The selected consolidated income statement data for the years ended December 31, 2009, 2008, 2007, and the balance sheet data as of December 31, 2009 and 2008 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.
Includes acquisition expenses and other underwriting expenses (which are general administrative expenses related to underwriting operations in our Insurance Subsidiaries) as well as other insurance services expenses (which are general administrative expenses related to insurance services operations).
The gross loss ratio is calculated by dividing gross losses (consisting of losses and loss adjustment expenses) by gross premiums earned.
Prior year earnings per share have been restated for new GAAP guidance adopted in 2009 which requires unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents be considered participating securities and included in the computation of earnings per share.
As a result of the significant changes in our business, we have changed the presentation of our business results by allocating our previously reported insurance segment into our Brokerage Insurance and Specialty Business segments based on the way management organizes the segments for making operating decisions and assessing profitability. Accordingly, we now report results for three segments: Brokerage Insurance, Specialty Business and Insurance Services. The prior year segment disclosures have been restated to conform to the current presentation. Because we do not manage our assets by segments, our investment income is not allocated among our segments. Operating expenses incurred by each segment are recorded in such segment directly. General corporate overhead not incurred by an individual segment is allocated based upon the methodology deemed to be most appropriate which may include employee head count, policy count and premiums earned in each segment.
We offer our products and services through our Insurance Subsidiaries, which include TICNY, TNIC, PIC, NEIC, MVIC, CPIC, CPFL, HIC, KIC and CPNIC (operating as SUA in some jurisdictions) as well as our management services subsidiaries, which include TRM, CPM and CPRMFL (operating as AequiCap CP Services Group, Inc. in some jurisdictions). Results for our Insurance Subsidiaries are reported in our Brokerage Insurance segment for products distributed through our network of retail and wholesale agents and in our Specialty Business segment for products distributed through program underwriting agents and reinsurance. Results for our Management Services subsidiaries are reported in our Insurance Services segment.
Our commercial lines products include commercial multiple-peril (provides both property and liability insurance), monoline general liability (insures bodily injury or property damage liability), commercial umbrella, monoline property (insures buildings, contents or business income), workers’ compensation and commercial automobile policies. Our personal lines products consist of homeowners, dwelling, personal automobile and other liability policies.
On November 13, 2009, the Company completed the acquisition of SUA, a specialty property and casualty insurance company for approximately $107 million. SUA offers specialty commercial property and casualty insurance products through independent program underwriting agents that serve niche groups of insureds. The acquisition of SUA expands the Company’s Specialty Business segment and its regional presence in the Midwest.
On April 10, 2007, we completed the acquisition of 100% of the issued and outstanding common stock of Preserver. The transaction had a base purchase price of approximately $64.7 million. In addition, we assumed $12 million of Preserver’s trust preferred securities at the closing. Preserver was a privately-held holding company for a regional insurance company group specializing in small commercial and personal lines insurance in the Northeast. The acquisition gave the Company access to 250 new retail agencies and accelerated our Northeast expansion plans.
Losses and loss adjustment expenses. We establish loss and loss adjustment expense (“LAE”) reserves in an amount equal to our estimate of the ultimate liability for claims under our insurance policies and the cost of adjusting and settling those claims. Loss and loss adjustment expenses recorded in a period include estimates for losses incurred during the period and changes in estimates for prior periods.
We use various measures to analyze the growth and profitability of our business segments. In our Brokerage Insurance and Specialty Business segments, we measure growth in terms of gross, ceded and net premiums written, and we measure underwriting profitability by examining our loss, expense and combined ratios. We also measure our gross and net written premiums to surplus ratios to measure the adequacy of capital in relation to premiums written. In the Insurance Services segment, we measure growth in terms of premiums produced by TRM, CPM and CPRMFL on behalf of other insurance companies as well as fee and commission revenue received, and we analyze profitability by evaluating income before taxes and the size of such income relative to our Insurance Subsidiaries’ net premiums earned. On a consolidated basis, we measure profitability in terms of net income and return on average equity.
Loss and LAE reserves. The reserving process for loss and LAE reserves provides our best estimate at a particular point in time of the ultimate unpaid cost of all losses and LAE incurred, including settlement and administration of losses, and is based on facts and circumstances then known and including losses that have been incurred but not yet reported. The process includes using actuarial methodologies to assist in establishing these estimates, judgments relative to estimates of future claims severity and frequency, the length of time before losses will develop to their ultimate level and the possible changes in the law and other external factors that are often beyond our control. There are various actuarial methods that are appropriate for the different lines of business, and our actuaries’ use of a particular method or weighting of methods depends in part on the maturity of each accident year by line of business, the limits of liability covered under the policies, the presence or absence of large claims in the experience, and other factors. In general, the various actuarial methods can be grouped into three categories: loss ratio projection, incurred loss projection, and the Bornhuetter-Ferguson (“B-F”) method. For the most recent accident year and for liability lines of business the actuarial method given the most weight is usually the loss ratio method, since the percentage of ultimate claims reported to date is expected to be low and the immature reported claims experience is not a reliable indicator of ultimate losses for that accident year. For property lines of business for the most recent accident year the B-F method is usually given the most weight, because experience typically shows that there is a small percentage of claims reported in the subsequent period due to normal lags in reporting and processing of claims in these lines of business that can be relatively reliably estimated as a percentage of premiums, which is reflected in the B-F method. For each line of business, the actuarial reserving method usually given the most weight shifts from the loss ratio projection to the B-F method to the incurred loss projection as each accident year matures. These methods are described in “Business-Loss and Loss Adjustment Expense Reserves.”
produces loss reserves set by management based upon the actuaries’ best estimate, there is no explicit or implicit provision for uncertainty in the carried loss reserves, except for required provisions in connection with acquisitions which are separately determined.
We segregate our data for estimating loss reserves. The property lines include Fire, Homeowners, CMP Property, Multi-Family Dwellings and Auto Physical Damage. The casualty lines include CMP Liability, Other Liability, Workers’ Compensation, Commercial Auto Liability, and Personal Auto Liability. Brokerage Insurance segment reserves are estimated separately from Specialty Business segment reserves. For the Brokerage Insurance segment we analyze reserves by line of business and, where appropriate, we further segregate the data for analysis purposes between small, middle and large policies sizes and by state or region. We also analyze various producers’ business separately where the volume of business from those producers is considered significant and the characteristics of the business from those particular producers are perceived to be different. Within the Specialty Business segment, we estimate loss and loss expenses reserves utilizing similar line of business breakdowns, and generally we also estimate the loss and loss expense reserves by program and within the reinsurance business by treaty.
The chart below shows the average number of years by product line when we expect approximately 50%, 90% and 99% of losses to be reported for a given accident year, although these reporting lags may differ significantly by territory and for differences in underlying coverage characteristics:
For LAE stemming from defense by other attorneys who are not our employees, we implemented automated legal fee auditing in the fourth quarter of 2008 that we believe has become relatively common in the insurance industry and has been shown to reduce external attorneys bills by 5% to 10%.
ULAE for claims that are handled in-house by our claims adjusters utilize a similar process to that described above for ALAE. We determine fixed fees per claim by line of business, and assign these costs to line of business and accident year, with 50% of the fixed fee attributed to claims when a claim is opened and 50% attributed to claims when they are closed. The IBNR portion of ULAE for these claims is based upon 50% of the fixed fee per claims for in-house ULAE multiplied by the number of claims open and by 100% of the fixed fee multiplied by the estimated number of claims to be reported for prior accident dates.
Ceding commissions under a quota share reinsurance agreement are based on the agreed upon commission rate applied to the amount of ceded premiums written. Ceding commissions are realized as income as ceded premiums written are earned. The ultimate commission rate earned on our quota share reinsurance contracts is determined by the loss ratio on the ceded premiums earned. If the estimated loss ratio decreases from the level currently in effect, the commission rate increases and additional ceding commissions are earned in the period in which the decrease is recognized. If the estimated loss ratio increases, the commission rate decreases, which reduces ceding commissions earned. As a result, the same uncertainties associated with estimating loss and LAE reserves affect the estimates of ceding commissions earned. We monitor the ceded ultimate loss ratio on a quarterly basis to determine the effect on the commission rate of the ceded premiums earned that we accrued during prior accounting periods. The estimated ceding commission income relating to prior years recorded in 2009, 2008, and 2007 was a decrease of $2.2 million, a decrease of $1.8 million and a decrease of $0.5 million, respectively.
Reinsurance recoverables. Reinsurance recoverable balances are established for the portion of paid and unpaid loss and LAE that is assumed by reinsurers. Prepaid reinsurance premiums represent unearned premiums that are ceded to reinsurers. Reinsurance recoverables and prepaid reinsurance premiums are reported on our balance sheet separately as assets, instead of netted against the related liabilities, since reinsurance does not relieve us of our legal liability to policyholders and ceding companies. We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. Consequently, we bear credit risk with respect to our individual reinsurers and may be required to make judgments as to the ultimate recoverability of our reinsurance recoverables. Additionally, the same uncertainties associated with estimating loss and LAE reserves affect the estimates of the amount of ceded reinsurance recoverables. We continually monitor the financial condition and rating agency ratings of our reinsurers. Non-admitted reinsurers are required to collateralize their share of unearned premium and loss reserves either by placing funds in a trust account meeting the requirements of New York Regulation 114 or by providing a letter of credit. In addition, from October 2003 to December 31, 2005, we placed our quota share treaties on a “funds withheld” basis, under which TICNY retained the ceded premiums written and placed that amount in segregated trust accounts from which TICNY may withdraw amounts due to it from the reinsurers.
costs is dependent on the continued profitability of our insurance underwriting. We also consider anticipated invested income in determining the recoverability of these costs. If our insurance underwriting ceases to be profitable, we may have to write off a portion of our deferred acquisition costs, resulting in a further charge to income in the period in which the underwriting losses are recognized. The value of business acquired (“VOBA”) is an intangible asset relating to the estimated fair value of the unexpired insurance policies acquired in a business combination. VOBA is determined at the time of a business combination and is reported on the consolidated balance sheet with DAC and is amortized in proportion to the timing of the estimated underwriting profit associated with the in force policies acquired. The cash flow or interest component of VOBA is amortized in proportion to the expected pattern of future cash flows. The Company considers anticipated investment income in determining the recoverability of these costs and believes they are fully recoverable.
the current fair value compared to amortized cost or cost, as appropriate;
If an other-than-temporary-impairment (“OTTI”) loss is determined for a fixed-maturity security, the credit portion is recorded in the income statement as net realized losses on investments and the non-credit portion is recorded in accumulated other comprehensive income. The credit portion results in a permanent reduction in the cost basis of the underlying investment. The determination of OTTI is a subjective process and different judgments and assumptions could affect the timing of loss realization. We recorded OTTI losses in our fixed maturity and equity securities in the amounts of $44.2 million, $22.7 million and $10.1 million in 2009, 2008, and 2007, respectively.
See “Business-Investments” and “Note 4 - Investments” in the notes to consolidated financial statements for additional detail regarding our investment portfolio at December 31, 2009, including disclosures regarding other than temporary declines in investment value.
An impairment loss is recognized if the carrying value of an intangible asset or goodwill is not recoverable and its carrying amount exceeds its fair value. No impairment losses were recognized in 2009, 2008, and 2007. Significant changes in the factors we consider when evaluating our intangible assets and goodwill for impairment losses could result in a significant charge for impairment losses reported in our consolidated financial statements. See “Note 6 - Goodwill and Intangible Assets” in the notes to consolidated financial statements.
Accordingly, our consolidated revenues and expenses reflect significant changes as a result of these acquisitions particularly through the expansion of our distribution platform that now includes all of the specialty business produced through program underwriting agents and small insurance companies through CastlePoint and SUA, as reported in our Specialty Business segment, and excess and surplus lines distribution through Hermitage, as reported in our Brokerage Insurance segment.
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 each of our three segments.
The impact of net realized investment gains (losses) and acquisition-related transaction costs, net of tax lowered the return on average equity by 1.3%, 2.9% and 4.6% for the years ended December 31, 2009, 2008 and 2007, respectively.
We measure organic growth by including CPIC gross premiums written as if we owned CPIC in the comparable prior year period. We believe this is meaningful because CPIC wrote brokerage business that was managed by Tower and Tower wrote program business that was managed by CPIC. Organic growth, as defined, was 14% for the year ended December 31, 2009 and resulted from expansion of the brokerage business outside of the Northeast, the growth of programs that began in late 2008 in the Specialty Business segment and the addition of several new programs within the Specialty Business segment in 2009.
Premiums earned. Gross premiums earned increased significantly due to the CastlePoint and Hermitage acquisitions. Net premiums earned by CastlePoint and Hermitage since the respective acquisition dates were $351.2 million and $56.0 million, respectively, for the year ended December 31, 2009. Net premiums earned also increased relative to gross premiums earned, because, as a result of the additional capital obtained via the CastlePoint acquisition, as well as increased retained earnings, we did not cede as much premiums for year ended December 31, 2009 compared to the same period of 2008. Ceded premiums earned reflect runoff of quota share ceded premiums written in 2008, excess of loss and property catastrophe ceded premiums and a quota share reinsurance contract ceding our Brokerage Insurance segment’s liability business to Swiss Re and Allianz entered into in the fourth quarter of 2009. Under this quota share agreement, we ceded 50% of earned premiums and incurred losses on Brokerage Insurance segment liability lines that are part of Commercial Multi-Peril policies and Other Liability policies. We did not have any other quota share treaties in force in 2009. For periods prior to 2009 the quota share ceding percentages on our policies were as follows:
Quota share reinsures brokerage liability business for commercial multi-line and other liability.
Net realized investment gains were $1.5 million for 2009 compared to losses of $14.4 million in 2008. Included in the 2009 realized investment gains are approximately $23.5 million of credit-related OTTI losses. The $23.5 million of OTTI losses are comprised of $21.6 million related to certain structured securities and $1.9 million related to the impairment of our bond holdings of CIT Group, Inc.
Realized capital gains in 2009 were primarily from opportunistic sales of commercial and residential mortgage-backed securities, primarily purchased in the first and second quarters when yield spreads were wide and sold in the third quarter when yield spreads narrowed, as well as sales of corporate bonds which were positively affected by spread tightening. Proceeds were generally invested in corporate bonds and financial preferred stocks with better relative value.
Loss and loss adjustment expenses. The gross and net loss ratio increased for 2009 compared to 2008, due to a greater degree of favorable reserve development in 2008 and the inclusion of specialty business acquired from CastlePoint and SUA in the current period which had a higher loss ratio. The net accident year loss ratio increased over the prior period by 1.4 percentage points, which was comprised of approximately 1.4 percentage points increase due to the soft market conditions and 0.6 percentage points due to the increased mix of specialty business, offset by a favorable impact of 0.6 percentage points due to the amortization of the reserve risk premium on loss reserves in accordance with GAAP for the business combinations occurring during 2009.
Other income. Other income for 2009 includes a gain of $7.4 million on the revaluation of the shares owned in CastlePoint at the time of the acquisition, as well as a gain on bargain purchase of $13.2 million related to the acquisition of SUA. Our equity in net income (loss) of CastlePoint also decreased by $0.8 million due to CastlePoint’s operating loss during 2009 compared to 2008. As a result of the acquisition of CastlePoint on February 5, 2009, we only recorded equity in CastlePoint’s net income (loss) for the period of January 1, 2009 through February 5, 2009.
During 2008 we ceded $201.9 million of our premiums earned to CastlePoint as compared to $189.8 million in 2007. In 2008, we also ceded $9.3 million of ceded premiums earned to Swiss Re America. The quota share ceding percentages on our policies are noted in the table included in the “Consolidated Results of Operations 2009 Compared to 2008” above.
was 4.6% as of December 31, 2008 and 5.6% as of December 31, 2007.
Loss and loss adjustment expenses. The gross loss ratio for 2008 improved to 49.8% as compared to 50.7% for 2007, and the net loss ratio improved to 51.7% for 2008 as compared to 55.2% for 2007. These improvements resulted from favorable reserves development in 2008. The net accident year loss ratio improved to 54.6% for 2008 as compared to 55.7% for 2007.
Interest expense. Our interest expense decreased approximately $0.2 million due to lower rates on our floating rate debt and approximately $0.6 million on the amounts credited to reinsurers on funds withheld in segregated trust accounts as collateral for reinsurance recoverables due to reductions in the corresponding reinsured losses.
Other income. Our equity in net income of CastlePoint, which was not a wholly owned and consolidated subsidiary in 2008 or 2007, decreased $2.2 million due to a decrease in CastlePoint’s operating income, combined with $15.1 million of CastlePoint’s OTTI losses, of which our share was approximately $1.0 million, recorded in 2008.
Income tax expense. Our income tax expense was $32.1 million for 2008 compared to $26.2 million for 2007. The increased income tax expense was due primarily to the increase in income before income taxes, an increase in pre-tax income of TRM, which is taxed at both a local and state level resulting in a higher effective tax rate, offset by an increase in tax exempt interest received in 2008. The 2008 tax expense was also favorably impacted by changes recorded when we filed the final 2007 tax returns. The effective income tax rate was 35.8% for 2008 compared to 36.7% for 2007.
Gross premiums. Brokerage Insurance gross premiums written increased during 2009 as compared to 2008 primarily due to the acquisitions of CastlePoint and Hermitage on February 5, 2009 and February 27, 2009, respectively, which added $214.7 million and $55.9 million in gross premiums earned, respectively, for the year ended December 31, 2009. Our acquisition of Hermitage added significantly to our retail distribution particularly in the Southeast and to our non-admitted wholesale capabilities while the acquisition of CastlePoint broadened our Specialty business. Our organic growth was primarily from territorial expansion in commercial business and an increase in homeowners business. As measured to include business placed in CPIC in 2008, but excluding the effect of the Hermitage acquisition in 2009, this growth was 8.6% during the year ended December 31, 2009.
During 2009, premiums on renewed business increased 2.9% in personal lines and decreased 1.4% in commercial lines. Brokerage renewal retention overall was 80% for 2009, which was comprised of a renewal retention for personal lines of 88% and for commercial lines of 75%, compared to 86% and 78%, respectively, for 2008. In commercial lines we increased pricing on middle and large accounts that had the effect of lowering the renewal retention for those size categories, although these underwriting actions were largely offset by strong renewal retentions for small commercial policies.
Ceded premiums. Ceded premiums written and earned were significantly lower for 2009 compared to 2008 as a result of our decision to retain most of our business following the increase in our capital after the CastlePoint acquisition. In 2008 we had either placed with CPIC or ceded to CPRe a substantial portion of the brokerage premiums written, $171.7 million and $112.7 million, respectively, and for policies written during the first nine months of 2009 we did not cede premiums written to third party reinsurers on a quota share basis. In the fourth quarter of 2009 we ceded 50% of our new and renewal written and earned premiums on Commercial Multi-Peril and Other Liability policies to third party reinsurers amounting to $86.9 million and $27.2 million, respectively.
Catastrophe reinsurance ceded premiums were $37.6 million for 2009 compared to $16.9 million for 2008. The increase in catastrophe costs in 2009 was due primarily to increased gross premiums written from increased property exposures arising from the aforementioned acquisitions and higher cost of catastrophe coverage when our ceded catastrophe reinsurance treaty was renewed on July 1, 2009.
Ceding commission revenue. Ceding commission revenue decreased in 2009 by 43.9% compared to 2008. The decrease was due to the lower cession of quota share premiums described above and a reduction in the ceding commission rate. Ceding commission revenue also decreased by $2.2 million during 2009 as a result of increases in ceded loss ratios on prior years’ quota share treaties, compared to a decrease of $1.8 million for 2008.
The net underwriting expense ratio was 33.5% and 30.5% for 2009 and 2008, respectively. The increase was due in part to the increase in the commission expense ratio but more so due to the decrease in ceding commission revenue which reduced the net expense ratio less in 2009 than in 2008.
Gross premiums. Brokerage Insurance gross premiums written increased by 2.4% in 2008 as compared to 2007 as a result of various initiatives to appoint wholesale and other agents outside of the Northeast region. We had written excess and surplus lines business in Florida and Texas in the prior period, which was expanded to include California on an admitted basis in 2008.
Ceded premiums. Ceded premiums written decreased in 2008 as compared to 2007, because of a lower quota share ceding percentage in the second half of 2008. The reduction in ceding percentage to CastlePoint Re was offset by an increase in managed premiums that we placed in CastlePoint Insurance Company that benefited our Insurance Services segment.
Underwriting profit and combined ratio. The net combined ratio improved to 81.9% in 2008 from 83.7% due to the improvement in loss ratio described above, which was partially offset by the increase in the expense ratio.
Ceded premiums. Ceded premiums written and earned were reduced as a result of Tower’s acquisition of CastlePoint on February 5, 2009, as Tower had ceded a significant portion of the specialty programs business to CastlePoint Re in 2008. On certain specific programs we cede reinsurance on a quota share or excess of loss basis to reduce our risk, including quota share reinsurance to insurance companies affiliated with the program underwriting manager handling such program business, which we term “risk sharing.” As a result, ceded premiums written were $34.9 million and $96.4 million for 2009 and 2008, respectively. Ceded premiums as a percentage of gross premiums earned are lower in 2009 because of the termination and elimination of the reinsurance agreements with CPRe.
Net premiums. Net premiums written increased from $28.4 million to $229.3 million for 2009, as compared to the prior year. The increase reflects the increases in gross premiums written and decreases in ceded premiums written described above.
The increase in net premiums earned for the year ended December 31, 2009 mirrors the growth in net premiums written.
Underwriting expenses and underwriting expense ratio. The net underwriting expenses ratio decreased significantly from 34.6% for 2009 to 30.5% for 2008, reflecting the shift in business mix to decrease assumed reinsurance and increase programs business which has significantly lower commission costs. This shift resulted in the commission portion of the gross underwriting expense ratio decreasing 5 percentage points to 22.0% in 2009.
Gross premiums. Gross premiums written increased in 2008 from our participation in the specialty business managed by CastlePoint. The increased premiums were generated by CastlePoint from several programs that concentrated on small policies in low to moderate classes of workers compensation, particularly in California.
Net premiums. Net premiums written increased from $4.3 million in 2007 to $28.4 million for 2008, in line with the increases in gross premiums written described above.
Loss and loss adjustment expenses. The gross loss ratio was relatively unchanged between 2008 and 2007, while the net loss ratio improved to 57.2% for 2008 compared to 59.1% for 2007. The decline in the net loss ratio was due to retaining a larger percentage of workers’ compensation programs which had lower loss ratios in comparison to other programs.
Underwriting expenses and underwriting expense ratio. The gross and net underwriting expense ratios increased in 2008 due to an increase in the amount paid to CPM for specialty and traditional business managed and produced. We incurred a 5% additional commission on CPM managed business in 2008. This increase was partially offset as the mix of business changed and we wrote workers’ compensation program which had a lower commission rate.
Underwriting profit and combined ratio. The increase in underwriting profit for 2008 was generated from the significant increase in net premiums earned, although the combined ratio increased to 91.8% for 2008 compared to 88.8% for 2007 primarily due to the increase in expense ratio as described above.
Direct commission expense. The decrease in direct commission expenses was a result of the decrease in business produced by TRM on behalf of CPIC. Subsequent to the completion of the CastlePoint acquisition all of CPIC’s underwriting expenses were included in the Brokerage Insurance segment.
Claims expense reimbursement. The amount of reimbursement by TRM for claims administration is based on the terms of the expense sharing agreement with TICNY. Claims expense reimbursement has declined as a result of the CastlePoint acquisition as a majority of these reimbursements were due from CPIC.
Pre-tax income. Pre-tax income decreased to $0.9 million for the year ended December 31, 2009 as compared to $24.0 million in 2008. The decrease was primarily due to the decrease in premiums produced.
If the acquisition of OneBeacon’s Personal Lines Division is approved and completed, we expect to reflect fee income in this segment from managing the reciprocal insurance companies in 2010.
Direct commission expense. TRM’s direct commission expense paid to producers increased as a result of the increase in business produced by TRM on behalf of CPIC. The direct commission expense ratio decreased to 15.3% for 2008, compared to 16.5% for the comparable period in 2007, as a result of a change in the mix of business placed with CPIC in 2008 to include a greater proportion of homeowners’ and workers’ compensation lines that typically have lower commission rates. The CPIC book of business is produced through the same agents who produce brokerage business written through our Insurance Subsidiaries and TRM’s commission rates are similar to the commission rates in our Insurance subsidiaries for similar lines of business.
Claims expense reimbursement. The increased amount of reimbursement by TRM for claims administration pursuant to the terms of the expense sharing agreement with TICNY for 2008 resulted from an increase in the number of claims handled related to the CPIC book of business.
Pre-tax income. As a result of the factors discussed above, pre-tax income increased to $24.0 million for 2008 compared to $11.1 million for 2007.
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, in circumstances where quoted market prices are unavailable, based upon other observable or unobservable inputs including matrix pricing, benchmark interest rates, market comparables and other relevant inputs. 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 accumulated other comprehensive income, a component of stockholders’ equity. Realized gains and losses are charged or credited to income in the period in which they are realized.
The aggregate fair value of our invested assets as of December 31, 2009 was $1.9 billion. Our fixed maturity securities as of this date had a fair value of $1.8 billion and an amortized cost of $1.7 billion. Equity securities carried at fair value were $76.7 million with a cost of $ 78.3 million as of December 31, 2009.
The average credit rating of our fixed-maturity securities, using ratings assigned to securities by Standard & Poor’s, was AA- at December 31, 2009 and 2008. The following table shows the ratings distribution of our fixed-maturity portfolio:
The following table shows the composition of our fixed maturity portfolio by remaining time to maturity at December 31, 2009 and 2008. For securities that are redeemable at the option of the issuer and have a market price that is greater than redemption value, the maturity used for the table below is the earliest redemption date. For securities that are redeemable at the option of the issuer and have a market price that is less than redemption value, the maturity used for the table below is the final maturity date:
At December 31, 2009, $208 million of our municipal bonds, at fair value, were guaranteed by third parties from the total of $1.8 billion of fixed-maturity securities held by us. We do not have any direct exposure to guarantors and the amount of securities guaranteed by third parties along with the credit rating with and without the guarantee is as follows:
As disclosed in Note 5 - Fair Value Measurements in the notes to the consolidated financial statements, effective January 1, 2008, we adopted new GAAP guidance, which provides a revised definition of fair value, establishes a framework for measuring fair value and expands financial statements disclosure requirements for fair value. Under this guidance, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an “exit price”). The statement establishes a fair value hierarchy that distinguishes between inputs based on market data from independent sources (“observable inputs”) and a reporting entity’s internal assumptions based upon the best information available when external market data is limited or unavailable (“unobservable inputs”). The fair value hierarchy in GAAP prioritizes fair value measurements into three levels based on the nature of the inputs. Quoted prices in active markets for identical assets have the highest priority (“Level 1”), followed by observable inputs other than quoted prices including prices for similar but not identical assets or liabilities (“Level 2”), and unobservable inputs, including the reporting entity’s estimates of the assumption that market participants would use, having the lowest priority (“Level 3”).
In addition, in certain instances, given the market dislocation, we deemed it necessary to utilize Level 3 pricing over prices available through pricing services resulting in transfers from Level 2 to Level 3. In periods of market dislocation, the ability to observe stable prices and inputs may be reduced for many instruments as currently is the case for non-investment grade non-agency residential mortgage-backed securities.
A number of our Level 3 investments have been written down as a result of our impairment analysis. At December 31, 2009, there were 66 securities that were priced in Level 3 with a fair value of $13.6 million and an unrealized gain of $0.7 million.
The following table shows the number of securities, fair value, unrealized loss amount and percentage below amortized cost and the percentage of fair value by security rating:
to sell these fixed maturity securities and we do not believe that we will be required to sell these securities before recovering their cost basis. For equity securities not considered OTTI, we believe we have the ability to hold these investments until a recovery of fair value to our cost basis. A substantial portion of the unrealized loss relating to the mortgage-backed securities is the result of a lack of liquidity in the market that we believe to be temporary.
Tower is organized as a holding company with multiple intermediate holding companies, ten Insurance Subsidiaries and several management companies. Tower’s principal liquidity needs include interest on debt, income taxes and stockholder dividends. Our principal sources of liquidity include dividends and other permitted payments from our subsidiaries, as well as financing through borrowings and sales of securities.
Bermuda legislation imposes limitations on the dividends that CastlePoint Re may pay. We are subject to Bermuda regulatory constraints that affect our ability to pay dividends on our shares and make other payments. Under the Companies Act 1981 of Bermuda, as amended (the “Companies Act”), we may declare or pay a dividend out of distributable reserves only if we have reasonable grounds for believing that we are, or would after the payment, be able to pay our liabilities as they become due and if the realizable value of our assets would thereby not be less than the aggregate of our liabilities and issued share capital and share premium accounts.
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. As of December 31, 2009, the amount of distributions that our Insurance Subsidiaries could pay to Tower without approval of their domiciliary Insurance Departments was $52.8 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 $6.0 million, $7.2 million and $0 in 2009, 2008 and 2007, respectively.
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 equal to each entity’s separate income or tax divided by the total separate income or tax reported on the return. During 2009, Tower received $55.9 million in tax payments from its subsidiaries under this agreement.
The primary sources of cash flow in our Insurance Subsidiaries are net premiums collected, ceding commissions received from our quota share reinsurers, loss payments by our reinsurers, investment income and proceeds from the sale or maturity of investments. The Insurance Subsidiaries 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, fixed assets and to pay dividends to Tower. Funds are also used by the Insurance Subsidiaries for ceded premium payments to reinsurers, which are paid on a net basis after subtracting losses paid on reinsured claims and reinsurance commissions. TRM’s primary sources of cash are commission and fee income.
Net cash flows used in investing activities were $156.9 million in 2009 compared to net cash flow provided in 2008 of $1.6 million. In 2009, net cash acquired from acquisitions of $254.5 million was offset by the purchase of fixed assets of $26.3 million and the net increase in investments of $385.1 million. In 2008, we purchased $17.2 million of fixed assets and had a net cash inflow of $18.8 million from investments.
For 2008 and 2007, net cash provided by operating activities was $61.7 million and $75.9 million, respectively. The decrease in cash flow for 2008 was due, in part, to faster payments to CPIC by TRM in 2008 compared to 2007 as well as direct transaction costs for the CastlePoint acquisition.
The net cash flows provided by investing activities for 2008 was $1.6 million as compared to net cash used by investing activities of $182.9 million for the same period in 2007. During 2008, we capitalized $15.3 million for software, principally expenditures for operating systems and hardware. These expenditures were offset by net sales of fixed maturity securities totaling $19.9 million and net purchases of equities of $0.6 million.
Our Insurance Subsidiaries maintain sufficient liquidity to pay claims, operating expenses and meet our other obligations. We held $164.9 million and $136.3 million of cash and cash equivalents at December 31, 2009 and 2008, respectively. 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 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.”
In 2009 and 2008, we contributed $5.3 and $0.3 million to TICNY, respectively. We also contributed $1.3 million to CPIC in 2009. In 2007, we contributed $3.2 million to TICNY, $2.5 million to PIC and $2.5 million to NEIC.
The gross loss reserve payments due by period in the table above are based upon the loss and loss expense reserves estimates as of December 31, 2009 and actuarial estimates of expected payout patterns by line of business. As a result, our calculation of loss reserve payments due by period is subject to the same uncertainties associated with determining the level of reserves and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. The projected gross loss payments presented do not include the estimated amounts recoverable from reinsurers that amounted to $199.7 million, which are estimated to be recovered as follows: less than one year, $59.6million; one to three
years, $74.8 million; four to five years, $38 million; and after five years, $27.3 million. The interest on the subordinated debentures is calculated using interest rates in effect at December 31, 2009 for variable rate debentures.
For a discussion of our loss and LAE reserving process, see “Critical Accounting Policies-Loss and LAE 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 “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 adversely affected,” for a discussion of the uncertainties associated with estimating loss and LAE expense reserves. The estimated 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.
8.5625% until March 31, 2011; three-month LIBOR plus 330 basis points thereafter
8.155% until January 25, 2012; three-month LIBOR plus 300 basis points thereafter
higher pricing, reduced coverage terms and lower commissions paid to acquire business.
Despite the decline in net premiums written, A.M. Best expects the industry’s net income to increase to $30.6 billion in 2009 from $3.8 billion in 2008 as underwriting results benefited from lower catastrophe related losses, favorable development on prior accident years and an increase in investment gains. According to A.M. Best, the substantial increase in earnings combined with the $70 billion swing from unrealized losses in 2008 to unrealized gains in 2009 allowed policyholders’ surplus, which rebounded by 9.4%, to be replenished to levels that offered comfort to the market and prevented a turnaround in pricing. A.M. Best estimates that the industry combined ratio for 2009 will be 100.6%, a decrease of 4.5 percentage points from the 105.1% in 2008 of which 2.3 points is attributable to an improvement in the mortgage and financial guaranty results.
Our product and geographic expansion initiatives, including the acquisition and consolidation of existing profitable books of business completed in 2009, will be followed by the broadening of our personal lines segment in 2010. This will feature a private passenger automobile capability and a signature personal package policy resulting from the pending acquisition of the One Beacon personal lines division. These significant efforts will provide ample growth for us in 2010. Furthermore, our continued expansion into narrowly defined classes of specialty commercial business will generate growth in the small and lower middle market commercial segments. We will continue to be less interested in the higher premium per policy levels of the upper middle market, which are challenged by severe competitive conditions. It is expected that the industry’s loss of surplus in 2008 will be fully recovered in 2010. This will add to the excess underwriting capacity and, with the treasury yield curve remaining at its depressed level reducing investment income, continued pressure on top line growth will further extend the soft market conditions. In contrast to these trends, we expect to maintain underwriting integrity and premium adequacy in low to moderate hazard classes of business with a strong niche market focus providing solutions to our customers’ needs. This market discipline will span each of the commercial and personal lines, as well as specialty segments by demonstrating consistent risk selection and providing coverage terms and conditions at adequate pricing. Our broad product line portfolio and diversified distribution platform will allow us to manage our business mix by allocating capital in response to profit opportunities within the current market environment.
Consolidated Statements of Income and Comprehensive Income for the years ended December 31, 2009, 2008, and 2007
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate
As described in Management’s Annual Report on Internal Control over Financial Reporting, the Company has excluded Specialty Underwriters’ Alliance, Inc. from its assessment of internal control over financial reporting as of December 31, 2009 as Specialty Underwriters’ Alliance, Inc. and its subsidiary were acquired by the Company in a business combination during 2009. We have also excluded Specialty Underwriters’ Alliance, Inc. from our audit of internal control over financial reporting. The total assets and revenues of Specialty Underwriters’ Alliance, Inc. represent 15% and 3%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2009.
Tower Group, Inc. (the “Company”), through its subsidiaries, offers a broad range of commercial, personal and specialty property and casualty insurance products and services to businesses in various industries and to individuals. The Company’s common stock is publicly traded on the NASDAQ Global Select Market under the symbol “TWGP.”
Specialty Business (“Specialty”) Segment provides specialty classes of business through program underwriting agents. This segment also includes reinsurance solutions provided primarily to small insurance companies; and
Certain reclassifications have been made to prior year financial information to conform to the current year presentation. None of these reclassifications had an effect on the Company’s consolidated net earnings, total stockholders’ equity or cash flows.
Policy billing fees are earned as they are collected. These fees include installment and other fees related to billing and collections.
The liability for loss and LAE represents management’s best estimate of the ultimate cost and expense of all reported and unreported losses that are unpaid as of the balance sheet date and the fair value adjustments related to the acquisitions of CastlePoint, Hermitage and SUA. The liability for loss and LAE is generally estimated on an undiscounted basis, using individual case-basis valuations, statistical analyses and various actuarial procedures. The Company recorded a tabular reserve discount for workers’ compensation and excess workers’ compensation claims in the amount of $4.5 million at December 31, 2009, primarily due to the acquisition of SUA The gross undiscounted amount of these reserves was $166.8 million. The projection of future claims payments and reporting is based on an analysis of the Company’s historical experience, supplemented by analyses of industry loss data. Management believes that the liability for loss and LAE is adequate to cover the ultimate cost of losses and claims to date; however, because of the uncertainty from various sources, including changes in reporting patterns, claims settlement patterns, judicial decisions, legislation, and economic conditions, actual loss experience may not conform to the assumptions used in determining the estimated amounts for such liability at the balance sheet date. As adjustments to these estimates become necessary, such adjustments are reflected in expense for the period in which the estimates are changed. Because of the nature of the business historically written, the Company’s management believes that the Company has limited exposure to environmental claim liabilities.
Reinsurance recoverable represents management’s best estimate of paid and unpaid loss and LAE recoverable from reinsurers. Ceded losses recoverable are estimated using techniques and assumptions consistent with those used in estimating the liability for loss and LAE. These techniques and assumptions are continually reviewed and updated with any resulting adjustments recorded in current earnings. Loss and LAE incurred as presented in the consolidated statement of income and comprehensive net income are net of reinsurance recoveries.
Management estimates uncollectible amounts receivable from reinsurers based on an assessment of a number of factors. The Company recorded no allowance for uncollectible reinsurance at December 31, 2009 and 2008 and did not write-off any balances from reinsurers during the three year period ended December 31, 2009.
Cash consists of cash in banks, generally in operating accounts. The Company maintains its cash balances at several financial institutions. Management monitors balances in excess of insured limits and believes they do not represent a significant credit risk to the Company.
The Company regularly reviews its fixed-maturity and equity security portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. In evaluating potential impairment, management considers, among other criteria: (i) the overall financial condition of the issuer, (ii) the current fair value compared to amortized cost or cost, as appropriate; (iii) the length of time the security’s fair value has been below amortized cost or cost; (iv) specific credit issues related to the issuer such as changes in credit rating, reduction or elimination of dividends or non-
payment of scheduled interest payments; (v) whether management intends to sell the security and, if not, whether it is not more likely than not that the Company will be required to sell the security before recovery of its cost or amortized cost basis; (vi) specific cash flow estimations for certain mortgage-backed securities and (vii) current economic conditions. If an other-than-temporary-impairment (“OTTI”) loss is determined for a fixed-maturity security, the credit portion is recorded in the statement of income as net realized losses on investments and the non-credit portion is recorded in accumulated other comprehensive income. The credit portion results in a permanent reduction of the cost basis of the underlying investment.
The Company uses outside pricing services and, to a lesser extent, brokers to assist in determining fair values. For investments in active markets, the Company uses the quoted market prices provided by the outside pricing services to determine fair value. The outside pricing services used by the Company have indicated that they will only provide prices where observable inputs are available. In circumstances where quoted market prices are unavailable, the Company utilizes fair value estimates based upon other observable inputs including matrix pricing, benchmark interest rates, market comparables and other relevant inputs.
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 a premium for these policies to agents for payment to TRM, the premiums are 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 2009, 2008 and 2007 for this activity.
In business combinations, including the acquisition of a group of assets, the Company allocates the purchase price to the net tangible and intangible assets acquired based on their relative fair values. Any portion of the purchase price in excess of this amount results in goodwill. Identifiable intangible assets with a finite useful life are amortized over the period that the asset is expected to contribute directly or indirectly to the future cash flows of the Company. Intangible
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 to be three years, computer software, three to seven years, furniture and other equipment seven years and leasehold improvements is the term of the lease.
Although the Company owned less than 20% of the outstanding common stock of CastlePoint Holdings, Ltd. (“CastlePoint”) at December 31, 2008, it recorded its investment in CastlePoint under the equity method of accounting as it was able to significantly influence the operating and financial policies and decisions of CastlePoint. The Company acquired 100% of the common stock of CastlePoint on February 5, 2009, at which time it became a wholly-owned subsidiary.
The Company does not consolidate its interest in the statutory business trusts for which the Company holds 100% of the common trust securities because Tower is not the primary beneficiary of the trusts. See “Note 12 - Debt” for more details. 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.
Pursuant to a Tax Sharing Agreement, each of the entities in the group is required to make payments to Tower for federal income tax imposed on its taxable income in a manner consistent with filing a separate federal income tax return (but subject to certain limitations that are applied to the Tower consolidated group as a whole).
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, 2009.
Insurance related assessments are accrued in the period in which they have been incurred. A typical obligating event would be the issuance of an insurance policy or the payment of a claim. The Company is subject to a variety of assessments. Among such assessments are state guaranty funds as well as workers’ compensation second injury funds. State guaranty fund assessments are used by state insurance oversight boards to cover losses of policyholders of insolvent insurance companies and for the operating expenses of such agencies. The Company uses estimates derived from state regulators and/or NAIC Tax and Assessments Guidelines.
One agent accounted for approximately 4%, 7% and 12%, respectively, of the Insurance Subsidiaries and TRM’s premiums receivable balances at December 31, 2009, 2008 and 2007. The same agent accounted for 10%, 10% and 11% of the Insurance Subsidiaries’ direct premiums written and TRM’s premiums produced in 2009, 2008 and 2007, respectively. In addition, SUA has one agent that accounted for 12% of the Insurance Subsidiaries and TRM’s premiums receivable balance at 2009.
The Company’s Insurance Subsidiaries are required to prepare statutory basis financial statements in accordance with practices prescribed or permitted by the state in which they are domiciled. See “Note 20 - Statutory Financial Information and Accounting Policies” for more details.
In December 2007, the Financial Accounting Standards Board (“FASB”) issued guidance on business combinations, where an acquiring entity is required to recognize assets acquired and liabilities assumed at fair value, with very few exceptions. In addition, transaction costs are no longer included in the measurement of the cost of the business acquired, but are expensed as incurred. The new guidance applies to all business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The Company adopted the guidance on January 1, 2009. See Note 3 - “Acquisitions” for additional information.
On January 1, 2009, guidance regarding fair value measurements for certain nonfinancial assets and nonfinancial liabilities and associated required disclosures became effective and the Company applied the guidance to the nonfinancial assets and nonfinancial liabilities measured at fair value resulting from the business combinations during 2009.
In June 2008, the FASB issued new guidance related to earnings per share (“EPS”) calculations and the participating securities in the basic earnings per share calculation under the two-class method. This new guidance requires that unvested share-based awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS pursuant to the two-class method. This guidance is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years. All prior-period EPS data presented have been adjusted retrospectively (including interim financial statements, summaries of earnings, and selected financial data) to conform to the guidance. The Company adopted the guidance on January 1, 2009, which did not have a material effect on the Company’s earnings per share.
In April, 2009, the FASB issued new guidance to help an entity in determining whether a market for an asset is not active and when a price for a transaction is not distressed. The guidance includes the following two steps:
Evaluate the quoted price (i.e., a recent transaction or broker price quotation) to determine whether the quoted price is not associated with a distressed transaction.
This guidance is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The Company adopted the new provisions on January 1, 2009. The adoption did not have a material effect on the Company’s consolidated financial condition and results of operations.
In April 2009, the FASB issued new guidance for Other-Than-Temporary-Impairment (“OTTI”) of fixed-maturity securities for which management asserts that it does not have the intent to sell the security and it is more likely than not that it will not be required to sell the security before recovery of cost or amortized cost. Subsequent to this guidance, companies are required to separate OTTI into (a) the amount representing the credit loss, which continues to be recorded in earnings, and (b) the amount related to all other factors, which is recorded in other comprehensive net income/loss. The new guidance required a cumulative-effect adjustment for those securities that were other-than-temporarily-impaired at the effective date. This cumulative-effect adjustment reclassifies the noncredit portion of a previously other-than-temporarily-impaired instrument held at the effective date, net of related tax effects, to accumulated other comprehensive net income/loss from retained earnings. Early adoption was permitted for periods ending after March 15, 2009. The Company adopted the guidance on January 1, 2009, and was required to make a cumulative effect adjustment to the opening balance of retained earnings for the non-credit portion of the previously recorded other-than-temporarily securities in the amount of $1.6 million, net of tax.
As a result of adopting the guidance, the amounts of net investment income, net realized investment losses from impairment charges and net income reported for the year ended December 31, 2009 were different than the amounts that would have been reported under the previous accounting guidance. The guidance resulted in less net realized investment losses from impairment in 2009, and accordingly, an increase in net income of approximately $13.5 million ($20.7 million pretax) or $0.34 per share, basic and diluted.
In August 2009, the FASB issued new guidance concerning the fair value measurement of liabilities. This new guidance provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, fair value can be measured using a valuation technique that uses the quoted price of the identical liability when traded as an asset (Level 1) or similar liability when traded as an asset (Level 2) or another valuation technique that is consistent with the principals of fair value. Under this guidance, a company is not required to make an adjustment to reflect the existence of a restriction that prevents the transfer of the liability. This guidance is effective for the first reporting period, including interim periods, beginning after issuance. The Company adopted this guidance on October 1, 2009, with no material effect on the financial statements.
On November 13, 2009, the Company completed the acquisition of 100% of the issued and outstanding common stock of Specialty Underwriters’ Alliance, Inc. (“SUA”), a specialty property and casualty insurance company for $106.7 million.
The following table presents the fair value of assets acquired and liabilities assumed with the acquisition of SUA and the fair value hierarchy level under GAAP as of November 13, 2009:
On October 14, 2009, the Company completed the acquisition of the renewal rights to the workers’ compensation business of AequiCap Program Administrators Inc. (“AequiCap”), an underwriting agency based in Fort Lauderdale, Florida. The acquired business primarily consists of small, low to moderate hazard workers’ compensation policies in Florida. Most of the employees of AequiCap involved in the servicing of the workers’ compensation business became employees of the Company. The acquisition of this business strengthens the Company’s regional presence in the Southeast.
CastlePoint was a Bermuda holding company organized to provide property and casualty insurance and reinsurance business solutions, products and services primarily to small insurance companies and program underwriting managers in the United States. Program underwriting managers are insurance intermediaries that aggregate insurance business from retail and wholesale agents and manage business on behalf of insurance companies. Their functions may include some or all of risk selection, underwriting, premium collection, policy form and design, and client service. As a result of this transaction, the Company expects to expand and diversify its source of revenue by accessing CastlePoint’s programs, risk sharing and reinsurance businesses.
The Company began consolidating CastlePoint’s financial statements as of the closing date. The purchase consideration has been allocated to the assets acquired and liabilities assumed, including separately identified intangible assets, based on their fair values as of the close of the acquisition, with the amounts exceeding the fair value recorded as goodwill. The goodwill consists largely of the synergies and economies of scale expected from combining the operations of the Company and CastlePoint.
In connection with recording the acquisition, the Company revalued its previous investment in CastlePoint at fair value on the acquisition date, resulting in a gain of $7.4 million, before income taxes. This gain was included in the Consolidated Statements of Income in the first quarter of 2009. The Company incurred approximately $11.4 million of transaction costs, including legal, accounting, investment advisory and other costs directly related to the acquisition, which were expensed in the first quarter of 2009.
For the period covering their respective acquisition dates through year ended December 31, 2009, the Company included total revenues and net income for the companies acquired in 2009 in its Consolidated Statements of Income as follows:
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The valuation for the insurance policies that were in force on the acquisition dates was determined by using a cash flow model rather than an observable market price as a liquid market for valuing the in force business could not be determined. The valuation model used an estimate of the underwriting profit and the net nominal future cash flows associated with the in force policies that a market participant would expect as of the dates of the acquisitions. The estimated underwriting profit and the future cash flows were adjusted for the time value of money at a risk free rate and a risk margin to compensate an acquirer for bearing the risk associated with the in force business. An estimate of the expected level of policy cancellations that would occur after the acquisition dates was also included, where applicable.
The underwriting profit component of the VOBA will be amortized in proportion to the timing of the estimated underwriting profit associated with the in force policies acquired. The cash flow or interest component of the VOBA asset will be amortized in proportion to the expected pattern of the future cash flows. The amortization will be reflected as a component of underwriting expenses in both the brokerage insurance and specialty business segments. VOBA is determined at the time of a business combination and is reported on the consolidated balance sheet with DAC.
At the acquisition dates of CastlePoint, Hermitage and SUA, VOBA was $96.7 million, and the Company amortized $80.9 million for the year ended December 31, 2009 with the remainder to be amortized in 2010.
The valuation of loss and loss adjustment expense reserves acquired was determined using a cash flow model rather than an observable market price since a liquid market for such underwriting liabilities could not be determined. The valuation model used an estimate of net nominal future cash flows related to liabilities for losses and LAE that a market participant would expect as of the date of the acquisitions. These future cash flows were adjusted for the time value of money at a risk free rate and a risk margin to compensate an acquirer for bearing the risk associated with the liabilities.
The fair value adjustment for loss and LAE of $19.1 million will be amortized over the expected loss and LAE payout pattern and reflected as a component of loss and loss adjustment expenses. The Company amortized $5.0 million for the year ended December 31, 2009 with the remainder to be amortized over the next three to four years.
Selected unaudited pro forma results of operations assuming the CastlePoint, Hermitage, AequiCap and SUA acquisitions had occurred as of January 1, 2008, are set forth below:
Represents the gross unrealized loss on other-than-temporarily impaired securities as of December 31, 2009 recognized in accumulated other comprehensive income (loss).
At December 31, 2009 and 2008, U.S. Treasury Notes and other securities with carrying values of approximately $113.1 million and $21.7 million, respectively, were on deposit with various states to comply with the insurance laws of the states in which the Company is licensed.
Major categories of the Company’s net investment income are summarized as follows:
For certain non-highly rated structured fixed-maturity securities, the Company determines the credit loss component by utilizing discounted cash flow modeling to determine the present value of the security and comparing the present value with the amortized cost of the security. If the amortized cost is greater than the present value of the expected cash flows, the difference is considered a credit loss and included in net realized investment gains (losses). During the year ended December 31, 2009 the Company recorded $23.5 million of credit related OTTI primarily related to commercial and non-agency residential mortgage-backed securities.
The following table shows the number and amount of fixed-maturity and equity securities that the Company determined were OTTI for the years ended December 31, 2009, 2008 and 2007. This resulted in recording impairment write-downs included in net realized investment gains (losses), and reduced the unrealized loss in other comprehensive net income:
The following table provides a rollforward of the cumulative pre-tax amount of OTTI showing the amounts that have been included in earnings for securities still held for the year ended December 31, 2009:
The Company evaluated the severity of the impairment in relation to the carrying amount for the securities referred to above and considered all relevant factors, in assessing whether the loss was other-than-temporary. The Company does not intend to sell its fixed-maturity securities, and it is not more likely than not that the Company will be required to sell these investments until there is a recovery of fair value to the Company’s original cost or amortized cost basis, which, for fixed maturities, may be at maturity.
inputs used to measure the assets or liabilities fall within different levels of the hierarchy, the classification is based on the lowest level input that is significant to the fair value measurement of the asset or liability. Classification of assets and liabilities within the hierarchy considers the markets in which the assets and liabilities are traded, including during periods of market disruption, and the reliability and transparency of the assumptions used to determine fair value. The hierarchy requires the use of observable market data when available. The levels of the hierarchy and those investments included in each are as follows:
Level 1 - Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities traded in active markets. Included are those investments traded on an active exchange, such as the NASDAQ Global Select Market.
Level 2 - Inputs to the valuation methodology include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability and market-corroborated inputs. Included are investments in U.S. Treasury securities and obligations of U.S. government agencies, together with municipal bonds, corporate debt securities, commercial mortgage and asset-backed securities, certain residential mortgage-backed securities that are generally investment grade and certain equity securities.
Level 3 - Inputs to the valuation methodology are unobservable for the asset or liability and are significant to the fair value measurement. Material assumptions and factors considered in pricing investment securities may include projected cash flows, collateral performance including delinquencies, defaults and recoveries, and any market clearing activity or liquidity circumstances in the security or similar securities that may have occurred since the prior pricing period. Generally included in this valuation methodology are investments in certain mortgage-backed and asset-backed securities.
As at December 31, 2009 and 2008, the Company’s fixed-maturities and equity investments are allocated among levels as follows:
77% of the portfolio valuations classified as Level 1 or Level 2 in the above table are priced by utilizing the services of several independent pricing services that provide the Company with a price quote for each security. The remaining 23% of the portfolio valuations represents non-binding broker quotes. The Company has not made any adjustments to the prices obtained from the independent pricing sources and dealers on securities classified as Level 1 or Level 2.
The Level 3 classified securities in the table above consist of securities that were either not traded or very thinly traded due to concerns in the securities market. Management, in conjunction with its outside portfolio manager, considered the various factors that may indicate an inactive market and concluded that prices provided by the pricing sources represented an inactive or distressed market. As a result, prices from independent third party pricing services, broker quotes or other observable inputs were not always available, or were deemed unrealistically low, or, in the case of certain broker quotes, were non-binding. Therefore, the fair values of these securities were determined using a model to develop a security price using future cash flow expectations that were developed based on collateral composition and performance and discounted at an estimated market rate (including estimated risk and liquidity premiums) taking into account estimates of the rate of future prepayments, current credit spreads, credit subordination protection, mortgage origination year, default rates, benchmark yields and time to maturity. For certain securities, non-binding broker quotes were available and these were also considered in determining the appropriateness of the security price.
The Company has reviewed the pricing techniques and methodologies of the independent pricing sources and believes that their policies adequately consider market activity, either based on specific transactions for the issue valued or based on modeling of securities with similar credit quality, duration, yield and structure that were recently traded. The Company monitors security-specific valuation trends and discusses material changes or the absence of expected changes with the pricing sources to understand the underlying factors and inputs and to validate the reasonableness of pricing.
The components of intangible assets and their useful lives, accumulated amortization, and net carrying value as of December 31, 2009 and 2008 are as follows:
The Company recorded amortization expense related to intangibles, of $3.2 million, $1.2 million and $1.0 million in 2009, 2008, and 2007, respectively. The estimated amortization expense for each of the next five years is:
The Company acquired CastlePoint on February 5, 2009, at which time it became a wholly-owned subsidiary and the Company began consolidating its financial results. Changes in the carrying value of the equity investment in CastlePoint are as follows:
The Company and/or its subsidiaries were parties to a master agreement, certain reinsurance agreements, and other agreements, including program management agreements and service and expense sharing agreements, with CastlePoint prior to its acquisition on February 5, 2009. The more significant agreements were the Master Agreement and the Reinsurance Agreement with CastlePoint.
In April 2006, the Company entered into a master agreement with CastlePoint ( “Master Agreement”). The Master Agreement provided that, subject to the receipt of required regulatory approvals, CastlePoint would manage the traditional program business and the specialty program business, and the Company would manage the brokerage business. The program managers were required to purchase property and casualty excess of loss reinsurance and property catastrophe excess of loss reinsurance from third party reinsurers to protect the net exposure of the participants. In purchasing the property catastrophe excess of loss reinsurance, the manager could retain risk equating to no more than 10% of the combined surplus of the Company and CastlePoint Insurance Company (referred to as the pooled catastrophe retention).
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. The Master Agreement is no longer in force and effect as of the acquisition of CastlePoint by the Company on February 5, 2009.
The following table provides an analysis of the reinsurance activity between the Company and CastlePoint Reinsurance for the years ended December 31, 2008 and 2007, respectively:
Acquisition costs incurred and policy-related ceding commission revenue are deferred and amortized to income on property and casualty business as follows:
Additions of $15.1 million were attributable to the fair value of fixed assets of acquired companies in 2009.
Depreciation expense for 2009, 2008 and 2007 was $13.3 million, $10.5 million and $7.7 million, respectively.
The Company has automatic treaty capacity of $30.0 million for property risks, $1.0 million/ $2.0 million for liability coverages, $50.0 million for workers’ compensation, $5.0 million for umbrella liability and $100.0 million for equipment breakdown. The Company may offer higher limits through its use of facultative reinsurance. In addition, the Company has clash coverage in effect for 2009 for a limit of $9.0 million in excess of $1.0 million which applies to the aggregate liability losses from multiple insureds involved in the same occurrence.
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:
Certain of the Company’s reinsurance agreements contain provisions for loss ratio caps to provide the reinsurers with some limit on the amount of potential loss being assumed, while maintaining the transfer of significant insurance risk with the possibility of a significant loss to the reinsurer. Loss ratio caps cut off the reinsurers’ liability for losses above a specified loss ratio. The loss ratio caps in the 2005, 2004 and 2003 quota share agreements were 95.0%, 95.0% and 92.0%, respectively. The loss ratio cap in the 2008 Swiss Re quota share agreement was 120%. The loss ratio cap for the brokerage liability quota share agreements effective October 1, 2009 and January 1, 2010 is 110%. There was no loss ratio cap in 2007 and 2006.
The Company is obliged under the quota share reinsurance agreements, effective October 1, 2003, January 1, 2004 and January 1, 2005, to credit reinsurers with an annual effective yield of 2.5%, 2.5% and 3.0%, respectively, on the monthly balance in the funds held under reinsurance agreements liability accounts. The amounts credited for 2009, 2008 and 2007 were $0.7 million, $0.6 million and $1.2 million, respectively, and have been recorded as interest expense.
The Company earns ceding commissions under quota share reinsurance agreements for 2008, 2007, 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.
Incurred loss and LAE attributable to insured events of prior years decreased by $2.3 million, $8.9 million and $1.6 million in 2009, 2008 and 2007, respectively. Prior year development is based upon numerous estimates by line of business and accident year. No additional premiums or return premiums have been accrued as a result of the prior year effects; however, these changes in estimated losses impact the Company’s sliding scale commission income estimates. The Company’s management continually monitors claims activity to assess the appropriateness of carried case and IBNR reserves, giving consideration to Company and industry trends.
For each acquisition, the Company estimates and records the loss LAE reserves based upon its independent analysis of those reserves. In the case of SUA, the loss and LAE reserves were increased by $27.5 million above the amounts prior to the acquisition, which was comprised of an additional $25.7 million in nominal statutory and GAAP basis reserves based upon the Company’s independent actuarial analysis plus an additional $1.8 million in GAAP basis loss and LAE reserves pertaining to the reserves risk premium required under GAAP.
Included in the reserves for the loss and LAE reserve is $4.5 million of tabular reserve discount for workers’ compensation and excess workers’ compensation claims acquired as part of the SUA transaction.
For LAE stemming from defense by other attorneys who are not employees, the Company implemented automated legal fee auditing in the fourth quarter of 2008.
Loss development methods, the Bornhuetter-Ferguson (B-F) method and variations of this method, and loss ratio projections are the predominant methodologies the Company’s actuaries use to project losses and corresponding reserves. Based on these methods the Company’s actuaries determine a best estimate of the loss reserves. All of these methods are standard actuarial approaches in the industry. Generally, the loss development methods are relied upon for older accident years, and the loss ratio method is used for the most recent accident year when there is less reliability in the loss development methods. The B-F method combines the loss ratio method and the loss development methods to determine loss reserves by adding an expected development (loss ratio times premium times percent unreported) to the case reserves, and this method may be utilized for the most recent accident year or relatively immature accident years when the loss development methods are not fully reliable.
The Company and its wholly-owned subsidiaries have issued trust preferred securities through wholly-owned Delaware statutory business trusts. The trusts use the proceeds of the sale of the trust preferred securities and common securities that the Company acquired from the trusts to purchase junior subordinated debentures from the Company with terms that match the terms of the trust preferred securities. Interest on the junior subordinated debentures and the trust preferred securities is payable quarterly. In some cases, the interest rate is fixed for an initial period of five years after issuance, 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, including those which were assumed by the Company through acquisitions, are summarized in the following table:
At our option at par on or after December 14, 2011
At our option at par on or after September 27, 2012
Total interest expense incurred for all subordinated debentures, including amortization of deferred origination costs, was $17.4 million, $7.9 million and $8.2 million, respectively, for the three years ended December 31, 2009, 2008 and 2007.
In connection with the acquisition of Specialty Underwriters’ Alliance (“SUA”) on November 13, 2009, the Company issued 4,460,092 shares to the shareholders of SUA increasing Common Stock by $44,600 and Paid-in Capital by $105.8 million.
In 2007, the Company issued 3,450,200 shares from which it raised $89.4 million, net of underwriting discounts and expenses.
For the year ended December 31, 2009, the Company issued 52,310 new common shares as the result of employee stock option exercises and issued 310,208 new common shares as the result of restricted stock grants. For the year ended December 31, 2008, the Company issued 23,366 new common shares as the result of employee stock option exercises and issued 159,740 new common shares as the result of restricted stock grants. For the year ended December 31, 2007, the Company issued 81,100 new common shares as the result of employee stock option exercises and issued 93,581 new common shares as the result of restricted stock grants.
For the years ended December 31, 2009 and 2008, the Company purchased 43,820 and 24,615 shares, respectively 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 expected amount of tax liability owed by the employees from the vesting of those shares. In addition, for the year ended December 31, 2009 and 2008, 11,065 and 14,889 shares, respectively, of common stock were surrendered to the Company as a result of restricted stock forfeitures.
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 were exercisable for a term of five years beginning on October 20, 2004 and expired on October 20, 2009. During 2008, FBR assigned the then outstanding warrants to six of its employees, two of whom exercised their warrants during 2008. In 2009, the Company issued 16,193 treasury shares to FBR employees in cashless exercises of their warrants. As of December 31, 2009, there were no warrants outstanding.
The Company declared dividends on common stock of $10.7 million and $4.6 million year ended December 31, 2009 and 2008, respectively.
In 2004, the Company’s Board of Directors adopted and its stockholders approved a long-term incentive plan (the “2004 Long-Term Equity Compensation Plan”).
During the three years ended December 31, 2009, 2008 and 2007, restricted stock shares were granted to senior officers and key employees as shown in the table below. Included in the restricted stock shares granted in 2009 were 83,228 restricted stock shares that were originally issued to employees or directors of CastlePoint and were converted into restricted shares of the Company’s common stock upon the acquisition of CastlePoint. The fair value of all restricted stock awards on the date of grant during 2009,
2008 and 2007 was $7.3 million, $3.9 million and $3.0 million, respectively. Compensation expense recognized for the three years ended December 31, 2009, 2008 and 2007 was $2.6 million, $1.3 million and $1.0 million net of tax, respectively. The total intrinsic value of restricted stock vesting was $1.8 million, $2.0 million and $2.1 million during 2009, 2008 and 2007, respectively. The intrinsic value of the unvested restricted stock outstanding as of December 31, 2009 is $11.1 million.
Changes in restricted stock for the three years ended December 31, 2009, 2008 and 2007 were as follows:
Included in options granted in 2009 were 1,148,308 stock options that were originally issued to employees or directors of CastlePoint on four grant dates and were converted into options to acquire shares of the Company’s common stock upon the acquisition of CastlePoint. Also included in options granted in 2009 were 201,058 stock options that were originally issued to employees of SUA on two grant dates and were converted into options to acquire shares of the Company’s common stock upon the acquisition of SUA.
Compensation expense (net of tax) related to stock options was $1.0 million and $49,900 for the year ended December 31, 2009 and 2008, respectively. The intrinsic value of stock options outstanding as of December 31, 2009 is $8.0 million, of which $7.4 million is related to vested options.
The total remaining compensation cost related to non-vested stock options and restricted stock awards not yet recognized in the income statement was $8.9 million of which $0.6 million was for stock options and $8.3 million was for restricted stock as of December 31, 2009. The weighted average period over which this compensation cost is expected to be recognized is 3.3 years.
In assessing the valuation of deferred tax assets, the Company considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Prior to purchase, CPM established a valuation allowance of $1.9 million against its state NOL benefits. The Company has reviewed the CPM valuation allowance and determined that it should be recorded by the Company as of the acquisition date.
The Company recognizes interest and penalties related to uncertain tax positions in income tax expense which was zero for the years ended December 31, 2009, 2008 and 2007.
Tax years 2004 through 2008 are subject to examination by the Internal Revenue Service, which is currently performing an audit of the 2006 tax year. In addition, the Internal Revenue Service is auditing CPRE’s federal excise tax and protective income tax returns for the 2008 tax year and SUA’s federal income tax return for the 2007 tax year. There is currently a New York State Department of Taxation and Finance audit under way for the tax years of 2003 through 2004. The Company does not anticipate any material adjustments from these audits.
The SERP is a non-qualified defined contribution plan effective as of January 1, 2009 that is intended to enhance retirement benefits for the Company’s most senior executives and certain other key employees. Eligibility to participate in the SERP generally requires three years of prior employment with the Company for Senior Vice Presidents and between five and 10 years of prior employment with the Company for other key employees. In 2010, it is expected that all of the Named Executive Officers and certain other key executives selected at the discretion of the Compensation Committee will be eligible to participate in the SERP. The Company will make annual contributions to the SERP on behalf of each participant. For Mr. Lee, the amount of the annual contribution is equal to the product of 2.0% of his annual cash compensation multiplied by his number of years of service with the Company, up to a maximum of 30 years. For other participants, the amount of the annual contribution is equal to 5.0% of their annual cash compensation. Company contributions for each participant remain unvested until such participant has completed 10 years of service with the Company, and vest in full upon completion of 10 years of service. The Compensation Committee has discretion to terminate the SERP or to adjust upward or downward the level of the Company’s contribution each year.
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.
On May 28, 2009, Munich Reinsurance America, Inc. (“Munich”) commenced an action against Tower Insurance Company of New York ( “TICNY”) in the United States District Court for the District of New Jersey seeking, inter alia, to recover approximately $6.1 million under various retrocessional contracts pursuant to which TICNY reinsures Munich. On June 22, 2009, TICNY filed its answer, in which it, inter alia, asserted two separate counterclaims seeking to recover approximately $2.8 million under various reinsurance contracts pursuant to which Munich reinsures TICNY. On June 17, 2009, Munich commenced a separate action against TICNY in the United States District Court for the District of New Jersey seeking a declaratory judgment that Munich is entitled to access to the TICNY’s books and records pertaining to various quota share agreements, to which the TICNY filed its answer on July 7, 2009. Because the litigation is only in its preliminary stage, management is unable to assess the likelihood of any particular outcome, including what amounts, if any, will be recovered by the parties from each other under the reinsurance and retrocession contracts that are at issue. Accordingly, an estimate of the possible range of loss, if any, cannot be made.
For SAP purposes, changes in deferred income taxes relating to temporary differences between net income for financial reporting purposes and taxable income are recognized as a separate component of gains and losses in surplus rather than included in income tax expense or benefit as required under GAAP.
For Bermuda registered companies, there are some differences between financial statements prepared in accordance with GAAP and those prepared on a statutory basis. Certain assets are non-admitted under Bermuda regulations and deferred policy acquisition costs have been fully expenses to income under Bermuda regulations and prepaid expenses and fixed asset have been removed from the statutory balance sheet under Bermuda regulations.
GAAP guidance requires all entities to disclose the fair value of financial instruments, both assets and liabilities recognized and not recognized in the balance sheet, for which it is practicable to estimate fair value. See Note 3-“Acquisitions” for further information about the fair value of assets and liabilities of CastlePoint, Hermitage and SUA acquired upon acquisition. The Company uses the following methods and assumptions in estimating its fair value disclosures for financial instruments:
The following table reconciles the results of the Company’s individual segments to consolidated income before taxes:
As part of the Company’s capital management plan, the Board of Directors of Tower on February, 26, 2010, approved a $100 million share repurchase program. Purchases will be made from time to time in the open market or in privately negotiated transactions in accordance with applicable laws and regulations. The program has no expiration date. Based on the closing stock price of Tower common stock on February 26, 2010, the authorized repurchase would represent approximately 9.5% of outstanding shares.
Prior year earnings per share have been restated for new GAAP guidance adopted in 2009 which requires unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents be considered participating securities and included in the computation of earnings per share. Basic and diluted earnings per share for the years ended December 31, 2008 and 2007 decreased by $0.02 and $0.01, respectively.