We lease approximately 118,500 square feet of space at 120 Broadway, New York, New York, which consists of the 30th and 31st floors and part of the 29th floor. The lease will end on December 31, 2021. See Note 18-“Commitments and Contingencies” in the notes to our audited consolidated financial statements included elsewhere in this report.
The selected consolidated income statement data for the years ended December 31, 2008, 2007 and 2006 and the balance sheet data as of December 31, 2008 and 2007 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.
The gross combined ratio is the sum of the gross loss ratio and the gross underwriting expense ratio.
The net underwriting expense ratio is calculated by dividing net underwriting expenses (consisting of direct commission expenses and other underwriting expenses net of policy billing fees and ceding commission revenue) by net premiums earned. Historically, the ceding commission revenue we earn on our ceded premiums has been higher than our expenses incurred to produce those premiums; our extensive use of quota share reinsurance has caused our net underwriting expense ratio to be lower than our gross underwriting expense ratio under GAAP.
The net combined ratio is the sum of the net loss ratio and the net underwriting expense ratio.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated audited financial statements and accompanying notes which appear elsewhere in this Form 10-K. It contains forward-looking statements that involve risks and uncertainties. See “Business-Note on Forward-Looking Statements” for more information. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including
those discussed below and elsewhere in this Form 10-K, particularly under the headings “Business-Risk Factors” and “Business-Note on Forward-Looking Statements.”
In our insurance services segment, TRM generates management fees and commission income from its managing general agency by producing premiums on behalf of its issuing companies, including CPIC, and generates fees by providing claims administration and reinsurance intermediary services. The insurance services segment also generates other administration revenue from services provided to CastlePoint Reinsurance. See “Business-Reinsurance-CastlePoint Reinsurance” and “Business-Strategic Relationship and Agreements with CastlePoint.”
We organized and sponsored CastlePoint with an initial investment of $15.0 million on February 6, 2006. Our investment ownership as of December 31, 2008 was approximately 6.7% of CastlePoint after CastlePoint raised $249.9 million in a private placement stock offering in 2006 and $114.8 million in a public stock offering in 2007. This percentage does not include a warrant from CastlePoint to purchase an additional 1,127,000 shares of common stock which we received on April 6, 2006.
On February 5, 2009, we announced that we had completed the acquisition of CastlePoint in a transaction valued at approximately $533 million. This acquisition provides significant financial and operational benefits.
CastlePoint provides us with additional capital to support organic growth as well as external growth from acquisitions. From an operational standpoint, the CastlePoint acquisition provides us with access to program underwriting agents focused on specialty classes of business and to small insurance companies that need reinsurance solutions. While we have not written certain specialty classes of business in the past, CastlePoint is positioned to focus on specialty classes of business following its established underwriting process for all programs, treaties and risk-sharing arrangements.
On February 27, 2009, we completed the acquisition of HIG, Inc. (“Hermitage”), a specialty property and casualty insurance holding company, from a subsidiary of Brookfield Asset Management Inc. for $130 million. Hermitage offers both admitted and excess and surplus lines (“E&S”) products and wrote over $100 million of premiums in 2008. This transaction further expands our wholesale distribution system nationally and establishes a network of retail agents in the Southeast.
The Insurance Information Institute has projected the industry combined ratio for 2009 to be to 101%, assuming there is not a severe impact from weather-related catastrophe losses. Soft market conditions are anticipated to continue through the second quarter of 2009. However, we believe that aggressive competitive activity is lessening. As a result of projected increased combined ratios and continuing volatile market conditions; underwriting terms and conditions, including pricing are seen as stabilizing.
Our gross premiums written in 2008, 2007 and 2006 were $634.8 million, $524.0 million and $432.7 million, respectively. Premiums produced by TRM in 2008, 2007 and 2006 were $175.4 million, $85.1 million and $12.9 million, respectively.
Net premiums earned. Premiums written include all premiums received by an insurance company during a specified accounting period, even if the policy provides coverage beyond the end of the year. Premiums are earned over the term of the related policies. At the end of each accounting period, the portion of the premiums that are not yet earned is included in the unearned premium reserve and is realized as income in subsequent periods over the remaining term of the policy. Our policies typically have a term of 12 months. Thus, for example, for a policy that is written on July 1, 2008, one-half of the premiums would be earned in 2008 and the other half would be earned in 2009.
Net investment income and realized gains and losses on investments. We invest our statutory surplus and the funds supporting our insurance reserves (including unearned premium reserve and the reserves established to pay for losses and loss adjustment expenses) in cash, cash equivalents and securities. Our investment income includes interest and dividends earned on our invested assets. Realized gains and losses on invested assets are reported separately from net investment income. We earn realized gains when invested assets are sold for an amount greater than their amortized cost, in the case of fixed maturity securities, and cost, in the case of equity securities, and we recognize realized losses when invested assets are written down or sold for an amount less than their amortized cost or actual cost, as applicable.
Underwriting expense ratio. The underwriting expense ratio is the ratio of direct and ceding commission expenses and other underwriting expenses less policy billing fees and other administration revenue to premiums earned. The underwriting expense ratio measures a company’s operational efficiency in producing, underwriting and administering its insurance business. Due to our historically high levels of reinsurance, we calculate our underwriting expense ratio on a gross basis (before the effect of ceded reinsurance) and a net basis (after the effect of ceded reinsurance). Ceding commission revenue is applied to reduce our underwriting expenses in our insurance company operation. Because the ceding commission rate we earn on our premiums ceded has historically been higher than our underwriting expense ratio on those premiums, our extensive use of quota share reinsurance has caused our net underwriting expense ratio generally to be lower than our gross expense ratio.
Our most critical accounting policies involve the reporting of reserves for losses (including losses that have occurred but had not been reported by the financial statement date) and LAE, the reporting of ceding
commissions earned, the amount and recoverability of reinsurance recoverable balances, deferred acquisition costs and investments.
Beginning in the forth quarter of 2008, LAE stemming from defense by in-house attorneys’ is attributed to claims based upon a determined fixed fee per in-house litigated claim. We allocate to each of these litigated claims 50% of the fixed fee when litigation on a particular claim begins and 50% of the fee when the litigation is closed. The fee is determined actuarially based upon the projected number of litigated claims and expected closing patterns at the beginning of each year as well as the projected budget for our in-house attorneys, and these amounts are subject to adjustment each quarter based upon actual experience.
Net Premiums Earned. Insurance policies issued or reinsured by us are short-duration contracts. Accordingly, premium revenue, including direct writings and reinsurance assumed, net of premiums ceded to reinsurers, is recognized as earned in proportion to the amount of insurance protection provided, on a pro-rata basis over the terms of the underlying policies. Unearned premiums represent premium applicable to the unexpired portions of in-force insurance contracts at the end of each year. Prepaid reinsurance premiums represent the unexpired portion of reinsurance premiums ceded.
Ceding commissions earned. We have historically relied on quota share, excess of loss and catastrophe reinsurance to manage our regulatory capital requirements and limit our exposure to loss. Generally, we have ceded a significant portion of our insurance premiums to reinsurers in order to maintain our net leverage ratio at our desired target level.
Ceding commissions earned under a quota share reinsurance agreement is 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. Since 2001, the ultimate commission rate earned on our quota share reinsurance contracts has been determined by the loss ratio on the ceded premiums earned. If the estimated loss ratio decreases from the level currently in effect, the commission rate increases and additional ceding commissions are earned in the period in which the decrease is recognized. If the estimated loss ratio
When persuasive evidence exists that causes us to evaluate a decline in fair value to be other than temporary, we reduce the book value of such security to its current fair value, recognizing the decline as a realized loss in the income statement. All other unrealized gains (losses) are reflected in shareholders’ equity. We recorded OTTI losses in our fixed maturity and equity securities in the amounts of $22.7 million, $10.1 million and $0 in 2008, 2007 and 2006, respectively.
See “Business-Investments” and “Note 2. Investments” in the notes to our audited consolidated financial statements for additional detail regarding our investment portfolio at December 31, 2008, including disclosures regarding other than temporary declines in investment value.
Since total unrealized losses are a component of stockholders’ equity, any recognition of additional OTTI losses would have no effect on our comprehensive income or book value.
Intangible assets and potential impairment. The costs associated with a group of assets acquired in a transaction are allocated to the individual assets, including identifiable intangible assets, based on their relative fair values. Identifiable intangible assets with a finite useful life are amortized over the period in which the asset is expected to contribute directly or indirectly to our future cash flows. Identifiable intangible assets with finite useful lives are tested for recoverability whenever events or changes in circumstances indicate that a carrying amount may not be recoverable. An impairment loss is recognized if the carrying value of an intangible asset is not recoverable and its carrying amount exceeds its fair value. No impairment losses were recognized in 2008, 2007 and 2006. Significant changes in the factors we consider when evaluating our intangible assets for impairment losses could result in a significant change in impairment losses reported in our consolidated financial statements. See “Note 8. Intangible Assets” in the notes to our audited consolidated financial statements.
Total revenues. The increase is primarily due to the increase in total commission and fee income and net premiums earned, offset by decreased net investment income. Net premiums earned increased 9.9% as compared to last year. Net premiums earned decreased as a percentage of revenue due to the significant increase in commission and fee income. This was the result of an increase in direct commission revenue on premiums produced by TRM on behalf of CPIC. Net premiums earned increased principally due to reducing the quota share cession to CastlePoint on brokerage business. Net investment income decreased in 2008 primarily due to lower investment yields. Net realized investment losses were $14.4 million in 2008 compared to $17.5 million in 2007. Net realized investment losses in 2008 and 2007 included OTTI losses of
Premiums earned. The 9.9% increase in net premiums earned was due to the effect of 10.8% increase in gross premiums earned for 2008 compared to 2007, offset in part by an 11.9% increase in ceded premiums earned for 2008 compared to 2007.
Policies in-force for our brokerage business, including business managed by us and produced on behalf of CPIC, increased by 23.7% as of December 31, 2008 compared to December 31, 2007. During 2008, premiums on renewed business increased 3.4% in personal lines and decreased 2.0% in commercial lines. The retention rate including brokerage business renewed by TRM on behalf of CPIC was 86% for personal lines and 78% for commercial lines. Gross premiums written and produced increased 32.3% to $805.0 million compared to $608.4 million in 2007.
Net realized investment losses were $14.4 million and $17.5 million in 2008 and 2007, respectively. Net realized investment gains and (losses), excluding OTTI was $8.3 million and ($7.4) million in 2008 and 2007, respectively. The realized loss in 2007 was primarily related to the sale of a closed-end investment fund, Hyperion Brookfield Collateralized Securities Fund (“HCS Fund”), which was sold in December 2007. The HCS Fund invested in various investment grade mortgage-backed and asset-backed securities. In addition we recognized $22.7 million and $10.1 million of OTTI losses in 2008 and 2007, respectively. The OTTI losses in 2008 related principally to lower rated residential mortgage-backed securities with projected adverse cash
flows as well as the impairment of three Lehman Brothers fixed maturity securities and the impairment of an asset backed security which held collateralized bank debt. The OTTI losses in 2007 included all of our equity investments in REITs, as well as certain sub-prime securities within our residential mortgage-backed securities.
Loss and loss adjustment expenses. Gross loss and loss adjustment expenses and the gross loss ratio for 2008 were $288.3 million and 49.9%, respectively, compared to $264.7 million and 50.7%, respectively, for 2007. The net loss ratio for the combined segments was 51.7% for 2008 as compared to 55.2% in 2007. See “Insurance Segment Results of Operations” for an explanation of these changes.
investing activities was $181.2 million for 2008 and includes $66.2 million for the purchase of Preserver. On a tax equivalent basis, the book yield was 5.6% as of December 31, 2008 and 5.6% as of December 31, 2007.
Loss and loss adjustment expenses. Gross loss and loss adjustment expenses and the gross loss ratio for the insurance segment combined for 2007 were $264.7 million and 50.7%, respectively, compared to $199.9 million and 55.0%, respectively, for 2006. The net loss ratio for the combined segments was 55.2% for 2007 as compared to 60.3% in 2006. The net loss ratio in 2006 included a $1.6 million charge resulting from the commutation agreement with PXRE which was a present value discount on the reserves commuted. In addition to the commutation agreement with PXRE, we executed novation agreements with PXRE relating to other reinsurance agreements covering business written in 2001, 2002 and 2003. These agreements were written by other insurance companies with respect to business managed on their behalf by TRM. Under the novation agreements we assumed loss liabilities of $12.2 million and received consideration of $11.4 million. Since novation transactions are recorded by including the consideration received as premiums written and earned and the liabilities assumed as losses incurred, the gross and net loss ratios were also affected. The PXRE commutation and novation transactions added 1.7 and 3.2 percentage points to the gross and net loss ratios, respectively, in 2006.
Operating expenses. Operating expenses increased by 56.1% to $178.4 million for 2007 from $114.2 million for 2006. The increase was due primarily to the increase in underwriting expenses resulting from the growth in premiums earned and additional staffing and facility expenses. The acquisition of Preserver added $22.0 million of operating expenses in 2007. Preserver’s gross expense ratio was reduced to 33.6% in the portion of 2007 subsequent to the acquisition and to 31.2% in the fourth quarter of 2007.
Other income. For 2007 and 2006 we recorded other income of $5.1 million and $13.4 million, respectively. The $5.1 million of other income for 2007 represents our equity in CastlePoint’s 2007 net income as well as a $2.7 million gain which resulted from our investment in CastlePoint as a result of its initial public offering which occurred in the first quarter of 2007.
well as an increase in state and local income taxes for TRM, which is included in the insurance services segment. The effective income tax rate was 36.6% for 2007 compared to 34.9% for 2006.
Gross premiums written also increased due to growth in traditional and specialty program business premium managed by CastlePoint, which increased to $109.4 million for 2008 compared to $24.5 million for the same period in 2007. The increase in program business primarily resulted from writing low to moderate classes of workers’ compensation business in California.
Ceding commission revenue. For the year ended December 31, 2008, ceding commission revenue increased primarily due to an increase in ceded premiums earned and an increase in the brokerage business ceding commission rate which resulted from a higher ceding commission rate on the business ceded to Swiss Re America. This was slightly offset by an increase in the ceded loss ratios on prior years’ quota share treaties which decreased ceding commission revenue by $1.8 million and $0.5 million in 2008 and 2007, respectively.
Loss and loss adjustment expenses. Gross loss and loss adjustment expenses and the gross loss ratio for 2008 were $288.3 million and 49.9%, respectively, compared to $264.7 million and 50.7%, respectively, for 2007. The net loss ratio for the combined segments was 51.7% for 2008 as compared to 55.2% in 2007.
The decrease in the gross and net loss ratios for 2008 compared to 2007 was primarily due to lower than expected loss emergence for workers’ compensation, general liability, and homeowners’ lines of business. The decrease was also affected by the decrease in required LAE reserves as a result of changing to fixed fee billing for our in-house attorneys on claims handled and legal fee auditing of external attorneys’ bills. The net loss ratio in 2008 was also reduced by 1.0 loss ratio point due to the recovery from the aggregate stop loss contract with CPIC. During 2008, prior accident years’ loss reserves developed favorably to the extent of $8.9 million of which $4.0 million resulted from the revised estimates of required LAE reserves as mentioned above, whereas during 2007, prior accident years’ loss reserves developed favorably to the extent of $1.6 million. We also had favorable prior year development in the 2006 accident year from fire, homeowners, commercial multi peril property, commercial multi peril liability, workers’ compensation, and other liability lines partially offset by unfavorable development in the auto line. The increase in the 2008 gross accident year loss ratio compared to the 2007 gross accident year loss ratio was primarily due to three large property losses that increased the gross loss ratio by approximately two loss ratio points.
Loss and loss adjustment expenses are net of reimbursements for loss and loss adjustment expenses made by TRM pursuant to the expense sharing agreement between TICNY, TNIC and TRM. See “Insurance Services Segment Results of Operations” for the amounts of claims reimbursements.
programs, eliminated a special disability fund for new claims and imposed various administrative changes on the workers’ compensation system. As a result of this legislation, workers’ compensation rates in New York were decreased by approximately 16% on an overall basis in October 2007. The rate decrease for our core classes of business was approximately 25%. The legislation also required the rate decrease to take effect midterm on any policy with an effective date after October 1, 2007. We have taken steps to analyze our book of business and adjust our strategy in response to this legislation.
Net premiums. Net premiums written increased by 14.1% to $259.2 million for 2007 compared to $245.1 million for 2006. While gross premiums written increased by 21.1% in 2007, net premiums written did not increase as much because of the increased quota share ceding percentage mentioned above. Net premiums earned increased by 27.7% to $286.1 million in 2007 compared to $224.0 million for 2006. The growth was driven primarily by the increase in gross premiums earned, offset by an increase in the quota share ceding percentage and, to a lesser extent, by an increase in catastrophe reinsurance costs.
The decrease in the gross and net loss ratios for 2007 compared to 2006, excluding the effect of the PXRE transactions, was primarily due to lower than expected loss emergence for workers’ compensation, commercial auto liability and the property lines of business. However the decrease in the net loss ratio, excluding the impact of PXRE, was offset, in part, by the difference in the amount of reserves released from prior accident
Underwriting profit and combined ratio. The underwriting profit, which reflects our underwriting results on a net basis after the effects of reinsurance, was $46.6 million in 2007 and $27.8 million in 2006. Preserver’s contribution to underwriting profit was $4.2 million in 2007. The gross combined ratio was 79.9% for 2007 as compared with 83.7% for 2006. The lower gross combined ratio in 2007 resulted primarily from a lower gross loss ratio in 2007 compared to 2006. The net combined ratio was 83.7% for 2007 as compared to 87.6% for 2006. The decrease in the net combined ratio resulted from a decrease in the net loss ratio, offset in part, by a slight increase in the net underwriting expense ratio. The effects of the commutations reduced underwriting profit in 2006 by $5.6 million and added 3.3 percentage points to the net combined ratio.
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 segment and TRM’s commission rates are similar to the commission rates in the Insurance segment for similar lines of business.
Total revenues. Total revenues for the insurance services segment were $33.3 million for 2007 as compared with $8.0 million in 2006. The principal components of total revenues for our insurance services segment are direct commission revenue, claims administration revenue and other administration revenue. The increase in total revenues was primarily due to direct commission revenue increasing to $28.8 million for 2007 as compared to $3.5 million in 2006 mainly as a result of business produced on behalf of CPIC which began in May 2007 but increased substantially beginning in July 2007. Overall, premiums produced by TRM increased from $12.9 million in 2006 to $85.1 million in 2007, of which $84.2 million was produced on behalf of CPIC. In addition, there was an increase in commission revenue of $1.8 million and $0.8 million in 2007 and 2006, respectively, as a result of favorable loss development on the premiums produced in prior years. Claims administration revenues decreased to $2.3 million for 2007 compared to $3.2 million in 2006 as a result of fewer hours associated with claims handled on behalf of issuing carriers. Other administration revenue was $1.4 million for 2007 compared to $0.7 million in 2006 and consisted primarily of reimbursements from CastlePoint under a service and expense sharing agreement.
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 other observable inputs. In circumstances where quoted market prices are unavailable, we utilize fair value estimates based upon other observable 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 a component of accumulated other comprehensive net income in stockholders’ equity. Realized gains and losses are charged or credited to income in the period in which they are realized.
Impairment of investment securities results in a charge to net income when a market decline below cost is deemed to be other-than-temporary. As of December 31, 2008, we reviewed our fixed-maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. We recorded OTTI losses in our fixed maturity and equity securities in the amounts of $22.7 million and $10.1 in 2008 and 2007, respectively.
At December 31, 2008, $101.9 million of our municipal bonds, at fair value, were guaranteed by third parties from a total of $533.9 million, at fair value, of all fixed-maturity securities held by us. The amount of securities that are guaranteed by third parties along with the credit rating with and without the guarantee is as follows:
We do not have any direct exposure to guarantors, and our indirect exposure by guarantor is as follows:
(“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”).
Our process to validate the market prices obtained from the outside pricing sources include, but are not limited to, periodic evaluation of model pricing methodologies and analytical reviews of certain prices. We also periodically perform testing of the market to determine trading activity, or lack of trading activity, as well as market prices.
Note 5 of the Consolidated Financial Statements describes of the valuation methodology utilized to price Level 3 assets, how the valuation methodology is validated and the analysis of the change in fair value Level 3 assets. As of December 31, 2008, the fair value of Level 3 assets as a percentage of our total assets carried at fair value was as follows:
During 2008, credit spreads widened as a result of the economic crisis and lack of liquidity in the market. As reflected in other comprehensive income, the gross unrealized investment loss increased by $42.4 million. The increase in the unrealized investment loss was primarily related to our investments in corporate bonds and mortgage-backed securities. In addition, changes in interest rates directly impact the fair value for our fixed maturity portfolio. We regularly review both our fixed-maturity and equity portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments.
The following table presents information regarding our invested assets that were in an unrealized loss position at December 31, 2008 and 2007 by amount of time in a continuous unrealized loss position:
The following table shows the number of securities, fair value and unrealized loss, percentage below amortized cost and fair value by rating:
The following tables show the fair value and unrealized loss by sector and credit quality rating of our corporate and other bonds at December 31, 2008:
The majority of securitized assets are related to commercial and residential mortgage-backed securities. 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 appears to be temporary.
Impairment of investment securities results in a charge to operations when a market decline below cost is deemed to be other-than-temporary. As of December 31, 2008, we reviewed our fixed-maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. During the past year, we determined that certain of our investments were OTTI and recorded an impairment write-down of $22.7 million during 2008.
After recording the charges for the fixed-maturity and equity investments that were OTTI, we have determined that we did not hold any remaining investments that would have been considered OTTI and that the increase in the gross unrealized investment loss was caused by a lack of liquidity in the capital markets. We expect cash flows from operations to be sufficient to meet our liquidity requirements. We intend, and we believe we have the ability, to hold these investments, until a recovery of fair value to our cost or amortized cost basis, which may be at maturity for fixed maturity securities.
See Note 4-Investments in our financial statements for further information about other than temporary impairment losses recorded in 2008.
Tower is organized as a holding company with one intermediate holding company and five Insurance Subsidiaries and TRM. Tower’s principal liquidity needs include interest on debt, income taxes and stockholder dividends. Our principal sources of liquidity include dividends and other permitted payments from our subsidiaries, as well as financing through borrowings and sales of securities.
TICNY is the only Insurance Subsidiary that has historically paid dividends. Under New York law, TICNY is limited to paying dividends to Tower only out of statutory earned surplus. In addition, the New York Insurance Department must approve any dividend declared or paid by TICNY that, together with all dividends declared or distributed by TICNY during the preceding twelve months, exceeds the lesser of (1) 10% of TICNY’s policyholders’ surplus as shown on its latest statutory financial statement filed with the New York State Insurance Department or (2) 100% of adjusted net investment income during the preceding twelve months. TICNY declared approximately $5.2 million, $8.5 million, and $4.6 million in dividends to Tower in 2008, 2007, and 2006, respectively.
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, 2008, the maximum dividend distribution that our Insurance Subsidiaries could pay to Tower without approval of their domiciliary Insurance Departments was approximately $17.1 million.
On January 22, 2007, we signed an underwriting agreement providing for the issuance and sale of 2,704,000 shares of common stock at a price of $31.25 per share, less underwriting discounts, and granted to the underwriters an option to purchase up to 405,600 additional shares of common stock at the same price to cover over-allotments. On January 26, 2007, we closed on the sale of 2,704,000 shares of common stock. On February 5, 2007, the underwriters exercised their over-allotment option with respect to 340,600 shares of common stock. We received aggregate net proceeds of approximately $89.4 million from the offering and over-allotment option, after underwriting discounts and expenses.
In both January 2007 and March 2006, respectively, we issued $20 million of subordinated debentures.
Our Insurance Subsidiaries are required by law to maintain a certain minimum level of policyholders’ surplus on a statutory basis. Policyholders’ surplus is calculated by subtracting total liabilities from total assets. The NAIC maintains risk-based capital (“RBC”) requirements for property and casualty insurance companies. RBC is a formula that attempts to evaluate the adequacy of statutory capital and surplus in relation to investments and insurance risks. The formula is designed to allow the state Insurance Departments to identify potential weakly capitalized companies. Under the formula, a company determines its risk-based capital by taking into account certain risks related to the insurer’s assets (including risks related to its investment portfolio and ceded reinsurance) and the insurer’s liabilities (including underwriting risks related to the nature and experience of its insurance business). Applying the RBC requirements as of December 31, 2008, our Insurance Subsidiaries’ risk-based capital exceeded the minimum level that would trigger regulatory attention. In addition to monitoring RBC to ensure regulatory compliance, we monitor various financial ratios, including gross and net premiums written to surplus ratios. In 2008, we contributed $0.3 million to TICNY. In 2007, we contributed $3.2 million to TICNY, $2.5 million to PIC and $2.5 million to NEIC.
The statutory surplus that we are required to maintain varies depending on the type and amount of revenue that is derived. The statutory surplus requirements are based upon various capital adequacy tests and ratios established by rating agencies and insurance regulators. Statutory surplus requirements are greater for net premiums earned and retained than for premiums that we cede or transfer to reinsurers. Non-risk bearing revenues that are generated primarily from TRM do not require us to maintain any surplus, except capital necessary to meet TRM’s operating expenses. For these reasons, we attempt to reduce our statutory surplus requirement by limiting our net retention of premiums while generating ceding commissions in our Insurance Subsidiaries and non-risk bearing revenues in TRM.
The primary sources of cash flow in our Insurance Subsidiaries are gross premiums written, ceding commissions from our quota share reinsurers, loss payments by our reinsurers, investment income and proceeds from the sale or maturity of investments. Funds are used by 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. The Insurance Subsidiaries also use funds for loss payments and loss adjustment expenses on our net business, commissions to producers, salaries and other underwriting expenses as well as to purchase investments and to pay dividends to Tower. TRM’s primary sources of cash are commission and fee income. TRM’s primary uses of cash are commissions to producers and expenses reimbursed to TICNY under an expense sharing agreement.
Our reconciliation of net income to cash provided from operations is generally influenced by the collection of premiums in advance of paid losses, the timing of reinsurance, issuing company settlements and the timing of our loss payments.
Our insurance companies are subject to significant regulatory restrictions limiting their ability to declare and pay dividends. As of December 31, 2008, the maximum amount of distributions that our insurance companies could pay to us without approval of their domiciliary Insurance Department was approximately $17.1 million. Cash flow needs at the holding company level are primarily for dividends to our stockholders and interest payments on our $101.0 million of subordinated debentures.
During 2007, yield spreads widened as a result of the lack of liquidity in the market, increasing the gross unrealized investment loss significantly. The increase in the unrealized investment loss was primarily in our residential and commercial mortgage-backed and asset-backed securities, as well as our corporate bond securities. At December 31, 2007, following our regular periodic review, we recorded $10.1 million of OTTI on our equity and fixed maturity securities. Our equity securities are primarily invested in REITs and the OTTI for these securities was $5.2 million in 2007. The fixed maturity securities included sub-prime residential mortgage-backed securities and the OTTI for the sub-prime securities was $2.6 million in 2007. As a result of performing cash flow testing in accordance with Emerging Issues Task Force Number 99-20, we determined that additional OTTI related to other fixed maturity securities was $1.8 million. In January 2008, we sold two corporate bonds and recorded OTTI related to these bonds as of December 31, 2007, because we no longer had the intent to hold them to maturity.
We intend, and we believe we have the ability, to hold these investments, excluding the investments we determined were OTTI, until a recovery in value, which may be at maturity for fixed maturity securities.
During 2007, yield spreads widened as a result of the lack of liquidity in the market, increasing the gross unrealized investment loss significantly. The increase in the unrealized investment loss was primarily in our residential and commercial mortgage-backed and asset-backed securities, as well as our corporate bond securities. At December 31, 2007, following our regular periodic review, we recorded $10.1 million of OTTI on our equity and fixed maturity securities. Our equity securities are primarily invested in REITs and the OTTI for these securities was $5.2 million in 2007. The fixed maturity securities included sub-prime residential mortgage-backed securities and the OTTI for the sub-prime securities was $2.6 million in 2007. As a result of performing cash flow testing in accordance with Emerging Issues Task Force Number 99-20, we determined that additional OTTI related to other fixed maturity securities was $1.8 million. In January 2008,
We have determined that we do not hold any remaining investments, after recording the charge for OTTI, that would have been considered other than temporarily impaired, and that the recent increase in the gross unrealized investment loss was caused by the lack of liquidity in the capital markets. We expect cash flows from operations to be sufficient to meet our liquidity requirements. We intend, and we believe we have the ability, to hold these investments, excluding the investments we determined were OTTI, until a recovery in value, which may be at maturity for fixed maturity securities.
The net cash flow used in investing activities for 2007 was $181.2 million as compared to $132.0 million for the same period in 2006. Cash flow used for investing activities in 2007 included the payment of $66.0 million for the acquisition of Preserver Group, Inc. In addition, we paid $4.7 million of Preserver’s direct transaction costs in connection with the acquisition. During 2007, we capitalized $10.8 million for software, principally expenditures for operating systems, hardware and approximately $5.0 million as a result of the Preserver acquisition. In addition, there were increases in investments in municipal securities, corporate bonds, U.S. Treasuries and mortgage-backed investments for 2007 of $105.3 million and net sales in our equity investments of $8.9 million. During 2006, we capitalized $22.9 million for the purchase of fixed assets and entered into a sale leaseback on $5.2 million of these assets. We relocated our New York City corporate headquarters within the same building and capitalized $10.4 million for leasehold improvements, $3.9 million and $6.1 million for furniture and equipment and $6.4 million for computer hardware and software. The landlord provided a $4.8 million build-out allowance which partly financed the $10.4 million of leasehold improvements. In addition, we had net fixed maturity security purchases of $83.4 million and net purchases in our equity investments of $16.6 million. Also in 2006, we invested $14.4 million to start up CastlePoint.
We maintain sufficient liquidity to pay claims, operating expenses and meet our other obligations. We held $136.3 million and $77.7 million of cash and cash equivalents at December 31, 2008 and 2007, 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. Cash and cash equivalents at December 31, 2008 include $16.0 million of premiums collected through TRM on behalf of CPIC. These funds will be paid to CPIC within 30 days from December 31, 2008. As of December 31, 2008, cash and cash equivalents were approximately equal to the estimated $102.2 million of net loss reserves as of that date that we expect to pay within the next year. As necessary, we adjust our
The following table summarizes information about contractual obligations and commercial commitments. The minimum payments under these agreements as of December 31, 2008 were as follows:
Under the terms for all of the trust preferred securities, an event of default may occur upon:
If an event of default occurs and is continuing, the entire principal and the interest accrued on the affected trust preferred securities and junior subordinated debentures may be declared to be due and payable immediately.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Tower Group, Inc. as of December 31, 2008 and 2007, and the results of its consolidated operations and its cash flows for each of the years in the three-year period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States. In addition, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements as a whole, present fairly, in all material respects, the information set forth therein. Also in our opinion, Tower Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Tower Group, Inc. (the “Company”) through its subsidiaries offers property and casualty insurance products and diversified insurance services and products. The Company’s common stock is publicly traded on the NASDAQ Global Select Market under the symbol “TWGP.”
The Insurance Segment offers a broad range of property and casualty insurance products and services to small to mid-sized businesses and to individuals primarily in the Northeast states; and
services are earned when the Company’s Insurance Subsidiaries or TRM’s issuing companies cede premiums to reinsurers. Claims administration fees and other administration revenues are earned as services are performed.
The liability for loss and LAE represents management’s best estimate of the ultimate cost of all reported and unreported losses that are unpaid as of the balance sheet date. The liability for loss and LAE is estimated on an undiscounted basis, using individual case-basis valuations, statistical analyses and various actuarial procedures. The projection of future claim payment and reporting is based on an analysis of the Company’s historical experience, supplemented by analyses of industry loss data. Management believes that the reserves for loss and LAE are adequate to cover the ultimate cost of losses and claims to date; however, because of the uncertainty from various sources, including changes in reporting patterns, claims settlement patterns, judicial decisions, legislation, and economic conditions, actual loss experience may not conform to the assumptions used in determining the estimated amounts for such liability at the balance sheet date. As adjustments to these estimates become necessary, such adjustments are reflected in expense for the period in which the estimates are changed. Because of the nature of the business historically written, the Company’s management believes that the Company has limited exposure to environmental claim liabilities.
Cash and cash equivalents are presented at cost, which approximates fair value. The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents.
The fair value hierarchy in SFAS 157 prioritizes fair value measurements into three levels based on the nature of the inputs. Quoted prices in active markets for identical assets or liabilities 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 assumptions that market participants would use, having the lowest priority (“Level 3”).
The Company’s process to validate the market prices obtained from the outside pricing sources include, but are not limited to, periodic evaluation of model pricing methodologies and analytical reviews of certain prices. The Company also periodically performs back-testing of selected sales activity to determine whether there are any significant differences between the market price used to value the security prior to sale and the actual sale price.
Premiums receivable are presented net of an allowance for doubtful accounts of $550,000 and $204,000 at December 31, 2008 and 2007, respectively. The allowance for uncollectible amounts is based on an analysis of amounts receivable giving consideration to historical loss experience and current economic conditions and reflects an amount that, in management’s judgment, is adequate. Uncollectible agent’s balances of $361,000, $201,000 and $37,000 were written off in 2008, 2007, and 2006 respectively.
With respect to the business produced by TRM for other issuing carriers, agents collect premiums from the policyholders and forward them to TRM. In certain jurisdictions, when the insured pays premium for these policies to agents for payment to TRM, the premium might be considered to have been paid and the insured will no longer be liable to TRM for those amounts, whether or not TRM has actually received the premiums from the agent. Consequently, TRM assumes a degree of credit risk associated with agents and brokers. The Company recorded no losses in 2008, 2007 and 2006 for this activity.
Receivable-claims paid by agency represent claim payments due from issuing carriers to reimburse claims paid by TRM on their behalf in conjunction with claims administration services. The receivables are partially secured by funds held totaling $3.5 million and $4.8 million as of December 31, 2008 and 2007, respectively. As of December 31, 2008 and 2007, no reserve for uncollectible recoverables was recorded. During 2008, 2007 and 2006, no amounts relating to these receivables were written-off. See Note 12-Other Assets
The Company has recorded acquired identifiable intangible assets. In accounting for such assets, the Company follows Statement of Financial Accounting Standard No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). The cost of a group of assets acquired in a transaction is allocated to the individual assets including identifiable intangible assets based on their relative fair values. Identifiable intangible assets with a finite useful life are amortized over the period that the asset is expected to contribute directly or indirectly to the future cash flows of the Company. Intangible assets with an indefinite life and goodwill are not amortized and are subject to annual impairment testing. All identifiable intangible assets and goodwill are tested for recoverability whenever events or changes in circumstances indicate that a carrying amount may not be recoverable. No impairment losses were recognized in 2008, 2007 and 2006.
Although the Company owns less than 20% of the outstanding common stock of CastlePoint Holdings, Ltd. (“CastlePoint”), it records its investment in CastlePoint under the equity method of accounting as it is able to significantly influence the operating and financial policies and decisions of CastlePoint. The Company organized and sponsored CastlePoint with an initial investment of $15.0 million on February 6, 2006. The Company’s investment ownership as of December 31, 2008 was approximately 6.7% of CastlePoint after CastlePoint raised $249.9 million in a private placement stock offering in 2006 and $114.8 million in a public stock offering in 2007. This percentage does not include a warrant from CastlePoint to purchase an additional 1,127,000 shares of common stock which the Company received on April 6, 2006. See “Note 11-Investment in Unconsolidated Affiliate-CastlePoint.” As more fully described in “Note 25-Subsequent Events”, the Company acquired CastlePoint on February 5, 2009, at which time it became a wholly-owned subsidiary.
Pursuant to a Tax Sharing Agreement, each of the entities in the group are required to make payments to the parent 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) .
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and for operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
The Company manages its operations through two reportable segments: insurance (commercial and personal lines underwriting, reinsurance), and insurance services (managing general agency, claims administration and reinsurance intermediary operations). See “Note 24-Segment Information.”
One agent accounted for approximately 7%, 12% and 9%, respectively, of the Insurance Subsidiaries and TRM’s agents’ balances at December 31, 2008, 2007 and 2006. The same agent accounted for 10%, 11% and 11% of the Insurance Subsidiaries’ direct premiums written and TRM’s premiums produced in 2008, 2007 and 2006, respectively.
In September 2005, the Accounting Standards Executive Committee issued Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (SOP 05-1). SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. The adoption of SOP 05-1 effective January 1, 2007, did not have a material impact on the Company’s financial condition or results of operations.
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements,” (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosure about fair value measurements. It applies to other pronouncements that require or permit fair value but does not require any new fair value measurements. The statement defines fair value 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.” SFAS No. 157 establishes a fair value hierarchy to increase consistency and comparability in fair value measurements and disclosures. The hierarchy is based on the inputs used in valuation and gives the highest priority to quoted prices in active markets. The Company adopted the provisions of SFAS No. 157 on January 1, 2008, which did not have an effect on the Company’s consolidated financial condition or results of operation. See Note 5 for further financial statement disclosure required pursuant to SFAS 157.
requires that the tax benefit related to dividend equivalents paid on restricted stock, which are expected to vest, be recorded as an increase to additional paid-in capital. The Company currently accounts for this tax benefit as a reduction to income tax expense. EITF Issue No. 06-11 is to be applied prospectively for tax benefits on dividends declared in fiscal years beginning after December 15, 2007, and the Company adopted the provisions of EITF Issue No. 06-11 beginning in the first quarter of 2008. EITF Issue No. 06-11 did not have a material impact on the Company’s consolidated financial condition or results of operations.
In February 2008, the FASB issued FSP No. FAS 157-2, “Effective Date of FASB Statement No. 157” (“FSP FAS 157-2”) which delays the effective date of SFAS 157 to fiscal years beginning after November 15, 2008 for certain nonfinancial assets and nonfinancial liabilities. Examples of applicable nonfinancial assets and nonfinancial liabilities to which FSP FAS 157-2 applies include, but are not limited to:
Nonfinancial assets and nonfinancial liabilities initially measured at fair value in a business combination that are not subsequently remeasured at fair value;
As a result of the issuance of FSP FAS 157-2, the Company did not apply the provisions of SFAS 157 to the nonfinancial assets and nonfinancial liabilities within the scope of FSP FAS 157-2.
In October 2008, the FASB issued FSP No. FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP FAS 157-3”). This FSP clarifies the application of SFAS 157 in a market that is not active and provides an example to illustrate key considerations in the determination of the fair value of a financial asset when the market for that asset is not active. The key considerations illustrated in the FSP FAS 157-3 example include the use of an entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates, appropriate risk adjustments for nonperformance and liquidity risks, and the reliance that an entity should place on quotes that do not reflect the result of market transactions. FSP FAS 157-3 was preceded by a press release that was jointly issued by the Office of the Chief Accountant of the SEC and the FASB staff on September 30, 2008 that provides immediate clarification on fair value accounting based on the measurement guidance of SFAS 157. FSP FAS 157-3 and was effective upon issuance. The Company applied the guidance set forth in this FSP in determining the fair value of certain of its investments at December 31, 2008.
On April 10, 2007, the Company completed the acquisition of 100% of the issued and outstanding common stock of Preserver Group, Inc., a New Jersey corporation.
the intangible assets recognized in connection with the acquisition of Preserver. See Note 9-Goodwill for a discussion of the purchase price allocation.
At December 31, 2008 and 2007, U.S. Treasury Notes with carrying values of approximately $21.7 million and $19.4 million, respectively, were on deposit with various states to comply with the insurance laws of the states in which the Company is licensed.
Proceeds from the sale and maturity of fixed-maturity securities were $356.0 million, $199.6 million and $71.7 million in 2008, 2007 and 2006, respectively. Proceeds from the sale of equity securities were $6.5 million, $24.8 million and $1.0 million in 2008, 2007 and 2006, respectively. The Company’s gross realized gains and losses on investments are summarized as follows:
The Company regularly reviews its fixed-maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. In evaluating potential impairment, management considers, among other criteria: (i) the current fair value compared to amortized cost or cost, as appropriate; (ii) the length of time the security’s fair value has been below amortized cost or cost; (iii) 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; (iv) management’s intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in value to cost; (v) specific cash flow estimations for certain mortgage-backed securities and (vi) current economic conditions.
In reviewing specific cash flow estimations for certain mortgage-backed securities (other than those of high credit quality or sufficiently collateralized to ensure that the possibility of credit loss is remote), management follows the guidance of FSP EITF 99-20-1. Accordingly, on a quarterly basis, if significant changes in estimated cash flows compared with the cash flows previously estimated occur due to actual prepayment and
credit loss experience, and the present value of the revised cash flow is significantly less than the present value previously estimated, an other-than-temporary impairment (“OTTI”) is deemed to have occurred. OTTI losses are recorded in the statement of income as net realized losses on investments and result in a permanent reduction of 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.
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, 2008, 2007 and 2006. This resulted in recording impairment write-downs as part of net realized gains (losses) on investments indicated, and reduced the unrealized loss in other comprehensive loss.
The unrealized position associated with the fixed maturity portfolio included $57.5 million in gross unrealized losses, consisting of asset-backed and mortgage-backed securities representing 53.7%, corporate bonds representing 41.7% and municipal bonds representing 4.6% of the total. The total fixed maturity portfolio of gross unrealized losses included 410 securities which were, in aggregate, approximately 17.6% below amortized cost. Of the 410 investments evaluated, 114 have been in an unrealized loss position for more than 12 months. The total unrealized loss on these 114 investments at December 31, 2008 was $30.5 million. The Company does not consider these investments to be other-than-temporarily impaired.
The unrealized losses on the Company’s investments in preferred securities were primarily due to the market disruption caused by temporary market conditions. The Company evaluated all six preferred securities that were in an unrealized loss position as of December 31, 2008. These securities have been in an unrealized loss position for a period ranging from 18 to 23 months. The severity of the impairment in relation to the carrying amounts of preferred stock is between 27% to 32% for five of these securities, while the remaining security is impaired by 61%. The Company has the ability and the intent to hold these investments until a recovery of fair value. The Company does not consider these investments to be other-than-temporarily impaired.
The following tables stratifies, by securitized assets and all other assets, the length of time the gross unrealized losses in our portfolio at December 31, 2008, by duration in a loss position and magnitude of the loss as a percentage of the cost of the security,
On January 1, 2008, the Company adopted SFAS No. 157 regarding fair value measurements. The valuation technique used to fair value the financial instruments is the market approach which uses prices and other relevant information generated by market transactions involving identical or comparable assets.
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 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. Included in this valuation methodology are investments in certain mortgage-backed and asset-backed securities.
As at December 31, 2008, the Company’s investments are allocated among pricing input levels as follows:
The following table summarizes changes in Level 3 assets measured at fair value for the year ended December 31, 2008:
The following collateral is available to the Company for amounts recoverable from reinsurers as of December 31, 2008 and 2007:
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.
As of December 31, 2008, the Company’s estimated ultimate loss ratios attributable to these contracts are lower than the contractual ultimate loss ratios at which the minimum amount of ceding commissions can be earned. Accordingly, the Company has recorded ceding commissions earned that are greater than the minimum commissions. The relevant estimated ultimate loss ratios and commissions as of December 31, 2008 are set forth below for treaties that remain in effect as of December 31, 2008 ($ in millions):
The estimated ultimate loss ratios are the Company’s best estimate based on facts and circumstances known at the end of each period that losses are estimated. The estimation process is complex and involves the use of informed estimates, judgments and actuarial methodologies relative to future claims severity and frequency, the length of time for losses to develop to their ultimate level, possible changes in law and other external factors. The same uncertainties associated with estimating loss adjustment expense reserves affect the estimates of ceding commissions earned. The Company monitors and adjusts the ultimate loss ratio on a quarterly basis to determine the effect on the commission rate and ceding commissions earned. The increase (decrease) in estimated ceding commission income relating to prior years recorded in 2008, 2007 and 2006 was ($1.8) million and ($0.5) million and $1.1 million, respectively.
During 2008, 2007 and 2006, the Company recorded amortization expense, related to intangibles, of $1.2 million, $1.0 million and $0.4 million, respectively. The estimated aggregate amortization expense for each of the next five years is:
As of December 31, 2008 the Company performed its annual impairment testing and concluded that none of intangible assets were impaired.
The determination of goodwill as it relates to the Preserver acquisition in accordance with SFAS 141 is based upon the following:
The purchase price was allocated to balance sheet assets acquired (including identifiable intangible assets arising from the acquisition) and liabilities assumed based on their estimated fair value. The purchase price allocation of fair value to the acquired assets and liabilities was adjusted in December 2007 and March 2008 in finalizing the allocation of the purchase price. The December 2007 adjustment related to an adjustment to Preserver’s proportionate share of assets and liabilities relating to involuntary residual market plans. The March 2008 adjustment resulted from recording a deferred tax liability related to the intangible assets recognized in connection with the acquisition of Preserver.
Goodwill at December 31, 2008 and December 31, 2007 was $19.0 million and $13.3 million, respectively. The Company performs an annual impairment analysis to identify potential goodwill impairment and measures the amount of a goodwill impairment loss to be recognized. This annual test is performed at December 31 of each year or more frequently if events or circumstances change in a way that requires the Company to perform the impairment analysis on an interim basis. Goodwill impairment testing requires an evaluation of
For the years ended December 31, 2008 and 2007, the Company determined that no loss on impairment of goodwill had occurred.
The Company also acquired Preserver Group, Inc., which had fixed assets with an assigned fair value of $5.5 million on April 10, 2007.
In April 2007 and December 2007, the Company entered into two sale and leaseback arrangements of certain furniture and equipment in the aggregate amount of $1.3 million. The Company will lease the assets back under a 60 month lease arrangement at an annual cost of $0.3 million. The Company has an early buy-out option for both agreements on the date that is 48 months after the rent commencement date (April 2011 and December 2011) at rates equaling 32.88% and 32.76% of the original sales price. In addition, the Company has early termination options in October 2009 at a rate of 47.89% and June 2010 at a rate of 47.82% of the original sale price and must return the equipment to the lessor.
Ceded premiums written with CastlePoint Reinsurance were reduced by $31.7 million in the third quarter of 2008 as a result of the reduction of the quota share ceding percentage under the brokerage business quota share reinsurance agreement to 25% on all unearned premiums on policies in force as of July 1, 2008.
In addition, the Company entered into two aggregate excess of loss reinsurance agreements for the brokerage business with CastlePoint effective October 1, 2007. The purpose of the two aggregate excess of loss reinsurance agreements is to equalize the loss ratios for the brokerage business written by CastlePoint Insurance Company (“CPIC”) and the Company. Under the first agreement, TICNY reinsures approximately 85% (which percentage will be adjusted to equal Tower’s actual percentage of the total brokerage business written by the Company and CPIC) of CPIC’s brokerage business losses above a loss ratio of 52.5%. Under the second agreement, CPIC reinsures approximately 15% (which percentage will be adjusted to equal CastlePoint’s actual percentage of the total brokerage business written by the Company and CPIC) of the Company’s brokerage business losses above a loss ratio of 52.5%. For the years ended December 31, 2008 and 2007, the Company paid $3.0 million and $0.8 million to CPIC for reinsurance brokerage business written by the Company and received $3.0 million and $0.8 million from CPIC for business assumed which was produced by TRM as part of the brokerage business pool, respectively. The Company recorded $2.7 million and $0 million in net loss recoveries from the aggregate stop loss agreements with CPIC for the years ended December 31, 2008 and 2007, respectively.
The following table provides a reconciliation of the beginning and ending balances for unpaid losses and LAE for the years ended December 31, 2008, 2007 and 2006:
Loss and loss adjustment expense reserves. The reserving process for loss adjustment expense reserves provides for the Company’s best estimate at a particular point in time of the ultimate unpaid cost of all losses and loss adjustment expenses incurred, including settlement and administration of losses, and is based on facts and circumstances then known and including losses that have been incurred but not yet been reported. The process includes using actuarial methodologies to assist in establishing these estimates, judgments relative to estimates of future claims severity and frequency, the length of time before losses will develop to their ultimate level and the possible changes in the law and other external factors that are often beyond the Company’s control. The methods used to select the estimated loss reserves include the loss ratio projection, incurred loss projection, and the Bornhuetter-Ferguson (B-F) method. The process produces carried reserves set by management based upon the actuaries’ best estimate and is the result of numerous best estimates made by line of business, accident year, and loss and loss adjustment expense. The amount of loss and loss adjustment expense reserves for reported claims is based primarily upon a case-by-case evaluation of coverage, liability, injury severity, and any other information considered pertinent to estimating the exposure presented by the claim. The amounts of loss and loss adjustment expense reserves for unreported claims are determined using historical information by line of insurance as adjusted to current conditions. Since our process produces loss reserves set by management based upon the actuaries’ best estimate, there is no explicit or implicit provision for uncertainty in the carried loss reserves.
The Company has implemented two improvements in estimating LAE reserves. These two changes impacted costs to handle litigation for claims handled by the Company’s attorneys and costs to handle litigation for claims handled by attorneys who are not employed by the Company.
The Company segregates data for estimating loss reserves. Property lines include Fire, Homeowners, CMP Property, Multi-Family Dwellings and Auto Physical Damage. Casualty lines include CMP Liability, Other Liability, Workers’ Compensation, Commercial Auto Liability, and Personal Auto Liability. The actuarial methods used by segment have been consistent since the 2003 year-end review. During the year-end review the accident years are split into most recent, first prior and all other accident years. For the 2008 review the most recent accident year is 2008, the first prior is 2007, and all other accident years are 2006 and prior. The
The paid development, incurred development, the Bornhuetter-Ferguson (B-F) 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 and have been used consistently since 2003. The selected development factors within the paid and incurred development methods are derived from the Company’s data while the loss ratio method is used for the most recent accident year when there is high volatility in the development patterns. The B-F method combines the loss ratio method and the loss development method to determine loss reserves by adding an expected development (loss ratio times premium times percent unreported) to the case reserves.
Also, in New York State, lawsuits for negligence, subject to certain limitations, must be commenced within three years from the date of the accident or are otherwise barred. Accordingly, the Company’s exposure to IBNR for accident years 2003 and prior is limited although there remains the possibility of adverse development on reported claims. This is reflected by the loss development as of December 31, 2008 showing developed redundancies since 2003. However, there are no assurances that future loss development and trends will be consistent with its past loss development history, and so adverse loss reserves development remains a risk factor to the Company’s business.
Accounts payable, accrued liabilities and other liabilities consist of the following:
The Company has issued trust preferred securities through wholly-owned Delaware statutory business trusts. The trusts use the proceeds of the sale of the trust preferred securities and common securities that the Company acquires from the trusts to purchase a junior subordinated debenture from the Company with terms that match the terms of the trust preferred securities. Interest on the junior subordinated debentures and the trust preferred securities is payable quarterly. In some cases, the interest rate is fixed for an initial period of five years after issuance and then floats with changes in the London Interbank Offered Rate (“LIBOR”). In other cases the interest rate floats with LIBOR without any initial fixed-rate period. The principal terms of the outstanding trust preferred securities are summarized in the following table.
Three-month LIBOR plus 410 basis points (capped at 12.5% until May 15, 2008)
For the year ended December 31, 2008 and 2007, 10,697 and 9,900 shares, respectively, were issued to FBR or its employees in connection with the warrants referenced above.
In May 2004, the Company’s Board of Directors authorized the issuance of 131,888 shares of restricted Common Stock to the President and Chief Executive Officer and 8,793 shares of restricted Common Stock to the Senior Vice President, Chief Financial Officer and Treasurer. The shares vest in installments over a varying period from one to four years from the date of grant contingent upon continuous employment with the Company from the date of grant through the vesting date. During the vesting period, the recipients have voting rights and will receive dividends but the shares may not be sold, assigned, transferred, exchanged, pledged or otherwise encumbered. The fair value of the restricted shares was $1.6 million on the grant date. These restricted shares were authorized and issued prior to the adoption and approval of the 2004 Long-Term Equity Compensation Plan.
For the years ended December 31, 2008, 2007 and 2006, the Company incurred restricted stock expense of $1.3 million, $1.0 million and $0.6 million, respectively, net of tax that was included in net income.
Changes in restricted stock for the three years ended December 31, 2008 were as follows:
Options outstanding and exercisable as of December 31, 2008 are shown on the following schedule:
The fair value of the 2004 options granted was estimated using the Black-Scholes pricing model as of September 29, 2004, the date of the initial grant, with the following weighted average assumptions: risk free interest rate of 3.8%, dividend yield of 1.2%, volatility factors of the expected market price of the Company’s common stock of 30.6% and a weighted-average expected life of the options of 7 years.
The Company adopted the provision of SFAS No. 123(R) effective January 1, 2006 and has elected the modified prospective application method and is expensing all unvested stock options outstanding as of January 1, 2006. The compensation expense is recognized over the requisite service period that has not been
Compensation expense net of tax recorded related to stock options was $49,900, $67,700 and $62,800 for 2008, 2007 and 2006, respectively, and has been included in net income.
Deferred tax assets and liabilities are determined using the enacted tax rates applicable to the period the temporary differences are expected to be recovered. Accordingly, the current period income tax provision can be affected by the enactment of new tax rates. The net deferred income taxes on the balance sheet reflect temporary differences between the carrying amounts of the assets and liabilities for financial reporting
Preserver, which was acquired by the Company on April 10, 2007, has tax loss carryforwards and other tax assets that the Company believes will be used in the future, subject to change of ownership limitations pursuant to Section 382 of the Internal Revenue Code and to the ability of the combined post-merger company to generate sufficient taxable income to use the benefits before the expiration of the applicable carryforward periods.
Section 382 imposes limitations on a corporation’s ability to utilize its net operating loss carry forwards (NOL) if it experiences an “ownership change.” In general terms, an ownership change results from transactions increasing the ownership of certain stockholders in the stock of a corporation by more than 50 percentage points over a three-year period. As a result of the acquisition, Preserver underwent an ownership change. Use of Preserver’s NOL of $43.7 million is subject to an annual limitation under Section 382 determined by multiplying the value of Preserver’s stock at the time of purchase by the applicable long-term rate resulting in an annual limitation amount of approximately $2.8 million. Any unused annual limitation may be carried over to later years. The NOL balance has been adjusted to reflect the finalization of filing Preserver income tax returns with the IRS.
Tax years 2004 through 2007 are subject to examination by the federal authorities who are currently performing an audit of the 2006 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 Company maintains a defined contribution Employee Pretax Savings Plan (401(k) Plan) for its employees. The Company matches 50% of each participant’s contribution up to 8% of the participant’s eligible contribution. The Company incurred approximately $1.3 million, $1.0 million and $0.8 million of expense in 2008, 2007 and 2006, respectively, related to the 401(k) SERP Plan.
Total rental expense charged to operations was approximately $3.8 million, $4.3 million and $3.8 million in 2008, 2007 and 2006, respectively.
Certain assets including certain receivables, a portion of the net deferred tax asset, prepaid expenses and furniture and equipment are not admitted.
Statement of Financial Accounting Standards No. 107, “Disclosures about Fair Value of Financial Instruments” requires all entities to disclose the fair value of financial instruments, both assets and liabilities recognized and not recognized in the balance sheet, for which it is practicable to estimate fair value. The company uses the following methods and assumptions in estimating its fair value disclosures for financial instruments:
Investment in unconsolidated affiliate: Investment in unconsolidated affiliates is an investment in related parties; and is reported using the equity method. As of December 31, 2008 the aggregate fair value of the Company’s investment in the common stock of CastlePoint Holdings Ltd. was $34.6 million.
The Company changed its presentation of its business results in the first quarter of 2008, by combining its previously reported reinsurance segment with its insurance segment based on the way management organizes the segments for making operating decisions and assessing profitability. This results in reporting two segments: insurance (commercial and personal lines underwriting) and insurance services (managing general agency, claim administration and reinsurance intermediary operations). The prior period segment disclosures have been restated to conform to the current presentation. The Company considers many factors in determining reportable segments including economic characteristics, production sources, products or services offered and regulatory environment.
multiple-peril, monoline general liability, commercial umbrella, monoline property, workers’ compensation and commercial automobile policies. Its personal lines products consist of homeowners, dwelling and other liability policies. TICNY also assumes reinsurance directly from TRM’s issuing companies excluding CPIC or indirectly from reinsurers that provide reinsurance coverage directly to the issuing companies.
The insurance services segments direct commission revenue is from three issuing carriers, including CPIC. Other than CPIC, each issuing carrier provides less than 10% of the Company’s consolidated total revenues. Although this segment is dependent upon three issuing carriers, it is management’s opinion that the loss of one or both can be remedied by replacement issuing carriers. There is no intercompany commission revenue in the insurance services segment.
On February 5, 2009, the Company completed the acquisition of 100% of the issued and outstanding common stock of CastlePoint Holdings Ltd. (“CastlePoint”), a Bermuda exempted corporation, pursuant to the stock purchase agreement (“the Agreement”), dated as of August 4, 2008, by and among the Company, and CastlePoint. The acquisition will be accounted for using the purchase method in accordance with SFAS No. 141R, “Business Combinations” (“SFAS 141R”). Under the terms of the Agreement, the Company acquired CastlePoint for approximately $489.5 million comprised of 16,802,845 shares of Tower common stock with an aggregate value of approximately $419.7 million, plus $65.4 million of cash. The purchase consideration also includes the fair value of the warrants held by Tower of approximately $4.4 million which were surrendered unexercised as part of the merger agreement and is presented as follows:
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 agents in the United States. Reinsurance is an arrangement by which one insurance company, called the reinsurer, agrees to indemnify another insurance (or reinsurance) company, called the ceding company, against all or a portion of the insurance (or reinsurance) risks underwritten by the ceding company under one or more policies. Program underwriting agents 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, Tower expects to expand and diversify its source of revenue by accessing CastlePoint’s programs, risk sharing and reinsurance businesses.
Tower will begin to consolidate the financial statements as of the closing date and in accordance with SFAS 141R, the purchase consideration will be 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. Direct costs of the acquisition are accounted for separately from the business combination and are expensed as incurred. As the values of certain assets and liabilities are preliminary in nature, they are subject to adjustment as additional information is obtained, including, but not limited to, valuation of separately identifiable intangibles, fixed assets, and deferred taxes. The valuations will be finalized within 12 months of the close of the acquisition. When the valuations are finalized, any changes to the preliminary valuation of assets acquired or liabilities assumed may result in adjustments to separately identifiable intangibles and goodwill.
In connection with recording the acquisition, Tower will revalue its investment in CastlePoint, which will result in a gain expected to be in the range of $9 million to $11 million, before income taxes. This gain will be included in the Statement of Income in the first quarter of 2009. Tower has incurred approximately $12 million of transaction costs, including legal, accounting and other costs directly related to the acquisition, which will be expensed in the first quarter of 2009. Management expects to record goodwill arising from the acquisition in the range of $145 to $155 million. The goodwill consists largely of the synergies and economies of scale expected from combining the operations of Tower and CastlePoint.
Under SFAS 142, the Company is required to allocate goodwill to its reportable segments in accordance with FASB No. 131, “Disclosures About Segments of an Enterprise and Related Information.” Management is currently reviewing the assignment of goodwill related to the acquisition of CastlePoint to its reporting segments and reporting units.
The Company and CastlePoint have incurred approximately $2.1 million of transaction costs, including legal, accounting and other costs directly related to the acquisition, which will be expensed in the first quarter of 2009. The Company expects to record goodwill arising from the acquisition in the range of $15 to $20 million. The goodwill consists largely of the synergies and economies of scale expected from combining the operations of the Company and Hermitage.
Under SFAS 142, the Company is required to allocate goodwill to its reportable segments in accordance with FASB No. 131, “Disclosures About Segments of an Enterprise and Related Information.” The Company is currently reviewing the assignment of goodwill related to the acquisition of Hermitage to its reporting segments and reporting units.