We lease approximately 118,500 square feet of space at 120 Broadway, New York, New York, which consists of the 30th and 31st floors and part of the 29th floor. The lease will end on December 31, 2021. See Note 18 - “Commitments and Contingencies” in the notes to our audited consolidated financial statements included elsewhere in this report.
The selected consolidated income statement data for the years ended December 31, 2007, 2006 and 2005 and the balance sheet data as of December 31, 2007 and 2006 are derived from our audited financial statements included elsewhere in this document, which have been prepared in accordance with GAAP and have been audited by Johnson Lambert & Co. LLP, our independent registered public accounting firm. 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.
See “Business-Note on Forward-Looking Statements” for more information. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Form 10-K, particularly under the headings “Business-Risk Factors” and “Business-Note on Forward-Looking Statements.”
In our insurance segment, our Insurance Subsidiaries provide commercial and personal lines insurance policies to businesses and individuals. 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 and commercial automobile policies. Our personal lines products consist of homeowners, dwelling, personal automobile and other liability policies. In our reinsurance segment, TICNY assumes reinsurance directly from the insurance companies for which TRM produces insurance premiums (which we refer to as TRM’s “issuing companies”), except CPIC, or indirectly from reinsurers that provide reinsurance coverage directly to these issuing companies. In our insurance services segment, TRM generates management fees and commission income from its managing general agency by producing premiums on behalf of its issuing companies, including CPIC, and generates fees by providing claims administration and reinsurance intermediary services. The insurance services segment also generates other administration revenue from services provided to CastlePoint Reinsurance. See “Business-Reinsurance-CastlePoint Reinsurance” and “Business-Strategic Relationship and Agreements with CastlePoint.”
We have invested in CastlePoint, an unconsolidated Bermuda holding company, which we organized and sponsored with an initial investment of $15.0 million on February 6, 2006. We consolidated the activities of CastlePoint as a wholly owned subsidiary during the first quarter of 2006 and recognized approximately $0.5 million of non-recurring start-up costs. CastlePoint raised net proceeds of $249.9 million, in a private placement of shares in 2006 and $114.8 million in an initial public offering of shares in 2007 which reduced our investment ownership from 100% to 6.7%. The carrying value of our investment in CastlePoint increased from $15.0 million to $22.9 million at the end of 2006 and to $32.6 million at the end of 2007. We recorded gains of $7.9 million and $2.7 million in income before taxes in accordance with the SEC’s Staff Accounting Bulletin (“SAB”) No. 51, “Accounting for Sales of Stock by a Subsidiary” in the twelve months ended December 31, 2006 and 2007, respectively.
On April 10, 2007, we completed the acquisition of 100% of the issued and outstanding stock of Preserver for a base purchase price of approximately $64.7 million. In addition, $12 million of Preserver’s trust preferred securities remain outstanding. Preserver was a privately-held company that offered products similar to ours in the Northeast, particularly in New Jersey, Maine and Massachusetts. Preserver contributed approximately $63.7 million in direct written premiums to the Company’s operations in 2007 after the acquisition. Preserver’s insurance subsidiaries, PIC, NEIC and MVIC, are rated “B++” (Good) by A.M. Best Company. This transaction accelerated our regional expansion by allowing us to access Preserver’s approximately 300 agents that produce business in various Northeastern states.
The competitive market conditions have affected middle market and larger package policies, commercial automobile, workers’ compensation and umbrella policies. However, in the urban and metropolitan segments in which we participate, in particular, homeowners, smaller commercial accounts and the lower end of the
middle market, increased competition and price softening have not been as evident as in the larger commercial account segment.
Our gross premiums written in 2007, 2006 and 2005 were $524.0 million, $432.7 million and $300.1 million, respectively. Premiums produced by TRM in 2007, 2006 and 2005 were $85.1 million, $12.9 million and $35.2 million, respectively.
We derive our revenue from the net premiums earned, ceding commissions, direct commission revenue, fees and net investment income and net realized gains from investments.
Ceding commission revenues. We earn ceding commission revenues (generally a percentage of the premiums ceded) on the gross premiums written that we cede to reinsurers under quota share reinsurance agreements.
Direct commission revenues and fees. Direct commission revenues and fees consist of commissions earned by TRM on premiums produced by its managing general agency and fees earned from its claims administration, other administration services and reinsurance intermediary services. It also includes policy billing fees that we earn in the course of collecting premiums from our policyholders. This fee is charged primarily on policies written through our insurance segment.
Losses and loss adjustment expenses. We establish loss and loss adjustment expenses (“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. Our provision for loss and LAE reserves in any period, which is the expense recorded, includes estimates for losses incurred during the period and changes in estimates for prior periods.
Operating expenses. In our insurance and reinsurance segments, we refer to the operating expenses that we incur to underwrite risks as underwriting expenses. Underwriting expenses consist of direct and ceding commission expenses and other underwriting expenses. In our insurance services segment, we refer to our operating expenses as insurance services expenses, which consist of direct commission expense and other insurance services expenses. On a consolidated basis, operating expenses for all three business segments are divided into direct and ceding commission expenses and other operating expenses as explained below:
Other operating expenses. Other operating expenses consist of other underwriting expenses related to our Insurance Subsidiaries’ underwriting operations in our insurance and reinsurance segments and other insurance services expenses related to our managing general agency and reinsurance intermediary operations conducted through TRM in our insurance services segment. Other underwriting expenses consist of general administrative expenses such as salaries, rent, office supplies, depreciation and all other operating expenses not otherwise classified separately and boards, bureaus and taxes, which are the assessments of statistical agencies for items such as rating manuals, rating plans and experience data, as well as state and local taxes based on premiums, licenses and fees, assessments for fire patrol and contributions to workers’ compensation and state and local security funds. Other insurance services expenses include general administrative expenses, principally reimbursements to TICNY for underwriting services, and exclude expenses that are incurred by TRM’s issuing companies such as boards, bureau and taxes. General administrative expenses related to claims administration services, which are billed on an hourly basis to TRM’s issuing companies are also excluded.
Interest expense. We pay interest on our loans, on subordinated debentures and on segregated assets placed in trust accounts on a “funds withheld” basis in order to collateralize reinsurance recoverables. In addition, interest expense includes amortization of any debt issuance costs over the remaining term of our subordinated debentures.
Loss ratio. The loss ratio is the ratio of losses and loss adjustment expenses incurred to premiums earned and measures the underwriting profitability of a company’s insurance business. We measure our loss ratio on a gross (before reinsurance), and net basis (after reinsurance) as well as the loss ratio on the ceded portion (the difference between gross and net premium) for our insurance and reinsurance segments. We use the gross loss ratio as a measure of the overall underwriting profitability of the insurance business we write and to assess the adequacy of our pricing. We use the ceded loss ratio to measure the experience on the premiums that we cede to reinsurers, including the premiums ceded under our quota share treaties. Since 2001, the loss ratio on such ceded business has determined the ceding commission rate that we earn on ceded premiums. Our net loss ratio is meaningful in evaluating our financial results, which are net of ceded reinsurance, as reflected in our consolidated financial statements. In addition, we use accident year and calendar year loss ratios to measure our underwriting profitability. An accident year loss ratio measures losses and loss adjustment expenses for insured events occurring in a particular year, regardless of when they are reported, as a percentage of premiums earned during that year. A calendar year loss ratio measures losses and loss adjustment expense for insured events occurring during a particular year and the changes in estimates in loss reserves from prior accident years as a percentage of premiums earned during that year.
Underwriting expense ratio. The underwriting expense ratio is the ratio of direct and ceding commission expenses and other underwriting expenses less policy billing fees and other administration revenue to premiums earned. The underwriting expense ratio measures a company’s operational efficiency in producing, underwriting and administering its insurance business. Due to our historically high levels of reinsurance, we calculate our underwriting expense ratio on a gross basis (before the effect of ceded reinsurance) and net basis (after the effect of ceded reinsurance). Ceding commission revenue is applied to reduce our underwriting expenses in our insurance company operation. Because the ceding commission rate we earn on our premiums ceded has historically been higher than our underwriting expense ratio on those premiums, our extensive use of quota share reinsurance has caused our net underwriting expense ratio generally to be lower than our gross expense ratio.
Premiums produced by TRM. TRM operates a managing general agency that earns commissions on written premiums produced on behalf of its issuing companies. Although TRM is not an insurance company, we have historically used 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. As part of our strategic relationship with CastlePoint, we entered into a management agreement on July 1, 2007, with CPIC to produce and manage brokerage business on behalf of CPIC. For this reason, we use written premiums produced by TRM on behalf of its issuing companies as well as TRM’s commission revenue to evaluate our ability to achieve growth and generate fees.
Net income and return on average equity. We use net income to measure our profits and return on average equity and to measure our effectiveness in using our stockholders’ equity to generate net income on a consolidated basis. In determining return on average equity for a given year, net income is divided by the average of stockholders’ equity for that year.
Our most critical accounting policies involve the reporting of reserves for losses (including losses that have occurred but had not been reported by the financial statement date) and loss adjustment expenses, the reporting of ceding commissions earned, the amount and recoverability of reinsurance recoverable balances, deferred acquisition costs and investments.
Loss and LAE reserves. The reserving process for loss and LAE reserves provides for our best estimate at a particular point in time of the ultimate unpaid cost of all losses and loss adjustment expenses incurred, including settlement and administration of losses, and is based on facts and circumstances then known and including losses that have been incurred but not yet been reported. The process includes using actuarial methodologies to assist in establishing these estimates, judgments relative to estimates of future claims severity and frequency, the length of time before losses will develop to their ultimate level and the possible changes in the law and other external factors that are often beyond our control. The methods used to select the estimated loss reserves include the loss ratio projection, incurred loss projection, and the Bornhuetter-Ferguson (B-F) method. The methods are described in “Business-Loss and Loss Adjustment Expense Reserves.” The process produces carried reserves set by management based upon the actuaries’ best estimate and is the result of numerous best estimates made by line of business, accident year, and loss and loss adjustment expense. The amount of loss and loss adjustment expense reserves for reported claims is based primarily upon a case-by-case evaluation of coverage, liability, injury severity, and any other information considered pertinent to estimating the exposure presented by the claim. The amounts of loss and loss adjustment expense reserves for unreported claims are determined using historical information by line of insurance as adjusted to current conditions. Since our process produces loss reserves set by management based upon the actuaries’ best estimate, there is no explicit or implicit provision for uncertainty in the carried loss reserves.
We have has made only minor changes to the key assumptions used during the last three annual reserve estimates.
Net Premiums Earned. Insurance policies issued or reinsured by the Company are short-duration contracts. Accordingly, premium revenue, including direct writings and reinsurance assumed, net of premiums ceded to reinsurers, is recognized as earned in proportion to the amount of insurance protection provided, on a pro-rata basis over the terms of the underlying policies. Unearned premiums represent premium applicable to the unexpired portions of in-force insurance contracts at the end of each year. Prepaid reinsurance premiums represent the unexpired portion of reinsurance premiums ceded.
Insurance Services Revenue. Direct commission revenue from the Company’s managing general underwriting services is recognized and earned as insurance policies are placed with TRM’s issuing companies. Fees from reinsurance intermediary services are earned when the Company’s Insurance Subsidiaries or TRM’s issuing companies cede premiums to reinsurers. Claims administration fees and other administration revenues are earned as services are performed.
We conduct our business in three distinct segments: insurance, reinsurance and insurance services. 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 each segment directly. General corporate overhead not incurred by an individual segment is allocated based upon a combination of employee head count, policy count or premiums written, whichever method is most appropriate.
Premiums earned. Net premiums earned increased by 27.7% to $286.1 million for 2007 compared to $224.0 million for 2006. The increase in net premiums earned was due to the 21.1% increase in gross premiums written for 2007 compared to 2006, offset in part by a 69.1% increase in ceded premiums earned for 2007 compared to 2006. Other items affecting the year to year comparison are shown below:
Commission and fee income. Total commission and fee income increased by 103.6% to $106.3 million for 2007 compared to $52.2 million in 2006. Ceding commission revenue earned increased as a result of the overall increase in ceded premiums earned as discussed above. Also, as discussed above, in 2007 our managing general agency subsidiary, TRM, produced $84.2 million in premium on behalf of CPIC and earned $27.0 million in fee income. Preserver’s inclusion in the CastlePoint quota share agreement added $4.0 million in commission and fee income for 2007. In addition, commission and fee income includes other administration revenue of $1.4 million from services provided to and reimbursed by CastlePoint. For 2007 the change in estimated sliding scale commission rate for commissions earned in prior periods in both the insurance segment and the insurance services segment resulted in a net increase of $1.3 million compared to a net increase of $1.9 million in 2006.
The decrease in the gross and net loss ratios for 2007 compared to 2006, excluding the effect of the PXRE transactions, was primarily due to lower than expected loss emergence for workers’ compensation, commercial auto liability and the property lines of business. However the decrease in the net loss ratio, excluding the impact of PXRE, was offset, in part, by the difference in the amount of reserves released from prior accident years in 2007 compared to 2006. During 2007, prior accident years’ loss reserves developed favorably to the extent of $1.6 million, whereas during 2006, prior accident years’ loss reserves developed favorably to the extent of $2.3 million excluding the $1.6 million loss related to the commutation with PXRE, resulting in net favorable development of $0.7 million.
Interest expense. Our interest expense increased to $9.3 million for 2007, compared to $6.9 million for 2006. The increase resulted from $1.6 million of interest expense from the $20.6 million of subordinated debentures issued on January 25, 2007, $0.4 million of interest expense from the $20.6 million of subordinated debentures issued on March 31, 2006, $0.1 million resulting from an increase in interest rates on the floating rate portions of our subordinated debentures and $0.9 million from $12.3 million of outstanding junior subordinated notes of Preserver. These increases were partially offset by a decrease of $0.4 million in the amounts credited to reinsurers on funds withheld in segregated trusts as collateral for reinsurance recoverables due to the reduction in the corresponding reinsured losses.
Income tax expense. Our income tax expense was $26.2 million for 2007 compared to $19.7 million for 2006. The increased income tax expense was due primarily to the increase in income before income taxes, as
Net income and return on average equity. Our net income and return on average equity was $45.1 million and 18.0%, respectively, for 2007 compared to $36.8 million and 22.2%, respectively, for 2006. Excluding net realized losses on investments, return on equity for 2007 would have increased 4.6%. For 2007, the return was calculated by dividing net income, after deducting $0.7 million of preferred stock dividends and excess consideration paid for the redemption of preferred stock in January, 2007, of $44.4 million, by average stockholders’ equity of $246.9 million. In 2006, the return was calculated by dividing net income of $36.6 million, excluding preferred stock dividends of $0.2 million, by an average stockholders’ equity of $164.6 million.
During 2006 a number of significant events affected the consolidated results of operations. We executed commutation and novation agreements between us and PXRE in order to eliminate our exposure to uncollateralized reinsurance recoverables from PXRE. We recorded a net charge as a result of these agreements of $5.5 million. In addition, we realized gains on our investment in CastlePoint as result of CastlePoint’s sale of unissued CastlePoint shares in a private offering, which resulted in a $7.9 million gain. We also received a warrant to purchase additional CastlePoint shares which was valued at $4.6 million resulting in additional income in that amount, in exchange for sponsorship services, which included management, organizational and industry expertise. Lastly, we entered into three multi-year quota share reinsurance agreements and a service and expense agreement with CastlePoint. Since we did not place quota share reinsurance in the first quarter of 2006, pending the formation of CastlePoint Reinsurance, we ceded $40.9 million of unearned premiums to CastlePoint Reinsurance as of April 1, 2006. In addition we completed our acquisition of MIIX Insurance Company of New York which we renamed Tower Indemnity Company of America. In October 2006, we entered into an agreement to sell all of the issued and outstanding capital stock of TICA to Castle Point for a cash purchase price of $350,000 plus an amount equal to the value of the statutory surplus of TICA at closing. Following the closing of the TICA transaction which occurred on December 4, 2006, CastlePoint renamed TICA “CastlePoint Insurance Company.” In December 2006, we issued 40,000 shares of perpetual preferred stock for $40.0 million less $0.4 million of issuance costs. On January 26, 2007 the perpetual preferred stock was redeemed in full.
Premiums earned. Net premiums earned increased by 36.2% to $224.0 million in 2006 compared to $164.4 million for 2005. The increase in net premiums earned was due to the overall increase in gross premiums written through December 31, 2006 especially in our other liability, homeowners and commercial multi peril lines and the novation agreements with PXRE. The novation agreements added $11.4 million to gross and net premiums earned in 2006. Since we did not place quota share reinsurance in the first quarter of 2006, pending the formation of CastlePoint Reinsurance, we ceded $40.9 million of unearned premiums as of April 1, 2006 and $114.2 million of premiums on policies written in 2006. The second, third and fourth quarter cessions to CastlePoint reflected a 30%, 40% and 40% quota share ceding percentage for the brokerage business, respectively, resulting in a total quota share ceded premium earned to CastlePoint in 2006 of $75.5 million. The total quota share ceded premium earned in 2006, including premiums ceded to other reinsurers under the 2005 quota share agreements, was $115.1 million. This represents a 91.5% increase in comparison to $60.1 million in 2005. The traditional program business and specialty program business quota share ceding percentages were 50% and 85%, respectively, in 2006. In 2006, we ceded $2.2 million to CastlePoint for the traditional and specialty program business.
Commission and fee income. Total commission and fee income increased by 29.9% to $52.2 million in 2006 compared to $40.2 million in 2005. This was due to the increase in the ceding commission revenue earned as a result of the overall increase in ceded premiums earned as discussed above. In addition, commission and fee income includes other administration revenue of $0.7 million from services provided to and reimbursed by CastlePoint. This increase was offset in part by a reduction in fee income in our insurance services segment as more policies previously produced in that segment were written in our insurance segment. Additionally, as a result of the commutation agreements with PXRE, we recorded a charge (reduction) of $3.2 million to ceding commissions representing the difference between the carried amount of commissions due from PXRE and the amount received at an estimated present value. In 2006 the change in estimated sliding scale commission rate for commissions earned in prior periods in both the insurance segment and the insurance services segment resulted in a net increase of $1.9 million of commission and fee income compared to a reduction of $1.2 million in 2005.
The decrease in the gross and net loss ratios, excluding the effect of the PXRE transactions, in 2006 compared to 2005 was primarily due to lower than expected loss emergence for the property lines for the 2005 and 2006 accident years. However the decrease in the net loss ratio, excluding the effect of PXRE, was offset, in part, by the increase in the catastrophe reinsurance premiums ceded. Also, during 2006, prior accident years’ net loss reserves developed favorably to the extent of $2.3 million. The $1.6 million charge related to the PXRE commutation affected prior accident years’ reserves. Accordingly the net favorable development on prior year’s reserves was $0.7 million. There was favorable development from prior years’ loss reserves on a net basis of approximately $0.4 million in 2005. See “Insurance Services Segment Results of Operations” and “Reinsurance Segment Results of Operations” for further discussion.
Operating expenses. Operating expenses increased by 32.1% to $114.2 million in 2006 from $86.5 million in 2005. The increase was due primarily to the increase in underwriting expenses resulting from the growth in premiums earned. Operating expenses in 2006 also includes organizational and start up costs of approximately $0.5 million related to our sponsorship of CastlePoint which was a wholly owned subsidiary during the first quarter of 2006.
Other Income. In 2006 we recorded a gain of $7.9 million resulting from CastlePoint’s private offering of unissued shares and other income of $4.6 million from a warrant that we received from CastlePoint for our sponsorship and formation activities. We also recorded $0.9 million income representing our 8.6% equity in CastlePoint’s net income for the nine months ended December 31, 2006. See “Note 3.-Investments in Unconsolidated Affiliate-CastlePoint” elsewhere in our consolidated financial statements included in this report for further details regarding gains and losses recorded on these transactions.
Income tax expense. Our income tax expense was $19.7 million in 2006 compared to $11.1 million in 2005. The increased income tax expense was due primarily to the increase in income before income taxes. The effective income tax rate was 34.9% in 2006 compared to 34.8% in 2005.
Gross premiums. Gross premiums written increased by 28.2% to $523.3 million for 2007 compared to $408.3 million for 2006. Gross premiums earned increased by 50.0% to $516.1 million for 2007 compared to $344.0 million for 2006. The lesser increase in gross premiums written than gross premium earned resulted from the implementation of insurance risk sharing with CastlePoint by placing premiums with CPIC through TRM, which generated a significant increase in commission and fee income in our insurance services segment. Other items affecting gross premiums included the acquisition of Preserver on April 10, 2007 that added $63.7 million and $63.6 million in gross premiums written and earned, respectively, for 2007 and growth in specialty program business premium, managed by CastlePoint which increased to $24.5 million in 2007, compared to $11.1 million in 2006. Also, in 2007 we initiated a wholesale producer program which will allow us to strategically expand our core brokerage book of business locally and geographically into larger insurance
Net premiums. Net premiums written increased by 17.0% to $258.5 million for 2007 compared to $220.8 million for 2006. While gross premiums written increased by 28.2% in 2007, net premiums written did not increase as much because of the increased quota share ceding percentage mentioned above. Net premiums earned increased by 36.9% to $280.3 million in 2007 compared to $204.7 million for 2006. The growth was driven primarily by the increase in gross premiums earned, offset by an increase in the quota share ceding percentage and, to a lesser extent, by an increase in catastrophe reinsurance costs.
Loss and loss adjustment expenses are net of reimbursements for loss and loss adjustment expenses made by TRM pursuant to the expense sharing arrangement between TICNY and TRM. See “Insurance Services Segment Results of Operations” for the amounts of loss and loss adjustment expense reimbursements.
Underwriting expenses. Underwriting expenses, which include direct commission expenses and other underwriting expenses, were $152.0 million for 2007 as compared with $101.7 million for 2006. Our gross expense ratio was 29.1% for 2007 as compared with 29.2% for 2006. We have made significant progress integrating Preserver into our operations. Preserver’s gross expense ratio for the portion of 2007 subsequent to the acquisition declined to 33.6% and 31.2% in the fourth quarter of 2007, compared to 41.1% prior to acquisition.
The commission portion of the gross expense ratio, which expresses direct commission expense paid to our producers as a percentage of gross premiums earned, was 16.5% for 2007, compared to 16.3% for 2006. The increase is partially due to higher commissions on program business.
written during 2006 through former OneBeacon producers that we appointed in connection with the 2004 renewal rights transaction amounted to $21.5 million compared to $17.3 million in 2005.
Ceded premiums. Ceded premiums written increased by 112.6% to $187.5 million in 2006 compared to $88.2 million for 2005. This increase was greater than the increase in gross premiums written for the following reasons. In April 2006, we entered into three multi-year quota share reinsurance agreements with CastlePoint Reinsurance. Since we did not place quota share reinsurance in the first quarter of 2006, we ceded to CastlePoint Reinsurance $40.9 million of unearned premiums as of April 1, 2006. In addition, we ceded $114.2 million of premiums written on policies that began on April 1, 2006 through the period ending December 31, 2006. Consistent with our business plans and targeted net premiums written levels, the second, third and fourth quarter cessions to CastlePoint Reinsurance reflected a 30%, 40% and 40% quota share ceding percentage, respectively, for the brokerage business resulting in a total quota share ceded premium earned to CastlePoint in 2006 of $75.5 million. The total quota share ceded premium earned in 2006, including premiums ceded to other reinsurers under the 2005 quota share agreements, was $115.1 million. This represents a 91.5% increase in comparison to $60.1 million in 2005. The traditional program business and specialty program business quota share ceding percentages were 50% and 85%, respectively, in 2006. In 2006, we ceded $2.2 million to CastlePoint for the traditional and specialty program business.
Ceded premiums earned increased 90.2% during 2006 as compared to 2005 as a result of the increase in gross premiums earned and the aforementioned changes in quota share ceding percentages, as well as an additional $19.2 million of ceded premiums earned included in the $40.9 million portfolio of unearned premiums that was ceded to CastlePoint Reinsurance as of April 1, 2006 which related to business written in 2005 that we had previously retained.
Net premiums. Net premiums written increased by 4.9% to $220.8 million for 2006, compared to $210.4 million for 2005 notwithstanding the 36.7% increase in gross premiums written. This was due to the increased ceded premiums written as described above.
Ceding commission revenue. Ceding commission revenue increased by 71.0% to $43.1 million in 2006 compared to $25.2 million for 2005 due to the 90.2% increase in ceded premiums earned offset, in part, by a lower quota share ceding commission rate of 34% as compared to a ceding commission rate of 41% in 2005. Also, as a result of the commutation agreements with PXRE, we recorded a charge of $3.2 million to ceding commission revenue in 2006. Ceding commission revenue increased by $1.1 million in 2006 as a result of an improvement in the ceded loss ratios on prior years’ quota share treaties compared to a decrease of $0.8 million as a result of deterioration in the ceded loss ratios on prior years’ quota share treaties in 2005.
Loss and loss adjustment expenses and loss ratio.. Gross and net losses and loss adjustment expenses were $182.9 million and $118.0 million, respectively, in 2006 compared with $134.8 million and $95.7 million, respectively, for 2005. Our gross loss ratio was 53.2% in 2006 as compared with 57.1% for 2005. The net loss ratio was 57.6% for 2006 and reflected the $1.6 million charge resulting from the commutation agreement with PXRE referred to previously. The effect of the commutation added 0.7% percentage point to the net loss ratio in 2006. The net loss ratio was 58.7% in 2005. The decrease in the gross and net loss ratios, excluding the impact of PXRE, in 2006 compared to 2005 was primarily due to lower than expected loss emergence for the property lines for the 2006 accident year compared to 2005. However the decrease in the net loss ratio, excluding the impact of PXRE, was offset, in part, by the significant increase in the amount of catastrophe reinsurance premiums ceded which reduced net earned premiums thereby increasing the net loss ratio. We ceded catastrophe reinsurance premiums equal to 5.0% of net premiums earned during 2006 as compared to 2.5% in 2005. During 2006, prior accident years’ loss reserves developed favorably to the extent of $2.6 million excluding the $1.6 million loss related to the commutation with PXRE, resulting in net favorable development of $1.0 million. There was favorable development from prior years’ loss reserves on a net basis of approximately $0.4 million in 2005.
The commission portion of the gross expense ratio, which expresses direct commission expense paid to our producers as a percentage of gross premiums earned, was 16.3% in 2006, compared to 16.4% for 2005.
The underwriting expense portion of the gross expense ratio was 13.0% in 2006 as compared to 14.6% for 2005. Although underwriting expenses increased due to the growth in premium volume, the gross ratio declined as gross premiums earned increased more rapidly than underwriting expenses.
Gross premiums. Gross premiums written decreased to $0.7 million for 2007 as compared to $24.3 million in 2006. During 2007, principally in the fourth quarter, we assumed $0.7 million of premiums produced by TRM on behalf of an issuing carrier, other than CPIC. In 2006, we entered into novation agreements with PXRE which increased gross premiums written and earned by $11.4 million, in addition to the other premiums produced by TRM. Gross premiums earned decreased to $5.9 million for 2007 from $19.4 million in 2006. Almost all of the premiums earned in 2007 arise from premiums written in 2006.
to 87.3% and 88.8%, respectively, in 2006. Both gross and net losses in 2006 increased by $12.2 million as a result of the novation agreements with PXRE that added 27.9 percentage points and 26.1 percentage points to the gross and net loss ratio, respectively, in 2006.
There was favorable development from prior years’ loss reserves on a net basis of approximately $1.2 million in 2007, compared to unfavorable development from prior years’ loss reserves on a net basis of approximately $0.3 million in 2006.
Net premiums. Net premiums written increased to $24.2 million for the twelve months ended December 31, 2006 as compared to $1.3 million in 2005. The increase in net premiums written was due to an increase in gross premiums as discussed above. Net premiums earned increased to $19.3 million in 2006 as compared to $1.5 million in 2005 as a result of the increase in gross premiums earned, which included the premiums arising from the novation agreements with PXRE.
Underwriting expenses and underwriting expense ratio. Gross underwriting expenses increased in 2006 to $3.7 million as compared to $0.2 million in 2005. Our net underwriting expense ratio increased to 19.0% in 2006 from 12.5% in 2005. These increases resulted from approximately a 34% to 35% ceding commission paid to issuing carriers in 2006. In 2005, this segment assumed premiums on an excess of loss basis which did
not result in a ceding commission payment. Additionally, the increase in gross premiums written resulted in an increase in the allocated share of other underwriting expenses to this segment. The gross and net underwriting expense ratios were 18.9% and 19.0%, respectively, in 2006 compared to 11.4% and 12.4%, respectively, in 2005. The PXRE novation added $11.4 million of additional gross and net premiums earned but did not include any commission expense and thus lowered the gross and net expense ratios. The effects of the PXRE novation reduced the gross and net underwriting expense ratios by 27.1 percentage points and 27.6 percentage points, respectively, in 2006.
Underwriting (loss) profit and combined ratio. The underwriting loss from assumed reinsurance in 2006 was $1.5 million compared to underwriting profit of $0.4 million in 2005 and includes the charge of $0.8 million resulting from the novation agreements with PXRE. The net combined ratio was 107.8% in 2006 compared to 72.3% in 2005. The higher net combined ratio in 2006 was the result of the increased net loss ratio as explained above.
Other administration revenue includes amounts reimbursed by CastlePoint Reinsurance for services rendered pursuant to a service and expense sharing agreement.
Reinsurance intermediary fees include commissions earned for placement of reinsurance on behalf of TICNY and TNIC.
For 2006, direct commission revenues decreased as compared to 2005 as a result of the 63.3% decrease in premiums produced by TRM to $12.9 million from $35.2 million as more policies previously produced in insurance services segment were renewed in the insurance segment. In addition there was an increase in commission revenue of $0.8 million in 2006 as a result of favorable loss development on the premiums produced in prior years, compared to a reduction of commission income of $0.4 million in 2005 resulting from unfavorable loss development on premiums produced in periods prior to 2005. As a result of the PXRE novation, TRM recognized $0.2 million of direct commission revenue.
We classify our investments in fixed maturity securities as available for sale and report these securities at their estimated fair values based on quoted market prices or a recognized pricing service. Changes in unrealized gains and losses on these securities are reported as a separate component of comprehensive net income and accumulated unrealized gains and losses are reported as a component of accumulated other comprehensive net income in stockholders’ equity. Realized gains and losses are charged or credited to income in the period in which they are realized.
On November 3, 2005, the FASB issued FSP FAS 115-1 and FAS 124-1, “Other-Than-Temporary Impairment and Its Application to Certain Investments.” The guidance in this FSP addresses the determination of when an investment is considered impaired, whether that impairment is other-than-temporary, and the measurement of an impairment loss. The FSP also includes accounting considerations subsequent to the recognition of other than temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as OTTI. The guidance in this FSP applies to reporting periods beginning after December 15, 2005.
Impairment of investment securities results in a charge to net income when a market decline below cost is deemed to be other-than-temporary. As of December 31, 2007, we reviewed our fixed-maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments in accordance with the provisions of this FSP and EITF 99-20. We recorded OTTI in our fixed maturity and equity securities in the amounts of $10.1 million and $0 in 2007 and 2006, respectively. The following table provides a breakdown of the amortized cost, aggregate fair value and unrealized gains and losses by investment type as of December 31, 2007 and December 31, 2006.
The following table presents information regarding our invested assets that were in an unrealized loss position at December 31, 2007 and 2006 by amount of time in a continuous unrealized loss position.
Tower is organized as a holding company with one intermediate holding company and five Insurance Subsidiaries and TRM. Tower’s principal liquidity needs include interest on debt, income taxes and stockholder dividends. Tower’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 other Insurance Subsidiaries are subject to similar restrictions, usually related to policyholders’ surplus, unassigned surplus or net income and notice requirements of their domiciliary state.
TRM is not subject to any limitations on its dividends to Tower, other than the basic requirement that dividends may be declared or paid if the net assets of TRM remaining after such declaration or payment will at least equal the amount of TRM’s stated capital. TRM declared dividends of $0 in 2007, $0.7 million in 2006 and $2.6 million in 2005.
Pursuant to a Tax Allocation Agreement, we compute and pay Federal income taxes on a consolidated basis. At the end of each consolidated return year, each entity must compute and pay to Tower its share of the Federal income tax liability primarily based on separate return calculations. The tax allocation agreement allows Tower to make certain Code elections in the consolidated Federal tax return. In the event such Code elections are made, any benefit or liability is accrued or paid by each entity. If a unitary or combined state income tax return is filed, each entity’s share of the liability is based on the methodology required or established by state income tax law or, if none, the percentage of each entity’s separate income or tax divided by the total separate income or tax reported on the return. During 2007, Tower received $27.1 million in tax payments from its subsidiaries under this agreement.
On January 22, 2007, we signed an underwriting agreement providing for the issuance and sale of 2,704,000 shares of common stock at a price of $31.25 per share, less underwriting discounts, and granted to the underwriters an option to purchase up to 405,600 additional shares of common stock at the same price to cover over-allotments.
In both January 2007 and March 2006, we issued $20 million of subordinated debentures, respectively.
On November 13, 2006, we entered into the Stock Purchase Agreement with a subsidiary of CastlePoint pursuant to which the Company agreed to issue and sell 40,000 shares of perpetual preferred stock to the subsidiary for aggregate consideration of $40 million. The transaction closed on December 4, 2006. On January 26, 2007, we fully redeemed all 40,000 shares of the preferred stock for $40.0 million using $20.0 million of the net proceeds from our trust preferred securities issued on January 25, 2007 and $20.0 million of the net proceeds from our common stock offering.
The statutory surplus that we are required to maintain varies depending on the type and amount of revenue that is derived. The statutory surplus requirements are based upon various capital adequacy tests and ratios established by rating agencies and insurance regulators. Statutory surplus requirements are greater for net premiums earned and retained than for premiums that we cede or transfer to reinsurers. Non-risk bearing revenues that are generated primarily from TRM do not require us to maintain any surplus, except capital necessary to meet TRM’s operating expenses. For these reasons, we attempt to reduce our statutory surplus
For 2007 and 2006, net cash provided by operating activities was $75.9 million and $134.1 million, respectively. The decrease in cash flow for 2007 was a result of Federal income tax payments of $27.6 million for 2007, compared to $15.3 million for 2006, as well as increased reinsurance costs. In addition, net cash provided by operating activities in 2006 included $37 million received from PXRE which resulted from the commutation and novation transactions.
The net cash flows provided by financing activities for 2007 and 2006 were $67.5 million and $59.7 million, respectively. The 2007 amount included the net proceeds from the issuance of $20.6 million in subordinated debentures on January 25, 2007, the $89.4 million of net proceeds from the January 26, 2007 equity offering and the related exercise of the underwriters’ over allotment option, offset by $40.0 million used for the redemption of preferred stock. In 2006, net cash flows provide by financing activities included the net proceeds from the issuance of $20.6 million of subordinated debentures on March 31, 2006 and the issuance of the perpetual preferred stock in December 2006, net of issuance costs.
Our insurance companies are subject to significant regulatory restrictions limiting their ability to declare and pay dividends. As of December 31, 2007, the maximum amount of distributions that our insurance companies could pay to us without approval of their domiciliary Insurance Department was approximately $17.0 million. Cash flow needs at the holding company level are primarily for dividends to our stockholders and interest payments on our $101.0 million of subordinated debentures.
In 2006 we had $132.0 million of net cash flows used in investing activities that were funded from operating cash flow compared to $143.3 million in 2005. During 2006, we capitalized $22.8 million for the purchase of fixed assets and entered into a sale-leaseback on $5.2 million of these assets. We relocated our New York City corporate headquarters within the same building during 2006. We capitalized $10.4 million for leasehold improvements, $6.1 million for furniture and equipment and $6.4 million for computer hardware and software in 2006. The landlord provided a $4.8 million build-out allowance which partly financed the $10.4 million of leasehold improvements. We had net purchases of $83.4 million of fixed-maturity securities and net purchases of $16.6 million of equity investments in 2006. In addition, during 2006 we invested $14.4 million to start up CastlePoint.
We maintain sufficient liquidity to pay claims, operating expenses and meet our other obligations. We held $77.7 million and $100.6 million of cash and cash equivalents at December 31, 2007 and 2006, respectively, which included $19.2 million and $20.0 million, respectively, of securities with an original maturity of less than ninety days that were recorded as cash equivalents on the balance sheet. We monitor our expected claims payment needs and maintain a sufficient portion of our invested assets in cash and cash equivalents to enable us to fund our claims payments without having to sell longer-duration investments. Cash and cash equivalents at December 31, 2007 includes $16 million of premiums collected through TRM on behalf of CPIC. These funds will be paid to CPIC within 90 days from December 31, 2007. As of December 31, 2007, cash and cash equivalents were approximately equal to the estimated $85.4 million of net loss reserves as of that date that we expect to pay within the next year. As necessary, we adjust our holdings of short-term investments and cash and cash equivalents to provide sufficient liquidity to respond to changes in the anticipated pattern of claims payments. See “Business - Investments.”
We have posted an irrevocable letter of credit for $1.0 million for the benefit of OneBeacon Insurance Group LLC (“OneBeacon”) representing the estimated commissions due to OneBeacon for the first year of the Commercial Renewal Rights Agreement dated September 13, 2004. The letter of credit was required by OneBeacon prior to entering into the renewal rights agreement. We paid the third fiscal year commission and final payment in February 2008 and we are in the process of terminating the letter of credit.
We have audited the accompanying consolidated balance sheets of Tower Group, Inc. (together with its consolidated subsidiaries, the “Company”) as of December 31, 2007 and 2006, and the related consolidated statements of income and comprehensive income, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2007. Our audits also included the financial statement schedules listed in Item 15. We also have audited the Company’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). 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 the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the company’s internal control over financial reporting based on our audits.
2007 amount includes $16,563 of cash acquired with the acquisition of Preserver Group, Inc.
to reinsurers. Claims administration fees and other administration revenues are earned as services are performed.
The liability for loss and LAE represent management’s best estimate of the ultimate cost of all reported and unreported losses that are unpaid as of the balance sheet date. The liability for loss and LAE is estimated on an undiscounted basis, using individual case-basis valuations, statistical analyses and various actuarial procedures. The projection of future claim payment and reporting is based on an analysis of the Company’s historical experience, supplemented by analyses of industry loss data. Management believes that the reserves for loss and LAE are adequate to cover the ultimate cost of losses and claims to date; however, because of the uncertainty from various sources, including changes in reporting patterns, claims settlement patterns, judicial decisions, legislation, and economic conditions, actual loss experience may not conform to the assumptions used in determining the estimated amounts for such liability at the balance sheet date. As adjustments to these estimates become necessary, such adjustments are reflected in expense for the period in which the estimates are changed. Because of the nature of the business historically written, the Company’s management believes that the Company has limited exposure to environmental claim liabilities.
The Company maintains its cash balances at several financial institutions. The Federal Deposit Insurance Corporation (“FDIC”) secures accounts up to $100,000 at these institutions. Management monitors balances in excess of insured limits and believes they do not represent a significant credit risk to the Company.
With respect to the business produced by TRM for other issuing carriers, agents collect premiums from the policyholders and forward them to TRM. In certain jurisdictions, when the insured pays premium for these policies to agents for payment to TRM, the premium might be considered to have been paid and the insured will no longer be liable to TRM for those amounts, whether or not TRM has actually received the premiums from the agent. Consequently, TRM assumes a degree of credit risk associated with agents and brokers. The Company recorded no losses in 2007, 2006 and 2005 for this activity.
Furniture, leasehold improvements, computer equipment, and software are reported at cost less accumulated depreciation and amortization. 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 is three years, computer software three years, furniture and other equipment is seven years and leasehold improvements is the term of the lease.
The Company does not consolidate interest in its statutory business trusts for which the Company holds 100% of the common trust securities because Tower is not the primary beneficiary of the trusts in accordance with FIN No. 46(R), “Consolidation of Variable Interest Entities”. See “Note 12-Debt.” The Company’s investment in common trust securities of the statutory business trust are reported in balance sheet at equity. The Company reports as a liability the outstanding subordinated debentures owed to the statutory business trusts.
The Company accounts for the treasury stock at the repurchase price as a reduction to stockholders’ equity as it does not intend to retire the treasury stock held at December 31, 2007.
In accordance with Statement of Financial Accounting Standards No. 128, “Earnings Per Share,” (SFAS No. 128) the Company measures earnings per share at two levels: basic earnings per share and diluted earnings per share. Basic earnings per share is calculated by dividing income (loss) allocable to common stockholders by the weighted average number of common shares outstanding during the year excluding issued but unvested restricted stock shares. Diluted earnings per share is calculated by dividing income (loss) allocable to 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, unless common equivalent shares are antidilutive.
The Company has reclassified certain amounts in its 2006 consolidated balance sheet to conform to the 2007 presentation. None of these reclassifications had an effect on the Company’s consolidated net earnings, total stockholders’ equity or cash flows.
Financial instruments that potentially subject the Company to concentration of credit risk are primarily cash and cash equivalents, investments and accounts receivable. Investments are diversified through many industries and geographic regions through the use of money managers who employ different investment strategies. The Company limits the amount of credit exposure with any one financial institution and believes that no significant concentration of credit risk exists with respect to cash and investments. At December 31, 2007 and 2006, the outstanding premiums receivable balance is generally diversified due to the number of entities composing the Company’s customer base, which is largely concentrated in the Northeast. To reduce credit risk, the Company performs ongoing evaluations of its 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 to minimize its exposure to significant losses from reinsurer insolvencies. It is the policy of management 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 December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS No. 141(R)”). This standard establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. SFAS No. 141(R) also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The guidance will become effective as of the beginning of the Company’s fiscal year beginning after December 15, 2008. The Company is currently evaluating the impact that the adoption of SFAS No. 141(R) will have on its consolidated financial condition or results of operations.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements-an amendment of ARB No. 51” (“SFAS No. 160”). This standard establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. The guidance will become effective as of the beginning of the Company’s fiscal year beginning after December 15, 2008. The Company is currently evaluating the impact that the adoption of SFAS No. 160 will have on its consolidated financial condition or results of operations.
On April 10, 2007, the Company completed the acquisition of 100% of the issued and outstanding common stock of Preserver Group, Inc., a New Jersey corporation, pursuant to the stock purchase agreement (the “Agreement”), dated as of November 13, 2006, by and among the Company, Preserver and the Sellers named therein. The acquisition gave the Company access to 300 new retail agencies and accelerated the Company’s Northeast expansion plans by adding premium volume in New Jersey, Maine, New York, New Hampshire, Massachusetts, Vermont, Rhode Island and Pennsylvania.
The acquisition was accounted for using the purchase method in accordance with the FASB SFAS No. 141, “Business Combinations”. Under the terms of the Agreement, the Company acquired Preserver for approximately $64.7 million comprised of $33.9 million in cash paid to the Sellers and a contribution of $30.8 million to the capital of Preserver to enable Preserver to repay the principal and accrued interest on indebtedness held by certain of the Sellers.
In accordance with SFAS No. 141, the cost of the acquisition was preliminarily allocated to the assets acquired and liabilities assumed based on their fair values as of the close of the acquisition, with the amounts exceeding the fair value recorded as goodwill. As the values of certain assets and liabilities are preliminary in nature, they are subject to adjustment as additional information is obtained, including, but not limited to,
valuation of separately identifiable intangibles, fixed assets, and deferred taxes. The valuations will be finalized within 12 months of the close of the acquisition. When the valuations are finalized, any changes to the preliminary valuation of assets acquired or liabilities assumed may result in adjustments to separately identifiable intangibles and goodwill. The results of operations of Preserver have been included in the Company’s consolidated financial statements since April 10, 2007.
Selected unaudited pro forma results of operations assuming the acquisition had occurred as of January 1, 2006, are set forth below:
The purchase price allocation of fair value to the acquired assets and liabilities was adjusted in December 2007 as part of the Company’s effort to finalize the allocation of the purchase price. The adjustment primarily resulted from Preserver not properly recording its proportionate share of assets and liabilities relating to involuntary residual market plans. Certain states require insurance companies to participate in these plans as a
proportionate share of the specific states voluntary markets for workers’ compensation,
commercial auto liability and property lines of business. The net impact on Preserver’s fair value at April 10, 2007 was $3.9 million, net of federal income taxes. As of December 31, 2007, the Company has not finalized its purchase price allocation due to these adjustments.
The base purchase price was reduced by the amount (net of taxes) of certain expenses paid by Preserver in connection with the transaction including amounts that were paid or payable to officers, directors and employees of Preserver and legal and financial advisor fees in connection with the sale of Preserver. The amount of this reduction was approximately $3.5 million. An additional purchase price may be payable approximately three years following the closing if Preserver has favorable development on its June 30, 2006 reserves for losses and loss adjustment expenses. The amount of this additional purchase price will be 65% of any such favorable development but will not exceed $13 million.
A summary of the amortized cost and fair value of the Company’s investments in fixed-maturity securities at December 31, 2007 by contractual maturity is shown below:
At December 31, 2007 and 2006, U.S. Treasury Notes with fair values of approximately $19.4 million and $8.7 million, respectively, were on deposit with various states to comply with the insurance laws of the states in which the Company is licensed.
The unrealized losses on the Company’s investments in preferred securities was primarily due to the market disruption caused by sub-prime related issues and other temporary market conditions. The Company evaluated all five preferred securities that were in an unrealized loss position as of December 31, 2007. These securities have been in an unrealized loss position for a period ranging from 6 to 11 months. The severity of the impairment in relation to the carrying amounts of preferred stock is between 16.8% to 54.2%. The Company has the ability and the intent to hold these investments until a recovery of fair value, which may be maturity. The Company does not consider these investments to be other-than-temporarily impaired.
At December 31, 2007, the Company’s maximum exposure to a loss from its investment in CastlePoint was approximately $32.6 million, which consists of its equity ownership interest of approximately $28.0 million and the fair value of the warrant the Company received from CastlePoint of $4.6 million.
The Company has determined that CastlePoint qualifies as a variable interest entity (“VIE”) under the provisions of Financial Accounting Standards Board Interpretation (“FIN”) 46-(R). The Company has determined that its investment in CastlePoint does not meet the requirements for consolidation because the Company is not the primary beneficiary of the VIE as defined in FIN 46-(R). However, the Company has recorded its investment in CastlePoint using the equity method of accounting as the Company exercises significant influence over CastlePoint. The Company and CastlePoint have the same Chief Executive Officer, Michael H. Lee.
The Company has recorded $383,000 of CastlePoint dividends received or accrued since inception as a reduction to its investment in CastlePoint.
The Company and/or its subsidiaries are parties to a master agreement, certain reinsurance agreements, and other agreements, including program management agreements and service and expense sharing agreements, with CastlePoint.
The parties to the Master Agreement agreed to exercise good faith, and to cause their respective subsidiaries to exercise good faith, to carry out the intent of parties in the event the specific agreements contemplated by the Master Agreement must be revised to comply with regulatory requirements.
Under the brokerage business quota share reinsurance agreement, which covers business that the Company has historically written through its retail and wholesale agents, the Company’s Insurance Subsidiaries cede between 25% and 50% of premiums and losses, such ceding percentage being subject to periodic adjustment by the Company. For the period April 1, 2007 through June 30, 2007, CastlePoint Insurance Company (“CPIC”) was added as a reinsurer under the brokerage business quota share reinsurance agreement and the Company ceded 9% of its premiums and losses to CPIC and 40% of its premiums and losses to CastlePoint Reinsurance.
Effective April 1, 2007, under the brokerage business quota share reinsurance agreement, CastlePoint agreed to pay 30% of the Company’s property catastrophe reinsurance premiums relating to the brokerage business pool managed by the Company and 30% of the Company’s net retained property catastrophe losses. CastlePoint and the Company will participate proportionately in catastrophe reinsurance on the underlying brokerage business pool. The premium payment was $2.3 million in 2007. CastlePoint Reinsurance also participated as a reinsurer on the Company’s overall property catastrophe reinsurance program from July 1, 2006 to June 30, 2007, and the Company’s excess of loss reinsurance program, effective May 1, 2006. Under the catastrophe reinsurance program, the Company ceded $1.2 million and $1.0 million to CastlePoint Reinsurance in 2007 and 2006, respectively. Effective July 1, 2007, CastlePoint Reinsurance no longer participates as a reinsurer on the Company’s catastrophe reinsurance program, which now includes coverage for business written by CPIC and produced and managed by TRM. Under the excess of loss program, the Company ceded excess of loss reinsurance of $3.2 million and $1.6 million to CastlePoint Reinsurance in 2007 and 2006, respectively.
In addition, the Company and CastlePoint entered into two aggregate excess of loss reinsurance agreements for the brokerage business with CastlePoint effective October 1, 2007. The purpose of the two aggregate excess of loss reinsurance agreements is to equalize the loss ratios for the brokerage business written by CPIC
At December 31, 2007, the Company had receivables and payables with CastlePoint arising in the normal course of business, as follows:
Under the program management agreement, CastlePoint Management Corp. (“CPM”) was appointed by TICNY to perform certain underwriting and claims services, effective January 1, 2007, with respect to the traditional and specialty program business and insurance risk-sharing business, such as soliciting, underwriting, quoting, binding, issuing and servicing of insurance policies. In circumstances where CPM cannot fully perform these functions on its own, CPM plans to delegate authority to the program underwriting agents or to purchase services from the Company under the service and expense sharing agreement. The Company reimburses CPM for expenses it incurs under this agreement. All expenses paid by the Company were included as direct commission expenses to CPM in the insurance segment. The total direct commission expenses paid in 2007 and 2006 by the Company was $3.4 million and $0.6 million, respectively.
TRM agreed to produce and manage, on behalf of CPM, CPIC’s share of the Company’s brokerage business. During 2007, TRM produced $0.5 million of premium and earned $0.2 million in management fees from CPIC pursuant to this agreement. In addition, CastlePoint paid $0.3 million in 2007 for claims adjustment services pursuant to this agreement. As discussed above, effective July 1, 2007, TRM entered into a new agreement to produce and manage CPIC business, as more fully described under “Management Agreement” above.
The incurred method relies on historical development factors derived from changes in the Company’s incurred estimates of claims paid and case reserves over time. The paid method relies on the Company’s claim payment patterns and ultimate claim costs. The incurred method is sensitive to changes in case reserving practices over time, thus if case reserving practices change over time, the incurred method may produce significant variation in estimates of ultimate losses. The paid method relies on actual claim payments and therefore is not sensitive to changes in case reserve estimates.
reinsurance. Through various quota share, excess of loss and catastrophe reinsurance agreements, as described further below, the Company limits its exposure to a maximum loss on any one risk
the funds held under reinsurance agreements liability accounts of 3.0% in 2007, 3.0% in 2006 and 3.0% in 2005. The amounts credited for 2007, 2006 and 2005 were $1.2 million, $1.6 million and $1.3 million respectively, and have been recorded as interest expense. The quota share agreement effective January 1, 2006 is collateralized in a New York Regulation 114 compliant trust account.
As of December 31, 2007, the Company’s estimated ultimate loss ratios attributable to these contracts are lower than the contractual ultimate loss ratios at which the minimum amount of ceding commissions can be earned. Accordingly, the Company has recorded ceding commissions earned that are greater than the minimum commissions. The relevant estimated ultimate loss ratios and commissions as of December 31, 2007 are set forth below ($ in millions) for treaties that remain in effect as of December 31, 2007:
As of December 31, 2007, there was no impairment on any of the intangible assets as per the Company’s annual impairment testing.
In December 2006, the Company entered into a sale and leaseback arrangement whereby it sold for $5.2 million nearly all of the furniture and fixtures it purchased in 2006 and leased them back under a 60 month lease arrangement at an annual cost of $1.1 million. The Company has an early buy-out option in December 2010 at a rate of 32.41% of the original sale price and has an early termination option in June 2009 at a rate of 45.27% of the original sale price and must return the equipment to the lessor.
Depreciation expense for 2007 and 2006 was $7.7 million and $4.8 million, respectively.
The Company has 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 acquires from the trusts to purchase a junior subordinated debenture 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, then floats with changes in the London Interbank Offered Rate (“LIBOR”) and in
other cases the interest rate floats with LIBOR without any initial fixed-rate period. The principal terms of the outstanding trust preferred securities are summarized in the following table.
At our option at par on or after March 15, 2012
At our option at par on or after April 7, 2011
At our option at par on or after May 15, 2008
At our option at par on or after May 24, 2009
As part of the IPO in October 2004, the Company issued to Friedman, Billings, Ramsey & Co., Inc. (“FBR”), the lead underwriter, warrants to purchase 189,000 shares of the Company’s common stock at an exercise price of $8.50 per share. The warrants are exercisable for a term of five years beginning on October 20, 2004 and expire on October 20, 2009. On October 28, 2005, FBR exercised warrants and paid the Company the warrant exercise price of $8.50 per share or $89,820 and was issued 10,567 shares by the Company from treasury shares. In addition, FBR exercised 132,300 warrants on October 28, 2005 via a cashless exercise which resulted in the issuance of 64,244 shares by the Company from treasury shares. As of December 31, 2007 and 2006, FBR has 36,233 and 46,133 warrants outstanding that are included in the calculation of diluted EPS.
In 2007, the Company purchased 14,022 shares of its common stock from employees in connection with the vesting of restricted stock issued in conjunction with its 2004 Long Term Equity Compensation Plan (the “Plan”). The shares were withheld at the direction of employee as permitted under the Plan in order to pay the minimum amount of tax liability owed by the employee from the vesting of those shares. In addition, 10,292 shares of common stock were surrendered to the Company as a result of restricted stock forfeitures and 9,900 were issued to FBR in connection with the warrants referenced above. During 2006, the Company repurchased 1,312 shares of common stock and surrendered 6,259 shares of common stock as a result of restricted stock forfeitures.
The 2004 Long-Term Equity Compensation Plan provides for the granting of non-qualified stock options, incentive stock options (within the meaning of Section 422 of the Code), stock appreciation rights (“SARs”), restricted stock and restricted stock unit awards, performance shares and other cash or share-based awards. The activity in the plan is, as follows:
rights and will receive dividends but the shares may not be sold, assigned, transferred, exchanged, pledged or otherwise encumbered. The fair value of the restricted shares was $1.6 million on the grant date. These restricted shares were authorized and issued prior to the adoption and approval of the 2004 Long-Term Equity Compensation Plan.
For the years ended December 31, 2007, 2006 and 2005, the Company incurred restricted stock expense of $1.0 million, $0.6 million and $0.4 million, respectively, net of tax that was included in net income.
Options outstanding and exercisable as of December 31, 2007 are shown on the following schedule:
$3.8 million was for restricted stock as of December 31, 2007. The weighted average period over which this compensation cost is expected to be recognized is 3.4 years.
Deferred tax assets and liabilities are determined using the enacted tax rates applicable to the period the temporary differences are expected to be recovered. Accordingly, the current period income tax provision can be affected by the enactment of new tax rates. The net deferred income taxes on the balance sheet reflect temporary differences between the carrying amounts of the assets and liabilities for financial reporting purposes and income tax purposes, tax effected at a 35% rate. Significant components of the Company’s deferred tax assets and liabilities are as follows:
Preserver, which was acquired by the Company on April 10, 2007, has tax loss carryforwards and other tax assets that the Company believes will be used in the future, subject to change of ownership limitations pursuant to Section 382 of the Internal Revenue Code and to the ability of the combined post-merger company
At December 31, 2007, the Company had $34.7 million of net operating loss carryforwards that will expire if unused in 2027 and $6.5 million of capital loss carryforwards that will expire if unused in 2012.
The Company recognizes interest and penalties related to uncertain tax positions in income tax expense which were zero for the years ended 2007, 2006 and 2005.
Tax years 2004 through 2007 are subject to examination by the federal authorities. There is currently a New York State Department of Taxation and Finance audit under way for the tax years of 2003 through 2004, but the Company does not anticipate any material adjustments.
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 income taxes. The items causing this difference are as follows:
From time to time, the Company is involved in various legal proceedings in the ordinary course of business. For example, to the extent a claim asserted by a third party in a law suit against one of the Company’s insureds covered by a particular policy, the Company may have a duty to defend the insured party against the claim. These claims may relate to bodily injury, property damage or other compensable injuries as set forth in the policy. Such proceedings are considered in estimating the liability for loss and LAE expenses. The Company is not subject to any other pending legal proceedings that management believes are likely to have a material adverse effect in the financial statements.
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 was assessed approximately $624,000, $2,042,000 and $941,000 in 2007, 2006 and 2005, respectively, for its proportional share of the total assessment for the Property/Casualty Security Fund and approximately $1,409,000, $1,470,000 and $589,000 in 2007, 2006 and 2005, 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 ($2,156,000), ($127,000) and $0 in 2007, 2006 and 2005, respectively. The Company estimates its liability for future assessments based on actual written premiums and historical rates and available information. As of December 31, 2007 the liability for the various workers’ compensation funds, which includes amounts assessed on workers’ compensation policies was $2,813,000. This amount is expected to be paid over an eighteen month period ending June 30, 2009. As of December 31, 2006, the liability for the various workers’ compensation funds was $4,463,000.
The Company’s insurance company subsidiaries declared approximately $8.5 million, $4.6 million, and $2.1 million in dividends to Tower in 2007, 2006, and 2005, respectively. As of December 31, 2007, the maximum distribution that Tower’s Insurance Subsidiaries could pay without prior regulatory approval was approximately $17.0 million.
Statement of Financial Accounting Standards No. 107, “Disclosures about Fair Value of Financial Instruments” requires all entities to disclose the fair value of financial instruments, both assets and liabilities recognized and
Equity and fixed income investments: Fair value disclosures for investments are included in “Note 2 - Investments.”
Subordinated debentures: The carrying values reported in the accompanying balance sheets for these financial instruments approximate fair value. Fair value was estimated using projected cash flows, discounted at rates currently being offered for similar notes.
In the reinsurance segment, TICNY assumes reinsurance directly from TRM’s issuing companies excluding CPIC or indirectly from reinsurers that provide reinsurance coverage directly to the issuing companies.
In the insurance services segment, TRM generates commission revenue from its managing general agency by producing premiums on behalf of its issuing companies and generates fees by providing claims administration and reinsurance intermediary services. The insurance services segment also includes other administration services provided by TICNY to CastlePoint. Prior to 2006, placing risks through TRM’s issuing companies allowed the Company to underwrite larger policies and gain exposure to market segments that were unavailable to TICNY due to its rating, financial size and geographical licensing limitations. In 2006, TRM allowed the Company to write business through issuing carriers in states in which it was not licensed. TRM does not assume any risk on business produced by it. All of the risk is ceded by the issuing companies to a variety of reinsurers pursuant to reinsurance programs arranged by TRM’s reinsurance intermediary working with outside reinsurance intermediaries. Through its issuing companies, TRM’s managing general agency offers commercial package, monoline general liability, monoline property, commercial automobile and commercial umbrella products.
Underwriting expenses in the insurance segment are net of expense reimbursements that are made by the insurance services segment pursuant to an expense sharing agreement between TRM and TICNY. In accordance with terms of this agreement, TRM reimburses TICNY for a portion of TICNY’s underwriting and other expenses resulting from TRM’s use of TICNY’s personnel, facilities and equipment in underwriting insurance on behalf of TRM’s issuing companies. The reimbursement for underwriting and other expenses is calculated as a minimum reimbursement of 5% of the premiums produced by TRM, and is adjustable
according to the terms of the agreement based on the number of policies in force and additional expenses that may be incurred by TRM. The amount of this reimbursement was $5.8 million, $1.6 million, and $2.0 million in 2007, 2006 and 2005, respectively. TRM also reimburses TICNY, at cost, for claims administration expenses pursuant to the terms of this expense sharing agreement. Claims expenses reimbursed by TRM were $2.3 million, $3.2 million and $4.3 million in 2007, 2006 and 2005, respectively. TICNY is also reimbursed, at cost, for other administrative services provided to CastlePoint, pursuant to the terms of the service and expense sharing agreement which were $1.4 million and $0.7 million in 2007 and 2006, respectively.
The following table reconciles the results of our individual segments to consolidated income before taxes:
Tower Group, Inc.’s Board of Directors approved a quarterly dividend on February 21, 2008 of $0.05 per share payable March 27, 2008 to stockholders of record as of March 14, 2008.
Subsequent to December 31, 2007, the publicly traded REITs have continued to experience reductions in market prices. The fair market value of the REITs on March 12, 2008 was $5.4 million, compared to $7.4 million at December 31, 2007.
Since the weighted-average shares for the quarters are calculated independently of the weighted-average shares for the year, quarterly earnings per share may not total to annual earnings per share. In addition, preferred dividends are excluded from the quarterly calculations of earnings per share in 2007 and 2006 since they are anti-dilutive, but are included in the calculations.
In the first quarter calculations, earnings per share were calculated incorrectly. The correction resulted in a reduction in the basic and diluted earnings per share for the first quarter of 2007 by $0.02 and $0.02, respectively.