We also lease office space in Atlanta, Georgia; Buffalo, New York; Canton Massachusetts; Chicago, Illinois; Charlotte, North Carolina; Fort Lauderdale, Florida; Glastonbury, Connecticut; Irvine California; Irving, Texas; Maitland, Florida; Marlborough, Massachusetts; Melville, New York; Mobile, Alabama; Moorestown, New Jersey; Palm Springs, California; Paramus, New Jersey; Philadelphia, Pennsylvania; Petaluma, California; Shelton, Connecticut; Portland, Maine.
The selected consolidated income statement data for the years ended December 31, 2011, 2010 and 2009, and the balance sheet data as of December 31, 2011 and 2010 are derived from our audited financial statements included elsewhere in this document, which have been prepared in accordance with GAAP. You should read the following selected consolidated financial information along with the information contained in this document, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes included elsewhere in this Form 10-K.
(5) Book value per share is based on total stockholders’ equity divided by common shares outstanding at year end.
Our consolidated results of operations in 2011 reflect organic growth from our Customized Solutions and Assumed Reinsurance products as well as growth from acquisitions completed in the current and prior years. Our consolidated revenues and expenses reflect the results of these acquired companies from their respective acquisition dates and this affects the comparability of our results between years.
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 includes fees earned by the management companies. This change in presentation reflects the way management organizes the Company for making operating decisions and assessing profitability. 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.
We offer our products and services through our insurance subsidiaries, managing general agencies and management companies. Results for our insurance subsidiaries are reported in our Commercial and Personal Insurance segments. Results for our managing general agencies and management companies are reported in our Insurance Services segment.
Our commercial lines products include commercial multiple-peril (provides both property and liability insurance), monoline general liability (insures bodily injury or property damage liability), commercial umbrella, monoline property (insures buildings, contents or business income), workers’ compensation, fire and allied lines, inland marine, commercial automobile policies and assumed reinsurance. Our personal lines products consist of homeowners, personal automobile and umbrella policies.
In our Insurance Services segment, we generate management fees primarily from the services provided by management companies to the Reciprocal Exchanges and other fees generated by the managing general agencies.
On January 14, 2011, Tower obtained the renewal rights to the middle market commercial package and commercial automobile business underwritten through the NAV PAC division of Navigators Group, Inc. This business will allow us to continue to expand our middle market commercial product offering into certain niche classes of business. The underwriting personnel from NAV PAC became part of our recently formed Customized Solutions business unit focused on developing customized products for our key partner agents.
On February 27, 2009, the Company completed the acquisition of Hermitage, a property and casualty insurance holding company, pursuant to a stock purchase agreement, from a subsidiary of Brookfield Asset Management Inc. Hermitage offers both admitted and E&S lines products. This transaction further expanded the Company’s wholesale distribution system nationally and established a network of retail agents in the Southeast.
On February 5, 2009 the acquisition of 100% of the issued and outstanding common stock of CastlePoint, a Bermuda exempted corporation, was completed. This transaction has expanded and diversified revenues by accessing CastlePoint’s programs and risk sharing businesses.
Ceding commission revenue. We earn ceding commission revenue (generally a percentage of the premiums ceded) on the gross premiums written that we cede to reinsurers under quota share reinsurance agreements. We typically do not earn ceding commission revenue on property catastrophe or excess of loss reinsurance that we purchase.
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 and fee income is generated on premiums produced by the managing general agencies on behalf of third-party reinsurance companies.
Losses and loss adjustment expenses. We establish loss and loss adjustment expense (“LAE”) reserves in an amount equal to our estimate of the ultimate liability for claims under our insurance policies and the cost of adjusting and settling those claims. Loss and LAE recorded in a period include estimates for losses incurred during the period and changes in estimates for prior periods.
Management fee income earned by the management companies. Our management companies provide various underwriting, claims, investment management and other services to the Reciprocal Exchanges. We receive a percentage of the gross written premiums issued by the Reciprocal Exchanges.
Book value per share. Book value per share is calculated as Tower Group, Inc, stockholders’ equity over the number of shares outstanding. We use this as a measure of value per share of the Company independent from the market price per share.
Loss and loss adjustment expense reserves. The reserving process for loss and LAE reserves provides our best estimate at a particular point in time of the ultimate unpaid cost of all losses and LAE incurred, including settlement and administration of losses, and is based on facts and circumstances then known and including losses that have been incurred but not yet reported. The process includes using actuarial methodologies to assist in establishing these estimates, judgments relative to estimates of future claims severity and frequency, the length of time before losses will develop to their ultimate level and the possible changes in the law and other external factors that are often beyond our control. There are various actuarial methods that are appropriate for the different lines of business, and our actuaries’ use of a particular method or weighting of methods depends in part on the maturity of each accident year by line of business, the limits of liability covered under the policies, the presence or absence of large claims in the experience, and other considerations. In general, the various actuarial methods can be grouped into three categories: loss ratio projection, loss development methods, and the B-F method. For the most recent accident year, and especially for liability lines of business, the actuarial method given the most weight is usually the loss ratio method, since the percentage of ultimate claims reported to date is expected to be low and the immature reported claims experience is not a reliable indicator of ultimate losses for that accident year. For property lines of business for the most recent accident year, the B-F method is usually given the most weight, because experience typically shows that there is a small percentage of claims reported in the subsequent period due to normal lags in reporting and processing of claims in these lines of business that can be relatively reliably estimated as a percentage of premiums, which is reflected in the B-F method. For each line of business, the actuarial reserving method usually given the most weight shifts from the loss ratio projection to the B-F method to the incurred loss projection as each accident year matures. These methods are described in “Business-Loss and Loss Adjustment Expense Reserves.”
reserves and within LAE reserves estimates are made for defense and cost containment expenses or Allocated Loss Adjustment Expenses (“ALAE”) and for other claims adjusting expenses or Unallocated Loss Adjustment Expenses (“ULAE”). The amount of loss and LAE reserves for reported claims is based primarily upon a case-by-case evaluation of coverage, liability, injury severity, and any other information considered pertinent to estimating the exposure presented by the claim. The amounts of loss and LAE reserves for unreported claims are determined using historical information by line of business as adjusted to current conditions. Since our process 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, except for required provisions in connection with acquisitions which are separately determined.
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.
Two key assumptions that materially impact the estimate of loss reserves are the loss ratio estimate for the current accident year and the loss development factor selections for all accident years. The loss ratio estimate for the current accident year is selected after reviewing historical accident year loss ratios adjusted for rate and price changes, trend, mix of business, and other factors. In addition, as the year matures and, depending upon the line of business, we utilize B-F methods or loss development methods for the current accident year.
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. This adjustment is referred to as the “reserve risk premium”, which is amortized over the expected payout pattern of the claims.
If an other-than-temporary-impairment (“OTTI”) loss is determined for a fixed-maturity security (for which we do not have the intent to sell or it is not more likely than not we would be required to sell), the credit portion is recorded in the income statement as realized investment losses and the non-credit portion is recorded in accumulated other comprehensive income. The credit portion results in a permanent reduction in the cost basis of the underlying investment. For all other fixed-maturity security and equity security impairments, the entire impairment is reflected as a realized investment loss and reduces the cost basis of the security. The determination of OTTI is a subjective process and different judgments and assumptions could affect the timing of loss realization. We recorded OTTI losses on our fixed maturity and equity securities in the amounts of $3.5 million, $16.1 million and $44.2 million in 2011, 2010, and 2009, respectively, of which $3.2 million, $4.2 million and $23.5 million were recorded in earnings in 2011, 2010, and 2009, respectively.
Since total unrealized losses are a component of stockholders’ equity, the recognition of OTTI losses have no effect on our comprehensive income or stockholders’ equity.
(3) Commission and fee income for the years ended December 31, 2011 and 2010 excludes management fee income earned by Tower from the Reciprocal Exchanges. These amounts are eliminated in reporting consolidated net income.
Overall, the Company’s net earned premiums increased $301.2 million, or 23.3%, to $1,593.9 million in 2011 from $1,292.7 million in 2010.
The Company had net realized investment gains of $9.4 million for the year ended December 31, 2011 compared to gains of $13.5 million in 2010. OTTI losses recorded in earnings for the year ended December 31, 2011 were $3.2 million, a decline from $4.2 million of OTTI losses recorded for 2010.
Loss and loss adjustment expenses. The consolidated net loss ratio, which includes the Reciprocal Exchanges, was 66.2% and 60.7% for the years ended December 31, 2011 and 2010, respectively. Excluding the Reciprocal Exchanges, the net loss ratio was 67.6% and 60.2% for the years ended December 31, 2011 and 2010, respectively. The Reciprocal Exchanges’ net loss ratio was 55.8% and 66.3% for the years ended December 31, 2011 and 2010, respectively.
Operating expenses. Operating expenses, which include direct and ceding commission expenses and other operating expenses, were $589.6 million for the year ended December 31, 2011, an increase of 18.5% over the prior year, primarily as a result of the OBPL acquisition, which was not included in the Company’s results for the first six months of 2010. In addition, the Company amortized the value of business acquired (“VOBA”) asset recorded on July 1, 2010 in connection with the OBPL purchase accounting. This resulted in $10.2 million of expense recorded in 2011 and exceeded the amount of acquisition costs that were capitalized in 2011as DAC. The VOBA was fully amortized as of June 30, 2011. In addition, the Company incurred $23.9 million in 2011 compared to $13.3 million in 2010, under the transition services agreements with OneBeacon. The net underwriting expense ratio improved to 34.1% in 2011 from 35.7% in 2010.
The consolidated gross underwriting expense ratio improved slightly to 32.3% in 2011 from 32.9% in 2010. The commission portion of the gross underwriting expense ratio was 17.4% and 17.6% for years ended December 31, 2011 and 2010, respectively. The improvement in the commission ratio reflects the impact of lower commission rates in the Reciprocal Exchanges. The gross other underwriting expense (“OUE”) ratio, which includes boards, bureaus and taxes (“BB&T”), improved to 14.9% in 2011 from 15.3% in 2010.
Income tax expense. Income tax expense decreased in 2011 compared to 2010 due to the decrease in pre-tax income. The effective income tax rate (including state and local taxes) was 25.9% for the year ended December 31, 2011, compared to 33.7% for the same period in 2010. The effective rate is lower than the statutory rate due to, among other things, our tax exempt municipal investment and dividends received deductions related to our equity securities portfolio, as well as the reversal of a $1.3 million valuation allowance at the Reciprocal Exchanges.
Total revenues. Total revenues increased by 48.4% for the year ended December 31, 2010 as compared to 2009, primarily due to increased net premiums earned and net investment income resulting from the acquisition of OBPL at the beginning of the third quarter of 2010 and the full year results of SUA in 2010 compared to only one month of results in 2009. The following table shows the effects of the various acquisitions on our gross premiums written in 2010:
Premiums earned. Gross premiums earned in the year ended December 31, 2010 increased 45.2% compared to the prior year, primarily as a result of the aforementioned acquisitions. Ceded premiums earned increased by a lower percentage than the gross growth percentage as we retained a larger percentage of our gross premiums because of our increased capital base. Accordingly, net premiums earned in the year ended December 31, 2010 increased by $438.0 million compared to 2009.
Commission and fee income. Commission and fee income decreased by $5.5 million in the year ended December 31, 2010. This decrease is due to our decision to use less quota share reinsurance in 2010 compared to 2009 leading to reduced ceding commission revenue. Insurance services revenue declined for the year ended December 31, 2010 compared to 2009 caused by our managing general agency ceasing to produce business on behalf of CastlePoint’s insurance companies subsequent to the CastlePoint acquisition in 2009. Partially offsetting these decreases was a $3.3 million increase in policy billing fees generated in connection with the OBPL business for the last six months of 2010.
Loss and loss adjustment expenses. For the year ended December 31, 2010 the net loss ratio increased 5.1 percentage points due to the impact of changing business mix, price competition and losses from the storms in the northeastern U.S. occurring in March 2010 which increased the loss ratio by 1.2 points. These impacts were partially offset during the second half of the year by lower property losses.
The amortization of the reserves risk premium, which was established in connection with the acquisitions completed in 2010 and 2009, reduced consolidated losses by $7.1 million, comprised of $6.3 million excluding the Reciprocal Exchanges and $0.8 million for the Reciprocal Exchanges. The amortization of reserves risk premium lowered the loss ratio, excluding the Reciprocal Exchanges by 0.5 loss ratio points for the year ended December 31, 2010 as compared to 0.6 loss points for 2009.
LAE 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.
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 entered into 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.
Other income (expense). Other income for the year ended 2009 was $19.8 million whereas in 2010, we recorded other expenses of $0.4 million. The other income in 2009 consisted of $13.2 million gain on bargain purchase related to the acquisition of SUA in the fourth quarter of 2009 and a gain of $7.4 million on the revaluation of the shares owned in CastlePoint at the time of the acquisition offset by the Company’s $0.8 million equity in the net loss of CastlePoint prior to its acquisition on February 5, 2009. Other expenses in 2010 were not significant at $0.4 million.
Loss and loss adjustment expenses and loss ratio. The net loss ratios were 67.7% and 62.6% for the years ended December 31, 2011 and 2010, respectively. The loss ratios increased in the current calendar year by 5.1 points in total, which is attributable to 2.9 points primarily due to severe weather related events losses and 2.2 points as a result of revised estimates of losses from prior years. The 2011 severe weather related losses, which include Hurricane Irene, were $31.5 million.
We increased reserves for prior years by approximately $46.1 million comprised of $26.4 million for other liability, $30.5 for workers compensation, and $7.9 million for commercial automobile. This was offset in part by favorable development on commercial packages and monoline property totaling $6.4 million, by favorable development in CPRE of $10.4 million, and $1.9 million for amortization of reserves risk premium that was established in 2009 as part of fair value accounting for the acquisitions made that year. Other liability unfavorable development included $8.1 million unfavorable related to excess liability coverage pertaining to one of our specialty programs. The unfavorable development in workers compensation included $8.3 million for programs and $10.3 million for transactional business.
The gross underwriting expense ratio was 30.3% for the year ended December 31, 2011 as compared to 31.3% in 2010. The commission portion of the gross underwriting expense ratio, which is expressed as a percentage of gross premiums earned, was 17.8% for the year ended December 31, 2011 compared to 17.4% for the same periods in 2010. This increase is attributable to the assumed reinsurance which has a higher commission. The OUE ratio, including BB&T, was 12.5% for the year ended December 31, 2011 compared 13.9% for the same period in 2010. The improvement in OUE in 2011 resulted from of our continued efforts to reduce expenses through integration, with many functions consolidated into one office.
The change in net premiums written and earned increased in line with increases in gross premiums that were driven primarily by the acquisitions described above and the aforementioned decrease in ceded premiums.
Renewal retention, particularly for small policies, continued to offset a challenging market environment for new business. We restricted underwriting in some of our programs and for middle market and larger accounts, which resulted in a decline in premiums from these customer types. Excluding programs, the renewal retention rate was 77% for the year ended December 31, 2010. Premiums on renewed commercial business, other than programs, increased 0.6%. Excluding programs, policies in-force for our commercial business increased by 0.2% as of December 31, 2010.
Ceding commission revenue. Ceding commission revenue decreased for the year ended December 31, 2010 by $7.4 million compared to 2009. The decrease was a result of a lower ceded commission rate on our liability quota share treaty earned in 2010 compared to the ceded commission rate on our multi-line quota share which was earned in 2009. Ceding commission revenue decreased by $2.3 million for the year ended December 31, 2010 as a result of increases in ceded loss ratios on prior year’s quota share treaties compared to a decrease of $1.8 million for 2009.
More competitive market conditions contributed to the increase in loss ratio despite small increases in premiums for renewed commercial business. We cancelled several of our workers’ compensation and commercial automobile programs early in the year due to poor performance, but the runoff for these cancelled programs was relatively poor. We also increased loss development factors for commercial lines which impacted reserves for prior years, described below, and also caused us to increase our loss ratio estimates for the current year.
We increased reserves for prior years by approximately $19.8 million comprised of $18.7 million for commercial automobile and $6.6 million for commercial multi-peril, which was offset in part by favorable development on workers’ compensation of $10.1 million and amortization of reserves risk premium of $4.6 million that was established in 2009 as part of fair value accounting for the acquisitions of CastlePoint, Hermitage, and SUA in that year. The unfavorable development in commercial automobile and commercial packages resulted from higher loss development factors based upon detailed studies of our business that we completed in the fourth quarter. The favorable development in workers’ compensation included lower estimates of incurred losses for small workers’ compensation policies as well as higher estimated ceded losses for excess of loss reinsurance that we purchase. We also had adverse development of $8.0 million in assumed reinsurance that resulted from participation on quota share business written by CastlePoint prior to its acquisition by Tower.
The adverse development was reduced as a result of lowering estimated costs for litigation defense claims in our commercial multi-peril and other liability business of approximately $10 million. Since 2009 we have been increasing the number of staff attorneys defending third-party liability claims defense in-house, which we believe results in better loss ratios as well as significantly lower ALAE. As part of our acquisition of OBPL on July 1, 2010 we hired additional defense attorneys that we were able to reassign, in part, to commercial lines.
The commission portion of the gross underwriting expense ratio, which is expressed as a percentage of gross premiums earned, was 17.4% for the year ended December 31, 2010 compared to 19.6% for 2009. The decrease in commission rate for 2010 resulted from significantly higher amortization costs in 2009 for the value of business acquired (“VOBA”) of CastlePoint.
Underwriting profit and combined ratio. The net combined ratios were 95.7% for the year ended December 31, 2010 and 88.6% 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.
Premiums. Gross premiums written for the year ended December 31, 2011 were $585.6 million as compared to $412.5 million in 2010. The increase of $173.1 million is primarily attributable to OBPL which was acquired on July 1, 2010, and was reflected in Tower’s consolidated results for twelve months in 2011 as compared to six months in 2010. Excluding the effects of OBPL, Tower’s other personal lines gross premiums written increased $7.7 million from $201.0 million in 2010 to $208.7 million in 2011 due principally to organic growth in the homeowners business.
Net premiums written and earned increased $159.5 million and $154.2 million, respectively, in 2011 as compared to 2010. The increase in net premiums written and earned is a result of the OBPL acquisition, as discussed above. Net premiums written and earned associated with the OBPL business were $311.6 million and $335.2 million, respectively, in 2011 compared to $170.0 million and $191.8 million, respectively, in 2010.
Ceding commission revenue. The increase in ceding commission revenue for the year ended December 31, 2011 compared to the prior year is attributed to the commission revenue earned on the previously mentioned homeowners and umbrella quota share treaties on the OBPL acquired business.
Excluding the Reciprocal Exchanges, the increase in the loss ratio as compared to 2010 was primarily due to winter storms and property catastrophes, the most significant of which was Hurricane Irene. These storms, together, added $42.8 million in losses and 13.4 points to the net loss ratio. Excluding these storms the loss ratio would have been 53.8% in 2011.
Underwriting expenses. Underwriting expenses increased by $67.2 million for the year ended December 31, 2011 as compared to the prior year. Nearly all of the increase is related to the OBPL acquisition. The net underwriting expense ratio improved 2.8 percentage points from 2010 to 2011.
Premiums. Gross premiums written for the year ended December 31, 2010 were $412.5 million, an increase of $226.5 million over the 2009 gross premiums written of $186.0 million. The acquisition of OBPL accounted for $224.3 million of the increase. The remaining growth from the existing business was predominately from our California homeowners book. Immediately following the OBPL acquisition, actions were taken to shed unprofitable business and to reduce coastal exposures.
Ceded premiums written for 2010 were $85.7 million as compared to $30.7 million in 2009. The increase in ceded premiums is principally due to the acquisition of OBPL which generated $41.5 million in ceded premiums. The Company reinsures the homeowners and umbrella business obtained from OBPL through a quota share program. The Company also purchases catastrophe reinsurance for all property business.
Ceding commission revenue. Ceding commission revenue for 2010 was $6.1 million, an increase of $1.5 million over 2009. The increase was primarily attributable to the commission revenue associated with the previously mentioned homeowner and umbrella quota share treaties.
Loss and loss adjustment expenses. Our gross and net loss ratios for 2010 decreased by 0.8 and of 3.7 percentage points, respectively, compared to 2009. The net loss ratio excluding the Reciprocal Exchanges was 51.4%. The improvement in loss ratio resulted from lower than expected losses in 2010 and favorable reserve development, which was offset in part by winter storm losses that occurred in March 2010. Winter storm losses were $15.5 million in 2010, which represented 4.4 loss ratio points overall. Third and fourth quarter 2010 homeowners losses were better than expected for the current accident year due to relatively mild winter weather even considering the snow storm that occurred in the Northeast on December 26, 2010.
Total revenue. The increase in total revenue for the year ended December 31, 2011 compared to 2010 was primarily due to the management fee income earned by Tower for underwriting, claims, investment management and other services provided to the Reciprocal Exchanges pursuant to management services agreements with the Reciprocal Exchanges. The management fee income is calculated as a percentage of the Reciprocal Exchanges’ gross written premiums of $209.3 million and $126.8 million in 2011 and 2010, respectively. The effects of these management services agreements 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. We had no premiums managed by our managing general agencies in 2011 and 2010.
The following table shows the composition of our fixed maturity portfolio by remaining time to maturity at December 31, 2011 and December 31, 2010. 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:
As of December 31, 2011, our municipal bonds consisted of state general obligations, municipal general obligations and special revenue bonds. Municipal bonds by state at December 31, 2011 are as follows:
No one jurisdiction within “Other” in the table above exceeded 4% of the total fair value of municipal bonds. As of December 31, 2011, the special revenue bonds are supported primarily by water and sewer utilities, electric utilities, college revenues and highway tolls.
As of December 31, 2011, 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.
A number of our Level 3 investments have also been written down as a result of our impairment analysis. At December 31, 2011, two securities included in other invested assets were priced in Level 3 with a fair value of $25.0 million, which was also our cost basis.
“Note 6-Fair Value Measurements” to the consolidated financial statements provides a description of the valuation methodology utilized to value Level 3 assets, how the valuation methodology is validated and an analysis of the change in fair value of Level 3 assets. As of December 31, 2011, the fair value of Tower Level 3 assets as a percentage of Tower’s total assets carried at fair value was as follows (the Reciprocal Exchanges had no Level 3 assets):
At December 31, 2011, the fixed-maturity securities in an unrealized loss position for twelve months or greater were primarily in our residential non-agency mortgage-backed securities.
The majority of our corporate bonds that are in an unrealized loss position are rated below AA. Based on our analysis of these securities and current market conditions, we expect price recovery on these over time, and we have determined that these securities are not other than temporarily impaired as of December 31, 2011.
Tower is organized as a holding company (the “Holding Company”) with multiple intermediate holding companies, 13 insurance subsidiaries and several management companies. The Holding Company’s principal liquidity needs include interest on debt, stockholder dividends and share repurchases under its share repurchase program. The Holding Company’s principal sources of liquidity include dividends and other permitted payments from our subsidiaries, as well as financing through borrowings and sales of securities.
The management companies are not subject to any statutory limitations on their dividends to the Holding Company. The management companies declared dividends of $19.9 million, $7.5 million and $ 6.0 million in 2011, 2010 and 2009, respectively.
At various times over the past nine 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. See “Note 12-Debt” for the principal terms of the subordinated debentures. The interest on the subordinated debentures is calculated using interest rates in effect at December 31, 2011 for variable rate debentures.
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, 2011 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 $319.7 million, which are estimated to be recovered as follows: less than one year, $130.2 million; one to three years, $115.2 million; four to five years, $47.4 million; and after five years, $26.9 million. The interest on the subordinated debentures is calculated using interest rates in effect at December 31, 2011 for variable rate debentures.
Our capital resources consist of funds deployed or available to be deployed to support our business operations. At December 31, 2011 and December 31, 2010, 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.
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 acting as the attorneys-in-fact for the Reciprocal Exchanges.
The Company continues to direct excess cash balances to higher yielding investments to maximize investment income. Accordingly, Tower’s cash balances declined from December 31, 2010 to 2011.
For the year ended December 31, 2011, net cash provided by operating activities was $74.3 million as compared to $170.0 million for 2010. The decrease in cash flow for the year ended December 31, 2011 primarily resulted from a $66.2 million cash transfer to provide collateral support for business written on our behalf, claims payments on third quarter 2011 catastrophes and severe storms, tornado losses in the second quarter of 2011 and winter storms in late December 2010. These were partially offset by the receipt of a $22.0 million Federal income tax refund in 2011.
The net cash flows provided by financing activities for the year ended December 31, 2010 primarily result from net cash inflows of $134.1 million for the issuance of the senior convertible notes, senior convertible noted hedge, and warrants offset by uses of cash for the repurchase of common stock and dividend payments of $88.0 million and $16.6 million, respectively.
Cash flow needs at the holding company level are primarily for dividends to our stockholders and interest payments on our outstanding debt.
In 2011 and 2010, the Holding Company made no capital contributions to the insurance subsidiaries. In 2009, the Holding Company contributed $6.6 million to two separate insurance subsidiaries.
Consolidated Statements of Income and Comprehensive Income for the years ended December 31, 2011, 2010, and 2009
Consolidated Statements of Cash Flows for the years ended December 31, 2011, 2010, and
In our opinion, the accompanying consolidated balance sheets as of December 31, 2011 and 2010 and the related consolidated statements of income and comprehensive income, changes in stockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2011 present fairly, in all material respects, the financial position of Tower Group, Inc. and its subsidiaries (the “Company”) at December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2011 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing on page S-1 present fairly, in all material respects, the information set forth therein at December 31, 2011 and 2010, and for each of the years in the two year period ended December 31, 2011 when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
We have audited the consolidated statements of income and comprehensive income, changes in stockholders’ equity, and cash flows for the year ended December 31, 2009 of Tower Group, Inc. (“the Company”). Our audit also included the financial statement schedules for the year ended December 31, 2009 listed in the Index at Item 15. These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audit.
As discussed in Note 2, the consolidated financial statements for the year ended December 31, 2009 have been restated to give effect to the retrospective adoption of the Financial Accounting Standards Board’s new accounting standard related to accounting for costs associated with acquiring or renewing insurance contracts.
March 1, 2010, except for Note 21, as to which the date is March 1, 2011 and Note 2, as to which the date is February 29, 2012
On July 1, 2010, the Company completed its acquisition of the Personal Lines Division of OneBeacon Insurance Group, Ltd. (“OBPL”). Subsequent to this acquisition, the Company changed the presentation of its business results, beginning July 1, 2010, by allocating the personal insurance business previously reported in the Brokerage Insurance segment along with the newly acquired OBPL business to a new Personal Insurance segment and merged the commercial business previously reported in the Brokerage Insurance and Specialty Business segments in a new Commercial Insurance segment. The Company’s Insurance Services segment also includes fees earned by the management companies acquired as a part of the OBPL transaction. This change in presentation reflects the way management organizes the Company for making operating decisions and assessing profitability.
Insurance Services (“Services”) Segment provides underwriting, claims and reinsurance brokerage services to insurance companies.
The accompanying consolidated financial statements include the accounts of Tower and its insurance subsidiaries, managing general agencies and management companies. The consolidated financial statements also include the accounts of Adirondack Insurance Exchange, a New York reciprocal insurer, and New Jersey Skylands Insurance Association, a New Jersey reciprocal insurer (together, the “Reciprocal Exchanges”). The Company does not own the Reciprocal Exchanges but manages them through its management companies.
Effective January 1, 2011, the Company adopted new accounting guidance concerning the accounting for costs associated with acquiring or renewing insurance contracts. This guidance was adopted retrospectively and has been applied to all prior period financial information contained in these consolidated financial statements.
The 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.
The liability for loss and LAE represents management’s best estimate of the ultimate cost and expense of all reported and unreported losses that are unpaid as of the balance sheet date. The liability for loss and LAE is recorded net of a tabular reserve discount for workers’ compensation and excess workers’ compensation claims in the amount of $3.7 million and $3.7 million at December 31, 2011 and 2010, respectively. The 2011 discount relates to $271.3 million portion of reserves for workers’ compensation. The projection of future claims payments and reporting is based on an analysis of the Company’s historical experience, supplemented by analyses of industry loss data. Management believes that the liability for loss and LAE is 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 expense for the period in which the estimates are changed.
The Company’s other invested assets consist of investments in limited partnerships accounted for using the equity method of accounting, real estate and certain securities for which the Company has elected the fair value option. In accounting for the partnerships, management uses the financial information provided by the general partners, which is on a three-month lag. As of December 31, 2011, the Company had future funding commitments of $14.7 million to these limited partnerships. For securities in which the Company has elected the fair value option, interest and dividends are reported in net investment income with the remaining change in overall fair value reported in other net realized investment gains (losses).
Premiums receivable represent amounts due from insureds and reinsureds for insurance coverage and are presented net of an allowance for doubtful accounts of $2.5 million and $2.1 million at December 31, 2011 and 2010, respectively. The allowance for uncollectible amounts is based on an analysis of amounts receivable giving consideration to historical loss experience and current economic conditions and reflects an amount that, in management’s judgment, is adequate. Uncollectible premiums receivable of $4.1 million, $1.8 million and $0.9 million were written off in 2011, 2010 and 2009, respectively.
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 2011. Additionally, identifiable intangible assets and goodwill are tested for recoverability whenever events or changes in circumstances indicate that a carrying amount may not be recoverable. No impairment losses were recognized in 2011, 2010 or 2009.
The Company consolidates the Reciprocal Exchanges as it has determined that these are variable interest entities and that the Company is the primary beneficiary. See “Note 4 - Variable Interest Entities” for more details.
The Company’s insurance subsidiaries are required to prepare statutory basis financial statements in accordance with practices prescribed or permitted by the state or country in which they are domiciled. See “Note 17 - Statutory Financial Information and Accounting Policies” for more details.
Financial instruments that potentially subject the Company to concentration and credit risk are primarily cash and cash equivalents, investments, interest rate swaps, premiums receivable and reinsurance recoverables. 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 network and its customer base, which is largely concentrated in the Northeast, Florida, Texas and California. To reduce credit risk, the Company performs ongoing evaluations of its distribution network’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. As at December 31, 2011, the largest uncollateralized reinsurance recoverable balance from any one reinsurer was $49.4 million representing 14% of the Company’s total reinsurance recoverable balance. 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.
Guidance issued by the Financial Accounting Standards Board (“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 previously required. This disclosure is included in “Note 6 - Fair Value Measurements”.
In October 2010, the FASB issued new guidance concerning the accounting for costs associated with acquiring or renewing insurance contracts. Under the new guidance, only direct incremental costs associated with successful insurance contract acquisitions or renewals are deferrable. The Company adopted this guidance retrospectively effective January 1, 2011 and has adjusted its previously issued financial information.
Adoption of this guidance affected the carrying value of the categories of acquisition costs included within the 2010 caption “Deferred acquisition costs, net” as follows:
The effect of adoption of this new guidance on the consolidated balance sheet as of December 31, 2010 and on stockholders’ equity as of December 31, 2009 was as follows:
Guidance issued by the FASB in July 2010 clarified whether a modification or restructuring of a loan or receivable is considered to be troubled debt restructuring. This guidance requires additional disclosure on the income statement impact of any such troubled debt restructurings. This guidance is effective for interim and annual periods beginning after June 15, 2011. The Company adopted this guidance with no impact on its financial statements as of September 30, 2011.
In May 2011, the FASB issued new guidance concerning fair value measurement and disclosure. This guidance will be effective for annual and interim periods beginning after December 15, 2011. The Company is currently analyzing the effect this accounting guidance will have on its financial statements.
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 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.
Effective July 1, 2010, Tower entered into transition service agreements with OneBeacon whereby OneBeacon will provide certain information technology and operational support to Tower until such time that these processes are migrated to Tower. Expenses incurred under such transition service agreements were $23.9 million and $13.3 million for the years ended December 31, 2011 and 2010, respectively.
Tower has consolidated OBPL as of July 1, 2010 and the purchase consideration has been allocated to the assets acquired and liabilities assumed, including separately identified intangible assets, based on their fair values as of the close of the acquisition, with the amounts exceeding the fair value recorded as goodwill. The goodwill consists largely of the synergies and economies of scale expected from combining the operations of the Company and OBPL.
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 as of July 1, 2010. See “Note 4 - Variable Interest Entities (“VIEs”)” for a description of accounting for the Reciprocal Exchanges.
SUA, a specialty property and casualty insurance company, was acquired in 2009 for $106.7 million. The acquisition strengthened Tower’s regional presence in the Midwest.
The following table presents the fair value of assets acquired and liabilities assumed as of November 13, 2009, the closing date of the acquisition:
The Company began consolidating the financial results of SUA as of the date of acquisition. As the fair value of net assets acquired was in excess of the total purchase consideration, the gain on bargain purchase of $13.2 million shown in the schedule above has been recognized in other income for the year ended December 31, 2009.
On October 14, 2009, the acquisition of the renewal rights to the workers’ compensation business of AequiCap was completed (“AequiCap I”). The acquired business primarily consists of small, low to moderate hazard workers’ compensation policies in Florida. Most of the employees of AequiCap I involved in the servicing of the workers’ compensation business became employees of the Company. The acquisition of this business strengthened the regional presence in the Southeast.
The following table presents assets acquired and liabilities assumed with the acquisition of Hermitage, based on their fair values as of February 27, 2009, the closing date of this acquisition:
In connection with recording the acquisition, the previous investment in CastlePoint was revalued resulting in a gain of $7.4 million, before income taxes. This gain was included in the Consolidated Statements of Income in the first quarter of 2009. There were $11.4 million of transaction costs, including legal, accounting, investment advisory and other costs directly related to the acquisition incurred, which were expensed in the first quarter of 2009.
The following presents assets acquired and liabilities assumed with the acquisition of CastlePoint, based on their fair values as of February 5, 2009, the closing date of this acquisition:
The Company determined that each of the Reciprocal Exchanges qualifies as a VIE and that the Company is the primary beneficiary as it has both the power to direct the activities of the Reciprocal Exchanges that most significantly impact their economic performance and the risk of economic loss through its ownership of the surplus notes. Accordingly, the Company consolidates these Reciprocal Exchanges and eliminates all intercompany balances and transactions with Tower.
For the years ended December 31, 2011 and 2010, the Reciprocal Exchanges results of operations were as follows:
As at December 31, 2011 and 2010, U.S. Treasury Notes and other securities with carrying values of $226.8 million and $188.5 million, respectively, were on deposit with various states to comply with the insurance laws in which the Company is licensed.
Gross realized gains, losses and impairment write-downs on investments are summarized as follows:
Management may dispose of a particular security due to changes in facts and circumstances related to the invested asset that have arisen since the last analysis supporting management’s determination whether or not it intended to sell the security, and if not, whether it is more likely than not that the Company would be required to sell the security before recovery of its amortized cost basis.
The evaluation of equity securities includes management’s intent and ability to hold the security to recovery. Management will record OTTI in those situations where it does not intend to hold the security to recovery or if the security is not expected to recover in value.
The following table provides a rollforward of the cumulative amount of OTTI for securities still held showing the amounts that have been included in earnings on a pretax basis for the years ended 2011 and 2010 (none of such OTTI was included within the Reciprocal Exchanges):
There are 385 securities at December 31, 2011, including fixed maturities and equity securities, which account for the gross unrealized loss, none of which is deemed by management to be OTTI. Temporary losses on corporate and other bonds result 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. The structured securities that had significant unrealized losses resulted primarily from 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 in the current period. Management considered all relevant factors, including expected recoverability of cash flows, in assessing whether a 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.
The unrealized loss position associated with the fixed-maturity portfolio was $11.4 million as of December 31, 2011, consisting primarily of corporate bonds and mortgage-backed securities of $10.4 million. The total fixed-maturity portfolio of gross unrealized losses included 360 securities which were, in aggregate, approximately 2.9% below amortized cost. Of the 360 fixed maturity investments identified, 22 have been in an unrealized loss position for more than 12 months. The total unrealized loss on these investments at December 31, 2011 was $0.7 million. Management does not consider these investments to be other-than-temporarily impaired.
For common stocks, there were 18 securities in a loss position at December 31, 2011 totaling $4.2 million. Management evaluated the financial condition of the common stock issuers, the severity and duration of the impairment, and our ability and intent to hold to recovery and determined these securities are not OTTI. The evaluation consisted of a detailed review, including but not limited to some or all of the following factors for each security: the current S&P rating, analysts’ reports, past earnings trends and analysts’ earnings expectations for the next 12 months, liquidity, near-term financing risk, and whether the company was currently paying dividends on its equity securities. Management does not consider these investments to be other-than-temporarily impaired.
The following table shows the composition of the fixed-maturity portfolio by remaining time to maturity at December 31, 2011 and 2010. For securities that are redeemable at the option of the issuer and have a market price that is greater than par value, the maturity used for the table below is the earliest redemption date. For securities that are redeemable at the option of the issuer and have a market price that is less than par value, the maturity used for the table below is the final maturity date.
In December 2011, the Company purchased two securities for which it elected the fair value option. This election was made to simplify the accounting for these instruments which contain embedded derivatives and other features.
The fair values of the fixed-maturity, equity securities and short-term investments are determined by management after taking into consideration available sources of data. Various factors are considered that may indicate an inactive market, including levels of activity, source and timeliness of quotes, abnormal liquidity risk premiums, unusually wide bid-ask spreads, and lack of correlation between fair value of assets and relevant indices. If management believes that the price provided from the pricing source is distressed, management will use a valuation method that reflects an orderly transaction between market participants, generally a discounted cash flow method that incorporates relevant interest rate, risk and liquidity factors.
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. Management also back-tests the prices on numerous sales of securities during the year to validate the previous pricing provided as well as utilizes other pricing sources to validate the pricing provided by our primary provider of the majority of the non-U.S. Treasury securities and non-agency securities included in Level 2.
The following table summarizes changes in Level 3 assets measured at fair value for the year ended December 31, 2011 and 2010 for Tower (the Reciprocal Exchanges have no Level 3 assets):
(a) Primarily relates to the acquisitions of OBPL and AequiCap II in 2010.
The Company performs an analysis annually to identify potential goodwill impairment and measures the amount of any goodwill impairment loss that may need to be recognized. Goodwill impairment testing requires an evaluation of the estimated fair value of each reporting unit to its carrying value, including the goodwill. An impairment charge could be recorded if the estimated fair value is less than the carrying amount of the reporting unit. No impairments have been identified.
The activity in the components of intangible assets for the years ended December 31, 2011 and 2010 consisted of intangible assets acquired from business combinations and amortization expense as shown in the table below:
Under the terms of the excess of loss programs in 2011, Tower was at risk of loss for the first $5.0 million on property, $2.5 million on workers’ compensation and $2.5 million on umbrella. The Company then had reinsurance coverage up to $30 million for property, $50 million for workers’ compensation, $5 million for umbrella. In addition, the Company also had “clash coverage” in effect for 2011 for a limit of $5 million in excess of $5 million which applies to the aggregate liability for liability losses from multiple insureds involved in the same occurrence.
Tower’s 2011 quota share reinsurance cedes 30% of the homeowners business written by the companies obtained in the OBPL transaction. This coverage has a $340 million per occurrence cap.
The table below shows direct, assumed and ceded premiums for the years ended December 31, 2011, 2010 and 2009:
As of December 31, 2011 and 2010, the Company had $314.0 million and $291.5 million, respectively, of reinsurance recoverables with reinsurers rated A- or higher by A.M. Best. These represented 91% and 97%, respectively, of the Company’s total reinsurance recoverables as of those dates. As of December 31, 2011 and 2010, the largest reinsurance recoverable balance with any one reinsurer was approximately 4.8% and 6.6% of the Company’s stockholders’ equity.
The Company did not record any modifications of its reinsurance recoverables on paid or unpaid losses in the years ended December 31, 2011, 2010 or 2009. The Company recorded no allowance for credit losses on its reinsurance recoverables on paid or unpaid losses as of December 31, 2011 or 2010. The Company did not consider that any of its undisputed reinsurance recoverables on paid or unpaid losses as of years ended December 31, 2011 and 2010 to be past due. As discussed in “Note 16 - Contingencies”, certain reinsurance agreements are subject to legal proceedings.
The following table provides a reconciliation of the beginning and ending consolidated balances for unpaid losses and LAE for the years ended December 31, 2011, 2010 and 2009:
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 incurred but not reported (“IBNR”) reserves, giving consideration to Company and industry trends.
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
The Company has long defended third-party liability claims utilizing attorneys who are employees of the Company. 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 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. Because of the cost advantage for ALAE utilizing attorneys who are employees of the Company, we had been increasing the number of employed attorneys. Currently, we are handling over 85% of new litigated third-party claims utilizing attorneys who are employees of the Company.
The Company segregates data for estimating loss reserves. Property lines include Fire, Homeowners, CMP Property, Multi-Family Dwellings, Fire and Allied Lines, Inland Marine 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.
Two key assumptions that materially impact the estimate of loss reserves are the loss ratio estimate for the current accident year and the loss development factor selections for all accident years. The loss ratio estimate for the current accident year is selected after reviewing historical accident year loss ratios adjusted for rate changes, trend, and mix of business. As the current year matures the estimated loss and LAE is determined with more weight given to reported experience during the year by utilizing the B-F method or potentially for relatively fast developing lines of business giving more weight to loss development methods.
In connection with the acquisition of SUA in 2009, 4.5 million shares were issued to the shareholders of SUA increasing Common Stock by $44,600 and Paid-in Capital by $105.8 million.
Dividends on common stock of $27.9 million, $16.6 million and $10.7 million for the years ended December 31, 2011, 2010 and 2009, respectively, were declared.
The Company’s borrowings consisted of the following at December 31, 2011 and 2010:
Aggregate scheduled maturities of the Company’s borrowings at December 31, 2011 are:
(a) Amount reflected in balance sheet for convertible senior notes is net of unamortized original issue discount of $8.2 million
Total interest expense incurred, including interest expense on the funds held liabilities disclosed in “Note 9 - Reinsurance”, was $34.5 million, $24.6 million and $18.1 million for the years ended December 31, 2011, 2010 and 2009, respectively.
The Company and its wholly-owned subsidiaries have issued trust preferred securities through wholly-owned Delaware statutory business trusts. The trusts use the proceeds of the sale of the trust preferred securities and common securities that the Company acquired from the trusts to purchase junior subordinated debentures from the Company with terms that match the terms of the trust preferred securities. Interest on the junior subordinated debentures and the trust preferred securities is payable quarterly. In some cases, the interest rate is fixed for an initial period of five years after issuance and then floats with changes in the London Interbank Offered Rate (“LIBOR”) and in other cases the interest rate floats with LIBOR without any initial fixed-rate period. The principal terms, before any effects of interest rate swaps, of the outstanding trust preferred securities, including those which were assumed by the Company through acquisitions, are summarized in the following table:
The Company may request that the facility be increased by an amount not to exceed $50 million. The credit facility contains customary covenants for facilities of this type, including restrictions on indebtedness and liens, limitations on mergers, dividends
and the sale of assets, and requirements to maintain certain consolidated net worth, debt to capitalization ratios, minimum risk-based capital and minimum statutory surplus. The credit facility also provides for customary events of default, including failure to pay principal when due, failure to pay interest or fees within three days after becoming due, failure to comply with covenants, any representation or warranty made by the Company being false in any material respect, default under certain other indebtedness, certain insolvency or receivership events affecting the Company and its material subsidiaries, the occurrence of certain material judgments, or a change in control of the Company, and upon an event of default the administrative agent (subject to the consent of the requisite percentage of the lenders) may immediately terminate the obligations to make loans and to issue letters of credit, declare the Company’s obligations under the credit facility to become immediately due and payable, and require the Company to deposit in a collateral account cash collateral with a value equal to the then outstanding amount of the aggregate face amount of any outstanding letters of credit. The Company was in compliance with all covenants under the credit facility at December 31, 2011.
To the extent the market value per share of the Company’s common stock exceeds the conversion price, the Company will use the “treasury stock” method in calculating the dilutive effect on earnings per share.
In 2004, the Company’s Board of Directors adopted and its stockholders approved a long-term incentive plan (the “Plan”).
On November 13, 2009, the date of acquisition, SUA non-vested restricted stock awards were converted into 92,276 shares of the Company’s common stock. These awards had a weighted grant date fair value of $23.74. No additional grants have been made under this plan since the date of acquisition. For the period from acquisition to December 31, 2009, 46,088 of these vested. For the year ended December 31, 2010, 41,820 of these vested while for the year ended December 31, 2011, 4,368 of these vested resulting in none outstanding at December 31, 2011.
The following table provides an analysis of stock option activity for the years ended December 31, 2011, 2010 and 2009:
Options outstanding and exercisable as of December 31, 2011 are shown on the following table:
The provision for Federal, state and local income taxes consist of the following components for the years ended December 31, 2011, 2010 and 2009:
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 $4.3 million and $5.6 million at December 31, 2011 and 2010, respectively, to reflect the amount of the Reciprocal Exchanges’ deferred taxes that may not be realized.
The Internal Revenue Service performed an audit of The Company’s 2006 and 2007 tax years and closed these audits in 2011 with no changes. Additionally, in 2011 the IRS performed an audit of CastlePoint and subsidiary’s federal income tax return for the period ended February 2009 and closed this audit with no changes. CastlePoint’s federal excise tax and protective income tax returns for the 2008 tax year and SUA’s federal income tax return for the 2007 tax year are still under IRS audit. However, the Company does not anticipate any material adjustments from these audits.
The provision for Federal income taxes incurred is different from that which would be obtained by applying the Federal income tax rate to net income before taxes. The items causing this difference at the consolidated level are as follows:
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 $3.2 million, $2.7 million and $1.4 million of expense in 2011, 2010 and 2009, respectively, related to the 401(k) Plan.
The SERP is a non-qualified defined contribution plan effective as of January 1, 2009 that is intended to enhance retirement benefits for the Company’s most senior executives and certain other key employees. Eligibility to participate in the SERP generally requires three years of prior employment with the Company for Senior Vice Presidents and between five and 10 years of prior employment with the Company for other key employees. In 2011, all of the Named Executive Officers other than the Chief Financial Officer (who is not yet eligible), as well as certain other key executives selected at the discretion of the Compensation Committee, became eligible to participate in the SERP. Subject to the approval of the Compensation Committee, the Company may make annual contributions to the SERP on behalf of each participant. For the Chief Executive Officer, the current annual contribution level is intended to provide him with a target annual benefit equal to 60% of his annual cash compensation upon retirement after 30 years of service. The SERP is not a defined benefit plan and such target benefit level cannot be guaranteed. For other participants, the amount of the annual contribution is equal to 5.0% of their annual cash compensation. Company contributions for each participant remain unvested until such participant has completed 10 years of service with the Company, and vest in full upon completion of 10 years of service. The Compensation Committee has discretion to terminate the SERP at any time or to adjust upward or downward the level of the Company’s contribution each year.
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.
Policy acquisition costs are charged to operations in the year such costs are incurred, rather than being deferred and amortized as premiums are earned over the terms of the policies.
The Company’s insurance subsidiaries paid $35.0 million, $4.7 million and $15.0 million in dividends and or return of capital to Tower in 2011, 2010 and 2009, respectively. As of December 31, 2011, the maximum distribution that Tower’s insurance subsidiaries could pay without prior regulatory approval was $29.3 million and the maximum return of capital available from CastlePoint Re without Bermuda regulatory permission was $61.0 million.
CastlePoint Re is registered as a Class 3 reinsurer under The Insurance Act 1978 (Bermuda), amendments thereto and related regulations (the “Insurance Act”). Under the Insurance Act, CastlePoint Re is required to prepare Statutory Financial Statements and to file a Statutory Financial Return. The Insurance Act also requires CastlePoint Re to maintain minimum share capital and surplus, and it has met these requirements as of December 31, 2011.
For the year ended December 31, 2011, CastlePoint Re had statutory net income of $32.7 million and at December 31, 2011, had statutory surplus of $295.0 million.
For Bermuda registered companies, there are some differences between financial statements prepared in accordance with GAAP and those prepared on a statutory basis. Certain assets are non-admitted under Bermuda regulations. Accordingly, for Bermuda statutory reporting, deferred policy acquisition costs have been fully expensed to income and prepaid expenses and fixed assets have been removed from the statutory balance sheet.
Other invested assets: The fair value of securities which are reported under the fair value option are included in “Note 6-Fair Value Measurements.” The fair value of limited partnerships approximates their carrying value under the equity method of accounting which was $12.5 million at December 31, 2011.