We lease 118,500 square feet of space at 120 Broadway, New York, New York, which consists of the 30th and 31st floors and part of the 29th floor. The lease will end on December 31, 2021. We also lease space at 100 William Street, New York, New York. See “Note 17-Contingencies” in the notes to our audited consolidated financial statements included elsewhere in this report.
We also lease office space in Atlanta, Georgia; Bedford, New Hampshire; Buffalo, New York; Canton Massachusetts; Chicago, Illinois; Fort Lauderdale, Florida; Glastonbury, Connecticut; Hamilton, Bermuda; Irvine California; Irving, Texas, Lake Success, New York; Lisle, Illinois; Melville, New York; Maitland, Florida; Marlborough, Massachusetts; Mobile, Alabama; Moorestown, New Jersey; Palm Springs, California; Quincy, Massachusetts; Paramus, New Jersey; Philadelphia, Pennsylvania; Petaluma, California; Scarborough, Maine; Shelton, Connecticut; South Portland, Maine; White Plains, New York.
The net loss ratio is calculated by dividing net losses and loss adjustment expenses by net premiums earned.
Book value per share is based on total stockholders’ equity divided by common shares outstanding at year end.
Subsequent to the acquisition of OBPL on July 1, 2010, the Company changed the presentation of its business results, by allocating the personal insurance business previously reported in Brokerage Insurance segment along with the newly acquired OBPL business to a new Personal Insurance segment and merged the commercial business previously reported in either the Brokerage Insurance or Specialty Business segments in a new Commercial Insurance segment. The Company has retained its Insurance Services segment which will include fees earned by management companies, acquired as a part of the OBPL
transaction. This change in presentation reflects the way management organizes the Company for making operating decisions and assessing profitability subsequent to the OBPL acquisition. In developing cost allocations between the commercial and personal lines segments, management has made significant assumptions regarding costs of reinsurance and internal services provided on behalf of such segments. As management receives additional facts which enhance its ability to apportion such costs, it may modify such allocation. If modifications are made, such adjustments will be made to all reporting periods disclosed. The results for all prior periods presented in this Management Discussion and Analysis have been restated to reflect the re-segmentation.
Because we do not manage our assets by segments, our investment income is not allocated among our segments. Operating expenses incurred by each segment are recorded in such segment directly. General corporate overhead not incurred by an individual segment is allocated based upon the methodology deemed to be most appropriate which may include employee head count, policy count and premiums earned in each segment.
We offer our products and services through our Insurance Subsidiaries, which include TICNY, TNIC, PIC, NEIC, MVIC, CPIC, CPFL, HIC, KIC, MHIC, York and CPNIC (operating as SUA in some jurisdictions) as well as our management services subsidiaries, which include two attorney-in-facts, TRM, CPM and CPRMFL (operating as AequiCap CP Services Group, Inc. in some jurisdictions). Results for our Insurance Subsidiaries are reported in our Commercial and Personal Insurance segments. Results for our management services subsidiaries are reported in our Insurance Services segment.
In our Insurance Services segment, we generate management fees from the services provided by the attorney-in facts to the Reciprocal Exchanges, commission income from our managing general agencies by producing premiums on behalf of issuing companies, and other fees by providing claims administration and reinsurance intermediary services.
See “Note 3 - Acquisitions” in the consolidated financial statements for more detail on each of the acquisitions discussed below.
On November 2, 2010, Tower acquired the renewal rights to the commercial automobile liability and physical damage business of AequiCap Program Administrators Inc. (“AequiCap II”), an underwriting agency based in Fort Lauderdale, Florida. The business subject to the agreement covers both trucking and taxi risks that are consistent with Tower’s current underwriting guidelines. Most of the employees of AequiCap II involved in the servicing of this commercial liability and physical damage business became employees of the Company. The acquisition was accounted for as a business combination under GAAP.
Prior to the acquisition, we had an investment in CastlePoint which was revalued at acquisition resulting in a $7.4 million pre-tax gain in 2009.
Insurance Service revenue. We earn fee income primarily from services provided to the Reciprocal Exchanges for underwriting, claims, investment management and other services. Additional commission income is generated by TRM, CPM and CPRMFL on premiums produced by their managing general agencies and fees earned from their claims administration, other administration services and reinsurance intermediary services. We also earn fee income in the form of policy billing fees arising in the course of collecting premiums from our policyholders
Net investment income and realized gains and losses on investments. We invest our available funds in cash, cash equivalents and securities. Our investment income includes interest and dividends earned on our invested assets. Realized gains and losses on invested assets are reported separately from net investment income. We earn realized gains when invested assets are sold for an amount greater than their amortized cost, in the case of fixed maturity securities, and cost, in the case of equity securities, and we recognize realized losses when invested assets are written down or sold for an amount less than their amortized cost or actual cost, as applicable.
Combined ratio. We use the combined ratio to measure our underwriting performance. The combined ratio is the sum of the loss ratio and the underwriting expense ratio. We analyze the combined ratio on a gross (before the effect of reinsurance) and net (after the effect of reinsurance) basis. If the combined ratio is at or above 100%, an insurance company is not underwriting profitably and may not be profitable unless investment income is sufficient to offset underwriting losses.
Premiums produced by TRM, CPM and CPRMFL. These companies operate managing general agencies that earn commissions on written premiums produced on behalf of their issuing companies. Although TRM is not an insurance company, we have historically utilized TRM’s access to its issuing companies as a means to expand our ability to generate premiums in states where our Insurance Subsidiaries were not yet licensed.
Operating income. Operating income excludes realized gains and losses and acquisition-related transaction costs, net of tax. This is a common measurement for property and casualty insurance companies. We believe this presentation enhances the understanding of our results of operations by highlighting the underlying profitability of our insurance business. Additionally, these measures are a key internal management performance standard.
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 and LAE reserves.
Establishing fair value of loss and LAE reserves for acquired companies. At acquisition date, loss and LAE reserves must be set to fair value. As there are no readily observable markets for these liabilities, we use a valuation model that estimates net nominal future cash flows related to the loss and LAE reserve. This valuation is adjusted for the time value of money and a risk margin to compensate the Company for bearing the risk associated with the liabilities.
Ceding commissions under a quota share reinsurance agreement are 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. The ultimate commission rate earned on our quota share reinsurance contracts is 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 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 2010, 2009, and 2008 was a decrease of $2.7 million, a decrease of $2.2 million and a decrease of $1.8 million, respectively. These decreases are attributed to prior year reserve development that was not initially anticipated
to the estimated fair value of the unexpired insurance policies acquired in a business combination. VOBA is determined at the time of a business combination and is reported on the consolidated balance sheet with DAC and is amortized in proportion to the timing of the estimated underwriting profit associated with the in force policies acquired. The cash flow or interest component of VOBA is amortized in proportion to the expected pattern of future cash flows. The Company considers anticipated investment income in determining the recoverability of these costs and believes they are fully recoverable.
whether management intends to sell the security and, if not, whether it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis;
Since total unrealized losses are a component of stockholders’ equity, any recognition of additional OTTI losses would have no effect on our comprehensive income or stockholders’ equity.
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. No impairment losses were recognized in 2010, 2009 and 2008. Significant changes in the factors we consider when evaluating our intangible assets and goodwill for impairment losses could result in a significant charge for impairment losses reported in our consolidated financial statements. See “Note 7 - Goodwill and Intangible Assets” in the notes to consolidated financial statements.
Insurance Services segment pretax income for the year ended December 31, 2010 includes results related to Tower’s management services agreements with the Reciprocal Exchanges.
Commission and fee income for the year ended December 31, 2010 excludes management fee income earned by Tower from the Reciprocal Exchanges. These amounts are eliminated in reporting consolidated net income.
Net investment income and net realized gains (losses). Net investment income increased 41.7% in the year ended December 31, 2010 compared to 2009. The increase in net investment income resulted from an increase in average cash and invested assets for the year ended December 31, 2010 that resulted primarily from invested assets acquired from OBPL and SUA. The tax equivalent investment yield at amortized cost was 4.7% at December 31, 2010 compared to 5.5% for 2009. Operating cash invested in 2009 and in 2010 has been affected by a low yield environment, as asset classes other than US Treasuries have experienced tightening spreads, the result of investors reaching for yield in a low interest rate environment. We have increased our investment in high yield securities to partially reduce the impact of this low rate environment and in the fourth quarter of 2010. We made investments in dividend paying common equities as a further strategy to mitigate the current low interest rate environment.
Net realized investment gains were $13.5 million for the year ended December 31, 2010 compared to gains of $1.5 million in the same period last year. Credit related OTTI losses in the year ended December 31, 2010 of $4.2 million were considerably lower than the $23.5 million which were recorded for 2009.
Loss adjustment expenses improved during the year by approximately $10 million as a result of bringing in-house the defense of a large portion of our third-party liability claims, and by approximately $14 million as a result of a revised study of the costs of settling claims. The improvement in litigation loss adjustment expenses favorably impacted our Commercial Insurance segment. See “Commercial Insurance Segment Results of Operations ” for more details.
Operating expenses. Operating expenses were $463.0 million for the year ended December 31, 2010, an increase of 39.2% over the prior year, primarily as a result of the aforementioned acquisitions. Also contributing to the increase were investments in technology and restructuring, primarily in our Commercial Insurance segment, following the various acquisitions over the past eighteen months.
Interest expense. Interest expense increased by $6.5 million for the year ended December 31, 2010 compared to 2009. Interest expense increased mainly due to the issuance of $150 million of convertible senior notes in September 2010, interest expense on subordinated debentures which were assumed as a result of the merger with CastlePoint, and, to a much lesser extent, interest of $0.1 million on the $56.0 million draw-down under our credit facility on May 24, 2010. The credit facility draw-down was repaid in September 2010. Interest on funds withheld was $2.7 million in 2010 as compared to $0.7 million in 2009.
Net income and return on average equity. Net income and annualized return on average equity were $ 118.0 million and 11.0% for the year ended December 31, 2010 compared to $109.3 million and 13.9% for the 2009. The decline in the annualized return on equity in 2010 is primarily due to the reduced earnings resulting from higher incurred loss and LAE, including the $17.5 million pre-tax charge for the Northeast U.S. Storm occurring during March 13 to March 15, 2010. The return on average equity is calculated by dividing net income by average stockholders’ equity. Average stockholders’ equity was $1,075.2 million and $787.9 million at December 31, 2010 and 2009, respectively.
Total revenues. Total revenues increased due to significant increases in net premiums earned and net investment income stemming primarily from the acquisitions of CastlePoint and Hermitage that occurred in the first quarter of 2009. Net premiums earned also increased due to the inclusion of premiums managed by Tower but previously placed with CastlePoint Insurance Company prior to its acquisition. These sources of growth in total revenues were partially offset by reductions in commission and fee income due to lower ceding quota share reinsurance in 2009 as compared to prior years. Taken together, these changes caused net premiums earned to be a significantly higher percentage of total revenues in 2009 as compared to 2008. This is discussed more fully under “Commercial Insurance Segment Results of Operations” and “Personal Insurance Segment Results of Operations” below. The following table shows the effects of the various acquisitions on our gross premiums written in 2009:
businesses acquired, were higher by 5.2 basis points in 2009 as compared to 2008 primarily due to the reinvestment of cash in the Tower portfolios in the fourth quarter of 2009.
Net income and return on average equity. Net income and return on average equity were $109.3 million and 13.9%, respectively, for 2009 compared to $57.5 million and 17.8%, respectively, for 2008. For 2009, the return on average equity was calculated by dividing net income of $109.3 million by average common stockholders’ equity of $787.9 million. For 2008, the return on average equity was calculated by dividing net income of $57.5 million by an average common stockholders’ equity of $322.3 million. Net income for 2009 was negatively impacted by $11.5 million, net of tax, of acquisition-related transaction expenses pertaining to the acquisitions of CastlePoint and SUA which reduced the return on average equity by 1.3 percentage points for the year ended December 31, 2009.
Gross premiums. Commercial Insurance gross premium written increased by $199.1 million for the year ended December 31, 2010 compared to 2009. $173.3 million of the increase was due to twelve months of SUA production in 2010 compared to less than two months in 2009. The remaining increase was due to the acquisition of CastlePoint and Hermitage in February 2009. These increases were slightly offset by the reduction of third-party reinsurance written by CastlePoint Re.
Ceded premiums. Ceded premiums written and earned for the year ended December 31, 2010 were $96.6 million and $155.7 million, respectively compared to $153.8 million and $149.2 million, respectively, for the year ended December 31, 2009. The decrease in ceded premiums written for the year ended December 31, 2010 compared to 2009 resulted from our decision to lower the ceded percentage on a liability quota share reinsurance treaty during the year. In addition, we ceded commercial liability premiums on in-force new and renewal business, effective October 1, 2009.
Catastrophe reinsurance ceded premiums were $11.4 million for the years ended December 31, 2010 and 2009. Catastrophe costs remained flat because there were no changes in property exposure.
Net premiums. The change in net premiums written and earned increased in line with increases in gross premiums that were driven primarily by the acquisition of SUA and the aforementioned increase in ceded premiums.
Underwriting profit and combined ratio. The net combined ratios were 94.5% for the year ended December 31, 2010 and 86.6% for 2009. The increase in the combined ratio in 2010 resulted from an increase in the net loss ratio due to catastrophe losses, softer market conditions and from increases in the net expense ratios as describe above.
Ceded premiums. Ceded premiums written and earned were significantly lower for 2009 compared to 2008 as a result of our decision to retain most of our business following the increase in our capital after the CastlePoint acquisition. In 2008 we had either placed with CPIC or ceded to CastlePoint Re a substantial portion of the commercial premiums written, both program and non-program, and for policies written during the first nine months of 2009 we did not cede premiums written to third party reinsurers on a quota share basis. In the fourth quarter of 2009 we ceded 50% of our new and renewal written and earned premiums on commercial multi-peril and other liability policies to third party reinsurers amounting to $86.9 million and $27.2 million, respectively.
Catastrophe reinsurance ceded premiums were $11.4 million for 2009 compared to $5.1 million for 2008. The increase in catastrophe costs in 2009 was due primarily to increased gross premiums written from increased property exposures arising from the aforementioned acquisitions and higher cost of catastrophe coverage when our ceded catastrophe reinsurance treaty was renewed on July 1, 2009.
Net premiums. As a result of the increase in gross premiums and the decrease in ceded premiums described above, net premiums earned increased $476.8 million in 2009 compared to 2008. The increase in net premiums earned was consistent with the increase in net premiums written.
Underwriting expenses and underwriting expense ratio. Underwriting expenses include direct commissions and other underwriting expenses. The increase in underwriting expenses resulted from the increase in gross premiums earned, which was primarily due to the CastlePoint, Hermitage and SUA acquisitions. Partially offsetting this was a decrease in assumed reinsurance and an increase in premiums in our program business which has significantly lower commission costs. Our gross underwriting expense ratio was 30.6% for 2009 as compared to 29.6% for 2008.
The commission portion of the gross underwriting expense ratio was 19.6% for 2009 compared to 18.5% for 2008. Our producer commissions did not vary significantly in 2009. The increase in the commission ratio resulted from the amortization of CastlePoint’s VOBA which was based on CastlePoint’s higher commission ratio.
The net underwriting expense ratio was 31.5% and 28.9% for 2009 and 2008, respectively. The increase was due in part to the increase in the commission expense ratio but more so due to the decrease in ceding commission revenue which reduced the net expense ratio less in 2009 than in 2008.
Underwriting profit and combined ratio. The net combined ratio was 86.6% for 2009, an increase of 4.6 percentage points compared to 2008. The increase in the combined ratio resulted from increases in the net loss ratio described above due to relatively less favorable development in the 2009 calendar year as compared to 2008 and softer market conditions, as well as increases in the net expense ratio due primarily to the change in ceding commission revenue described above.
Underwriting profits increased 111.7% for the year ended December 31, 2009 compared to the prior year. This increase was driven by the increase in net premiums earned, but was partially offset by the increase in the combined ratio described above.
Prior year losses developed favorably by $32.1 million, comprised of $22.3 million favorable development in our stock companies and $9.9 million favorable development in the reciprocals. For the OBPL business we recorded favorable development that we experienced relative to expected patterns only for the third and fourth quarters after our acquisition of this business.
Underwriting profit and combined ratio. The net combined ratio for the Personal Insurance segment was 91.3%, 8.3 points better than prior year. Underwriting income of $30.6 million was $30.1 million better than 2009 and was largely driven by the addition of the OBPL business. Changes in combined ratio reflect the changes in the loss ratio and the expense ratio for reasons described above.
Gross premiums. Gross written premiums increased for the year ended December 31, 2009 by $90.3 million compared to 2008. The increase was primarily attributable to the acquisition of CastlePoint in 2009 as well as organic growth, particularly in our homeowners line of business in California. Prior to the acquisition of OBPL, the personal lines segment was primarily homeowners business, with personal automobile representing less than 10% of written premiums in 2009 and 2008. During 2009,
premium rates on renewed business increased 2.9% in personal lines. Renewal retention in the segment was 88% in 2009 compared to 86% for 2008.
Net premiums. Net premiums written increased by $97.8 million to $155.3 million for the year ended December 31, 2009, as compared 2008. The acquisition of CastlePoint in 2009, as well as general organic growth in our personal lines business accounted for this increase.
Ceding commission revenue. Ceding commission revenue, as a percentage of ceded premiums written and earned declined from 2008 to 2009. The decrease was due to the lower cession of quota share premiums described above and a reduction in the ceding commission rate.
Underwriting profit and combined ratio. The increase in underwriting profit for the year ended December 31, 2009 primarily resulted from growth in revenues from the CastlePoint acquisition and from organic growth in homeowners business. The increase in combined ratios reflect increased loss costs and costs of catastrophe protection for the growing homeowners business, offset by lower underwriting expense growth relative to premium growth.
Total revenues. The decrease in total revenues, of which direct commission revenue is the principal component, for 2010 compared to 2008 was primarily due to the acquisition of CastlePoint in February 2009. Premiums produced and managed by TRM on behalf of CPIC decreased to $10.7 million in 2010 compared to $85.1 million for 2009. As a result of the decrease in premiums produced, revenues declined to $5.1 million in 2010 compared to $68.5 million in 2009. Claims administration and other administration revenues earned in 2008 were primarily earned from CPIC managed business and declined in 2009 as intercompany transactions between us and CPIC were eliminated. The decline in both claims and other administration revenues was partially offset as a result of entering into two new agreements in 2009. During 2009 we recorded $0.4 million of claims administration revenues as a result of entering into an agreement with AequiCap to provide claims handling services for workers’ compensation claims. The decline in other administration revenue was also offset as a result of the Hermitage acquisition. Hermitage provides administrative services to an insurance company and earned $0.3 million in 2009.
Direct commission expense. The decrease in direct commission expenses was a result of the decrease in business produced by TRM on behalf of CPIC. Subsequent to the completion of the CastlePoint acquisition all of CPIC’s underwriting expenses were included in the Commercial Insurance segment.
Other insurance services expenses. The decrease in other insurance expenses resulted from the decline in premium produced. The amount of reimbursement for underwriting expenses by TRM to TICNY for the year ended December 31, 2010 was $1.4 million as compared to $12.3 million for 2009.
The following table shows the composition of our fixed maturity portfolio by remaining time to maturity at December 31, 2010 and December 31, 2009. For securities that are redeemable at the option of the issuer and have a market price that is greater than redemption value, the maturity used for the table below is the earliest redemption date. For securities that are redeemable at the option of the issuer and have a market price that is less than redemption value, the maturity used for the table below is the final maturity date:
Under GAAP, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an “exit price”). GAAP establishes a fair value hierarchy that distinguishes between inputs based on market data from independent sources (“observable inputs”) and a reporting entity’s internal assumptions based upon the best information available when external market data is limited or unavailable (“unobservable inputs”). The fair value hierarchy in GAAP prioritizes fair value measurements into three levels based on the nature of the inputs. Quoted prices in active markets for identical assets have the highest priority (“Level 1”), followed by observable inputs other than quoted prices including prices for similar but not identical assets or liabilities (“Level 2”), and unobservable inputs, including the reporting entity’s estimates of the assumption that market participants would use, having the lowest priority (“Level 3”).
As of December 31, 2010, substantially all of the investment portfolio recorded at fair value was priced based upon quoted market prices or other observable inputs. For investments in active markets, we used the quoted market prices provided by the outside pricing services to determine fair value. In circumstances where quoted market prices were unavailable, we used fair value estimates based upon other observable inputs including matrix pricing, benchmark interest rates, market comparables and other relevant inputs. When observable inputs were adjusted to reflect management’s best estimate of fair value, such fair value measurements are considered a lower level measurement in the GAAP fair value hierarchy.
In certain instances, we deemed it necessary to utilize Level 3 pricing over prices available through pricing services used throughout 2009 and 2010. In the periods of market dislocation, the ability to observe stable prices and inputs may be reduced for some instruments as currently is the case for certain non-agency residential, commercial mortgage-backed securities and asset-backed securities.
For the year ended December 31, 2010, our gross unrealized losses improved from 2009 and were attributed primarily to improvements in the credit markets and, to a lesser extent, our sale of certain securities in unrealized loss positions in the second quarter of 2010 in contemplation of the cash purchase of OBPL.
The following table presents information regarding our invested assets that were in an unrealized loss position at December 31, 2010 and December 31, 2009 by amount of time in a continuous unrealized loss position:
At December 31, 2010, the fixed-maturity securities in an unrealized loss position for twelve months or greater were primarily in our investments in commercial mortgage-backed securities, and residential non-agency mortgage-backed securities.
The following table stratifies the gross unrealized losses in the portfolio at December 31, 2010, by duration in a loss position and magnitude of the loss as a percentage of the cost or amortized cost of the security:
See “Note 5-Investments” in our consolidated financial statements for further information about impairment testing and other-than-temporary impairments.
The following tables show the fair value and unrealized loss by credit quality rating and deal origination year of our commercial, residential non-agency-backed and asset-backed securities in an unrealized loss position at December 31, 2010:
Under the Insurance Act 1978 of Bermuda, as amended (the “Insurance Act”), CastlePoint Re is required to maintain a specified solvency margin and a minimum liquidity ratio and is prohibited from declaring or paying any dividends if doing so would cause CastlePoint Re to fail to meet its solvency margin and its minimum liquidity ratio. Under the Insurance Act, CastlePoint Re is prohibited from declaring or paying dividends without the approval of the Bermuda Monetary Authority (“BMA”), if CastlePoint Re failed to meet its solvency margin and minimum liquidity ratio on the last day of the previous fiscal year. Under the Insurance Act, CastlePoint Re is prohibited, without the approval of the BMA, from reducing by 15% or more its total statutory capital as set forth on its audited statutory financial statements for the previous year.
The management companies, including TRM, CPRMFL and the attorneys-in-fact, are not subject to any limitations on their dividends to the Holding Company, other than the basic requirement that dividends may be declared or paid if the net assets of
At various times over the past seven years we have issued trust preferred securities through wholly-owned Delaware statutory business trusts. The trusts used the proceeds of the sale of the trust preferred securities to third-party investors and common trust securities to Tower to purchase junior subordinated debentures from the Company. The terms of the junior subordinated debentures match the terms of the trust preferred securities. Interest on the junior subordinated debentures and the trust preferred securities is payable quarterly. In some cases, the interest rate is fixed for an initial period of five years after issuance and then floats with changes in the London Interbank Offered Rate (“LIBOR”). In other cases the interest rate floats with LIBOR without any initial fixed-rate period. In the fourth quarter of 2010, Tower entered into interest rate swap contracts with $190 million notional value to fix the floating interest rates on certain of the trust preferred securities.
In October 2010, the Company effected interest rate swap contracts with $190 million notional on the subordinated debentures. As described in the table above, certain of these subordinated debentures are currently paying a variable interest rate and other subordinated debentures will convert to variable rates over the next two years. The interest rate swaps will fix the variable interest payments on the subordinated debentures to rates from 5.1% to 5.9%. The interest rate swaps mature in 2015.
In September 2010, the Company issued $150 million principal amount of 5.0% convertible senior notes (the “Notes”) due September 2015. Interest will be paid semi-annually commencing March 2011. Holders may convert their Notes into cash or common shares, at the Company’s option, at any time on or after March 14, 2014 or earlier under certain circumstances determined by: (i) the market price of the Company’s stock, (ii) the trading price of the Notes, or (iii) the occurrence of specified corporate transactions. Upon conversion, the Company intends to settle its obligation either entirely or partially in cash. The initial conversion rate is 36.3782 shares of common stock per $1,000 principal amount of the Notes (equivalent to an initial conversion price of $27.49 per share), subject to adjustment upon the occurrence of certain events. Additionally, in the event of a fundamental change, the holders may require the Company to repurchase the Notes for a cash price equal to 100% of the principal plus any accrued and unpaid interest.
The gross loss reserve payments due by period in the table above are based upon the loss and loss expense reserves estimates as of December 31, 2010 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 amounts recoverable from reinsurers that amounted to $282.7 million, which are estimated to be recovered as follows: less than one year, $114.1 million; one to three years, $106.7 million; four to five years, $43.0 million; and after five years, $18.9 million. The interest on the subordinated debentures is calculated using interest rates in effect at December 31, 2010 for variable rate debentures.
Our capital resources consist of funds deployed or available to be deployed to support our business operations. At December 31, 2010 and December 31, 2009, our capital resources were as follows:
We monitor our capital adequacy to support our business on a regular basis. The future capital requirements of our business will depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. Our ability to underwrite is largely dependent upon the quality of our claims paying and financial strength ratings as evaluated by independent rating agencies. In particular, we require (1) sufficient capital to maintain our financial strength ratings, at a level considered necessary by management to enable our Insurance Subsidiaries to compete, and
(2) sufficient capital to enable our Insurance Subsidiaries to meet the capital adequacy tests performed by statutory agencies in the United States and Bermuda.
As part of Tower’s capital management strategy, the Board of Directors approved a $100.0 million share repurchase program on February 26, 2010. Purchases are permitted from time to time at prevailing prices in open market or privately negotiated transactions. The share repurchase program has no expiration date. The timing and amount of purchases under the program depend on a variety of factors, including the trading price of the stock, market conditions and corporate and regulatory considerations. For the year ended December 31, 2010, 4.0 million shares of common stock were purchased under this program at an aggregate consideration of $88.0 million.
The primary sources of consolidated cash flows are from the Insurance Subsidiaries’ gross premiums collected, ceding commissions from quota share reinsurers, loss payments by reinsurers, investment income and proceeds from the sale or maturity of investments. Funds are used by the Insurance Subsidiaries for loss payments and loss adjustment expenses. The Insurance Subsidiaries also use funds for ceded premium payments to reinsurers, which are paid on a net basis after subtracting losses paid on reinsured claims and reinsurance commissions on our net business, commissions to producers, salaries and other underwriting expenses as well as to purchase investments, fixed assets and to pay dividends to the Holding Company. The management companies’ primary sources of cash are management fees for the attorneys-in-fact from the Reciprocal Exchanges and TRM’s commissions and fees collected.
Net cash flows used in investing activities were $260.1 million for the year ended December 31, 2010 compared to $175.2 million used for the year ended December 31, 2009. The year ended December 31, 2009 included net cash acquired of $226.7 million with the acquisitions of CastlePoint and Hermitage whereas for the year ended December 31, 2010 we used $171.9 million net cash to acquire OBPL and AequiCap. The remaining cash flows in both years primarily related to purchases and sales of fixed-maturity securities and preferred stock.
The net cash flows provided by financing activities for the year ended December 31, 2010 are primarily the result of new borrowings of $145.6 million from the issuance of our convertible senior notes, reduced by the repurchase of common stock for $88.0 million and dividends of $16.6 million.
Net cash flows used in investing activities were $175.2 million in 2009 compared to net cash flow provided in 2008 of $1.6 million. In 2009, net cash acquired from acquisitions of $226.7 million was offset by the purchase of fixed assets of $26.3 million and the net increase in investments of $375.6 million. In 2008, we purchased $17.2 million of fixed assets and had a net cash inflow of $18.8 million from investments.
In 2010, CNIC contributed $10.0 million to York. In 2009, the Holding Company contributed $5.3 million to TICNY. The Holding Company also contributed $1.3 million to CPIC in 2009 and in 2008 contributed $0.3 million to TICNY.
The 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, 2010, the Insurance Subsidiaries’ risk-based capital exceeded the minimum level that would trigger regulatory attention.
Substantial future increases in inflation could also result in future increases in interest rates, which in turn are likely to result in a decline in the market value of the investment portfolio and cause unrealized losses or reductions in stockholders’ equity.
For a discussion of accounting standards, see “Note 2 - Accounting Policies and Basis of Presentation” to Consolidated Financial Statements.
Consolidated Statements of Income and Comprehensive Income for the years ended December 31, 2010, 2009, and 2008
As described in Management’s Report on Internal Control over Financial Reporting, management has excluded the Personal Lines Division of OneBeacon Insurance Group, Ltd (“OBPL”) (consisting of the wholly owned subsidiaries Massachusetts Homeland Insurance Company, York Insurance Company of Maine, Adirondack AIF, LLP and New Jersey Skylands management, LLC, and the interest held in the Reciprocal Exchanges, Adirondack Insurance Exchange and New Jersey Skylands Insurance Association, consolidated in the Company’s financial statements pursuant to FASB Accounting Standards Codification 810-10) from its assessment of internal control over financial reporting as of December 31, 2010 because it was acquired by the Company in a purchase business combination on July 1, 2010. We have also excluded OBPL from our audit of internal control over financial reporting. OBPL’s total assets and total revenues represent 20.2% and 7.9%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2010.
Commercial Insurance (“Commercial”) Segment offers a broad range of commercial lines property and casualty insurance products to small to mid-sized businesses distributed through a network of retail and wholesale agents on both an admitted and non-admitted basis. This segment also includes reinsurance solutions provided primarily to small insurance companies;
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant inter-company accounts and transactions have been eliminated in consolidation.
Certain reclassifications have been made to prior years’ financial information to conform to the current year presentation. As disclosed in “Note 1 - Nature of Business”, the Company has restated its segments for prior years to be consistent with the presentation in 2010.
Insurance policies issued or reinsured by the Company are short-duration contracts. Accordingly, premium revenue, including direct business and reinsurance assumed, net of business ceded to reinsurers, is recognized on a pro-rata basis over the terms of the underlying policies. Unearned premiums represent premium applicable to the unexpired risk of in-force insurance contracts at each balance sheet date. Prepaid reinsurance premiums represent the unexpired portion of reinsurance premiums on risks ceded and are earned consistent with premiums.
attorneys, claims that are handled by other attorneys that are not employees, and miscellaneous ALAE costs such as witness fees and court costs. Similarly, Tower estimates the ULAE liability separately for claims which are handled internally by our employees and for claims which are handled by third party administrators.
The Company determines a fixed fee per in-house litigated claim for ALAE stemming from defense by in-house attorneys and allocates to each of these litigated claims 50% of this fixed fee when litigation on a particular claim begins and 50% of the fee when the litigation is closed. The fee is determined actuarially based upon the projected number of litigated claims and expected closing patterns at the beginning of each year as well as the projected budget for the Company’s in-house attorneys, and these amounts are subject to adjustment each quarter based upon actual experience.
The Company determines a standard cost per claim for ULAE for each line of business that represents the ultimate average cost to administer that claim. 50% of this standard cost is recorded as paid ULAE when a claim is opened, and 50% of this standard cost is recorded as paid ULAE when a claim is closed. The standard costs are determined actuarially and subject to adjustment each quarter. Calendar period costs for the claims function is recorded as paid ULAE each quarter.
Management estimates uncollectible amounts receivable from reinsurers based on an assessment of a number of factors. The Company recorded no allowance for uncollectible reinsurance at December 31, 2010 or 2009. The Company did not write-off balances from reinsurers during the three year period ended December 31, 2010.
The Company, along with its outside portfolio managers, regularly reviews its fixed-maturity and equity security 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: (i) the overall financial condition of the issuer, (ii) the current fair value compared to amortized cost or cost, as appropriate; (iii) the length of time the security’s fair value has been below amortized cost or cost; (iv) specific credit issues related to the issuer such as changes in credit rating, reduction or elimination of dividends or non-payment of scheduled interest payments; (v) whether management intends to sell the security
Acquisition costs represent the costs of writing business that vary with, and are primarily related to, the production of insurance business (principally commissions, premium taxes and certain underwriting costs). Policy acquisition costs are deferred and recognized as expense as related premiums are earned. Deferred acquisition costs (“DAC”) presented in the balance sheet are net of deferred ceding commission revenue. The value of business acquired (“VOBA”) is an intangible asset relating to the estimated fair value of the unexpired insurance policies acquired in a business combination. VOBA is determined at the time of a business combination and is reported on the consolidated balance sheet with DAC and is amortized in proportion to the timing of the estimated underwriting profit associated with the in force policies acquired. The Company considers anticipated investment income in determining the recoverability of these costs and believes they are fully recoverable. See “Note 8 - Deferred Acquisition Costs” for additional information regarding deferred acquisition costs.
In business combinations, including the acquisition of a group of assets, the Company allocates the purchase price to the net tangible and intangible assets acquired based on their relative fair values. Any portion of the purchase price in excess of this amount results in goodwill. 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 and are subject to annual impairment testing. The Company conducted the required annual goodwill and intangible asset impairment testing as of September 30 for 2010. Additionally, identifiable intangible assets and goodwill are
Furniture, leasehold improvements, computer equipment, and software, including internally developed software, are reported at cost less accumulated depreciation and amortization. Gross fixed assets were $174.4 million and $113.4 million as of December 31, 2010 and 2009, respectively. Accumulated depreciation and amortization of $86.0 million and $47.0 million were recorded as of December 31, 2010 and 2009, respectively. Depreciation and amortization is provided using the straight-line method over the estimated useful lives of the assets. The Company estimates the useful life for computer equipment to be three years, computer software, three to seven years, furniture and other equipment seven years and leasehold improvements is the term of the lease. Depreciation and amortization expense of $15.0 million, $13.3 million and $10.5 million were recorded for the years ended December 31, 2010, 2009 and 2008, respectively. Fixed assets are recorded in Other Assets on the balance sheet.
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. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that all or some portion of the deferred tax asset will not be realized.
The Company accounts for restricted stock shares and options awarded at fair value at the date awarded and compensation expense is recorded over the requisite service period that has not been rendered. The Company amortizes awards with graded vesting on a straight-line basis over the requisite service period.
earnings per share is calculated by dividing income net income attributable to Tower common stockholders by the weighted average number of common shares outstanding during the year, as adjusted for the potentially dilutive effects of stock options, warrants, unvested restricted stock and/or preferred stock that are not participating securities, unless such items are not dilutive.
Financial instruments that potentially subject the Company to concentration and credit risk are primarily cash and cash equivalents, investments, interest rate swaps and accounts receivable. Investments are diversified through many industries and geographic regions through the use of money managers who employ different investment strategies. The Company limits the amount of credit exposure with any one financial institution and believes that no significant concentration of credit risk exists with respect to cash and investments. The interest rate swap contracts contain credit support annex agreements with collateral posting provisions which reduces counterparty non-performance risk. The premiums receivable balances are generally diversified due to the number of entities comprising the Company’s distribution force and its customer base, which is largely concentrated in the Northeast (primarily New York), Florida, Texas and California. To reduce credit risk, the Company performs ongoing evaluations of its distribution force’s and customers’ financial condition. The Company also has receivables from its reinsurers. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company periodically evaluates the financial condition of its reinsurers and, in certain cases, requires collateral from its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. Management’s policy is to review all outstanding receivables at period end as well as the bad debt write-offs experienced in the past and establish an allowance for doubtful accounts, if deemed necessary.
In June 2009, the FASB issued new guidance which concerns the consolidation of variable interest entities and changes how a reporting entity determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a reporting entity is required to consolidate another entity is based on, among other things, the other entity’s purpose and design and the reporting entity’s ability to direct the activities of the other entity that most significantly affect the other entity’s economic performance. The new guidance requires a reporting entity to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement. A reporting entity is required to disclose how its involvement with a variable interest entity affects the reporting entity’s financial statements. The Company adopted this new guidance on January 1, 2010, with no material effects as of the date of adoption. As disclosed in “Note 4 - Variable Interest Entities (“VIEs”)”, the Company has determined that the Reciprocal Exchanges managed by the management companies acquired in the OBPL transaction qualify as VIEs and that the Company is their primary beneficiary. Accordingly, the Company has consolidated these VIEs in its financial statements as of July 1, 2010, the closing date of the OBPL transaction.
In July 2010, the FASB issued new guidance concerning the credit quality of financing receivables and the allowance for credit losses. This guidance requires additional disclosures about the credit quality of financing receivables, which include reinsurance recoverables. The additional disclosures cover credit quality indicators, past due information and modifications of its financing receivables. These disclosures must be disaggregated by portfolio segment or class based on how a company develops its allowance for credit losses and how it manages its credit exposure. The required disclosures are included in “Note 9 - Reinsurance”.
Guidance issued by the FASB in January 2010 requires additional disclosure about the gross activity within Level 3 of the fair value hierarchy within GAAP as opposed to the net disclosure currently required. This disclosure will be effective for annual and interim periods beginning after December 15, 2010. As this guidance relates to disclosure rather than measurement of assets and liabilities, there will be no effect on the financial results or position of the Company. The Company will comply with this disclosure requirement when it becomes effective.
Acquisition of the Renewal Rights of AequiCap Program Administrators Inc. (“AequiCap”)
On November 2, 2010, Tower acquired the renewal rights to the commercial automobile liability and physical damage business of AequiCap for $12 million (“AequiCap II”). The business subject to the agreement covers both trucking and taxi risks that are consistent with Tower’s current underwriting guidelines. Most of the employees of AequiCap II involved in the servicing of this commercial liability and physical damage business became employees of the Company. The acquisition was accounted for as a business combination under GAAP. The distribution network was the only identifiable asset acquired and had a fair value of $11.3 million determined using Level 3 inputs. No liabilities were assumed. $0.7 million of goodwill was recorded as a result of this transaction.
Under the terms of the Agreement, the Company acquired Massachusetts Homeland Insurance Company (“MHIC”), York Insurance Company of Maine (“York”) and two management companies (collectively the “Stock Companies”). The management companies are the attorneys-in-fact for Adirondack Insurance Exchange, a New York reciprocal insurer, and New Jersey Skylands Insurance Association, a New Jersey reciprocal insurer (together, the “Reciprocal Exchanges”). Tower purchased $102 million principal of surplus notes issued by the Reciprocal Exchanges (the “surplus notes”). In addition, Tower also reinsured the personal lines business written by other subsidiaries of OneBeacon not acquired by Tower. The total consideration paid for OBPL was $167 million.
The following presents assets acquired and liabilities assumed from the OBPL acquisition, including the assets and liabilities of the Reciprocal Exchanges, based on their fair values and the fair value hierarchy level under GAAP as of July 1, 2010. See “Note 4 - Variable Interest Entities (“VIEs”)” for a description of accounting for the Reciprocal Exchanges.
The Company incurred $1.6 million of transaction costs, including legal, accounting, investment advisory and other costs directly related to the acquisition, which were expensed in the year ended December 31, 2010.
The acquisition was accounted for using the purchase method in accordance with GAAP guidance on business combinations effective in 2009. The purchase consideration consists primarily of 4,460,092 shares of Tower common stock with an aggregate value of $105.9 million issued to SUA shareholders at a ratio of 0.28 shares of Tower common stock for each share of SUA common stock. Additionally, $0.7 million related to the replacement of SUA employee stock options with Tower common stock options was included in the purchase consideration. The Company issued 201,058 employee stock options to replace the SUA employee stock options as of the acquisition date and 92,276 shares for deferred restricted stock awards.
The following table presents the fair value of assets acquired and liabilities assumed with the acquisition of SUA and the fair value hierarchy level under GAAP as of November 13, 2009, the closing date of the acquisition:
The acquisition was accounted for using the purchase method in accordance with recently issued GAAP guidance on business combinations. Under the terms of the Agreement, the Company acquired AequiCap I for $5.5 million in cash. The distribution network was the only identifiable intangible asset acquired. The fair value the distribution network was $5.3 million and the fair value of other assets acquired was $0.1 million resulting in $0.1 million of goodwill.
as of the close of the acquisition, with the amounts exceeding the fair value recorded as goodwill. The goodwill consists largely of the synergies and economies of scale expected from combining the operations of the Company and CastlePoint.
The following presents assets acquired and liabilities assumed with the acquisition of CastlePoint, based on their fair values and the fair value hierarchy level under GAAP as of February 5, 2009, the closing date of this acquisition:
Selected unaudited pro forma results of operations, assuming the OBPL, SUA, AequiCap I, AequiCap II, Hermitage and CastlePoint acquisitions had occurred as of January 1, 2009 are set forth below:
economic performance and the obligation to absorb losses or receive benefits from the management services provided to the Reciprocal Exchanges. Accordingly, the Company consolidates these Reciprocal Exchanges and eliminates all intercompany balances and transactions with Tower.
Represents the gross unrealized loss on other-than-temporarily impaired securities recognized in accumulated other comprehensive income (loss).
Management regularly reviews the Company’s fixed-maturity and equity security portfolios in accordance with its impairment policy to evaluate the necessity of recording impairment losses for OTTI. The determination of OTTI is a subjective process and different judgments and assumptions could affect the timing of loss realization.
The CMBS holdings are evaluated using analytical techniques and various metrics including the level of subordination, debt-service-coverage ratios, loan-to-value ratios, delinquencies, defaults and foreclosures.
There are 793 securities at December 31, 2010, that account for the gross unrealized loss, none of which is deemed by management to be OTTI. Temporary losses on corporate and other bonds resulted from purchases made in a lower interest rate environment or lower yield spread environment. In addition, there have been some ratings downgrades on certain of these securities. After analyzing the credit quality, balance sheet strength and company outlook, management believes these securities will recover in value as liquidity and the economy continue to improve. The structured securities that had significant unrealized losses resulted primarily from increased spreads driven in part by declines in both residential and commercial real estate prices. To the extent projected cash flows on structured securities change adversely, they would be considered OTTI, and an impairment loss would be recognized. Management considered all relevant factors, including expected recoverability of cash flows, in assessing whether the loss was other-than-temporary. The Company does not intend to sell these fixed maturity securities, and it is not more likely than not that these securities will be sold before recovering their cost basis.
Management evaluated the severity of the impairment in relation to the carrying values for the securities referred to above and considered all relevant factors in assessing whether the loss was other-than-temporary. Management does not intend to sell its fixed-maturity securities, and it is not more likely than not that these securities will be sold until there is a recovery of fair value to the original cost basis, which may be at maturity.
Level 2 - Inputs to the valuation methodology include quoted prices for similar assets or liabilities in active markets, inputs other than quoted prices that are observable for the asset or liability and market-corroborated inputs. Included are investments in U.S. Treasury securities and obligations of U.S. government agencies, together with municipal bonds, corporate debt securities, commercial mortgage and asset-backed securities, certain residential mortgage-backed securities that are generally investment grade and certain equity securities. Additionally, interest-rate swap contracts utilize Level 2 inputs in deriving fair values.
As at December 31, 2010 and 2009, the Company’s fixed-maturities, equity investments, short-term investments and interest rate swaps are allocated among levels as follows:
In 2010, there were no transfers of investments between Level 1 and Level 2. Approximately $5.3 million consisting of commercial mortgage-backed securities and non-agency backed RMBS securities were transferred from Level 3 to Level 2 when quoted market prices for similar securities that were considered reliable and could be validated against an alternative source became available in 2010.
Use of Level 3 (the unobservable) inputs included 7 securities and accounted for less than 0.1% of total investments at December 31, 2010.
Management has reviewed the pricing techniques and methodologies of the independent pricing sources and believes that their policies adequately consider market activity, either based on specific transactions for the issue valued or based on modeling of securities with similar credit quality, duration, yield and structure that were recently traded. Management monitors security-specific valuation trends and discusses material changes or the absence of expected changes with the portfolio managers to understand the underlying factors and inputs and to validate the reasonableness of pricing.
Goodwill is calculated as the excess of purchase price over the net fair value of assets acquired. See Note 3 - “Acquisitions” for information regarding the calculation of goodwill related to the acquisition of OBPL and AequiCap II in 2010 and the acquisitions of CastlePoint, Hermitage and AequiCap in 2009. The acquisition of SUA resulted in negative goodwill which was recorded as a gain on bargain purchase in 2009. Under GAAP, the Company is required to allocate goodwill to its reportable segments. The following is a summary of goodwill by reporting units:
The components of intangible assets and their useful lives, accumulated amortization, and net carrying value as of December 31, 2010 and 2009 are as follows:
The activity in the components of intangible assets for the years ended December 31, 2010 and 2009 consisted of intangible assets acquired from business combinations and amortization expense as shown in the table below:
Relates to the acquisition of CastlePoint, Hermitage, AequiCap I and SUA in 2009 and OBPL and AequiCap II in 2010.
Through various quota share, excess of loss and catastrophe reinsurance agreements, the Company limits its exposure to a maximum loss on any one risk. For 2011, the maximum loss exposure is $5.0 million on property, automobile and liability; $2.35 million on workers’ compensation and $2.5 million on umbrella. In 2010 and 2009, the maximum loss exposure was $1.5 million on property, automobile and workers’ compensation policies.
The Company purchases property catastrophe reinsurance for the Insurance Subsidiaries on an excess of loss basis above a specified retention to protect itself from an accumulation of losses resulting from a catastrophic event. At the July 1, 2010 renewal of its property catastrophe program, the Company maintained a retention of $75 million per catastrophe, has 50% catastrophe protection for the next $50 million of loss above the $75 million, and has 100% percent catastrophe protection for the next $650 million of loss in excess of $125 million.
The Company did not record any modifications of its reinsurance recoverables on paid or unpaid losses in the years ended December 31, 2010, 2009 or 2008. The Company recorded no allowance for credit losses on its reinsurance recoverables on paid or unpaid losses as of December 31, 2010 or 2009. The Company did not consider that any of its undisputed reinsurance recoverables on paid or unpaid losses as of December 31, 2010 and 2009 to be past due. As discussed in “Note 17 - Contingencies”, certain reinsurance agreements are subject to legal proceedings.
The following collateral is available to the Company for amounts recoverable from reinsurers as of December 31, 2010 and 2009:
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 $29.3 million for all treaties for all five years. The ceded premiums for treaty years prior to 2010 have been fully earned as of December 31, 2010. As of December 31, 2010, the ceded premium earned and prepaid reinsurance premiums for the 2010 treaty year were $31.0 million and $23.0 million, respectively.
Incurred losses and LAE in 2010 of $784.0 million included a reduction of $7.1 million pertaining to the amortization of the reserve risk premium on loss reserves in accordance with GAAP for the business combinations occurring during 2010 and 2009. Incurred losses and LAE in 2009 of $475.5 million included a reduction of $5.0 million pertaining to the amortization of the reserve risk premium on loss reserves in accordance with GAAP for the business combinations occurring during 2009.
Incurred loss and LAE attributable to insured events of prior years decreased by $12.3 million, $2.3 million and $8.9 million in 2010, 2009 and 2008, respectively. The $12.3 million of favorable development in 2010 was comprised of $2.4 million of favorable development in our stock companies and $9.9 million of favorable development in the reciprocals. Prior year development is based upon numerous estimates by line of business and accident year. No additional premiums or return premiums have been accrued as a result of the prior year effects, although we recorded changes in ceding commissions on reinsurance treaties that we purchase and for which the commissions depend in part on loss experience. 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.
Loss and loss adjustment expense reserves. The reserving process for loss and LAE reserves provides for the Company’s best estimate at a particular point in time of the ultimate unpaid cost of all losses and LAE incurred, including settlement and administration of losses, and is based on facts and circumstances then known and including losses that have been incurred but not yet been reported. The liability for loss and LAE also includes the fair value adjustment related to the acquisitions of CastlePoint, Hermitage, SUA and OBPL. 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 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 loss ratio projections, loss development projections, and Bornhuetter-Ferguson (B-F) method projections. The actuaries’ best estimates are the result of numerous analyses made by line of business, accident year, and for loss, ALAE and ULAE, and the actuarial analyses also consider input from underwriting and claims managements about the nature of the underlying risks, claims and other trends in the business. Management sets the carried reserves based upon the actuaries’ best estimate, and the difference between the actuaries’ best estimates of loss and LAE and reported losses is recorded in IBNR. The amount of loss and LAE reserves for reported claims is based primarily upon a case-by-case evaluation of coverage, liability, injury severity, and any other information considered pertinent to estimating the exposure presented by the claim. The amounts of loss and LAE reserves for unreported claims are determined using historical information by line of insurance as adjusted to current conditions. Since our process produces loss and LAE reserves set by management based upon the actuaries’ best estimate, there is no explicit or implicit risk premium provision for uncertainty in the carried loss and LAE reserves, excluding the loss and LAE reserves assumed through business combinations in either 2010 or 2009.
For each acquisition, the Company estimates and records the loss and LAE reserves based upon its independent analysis of those reserves. For both the SUA and OBPL acquisitions, based upon our actuaries best estimates of the required reserves at the time of each acquisition we increased the loss and LAE reserves by $27.5 million and $41.4 million for SUA and OBPL, respectively, above the amounts prior to the acquisition. For SUA the increase in reserves was comprised of an additional $25.7 million in statutory and GAAP basis reserves based upon the Company’s independent actuarial analysis plus an additional $1.9 million in GAAP basis loss and LAE reserves pertaining to the reserves risk premium required under GAAP. For OBPL the increase in reserves was comprised of an additional $29.7 million in statutory and GAAP basis reserves based upon the Company’s independent actuarial analysis plus an additional $11.7 million in GAAP basis loss and LAE reserves pertaining to the reserves risk premium required under GAAP comprised of $7.2 million excluding the Reciprocal Exchanges and $4.5 million for the Reciprocal Exchanges. The reserves risk premium established with each acquisition is amortized based upon GAAP according to the expected payout pattern of those reserves. During 2010 the reserves risk premium was reduced by $7.1 million, which was comprised of $4.7 million reduction for accident year 2009 and pertaining to the acquisitions of CastlePoint, Hermitage, and SUA and $2.4 million reduction for accident year 2010 pertaining to the acquisition of OBPL.
As of December 31, 2010 and 2009, the Company had a remaining $14.6 million and $14.1 million, respectively, of reserve risk premium on loss reserves in accordance with GAAP for the business combinations occurring during 2010 and 2009.
The Company has long defended third-party liability claims utilizing attorneys who are employees of the Company, and in 2008 we changed the manner in which we reimburse the employed attorneys costs to a standard cost per litigated claim. The average cost for defending third-party liability claims is significantly less when handled by attorneys who are employees of the Company. For third-party liability claims defended by employed attorneys, the Company allocates to each of these litigated claims 50% of the fixed fee when litigation on a particular claim begins and 50% of the fee when the litigation is closed. The standard fee, which is currently $5,000 per claim, is determined actuarially based upon the projected number of litigated claims and expected closing patterns at the beginning of each year, as well as the projected budget for the Company’s in-house attorneys, and these amounts are subject to adjustment each quarter based upon actual experience.
ULAE reserves were reduced by $14.0 million as result of a revised study of the cost of settling claims, which was finalized at the end of the year.
The Company segregates data for estimating loss reserves. Property lines include Fire, Homeowners, CMP Property, Multi-Family Dwellings and Automobile Physical Damage. Casualty lines include CMP Liability, Other Liability, Workers’ Compensation, Commercial Automobile Liability, and Personal Automobile Liability. The Company also analyzes and records reserves separately for Commercial Insurance and for Personal Insurance.
In most cases, the Company’s data have sufficient credibility and historical experience to base development factors on its own data. Where necessary, we supplement our own data with historical experience for the business that is available from the previous insurance carrier, and we may utilize industry loss development factors, where appropriate.
Total interest expense incurred was $24.6 million, $18.1 million and $8.4 million for the years ended December 31, 2010, 2009 and 2008, respectively.
Fees payable by the Company under the credit facility include a fee on the daily unused portion of each letter of credit, a letter of credit fronting fee with respect to each fronted letter of credit and a commitment fee.
In September 2010, the Company issued $150.0 million principal amount of 5.0% convertible senior notes (“the Notes”), which mature on September 15, 2014. Interest on the Notes is payable semi-annually in arrears on March 15 and September 15 of each year, commencing March 15, 2011. Holders may convert their Notes into cash or common shares, at the Company’s option, at any time on or after March 15, 2014 or earlier under certain circumstances determined by: (i) the market price of the Company’s stock, (ii) the trading price of the Notes, or (iii) the occurrence of specified corporate transactions. Upon conversion, the Company intends to settle its obligation either entirely or partially in cash. The initial conversion rate is 36.3782 shares of common stock per $1,000 principal amount of the Notes (equivalent to an initial conversion price of $27.49 per share), subject to adjustment upon the occurrence of certain events. Additionally, in the event of a fundamental change, the holders may require the Company to repurchase the Notes for a cash price equal to 100% of the principal plus any accrued and unpaid interest.
The following table shows the amounts recorded for the Notes as of December 31, 2010:
The Company paid $15.3 million for the Note Hedges which cover 5.5 million shares of common stock at a strike price of $27.49 per share, subject to anti-dilution provisions, and are exercisable upon conversion of the Notes. The Note Hedges have been accounted for as an adjustment to the Company’s paid-in-capital, net of deferred taxes.
To the extent the Company’s common stock price is above $27.49 but below the Warrant strike price of $33.42, there is no dilutive effect to common stockholders’ equity because the Note Hedge offsets any shares to be issued under the Notes. If the market value per share of the Company’s common stock exceeds the strike price of the warrants, the warrants will have a dilutive effect on the Company’s net income per share.
In October 2010, the Company entered into interest rate swap contracts (the “Swaps”) with $190 million notional value to manage interest costs and cash flows associated with the floating rate subordinated debentures. The Swaps have terms of five years. The majority of the Swaps is forward starting and become effective when the respective subordinated debentures change from fixed rates to floating rates and convert the subordinated debentures’ to rates ranging from 5.1% to 5.9%. As of December 31, 2010, the Swaps had fair values of $3.2 million and are reported in Other Assets.
On January 28, 2009, an amendment to increase the number of authorized shares of common stock, par value $0.01 per share, from 40,000,000 shares to 100,000,000 shares was approved at a special meeting of stockholders.
For the years ended December 31, 2010 and 2009, 242,169 and 52,310 new common shares, respectively, were issued as the result of employee stock option exercises and 355,539 and 310,208 new common shares, for the same periods, respectively, were issued as the result of restricted stock grants.
For the years ended December 31, 2010 and 2009, 77,670 and 43,820 shares, respectively, of common stock were purchased from employees in connection with the vesting of restricted stock issued under the 2004 Long Term Equity Compensation Plan (the “Plan”). The shares were withheld at the direction of employees as permitted under the Plan in order to pay the expected amount of tax liability owed by the employees from the vesting of those shares. In addition, for the years ended December 31, 2010 and 2009, 28,833 and 11,065 shares, respectively, of common stock were surrendered as a result of restricted stock forfeitures.
The plan provides for the granting of non-qualified stock options, incentive stock options (within the meaning of Section 422 of the Code), stock appreciation rights (“SARs”), restricted stock and restricted stock unit awards, performance shares and other cash or share-based awards. The maximum amount of share-based awards authorized is 2,325,446 of which 1,213,734 are available for future grants as of December 31, 2010.
In December 2000, the Board of Directors adopted a long-term incentive plan. The plan provided for a variety of awards, including incentive or non-qualified stock options, performance shares, SARs or any combination of the foregoing. As of December 31, 2010, all shares awarded under the plan have been exercised. With the adoption of the 2004 Long-Term Incentive Compensation Plan, no further awards may be granted under the 2001 Stock Award Plan.
During the years ended December 31, 2010, 2009 and 2008, restricted stock shares were granted to senior officers, key employees and directors as shown in the table below. Restricted stock expense recognized for the years ended December 31, 2010, 2009 and 2008 was $4.1 million, $2.6 million and $1.3 million net of tax, respectively. The total value of restricted stock vesting was $4.7 million, $1.8 million and $2.0 million for the years ended December 31, 2010, 2009 and 2008, respectively. The value of the unvested restricted stock outstanding as of December 31, 2010 and 2009 was $15.1 million and $11.1 million, respectively.
Options outstanding and exercisable as of December 31, 2010 are shown on the following table:
The Company files a consolidated Federal income tax return. The Reciprocal Exchanges are not included in the Company’s consolidated tax return as the Company does not have an ownership interest in the Reciprocal Exchanges, and they are not a part of the consolidated tax sharing agreement.
The provision for Federal, state and local income taxes consist of the following components:
Preserver Group, Inc. (“PGI”), acquired by the Company in 2007 and CastlePoint and SUA, acquired in 2009, have net operating tax loss carryforwards (“NOLs”) that the Company expects will be used in the future, subject to change of ownership limitations pursuant to Section 382 of the Internal Revenue Code (“Section 382”). As of December 31, 2010, the Tower NOLs totaled $42.6 million and are related to PGI, CastlePoint and SUA for $33.4 million, $6.5 million and $2.6 million, respectively. In addition, the Reciprocal Exchanges have NOLs of $13.0 million.
Section 382 imposes annual limitations on a corporation’s ability to utilize its NOLs if it experiences an “ownership change.” As a result of the acquisitions, Preserver, CastlePoint and SUA’s NOLs are subject to annual limitations of $2.8 million, $11.1 million and $4.6 million, respectively. Any unused annual limitation may be carried over to later years. The NOLs will expire in years 2019 through 2030.
The Company believes it is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax assets, including the NOLs, except for those associated with the Reciprocal Exchanges. The Company has recorded a valuation allowance of $5.6 million at December 31, 2010 to reflect the amount of the Reciprocal Exchanges’ deferred taxes that may not be realized.
As of December 31, 2010 and 2009, the Company had no material uncertain tax positions and no adjustments to liabilities or operations were required.
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 eligible contribution. The Company incurred $2.7 million, $1.4 million and $1.3 million of expense in 2010, 2009 and 2008, respectively, related to the 401(k) Plan.
On May 28, 2009, Munich Reinsurance America, Inc. (“Munich”) commenced an action against Tower Insurance Company of New York (“TICNY”), a wholly-owned subsidiary of Tower Group, Inc., in the United States District Court for the District of New Jersey seeking, among other things, to recover $6.1 million under various retrocessional contracts pursuant to which TICNY reinsures Munich. On June 22, 2009, TICNY filed its answer, in which it, inter alia, asserted two separate counterclaims seeking to recover $2.8 million under various reinsurance contracts pursuant to which Munich reinsures TICNY. A separate action commenced by Munich against TICNY on June 17, 2009 in the United States District Court for the District of New Jersey seeking a declaratory judgment that Munich is entitled to access to TICNY’s books and records pertaining to various quota share agreements, to which TICNY filed its answer on July 7, 2009, was subsequently dismissed pursuant to the stipulation of the parties on March 17, 2010. The parties are currently engaged in discovery and the Company is therefore unable to assess the likelihood of any particular outcome.
Tower’s Insurance Subsidiaries are also required to participate in various mandatory insurance facilities or in funding mandatory pools, which are generally designed to provide insurance coverage for consumers who are unable to obtain insurance in the voluntary insurance market. The Insurance Subsidiaries are subject to assessments in New York, New Jersey and other states for various purposes, including the provision of funds necessary to fund the operations of the New York Insurance Department and
the New York Property/Casualty Insurance Security Fund, which pays covered claims under certain policies provided by impaired, insolvent or failed insurance companies and various funds administered by the New York Workers’ Compensation Board, which pays covered claims under certain policies provided by impaired, insolvent or failed insurance companies. The Company paid $4.8 million, $4.0 million and $2.0 million in 2010, 2009 and 2008, respectively, for its proportional share of the operating expenses of the New York Insurance Department. Property casualty insurance company insolvencies or failures may result in additional security fund assessments to the Company at some future date. At this time the Company is unable to estimate the possible amounts, if any, of such assessments. Accordingly, the Company is unable to determine the impact, if any; such assessments may have on financial position or results of operations of the Company. The Company is permitted to assess premium surcharges on workers’ compensation policies that are based on statutorily enacted rates. Actual assessments have resulted in differences to the original estimates based on permitted surcharges of $4.1 million, $2.2 million and $0 million in 2010, 2009 and 2008, respectively. The Company estimates its liability for future assessments based on actual written premiums and historical rates and available information. As of December 31, 2010 the liability for the various workers’ compensation funds, which includes amounts assessed on workers’ compensation policies was $4.3 million. This amount is expected to be paid over an eighteen month period ending June 30, 2012. As of December 31, 2009, the liability for the various workers’ compensation funds was $11.6 million.
For regulatory purposes, the Company’s Insurance 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:
Investments in fixed-maturity securities are valued at NAIC value for statutory financial purposes, which is primarily amortized cost. GAAP requires investments in fixed-maturity securities classified as available for sale, to be reported at fair value.
State insurance laws restrict the ability of our Insurance 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 Subsidiaries can declare and pay an “extraordinary dividend” to the Company.
For the years ended December 31, 2010, 2009 and 2008, the Company’s Insurance Subsidiaries had SAP net income of $93.5 million, $32.8 million and $30.2 million, respectively. At December 31, 2010 and 2009 the Company’s Insurance Subsidiaries had reported SAP surplus as regards policyholders of $659.2 million and $593.9 million, respectively, as filed with the insurance regulators.
The Company’s Insurance Subsidiaries paid $4.7 million, $15.0 million and $5.2 million in dividends and or return of capital to Tower in 2010, 2009 and 2008, respectively. As of December 31, 2010, the maximum distribution that Tower’s Insurance Subsidiaries could pay without prior regulatory approval was $30.8 million and the maximum return of capital available from CastlePoint Re without permission was $39.3 million.
CastlePoint Re is also subject to dividend limitations imposed by Bermuda. Under the Companies Act 1981 of Bermuda, as amended (the “Companies Act”), we may declare or pay a dividend out of distributable reserves only if we have reasonable grounds for believing that we are, or would after the payment, be able to pay our liabilities as they become due and if the realizable value of our assets would thereby not be less than the aggregate of our liabilities and issued share capital and share premium accounts.
Equity and fixed income investments: Fair value disclosures for investments are included in “Note 5-Investments.”
The computation of diluted earnings per share excludes outstanding options and other common stock equivalents in periods where inclusion of such potential common stock instruments would be anti-dilutive. For the years ended December 31, 2010, 2009 and 2008, 193,000, 401,700 and 0, respectively, options and other common stock equivalents to purchase Tower shares were excluded from the computation of diluted earnings per share because the exercise price of the options was greater than the average market price.
The Personal Insurance segment includes revenues and expenses associated with the Reciprocal Exchanges, including fees paid to Tower for underwriting, claims, investment management and other services provided pursuant to a management services agreement with the Reciprocal Exchanges. The Insurance Services segment reports revenues earned by Tower from the Reciprocal Exchanges as management fee income, which is calculated as a percentage of the Reciprocal Exchanges’ gross written premiums. The effects of this management services agreement between Tower and the Reciprocal Exchanges are eliminated in consolidation to derive consolidated net income. However, the management fee income is reported in net income attributable to Tower Group, Inc. and included in basic and diluted earnings per share.
Segment performance is evaluated based on segment profit, which excludes investment income, realized gains and losses, interest expense, income taxes and incidental corporate expenses. Assets are not allocated to segments because assets, which consist primarily of investments and fixed assets, other than intangibles and goodwill, are considered in total by management for decision-making purposes.
The following table presents the unaudited quarterly financial information for the Company: