.9 million for 2005 as compared to benefit of $0.7 million in 2004. The gross and net loss ratios in 2005 were 24.7% and 59.9%, respectively compared to a negative 52.0% and a negative 60.9% in 2004. The 2005 gross loss and loss adjustment expenses were reduced by a favorable prior year loss reserve development of $0.5 million. This was outweighed, however, by a higher gross loss ratio on current accident year assumed business and the release of ceded reserves from prior years’ resulting in an increase in the 2005 net loss ratio compared to 2004. The improvement in the loss ratios in 2004 resulted from the full conversion of the current treaties to an aggregate excess of loss basis with improved pricing on the current treaties, improvement in the loss experience of the underlying business and favorable development of prior years’ gross and net reserves of $0.7 million.
Underwriting expenses and underwriting expense ratio. Underwriting expenses for the reinsurance segment are comprised of ceding commission expense paid to TRM’s issuing companies and other third-party reinsurers to acquire the ceded premium and this segment’s allocated share of our other underwriting expenses. Gross underwriting expenses decreased in 2005 to $189,000 as compared to $248,000 in 2004. Our net underwriting expense ratio decreased to 12.4% for 2005 from 21.8% in 2004. The decrease in both the gross and net underwriting expense ratios was due to lower ceding commission expenses as a smaller portion of the premiums earned require a commission payment and lower other underwriting expenses due to the reduced allocation of expenses to the reinsurance segment.
(1) The other administration revenue includes amounts reimbursed by CastlePoint Reinsurance for services rendered pursuant to a service and expense sharing agreement.
Total revenues. Total revenues for the insurance services segment were $8.0 million for 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 for 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 for 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.
For the twelve months of 2006, direct commission revenues decreased as compared to last year as a result of the 63.3% decrease in premiums produced by TRM to $12.9 million from $35.2 million as more policies previously produced in insurance services segment were renewed in the insurance segment. In addition there was an increase in commission revenue of $0.8 million in 2006 as a result of favorable loss development on the premiums produced in prior years, compared to a reduction of commission income of $0.4 million in 2005 resulting from unfavorable loss development on premiums produced in periods prior to 2005. As a result of the PXRE novation, TRM recognized $0.2 million of direct commission revenue.
commission rate as compared to 2005 when there was a larger proportion of policies with larger premiums and lower commission rates.
Claims expense reimbursement. The amount of reimbursement by TRM for claims administration pursuant to the terms of the expense sharing agreement with TICNY in 2006 was $3.2 million as compared to $4.3 million in 2005 due to a decrease in the number of claims handled.
Total revenues. Total revenues for the insurance services segment were $14.1 million in 2005 as compared with $16.4 million in 2004. The decrease in total revenues was primarily due to a 20.8% reduction in direct commission revenue to $9.1 million in 2005 compared to $11.5 million in 2004 and to a 5.8% decrease in reinsurance intermediary fees to $688,000 in 2005, compared to $730,000 in 2004 due to the reduction in the quota share treaty ceding percentages. Claims administration revenue increased by 4.0% to $4.3 million in 2005 as compared to $4.1 million in 2004. Premiums produced during 2005 on business subject to the renewal rights agreement with OneBeacon amounted to $5.1 million compared to $0.8 million in 2004. New business produced through former OneBeacon producers that we appointed in connection with the renewal rights transaction amounted to $1.5 million in 2005 compared to $0.7 million in 2004.
For 2005 the decrease in direct commission revenues resulted from a 34.2% decrease in premiums produced by TRM as certain policies were renewed in the Insurance Segment and a reduction in commission income of $397,000 resulting from unfavorable loss development on the premiums produced in prior years compared to an increase in commission income of $187,000 in 2004 from favorable loss development on the premiums produced in prior years. The composite commission revenue rate increased to 27.1% in 2005 compared to 21.3% in 2004 due to the greater mix of premiums produced in the small and middle market programs that carry a higher commission rate.
TNIC may not pay any dividend that, together with all dividends declared or distributed by TNIC during the preceding twelve months, excluding pro rata distributions of any class of the TNIC’s own securities, exceeds the greater of (1) 10% of TNIC’s policyholders’ surplus as of the end of the preceding calendar year or (2) TNIC’s net income for the next preceding calendar year, until thirty days after the Massachusetts Commissioner of Insurance has received notice of the intended dividend and not objected in such time. As of December 31, 2006, the maximum amount of distributions that TNIC could pay to its parent without approval of the Massachusetts Commissioner of Insurance was $89,000.
Pursuant to a Tax Allocation Agreement, by and among Tower, TICNY, TNIC, TICA and TRM, we compute and pay Federal income taxes on a consolidated basis. TICA will file a short year tax return in
In March 2006, we issued $20 million of subordinated debentures and in December 2006, we issued 40,000 shares of perpetual preferred stock for $39.6 million, net of issuance costs.
TICNY and TNIC are required by law to maintain a certain minimum level of policyholders’ surplus on a statutory basis. Policyholders’ surplus is calculated by subtracting total liabilities from total assets. The NAIC maintains risk based capital (“RBC”) requirements for property and casualty insurance companies. RBC is a formula that attempts to evaluate the adequacy of statutory capital and surplus in relation to investments and insurance risks. The formula is designed to allow the state insurance departments to identify potential weakly capitalized companies. Under the formula, a company determines its “risk-based capital” by taking into account certain risks related to the insurer’s assets (including risks related to its investment portfolio and ceded reinsurance) and the insurer’s liabilities (including underwriting risks related to the nature and experience of its insurance business). Applying the RBC requirements as of December 31, 2006, TICNY’s and TNIC’s risk-based capital exceeded the minimum level that would trigger regulatory attention. In addition to monitoring RBC to ensure regulatory compliance, we monitor various financial ratios, including gross and net premiums written to surplus ratios. There were capital contributions to TICNY of $49.6 in 2006 and none in 2005. In June 2005, we contributed $10.0 million in cash to TNIC and an additional $1.3 million for the state insurance licenses we acquired as part of the 2005 purchase of a shell insurance company that was renamed TNIC.
The statutory surplus that we are required to maintain varies depending on the type and amount of revenue that is derived. The statutory surplus requirements are based upon various capital adequacy tests and ratios established by rating agencies and insurance regulators. Statutory surplus requirements are greater for net premiums earned and retained than for premiums that we cede or transfer to reinsurers. Non-risk bearing revenues that are generated primarily from TRM do not require us to maintain any surplus, except capital necessary to meet TRM’s operating expenses. For these reasons, throughout our history before the October 2004 IPO, we attempted to reduce our statutory surplus requirement by limiting our net retention of premiums while emphasizing ceding commissions and non-risk bearing revenues from TRM.
For 2006 we had $131.8 million of net cash flows used in investing activities that were funded from operating cash flow compared to $143.3 million in 2005. During 2006, the Company capitalized $22.9 million for the purchase of fixed assets and entered into a sale leaseback on $5.2 million of these assets. The Company relocated its New York City corporate headquarters within the same building during 2006. The Company capitalized $10.4 million for leasehold improvements, $6.1 million for furniture & equipment and $6.4 million for computer hardware and software in 2006. The landlord provided a $4.8 million build-out allowance which partly financed the $10.4 million of leasehold improvements. In addition, we had net purchases in our fixed-maturity securities for $83.4 million and net purchases in our equity investments for $16.6 million in 2006. In addition, during 2006 we invested $14.4 million to start up CastlePoint.
On January 26, 2007 we closed on our sale of 2,704,000 shares of common stock at an offering price of $31.25 per share. Our gross proceeds of $84.5 million were reduced by $4.2 million for the underwriters discount and $1.0 million for other offering expenses which left us approximately $79.3 million of new proceeds. We used $20.0 million of these net proceeds to redeem our remaining $20.0 million of perpetual preferred stock. As of January 26, 2007 all of our perpetual preferred stock was fully redeemed.
The gross loss reserves payments due by period in the table above are based upon the loss and loss expense reserves estimates as of December 31, 2006 and actuarial estimates of expected payout patterns by line of business. As a result, our calculation of loss reserve payments due by period is subject to the same uncertainties associated with determining the level of reserves and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. The projected gross loss payments presented do not include the estimated ceded reserves recoverable from reinsurers that amounted to $110.0 million which are estimated to be recovered as follows: less than one year, $25.8 million; one to three years, $42.6 million; four to five years, $25.5 million; and after five years, $16.2 million. The interest on the subordinated debentures is calculated using interest rates in effect at December 31, 2006 for variable rate debentures.
On March 31, 2006, we participated in a private placement of $20.0 million of fixed /floating rate capital securities (the “Trust Preferred Securities”) issued by Tower Group Statutory Trust V (the “Trust”), an affiliated Delaware trust formed on March 29, 2006. The Trust Preferred Securities mature in April 2036, are redeemable at our option at par beginning April 7, 2011, and require quarterly distributions of interest by the Trust to the holder of the Trust Preferred Securities. Interest distributions are initially at a fixed rate of 8.5625% for the first five years and will then reset quarterly for changes in the three-month London Interbank Offered Rate (“LIBOR”) plus 330 basis points. The Trust simultaneously issued 619 of the Trust’s common securities to us for a purchase price of $0.6 million, which constitutes all of the issued and outstanding common securities to purchase for $20.6 million a junior subordinated debt security due 2036 issued by the Company.
In 2003, we formed two statutory business trusts and we own all of the common trust securities of each trust. The trusts issued $20.0 million of trust preferred securities in private placements and invested the proceeds thereof and the proceeds from the sale of common trust securities in exchange for $20.6 million of junior subordinated debentures issued by our holding company. In December 2004, we formed two additional statutory business trusts and we own all of the common securities of each of those trusts. The trusts issued $26 million of trust preferred securities in a private placement and invested the proceeds thereof and the proceeds from the sale of common trust securities in exchange for $26.8 million of junior subordinated debentures issued by our holding company. All of the debentures have stated maturities of thirty years. We have the option to call any or all of the securities at par beginning five years from the date of issuance. The interest rate on $10.3 million of the subordinated debentures issued in May 2003 will float quarterly for changes in the three month LIBOR plus 4.1% and may not exceed 12.5% prior to the first call date of May 15, 2008. The interest rate on $10.3 million of subordinated debentures issued in September 2003 is a combination fixed and floating rate with a fixed rate of 7.5% during the no call period of five years after which the interest rate will float quarterly for changes in the three month LIBOR interest rate plus 4%. The interest rate on $13.4 million of subordinated debentures issued on December 17, 2004 is fixed at 7.4% for the first five years after which the interest rate will float quarterly for changes in the three month LIBOR interest rate plus 3.4%. The interest rate on $13.4 million of subordinated debentures issued on December 21, 2004 will float based on the three month LIBOR interest rate plus 3.4%.
· non-payment of interest on the trust preferred securities, unless such non-payment is due to a valid extension of an interest payment period;
If an event of default occurs and is continuing, the entire principal and the interest accrued thereon may be declared to be due and payable immediately.
Property and casualty insurance premiums are established before we know the amount of losses and loss adjustment expenses or the extent to which inflation may affect such amounts. We attempt to anticipate the potential impact of inflation in establishing our reserves. Inflation in excess of the levels we have assumed could cause loss and loss adjustment expenses to be higher than we anticipated.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of December 31, 2006 and 2005, and the related consolidated statements of income and comprehensive net income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006 and our report dated March 5, 2007 expressed an unqualified opinion thereon.
The consolidated financial statements include the accounts of Tower Group, Inc. (“Tower”) and its wholly-owned subsidiaries, Tower Insurance Company of New York (“TICNY”), Tower National Insurance Company (“TNIC”), Tower Indemnity Company of America (“TICA”) and Tower Risk Management Corporation (“TRM”) (collectively “the Company”). The Company’s stock is traded on the NASDAQ National Market under the symbol “TWGP.”
On March 25, 2005, Tower Group, Inc. closed on its purchase of the outstanding common stock of a shell insurance Company, North American Lumber Insurance Company (“NALIC”), that was renamed Tower National Insurance Company. As of December 31, 2006, Tower National Insurance Company was authorized to write business in twenty-five states and is subject to comprehensive regulation and supervision, including limitations relating to reserves and statutory surplus, in Massachusetts, its state of domicile.
On June 28, 2006, the Company closed on its purchase of 100% of the outstanding common stock of a shell insurance company, MIIX Insurance Company of New York, which was renamed Tower Indemnity Company of America (“TICA”). The Company acquired TICA for the value of its statutory surplus at closing plus $225,000. In October 2006, the company entered into an agreement to sell all of the issued and outstanding capital stock of TICA to CastlePoint for a cash purchase price of $350,000 plus an amount equal to the value of the statutory surplus of TICA at closing. The $125,000 difference in the price reflects the legal and brokerage fees paid by Tower in connection with its acquisition of the company. CastlePoint will rename TICA “CastlePoint Insurance Company.” The Company has agreed to enter into various pooling agreements with CastlePoint Insurance Company, subject to its obtaining regulatory approval from the State Insurance Department of New York, which agreements will be effective January 1, 2007 pending the approval of the New York State Department of Insurance.
The Company has invested in an unconsolidated Bermuda holding company, CastlePoint Holdings, Ltd. (“CastlePoint”), which the Company organized and sponsored with an initial investment of $15.0 million on February 6, 2006. The Company consolidated the activities of CastlePoint as a wholly owned subsidiary during the first quarter of 2006 and recognized approximately $0.5 million of non-recurring start-up costs. 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.
TNIC is a property and casualty insurance company incorporated in the Commonwealth of Massachusetts in December 1983. TNIC provides coverage for preferred risks and offers commercial multiple-peril, monoline general liability, commercial umbrella, monoline property, workers’ compensation and commercial automobile policies as well as personal lines products such as homeowners, dwelling and other liability policies. As of December 31, 2006 TNIC was authorized to write business in twenty-five
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant inter-company transactions have been eliminated in consolidation. The Company has reclassified certain amounts in its 2005 consolidated balance sheet to conform to the 2006 presentation. None of these reclassifications had an effect on the Company’s consolidated net earnings, total shareholders’ equity or cash flows.
The liability for loss and loss adjustment expenses represents management’s best estimate of the ultimate cost of all reported and unreported losses that are unpaid as of the balance sheet date. The liability for loss and loss adjustment expenses is estimated on an undiscounted basis, using individual case-basis valuations, statistical analyses, and various actuarial procedures. The projection of future claim payment and reporting is based on an analysis of the Company’s historical experience, supplemented by analyses of industry loss data. Management believes that the reserves for loss and loss adjustment expenses are adequate to cover the ultimate cost of losses and claims to date; however, because of the uncertainty from various sources, including changes in reporting patterns, claims settlement patterns, judicial decisions, legislation, and economic conditions, actual loss experience may not conform to the assumptions used in determining the estimated amounts for such liability at the balance sheet date. As adjustments to these estimates become necessary, such adjustments are reflected in current operations. Because of the nature of the business historically written, the Company’s management believes that the Company has limited exposure to environmental claim liabilities.
Commissions on reinsurance premiums ceded are earned in a manner consistent with the recognition of the costs of the reinsurance, generally on a pro-rata basis over the terms of the policies reinsured.
Certain reinsurance agreements contain provisions whereby the ceding commission rates vary based on the loss experience under the agreements. The Company records ceding commission revenue based on its current estimate of subject losses. The Company records adjustments to the ceding commission revenue in the period that changes in the estimated losses are determined.
At December 31, 2006 and 2005, U.S. Treasury Notes with fair values of approximately $8,681,000 and $6,597,000, respectively, were on deposit with various states to comply with the insurance laws of the states in which the Company is licensed.
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 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. Indefinite lived intangible assets are not amortized. All identifiable intangible assets are tested for recoverability whenever events or changes in circumstances indicate that a carrying amount may not be recoverable and are subject to annual impairment testing as well. 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 2006, 2005 and 2004.
Pursuant to a Tax Allocation Agreement, Tower, TICNY, TNIC, TRM and TICA compute and pay Federal income taxes on a consolidated basis. TICA will file a short-period tax return for 2006. 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 the treasury stock at the repurchase price as a reduction to stockholders’ equity as it does not intend to retire the treasury stock held at December 31, 2006.
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 for the entire award.
The Company manages its operations through three reportable segments: insurance (commercial and personal lines underwriting), reinsurance, and insurance services (managing general agency, claims administration and reinsurance intermediary operations). See “Note 18. Segment Information.”
In June, 2006 FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes.” This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provided guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. This interpretation is effective for fiscal years beginning after December 15, 2006. The Company reviewed whether it is more likely than not that its tax positions will be sustained upon examination and concluded that it has no uncertain tax positions as of December 31, 2006.
In September, 2006 the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and other Postretirement Plans.” The Company has no defined benefit pension plan or other post retirement plans and therefore, SFAS 158 will have no effect on the Company’s results of operations or financial position.
A summary of the amortized cost and fair value of the Company’s investments in fixed-maturity securities at December 31, 2006 by contractual maturity is shown below (in 000’s):
The cost and estimated fair value of investments in equity securities are as follows (in 000’s):
The unrealized losses on the Company’s investments in fixed maturity securities were caused by interest rate changes. The Company evaluated 191 investments, which were in an unrealized loss position as of December 31, 2006, of which 129 have been in an unrealized loss position for more than 12 months. Of these 191 securities the severity of the impairment in relation to the carrying amount of the individual investment for 186 of these investments was between 0.01% and 4.8%. Four of the remaining five investments were impaired between 5.6% and 8.9% of their carrying value and one investment was impaired by 11.5%. The unrealized loss on these five investments was $252,000 and accounted for 4.9% of the unrealized loss as of December 31, 2006. These investments are extremely sensitive to interest rate changes as they do not mature until at least 15 years from December 31, 2006. The Company has the ability and the intent to hold these investments until a recovery of fair value, which may be maturity. 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, 2006 is as follows in millions:
A general dividend and a special dividend of $0.025 per share each were declared and paid by CastlePoint in September 2006. The Company recorded its $128,000 of CastlePoint dividends as a reduction to its investment in CastlePoint.
TICNY and TNIC entered into a service and expense sharing agreement with CastlePoint, pursuant to which they will provide services, such as claims adjustment, policy administration, technology solutions, underwriting, and risk management services, to the U.S. domiciled insurance subsidiaries of CastlePoint, as well as to companies appointed as managing general underwriters by the CastlePoint companies. The Company charged CastlePoint $0.7 million in 2006 for these services.
Incurred loss and loss adjustment expenses attributable to insured events of prior years excluding the PXRE commutation loss of $1,602,000, decreased by $2,341,000, $392,000 and $199,000 in 2006, 2005 and 2004, respectively. Prior year development is based upon numerous estimates by line of business and accident year. 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. During calendar year 2005 commercial multi peril liability, workers’ compensation, and auto liability had favorable prior year development that was partially offset by unfavorable development in other lines. During 2004 the reinsurance operations had favorable prior year development that offset any unfavorable development in the insurance operations. No additional premiums or return premiums have been accrued as a result of these prior year effects. The Company’s management continually monitors claims activity to assess the appropriateness of carried case and IBNR reserves, giving consideration to Company and industry trends. See “Note 6-Reinsurace-Commutation and Novation with PXRE Reinsurance Company.”
Loss and loss adjustment expense reserves. The reserving process for 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
Due to the inherent uncertainty associated with the reserving process, the ultimate liability may differ, perhaps substantially, from the original estimate. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current year’s results. Reserves are closely monitored and are recomputed periodically using the most recent information on reported claims and a variety of statistical techniques. Specifically, on at least a quarterly basis, the Company reviews by line of business existing reserves, new claims, changes to existing case reserves and paid losses with respect to the current and prior years.
The Company segregates its 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 and 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 2003 year-end review the most recent accident year is 2003, the first prior is 2002, and all other accident years are 2001 and prior. Similarly for the 2006 review the most recent accident year is 2006, the first prior is 2005, and all other accident years are 2004 and prior. The table below shows the method used by segment and accident year to select the estimated year-ending loss reserves:
The incurred method relies on historical development factors derived from changes in the Company’s incurred estimates of claims paid and case reserves over time. The paid method relies on the Company’s claim payment patterns and ultimate claim costs. The incurred method is sensitive to changes in case reserving practices over time thus if case reserving practices change over time the incurred method may produce significant variation in estimates of ultimate losses. The paid method relies on actual claim payments and therefore is not sensitive to changes in case reserve estimates.
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, 2006 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.
Acquisition costs incurred and policy-related ceding commission revenue are deferred and amortized to income on property and casualty business as follows (in 000’s):
In an effort to manage the cost of quota share reinsurance in the time of rising cost and limited availability, the Company implemented provisions for loss ratio caps to provide the reinsurers with some limit on the amount of potential loss being assumed, while maintaining the transfer of significant insurance risk with the possibility of a significant loss to the reinsurer, and thereby to reduce the cost of reinsurance. Loss ratio caps cut off the reinsurers’ liability for losses above a specified loss ratio. The loss ratio caps in the 2005, 2004 and 2003 quota share agreements were 95.0%, 95.0% and 92.0%, respectively, and there was no loss ratio cap for 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 and loss adjustment expense payments and commission adjustments. Segregated assets in trust accounts amounted to $54,425,000 and $60,047,000 at December 31, 2006 and 2005 and are included in invested assets. The Company is obliged under the reinsurance agreements to credit reinsurers with an annual effective yield on the monthly balance in the funds held under reinsurance agreements liability accounts of 3% in 2006 3% in 2005 and 2.5% in 2004. The amounts credited for 2006, 2005 and 2004 were $1,599,000 and $1,339,000, and $1,069,000 respectively, and have been recorded as interest expense. The quota share agreement effective January 1, 2006 is collateralized in a New York Regulation 114 compliant trust account
Effective April 4, 2006, the Company novated business assumed from the Accident Insurance Company (“AIC”) by TICNY to CastlePoint Reinsurance. TICNY recorded $0.1 million as ceded premiums written and earned and eliminated liabilities of $0.1 million.
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 and 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 2006, 2005 and 2004 was $1,138,000, ($810,000) and $1,663,000, respectively.
The Company entered into a Commercial Renewal Rights Agreement with OneBeacon Insurance Group, LLC (“OneBeacon”) on September 13, 2004 under which it has acquired OneBeacon’s rights to seek to renew a block of commercial lines insurance policies in New York State consisting of commercial multiple-peril, worker’s compensation, commercial umbrella, commercial inland marine, commercial auto, fire and allied lines and general liability coverages. Under the terms of the agreement, the Company did not acquire any in-force business or historical liabilities associated with the policies. Pursuant to the agreement, the Company also obtained the rights to establish contractual relationships with certain OneBeacon agents. The Company agreed to pay OneBeacon an amount equal to 5% of the direct premiums written resulting from the Company’s renewal of any subject policies in the first year, 4% in the second year and 1% in the third year, with no payments due after the third year, subject to the Company’s obligation to pay a minimum of $5,000,000 in the aggregate over the three year period. The Company has recorded this transaction as $5,000,000 of intangible assets. Shortly after signing this agreement the Company provided an irrevocable letter of credit for the benefit of OneBeacon in the amount of $2,000,000 representing the estimated payments for the first year of the agreement.
The Company has determined that two intangible assets were acquired in this transaction: renewal rights and new agent contractual relationships, both of which were determined to be intangible assets with a finite useful life. The renewal rights were recorded at $1,250,000 and will be amortized over ten years in proportion to anticipated renewal premiums to be written during this time period. The new agent contractual relationships have been recorded at $3,750,000 and will be amortized over twenty years on a straight-line basis. During 2006 and 2005, the Company recorded amortization expense of $412,000 and $446,000, respectively, on the intangible assets. The weighted average amortization period of identified intangible assets of finite useful life is 16.5 years. The estimated aggregate amortization expense for each of the next five years is (in 000’s):
As of December 31, 2006 there was no impairment on any of the intangible assets as per the Company’s annual impairment testing.
In December 2004, Tower formed two statutory business trusts (“Trust III” and “Trust IV”), of which the Company owns all of the common trust securities. On December 7, 2004 and December 17, 2004, Trust III and Trust IV, respectively, each issued $13,000,000 floating rate trust preferred securities totaling $26,000,000 to investment pools. The trusts invested the proceeds thereof and the proceeds received from the issuance of the common trust securities to Tower in exchange for $26,806,000 of floating rate junior subordinated debentures (“subordinated debentures”) issued by Tower. The subordinated debentures are unsecured obligations of Tower and are subordinated and junior in right of payment to all present and future senior indebtedness of Tower. Tower has entered into guarantee agreements, which provide for full and unconditional guarantee of the trust securities. The Trust III preferred securities bear interest that is fixed at 7.4% until December 7, 2009 and the coupon will float quarterly thereafter at the three months LIBOR rate plus 3.4%. The Trust IV preferred securities bear interest that will float based on the 3-month LIBOR interest rate plus 3.4% and their rate as of December 31, 2006 was 8.76% compared to 7.89% in 2005. The final maturity on the subordinated debentures is December 15, 2034 and March 15, 2035 for Trust III and Trust IV, respectively, with prepayment at the option of the Company available beginning in 2009. Issuance costs, primarily legal fees, of $262,000 and $252,000 for the Trust III and Trust IV offerings, respectively, were deferred and are being amortized over the term of the subordinated debentures using the effective interest method.
of $505,100 were deferred and are being amortized over the term of the subordinated debentures using the effective interest method.
Total interest expense incurred for all subordinated debentures, including amortization of deferred origination costs, was $ 5,271,000, $3,514,000 and $1,461,000, respectively for the years ended December 31, 2006, 2005 and 2004.
Aggregate scheduled maturities of the subordinated debentures at December 31, 2005 are (in 000’s):
The roll-forward of shares of common stock is as follows (in 000’s):
The Company issued 40,000 perpetual series A preferred shares on December 4, 2006 with a $0.01 par value per share and a $1,000 liquidation preference per share to CastlePoint Reinsurance Company, Ltd. which are potentially convertible into common stock upon a public offering of common shares by the Company. The carrying value of this stock is $40 million less issuing cost of $0.4 million or $39.6 million and pays a fixed 8.66% annual dividend that is not cumulative. As more fully described in Note 20, the Company redeemed the 40,000 shares of perpetual preferred stock in January 2007.
For the twelve months 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 2004 Long-Term Equity Compensation plan provides for the granting of non-qualified stock options, incentive stock options (within the meaning of Section 422 of the Code), stock appreciation rights (“SARs”), restricted stock and restricted stock unit awards, performance shares and other cash or share-based awards. The current maximum number of shares of common stock that may be issued in connection with awards under the plan is 874,883, of which 717,271 may be issued under awards other than stock options or SARs. As of December 31, 2006, awards in respect of 287,840 shares have been made under the plan.
As of December 31, 2006, there are 225,680 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.
For the years ended December 31, 2006, 2005 and 2004, the Company incurred restricted stock expense of $559,000, $402,000 and $201,000, respectively, net of tax that was included in net income.
The following table provides an analysis of stock option activity during the three years ended December 31, 2006.
Compensation expense net of tax recorded related to stock options was $62,808 for 2006 and has been included in net income.
Prior to the adoption of SFAS 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 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
Deferred tax assets and liabilities are determined using the enacted tax rates applicable to the period the temporary differences are expected to be recovered. Accordingly, the current period income tax provision can be affected by the enactment of new tax rates. The net deferred income taxes on the balance sheet reflect temporary differences between the carrying amounts of the assets and liabilities for financial reporting purposes and income tax purposes, tax effected at a 35% rate. Significant components of the Company’s deferred tax assets and liabilities are as follows (in 000’s):
In assessing the valuation of deferred tax assets, the Company considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. No valuation allowance against deferred tax assets has been established as the Company believes it is more likely than not the deferred tax assets will be realized.
The Company has various lease agreements for office space and equipment. The terms of the office space lease agreements provide for annual rental increase 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 ($’s in 000’s):
Total rental expense charged to operations was approximately $3,779,000, $2,333,000, and $1,536,000 in 2006, 2005 and 2004, respectively.
· For SAP purposes, changes in deferred income taxes relating to temporary differences between net income for financial reporting purposes and taxable income are recognized as a separate component of gains and losses in surplus rather than included in income tax expense or benefit as required under GAAP.
For the years ended December 31, 2006, 2005 and 2004, TICNY reported statutory basis net income/ (loss) of $21,136,000, $6,249,000 and ($5,705,000), and respectively. At December 31, 2006 and 2005 TICNY reported statutory basis surplus as regards policyholders of $200,650,000, and $132,409,000, respectively as filed with the insurance regulators. As of December 31, 2006 TICNY is required to maintain $7,900,000 of minimum capital and surplus in accordance with New York Insurance Law.
Under New York law, TICNY is limited in the amount of dividends it can pay to Tower. Under New York law, TICNY may pay dividends to Tower only out of statutory earned surplus. In addition, the New York Insurance Department must approve any dividend declared or paid by TICNY that, together with all dividends declared or distributed by TICNY during the preceding twelve months, exceeds the lesser of (1) 10% of TICNY’s policyholders’ surplus as shown on its latest statutory financial statement filed with the New York State Insurance Department or (2) 100% of adjusted net investment income during the preceding twelve months immediately preceding the declaration or distribution of the current dividend increased by the excess, if any, of net investment income over dividends declared or distributed during the period commencing thirty-six months prior to the declaration or distribution of the current dividend and ending twelve months prior thereto. TICNY declared approximately $4,600,000, $2,050,000, and $850,000 in dividends to Tower in 2006, 2005, and 2004, respectively. As of December 31, 2006, the maximum distribution that TICNY could pay without prior regulatory approval was approximately $10,477,000.
TNIC may not pay any dividend that, together with all dividends declared or distributed by TNIC during the preceding twelve months, excluding pro rata distributions of any class of the TNIC’s own securities, exceeds the greater of (1) 10% of TNIC’s policyholders’ surplus as of the end of the preceding calendar year or (2) TNIC’s net income for the next preceding calendar year, until thirty days after the Massachusetts Commissioner of Insurance has received notice of the intended dividend and not objected in such time. In addition, dividends may only be paid out of unassigned funds. As of December 31, 2006, TNIC’s maximum dividend it could pay without the approval of the Massachusetts Commissioner of Insurance was $89,000.
Agents’ balances receivable, assumed premiums receivable, receivable-claims paid by agency: The carrying values reported in the accompanying balance sheets for these financial instruments approximate their fair values.
The following table shows the computation of the company’s earnings per share (in 000’s, except shares and per share amounts):
In the insurance segment, TICNY provides commercial and personal lines insurance policies to businesses and individuals. TICNY’s 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 insurance services segments direct commission revenue is from two issuing carriers. Each issuing carrier provides less than 10% of the Company’s consolidated total revenues. Although this segment is dependent upon two issuing carriers, it is management’s opinion that the loss of one or both can be remedied by replacement issuing carriers. There is no intercompany commission revenue in the insurance services segment.
Underwriting expenses in the insurance segment are net of expense reimbursements that are made by the insurance services segment pursuant to an expense sharing agreement between TRM and TICNY. In accordance with terms of this agreement, TRM reimburses TICNY for a portion of TICNY’s underwriting and other expenses resulting from TRM’s use of TICNY’s personnel, facilities and equipment in underwriting insurance on behalf of TRM’s issuing companies. The reimbursement for underwriting and other expenses is calculated as a minimum reimbursement of 5% of the premiums produced by TRM, and is adjustable according to the terms of the agreement based on the number of policies in force and additional expenses that may be incurred by TRM. The amount of this reimbursement was $1,578,000 in 2006, $1,981,000 in 2005 and $2, 987,000 in 2004. TRM also reimburses TICNY, at cost, for claims administration expenses pursuant to the terms of this expense sharing agreement. Claims expenses reimbursed by TRM were $3,176,000 in 2006, $4,255,000 in 2005 and $4,019,000 in 2004. TICNY is also
The following table reconciles revenues by segment to consolidated revenue (in 000’s):
On November 13, 2006, the Company signed an agreement to acquire Preserver Group, Inc. (“Preserver”) for a base purchase price of $68.3 million (approximately $64.8 million after deduction for expenses incurred by Preserver, net of tax). Preserver is a privately-held company that offers products similar to the Company’s in the Northeast, particularly in New Jersey, Maine and Massachusetts. Preserver is rated “B++” (Good) by A.M. Best. On December 7, 2006, A.M. Best placed the ratings of Preserver under review with positive implications. The acquisition is subject to regulatory approvals and is expected to close in the second quarter of 2007. The Company incurred $0.6 million of acquisition costs for legal, accounting and other expenses that has been capitalized and is recorded as other assets as of December 31, 2006.
On January 22, 2007, the Securities and Exchange Commission declared Tower Group, Inc.’s registration statement effective on Form S-3 relating to $84,500,000 of the Company’s common stock, par value $.01 per share, of the Company (“common stock”). On January 22, 2007, the Company signed an underwriting agreement providing for the issuance and sale by the Company of 2,704,000 shares of common stock at a price of $31.25 per share, less underwriting discounts, and the grant to the underwriters of an option to purchase up to 405,600 additional shares of common stock at the same price to cover over-allotments.
On January 10, 2007, the Company converted its perpetual preferred series A stock into preferred series A-1 stock. On January 26, 2007, the company fully redeemed all 40,000 shares for $40.0 million using $20.0 million of the net proceeds from its trust preferred securities issued on January 25, 2007 and $20.0 million of the net proceeds from its common stock offering on January 26, 2007.
On February 5, 2007 the underwriters exercised their over-allotment option with respect to 340,600 shares of common stock at the offering price of $31.25 per shares, less underwriting discounts. The Company received $10.6 million net proceeds from this exercise $10.1 million after the underwriting discount. The exercise of the over-allotment option brings the Company’s aggregate net proceeds from the offering and over-allotment option, after underwriting discounts, and expenses, to approximately $89.4 million.
Tower Group, Inc’s Board of Directors approved a quarterly dividend on February 22, 2007 of $0.025 per share payable March 27, 2007 to stockholders of record as of March 15, 2007.