During the fourth quarter of 2004, we established two branch offices. The first was in Melville, New York (Long Island Branch) for 17,127 square feet of space at 225 Broadhollow Road, Melville, New York. We entered into a sublease agreement for this property from April 15, 2005 until September 30, 2006 and entered into a lease agreement for the same property for the period commencing October 1, 2006 and ending on December 15, 2015 The second branch was for 4,900 square feet of temporary space in Buffalo, New York (Buffalo Branch).
The selected consolidated income statement data for the years ended December 31, 2005, 2004 and 2003 and the balance sheet data as of December 31, 2005 and 2004 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., our independent registered public accounting firm. The selected consolidated income statement data for the years ended December 31, 2001 and the balance sheet data as of December 31, 2002, 2001 are derived from our unaudited financial statements. These historical results are not necessarily indicative of results to be expected from any future period. You should read the following selected consolidated financial information along with the information contained in this document, including “
We manage these operations through three business segments: insurance (commercial and personal lines underwriting), reinsurance, and insurance services (managing general agency, claims administration and reinsurance intermediary operations).
On March 25, 2005, we closed on our purchase of the outstanding common stock of a shell insurance Company, North American Lumber Insurance Company (“NALIC”), that was renamed Tower National Insurance Company. The purchase price was for $1,050,000 and included nine active state licenses and two inactive state licenses. The nine active states licenses are for New Jersey, Connecticut, Massachusetts, Rhode Island, Vermont, Maryland, Delaware, South Carolina and Wisconsin. The two inactive states are Pennsylvania and Maine. The inactive state licenses have an additional contingent purchase price of $75,000 per state payable upon license reactivation within one year of the closing. Prior to the closing, all liabilities and assets (other than insurance licenses) of Tower National Insurance Company were transferred to a liquidating trust. We capitalized this purchase as an intangible asset related to state licenses with an indefinite life subject to annual impairment testing. On July 25, 2005, the license for Pennsylvania was reactivated and the additional contingent purchase price of $75,000 was paid. In December 2005, the license for Maine was reactivated and the additional contingent purchase price of $75,000 was paid. The total amount capitalized as of December 31, 2005, was $1,303,000 and included the purchase price, legal fees and a broker’s fee. As of December 31, 2005, Tower National Insurance Company was authorized to write business in sixteen states.
The property and casualty insurance industry is affected by naturally occurring industry cycles known as “hard” and “soft” markets. Since we began operations in 1990 and continuing into 2000, we operated in a soft market cycle, generally considered an adverse industry cycle in the property and casualty insurance industry. A soft market cycle is characterized by intense competition that results in inadequate pricing, expanded coverage terms and increased commissions paid to distribution sources in order to compete for business. We believe that a hard market began sometime in late 2000. A hard market, generally considered a beneficial industry trend, is characterized by reduced competition that results in higher pricing, reduced coverage terms and lower commissions paid to acquire business.
Beginning in late 2004 and in the first half of 2005, segments of both the reinsurance and commercial lines market started to exhibit signs of a softening market. The market softening was slowed by the effects of hurricanes Katrina, Rita and Wilma. According to A.M. Best, these catastrophic hurricanes in the Gulf states of the United States caused an estimated $60 billion of insured losses for the insurance and reinsurance industries and triggered the raising of an estimated $20 billion of new reinsurance capital or capacity in 2005.
commercial accounts, that are our focus, have not experienced the increased competition and price softening as in the larger accounts.
A.M. Best estimates that the industry wide change in net premiums written in the property casualty industry was 0.7% in 2005 compared to 4.7% in 2004 and is estimated to be 3.3% in 2006. The change in industry policyholders’ surplus as estimated by A.M. Best was 6.2% in 2005 compared to 13.6% in 2004 and is estimated to be 8.0% in 2006. In addition, in 2005, A.M. Best estimated new capital or capacity of $20 billion was raised by the property casualty insurance and reinsurance industry. This additional underwriting capacity may result in increased competition from other insurers in order to generate an adequate return on capital or cause a shift in focus by some insurers to maintaining market share at the expense of underwriting discipline. These factors could lead to a significant reduction in premium rates and less favorable policy terms. However, we believe that premium levels remain relatively attractive in the sizeable underserved market segments where we can continue to maintain underwriting discipline and selectivity in low hazard classes of business, as well as adequate pricing and coverage terms. Additionally, our broad product line platform allows us to achieve an optimal business mix in response to varying market conditions.
· Other operating expenses. Other operating expenses consist of other underwriting expenses related to TICNY’s underwriting operations in our insurance and reinsurance segments and other insurance services expenses related to our managing general agency and reinsurance intermediary operations conducted through TRM in our insurance services segment. Other underwriting expenses consist of general administrative expenses such as salaries, rent, office supplies, depreciation and all other operating expenses not otherwise classified separately and boards,
We use various measures to analyze the growth and profitability of our three business segments. In the insurance and reinsurance 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 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 TICNY’s net premiums earned. On a consolidated basis, we measure profitability in terms of net income and return on average equity.
Premiums written. We use gross premiums written to measure our sales of insurance products and, in turn, our ability to generate ceding commission revenues from premiums that we cede to reinsurers. Gross premiums written also correlates to our ability to generate net premiums earned.
Combined ratio. We use the combined ratio to measure our underwriting performance. The combined ratio is the sum of the loss ratio and the underwriting expense ratio. We analyze the combined ratio on a gross (before the effect of reinsurance) and net basis (after the effect of reinsurance). If the combined ratio is at or above 100%, an insurance company is not underwriting profitably and may not be profitable unless investment income is sufficient to offset underwriting losses.
The net loss reserves for the most recent accident years on a consolidated basis as of December 31, 2005 were $76.1 million for accident year 2005 and $12.7 million for accident year 2004. A 5% deficiency in net reserves for these years would impact our income before income taxes by $3.8 million and $0.6 million for accident years 2005 and 2004, respectively.
Ceding commission 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 increases, the commission rate decreases, which reduces ceding commissions earned. As a result, the same uncertainties associated with estimating loss and loss adjustment expense reserves affect the estimates of ceding commissions earned. We monitor the ceded ultimate loss ratio on a quarterly basis to determine the effect on the commission rate of the ceded premiums earned that we accrued during prior accounting periods. The estimated ceding commission income relating to prior years recorded in 2005, 2004 and 2003 was a decrease of $1.2 million, an increase of $1.7 million and an increase of $1.3 million, respectively.
credit. In addition, since October 2003, we have placed our new quota share treaties on a “funds withheld” basis, under which TICNY retains the ceded premiums written and places that amount in segregated trust accounts from which TICNY may withdraw amounts due to it from the reinsurers. Tokio Millennium Re Ltd., a reinsurer under the October 1, 2003 quota share treaty, posted a letter of credit at December 31, 2003 and replaced it with a Regulation 114 trust during the first quarter of 2004. At December 31, 2005 approximately 62.6% of our reinsurance recoverables were collateralized. As of December 31, 2005, we had unsecured reinsurance recoverables and ceding commissions receivable totaling $33.2 million owed by PXRE Reinsurance Company. On February 16, 2006, A.M. Best downgraded to “B++”(Very Good) its former “A-”(Excellent) financial strength rating on PXRE and issued a negative outlook. On February 24, 2006 A.M. Best downgraded PXRE to “B+”(Very Good) with a negative outlook. We believe that the unsecured reinsurance recoverables and ceding commissions receivable from PXRE, none of which are past due nor in dispute, are fully collectible. Our judgment is based primarily on PXRE’s capital position as a result of its recent capital raising initiatives.
Investments. In accordance with our investment guidelines, our investments consist largely of high-grade marketable fixed maturity securities. Investments are carried at estimated fair value as determined by quoted market prices or recognized pricing services at the reporting date for those or similar investments. Equity investments carried at cost include private placement real estate investment trusts (REITs) that are not publicly traded and common shares of a closed-end management investing company investing in predominately asset-backed and mortgage-backed securities. Changes in unrealized gains and losses on our investments, net of any deferred tax effect, are included as an element of other comprehensive income, and cumulative unrealized gains and losses are included as a separate component of stockholders’ equity. Realized gains and losses on sales of investments are determined on a specific identification basis. In addition, unrealized depreciation in the value of individual securities that management considers to be other than temporary is charged to income in the period it is determined. Investment income is recorded when earned and includes the amortization of premium and discounts on investments.
Impairment of invested assets. Impairment of investment securities results in a charge to income when a market decline below cost is deemed to be other than temporary. We regularly review our fixed maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other than temporary declines in the fair value of investments. In general, we focus our attention on those securities whose fair value was less than 80% of their amortized cost or cost, as appropriate, for six or more consecutive months. In evaluating potential impairment, we consider, among other criteria: the current fair value compared to amortized cost or cost, as appropriate; the length of time the security’s fair value has been below amortized cost or cost; our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in value; specific credit issues related to the issuer; and current economic conditions. Other than temporary impairment losses result in a permanent reduction of the cost basis of the underlying investment. There were no other than temporary declines in the fair value
Intangible assets and potential impairment. The costs 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 which the asset is expected to contribute directly or indirectly to the future cash flows of the Company. 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 2005, 2004 and 2003. 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 6.- Intangible Assets” in the notes to our audited financial statements.
Premiums earned. Net premiums earned increased by 260.9% to $164.4 million in 2005 compared to $45.6 million in 2004. The increase in net premiums earned was due to the overall increase in gross premiums written through December 31, 2005 and a reduced ceding percentage under our quota share
reinsurance agreement from 60% to 25% beginning October 1, 2004 which was maintained throughout 2005. In addition, the net premiums earned in 2005 included all of the $13.1 million of unearned premiums as of December 31, 2004 that would have been ceded to Converium Reinsurance (North America) Inc. “Converium” absent a novation of our reinsurance agreement in 2004. See “Item 7 - -Insurance Segment Results of Operations” and “Reinsurance Segment Results of Operations” for further discussion of premiums.
Commission and fee income. Total commission and fee income decreased by 29.5% to $40.2 million in 2005 compared to $57.0 million in 2004. This decrease was due principally to a 36.9% decrease in ceding commission revenue in 2005 as a result of a reduced ceding percentage under our quota share reinsurance agreement to 25% for the full year of 2005 compared to 60% in the first nine months of 2004 and 25% for the last three months of 2004. Our quota share reinsurance agreements contain provisions whereby the ceding commission rates vary based on the loss experience of the underlying policies. The Company records ceding commission revenue based on its current estimate of losses and adjustments to the ceding commission revenue are recorded in the period that the ceded losses are re-estimated. For 2005 the change in the estimated sliding scale commission rate for commissions earned in prior periods in both the Insurance Segment and the Insurance Services Segment resulted in a net reduction of $1.2 million of commission and fee income in 2005 compared to a net increase in ceding commission and fee income of $1.7 million in 2004.
There was no impact on net realized gains attributable to adjustments for other than temporary impairment of securities held in 2005 and 2004.
December 2004 and $0.3 million credited to reinsurers on funds withheld in segregated trusts as collateral for reinsurance recoverables. This increase was offset by reductions of $0.6 million of interest expense on other borrowings and preferred stock repaid in the fourth quarter of 2004.
Total revenues. Total revenues increased by 44.2% in 2004 to $107.7 million compared to $74.7 million in 2003. The increases were primarily due to the increase in net earned premiums, ceding commission and fee income as well as investment income. Net earned premium represented 42.3% of total revenues for 2004 compared to 30.7% in 2003. Ceding commission and fee income represented 53.0% of total revenue in 2004 compared to 65.6% in 2003. Net investment income, excluding realized capital gains, represented 4.7% and 3.0% of total revenue for 2004 and 2003, respectively.
Premiums earned. Net premiums earned in 2004 increased by 98.6% to $45.6 million compared to $22.9 million in 2003. The increase in net premiums earned was due to the overall increase of 32.2% in gross premiums written in 2004 and to our decision to cede less business in 2004 than 2003. See “Item 7.-Insurance Segment Results of Operations” and “Reinsurance Segment Results of Operations” for a discussion of premiums and total commissions and fee income.
Interest expenses. Our interest expense increased in 2004 to $3.1 million compared to $1.5 million in 2003. The increase resulted from an increase in interest of $1.0 million on subordinated debentures underlying our trust preferred securities issued in December, 2004 for $26.8 million and $20.6 million issued in 2003. In addition, $1.1 million of interest expense was incurred as a result of crediting reinsurers on funds withheld in segregated trusts as collateral for reinsurance recoverables effective January 1, 2004 with an annual effective yield of 2.5%. Lastly, we had an aggregate of $6.0 million of other borrowings issued in February and December 2003 that were repaid in 2004 and we recognized a loss on early extinguishment of debt of $133,000 in the fourth quarter of 2004. These increases in interest expense were offset by a $0.5 million reduction in interest on surplus notes repaid in 2003.
Income tax expense. Our income tax expense in 2004 was $5.7 million compared to $3.4 million in 2003. The increased income tax in 2004 was due primarily to an increase in income before income taxes. The effective income tax rate was 38.7% in 2004 compared to 34.9% in 2003. The effective tax rates were affected by TRM’s pre-tax profits which are subject to state income taxes. See “Note 11. Income Taxes”.
Net premiums. Net premiums written increased by 117.9% to $210.4 million in 2005 compared to $96.6 million in 2004. Net premiums earned in 2005 increased by 266.7% to $162.9 million compared to $44.4 million in 2004. Net premiums earned in 2005 included the entire $13.1 million of retained unearned premiums as of December 31, 2004 that would have been ceded to Converium. absent a novation of the reinsurance agreement in 2004. These percentage increases were greater than the percentage increase in gross premiums written and earned due to the decrease in the ceding percentage from 60% in the first nine months of 2004 to 25% beginning October 1, 2004 and continuing throughout 2005.
Loss and loss adjustment expenses and loss ratio. Gross and net losses and loss adjustment expenses were $134.8 million and $95.7 million, respectively, for 2005 compared with $84.8 million and $27.8 million, respectively, in 2004. Our gross and net loss ratios were 57.1% and 58.7%, respectively for 2005 as compared with 56.1% and 62.5%, respectively, in 2004. The decrease in the net loss ratio in 2005 compared to 2004 resulted from the increase in net premiums earned which reduced the effect of catastrophe
reinsurance premiums on the net loss ratio. We ceded catastrophe reinsurance premiums equal to 2.5% of net premiums earned during 2005 compared to 8.6% during the same period in 2004. There was favorable development from prior years’ loss reserves on both a gross and net basis of approximately $461,000 and $392,000, respectively, in 2005. There was $568,000 adverse development from prior years’ loss reserves on a net basis in 2004. Loss and loss adjustment expenses are net of reimbursements for loss adjustment expenses made by TRM pursuant to the expense sharing arrangement between TICNY and TRM. See “Insurance Services Segment Results of Operations” for the amounts of loss and loss adjustment expense reimbursements.
The underwriting expense portion of the gross expense ratio was 14.6% in 2005 as compared to 14.4% in 2004. The increase in underwriting expenses was the result of the costs related to the OneBeacon transaction, including establishing two new offices in Long Island and Western New York, additional staffing and an increase in insurance regulatory assessments.
The net underwriting expense ratio was 29.4% in 2005 as compared to 16.1% in 2004. This increase was due primarily to the reduced effects of ceding commission revenue on lowering the gross expense ratio as a result of the reduction in the quota share ceding percentage from 60% in the first nine months of 2004 to 25% beginning October 1, 2004 and continuing throughout 2005.
percentage was 41.6% in 2004 that also included a $13.1 million reduction to ceded written premiums from the retention of the unearned premium at December 31, 2004 that would have been ceded to Converium Re North America. Following the downgrade of Converium Reinsurance (North America) Inc.’s rating and decision by its parent to place that Company into runoff in September 2004, we terminated and novated Converium’s participation under its 2004 quota share treaty and decided to retain the ceded unearned premiums that would have been ceded to Converium absent the termination. Excluding the $13.1 million that we retained, the effective quota share ceding percentage would have been 49.1% in 2004. See “Note 5. Reinsurance-Converium” and “Item 1.-Reinsurance-2004 Reinsurance Program” for a further discussion. Despite the reduction in ceded premiums written, ceded premiums earned increased by 8.8% in 2004 resulting from the effect of earning ceded premiums that were written in 2003 and during the first nine months of 2004 under higher quota share ceding percentages as explained above.
Net premiums. Net premiums written in 2004 increased by 245.4% to $96.6 million compared to $28.0 million in 2003. This increase was greater than the increase in gross premiums written due to the decrease in the effective ceding quota share percentage from 77.2% in 2003 to 41.6% in 2004 which includes the effect of retaining $13.1 million that was not ceded to Converium as discussed above. Net premiums earned, which was not affected by the Converium novation, increased by 98.6% to $44.4 million in 2004 compared to $22.4 million in 2003. Only 46.0%, or $44.4 million of the net premiums written was earned in 2004, compared to 80.0% or $22.4 million earned in 2003. This lower earned percentage in 2004 reflects the lag in premiums written and earned resulting from the growth in premiums written caused by the significant reduction in the quota share ceding percentage.
Ceding commission revenue. Ceding commission revenue in 2004 increased by 13.2% to $40.0 million compared to $35.3 million in 2003. Despite the reduction in the quota share ceding percentage, ceding commission revenue increased as a result of an 8.8% increase in ceded premiums earned. Additionally, we experienced an improvement in the ceded loss ratios on prior years’ quota share treaties, which increased ceding commission revenue by $1.7 million in 2004 and $1.3 million 2003.
Loss and loss adjustment expenses and loss ratio. Gross and net losses and loss adjustment expenses in 2004 were $84.8 million and $27.8 million, respectively, compared with $73.4 million and $14.7 million, respectively, in 2003. Our gross and net loss ratios were 56.1% and 62.5%, respectively, in 2004 as compared to 60.9% and 65.7%, respectively, in 2003. The decrease in the net loss ratio in 2004 as compared to 2003 was due primarily to an increase in net premiums earned that reduced the effect of excess and catastrophe reinsurance premiums on the net loss ratio. We ceded excess and catastrophe reinsurance premiums equal to 15.8% of net premiums earned during 2004 compared to 25.0% in 2003. There was $568,000 adverse development from prior years’ reserves on a net basis in 2004 compared to $50,000 on a net basis in 2003 for the insurance segment. 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 and TRM. See “Item 7.-Insurance Services Segment Results of Operations” for the amounts of claims reimbursements.
including establishing two new offices in Long Island and Western New York, additional staffing of key positions in preparation for a public Company environment, and an increase in regulatory assessments.
Underwriting profits and combined ratio. The underwriting profit reflects our underwriting results on a net basis after the effects of reinsurance. The underwriting profit in 2004 increased by 45.0% to $9.6 million from $6.6 million in 2003. The net combined ratio was 78.6% in 2004 as compared with 70.6% in 2003. The increase in the net combined ratio resulted from an increase in the net expense ratio, which was primarily due to the effects of reduced ceding commission revenue in lowering gross expenses. Notwithstanding the increase in the net combined ratio, underwriting profits increased due to the overall increase in net premiums earned.
Net premiums. Net premiums written decreased 9.5% to $1.3 million in 2005 as compared to $1.5 million in 2004. However, net premiums earned increased by 34.1% to $1.5 million in 2005 as compared to $1.1 million in 2004 as a result of a 27.7% increase in gross premiums earned. The increase in gross
premiums earned resulted from an increase in premiums written in the later part of 2004 and earned in 2005.
Gross premiums. Gross written premiums written increased by 31.3% to $1.6 million in 2004 as compared to $1.2 million in 2003. The increase was due to an increase in the premiums produced by TRM’s issuing companies as well as higher rates charged on reinsurance assumed from these issuing companies. In 2003 our reinsurance assumed was converted from a pro rata reinsurance basis to an excess of loss basis, which significantly reduced the amount of premiums assumed although treaties written in 2002 still contributed somewhat to gross earned premiums in 2003.
Ceded premiums earned decreased by 82.1% to $162,000 in 2004 compared to $906,000 in 2003 because we no longer cede premiums in this segment to our quota share treaty reinsurers.
Net premiums written increased 50.7% to $1.5 million compared with $1.0 million in 2003 due to the increase in gross premiums written. Net premiums earned increased by 97.4% to $1.1 million in 2004 as compared with $0.6 million in 2003 as a result of the increase in net written premiums and the discontinuation of ceding premiums to our quota share treaty reinsurers.
Loss and loss adjustment expenses and loss ratio. The gross and net loss and loss adjustment expenses in 2004 were a benefit of $0.7 million compared to a $0.8 million and $0.4 million expense, respectively, in 2003. Our gross and net loss ratios were negative 52.0% and negative 60.9%, respectively in 2004 compared to 52.8% and 64.7% in 2003. The improvement in the loss ratios in 2004 resulted from the full
conversion of the current treaties to an aggregate excess of loss basis with improved pricing on the current treaties, improvement in the loss experience of the underlying business and favorable development of prior years’gross and net reserves of $0.7 million.
The gross combined ratio decreased to a negative 33.0% in 2004 compared to 67.1% in 2003 due to a reduction in the gross loss ratio to negative 52.0% in 2004 compared to 52.8% in 2003. This was offset by an increase in the gross underwriting expense ratio to 19.1% in 2004 compared to 14.3% in 2003 due to increased gross written premiums which is the basis for the allocation of underwriting expenses to this segment.
(1) The reinsurance intermediary fees include commissions earned for placement of reinsurance on behalf of TICNY.
Total revenues. Total revenues for the insurance services segment were $14.1 million in 2005 as compared with $16.4 million in 2004. The decrease in total revenues was primarily due to a 20.8% reduction in direct commission revenue to $9.1 million in 2005 compared to $11.5 million in 2004 and to a
Pre-tax income. Despite a reduction in premiums produced, pre-tax income in 2005 increased by 45.6% to $2.8million as compared to $2.0 million in 2004 primarily due to an increase in the direct commission revenue rate in 2005 compared to 2004.
Total Revenues. Total revenues in 2004 increased by 27.7% for the insurance services segment to $16.4 million compared to $12.8 million in 2003. The increase in total revenue was primarily due to direct commission revenue that increased by 44.6% to $11.5 million in 2004 as compared to $8.0 million in 2003 and claims administration revenue that increased by 9.6% to $4.1 million in 2004 from $3.7 million in 2003. The increase in revenue from direct commission revenue and claims administration revenue was offset by a reduction in reinsurance intermediary fees, which decreased by 33.6% to $0.7 million in 2004 as compared with $1.1 million in 2003. The reduction in reinsurance intermediary fees was primarily a result of lower ceded premiums in the insurance segment in 2004 and additional reinsurance intermediary fees recorded in 2003 pertaining to reinsurance arrangements in 2002.
The following table provides a breakdown of the amortized cost, aggregate fair value and unrealized gains and losses by investment type as of December 31, 2005 and December 31, 2004 including estimated fair values for equity securities carried at cost.
We are organized as a holding company with three operating company subsidiaries, TICNY, TNIC and TRM. The holding Company’s principal liquidity needs include interest on debt, income taxes and stockholder dividends. The holding Company’s principal sources of liquidity include dividends from TICNY, TNIC and TRM and other permitted payments from our subsidiaries, as well as financing through borrowings and sales of securities.
Under New York law, TICNY is limited in the amount of dividends it can pay to Tower. Under New York law, TICNY may pay dividends to Tower only out of statutory earned surplus. In addition, the New York Insurance Department must approve any dividend declared or paid by TICNY that, together with all dividends declared or distributed by TICNY during the preceding twelve months, exceeds the lesser of (1) 10% of TICNY’s policyholders’ surplus as shown on its latest statutory financial statement filed with the New York State Insurance Department or (2) 100% of adjusted net investment income during the preceding twelve months. TICNY declared approximately $2,050,000, $850,000, and $364,000 in dividends to Tower in 2005, 2004, and 2003, respectively. As of December 31, 2005, the maximum distribution that TICNY could pay without prior regulatory approval was approximately $4.0 million.
In addition, TNIC my not pay any dividend that, together with all dividends declared or distributed by TNIC during the preceding twelve months, excluding pro rata distributions of any class of the TNIC’s own securities, exceeds the greater of (1) 10% of TNIC’s policyholders’ surplus as of the end of the preceding calendar year or (2) TNIC’s net income for the next preceding calendar year, until thirty days after the Commissioner has received notice of the intended dividend and not objected in such time. Because TNIC has not yet commenced insurance operations it has no positive retained earning (or unassigned surplus) and therefore it may not pay dividends at this time without the approval of the Massachusetts Commissioner of Insurance.
Pursuant to a Tax Allocation Agreement, dated as of January 1, 2001, by and among Tower, TICNY,TNIC and TRM, 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 with allows Tower to make certain Code elections in the consolidated Federal tax return. In the event such Code elections are made, any benefit or liability is accrued or paid by each entity. If a unitary or combined state income tax return is filed, each entity’s share of the liability is based on the methodology required or established by state income tax law or, if none, the percentage of each entity’s separate income or tax divided by the total separate income or tax reported on the return. During 2005, TICNY paid $10.0 million and TRM paid $0.7 million to Tower under this agreement.
Immediately before the closing of the IPO on October 26, 2004, the Company redeemed 30,000 shares of our Series A Cumulative Redeemable Preferred Shares for $1.5 million plus accrued interest. After the closing the Company utilized some of the cash proceeds to pay off a $5.0 million loan and accrued interest to CIT Group/Equipment Financing, Inc. The Company recognized a loss on early extinguishment of debt of $133,000 in the fourth quarter of 2004.
On October 26, 2004 we contributed $98,000,000 in Paid in Capital to TICNY, which in turn invested this cash in its fixed-income portfolio.
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 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, throughout our history before the October 2004 IPO we attempted to reduce our statutory surplus requirement by limiting our net retention of premiums while emphasizing ceding commissions and non-risk bearing revenues from TRM.
The primary sources of cash flow in TICNY are gross premiums written, reinsurance commissions from our quota share reinsurers, loss payments by our reinsurers, investment income and proceeds from the sale or maturity of investments. Funds are used by TICNY for ceded premium payments, which are paid on a net basis after subtracting losses paid on reinsured claims and reinsurance commissions. TICNY also uses 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 premiums produced on behalf of issuing companies and commission and fee income. TRM’s primary uses of cash are premium payments and fees to issuing companies, net of paid losses and commission income, commissions to producers and expenses reimbursed to TICNY under an expense sharing agreement.
TNIC’s primary sources of cash flow are from net investment income in that underwriting operations have not commenced as of December 31, 2005.
Net cash used by investing activities was $143.3 million for the year ended December 31, 2005 compared to $177.0 in 2004 due principally to the investment in securities with cash provided by operations.
We maintain sufficient liquidity to pay claims, operating expenses and meet our other obligations. We held $38.8 million and $55.23 million of cash and cash equivalents at December 31, 2005 and 2004, respectively, which included $26.1 and $34.9 million, respectively, which were of short-term duration of less than ninety days and were recorded as cash equivalents on the balance sheet. We monitor our expected claims payment needs and maintain a sufficient portion of our invested assets in cash and cash equivalents to enable us to fund our claims payments without having to sell longer-duration investments. As of
The net loss reserves payments due by period in the table above are based upon the loss and loss expense reserves estimates as of December 31, 2005 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. For a discussion of our reserving process. See “Item 1.-Loss and Loss Adjustment Expense Reserves”. Actual payments of loss and loss adjustment expenses by period will vary, perhaps materially, from the above table to the extent that current estimates of loss reserves vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns. See “Item 1A.-Risks Related to Our Business-If our actual loss and loss adjustment expenses exceed our loss reserves, our financial condition and results of operations could be significantly affected”, for a discussion of the uncertainties associated with estimating loss and loss adjustment expense reserves. This payment pattern also assumes timely reimbursement from our reinsurers. If our reinsurers do not meet their contractual obligations or a timely basis, the payment assumptions presented above could vary materially.
In 2003, we formed two statutory business trusts and we own all of the common trust securities of each trust. The trusts issued $20.0 million of trust preferred securities in private placements and invested the proceeds thereof and the proceeds from the sale of common trust securities in exchange for $20.6 million of junior subordinated debentures issued by our holding company. In December 2004, we formed two additional statutory business trusts and we own all of the common securities of each of those trusts. The trusts issued $26 million of trust preferred securities in a private placement and invested the proceeds thereof and the proceeds from the sale of common trust securities in exchange for $26.8 million of junior subordinated debentures issued by our holding company. All of the debentures have stated maturities of thirty years. We have the option to call any or all of the securities at par beginning five years from the date of issuance. The interest rate on $10.3 million of the subordinated debentures issued in May 2003 will float quarterly for changes in the three month London Interbank Offered Rate (“LIBOR”) plus 4.1% and may not exceed 12.5% prior to the first call date of May 15, 2008. The interest rate on $10.3 million of subordinated debentures issued in September 2003 is a combination fixed and floating rate with a fixed rate of 7.5% during the no call period of five years after which the interest rate will float quarterly for changes in the three month LIBOR interest rate plus 4%. The interest rate on $13.4 million of subordinated debentures issued on December 17, 2004 is fixed at 7.4% for the first five years after which
the interest rate will float quarterly for changes in the three month LIBOR interest rate plus 3.4%. The interest rate on $13.4 million of subordinated debentures issued on December 21, 2004 will float based on the three month LIBOR interest rate plus 3.4%. Under the terms for all of the trust preferred securities, an event of default may occur upon:
Consolidated Statements of Income and Comprehensive Net Income for the years ended December 31, 2005, 2004 and 2003
Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005 has been audited by Johnson Lambert & Co., an independent registered accounting firm, as stated in their report included herein, which expresses unqualified opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005.
We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting, that Tower Group, Inc and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We have audited the accompanying consolidated balance sheets of Tower Group, Inc. and subsidiaries (the “Company”) as of December 31, 2005 and 2004 and the related consolidated statements of income and comprehensive net income, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated February 17, 2006 expressed an unqualified opinion thereon.
On March 25, 2005, Tower Group, Inc. closed on its purchase of the outstanding common stock of a shell insurance Company, North American Lumber Insurance Company (“NALIC”), that was renamed Tower National Insurance Company. As of December 31, 2005, Tower National Insurance Company was authorized to write business in sixteen states and is subject to comprehensive regulation and supervision, including limitations relating to reserves and statutory surplus, in Massachusetts, its state of domicile. As of December 31, 2005 TNIC has not written or assumed any premiums.
On November 8, 2005, the Securities and Exchange Commission declared Tower Group, Inc.’s Post-Effective Amendment No. 2 to Form S-1 on Form S-3 Registration Statement effective. This registration covers the resale of up to 500,000 shares of Tower Group, Inc.’s common stock from time to time by an affiliate of Friedman, Billings, Ramsey & Co., Inc., the lead underwriter for the Company’s IPO. The Company will not receive any of the proceeds from the sale of these shares.
During 2003, the Company engaged in significant transactions with PXRE Reinsurance Company (“PXRE”), which had a significant impact on the operations and financial statements of the Company. Transactions between PXRE and the Company include reinsurance arrangements, debt financing and equity transactions. To reduce the credit risk associated with having a significant amount of reinsurance recoverable from PXRE the Company cancelled PXRE’s participation in the 2003 quota share agreement as of September 30, 2003. See “Note 5. Reinsurance”.
Reinsurance recoverable represents management’s best estimate of paid and unpaid loss and loss adjustment expenses recoverable from reinsurers. Ceded losses recoverable are estimated using techniques and assumptions consistent with those used in estimating the liability for loss and loss adjustment expenses. Management believes that reinsurance recoverables as recorded represent its best estimate of such
Commissions on reinsurance premiums ceded are earned in a manner consistent with the recognition of the costs of the reinsurance, generally on a pro-rata basis over the terms of the policies reinsured. Certain reinsurance agreements contain provisions whereby the ceding commission rates vary based on the loss experience under the agreements. The Company records ceding commission revenue based on its current estimate of subject losses. The Company records adjustments to the ceding commission revenue in the period that changes in the estimated losses are determined. Ceding commissions receivable of $8,727,000 and $8,329,000 as of December 31, 2005 and 2004, respectively represent ceding commissions receivable from PXRE which are not due until final settlement of losses subject to the contracts or commutation of the agreements.
The Company accounts for its investments in accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”), which requires that fixed-maturity and equity securities that have readily determined fair values be segregated into categories based upon the Company’s intention for those securities. In accordance with SFAS 115, the Company has classified its fixed-maturity and equity securities as available-for-sale. The Company may sell its available-for-sale securities in response to changes in interest rates, risk/reward characteristics, liquidity needs or other factors.
Agents’ balances receivable are presented net of an allowance for doubtful accounts of $170,000 at December 31, 2005 and $123,000 at December 31, 2004 and 2003, 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 $26,000, $27,000 and $0 were written off in 2005, 2004 and 2003, respectively. One agent accounted for approximately 10%,12% and 16%, respectively, of TICNY’s
Receivable-claims paid by agency represent claim payments due from issuing carriers to reimburse claims paid by TRM on their behalf in conjunction with claims administration services. The receivables are partially secured by funds held totaling $8,191,000 and $785,000 as of December 31, 2005 and 2004, respectively. As of December 31, 2005 and 2004, no reserve for uncollectible recoverables was recorded. During 2005, 2004 and 2003, no amounts relating to these receivables were written-off.
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 2005, 2004 and 2003 for this activity.
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. 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. Identifiable intangible assets with indefinite useful lives, such as those related to state insurance licenses acquired through a shell purchase, are subject to annual impairment testing as well. 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 2005, 2004 and 2003.
Furniture, computer equipment, leasehold improvements and software are reported at cost less accumulated depreciation and amortization. Depreciation and amortization is provided using the straight-line method over the estimated useful lives of the assets. The Company estimates the useful life for computer equipment and software is three years, furniture is seven years and leasehold improvements is the term of the lease.
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, 2005.
The Company accounts for employee stock options using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock-Based Compensation” (“APB 25”). Under APB 25, because the exercise price of the Company’s employee stock options is equal to the estimated market price of the underlying stock at the date of the grant, no compensation expense is recognized. The effect of applying Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), as amended by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure” (“SFAS 148”) requires pro-forma disclosure of EPS for the impact on the financial statements as if the stock options were expensed. See “Note 1. Summary of Significant Accounting Policies-Recent Accounting Developments”.
The Company accounts for restricted stock shares awarded at fair value at the date awarded as a charge to Unearned Compensation-Restricted Stock, included as a separate component of Stockholders’ Equity, and a credit to Common Stock and Paid-in-Capital. The fair value of the shares will amortize ratably over their one to five year vesting period as a charge to compensation expense and a reduction to Unearned Compensation-Restricted Stock in Stockholders’ Equity.
In accordance with Statement of Financial Accounting Standards No. 128, “Earnings Per Share”, the Company measures earnings per share at two levels: basic earnings per share and diluted earnings per share. Basic earnings per share is calculated by dividing income (loss) allocable to common stockholders by the weighted average number of shares outstanding during the year excluding issued but unvested restricted stock shares. Diluted earnings per share is calculated by dividing income (loss) allocable to common stockholders by the weighted average number of shares outstanding during the year, as adjusted for the potentially dilutive effects of stock options, warrants, unvested restricted stock and/or convertible preferred stock, unless common equivalent shares are antidilutive.
In October 2005, the FASB issued FSP FAS 13-1, “Accounting for Rental Costs Incurred during a Construction Period,” which requires a lessee to start to record rental costs on a straight-line basis over the term of an operating lease starting on the date the lessee is given control of the leased asset (even during the leasehold improvement construction period). The Company has entered into an amended operating lease for the new space at its New York City Headquarters in September 2005. The Company will incur expenses under this amended lease beginning January 1, 2006.The implementation of FSP FAS13-1 is not expected to have a material effect on the Company’s financial position or results of operations.
In November 2005, the FASB issued FSP FAS 115-1 and FAS 124-1, “Other-Than-Temporary Impairment and Its Application to Certain Investments.” The guidance in this FSP addresses the determination of when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. The FSP also includes accounting considerations subsequent to the recognition of an other-than temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. This guidance in the FSP is required to be applied to reporting periods beginning after December 15, 2005. As
The amortized cost and fair value of investments in fixed-maturity securities are summarized as follows:
A summary of the amortized cost and fair value of the Company’s investments in fixed-maturity securities at December 31, 2005 by contractual maturity is shown below (in 000’s):
(A) Included in common stocks at cost as of December 31, 2005 are common shares of a closed-end management investment company investing predominately in asset-backed securities and mortgage-backed securities with a cost of $19,558,000 and an estimated fair value of $19,053,000. Because this security in not publicly traded the investment is carried at cost on the balance sheet and the unrealized loss has not been recorded in comprehensive income. Also included in equity securities at cost is an investment in a Real Estate Investment Trust (“REIT”) with a cost of $5,000,000 and an estimated fair value of $5,000,000. The estimated fair value for this security is determined based on recent trades and expected early 2006 IPO price for this security. The single REIT investment has not been registered under the Securities Act of 1933 and no active market exists for this investment.
The following table presents information regarding the Company’s invested assets that were in an unrealized loss position at December 31, 2005 by amount of time in a continuous unrealized loss position (in 000’s).
As of December 31, 2005, 184 securities accounted for the gross unrealized losses, all of which are deemed to be temporary. Significant factors influencing management’s determination that unrealized losses were temporary included the mild severity of the unrealized losses in relation to each securities cost, the nature of the investments and management’s intent and ability to retain the investment for a period of time sufficient to allow for anticipated recovery in value.
Of the 184 securities that were in an unrealized loss position as of December 31, 2005, 6 were equity investments and the other 178 were fixed-maturity investments. For the equity investments 4 are publicly traded Real Estate Investment Trusts (“REIT’s”) which are made up of real estate related mortgage backed securities. These 4 equity investments make up 17% of the gross unrealized loss position for the Company as of December 31, 2005. These REIT’s were evaluated for impairment by the Company and deemed to be only temporarily impaired. Publicly traded mortgage REIT stock prices as a sector did not perform well in 2005. The dividends paid on these funds were reduced significantly, which caused their stock prices to decline. These dividend reductions resulted from the flattening of the yield curve that reduced the yield these funds earn from leveraging the portfolios. The stock prices of these mortgage REITs have declined to below their book values per share, after trading at premiums to book value several months before December 31, 2005. Since the decline in the market values is based on the decline in the dividend rates, which could increase again when the yield curve steepens, the Company deems this decline to be temporary in nature. Additionally, the underlying value of the securities held by the REITs have not
declined in market value by nearly as much as the stock prices have declined and therefore, the liquidation value of the REITs is greater than the current market value of the stocks. The other 2 equity investments were a high dividend stock fund and an asset backed securities fund both of which had declined less than 3.1% of their book values as of December 31, 2005 and are deemed to be temporarily impaired.
The Company evaluated the 178 fixed maturity investments in an unrealized loss position as of December 31, 2005 for impairment and deemed them to be only temporarily impaired. The increase in the unrealized loss on the fixed maturity investments as of December 31, 2005 was attributable to the general rise in interest rates in 2005. The increased unrealized loss represents approximately 1.8% of the average market value of the fixed maturity portfolio during the year. Interest rates rose approximately 50 bps on average during the year (shorter maturities rose more than 50 bps and longer maturities rose less than 50 bps). Also, the portfolio duration averaged approximately 4 years during the year. Therefore, based on the interest rate increase and the portfolio duration, the expected impact on the unrealized loss would have been an increase of approximately 2.0% compared to the actual increase of only 1.8%, which is evidence that the increase in the unrealized loss is interest rate driven. Of the 178 fixed maturity investments in an unrealized position, 166 had fair values 5% or lower than their book values and the other 12 had fair values between 5.1% and 14% lower than their book value.
The Company is in discussions with a Bermuda reinsurance company in formation to enter into a multi-year quota share reinsurance agreement for 2006. Until this agreement is in place the Company is retaining all of the risk for 2006 that would have been ceded to quota share reinsurers. In 2005, the Company ceded 25% of its net premiums written to reinsurers in accordance with its quota share treaty. The Company’s 2005 Property Catastrophe Program warrants that a minimum 25% quota share cession be in place for the program. If a loss to the Property Catastrophe Program occurs after January 1, 2006 but before the inception of the proposed multi-year quota share agreement the Company would be required to retain 25% of the loss as if a 25% quota share cession was in place.
As of December 31, 2005, 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, 2005 are set forth below (dollars in 000’s):
Effective October 1, 2003, the Company commuted PMA’s participation under the 2003 quota share reinsurance treaty. Prior to the commutation, PMA assumed 17.5% of the layer of coverage representing the first $500,000 of each loss on policies written or renewed on or after January 1, 2003. The effect of this commutation was to conclude PMA’s participation in the quota share treaty and to discharge PMA from future related liabilities effective October 1, 2003. Loss related amounts recoverable from PMA at the commutation date including loss and loss adjustment expense reserve liabilities ceded of $2,700,000 and ceded paid losses of $4,000,000 that had not yet been recovered from PMA were settled with a payment received from PMA of $3,100,000. The Company also received $2,500,000 for ceded unearned premium at the commutation date resulting in a total cash settlement of $5,600,000. The Company incurred a cost of $800,000 representing consideration retained by PMA for reinsuring the Company from January 1, 2003 to September 30, 2003.
PXRE participated in various reinsurance agreements with the Company from 2001 through September 30, 2003, including a quota share participation in the layer of coverage representing the first $500,000 of each loss. Ceded written premiums include $20,261,000 ceded to PXRE in 2003. Effective September 30, 2003, the 2003 quota share agreement with PXRE was cancelled. The quota share agreements with PXRE are in run-off. As a result of the cancellation of the 2003 quota share agreement with PXRE as of September 30, 2003, the Company was owed $15,748,000 in return premium net of ceding commissions as of December 31, 2003. This amount was collected in January 2004.
In addition to the ceding commission provisions described above, the 2002 PXRE quota share agreement contained a provision that provided the Company with a non-refundable special commission of $5,000,000, which the Company received in December 2001. The Company deferred this special commission as of December 31, 2001 to be earned over the period during which the underlying premiums are earned.
In January 2003, the Company entered into an excess of loss reinsurance agreement with PXRE Barbados Ltd. (“PXRE Barbados”), an affiliate of PXRE, and remitted $10,000,000 as deposit premium to PXRE Barbados as called for by the contract. This excess of loss agreement inured solely to the benefit of PXRE in connection with its participation in the 2003 quota share agreement with the Company. Effective September 30, 2003, the Company and PXRE Barbados commuted the excess of loss agreement. As a result of the commutation of the agreement, the Company recorded $1,537,000 in ceding commission revenue in 2003.
The Company has participated in various reinsurance agreements with Am Re. Ceded written premiums include $3,742,000, $2,753,000 and $3,811,000 ceded to Am Re in 2005, 2004 and 2003, respectively. Am Re had owned all outstanding shares of the Company’s Series A Cumulative Redeemable Preferred Stock and held warrants for the purchase of common stock. See “Note 8. Debt” and “Note 9. Capital Stock”. During 2004, all of the preferred stock was redeemed and the warrants were exercised.
The components of fixed assets are summarized as follows (in 000’s):
During the second and third quarters of 2003, Tower formed two statutory business trusts (“Trust I” and “Trust II”), of which the Company owns all of the common trust securities. On May 15, 2003 and September 30, 2003, Trust I and Trust II, respectively, each issued $10,000,000 floating rate trust preferred securities totaling $20,000,000 to investment pools. The trusts invested the proceeds thereof and the proceeds received from the issuance of the common trust securities to Tower in exchange for $20,620,000 of floating rate junior subordinated debentures (“subordinated debentures”) issued by Tower. The subordinated debentures are unsecured obligations of Tower and are subordinated and junior in right of payment to all present and future senior indebtedness of Tower. Tower has entered into guarantee agreements, which provide for full and unconditional guarantee of the trust securities. The subordinated debentures and the floating rate preferred securities issued by Trust I accrue and pay interest quarterly based upon interest that will float on the 3-month LIBOR, plus 4.10%, which cannot exceed 12.50% prior to May 15, 2008. At December 31, 2005 this interest rate was 8.40%. The Trust II floating rate preferred securities bear interest at a fixed rate of 7.5% until September 30, 2008 and at a variable rate, reset quarterly, equal to the 3-month LIBOR, plus 4.00%, thereafter. The final maturity on the subordinated debentures is May 15, 2033 and September 30, 2033 for Trust I and Trust II, respectively, with prepayment at the option of the Company available beginning in 2008. Issuance costs, primarily legal fees, of $301,000 and $338,000 for the Trust I and Trust II offerings, respectively, were deferred and are being amortized over the term of the subordinated debentures using the effective interest method.
In December 2004, Tower formed two statutory business trusts (“Trust III” and “Trust IV”), of which the Company owns all of the common trust securities. On December 7, 2004 and December 17, 2004, Trust III and Trust IV, respectively, each issued $13,000,000 floating rate trust preferred securities totaling $26,000,000 to investment pools. The trusts invested the proceeds thereof and the proceeds received from the issuance of the common trust securities to Tower in exchange for $26,806,000 of floating rate junior subordinated debentures (“subordinated debentures”) issued by Tower. The subordinated debentures are unsecured obligations of Tower and are subordinated and junior in right of payment to all present and future senior indebtedness of Tower. Tower has entered into guarantee agreements, which provide for full and unconditional guarantee of the trust securities. The Trust III preferred securities bear interest that is fixed at 7.4% until December 7, 2009 and the coupon will float quarterly thereafter at the three months
On February 21, 2003, Tower entered into a Credit Agreement with The CIT Group/Equipment Financing, Inc. (“CIT”) for borrowings up to $6.0 million. As of December 31, 2003 there was $5.6 million of debt outstanding that was repaid in 2004 and the agreement was terminated in October 2004. Interest expense incurred for the years ended December 31, 2004 and 2003, including amortization of origination costs, was $283,000 and $158,000 respectively.
The 60,000 shares of the Company’s Series A Cumulative Redeemable Preferred Stock (“the preferred stock”), $0.01 par value were held by Am Re. The preferred stock carried a rate of 10.5% per annum with dividends payable quarterly and in arrears, and was redeemable in advance of the mandatory redemption dates at the option of the Company. The preferred stock did not have rights to vote with the holders of common stock. In January 2004, the Company redeemed 30,000 of the outstanding shares of the preferred stock for $1,500,000 and the remaining 30,000 shares were redeemed by the Company in October 2004 for $1,500,000 plus accrued interest.
Due to the adoption by the Company of SFAS 150, the mandatorily redeemable Series A Cumulative Redeemable Preferred Stock of $3,000,000 was reclassified as a liability as of July 1, 2003. Preferred stock dividends of $130,000 for 2004 and $158,000 for the period from July 1, 2003 through December 31, 2003, were reported as interest expense. The dividends paid prior to the adoption of SFAS 150 were accounted for as a direct reduction to stockholders’ equity.
The company declared dividends on common and preferred stock as follows in (000’s):
Under the 2001 Stock Award Plan, 450,000 shares may be made the subject of awards granted under the plan. At December 31, 2005, 358,200 shares of common stock have been issued or are subject to issuance upon the exercise or payment of outstanding awards under the plan. The remaining 91,800 shares eligible for grants under the plan that have not been the subject of awards are now eligible under our 2004 Long-Term Incentive Compensation Plan, such that no further awards may be granted under the 2001 Stock Award Plan.
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
In 2005 and 2004, respectively 10,107 and 216,685 restricted shares (net of canceled shares) of the Company’s common stock were granted to certain employees and directors of the Company. The fair value of the shares awarded (net of cancellations) in 2005 and 2004, determined on the grant date, was $174,000 and $2,218,000, respectively.
All restricted stock shares are recorded at fair value at the date of grant as a charge to Unearned Compensation-Restricted Stock in Stockholders’ Equity and a credit to Common Stock and Paid-in-Capital. These shares will amortize ratably over their vesting period as a charge to compensation expense and a credit to Unearned Compensation-Restricted Stock in Stockholders’ Equity on the balance sheet. In 2005 and 2004, the Company amortized approximately $618,000 and $310,000, respectively, as a charge to compensation expense and a credit to Unearned Compensation-Restricted Stock. During 2005, 3,725 restricted shares were forfeited resulting in a $32,000 reduction to compensation expense.
The following table provides an analysis of stock option activity during the three years ended December 31, 2005.
In December 2004, the Financial Accounting Standards Board issued the revised statement SFAS No. 123-R, an amendment to SFAS123, which suspends APB 25 and requires that the cost of share-based payment transactions be recognized in the financial statements after the fiscal quarter beginning after June 15, 2005. The intended adoption by the Company of SFAS 123-R has been postponed to
Significant components of the Company’s deferred tax assets and liabilities are as follows (in 000’s):
The Company sponsored a nonqualified deferred compensation plan (“the Plan”) for the Chairman of the Board, President and Chief Executive Officer of the Company. As of December 31, 2002, the Company has granted the maximum amount allowed under the Plan, $1,000,000. Amounts contributed to the Plan earned interest at the rate of 7% per year. During 2004 and 2003, the Company recognized deferred compensation expense of $44,000 and $85,000, respectively. On May 5, 2004 the Board of TRM approved the payment of the entire deferred compensation balance and terminated the plan.
TICNY is subject to assessments in New York for various purposes, including the provision of funds necessary to fund the operations of the New York Insurance Department and the New York Property/Casualty Insurance Security Fund, which pays covered claims under certain policies provided by impaired, insolvent or failed insurance companies and various funds administered by the New York Workers’ Compensation Board, which pays covered claims under certain policies provided by impaired, insolvent or failed insurance companies The Company was assessed approximately $941,000, $435,000, $340,000 in 2005, 2004 and 2003, respectively, for its proportional share of the total assessment for the Property/Casualty Security Fund and approximately $589,000,$556,000 and $312,000 and in 2005, 2004 and 2003, respectively, for its proportional share of the operating expenses of the New York Insurance
Department. Property casualty insurance company insolvencies or failures may result in additional security fund assessments to the Company at some future date. At this time the Company is unable to estimate the possible amounts, if any, of such assessments. Accordingly, the Company is unable to determine the impact, if any, such assessments may have on financial position or results of operations of the Company. The Company is permitted to assess premium surcharges on workers’ compensation policies that are based on statutorily enacted rates. However, assessments by the various workers’ compensation funds have recently exceeded the permitted surcharges resulting in additional expenses of $0, $1,143,000 and $0 in 2005, 2004 and 2003, respectively. As of December 31, 2005 the liability for the various workers’ compensation funds, which includes amounts assessed on workers’ compensation policies was $2,776,000. This amount is expected to be paid over an eighteen month period ending June 30, 2007.
· Certain assets including certain receivables, a portion of the net deferred tax asset, prepaid expenses and furniture and equipment are not admitted.
For the years ended December 31, 2005, 2004 and 2003, TICNY reported statutory basis net income/ (loss) of $6,249,000, ($5,705,000), and $2,782,000, respectively. At December 31, 2005 and 2004 TICNY reported statutory basis surplus as regards policyholders of $132,409,000, and $126,082,000, respectively. As of December 31, 2005 TICNY is required to maintain $7,900,000 of minimum capital and surplus in accordance with New York Insurance Law.
Statement of Financial Accounting Standards No. 107, “Disclosures about Fair Value of Financial Instruments” (“SFAS 107”) 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:
Equity securities at cost-Fair value disclosure for an asset-backed securities fund that is a closed-end management company is based on obtaining market prices for all of the securities in the fund from an outside third party pricing service and then dividing by the number of shares outstanding to determine its price per share. The estimated fair value for the private investment in a Real Estate Investment Trust (REIT) in our portfolio was determined based on an outside pricing service valuing the underlying schedules.
Am Re had the right to surrender shares of Series A Cumulative Preferred Stock for the exercise of warrants for the liquidation preference price of $50 per share of preferred stock surrendered. In applying the treasury stock method to the warrants, it was assumed that 16,000 preferred shares were liquidated at the beginning of each year presented and corresponding dividends were reduced. Am Re exercised these warrants in October 2004. These warrants are included in the computation of diluted EPS prior to their exercise.
PXRE had an option agreement to purchase 599,400 common shares of the Company for $16.67
administration and reinsurance intermediary operations). The Company considers many factors in determining reportable segments including economic characteristics, production sources, products or services offered and regulatory environment.
In the insurance services segment, TRM generates commission revenue from its managing general agency by producing premiums on behalf of its issuing companies and generates fees by providing claims administration and reinsurance intermediary services. Placing risks through TRM’s issuing companies allows the Company to underwrite larger policies and gain exposure to market segments that are unavailable to TICNY due to its rating, financial size and geographical licensing limitations. TRM does not assume any risk on business produced by it. All of the risk is ceded by the issuing companies to a variety of reinsurers pursuant to reinsurance programs arranged by TRM’s reinsurance intermediary working with outside reinsurance intermediaries. Through its issuing companies, TRM’s managing general agency offers commercial package, monoline general liability, monoline property, commercial automobile and commercial umbrella products.
Underwriting expenses in the insurance segment are net of expense reimbursements that are made by the insurance services segment pursuant to an expense sharing agreement between TRM and TICNY. In accordance with terms of this agreement, TRM reimburses TICNY for a portion of TICNY’s underwriting and other expenses resulting from TRM’s use of TICNY’s personnel, facilities and equipment in underwriting insurance on behalf of TRM’s issuing companies. The reimbursement for underwriting and other expenses is calculated as a minimum reimbursement of 5% of the premiums produced by TRM, and is adjustable according to the terms of the agreement based on the number of policies in force and additional expenses that may be incurred by TRM. The amount of this reimbursement was $1,981,000 in 2005, $2,987,000 in 2004 and $2,247,000 in 2003. TRM also reimburses TICNY, at cost, for claims administration expenses pursuant to the terms of this expense sharing agreement. Claims expenses reimbursed by TRM were $4,255,000 in 2005, $4,019,000 in 2004 and $3,648,000 in 2003.
On February 6, 2006 the Company capitalized a new Bermuda holding company for $15 million. Michael H. Lee, Chairman and Chief Executive Offices of Tower, is expected to serve as Chairman, Chief Executive Offices and President of the Bermuda holding company. Mr. Lee will devote his full business time between Tower and the Bermuda holding company. In addition, Greg T. Doyle is expected to resign as a director on Tower’s Board and become a director of the new Bermuda holding company.
Tower Group, Inc.’s Board of Directors approved a quarterly dividend on February 22, 2006 of $0.025 per share payable March 27, 2006 to stockholders of record as of March 15, 2006.