We also lease office space in Melville, New York, Buffalo, New York and Quincy, Massachusetts.
In our insurance segment, TICNY and TNIC provide commercial and personal lines insurance policies to businesses and individuals. TICNY and TNIC’s 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. Its personal lines products consist of homeowners, dwelling 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”) or indirectly from reinsurers that provide reinsurance coverage directly to these issuing companies. In our insurance services segment, TRM generates commission income 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 generates other administration revenue from services provided to CastlePoint Reinsurance and will earn management fees in 2007 from pooling business with CastlePoint. See “Item 1.-Reinsurance-CastlePoint Reinsurance and Pooling” and “Item 1.-Strategic Relationship and Agreements with CastlePoint.”
On March 25, 2005, we closed on our purchase of the outstanding common stock of a shell insurance Company, North American Lumber Insurance Company (“NALIC”), that was renamed Tower National Insurance Company (“TNIC”). The purchase price was $1,050,000 and included nine active state licenses and two inactive state licenses. The nine active states licenses were for New Jersey, Connecticut, Massachusetts, Rhode Island, Vermont, Maryland, Delaware, South Carolina and Wisconsin. The two inactive states were Pennsylvania and Maine. The inactive state licenses have an additional contingent purchase price of $75,000 per state payable upon license reactivation within one year of the closing. These licenses were activated in 2005. Prior to the closing, all liabilities and assets (other than insurance licenses) of TNIC were transferred to a liquidating trust. We capitalized this purchase as an intangible asset related to state licenses with an indefinite life subject to annual impairment testing. The total amount capitalized as of December 31, 2005, was $1,303,000 and included the purchase price, legal fees and a broker’s fee. As of December 31, 2006, TNIC was authorized to write business in twenty-five states.
Company of America (“TICA”). We acquired TICA for the value of its statutory surplus at closing plus $225,000. In October 2006, we entered into an agreement to sell all of the issued and outstanding capital stock of TICA to CastlePoint for a cash purchase price of $350,000 plus an amount equal to the value of the statutory surplus of TICA at closing. The $125,000 difference in the price reflects the legal and brokerage fees paid by us in connection with our acquisition of the company. Following the closing of the TICA transaction which occurred on December 4, 2006, CastlePoint intended to rename TICA “CastlePoint Insurance Company.” We have agreed to enter into various pooling agreements with CastlePoint Insurance Company, which will be effective January 1, 2007 pending regulatory approval from the State of New York Insurance Department
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. On April 4, 2006, CastlePoint raised $249.9 million, net of expenses, in a private placement offering of unissued shares, which reduced our investment ownership from 100% to 8.6%. The book value per share of our 2,555,000 shares of CastlePoint common stock increased from $5.87 per share to $8.96 per share as a result of this offering. The carrying value of our investment in CastlePoint increased from $15.0 million to $22.9 million. We have recorded this gain of $7.9 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.
months ending December 31, 2006 relating to non-recurring sponsorship services. The warrant has been recorded as an equity instrument at cost, which was determined to be the fair value of the warrant on the date it was received and will be subject to impairment testing.
CastlePoint Reinsurance entered into three multi-year quota share reinsurance agreements with our insurance subsidiaries that cede to CastlePoint Reinsurance between 25% and 45%, subject to a periodic adjustment by us, of premiums and losses on our brokerage insurance business that we have historically written through our retail and wholesale agents. These agreements have been extended for an additional year. The ceding commission for the brokerage business is fixed at 34% of ceded written premium for the period April 1, 2006 to March 31, 2007 and it then reverts to a sliding scale commission on April 1, 2007. During the second quarter of 2006, we ceded 30% of our in force, new and renewal brokerage insurance business to CastlePoint Reinsurance and ceded 40% of our new and renewal brokerage insurance business written in the third and fourth quarters of 2006 to CastlePoint Reinsurance. We ceded 50% of our traditional program business and 85% of our specialty program business written during 2006 to CastlePoint Reinsurance. Traditional program business written through program underwriting agencies is comprised of classes of business that we have historically written. The specialty program business covers business not historically written by us. The ceding commission rate for the traditional and specialty program business is 30%. During 2006, we ceded $40.9 million of unearned premiums as of April 1, 2006, which consisted of $19.2 million and $21.7 million of unearned premiums retained by us on policies written in 2006 and 2005, respectively, and $114.2 million on premiums written during the nine months ended December 31, 2006. In addition, CastlePoint Reinsurance participates as a reinsurer on our excess of loss reinsurance program, effective May 1, 2006 and our catastrophe reinsurance program, effective July 1, 2006. We ceded excess of loss reinsurance and catastrophe premiums to CastlePoint Reinsurance of $1.6 million and $1.0 million, respectively for the nine months ended December 31, 2006. Recoverables and prepaid reinsurance totaling $115.2 million from CastlePoint Reinsurance, which is an unauthorized reinsurer and are collateralized in a New York State Regulation 114 compliant trust account for our benefit with a balance of $95.3 million as of December 31, 2006 with the remaining amount offset by ceded balances payable.
Our pooling agreements with CastlePoint Insurance Company will impact the reporting of our business segments beginning in 2007. Our insurance segment will report premiums that we produce as part of our brokerage pool and our insurance services segment will record management fee income that we will earn as a result of managing the brokerage pool on behalf of CastlePoint. In addition, the insurance segment will include premiums from the traditional and specialty pools that CastlePoint Management
manages for TICNY and TNIC. Our brokerage business will also be written through CastlePoint Insurance Company or other insurance companies that CastlePoint may acquire in the future. When shown in the consolidated results, this amount will be included in total revenues and will have the effect of reducing the net underwriting expense ratio in the same manner as policy billing fees and ceding commission revenue. In addition, we plan to assume through a pooling agreement a certain percentage of the business written by us or CastlePoint utilizing CastlePoint Insurance Company. This business will be reported in our assumed reinsurance segment. See “Item 1.-Recent Developments and Reinsurance-CastlePoint Reinsurance and Pooling.”
The property and casualty insurance industry is affected by naturally occurring industry cycles known as “hard” and “soft” markets. For the first ten years after our company began, we operated in a soft market cycle, generally considered an adverse industry cycle in the property and casualty insurance industry. A soft market cycle is characterized by intense competition that results in inadequate pricing, expanded coverage terms and increased commissions paid to distribution sources in order to compete for business. We believe that a hard market began sometime in late 2000. A hard market, generally considered a beneficial industry
In the last three decades, there have been three hard markets in which industry-wide inflation-adjusted premiums grew. Each of these periods was followed by an increase in capacity, price competition and the aggressive terms and conditions that are typical of a soft market.
A.M. Best has stated that it expects rates for catastrophe-prone areas will remain elevated in 2007, a function of more conservative selection and pricing, reduced market capacity for certain segments and substantially higher reinsurance costs on these risks. Soft market conditions will prevail in most other lines and segments, with a gradual release of previously favorable terms and conditions for the industry. Overall personal lines pricing continues to be impacted by increased competition, predominantly in the personal auto line and soft market conditions are expected to continue in selected commercial lines. In 2007, A.M. Best believes that profit margins will likely be eroded to a certain extent as a result of stronger balance sheets encouraging increased competition for market share in specified segments. However; A.M. Best projects that financial results for the U.S. property/casualty industry as a whole in 2007 will be generally favorable especially if catastrophic losses remain modest.
The competition referred to above has affected non-catastrophe middle market and larger package policies, commercial automobile, workers’ compensation and umbrella policies. In the urban and metropolitan segments which we participate in, in particular, homeowners, smaller commercial accounts and the lower end of the middle market, increased competition and price softening has not been as evident as in the larger commercial account segment.
We derive our revenue from the net premiums earned, ceding commissions, direct commission revenue and fees and net investment income and net realized gains from investments. The limited surplus in TICNY before our October 2004 IPO constrained our ability to write net premiums because we are required to maintain a minimum level of surplus to support premiums. As a result, we relied on other reinsurance companies and ceded premiums to them to generate ceding commissions in TICNY and we produced premiums for TRM’s issuing companies to generate non-risk bearing revenues in our insurance services operation. Consistent with this strategy, during the five years ended December 31, 2004, we derived 34.6% and 36.9% of our total revenues from net premiums earned and ceding commissions, respectively from TICNY and 24.8% of our total revenue from direct commission and fees from our insurance services operation. Our investment income and realized gains from investments comprised 3.7% of our total revenues during this period. Immediately after the IPO we contributed $98 million of the proceeds from the IPO and the concurrent private placement to TICNY, which increased its statutory surplus. Additionally, TICNY received a rating upgrade from A.M. Best to “A-” (Excellent) in October 2004. With the higher rating we were able to more fully deploy the additional capital.
of adjusting and settling those claims. Our provision for loss and loss adjustment expense reserves in any period, which is the expense recorded, includes estimates for losses incurred during the period and changes in estimates for prior periods.
Underwriting expense ratios. 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 ratios 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.
Premium 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 utilize TRM’s access to its issuing companies as a means to expand our ability to generate premiums in states where TICNY and TNIC are not yet licensed. 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.
income as ceded premiums written are earned. Since 2001, the ultimate commission rate earned on our quota share reinsurance contracts has been determined by the loss ratio on the ceded premiums earned. If the estimated loss ratio decreases from the level currently in effect, the commission rate increases and additional ceding commissions are earned in the period in which the decrease is recognized. If the estimated loss ratio increases, the commission rate decreases, which reduces ceding commissions earned. As a result, the same uncertainties associated with estimating loss and loss adjustment expense reserves affect the estimates of ceding commissions earned. We monitor the ceded ultimate loss ratio on a quarterly basis to determine the effect on the commission rate of the ceded premiums earned that we accrued during prior accounting periods. The estimated ceding commission income relating to prior years recorded in 2006, 2005 and 2004 was an increase of $1.1 million, and a decrease of $1.2 million and an increase of $1.7 million, respectively.
in the period it is determined. Investment income is recorded when earned and includes the amortization of premium and discounts on investments.
Impairment of invested assets. Impairment of investment securities results in a charge to income when a market decline below cost is deemed to be other than temporary. We regularly review our fixed maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other than temporary declines in the fair value of investments. In general, we focus our attention on those securities whose fair value was less than 80% of their amortized cost or cost, as appropriate, for six or more consecutive months. In evaluating potential impairment, we consider, among other criteria: the current fair value compared to amortized cost or cost, as appropriate; the length of time the security’s fair value has been below amortized cost or cost; our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in value; specific credit issues related to the issuer; and current economic conditions. Other than temporary impairment losses result in a permanent reduction of the cost basis of the underlying investment. Only temporary declines in the fair value of our fixed maturity and equity securities were recorded during 2006, 2005 and 2004. Significant changes in the factors we consider when evaluating investments for impairment losses could result in a significant change in impairment losses reported in our consolidated financial statements. See “Business-Investments” and “Note 2. Investments” in the notes to our audited consolidated financial statements for additional detail regarding our investment portfolio at December 31, 2006, including disclosures regarding other than temporary declines in investment value.
Our results of operations are discussed below in two parts. The first part discusses the consolidated results of operations. The second part discusses the results of the two underwriting segments, the insurance and reinsurance segments, followed by the results of operations of our insurance services segment.
Total revenues. Total revenues increased by 36.2% to $299.3 million for 2006 compared to $219.8 million in 2005. The increase is primarily due to the increase in net premiums earned, total commission and fee income and net investment income. Net premiums earned represented 74.8% of total revenues in both 2006 and 2005. Net investment income, excluding realized capital losses, represented 7.7% and 6.8% of total revenues, 2006 and 2005, respectively. In addition, total commission and fee income increased to $52.2 million, or 17.5% of total revenue for 2006 compared to $40.2 million, or 18.3% of total revenue, for 2005.
Premiums earned. Net premiums earned increased by 36.2% to $224.0 million for 2006 compared to $164.4 million for the 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 quota share ceding percentage was 25%. The traditional program business and specialty program business quota share ceding percentages ceded 50% and 85%, respectively, in 2006. In 2006, we ceded $2.2 million to CastlePoint for the traditional and specialty programs business.
Net investment income and realized gains. Net investment income increased by 53.7% to $23.0 million for 2006 compared to $15.0 million in 2005. This resulted from an increase in invested assets and cash and cash equivalents to $564.6 million as of December 31, 2006 compared to $395.9 million as of December 31, 2005. Net cash flow provided by operations, including $37.0 million of cash received from PXRE resulting from the commutation and novation transactions, contributed to the $168.7 million increase in invested assets and cash and cash equivalents for 2006. On a tax equivalent basis, the yield was 5.7% as of December 31, 2006 and 5.2% as of December 31, 2005.
Net realized capital gains were $12,000 in 2006 compared to net realized capital gains of $122,000 for the same period in 2005. There was no impact on net realized gains attributable to adjustments for other than temporary impairment of securities held during 2006 or in 2005.
Loss and loss adjustment expenses. Gross loss and loss adjustment expenses and the gross loss ratio for the insurance and reinsurance segments combined for 2006 were $199.9 million and 55.0%, respectively, compared to $135.2 million and 56.8%, respectively, for the same period in 2005. The net loss ratio for the combined segments was 60.3% for the 2006 as compared to 58.8% in 2005. The net loss ratio for 2006 reflected a $1.6 million charge resulting from the commutation agreement with PXRE which was a present value discount on the reserves commuted. In addition to the commutation agreement with PXRE, we executed novation agreements with PXRE relating to other reinsurance agreements covering business written in 2001, 2002 and 2003. These agreements were written by other insurance companies with respect to business managed on their behalf by TRM. Under the novation agreements the Company assumed loss liabilities of $12.2 million and received consideration of $11.4 million. Since novation transactions are recorded by including the consideration received as premiums written and earned and the liabilities assumed as losses incurred, the gross and net loss ratios were also affected. The PXRE
commutation and novation transactions added 1.7 and 3.2 percentage points to the gross and net loss ratios, respectively, in 2006
Operating expenses. Operating expenses increased by 32.1% to $114.2 million for 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 for 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 the sale of CastlePoint’s 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 this report for further details regarding gains and losses recorded on these transactions.
Income tax expense. Our income tax expense was $19.7 million for 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% for 2006 compared to 34.8% in 2005.
Net income and return on average common equity. Our net income and return on average common equity was $36.8 million and 22.2%, respectively, in 2006 compared to $20.8 million and 15.1%, respectively, in 2005. For 2006, the return was calculated by dividing net income of $36.6 million excluding preferred stock dividends by an average common stockholders’ equity of $164.6 million. The net effects of the PXRE commutation and novation transactions, and the gains recorded on the CastlePoint investment and warrant, reduced by $0.5 million of start-up expenses for CastlePoint, added $4.1 million to our net income and 2.2 percentage points to our return on average common equity for 2006. For 2005, the return was calculated by dividing net income of $20.8 million by an average stockholders’ equity of $137.1 million.
Net realized capital gains were $122,000 in 2005 compared to $13,000 in 2004. The increase in net realized capital gains was the result of the sale of common stocks and corporate bonds from which the proceeds were reinvested into higher yielding securities.
Loss and loss adjustment expenses. Gross loss and loss adjustment expenses and the gross loss ratio for the Insurance and reinsurance segments combined in 2005 were $135.2 million and 56.8%, respectively, compared to $84.2 million and 55.2%, respectively, in 2004. The net loss ratio for the combined segments was 58.8% for 2005 and 59.4% for the same period in 2004. The improvement in the net loss ratio in 2005 compared to the same period in 2004 was due primarily to the increase in net premiums earned that reduced the effect of catastrophe reinsurance premiums on the net loss ratio and to favorable development from prior years’ reserves of $392,000 in 2005 compared to $199,000 in the same period in 2004. See “Item 7 - Insurance Segment Results of Operations” and “Reinsurance Segment Results of Operations” for further discussion.
Gross premiums. Gross premiums written increased by 36.7% to $408.3 million for 2006 compared to $298.6 million in 2005. Gross premiums earned increased by 45.7% to $344.0 million for 2006 compared to $236.2 million for the same period in 2005. Gross premiums earned was also affected by the significant increase in gross premiums written in 2005 and the overall increase in gross premiums written through December 31, 2006 especially in our homeowners and commercial multi peril and other liability lines. The number of policies in force increased by 18.8% as of December 31, 2006 compared to December 31, 2005.
Ceded premiums. Ceded premiums written increased by 112.6% to $187.5 million for 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 quota share ceding percentage was 25%. 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.
Net premiums earned increased by 25.6% to $204.7 million in 2006 compared to $162.9 million in 2005 as a result of the 45.7% increase in gross premiums earned offset by the 90.2% increase in ceded premiums earned discussed above.
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 “Item 7.-Insurance Service Segment Results of Operations” for the amounts of loss and loss adjustment expense reimbursements.
Underwriting expenses and underwriting expense ratio. Underwriting expenses, which include direct commission expenses and other underwriting expenses, were $101.7 million for 2006 as compared with $74.0 million for 2005. Our gross expense ratio was 29.2% for 2006 as compared with 31.0% for 2005.
The net underwriting expense ratio was 28.1% for 2006 as compared to 29.4% for 2005. The net expense ratio, which reflects ceding commission revenue, was affected by the reduction in ceding commissions of $3.2 million resulting from the commutations with PXRE which added 1.6 percentage points to the net expense ratio. The net expense ratio for 2006 also included the benefit of additional ceding commission revenue due to the additional ceded premiums to CastlePoint Reinsurance as of April 1, 2006.
Ceded premiums. Ceded premiums written increased by 10.8% to $88.2 million in 2005 compared to $79.6 million in 2004 as a result of the increases in gross premiums written offset by a reduction in the percentage ceded under the quota share agreements. For the first nine months of 2004, the ceding percentage under our quota share reinsurance agreements was 60% and beginning October 1, 2004 was 25%. The 2005 quota share reinsurance agreements maintained the 25% ceding percentage throughout 2005. The effective quota share ceding percentage was 41.6% in 2004 that also included a $13.1 million reduction to ceded written premiums from the retention of the unearned premium at December 31, 2004 that would have been ceded to Converium. Following the downgrade of Converium’s rating and decision by its parent to place that company into runoff in September 2004, we terminated and novated Converium’s participation under its 2004 quota share treaty and decided to retain the ceded unearned premiums that would have been ceded to Converium absent the termination. Excluding the $13.1 million that we retained, the effective quota share ceding percentage would have been 49.1% in 2004 compared to 25% in 2005. Notwithstanding the lower ceding percentage in 2005, ceded premiums written in 2005 decreased only 10.8% as a result of the increase in the gross written premium by 69.5%.
Ceding commission revenue. Ceding commission revenue decreased by 36.9% to $25.2 million in 2005 compared to $40.0 million in 2004 due to the reduction in the quota share ceding percentage. An increase in the ceded loss ratio on prior years’ quota share agreements resulted in a further decrease in ceding commission revenue of $0.8 million in 2005 compared to an increase in ceding commission revenue of $1.7 million in 2004.
Underwriting expenses and underwriting expense ratio. Underwriting expenses, which include direct commission expenses and other underwriting expenses, were $74.0 million for 2005 as compared with $47.8 million in 2004. Our gross expense ratio was 31.0% in 2005 compared to 31.2% in 2004.
Virginia Surety and State National where TICNY and TNIC were not yet licensed. In 2005, the majority of this business was reinsured by other reinsurers.
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 for 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.
Loss and loss adjustment expenses and loss ratio. Gross loss and loss adjustment expenses were $17.0 million for 2006 as compared to $0.4 million for 2005. Net losses were $17.1 million for 2006 as compared to $0.9 million in 2005. Both gross and net losses for 2006 were increased by $12.2 million as a result of the novation agreements with PXRE. The gross and net loss ratios were 87.3% and 88.8%, respectively, in 2006 as compared to 24.7% and 59.9%, respectively, in 2005. There was unfavorable development from prior years’ loss reserves on a net basis of approximately $0.3 million in 2006, compared to favorable development from prior years’ loss reserves on a net basis of approximately, $0.5 million in 2005. The effect of the PXRE novation agreements added 27.9 percentage points and 26.1 percentage points to the gross and net loss ratio, respectively, for 2006.
Underwriting (loss) profit and combined ratio. The underwriting loss from assumed reinsurance for 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% for 2006 compared to 72.3% in 2005. The higher net combined ratio for 2006 was the result of the increased net loss ratio as explained above.
The gross combined ratio increased to 106.2% for 2006 compared to 36.1% in 2005 due to the increase in the gross loss ratio and the other underwriting expense ratio. The effects of the PXRE novation agreements added 0.7 percentage points to the gross combined ratio and reduced the net combined ratio by 1.5 percentage points for 2006.
Net premiums. Net premiums written decreased 9.5% to $1.3 million in 2005 as compared to $1.5 million in 2004. However, net premiums earned increased by 34.1% to $1.5 million in 2005 as compared to $1.1 million in 2004 as a result of a 27.7% increase in gross premiums earned. The increase in gross premiums earned resulted from an increase in premiums written in the later part of 2004 and earned in 2005.
Underwriting profit and combined ratio. The underwriting profit from assumed reinsurance in 2005 was $0.4 million compared to $1.6 million in 2004. The net combined ratio was 72.3% in 2005 compared to a negative 39.1% in 2004. The higher net combined ratio in 2005 was the result of a higher net loss ratio while the negative net combined ratio for 2004 was the result of the negative net loss ratio.
(3) Consists of underwriting expenses reimbursed to TICNY pursuant to an expense sharing agreement and to CastlePoint Reinsurance pursuant to a service and expense sharing agreement.
Pre-tax income. Pre-tax income in 2006 decreased by 54.3% to $1.3 million as compared to $2.8 million in 2005. The decrease was due to the decrease in premiums produced offset partially by a favorable adjustment in direct commission revenue of $0.8 million in 2006 as compared to an unfavorable adjustment in direct commission income of $0.4 million resulting from unfavorable loss development on premiums produced in periods prior to 2005.
Other insurance services expenses. The amount of reimbursement for underwriting expenses by TRM to TICNY in 2005 was $2.0 million as compared to $3.0 million in 2004. The decrease resulted from the 34.2% decrease in premiums produced.
The aggregate fair value of our invested assets as of December 31, 2006 was $ 464.0 million. Our fixed maturity securities as of this date had a fair value of $414.6 million and an amortized cost of $416.6 million. The equity securities carried at fair value were $49.5 million with a cost of $48.0 million as of December 31, 2006. Equity securities carried at cost were reclassified to equity securities at fair value as of September 30, 2006 in accordance with GAAP for insurance companies.
Impairment of investment securities results in a charge to operations when a market decline below cost is deemed to be other-than-temporary. As of December 31, 2006, 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. We determined that we did not hold any investments were considered other than temporarily impaired.
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, 2006 and December 31, 2005.
The following table presents information regarding our invested assets that were in an unrealized loss position at December 31, 2006 by amount of time in a continuous unrealized loss position.
We are organized as a holding company with three operating company subsidiaries, TICNY, TNIC and TRM. The holding company’s principal liquidity needs include interest on debt, income taxes and stockholder dividends. The holding company’s principal sources of liquidity include dividends from TICNY, TNIC and TRM and other permitted payments from our subsidiaries, as well as financing through borrowings and sales of securities.
Under New York law, TICNY is limited in the amount of dividends it can pay to Tower. Under New York law, TICNY may pay dividends to Tower only out of statutory earned surplus. In addition, the New York Insurance Department must approve any dividend declared or paid by TICNY that, together with all dividends declared or distributed by TICNY during the preceding twelve months, exceeds the lesser of (1) 10% of TICNY’s policyholders’ surplus as shown on its latest statutory financial statement filed with the New York State Insurance Department or (2) 100% of adjusted net investment income during the preceding twelve months. TICNY declared approximately $4,600,000, $2,050,000, and $850,000 in dividends to Tower in 2006, 2005, and 2004, respectively. As of December 31, 2006, the maximum amount of distributions that TICNY could pay to its parent without approval of the New York State Insurance Department was $10.5 million.
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 $700,000 in 2006, $2,550,000 in 2005 and none in 2004.
2006. 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 2006, TICNY paid $14.7 million, TRM paid $0.1 million, and TNIC paid $0.1 million to Tower under this agreement.
On October 26, 2004 we contributed $98.0 million in paid in capital to TICNY, which in turn invested this cash in its fixed-income portfolio.
The primary sources of cash flow in TICNY and TNIC are gross premiums written, ceding commissions from our quota share reinsurers, loss payments by our reinsurers, investment income and proceeds from the sale or maturity of investments. Funds are used by TICNY and TNIC for ceded premium payments to reinsurers, which are paid on a net basis after subtracting losses paid on reinsured claims and reinsurance commissions. TICNY and TNIC also use funds for loss payments and loss adjustment expenses on our net business, commissions to producers, salaries and other underwriting expenses as well as to purchase investments and to pay dividends to Tower. TRM’s primary sources of cash are commission and fee income. TRM’s primary uses of cash are commissions to producers and expenses reimbursed to TICNY under an expense sharing agreement.
For 2006 net cash provided by operating activities was $134.0 million compared to $128.5 million for 2005. The increase in net cash provided by operations for 2006 resulted primarily from an increase in collected premiums as a result of the growth in gross premiums written and the PXRE commutation and novation agreements executed during the second quarter of 2006, offset by the increase in payments to our reinsurers which resulted from an increase in the quota share premiums ceded to CastlePoint and from the increase in catastrophe costs in 2006.
Net cash used by investing activities was $143.3 million for the year ended December 31, 2005 compared to $177.0 in 2004 due principally to investments in securities with cash provided by operations.
We maintain sufficient liquidity to pay claims, operating expenses and meet our other obligations. We held $100.6 million and $38.8 million of cash and cash equivalents at December 31, 2006 and 2005, respectively, which included $20.0 and $26.1 million, respectively, which were of short-term duration of less than ninety days and 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. As of December 31, 2006, cash and cash equivalents greatly exceeded the estimated $45.2 million of net loss reserves as of that date that we expected to pay within the next year. The $61.8 million increase in cash and cash equivalents as of December 31, 2006 compared to December 31, 2005 was due to the relatively flat yield curve and management’s decision to invest new funds short term and not taking on additional interest rate risk associated with longer term investments as well as the $39.6 million of new cash from the perpetual preferred stock offering. These funds will be reinvested longer term by our investment manager as we see advantages in the fixed maturity market. 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 “Item 1.-Investments.”
On February 5, 2007 the underwriters exercised their 340,600 shares of common stock available under their 30-day over-allotment option at the offering price of $31.25 per shares. We received gross proceeds of $10.6 million from this over-allotment option and net proceeds of $10.1 million after the underwriting discount. The exercise of the over-allotment option brings our aggregate net proceeds from the offering and follow-on offering, after underwriting discounts, commissions and expenses, to approximately $89.4 million.
For a discussion of our reserving process, see “Item 7.-Critical Accounting Policies-Loss and Loss Adjustment Expense Reserves.” Actual payments of losses and loss adjustment expenses by period will vary, perhaps materially, from the above table to the extent that current estimates of loss reserves vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns. See “Item 1A. - Risk Factors-Risks Related to Our Business-If our actual loss and loss adjustment expenses exceed our loss reserves, our financial condition and results of operations could be significantly affected,” for a discussion of the uncertainties associated with estimating loss and loss adjustment expense reserves. The ceded reserves recoverable referred to above also assumes timely reimbursement from our reinsurers. If our reinsurers do not meet their contractual obligations on a timely basis, the payment assumptions presented above could vary materially.
We do not consolidate interest in its statutory business trusts for which we hold 100% of the common trust securities because we are not the primary beneficiary of the trusts. The Company’s investment in common trust securities of the statutory business trust are reported in investments as equity securities. We report as a liability the outstanding subordinated debentures owed to the statutory business trusts.
On January 25, 2007, we participated in a private placement of $20.0 million of fixed/floating rate capital securities (the “Trust Preferred Securities”) issued by Tower Group Statutory Trust VI (the “Trust”), an affiliated Delaware trust formed on January 11, 2007. The Trust Preferred Securities mature in April 2036, are redeemable at our option at par beginning April 7, 2011, and require quarterly distributions of interest by the Trust to the holder of the Trust Preferred Securities. Interest distributions are initially at a fixed rate of 8.155% for the first five years and will then reset quarterly for changes in the three-month London Interbank Offered Rate (“LIBOR”) plus 300 basis points. The Trust simultaneously issued 619 of the Trust’s common securities to us for a purchase price of $0.6 million, which constitutes all of the issued and outstanding common securities of the Trust. The Trust used the proceeds from the sale of the Trust Preferred Securities and common securities to purchase for $20.6 million a Junior Subordinated Debt Security due 2037 issued by the Company.
· our failure to comply with the covenants or other provisions of the indentures or the trust preferred securities; or
We have posted an irrevocable letter of credit for $2.0 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. We paid the second fiscal year commission in February 2007 and we are in the process of reducing the letter of credit to $1.0 million.
Management of Tower Group, Inc. (together with its consolidated subsidiaries, the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting. Management conducted an assessment of the effectiveness, as of December 31, 2006, of the Company’s internal control over financial reporting, based on the framework established in Internal Control-Integrated Framework Issued by the Committee Sponsoring Organizations of the Treadway Commission (COSO). Based on our assessment under that framework, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2006.
Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006 has been audited by Johnson Lambert & Co. LLP an independent registered accounting firm, as stated in their report included herein, which expresses unqualified opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006.
We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting, that Tower Group, Inc and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We have audited the accompanying consolidated balance sheets of Tower Group, Inc. and subsidiaries (the “Company”) as of December 31, 2006 and 2005 and the related statements of income and comprehensive net income, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the Company’s financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2006 and 2005, and the results of its operations and its cash flows for the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States.
On October 20, 2004, the Securities and Exchange Commission declared Tower Group, Inc.’s registration statement effective. The Company’s IPO was for 13,000,000 shares and was priced at $8.50 per share. Also on October 20, 2004 Tower Group, Inc. offered a concurrent private placement of 500,000 shares of its common stock to an affiliate of Friedman, Billings, Ramsey & Co., Inc. the lead underwriter for the Company’s IPO, at the price of $8.50 per share. On November 10, 2004 the underwriters exercised their 30-day over-allotment option. Pursuant to this exercise, the underwriters purchased 629,007 additional shares of common stock from the Company and 1,320,993 shares of common stock from the selling stockholders at the IPO price of $8.50 per share, less the underwriting discount. The Company did not receive any proceeds from the sale of common stock by any selling stockholder. The Company received net cash proceeds of $107,845,000 from the offering and concurrent private placement after the underwriting discounts, commissions and offering expenses. The total costs of the IPO and private placement were $12,252,000 of which $8,407,000 was for the underwriters’ discount, and $3,845,000 was for all other costs. Costs of the IPO have been reflected as a reduction in Paid-in-Capital.
As previously announced, Michael H. Lee serves as chairman and chief executive officer of CastlePoint Holdings, Ltd. and Tower Group, Inc.
The Company issued 40,000 perpetual series A preferred shares to a subsidiary of CastlePoint on December 4, 2006 with a $0.01 par value per share and a $1,000 liquidation preference per share. The carrying value of this stock is $40 million less issuing cost of $0.4 million or $39.6 million and pays a fixed 8.66% annual dividend which is not cumulative.
TICNY is a property and casualty insurance company incorporated in the State of New York in June 1989. TICNY obtained its license to operate in the State of New York in December 1990, at which time it commenced underwriting operations. TICNY provides coverage for many different market segments, including nonstandard risks that do not fit the underwriting criteria of standard carriers due to factors such as type of business, location and the relatively small amount of premium per policy. TICNY offers commercial multiple-peril, monoline general liability, commercial umbrella, monoline property, workers’ compensation and commercial automobile policies as well as personal lines products such as homeowners, dwelling and other liability policies. Generally, TICNY targets customers that have a reduced potential for loss severity and are not normally exposed to long-tailed, complex or contingent risks, such as products liability, asbestos or environmental claims. TICNY’s commercial lines products provide insurance coverages to businesses such as retail and wholesale stores, grocery stores, restaurants, artisan contractors and residential and commercial buildings. Personal lines products focus on modestly valued homes and dwellings. TICNY’s products are marketed through independent agents. As of December 31, 2006, TICNY was authorized to write business in thirty-six states and has direct premium written in New York, Pennsylvania, New Jersey, Illinois, Maryland, Massachusetts and Tennessee in 2006.
states and has direct premium written in New Jersey, New York, Pennsylvania, Illinois and Massachusetts in 2006.
TRM is a non-risk-bearing insurance services company that produces, through its managing general agency, business on behalf of other insurance companies (which are referred to as TRM’s issuing companies) and primarily focuses on commercial risks with higher per policy premium, including risks that TICNY historically had not been able to target due to surplus, rating and geographical license constraints. However, since Tower’s IPO and private placement in 2004, TICNY has increased its surplus and its A.M. Best rating was upgraded to A- from B++. These changes resulted in TICNY writing more of the risks previously placed by TRM. TICNY also reinsures a portion of the premiums written by TRM’s issuing companies. In 2006, TRM continued to produce business on behalf of Virginia Surety Company Inc. from January 1, 2006 to August 31, 2006 and State National Insurance Company Inc. beginning on November 1, 2006 primarily to maintain business in states where TNIC and TICNY were not yet licensed. In 2006, TICNY directly reinsured 100% of the TRM business produced by Virginia Surety and State National. The Company uses these non-risk-bearing insurance services operations to generate commission income on premiums produced for other insurance companies. In 2006 and 2005, two companies accounted for 100% of the managing general agency commissions of TRM.
Reinsurance recoverable represents management’s best estimate of paid and unpaid loss and loss adjustment expenses recoverable from reinsurers. Ceded losses recoverable are estimated using techniques and assumptions consistent with those used in estimating the liability for loss and loss adjustment expenses. Management believes that reinsurance recoverables as recorded represent its best estimate of such amounts; however, as changes in the estimated ultimate liability for loss and loss adjustment expenses are determined, the estimated ultimate amount recoverable from the reinsurer will also change. Accordingly, the ultimate recoverable could be significantly in excess of or less than the amount indicated in the consolidated financial statements. As adjustments to these estimates become necessary, such adjustments are reflected in current operations. Loss and loss adjustment expenses incurred as presented in the consolidated statement of income and comprehensive net income are net of reinsurance recoveries.
In preparing financial statements, management estimates the amounts receivable from reinsurers to be uncollectible based on an assessment of factors including the creditworthiness of the reinsurers and the adequacy of collateral obtained, where applicable. The Company recorded no allowance for uncollectible reinsurance at December 31, 2006 and 2005 and did not expense any uncollectible reinsurance during 2006, 2005 and 2004. Significant uncertainties are inherent in the assessment of the creditworthiness of reinsurers and estimates of any uncollectible amounts due from reinsurers. Any change in the ability of the Company’s reinsurers to meet their contractual obligations could have a detrimental impact on the consolidated financial statements and TICNY’s ability to meet its regulatory capital and surplus requirements.
Direct commission revenue from the Company’s managing general underwriting services, which is the largest component of insurance services revenue, is generally recognized and earned as insurance policies are placed with TRM’s issuing companies. Fees from reinsurance intermediary services are earned when TICNY or TRM’s issuing companies cede premiums to reinsurers. Claims administration fees and other administration revenues are earned as services are performed.
Agents’ balances receivable are presented net of an allowance for doubtful accounts of $248,000, $170,000 and $123,000 at December 31, 2006, 2005 and 2004, respectively. The allowance for uncollectible amounts is based on an analysis of amounts receivable giving consideration to historical loss experience and current economic conditions and reflects an amount that, in management’s judgment, is adequate. Uncollectible agent’s balances of $139,000, $26,000 and $27,000 were written off in 2006, 2005, and 2004 respectively. One agent accounted for approximately 9%, 10% and 12%, respectively, of TICNY’s and TRM’s agents’ balances at December 31, 2006, 2005 and 2004. The same agent accounted for 11%, 11% and 14% of TICNY’s direct premiums written and TRM’s premiums produced in 2006, 2005 and 2004, respectively.
Receivable-claims paid by agency represent claim payments due from issuing carriers to reimburse claims paid by TRM on their behalf in conjunction with claims administration services. The receivables are partially secured by funds held totaling $8,181,000 and $8,191,000 as of December 31, 2006 and 2005, respectively. As of December 31, 2005 and 2004, no reserve for uncollectible recoverables was recorded. During 2006, 2005 and 2004, no amounts relating to these receivables were written-off.
Furniture, equipment, leasehold improvements 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 and software is 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 46 (R). See “Note 8. Debt.” The Company’s investment in common trust securities of the statutory business trust are reported in investments at equity. The Company reports as a liability the outstanding subordinated debentures owed to the statutory business trusts.
The Company adopted the provision of SFAS 123-R effective January 1, 2006 and has elected the modified prospective application method. All unvested stock options outstanding as of January 1, 2006 are being expensed over the requisite service period that has not been rendered and is based upon the original grant date fair value of the award as calculated for recognition of the pro forma disclosure under SFAS 123-R.
In accordance with Statement of Financial Accounting Standards (SFAS) No. 128, “Earnings Per Share,” 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.
In September, 2006 the FASB issued SFAS No. 157, “Fair Value Measurements.” This new standard provides guidance for using fair value to measure assets and liabilities. Under SFAS 157, fair value refers to the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts. In this standard, the FASB clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, SFAS 157 establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data such as the reporting entity’s own data. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy. The provisions of SFAS 157 are effective for financial statements issued beginning November 15, 2007. SFAS 157 is not expected to have a material impact on our results of operations or financial position.
Major categories of the Company’s net investment income are summarized as follows (in 000’s):
Proceeds from the sale and maturity of fixed-maturity securities were $71,672,000, $38,325,000 and $23,474,000 in 2006, 2005 and 2004, respectively. Proceeds from the sale of equity securities were $1,003,000, $1,972,000, and $50,000 and in 2006, 2005 and 2004, respectively. The Company’s gross realized gains and losses on investments are summarized as follows (in 000’s):
The following table presents information regarding the Company’s invested assets that were in an unrealized loss position at December 31, 2006 by amount of time in a continuous unrealized loss position (in 000’s).
The unrealized loss position for Equity securities were primarily due to the Company’s investment in four Real Estate Investment trusts (“REITs”) as of December 31, 2006. Three of the REITs were publicly traded and all four consist of real estate related mortgage backed securities. The severity of the impairment for three out of the four REIT investments in relation to their carrying amounts is between 1.03% and 9.7%. The severity of the impairment for one of the equity investments in relation to its carrying amount was 27.8% as of December 31, 2006 and it has been in an unrealized loss position for more than one year. Publicly traded mortgage REIT stock prices as a sector did not perform well in 2005. The dividends paid on these funds were reduced significantly, which caused their stock prices to decline. These dividend reductions resulted from the flattening of the yield curve that reduced the yield these funds earn from leveraging the portfolios. The quarterly dividend for the one investment which was impaired 27.8% has increased for four consecutive quarters and the stock price has rebounded from $10.94 per share at December 31, 2005 to $13.91 per share at December 31, 2006. The Company’s cost basis of this investment is $19.28 per share. The Company considered the financial condition and positive outlook for this investment, as well as its ability and intent to hold the investment for a long enough period to recover the unrealized loss which was $350,000 as of December 31, 2006. The Company has the ability and the intent to hold these equity investments until a recovery of fair value and therefore, the Company does not consider these investments to be other-than-temporarily impaired.
At December 31, 2006, the Company’s maximum exposure to a loss from its investment in CastlePoint was approximately $27.9 million, which consists of its equity ownership interest of approximately $23.3 million (after deducting dividends received in the third quarter of 2006) and the fair value of the warrant the Company received from CastlePoint of $4.6 million.
The components of the liability for loss and loss adjustment expenses and related reinsurance recoverables are as follows (in 000’s):
Activity in the liability for loss and loss adjustment expenses is summarized as follows (in 000’s):
Incurred losses and loss adjustment expenses are net of reinsurance recoveries under reinsurance contracts of $64,738,000, $38,584,000, and $57,104,000 in 2006, 2005 and 2004, respectively.
adjusted to current conditions. Since the Company’s process produces loss reserves set by management based upon the actuaries’ best estimate, there is no explicit or implicit provision for uncertainty in the carried loss reserves.
The Company’s data has sufficient credibility to base development factors on our own data. The loss development factors are reviewed annually. There have only been minor changes in selected loss development factors since 2003. The chart below shows the number of years by segment when the Company expects 50%, 90% and 99% of losses to be reported for a given accident year:
The Company has made only minor changes to the key assumptions used during the last three annual reserve estimates. In 2004 and 2005 the Company had favorable development in its net losses from prior accident years of $0.2 million and $0.4 million respectively. In 2006 the Company had favorable development in its net losses from prior accident years of $0.7 million. Excluding the PXRE commutation for 2006 the Company had favorable development of $2.3 million.
The paid development, incurred development, the Bornhuetter Ferguson (B-F) method, and loss ratio projections are the predominate methodologies the Companies actuaries utilize to project losses and corresponding reserves. Based upon these methods the Company’s actuaries determine a best estimate of the loss reserves. All of these methods are standard actuarial approaches and have been utilized consistently since 2003. The selected development factors within the paid and incurred development methods are derived from the Company’s data while the loss ratio method is used for the most recent accident year when there is high volatility in the development patterns. The B-F method combines the loss ratio method and the loss development method to determine loss reserves by adding an expected development (loss ratio times premium times percent unreported) to the case reserves.
The Company has automatic treaty capacity of $10,000,000 for property risks, $1,000,000/$2,000,000 for liability coverages, $10,000,000 for workers’ compensation, $5,000,000 for umbrella liability and $35,000,000 for equipment breakdown. The Company may offer higher limits through its use of facultative 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 of $600,000 for the period July 1, 2006 through December 31, 2006, $700,000 for the period April 1, 2006 to June 30, 2006, $1,000,000 during the period January 1, 2006 to March 31, 2006, $750,000 during the period January 1, through December 31, 2005, $400,000 during the period January 1 through September 30, 2004, $750,000 during the period October 1, through December 31, 2004, $450,000 during the period January 1, through September 30, 2003 (after commutation-see discussion below) and $312,500 during the period October 1 through December 31, 2003.
The following collateral is available to the Company for amounts recoverable from reinsurers (in 000’s) as of December 31, 2006 and 2005:
On June 29, 2006, to eliminate its exposure to uncollateralized reinsurance recoverables from PXRE Reinsurance Company (“PXRE”) which had requested the withdrawal of its financial strength and issuer rating from A.M. Best, the Company concluded, through commutation agreements PXRE’s participation under various reinsurance agreements with TICNY covering the 2001, 2002 and a portion of the 2003 policy periods. Ceded loss and loss adjustment expense recoverables of $20.5 million, ceded paid losses of $2.4 million and ceding commissions receivable of $8.7 million, totaling $31.6 million of unsecured recoverables were settled with a payment from PXRE of $26.7 million, which represents an estimate of the present value of these recoverables. These transactions resulted in a $4.8 million pre-tax charge, of which $1.6 million was recognized in loss and loss adjustment expenses and $3.2 million was recognized as a reduction to ceding commission income in the second quarter of 2006. In addition, on the same date, novation agreements were executed with PXRE relating to other reinsurance agreements covering business written in 2001, 2002 and 2003 by other insurance companies and managed on their behalf by TRM, the Company’s risk management subsidiary. As a result of the novation, TICNY assumed loss reserves of $12.2 million for which it received as consideration $11.4 million in cash and other assets and TRM recorded a reduction in commission liabilities for $0.2 million, the total of which resulted in a $0.6 million pre-tax charge. As a result of the commutation and novation agreements, which were effective as of
June 29, 2006, PXRE is discharged from future obligations under the reinsurance agreements. There are no other agreements outstanding with PXRE.
The Company’s insurance subsidiaries entered into three multi-year quota share reinsurance agreements with CastlePoint Reinsurance that will cede to CastlePoint Reinsurance between 25% and 45%, subject to a periodic adjustment by the Company, of premiums and losses on their brokerage insurance business that the Company has historically written through its retail and wholesale agents. During 2006, the Company ceded $40.9 million of unearned premiums as of April 1, 2006, which consisted of $19.2 million and $21.7 million of unearned premiums retained by the Company on policies written in 2006 and 2005, respectively. The Company ceded and $114.2 million on premiums written during the nine months ended December 31, 2006. In addition, CastlePoint Reinsurance participates as a reinsurer on the Company’s catastrophe reinsurance program, effective July 1, 2006, and excess of loss reinsurance program effective, May 1, 2006. The Company ceded excess of loss reinsurance and catastrophe premiums to CastlePoint Reinsurance of $2.6 million for the nine months ended December 31, 2006. Recoverables and prepaid reinsurance totaling $115.2 million from CastlePoint Reinsurance, which is an unauthorized reinsurer, are collateralized in a New York State Regulation 114 compliant trust account for the benefit of the Company with a balance of $95.3 million as of December 31, 2006 with the remaining amount offset by ceded balances payable.
The Company earns ceding commissions under quota share reinsurance agreements for 2005 and 2004 based on a sliding scale of commission rates and ultimate treaty year loss ratios on the policies reinsured under each of these agreements. The sliding scale includes minimum and maximum commission rates in relation to specified ultimate loss ratios. The commission rate and ceding commissions earned increase when the estimated ultimate loss ratio decreases and, conversely, the commission rate and ceding commissions earned decrease when the estimated ultimate loss ratio increases.
On December 31, 2006 the ceding commission receivable was $3,237,000 compared to $8,727,000 on December 31, 2005. The decrease was primarily due to the commutation with PXRE on June 27, 2006.
As of December 31, 2006, 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, 2006 are set forth below (dollars in 000’s) for treaties that remain in effect as of December 31, 2006:
Based on the amount of ceded premiums earned, the maximum potential reduction to ceding commissions earned related to an increase in the Company’s estimated ultimate loss ratios is $24.4 million
for all treaties for all three years. The ceded premiums for the 2003, 2004 and 2005 treaty years have been fully earned as of December 31, 2006.
In 2005, Tower Group, Inc. closed on its purchase of the outstanding common stock of a shell property casualty insurance company, North American Lumber Insurance Company (“NALIC”), subsequently renamed Tower National Insurance Company. Prior to the closing, all liabilities and assets (other than insurance licenses) of Tower National Insurance Company were transferred to a liquidating trust. The Company capitalized these purchases as an intangible asset related to state licenses with an
indefinite life subject to annual impairment testing. The total amount capitalized as of December 31, 2006 and 2005, was $1,303,000 and included the purchase price, legal fees and a broker’s fee.
During the second and third quarters of 2003, Tower formed two statutory business trusts (“Trust I” and “Trust II”), of which the Company owns all of the common trust securities. On May 15, 2003 and September 30, 2003, Trust I and Trust II, respectively, each issued $10,000,000 floating rate trust preferred securities totaling $20,000,000 to investment pools. The trusts invested the proceeds thereof and the proceeds received from the issuance of the common trust securities to Tower in exchange for $20,620,000 of floating rate junior subordinated debentures (“subordinated debentures”) issued by Tower. The subordinated debentures are unsecured obligations of Tower and are subordinated and junior in right of payment to all present and future senior indebtedness of Tower. Tower has entered into guarantee agreements, which provide for full and unconditional guarantee of the trust securities. The subordinated debentures and the floating rate preferred securities issued by Trust I accrue and pay interest quarterly based upon interest that will float on the 3-month LIBOR, plus 4.10%, which cannot exceed 12.50% prior to May 15, 2008. At December 31, 2006 this interest rate was 9.47% compared to 8.40% in 2005. The Trust II floating rate preferred securities bear interest at a fixed rate of 7.5% until September 30, 2008 and at a variable rate, reset quarterly, equal to the 3-month LIBOR, plus 4.00%, thereafter. The final maturity on the subordinated debentures is May 15, 2033 and September 30, 2033 for Trust I and Trust II, respectively, with prepayment at the option of the Company available beginning in 2008. Issuance costs, primarily legal fees, of $301,000 and $338,000 for the Trust I and Trust II offerings, respectively, were deferred and are being amortized over the term of the subordinated debentures using the effective interest method.
In March 2006, Tower formed a statutory business trusts (“Trust V”), of which the Company owns all of the common trust securities. On March 31, 2006, Trust V issued $20,000,000 floating rate trust preferred securities to investment pools. The trust invested the proceeds thereof and the proceeds received from the issuance of the common trust securities to Tower in exchange for $20,619,000 of floating rate junior subordinated debentures (“subordinated debentures”) issued by Tower. The subordinated debentures are unsecured obligations of Tower and are subordinated and junior in right of payment to all present and future senior indebtedness of Tower. Tower has entered into guarantee agreements, which provide for full and unconditional guarantee of the trust securities. The Trust V preferred securities bear interest that is fixed at 8.5625% until March 31, 2011 and the coupon will float quarterly thereafter at the three months LIBOR rate plus 3.4%. The final maturity on the subordinated debentures is April 7, 2036 with prepayment at the option of the Company available beginning in 2011. Issuance costs, primarily legal fees,
As part of the IPO in October 2004, the Company issued to Friedman Billings Ramsey (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 four 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 were 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, 2006, FBR has 46,133 warrants outstanding which are included in the calculation of diluted EPS.
The total intrinsic value of restricted stock vesting during the years ended December 31, 2006, 2005 and 2004 was $1,759,000, $701,000 and $0, respectively. The intrinsic value of unvested restricted stock outstanding as of December 31, 2006 is $5,674,000.
Changes in restricted stock for the three years ended December 31, 2006 were as follows:
Options outstanding and exercisable as of December 31, 2006 are shown on the following schedule:
The Company adopted the provision of SFAS 123-R effective January 1, 2006 and has elected the modified prospective application method and is expensing all unvested stock options outstanding as of January 1, 2006. The compensation expense is recognized over the requisite service period that has not been rendered and is based upon the original grant date fair value of the award as calculated for recognition of the pro forma disclosure under SFAS 123 R.
The total intrinsic value of stock options exercised during the years ended December 31, 2006, 2005 and 2004 was $1,434,000, $404,000 and $282,000, respectively. The intrinsic value of stock options outstanding as of December 31, 2006 is $9,600,000 of which $7,714,000 is related to vested options.
SFAS 123-R, the Company’s net earnings and earnings per share for the twelve months ended December 31, 2005 and 2004 would have been the following pro-forma amounts:
The total remaining compensation cost related to non vested stock option and restricted stock awards not yet recognized in the income statement was $2,808,000 of which $238,000 was for stock options and $2,570,000 was for restricted stock as of December 31, 2006. The weighted average period over which this compensation cost is expected to be recognized is 3.4 years.
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 compensation. The Company incurred approximately $789,000, $649,000 and $461,000 of expense in 2006, 2005 and 2004, respectively, related to this plan.
TICNY and TNIC are subject to assessments in New York 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 $2,042,000, $941,000 and $435,000 in 2006, 2005 and 2004, respectively, for its proportional share of the total assessment for the Property/Casualty Security Fund and approximately $1,470,000, $589,000 and $556,000 in 2006, 2005 and 2004, 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 $(127,000), $0 and $1,143,000 in 2006, 2005 and 2004,
respectively. The Company estimates its liability for future assessments based on actual written premiums and historical rates and available information. As of December 31, 2006 the liability for the various workers’ compensation funds, which includes amounts assessed on workers’ compensation policies was $4,463,000. This amount is expected to be paid over an eighteen month period ending June 30, 2008. As of December 31, 2005, the liability for the various workers’ compensation funds was $2,276,000.
The New York City Fire Patrol (“Fire Patrol”) which is governed by the New York Board of Fire Underwriters (“NYBFU”) was created to improve fire safety in the New York City and was responsible for the salvage and dewatering operations at the scene of fires and water leaks for the purpose of protecting property from loss due to these perils. Fire Patrol’s operations were supported by assessments made by the NYBFU upon the insurance company members of the NYBFU and, in some instances, other writers of fire insurance in New York City who had elected not to become members. The NYBFU’s membership voted to discontinue the Fire Patrol on January 31, 2006. Subsequently, the Company received a $505,748 assessment from the Fire Patrol for the 2006 year. The Company does not believe that it is a proper assessment and it has requested additional information from the NYFBU on the Fire Patrol assessment. The Company has not recorded any liability for this assessment as of December 31, 2006. The NYBFU has informed the Company that the Fire Patrol ceased operations on October 15, 2006. The Company cannot predict what action, if any, the NYBFU will take in this matter and whether the Company may ultimately be liable for some amount of the assessment.
· Ceding commission revenues are earned when ceded premiums are written except for ceding commission revenues in excess of anticipated acquisition costs which are deferred and amortized as ceded premiums are earned. GAAP requires that all ceding commission revenues be earned as the underlying ceded premiums are earned over the term of the reinsurance agreements.
Equity and fixed income investments: Fair value disclosures for investments are included in “Note 2. Investments.”
Investment in unconsolidated affiliate-Investments in unconsolidated affiliates are investments in related parties; as such it is not practical to estimate the fair value of these instruments. Accordingly, these amounts are reported using the equity method.
PXRE had an option agreement to purchase 599,400 common shares of the Company for $16.67 per share that it would terminate if certain conditions were met. These options were not included in the computation of diluted EPS in 2004 because their effect would be antidilutive. On June 8, 2005 the Company was notified that all conditions were met and that PXRE’s right to purchase 599,400 common shares of the Company was terminated.
reimbursed, at cost, for other administrative services provided to CastlePoint, pursuant to the terms of the service and expense sharing agreement which were $737,000 in 2006.
On January 25, 2007, the Company participated in a private placement of $20.0 million of fixed/floating rate capital securities (the “Trust Preferred Securities”) issued by Tower Group Statutory Trust VI (the “Trust”), an affiliated Delaware trust formed on January 11, 2007. The Trust Preferred Securities mature in April 2036, are redeemable at the Company’s option at par beginning April 7, 2011,
and require quarterly distributions of interest by the Trust to the holder of the Trust Preferred Securities. Interest distributions are initially at a fixed rate of 8.155% for the first five years and will then reset quarterly for changes in the three-month London Interbank Offered Rate (“LIBOR”) plus 300 basis points. The Trust simultaneously issued 619 of the Trust’s common securities to the Company for a purchase price of $0.6 million, which constitutes all of the issued and outstanding common securities of the Trust. The Trust used the proceeds from the sale of the Trust Preferred Securities and common securities to purchase for $20.6 million a junior subordinated debt security due 2037 issued by the Company. The Company does not consolidate interest in its statutory business trusts for which the Company holds 100% of the common trust securities because the Company is not the primary beneficiary of the trusts. The Company’s investment in common trust securities of the statutory business trust are reported in investments as equity securities. The Company reports as a liability the outstanding subordinated debentures owed to the statutory business trusts.
On January 26, 2007, the Company closed on its sale of 2,704,000 shares of common stock. The Company’s net proceeds were approximately $79.3 million.