We lease 407,096 rentable square feet across the United States, most notably 107,282 rentable square feet at 120 Broadway in New York City, NY and 76,892 at Harborside Plaza II in Jersey City, New Jersey. In addition to this space, we also lease 13,718 rentable square feet at 100 William Street in New York, New York.
The selected consolidated income statement data for the years ended December 31, 2013, 2012 and 2011, and the balance sheet data as of December 31, 2013 and 2012 are derived from our audited financial statements included elsewhere in this document, which have been prepared in accordance with GAAP. 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.
(5) Book value per share is based on Tower Group International, Ltd. shareholders’ equity divided by common shares outstanding at year end.
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”.
Because we do not manage our invested assets by segments, our investment income is not allocated among our segments. Operating expenses incurred by each segment are recorded in such segment directly. Our home office related expenses not directly allocable to an individual segment (for example, accounting, finance and general legal costs) are allocated based upon the methodology deemed to be most appropriate which may include employee head count, policy count and premiums earned in each segment.
Our commercial lines products include commercial multiple-peril (provides both property and liability insurance), mono line general liability (insures bodily injury or property damage liability), commercial umbrella, mono line property (insures buildings, contents or business income), workers’ compensation, fire and allied lines, inland marine, commercial automobile policies and assumed reinsurance. Our personal lines products consist of homeowners, personal automobile and umbrella policies and also include management fees primarily from the services provided by management companies to the Reciprocal Exchanges. Tower also writes assumed reinsurance, which is reported in the Assumed Reinsurance segment.
Loss and loss adjustment expenses for the twelve months ended December 31, 2013 recorded in the statement of operations included an increase of $533.0 million, excluding the Reciprocal Exchanges, relating to reserve increases associated with losses from prior accident years. This unfavorable loss development arose primarily from accident years 2008 through 2012 within the workers’ compensation, commercial multi-peril liability (“CMP”), other liability and commercial auto liability lines of business partially offset by a modest amount of favorable development from more recent years within the short tail property lines of business. The Company performed comprehensive updates to its internal reserve study in response to continued observance in the second, third and fourth quarters of 2013 of higher than expected reported loss development. In conjunction with its comprehensive internal reviews, the Company also retained a consulting actuary to perform an independent reserve study in the fourth quarter of 2013 covering lines of business comprising over 98% of the Company’s loss reserves. Since 2010, the Company has changed the mix of business by reducing the amount of program and middle market workers’ compensation and liability business that it underwrites.
The 2013 reserve increase was viewed by the Company as an event or circumstance that required the Company to perform a detailed quantitative analysis of whether its recorded goodwill was impaired. After performing the quantitative analysis in the second quarter of 2013, it was determined that $214.0 million of goodwill, which represents all of the goodwill allocated to the Commercial Insurance reporting unit, was impaired. In the third quarter of 2013, management in its judgment concluded that the remaining $55.5 million of goodwill, all of which was allocated to the Personal Insurance reporting unit, was impaired. In addition, $1.9 million of additional goodwill resulting from the acquisition of marine and energy business in July of 2013 was fully impaired as of September 30, 2013. Additionally, in 2013, the Company impaired $125.8 million of fixed assets. At December 31, 2013, there was no goodwill remaining on the balance sheet. See “Note 7 - Goodwill, Intangible and Fixed Assets Impairments” for additional detail on the goodwill and fixed asset impairments.
In the third quarter of 2013, Tower entered into agreements with three reinsurers, Arch Reinsurance Ltd. (“Arch”), Hannover Re (Ireland) Plc. (“Hannover”) and Southport Re (Cayman), Ltd. (“Southport Re”). These agreements provided for surplus enhancement and improved certain financial leverage ratios, while increasing the Company’s financial flexibility. The agreements with Arch and Hannover each consisted of one reinsurance agreement while the arrangement with Southport Re consists of several reinsurance agreements. Each of these is described below.
The first agreement was between Tower Insurance Company of New York (“TICNY”), on its behalf and on behalf of each of its pool participants, and Arch. Under this multi-line quota share agreement, TICNY ceded 17.5% on a quota share of certain commercial automobile liability, commercial multi-peril property, commercial multi-peril liability and brokerage other liability (mono line liability) businesses. The agreement covers losses occurring on or after July 1, 2013 for policies in-force as of June 30, 2013 and policies written or renewed from July 1, 2013 to December 31, 2013.
A.M. Best, Fitch and Demotech Downgrade the Company’s Financial Strength and Issuer Credit Ratings
Management expects these rating actions, in combination with other items that have impacted the Company in 2013, to result in a significant decrease in the amount of premiums the insurance subsidiaries are able to write. Direct written premiums were $1,606.2 million twelve months ended December 31, 2013. Business written through certain program underwriting agents requires an A.M. Best rating of A- or greater.
In January 2014, Tower’s Board of Directors approved Tower’s merger with ACP Re. In light of the adverse ratings actions, concurrent with entering into its merger agreement with ACP Re, Tower entered into cut-through reinsurance treaties with affiliates of ACP Re. As a result of this merger if it closes, and the execution of the cut-through reinsurance treaties, Tower believes its insurance subsidiaries will retain significant portions of their business. (See “Note 9 - Reinsurance” for a discussion of the cut-through reinsurance treaties).
The Company is required to maintain minimum capital and surplus for each of its insurance subsidiaries.
Based on RBC calculations as of December 31, 2013, six of Tower’s ten U.S. based insurance subsidiaries have capital and surplus below Company Action Level and do not meet the minimum capital and surplus requirements of their respective state regulators. As a result, management has discussed the ACP Re Merger Agreement and the Cut-Through Reinsurance Agreement and provided its 2014 RBC forecasts to the regulators to document the Company’s business plan to bring two of these U.S based insurance subsidiaries’ capital and surplus levels above Company Action Level.
On April 11, 2014, the New Jersey Department of Banking and Insurance imposed an enhanced reporting requirement on the intercompany transactions involving Tower’s two New Jersey domiciled insurance subsidiaries and Tower’s New Jersey managed insurer. Such companies are now required to submit for prior approval any transactions with affiliates, even transactions that would otherwise not be reportable under the applicable holding company act.
On December 13, 2013, TGI paid in full the $70.0 million outstanding on the bank credit facility and the bank credit facility has been terminated. The $70.0 million was provided, primarily, from the sale of Tower’s 10.7% ownership in Canopius Group Limited (“Canopius Group”) on December 13, 2013.
The Company’s plan to repay the Notes is related to the closing of the ACP Re Merger Agreement. In the event that the ACP Re Merger Agreement does not close prior to September 15, 2014, the Company would evaluate a combination of using proceeds from the sale of assets held at TGI, including but not limited to, renewal rights on its commercial and personal lines of business and certain of its insurance companies to pay down the principal of the Notes. The Company can provide no assurance that it will be successful in finalizing the liquidation of the assets held at TGI or selling certain of its operating assets to satisfy repayment of the Notes.
As of December 31, 2013, there were $235.1 million of subordinated debentures outstanding. The subordinated debentures do not have financial covenants that would cause an acceleration of their stated maturities. The earliest stated maturity date is on a $10 million debenture, which matures in May 2033. The Company has the ability to defer interest payments on its subordinated debentures for up to twenty quarters.
special purpose syndicate (“SPS Transaction Right and Acquisition Right”) (subject to required approvals) and granted TGI an option (the “Merger Option”) to combine with Canopius Bermuda. On July 30, 2012, TGI announced that it had exercised the Merger Option and executed an Agreement and Plan of Merger (the “Original Merger Agreement”) with Canopius Bermuda pursuant to which a wholly-owned subsidiary of Canopius Bermuda would acquire all of TGI’s common stock. TGI paid Canopius Group a fee of $1,000,000 to exercise the Merger Option. On November 8, 2012, the Original Merger Agreement was amended by Amendment No. 1 to the Agreement and Plan of Merger to reflect changes to the merger consideration to be received by TGI shareholders (the Original Merger Agreement as so amended, the “Merger Agreement”).
Prior to the Canopius Merger Transaction date, Canopius Group priced on March 6, 2013, a private sale of 100% of the shares of Canopius Bermuda to third party investors for net consideration of $205,862,755. This investment resulted in 14,025,737 shares being issued in the private placement immediately preceding the merger.
On March 13, 2013, Canopius Bermuda and TGI consummated the Canopius Merger Transaction contemplated by the Merger Agreement. Canopius Bermuda was re-named Tower Group International, Ltd. and became the ultimate parent company of TGI, with TGI becoming its indirect wholly-owned subsidiary. Pursuant to the terms of the Merger Agreement, among other things, (i) 100% of the issued and outstanding shares of TGI common stock was cancelled and automatically converted into the right to receive 1.1330 common shares of the Company, par value $0.01 per share (the “ Common Shares”), (ii) each outstanding option to acquire TGI common stock, whether vested or unvested and whether granted under TGI’s 2008 Long-Term Equity Compensation Plan or otherwise, automatically vested, free of any forfeiture conditions, and constituted a fully vested option to acquire that number of Common Shares (rounded down to the nearest whole number) equal to the number of shares of TGI common stock subject to such option multiplied by 1.1330, on the same terms and conditions (other than vesting and performance conditions) as were applicable to such TGI stock option immediately prior to the Canopius Merger Transaction, with the exercise price of such option adjusted to be the original exercise price divided by 1.1330, and (iii) substantially all issued and outstanding shares of TGI restricted stock, whether granted under TGI’s 2008 Long-Term Equity Compensation Plan or otherwise, automatically vested, free of any forfeiture conditions, and were converted into the right to receive, as soon as reasonably practicable after the effective time, 1.1330 Common Shares.
The Canopius Merger Transaction was expected to advance the Company’s strategy and create a more efficient global, diversified specialty insurance company consisting of commercial, specialty and personal lines, reinsurance and international specialty products. In addition, the establishment of a Bermuda domicile provided the Company with an international platform through which it accesses the U.S., Bermuda and the Lloyd’s of London (“Lloyd’s”) markets.
On December 13, 2013, Tower sold its 10.7% ownership in Canopius Group Limited.
balance sheet as unearned premium to be earned in subsequent accounting periods. Premiums can be assumed from or ceded to reinsurers. Direct premiums combined with assumed premiums are referred to as gross premiums and subtracting premiums ceded to reinsurers results in net premiums.
Insurance service revenue. We earn fee income primarily from services provided to the Reciprocal Exchanges for underwriting, claims, investment management and other services. The fees earned from the Reciprocal Exchanges are eliminated in the Company’s consolidated financial statements because the Reciprocal Exchanges are consolidated with Tower’s balance sheets and statements of operations, changes in shareholders’ equity and cash flows Additional commission and fee income is generated on premiums produced by the managing general agencies on behalf of third-party reinsurance companies.
Operating expenses. In our Commercial Insurance, Assumed Reinsurance and Personal Insurance segments, we refer to the operating expenses that we incur to underwrite risks as underwriting expenses. These include commission expenses (payments to our producers for the premiums that they generate for us) and other underwriting expenses.
Income taxes. We pay federal, state and local income taxes and non income-related other taxes.
We use various measures to analyze the growth and profitability of our business segments. In our Commercial Insurance, Assumed Reinsurance and Personal Insurance 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. We measure profitability in terms of net income attributable to Tower Group, International, Ltd. and return on average equity related to Tower Group International, Ltd.
Loss ratio. The loss ratio is the ratio of losses and LAE incurred to premiums earned and measures the underwriting results of a company’s insurance business. We measure our loss ratio on a gross (before reinsurance) and net (after reinsurance) basis. We also measure the loss ratio on the ceded portion (the difference between gross and net premiums) for our Commercial Insurance and Personal Insurance segments. We use the gross loss ratio as a measure of the overall underwriting profitability of the insurance business we write and to assess the adequacy of our pricing. We use the loss ratio on the ceded portion of our insurance business to measure the experience on the premiums that we cede to reinsurers, including the premiums ceded under our quota share treaties. In some cases, the loss ratio on such ceded business is considered in determining the ceding commission rate that we earn on ceded premiums. Our net loss ratio is meaningful in evaluating our financial results, which are net of ceded reinsurance, as reflected in our consolidated financial statements. In addition, we use accident year and calendar year loss ratios to measure our underwriting profitability. An accident year loss ratio measures losses and LAE for insured events occurring in a
Underwriting expense ratio. The gross underwriting expense ratio is the ratio of direct commission expenses and other underwriting expenses less policy billing fees to gross premiums earned. The gross underwriting expense ratio measures a company’s operational efficiency in producing, underwriting and administering its insurance business. We also calculate our net underwriting expense ratio after the effect of ceded reinsurance. Ceding commission revenue is applied to reduce our underwriting expenses in our insurance company operation.
Book value per share. Book value per share is calculated as Tower Group International, Ltd. shareholders’ equity divided by the number of shares outstanding. We use this as a measure of value per share of the Company independent from the market price per share.
Tangible book value per share. Tangible book value per share is calculated as Tower Group International, Ltd. shareholders’ equity, less intangible assets and goodwill, divided by the number of shares outstanding. We use this as a measure of value per share of the Company independent from the market price per share.
Because of the nature of the business historically written, the Company’s management believes that the Company has limited exposure to asbestos and environmental claim liabilities.
We estimate ALAE reserves separately for claims that are defended by in-house attorneys, claims that are handled by other attorneys that are not employees, and miscellaneous ALAE costs such as investigators, witness fees and court costs.
For claims that are defended by in-house attorneys, we attribute to each of these claims a fixed fee for defense work. 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 adjusted periodically to reimburse our in-house legal department for all their costs.
For some types of claims and for some programs where we utilize third-party administrators (“TPA”) to adjust claims, we pay them fees which are included in ULAE. In some cases, we arrange for fixed percentages of premiums earned to be the fee for claims administration, and in other cases we arrange for fixed fees per claim or hourly charges for ULAE services. The reserves for ULAE for these situations is estimated based upon the particular arrangement for these types of claims by product or program. Also see “Item 9A. - Controls and Procedures” for a discussion on the companies material weakness over financial reporting as they relate to the effectiveness of the loss reserving process.
Impairment of invested assets. Impairment of investment securities results in a charge to operations 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 evaluating potential impairment, we consider, among other criteria:
If an other-than-temporary-impairment (“OTTI”) loss is determined for a fixed-maturity security (for which we do not have the intent to sell or it is not more likely than not we would be required to sell), the credit portion is recorded in the income statement as realized investment losses and the non-credit portion is recorded in accumulated other comprehensive income. The credit portion results in a permanent reduction in the cost basis of the underlying investment. For all other fixed-maturity security and equity security impairments, the entire impairment is reflected as a realized investment loss and reduces the cost basis of the security. The determination of OTTI is a subjective process and different judgments and assumptions could affect the timing of loss realization. We recorded OTTI losses on our fixed maturity and equity securities in the amounts of $14.4 million, $9.9 million and $3.5 million in 2013, 2012, and 2011, respectively, of which $13.4 million, $9.6 million and $3.2 million were recorded in Net realized investment gains (losses) in 2013, 2012, and 2011, respectively.
See “Business-Investments” and “Note 5 - Investments” in the notes to consolidated financial statements for additional detail regarding our investment portfolio at December 31, 2013, including disclosures regarding OTTI.
Goodwill, intangible and fixed assets 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. Purchase consideration in excess of the fair value of tangible and intangible assets is recorded as goodwill.
The Company completed its annual indefinite lived intangible asset assessment as of December 31, 2013. An impairment loss is recognized if the carrying value of an intangible asset is not recoverable and its carrying amount exceeds its fair value. Any amount of intangible assets determined to be impaired will be recorded as an expense in the period in which the impairment determination is made. No impairment losses were recognized on indefinite lived intangible assets in 2013, 2012 or 2011.
Goodwill is not amortized. The Company tests goodwill balances for impairment annually in the fourth quarter of each year using a September 30 measurement date, or more frequently if circumstances indicate that the value of goodwill may be impaired. Goodwill impairment is performed at the reporting unit level and the test requires a two-step process. In performing Step 1 of the impairment test, management compared the estimated fair values of the applicable reporting units to their aggregate carrying values, including goodwill. If the carrying amount of a reporting unit including goodwill were to exceed the fair value of the reporting unit, Step 2 of the goodwill impairment would be performed. Step 2 of the goodwill impairment test requires comparing the implied fair value of the affected reporting unit’s goodwill against the carrying value of that goodwill.
In its 2012 annual impairment test, management determined that a greater risk of future impairment existed for the Commercial Insurance reporting unit. During the second quarter of 2013, management in its judgment concluded a quarterly impairment test was required as a result of the segment reorganization (see “Note 2 - Accounting Policies and Basis of Presentation”) and significant prior years’ loss reserves incurred (see “Note 10 - Loss and Loss Adjustment Expense”). In the third quarter of 2013, as a result of the additional significant prior years’ loss reserves incurred, management in its judgment concluded a quarterly impairment test was required again as of September 30, 2013 in the preparation of the September 30, 2013 consolidated financial statements.
In conducting the goodwill impairment analysis as of June 30, 2013, the Company tested the reporting units prior to the reorganization as required by GAAP. The Company estimated each of the reporting units’ fair values using a market multiple approach based on tangible book values. Historically, the Company also utilized market multiple approaches based on (i) book value, (ii) estimates of projected results for future periods, and (iii) a valuation technique using discounted cash flows. However, based upon the significance of the loss reserve charge recorded in the second quarter of 2013, the reduction to Tower’s insurance subsidiaries’ capital and surplus levels (see “Note 18 - Statutory Financial Information”), management in its judgment concluded a multiple of tangible book value was most indicative of a price a market participant would pay for the reporting units. In addition, the Commercial Insurance reporting unit’s estimated fair value was adjusted for the expected capital infusion a market participant would be expected to fund into the insurance businesses to maintain historical rating agency ratings.
Accordingly, the Company performed a Step 2 impairment test on the Commercial Insurance reporting unit. Based on the results, the Company recorded a non-cash goodwill impairment charge of $214.0 million to write-down all of the goodwill in the Commercial Insurance reporting unit as of June 30, 2013. As of June 30, 2013, the Company reported $55.5 million of goodwill, all of which related to the Personal Insurance reporting unit.
Fixed assets, including furniture, leasehold improvements, computer equipment, and software, including internally developed software, are reported at cost less accumulated depreciation and amortization. As of December 31, 2012, gross fixed assets and capital leases were $194.0 million and accumulated depreciation was $54.7 million (for net fixed assets and capital leases of $139.3 million).
As a result of the significant business developments discussed above, including the A.M. Best, Fitch and Demotech rating downgrades in December of 2013 and the expected significant declines in net written premiums and the orders and restrictions placed by various insurance departments, management tested fixed assets for recoverability.
Management determined the fair value of fixed assets by (i) calculating an estimated software charge (i.e. fee for use of software) a market participant would pay the owner of the asset in return for the ability to use the Company’s software and (ii) performing an orderly liquidation value analysis ranging from 0%-15% for furniture, leasehold improvements and computer equipment, and concluded the fixed assets were impaired as of September 30, 2013. The Company recorded a non-cash charge to earnings of $125.8 million. This charge is recorded within Goodwill and fixed-assets impairment in the statement of operations.
The following tables present the consolidating financial statements as of December 31, 2013 and 2012 and for the years ended December 31, 2013, 2012 and 2011:
Premiums earned. Net premiums earned for the years ended December 31, 2013 and 2012 were $1.5 billion and $1.7 billion respectively. The decrease of 12.1% for the year ended December 31, 2013 is primarily due to decreased direct written premiums in the fourth quarter of 2013 as a result of the rating downgrades and increased ceded premiums due to new multi-line quota share reinsurance agreements. The Company entered into (i) a new homeowners quota share reinsurance treaty effective January 1, 2013, (ii) the previously disclosed reinsurance treaties with Arch and Hannover in the third quarter of 2013, and (iii) a further homeowners treaty in the fourth quarter of 2013. In 2013, the Company increased its homeowner’s reinsurance to reduce property exposure concentrated in the Northeast region of the U.S, and entered into the Arch and Hannover treaties to provide for surplus enhancement and improve certain financial leverage ratios, while increasing the Company’s financial flexibility.
Commission and fee income. Commission and fee income, comprised of ceding commission revenue, insurance services revenue and policy billing fees, increased by $46.5 million for the year ended December 31, 2013 compared to the prior year. The increase is due primarily to ceding commission revenue earned on the new 2013 reinsurance quota share treaties.
Net investment income and net realized gains (losses). For the year ended December 31, 2013, net investment income decreased $18.0 million or 14.1% compared to 2012. Net investment income in 2013 decreased primarily due to a declining invested asset base and lower reinvestment rates from the prior year. Invested assets declined by approximately $702 million in 2013 due mostly to increased cash needs that arose from funding several large reinsurance contracts and increased collateral requirements that were triggered when the Company was downgraded by A.M. Best. The pre-tax yield at amortized cost was 3.46% at December 31, 2013 as compared to 3.98% at December 31, 2012.
For the year ended December 31, 2013 and 2012, OTTI losses of $13.4 million and $9.6 million, respectively, were recorded in net income. The OTTI for the year ended December 31, 2013 is related mostly to securities in the Company’s equity security portfolio.
Incurred losses and LAE for the year ended December 31, 2012 attributable to insured events of prior years were $79.2 million. Excluding the Reciprocal Exchanges, the incurred losses and LAE from prior accident years were $88.1 million. These prior accident year losses included unfavorable loss development of $86.6 million in the Commercial Insurance segment, favorable development of $2.5 million in the Assumed Reinsurance segment and unfavorable loss development of $4.0 million in the Personal Insurance segment for the year ended December 31, 2012. The Reciprocal Exchanges reported $8.9 million of favorable loss development for the year ended December 31, 2012.
Commission and Operating expenses. Operating expenses, which include commission expenses and other operating expenses, were $734.9 million for the year ended December 31, 2013, an increase of 8.6% compared to the prior year. This increase is primarily due to: (i) greater commission expense related primarily to a change in business mix. A larger proportion of earned premiums was from assumed reinsurance which have a higher commission rate compared to direct business, (ii) federal excise tax incurred by the Company on intercompany reinsurance transactions between CastlePoint Re and TRL, (iii) an impairment charge recorded on intangible assets and (iv) an increase in operating expenses related to improving information technology systems and infrastructure. The consolidated gross underwriting expense ratio increased to 34.6% for the year ended December 31, 2013 from 33.4% in the same period in 2012. This increase is due to the decline in gross earned premiums from 2012 to 2013, while commission and operating expenses increased from 2012 to 2013. The Company announced an expense control initiative whereby the Company is completing a workforce reduction affecting approximately 10% of the total employee population.
Acquisition-related transaction costs. Acquisition-related transaction costs for the years ended December 31, 2013 and 2012 were $21.3 million and $9.2 million, respectively. Acquisition-related transaction costs for the year ended December 31, 2013 relate primarily to costs associated with the Canopius Merger Transaction completed on March 13, 2013, and include $11.6 million in compensation expense (of which accelerated vesting of restricted stock was $10.3 million) and $8.7 million in legal and accounting fees. The 2012 expenses related to Tower’s acquisition of its equity interest in Canopius Group and expenses associated with the Canopius Merger Transactions.
Equity in income (loss) of unconsolidated affiliate. Tower recognized a gain of $7.0 million on its 10.7% interest in Canopius Group in 2013. This investment was accounted for under the equity method of accounting. On December 13, 2013, Tower closed a sale of all of the shares of the capital stock of Canopius Group owned by Tower. The initial sale price was $69.7 million (£42.5
million), which has been paid in full to Tower. In addition, it was agreed that, if a legally binding contract for the sale or other transfer of shares representing a majority of the voting power of Canopius Group is entered into within six months after the date of the stock purchase agreement between the third party and Tower, a further cash payment would be made to Tower. This additional cash payment would be equivalent to the excess, if any, of (1) one-third of the difference between the amount in British pound sterling paid for the shares previously owned by Tower in such sale and £40.6 million (plus Tower’s share of expenses of such sale), minus (2) £1.95 million (the “Additional Payment”). On December 18, 2013, NKSJ Holdings announced that it had entered into an agreement, through its insurance subsidiary Sompo Japan Insurance, Inc. to purchase 100% of the shares of Canopius Group. The $7.0 million represents the excess of the $69.7 million and the fair value of the Additional Payment over the carrying value of the 10.7% investment.
In 2012, Tower recognized a loss of $1.5 million relating to its equity method investment in Canopius Group. The Company records this investment on a one quarter lag (updated for significant events in the lag period). The loss is attributable to income incurred by Canopius Group in the third quarter of 2012 offset by fourth quarter 2012 losses associated with Superstorm Sandy claims.
Income tax expense. Tower pays federal income tax on its U.S. taxed insurance subsidiaries.
For the year ended December 31, 2013, Tower recorded a full valuation allowance of which $240.6 million was recorded through income tax expense in the statement of operations and $32.5 million was recorded as a direct reduction to shareholders’ equity ($33.7 million in accumulated other comprehensive income and $(1.2) million in additional paid in capital). Tower’s effective tax rate of (1.0)% and 47.7% for the years ended December 31, 2013 and 2012, respectively, reflect the impact of recording the valuation allowance.
Total revenues. Total revenues increased by 8.3% for the year ended December 31, 2012 as compared to 2011, primarily due to increased net premiums earned.
Loss and loss adjustment expenses. The consolidated net loss ratio, which includes the Reciprocal Exchanges, was 73.4% and 67.6% for the years ended December 31, 2012 and 2011, respectively. Excluding the Reciprocal Exchanges, the net loss ratio was 74.1% and 69.1% for the years ended December 31, 2012 and 2011, respectively. Severe weather losses, primarily from Superstorm Sandy, added 7.3 points and 5.3 points, respectively, to the loss ratio excluding the Reciprocal Exchanges in 2012 and 2011.
The consolidated gross underwriting expense ratio increased to 33.9% for the year ended December 31, 2012 from 32.6% in the same period in 2011. The commission portion of the gross underwriting expense ratio increased to 18.5% for the year ended December 31, 2012 compared to 17.3% in 2011. This increase is attributed to the increase in assumed reinsurance business written, as noted above, as assumed reinsurance has a significantly higher commission rate than direct written policies. The gross OUE ratio was 15.4% for the year ended December 31, 2012 compared to 15.2% for the prior year.
Acquisition-related transaction costs. Acquisition-related transaction costs for the year ended 2012 were $9.2 million and relate primarily to the acquisition of our equity interest in Canopius Group and expenses associated with the Canopius Merger Transactions. These costs were negligible for 2011.
Interest expense. Interest expense decreased by $1.7 million for the year ended December 31, 2012 compared to 2011. Interest expense declined as payments on certain of our subordinated debentures moved from higher fixed rates to floating rates per the terms of the contracts.
Equity in income (loss) of unconsolidated affiliate. Tower recognized a loss of $1.5 million in 2012 relating to its equity method investment in Canopius Group. The Company records this investment on a one quarter lag (updated for significant events in the lag period). The loss is attributable to income incurred by Canopius Group in the third quarter of 2012 offset by fourth quarter 2012 losses associated with Superstorm Sandy claims.
Income tax expense. Income tax expense was a benefit of $29.1 million in 2012 compared to an expense of $14.1 million in 2011. The change of $43.2 million in income tax expense is directly attributable to the change of pre-tax income from $69.5 million in 2011 to a pre-tax loss of $61.0 million in 2012. The effective income tax rate (including state and local taxes) was 47.7% for the year ended December 31, 2012, compared to 20.2% for 2011. The increase in the effective tax rate in 2012 is related to the permanent income tax adjustments and the movement of a valuation allowance on the Reciprocal Exchanges in 2012, offset by acquisition-related transaction costs which increased the 2012 income tax benefit.
Net loss and loss adjustment expenses. The net calendar year loss ratios were 127.3% and 77.8% for the years ended December 31, 2013 and 2012, respectively. The accident year loss ratios for the years ended December 31, 2013 and 2012 were 69.3% and 70.0%, respectively.
Incurred losses and LAE attributable to insured events of prior years were $539.8 million for the year ended December 31, 2013, which was attributed to increases in ultimate loss estimates from the company’s reserve studies completed during the year which primarily impacted the workers’ compensation, commercial package liability, other liability and commercial auto liability lines of business. Incurred losses and LAE for the year ended December 31, 2012 attributable to insured events of prior years had unfavorable loss development of $86.6 million.
Underwriting expenses. Underwriting expenses, which include direct commissions and other underwriting expenses, increased by $18.4 million, or 4.7%, for the year ended December 31, 2013 compared to the prior year. The net underwriting expense ratio increased 5.8 percentage points for year ended December 31, 2013 compared to 2012.
The gross underwriting expense ratio was 36.1% for the year ended December 31, 2013 compared to 31.9% for 2012. The commission portion of the gross underwriting expense ratio, which is expressed as a percentage of gross premiums earned, was 18.2% for the year ended December 31, 2013 compared to 17.1% for the prior year. The OUE ratio, including boards, bureaus and taxes (“BB&T”), was 17.8% for the year ended December 31, 2013 compared to 14.8% for 2012. The increases in the OUE and OUE ratios are due to (i) impairment charges recorded on the customer relationship intangible assets and (ii) increased costs associated with improving information technology systems and infrastructure.
Underwriting profit (loss) and combined ratio. The net combined ratio for the year ended December 31, 2013 was 167.1% compared to 111.8% for 2012. The increase in the combined ratio is driven primarily by the increase in loss reserves, as discussed above, and increase in the OUE expenses, and decline in net earned premiums.
Premiums. Net premiums written for the year ended December 31, 2012 decreased $2.5 million and net premiums earned for the year ended December 31, 2012 increased $52.5 million compared to 2011.
Gross premiums written for the year ended December 31, 2012 were $1,179.4 million as compared to $1,152.4 million during the same period in 2011. The increase of $27.0 million is primarily attributed to our growth in programs. Gross premiums earned were $1,201.9 million as compared to $1,142.5 million during 2011.
Ceded premiums written for the year ended December 31, 2012 were $102.2 million compared to $72.7 million for the prior year. Ceded premiums earned were $97.3 million compared to $90.4 million for the year ended December 31, 2012 compared to the same period in 2011. The increase in ceded premiums written in 2012 is attributable primarily (i) to increased written premiums on certain program business which is then reinsured through the quota share treaties and (ii) to the reinstatement premiums on our catastrophe reinsurance program as a result of Superstorm Sandy. In addition, the Company’s catastrophe reinsurance premiums increased in 2012 compared to 2011.
The Company’s renewal retention rate was 64.0% for the year ended December 31, 2012 compared to 65.2% during the prior year. Premiums on renewed commercial business, other than programs, increased 4.5% in 2012. Excluding programs, policies in-force for our commercial business increased 1.0% as of December 31, 2012 from December 31, 2011.
For the year ended December 31, 2012, the Company incurred net losses of $45.7 million relating to the Superstorm Sandy. Excluding the effects of Superstorm Sandy, the net loss ratio would have been 73.7% for the year ended December 31, 2012. For the year ended December 31, 2011, the Company incurred net losses of $31.5 million relating to Hurricane Irene and other severe weather events. Excluding the effects of these storms, the net loss ratio was 67.4% for the year ended December 31, 2011.
17.1% for the year ended December 31, 2012 compared to 17.3% in 2011. The decrease is primarily due to the assumed reinsurance business which has a higher commission ratio. The OUE ratio, including BB&T, was 14.8% for the year ended December 31, 2012 compared to 13.2% for 2011. The increase in the OUE ratio is primarily a result of ongoing efforts by us to build-out our information technology infrastructure to support our policy administration and claims processing needs.
Underwriting profit (loss) and combined ratio. Underwriting loss increased $108.1 million and the combined ratio increased 9.7 percentage points for the year ended December 31, 2012 compared to the year ended December 31, 2011. The increase in the combined ratio for the twelve months ended December 31, 2012 resulted primarily from the reserve increases the Company recorded in the first and second quarters of 2012 and losses from Superstorm Sandy in the fourth quarter of 2012. Such losses aggregated $34.7 million and increased the calendar year loss ratio by 4.1 percentage points. In 2011, the Company recorded catastrophe and other severe storm losses but to a much lower extent. Such losses aggregated $31.5 million and increased the loss ratio by points in 2011. In addition, as discussed above, the expense ratio increased by 3.0 percentage points from 2011 to 2012.
Premiums. Net premiums written for the year ended December 31, 2013 decreased $65.9 million and net premiums earned for the year ended December 31, 2013 decreased $3.6 million compared to the same period in 2012. In the fourth quarter of 2013, the Company commuted certain of its assumed reinsurance programs, which resulted in a decline in assumed premiums written and assumed premiums earned, compared to 2012.
Net loss and loss adjustment expenses. The net calendar year loss ratios were 35.6% and 44.1% for the year ended December 31, 2013 and 2012, respectively. The accident year loss ratios for the year ended December 31, 2013 and 2012 were 40.2% and 46.2%, respectively. Incurred losses and LAE attributable to insured events of prior years had a favorable loss development of $5.4 million for the year ended December 31, 2013, which were primarily attributed to the reduction in the reserve risk premium associated with the commuted Canopius reserves. Incurred losses and LAE for the year ended December 31, 2012 attributable to insured events of prior years were $2.5 million favorable.
Underwriting gain (loss) and combined ratio. Underwriting profit declined $5.5 million and the combined ratio moved unfavorably by 4.1 percentage points for the year ended December 31, 2013 compared to the year ended December 31, 2012. These changes are primarily related to the Company’s decline in net premiums earned offset by the increase in federal excise tax and OUE in 2013 compared to 2012.
Premiums. Net premiums written for the year ended December 31, 2012 increased $75.8 million and net premiums earned for the year ended December 31, 2011 increased $84.2 million compared to 2011. The increase in the net premiums written and earned in the year ended December 31, 2012 is attributable to Tower management actively increasing its participation in the assumed reinsurance market in 2012.
Net loss and loss adjustment expenses. The net calendar year loss ratios were 44.1% and 48.7% for the years ended December 31, 2012 and 2011, respectively. The accident year loss ratios for the years ended December 31, 2012 and 2011 were 46.2% and 49.1%, respectively. Incurred losses and LAE attributable to insured events of prior years had a favorable loss development of $2.5 million for the year ended December 31, 2012. Incurred losses and LAE for the year ended December 31, 2011 attributable to insured events of prior years were $0.1 million favorable.
Underwriting gain (loss) and combined ratio. Underwriting profit increased $16.4 million and the combined ratio improved by 0.9 percentage points for the year ended December 31, 2012 compared to the year ended December 31, 2011. The improvements in underwriting gain and combined ratio are due to the increase in business written in 2012 compared to 2011, and the management actively increasing its participation in the assumed reinsurance market in 2012.
Premiums. Net premiums written for the year ended December 31, 2013 decreased $115.4 million and net premiums earned for the year ended December 31, 2013 decreased $32.5 million, compared to the year ended December 31, 2012. The decrease in net premiums written is attributed to an increase in reinsurance purchased in 2013. The Company entered into two new homeowners quota share reinsurance treaties effective January 1, 2013 and November 1, 2013 both of which included an unearned premium portfolio. The effects of the new homeowners quota share treaty will reduce the net earned premiums over time as the ceded written premiums are earned over the life of the policies.
Ceding commission revenue. Ceding commission revenue increased for the year ended December 31, 2013 by $26.6 million compared to the year ended December 31, 2012. The increase was the result of the new homeowners quota share reinsurance treaties.
The gross underwriting expense ratio was 38.2% and 35.6% for the years ended December 31, 2013 and 2012, respectively. The commission portion of the gross underwriting expense ratio, which is expressed as a percentage of gross premiums earned, was 17.7% for the year ended December 31, 2013 compared to 17.9% for 2012. The gross OUE ratio, which includes BB&T, was 20.5% for the year ended December 31, 2013 compared 17.7% for the prior year.
Ceded premiums written for the year ended December 31, 2012 were $129.4 million, an increase of $30.1 million as compared to $99.3 million in 2011. Ceded premiums earned were $124.4 million for the year ended December 31, 2012 compared to $105.2 million in 2011. The Company reinsures the homeowners and umbrella business obtained from OBPL through a quota share program. The Company also purchased catastrophe reinsurance for certain property business. The increase in ceded premiums written is due to the increase in gross premiums written and to reinstatement premiums on our catastrophe reinsurance program as a result of Superstorm Sandy.
The Company’s personal lines renewal retention was 89.3% and 83.4% for the years ended December 31, 2012 and 2011, respectively. Premiums on renewed personal business increased by 0.1% in 2012 compared to a 5.4% decline in 2011. Policies-in-force decreased by 5.2% at December 31, 2012 as compared to December 31, 2011.
For Tower personal lines, excluding the Reciprocal Exchanges, the net calendar year loss ratios were 72.5% and 67.2% for the years ended December 31, 2012 and 2011, respectively. The accident year loss ratios for the years ended December 31, 2012 and 2011 were 71.3% and 76.4%, respectively. There was a reserve increase of $4.0 million for the year ended December 31, 2012, and net favorable loss development of $29.1 million for the year ended December 31, 2011. For the year ended December 31, 2012, the Company recorded $237.8 million of incurred losses, with $42.8 million relating to Superstorm Sandy.
Underwriting expenses. Underwriting expenses, which include direct commissions and other underwriting expenses, increased by $9.8 million, or 4.5% for the year ended December 31, 2012 as compared to the prior year. The net underwriting expense ratio increased 1.3 percentage points from 2011 to 2012.
The gross underwriting expense ratio for the year ended December 31, 2012 was 35.6% compared to 33.6% in 2011. The commission portion of the gross underwriting expense ratio, which is expressed as a percentage of gross premiums earned, was 17.9% for the year ended December 31, 2012 compared to 16.6% for the prior year. The increase in the commission ratio was due to the growth in OBPL business which carries a slightly higher commission rate than the traditional Tower business.
The following table shows the composition of the other invested assets as of December 31, 2013 and 2012:
The average credit rating of our fixed-maturity securities, using ratings assigned to securities by Standard & Poor’s, was A+ at December 31, 2013 and 2012. The following table shows the ratings distribution of our fixed-maturity portfolio:
As of December 31, 2013, our municipal bonds consisted of state general obligations, municipal general obligations and special revenue bonds. Municipal bonds by state at December 31, 2013 are as follows:
No one jurisdiction within “Other” in the table above exceeded 3% of the total fair value of municipal bonds. As of December 31, 2013, the special revenue bonds are supported primarily by water and sewer utilities, electric utilities, college revenues and highway tolls.
Our process to validate the market prices obtained from the outside pricing sources includes, but is 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. Several securities sold during the year were “back-tested” (i.e., the sales price is compared to the previous month end reported market price to determine reasonableness of the reported market price).
In certain instances, we deemed it necessary to utilize Level 3 pricing over prices available through pricing services used throughout 2013 and 2012. The ability to observe stable prices and inputs may be reduced for highly-customized an illiquid instruments as currently is the case for certain non-agency residential and commercial mortgage-backed securities and asset-backed securities.
(1) $43.6 million of the $95.8 million Other invested assets reported on the consolidated balance sheet at December 31, 2013 is reported at fair value. The remaining $52.2 million of Other invested assets is reported under the equity method of accounting or at amortized cost.
At December 31, 2013, the investments in an unrealized loss position for twelve months or greater were primarily in our corporate industrial bonds and preferred stocks.
The following table stratifies the gross unrealized losses in the portfolio at December 31, 2013, by duration in a loss position and magnitude of the loss as a percentage of the cost or amortized cost of the security:
The following tables show the fair value and unrealized loss by sector and credit quality rating of our corporate and other bonds in an unrealized loss position at December 31, 2013:
The following tables show the fair value and unrealized loss by credit quality rating and deal origination year of our commercial mortgage-backed, non-agency residential mortgage-backed and asset-backed securities in an unrealized loss position at December 31, 2013:
For the year ended December 31, 2012, net cash provided by operating activities was $109.3 million as compared to $82.8 million for 2011. The increase in operating cash flow in 2012 primarily resulted from the increase in written premiums in 2012. In addition, in the fourth quarter of 2011, Tower’s paid claims increased as a result of Hurricane Irene. In 2012, while Superstorm Sandy increased incurred losses in the fourth quarter of 2012, the majority of claims were paid in 2013.
U.S. based insurance companies are required to maintain capital and surplus above Company Action Level, which is a calculated capital and surplus number using a risk-based formula adopted by the state insurance regulators. The basis for this formula is the National Association of Insurance Commissioners’ (“NAIC’s”) risk-based capital (“RBC”) system and is designed to measure the adequacy of a U.S. regulated insurer’s statutory capital and surplus compared to risks inherent in its business. If an insurance entity falls into Company Action Level, its management is required to submit a comprehensive financial plan that identifies the conditions that contributed to the financial condition. This plan must contain proposals to correct the financial problems and provide projections of the financial condition, both with and without the proposed corrections. The plan must also outline the key assumptions underlying the projections and identify the quality of, and problems associated with, the underlying business. Depending on the level of actual capital and surplus in comparison to the Company Action Level, the state insurance regulators could increase their regulatory oversight, restrict the placement of new business, or place the company under regulatory control. Bermuda based insurance entities minimum capital and surplus requirements are calculated from a solvency formula prescribed by the Bermuda Monetary Authority (the “BMA”).
In 2013, the NYDFS issued orders for seven of Tower’s insurance subsidiaries, subjecting them to heightened regulatory oversight, which includes providing the NYDFS with increased information with respect to the insurance subsidiaries’ business,
On November 14, 2013, Tower announced that the Company’s Board of Directors determined it would not declare and pay a dividend to holders of Tower’s common shares in the fourth quarter of 2013.
On December 20, 2013, A.M. Best lowered the financial strength ratings of each of Tower’s insurance subsidiaries from “B++” (Good) to “B” (Fair) (the seventh highest of fifteen rating levels), as well as the issuer credit ratings of each of Tower’s insurance subsidiaries from “bbb” to “bb”. Previously, on October 8, 2013, A.M. Best had downgraded the financial strength rating of each of Tower’s insurance subsidiaries to “B++” (Good) and their respective issuer credit ratings to “bbb” from “a-”. In addition, on December 20, 2013 A.M. Best downgraded the issuer credit rating of TGI as well as the debt rating on its $146.9 million 5.00% senior convertible notes due 2014 (the “Notes”) to “b-” from “bb”. On the same date, A.M. Best also downgraded the financial strength rating of CastlePoint Reinsurance Company, Ltd. (Bermuda) to “B” (Fair) from “B++” (Good) and its issuer credit rating to “bb” from “bbb” and downgraded the issuer credit rating of Tower Group International, Ltd. to “b-” from “bb”. TGI and each of its insurance subsidiaries currently are and will continue to be under review with negative implications pending further discussions between A.M. Best and management. In downgrading Tower’s ratings, A.M. Best stated that its actions “consider the magnitude of the charges taken and the material adverse impact on Tower’s risk-adjusted capitalization, financial leverage, liquidity and coverage ratios,” “consider the reduced financial flexibility [of the Company] given [its] delay in earnings, the decline in shareholder confidence and the corresponding decline in share price” and “reflect the potential for further adverse reserve development, increased competitive challenges and due to the ratings downgrade, potential actions taken by third party reinsurers and lenders.” Following the announcement of the ACP Re merger, on January 10, 2014 A.M. Best maintained the under review status of Tower’s financial strength and issuer credit ratings and revised the implications from “negative” to “developing” for all of these ratings. A.M. Best stated that, “[t]he under review status with developing implications reflects the potential benefits to be garnered from the transaction as well as the potential downside from any additional adverse reserve development and/or any unforeseen events that might transpire up until the close of the transaction”
On January 2, 2014, Fitch downgraded Tower’s issuer default rating from “B” to “CC” and the insurer strength ratings of its insurance subsidiaries from “BB” to “B”. On October 7, 2013, Fitch downgraded Tower’s issuer default rating to “B” (the sixth highest of 11 such ratings) from “BBB” and the insurer strength ratings of its insurance subsidiaries to “B” (the fifth highest of Fitch Ratings’ nine such ratings) from “A-”. In downgrading such ratings, Fitch stated that it “is concerned that Tower’s
On December 24, 2013, Demotech, Inc. (“Demotech”) announced the withdrawal of its Financial Stability Ratings® (FSRs) assigned to the following insurance subsidiaries: Kodiak Insurance Company, Massachusetts Homeland Insurance Company, Tower Insurance Company of New York and York Insurance Company of Maine. Concurrently, Demotech advised that the FSRs assigned to Adirondack Insurance Exchange, Mountain Valley Indemnity Company, New Jersey Skylands Insurance Association and New Jersey Skylands Insurance Company remain under review.
In addition, one of Tower’s ceding companies requested as a result of contractual provisions that $26.3 million of additional collateral be provided to support the recoverability of their reinsurance receivable from Tower. The $26.3 million was funded in October 2013. Tower’s U.S. based insurance subsidiaries are also required to post collateral for various statutory purposes, and such requests are received from time to time from various regulatory authorities.
On December 13, 2013, TGI closed a sale to an investment fund managed by Bregal Capital LLP (Bregal) of all of the shares of the capital stock of Canopius Group owned by TGI. The initial purchase price for the Canopius shares was $69.7 million (£42.5 million), which has been paid in full to TGI. In addition, it was agreed that if a legally binding contract for the sale or other transfer of shares representing a majority of the voting power of Canopius Group is entered into within six months after the date of TGI’s stock purchase agreement with Bregal, a further cash payment would be made by Bregal to TGI. This additional cash payment would be equivalent to the excess, if any, of (1) one-third of the difference between the amount in British pound sterling paid for the shares previously owned by TGI in such sale and £40.6 million (plus TGI’s share of expenses of such sale), minus (2) £1.95 million. TGI purchased its 10.7% equity stake in Canopius Group in August 2012 for $71.5 million. On December 18, 2013, NKSJ Holdings announced that it had entered into an agreement, through its insurance subsidiary Sompo Japan Insurance Inc. to purchase 100% of the shares of Canopius Group.
The following table summarizes information about contractual obligations and commercial commitments. The minimum payments under these agreements as of December 31, 2013 were as follows:
At various times we have issued trust preferred securities through wholly-owned Delaware statutory business trusts. The trusts used the proceeds of the sale of the trust preferred securities to third-party investors and common trust securities to Tower to purchase junior subordinated debentures from the Company. The terms of the junior subordinated debentures 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. See “Note 13 - Debt” for the principal terms of the subordinated debentures.
non-payment of interest on the subordinated debentures, unless such non-payment is due to a valid extension of an interest payment period;
In September 2010, TGI issued $150 million principal amount of 5.0% convertible senior notes (the “Notes”) due September 15, 2014. Interest is being paid semi-annually commencing March 2011. Holders may convert their Notes into cash or common shares, at TGI’s option, at any time on or after March 15, 2014 or earlier under certain circumstances determined by: (i) the market price of the Company’s stock, (ii) the trading price of the Notes, or (iii) the occurrence of specified corporate transactions. Upon conversion, TGI intends to settle its obligation either entirely or partially in cash. The conversion rate was adjusted quarterly while the Company was paying its quarterly dividends. At December 31, 2013 the conversion rate is 41.4269 shares of common stock per $1,000 principal amount of the Notes (equivalent to a conversion price of $24.14 per share), subject to further adjustment upon the occurrence of certain events, including future dividend payments. Additionally, in the event of a fundamental change, the holders may require TGI to repurchase the Notes for a cash price equal to 100% of the principal plus any accrued and unpaid interest.
In May 2010, the Company entered into a $125.0 million credit facility agreement. The credit facility was a revolving credit facility with a letter of credit sublimit of $25.0 million. The credit facility was being used for general corporate purposes. The Company had the option to request that the facility be increased by an amount not to exceed $50.0 million. On February 15, 2012, the Company amended its $125.0 million credit facility by increasing borrowing capacity up to $150 million, extending the maturity out to February 2016, and resetting borrowing fees to more favorable current market terms. The Company had $70.0 million outstanding under the credit facility as of December 31, 2012. On November 26, 2012, the Company further amended its credit facility whereby the lenders provided consent to the proposed merger of TGI with a subsidiary of Canopius Holdings Bermuda Limited. The second amendment also increased the Company’s maximum revolving commitment by $70 million to $220 million upon the effectiveness of the Merger and the satisfaction of certain other conditions set forth in the Second Amendment. On October 11, 2013, the Company amended its credit facility to reduce its capacity from $220 million to $70 million and change its maturity date to May 30, 2014.
exceed our loss and loss adjustment expense reserves, our financial condition and results of operations could be significantly adversely affected,” for a discussion of the uncertainties associated with estimating loss and LAE expense reserves. The estimated ceded reserves recoverable referred to above also assumes timely reimbursement from our reinsurers. If our reinsurers do not meet their contractual obligations on a timely basis, the payment assumptions presented above could vary materially.
The Company had $70 million outstanding as of December 31, 2012 under the credit facility. The Company was in compliance with all covenants contained in the credit facility as of December 31, 2012. On December 13, 2013, TGI paid in full the $70.0 million outstanding on the bank credit facility and the bank credit facility was terminated.
The Company’s plan to repay TGI’s $150 million Convertible Senior Notes (due September 2014) is also related to the closing of the ACP Re Merger Agreement with ACP Re. In the event that the ACP Re Merger Agreement does not close, the Company would evaluate a combination of using proceeds from the sale of assets held at TGI, including but not limited to, renewal rights on its commercial and personal line of business and certain of its insurance companies to pay down the principal of the Notes. The Company can provide no assurance that it will be successful in finalizing the liquidation of the assets held at TGI or selling certain of its operating assets to satisfy repayment of the Notes.
For a discussion of accounting standards, see “Note 2 - Accounting Policies and Basis of Presentation” of Notes to Consolidated Financial Statements.
Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2013, 2012, and 2011
Consolidated Statements of Cash Flows for the years ended December 31, 2013, 2012, and
To the Board of Directors and Shareholders of Tower Group International, Ltd.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, comprehensive income, changes in shareholders’ equity and cash flows present fairly, in all material respects, the financial position of Tower Group International, Ltd. and its subsidiaries at December 31, 2013 and 2012, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2013 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company did not maintain, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) because the following material weaknesses in internal control over financial reporting existed at that date. The Company did not maintain effective controls over (i) the monitoring of other control activities, (ii) the loss reserve estimation process, (iii) the premiums receivable account reconciliation, (iv) the impairment process of the long-lived tangible and intangible assets, (v) information technology general controls with respect to segregation of duties, restricted access to programs and data, and change management activities, (vi) the income tax valuation allowance estimation process and (vii) the period-end financial reporting process. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. The material weaknesses referred to above are described in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. We considered these material weaknesses in determining the nature, timing, and extent of audit tests applied in our audit of the 2013 consolidated financial statements and our opinion regarding the effectiveness of the Company’s internal control over financial reporting does not affect our opinion on those consolidated financial statements. The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in management’s report referred to above. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
Notwithstanding any other statement in this Form 10-K or any other document, many of the conditions for closing the ACP Re Merger Agreement remain outstanding and there can be no assurance that they will be satisfied or that the transaction will be consummated or when it may close.
Pursuant to the terms of the ACP Re Merger Agreement, at the effective time of the merger, each outstanding share of Tower’s common stock, par value $0.01 per share (the “Common Shares”), following the settlement of all outstanding equity awards, will be converted into the right to receive $3.00 in cash, with an aggregate value of approximately $172.1 million.
Each of the parties has made representations and warranties in the ACP Re Merger Agreement. Tower has agreed to certain covenants and agreements, including, among others, (i) to conduct its business in the ordinary course of business, consistent with past practice, during the period between the execution of the ACP Re Merger Agreement and the closing of the merger, (ii) not to solicit alternate transactions, subject to a customary “fiduciary out” provision which allows Tower under certain circumstances to provide information to and participate in discussions with third parties with respect to unsolicited alternative acquisition proposals that Tower’s Board of Directors has determined, in its good faith judgment, is appropriate in furtherance of the best interests of Tower, and (iii) to call and hold a special shareholders’ meeting and recommend adoption of the ACP Re Merger Agreement.
The ACP Re Merger Agreement was unanimously approved by the respective Boards of Directors of ACP Re and Tower, and is conditioned, among other things, on: (i) the approval of Tower’s shareholders, (ii) receipt of governmental approvals, including antitrust and insurance regulatory approvals (on January 30, 2014, the Company was granted early termination of the Hart-Scott-Rodino waiting period which requires persons contemplating certain mergers or acquisitions to give the Federal Trade Commission and the Assistant Attorney General advanced notice and to wait designated periods before consummation of such plans), (iii) the absence of any law, order or injunction prohibiting the merger, (iv) the accuracy of each party’s representations and warranties (subject to customary materiality qualifiers), and (v) each party’s compliance with its covenants and agreements contained in the ACP Re Merger Agreement. In addition, ACP Re’s obligation to consummate the merger is subject to the non-occurrence of any material adverse effect on Tower, as well as the absence of any insolvency-related event affecting Tower. The transaction is also conditioned on holders of not more than 15% of Tower’s common stock dissenting to the merger.
The ACP Re Merger Agreement provides certain termination rights for each of Tower and ACP Re, and further provides that upon termination of the ACP Re Merger Agreement, under certain circumstances, Tower will be obligated to reimburse ACP Re for certain of its transaction expenses, subject to a cap of $2 million, and to pay ACP Re a termination fee of $8.18 million, net of any transaction expenses it has reimbursed.
Loss reserve increase, goodwill and fixed asset impairment and deferred tax valuation allowance
The 2013 reserve increase was viewed by the Company as an event or circumstance that required the Company to perform a detailed quantitative analysis of whether its recorded goodwill was impaired. After performing the quantitative analysis in the second quarter of 2013, it was determined that $214.0 million of goodwill, which represents all of the goodwill allocated to the Commercial Insurance reporting unit, was impaired. In the third quarter of 2013, management in its judgment concluded that the remaining $55.5 million of goodwill, all of which was allocated to the Personal Insurance reporting unit, was impaired. In addition, $1.9 million of additional goodwill resulting from the acquisition of marine and energy business in July of 2013 was fully impaired as of September 30, 2013. Additionally, in 2013, the Company impaired $125.8 million of fixed assets. At December 31, 2013, there was no goodwill remaining on the balance sheet. See “Note 7 - Goodwill, Intangible and Fixed Asset Impairments” for additional detail on the goodwill and fixed asset impairments.
As a result of the reserve increase and goodwill and fixed assets impairment charges, the Company’s U.S. based operations have a pre-tax loss for 2013, which results in a three-year cumulative tax loss position on its U.S. subsidiaries. After considering this negative evidence and uncertainty regarding the Company’s ability to generate sufficient future taxable income in the United States, the Company concluded that it should not recognize any net deferred tax assets (comprised principally of net operating loss carryforwards). The Company, therefore, has provided a full valuation allowance against its deferred tax asset at December 31, 2013.
The second agreement was between TICNY, on its behalf and on behalf of each of its pool participants, and Hannover. Under this multi-line quota share agreement, TICNY ceded 14% on a quota share of certain brokerage commercial automobile liability, brokerage commercial multi-peril property, brokerage commercial multi-peril liability, brokerage other liability (mono line liability) and brokerage workers’ compensation businesses. The agreement covers losses occurring on or after July 1, 2013 for policies in-force as of June 30, 2013 and policies written or renewed from July 1, 2013 to December 31, 2013.
The third arrangement with Southport Re consisted of two separate agreements with TICNY, on its behalf and on behalf of each of its pool participants, and a third reinsurance agreement with Tower Reinsurance, Ltd. (“TRL”). Under the first of the agreements with TICNY, TICNY ceded to Southport Re a 30% quota share of its workers’ compensation and employer’s liability business (the “Southport Quota Share”). The Southport Quota Share covers losses occurring on or after July 1, 2013 for policies in force at June 30, 2013 and policies written or renewed during the term of the agreement and has been accounted for using deposit accounting treatment. Deposit assets of $28.7 million as of December 31, 2013 related to the Southport Quota Share are reflected in Other assets in the consolidated balance sheet. Under the second of these agreements with TICNY, an aggregate excess of loss agreement, Southport Re assumed a portion of the losses incurred by TICNY on its workers’ compensation and employer’s liability business between January 1, 2011 and June 30, 2013, but paid by TICNY on or after June 1, 2013 (the “TICNY/Southport Re ADC”). Finally, TRL, a wholly-owned Bermuda-domiciled reinsurance subsidiary of Tower, also entered into an aggregate excess of loss agreement with Southport Re, in which Southport Re assumed a portion of the losses incurred by TRL on its assumed workers’ compensation and employer’s liability business between January 1, 2011 and June 30, 2013, but paid by TRL on or after June 1, 2013 (the “TRL/Southport Re ADC”, or, collectively, the “Southport Re ADCs”).
The reinsurance agreements with Arch and Hannover Re resulted in ceded premiums earned, ceding commission revenue and ceded loss and loss adjustment expenses of $76.8 million, $22.3 million, and $41.1 million, respectively, for the year ended December 31, 2013.
On December 20, 2013, A.M. Best lowered the financial strength ratings of each of Tower’s insurance subsidiaries from “B++” (Good) to “B” (Fair) (the seventh highest of fifteen rating levels), as well as the issuer credit ratings of each of Tower’s insurance subsidiaries from “bbb” to “bb”. Previously, on October 8, 2013, A.M. Best had downgraded the financial strength rating of each of Tower’s insurance subsidiaries to “B++” (Good) and their respective issuer credit ratings to “bbb” from “a-”. In addition, on December 20, 2013 A.M. Best downgraded the issuer credit rating of TGI as well as the debt rating on its $147.7 million 5.00% senior convertible notes due 2014 (the “Notes”) to “b-” from “bb”. On the same date, A.M. Best also downgraded the financial strength rating of CastlePoint Reinsurance Company, Ltd. (Bermuda) to “B” (Fair) from “B++” (Good) and its issuer credit rating to “bb” from “bbb” and downgraded the issuer credit rating of Tower Group International, Ltd. to “b-” from “bb”. TGI and each of its insurance subsidiaries currently are and will continue to be under review with negative implications pending further discussions between A.M. Best and management. In downgrading Tower’s ratings, A.M. Best stated that its actions “consider the magnitude of the charges taken and the material adverse impact on Tower’s risk-adjusted capitalization, financial leverage, liquidity and coverage ratios,” “consider the reduced financial flexibility [of the Company] given [its] delay in earnings, the decline in shareholder confidence and the corresponding decline in share price” and “reflect the potential for further adverse reserve development, increased competitive challenges and due to the ratings downgrade, potential actions taken by third party reinsurers and lenders.” Following the announcement of the ACP Re merger, on January 10, 2014 A.M. Best maintained the under review status of Tower’s financial strength and issuer credit ratings and revised the implications from “negative” to “developing” for all of these ratings. A.M. Best stated that, “[t]he under review status with developing implications reflects the potential benefits to be garnered from the transaction as well as the potential downside from any additional adverse reserve development and/or any unforeseen events that might transpire up until the close of the transaction”
Tower’s products include the following lines of business: commercial multiple-peril packages, other liability, workers’ compensation, commercial automobile, fire and allied lines, inland marine, personal package, homeowners, personal automobile and assumed reinsurance. These products are sold, primarily, through retail agencies, wholesale agencies, program underwriting agents, and reinsurance brokerage units. With the exception of the personal automobile insurance written through retail agencies and wholesale agencies, which represents $98.1 million of written premiums (excluding the Reciprocal Exchanges) for the year ended December 31, 2013, management believes the Company will be unable to continue writing the majority of its business following the second A.M. Best rating downgrade on December 20, 2013. The total effect of these ratings actions on the Company’s financial position, results of operations or liquidity is not determinable at this stage.
The Massachusetts Division of Insurance (“MDOI”) and Tower management have agreed to certain restrictions on the operations of Tower’s two Massachusetts domiciled insurance subsidiaries. Tower management has agreed to cause these subsidiaries to provide the MDOI with increased information with respect to their business, operations and financial condition, as well as limitations on payments and transactions outside the ordinary course of business and material changes in their management and related matters.
TGI was the obligor under the bank credit facility agreement dated as of February 15, 2012, as amended, with Bank of America, N.A. and other lenders named therein and is the obligor under the $150 million Convertible Senior Notes (“Notes”) due September 15, 2014. The indebtedness of TGI is guaranteed by TGIL, and for purposes of the credit facility was also guaranteed by several of TGIL’s non-insurance subsidiaries.
As of December 31, 2013, there were $235.1 million of subordinated debentures outstanding. The subordinated debentures do not have financial covenants that would cause an acceleration of their stated maturities. The earliest stated maturity date is on a $10 million debenture, which matures in May 2033. The Company has the ability to defer interest payments on its subordinated debentures for up to twenty quarters. If an event of default occurs and is continuing, the entire principal and the interest accrued on the affected subordinated indenture may be declared to be due and payable immediately.
The merger with ACP Re is expected to close in the summer of 2014, and there are contractual termination rights available to each of Tower and ACP Re under various circumstances. There can be no assurance that the merger will close, or that it will close under the same terms and conditions contained in the ACP Re Merger Agreement, or as to when it may close.
There can be no guarantee that the Company will be able to remedy current statutory capital deficiencies in certain of its insurance subsidiaries, maintain adequate levels of statutory capital in the future, or generate sufficient liquidity to repay the Notes due in 2014. Consequently, there is substantial doubt about the Company’s ability to continue as a going concern. Should the Company be unable to successfully execute the merger with ACP Re or generate sufficient funds to repay the Notes and remedy the capital deficiencies, these conditions would have a material adverse effect on its business, results of operations and financial position.
The Canopius Merger Transaction was accounted for as a reverse acquisition, under which TGI was identified and treated as the accounting acquirer. As such, the Company’s consolidated financial statements include the accounts and operations of TGI and its insurance subsidiaries, managing general agencies and management companies as its historical financial statements, with the results of Tower Group International, Ltd., as accounting acquiree, being included from March 13, 2013, the effective date of the Canopius Merger Transaction. The consolidated financial statements also include the accounts of Adirondack Insurance Exchange, a New York reciprocal insurer, and New Jersey Skylands Insurance Association, a New Jersey reciprocal insurer (together, the “Reciprocal Exchanges”). The Company does not own the Reciprocal Exchanges but manages their business operations through its wholly-owned management companies.
Assumed Reinsurance (“Assumed Reinsurance”) segment offers international assumed reinsurance and certain U.S. based assumed reinsurance; and
Since the Company accounted for the Canopius Merger Transaction as a reverse acquisition and recapitalization, it has retroactively restated Common Stock, Treasury Stock and Paid-in-Capital accounts and earnings per share for periods prior to the Canopius Merger Transaction to reflect the historical capitalization of TGI, adjusted for the 1.1330 conversion ratio as discussed in “Note 3 - Canopius Merger Transaction”. Certain other reclassifications have also been made to prior years’ financial information to conform to the current year presentation, including the changes in segment presentation discussed in “Note 1 - Nature of Business.”
In addition, as a result of the immaterial adjustments to the “cash and cash equivalents” balances discussed above, the Company also revised its statement of cash flows. Cash flows used in investing activities increased from $89.1 million as originally reported to $100.5 million for the year ended December 31, 2012, and cash and cash equivalents as of December 31, 2012 decreased from $102.3 million to $83.8 million. Cash flows used in investing activities increased from $104.5 million as originally reported to $111.9 million for the year ended December 31, 2011, and cash and cash equivalents as of December 31, 2011 decreased from $114.1 million to $107.1 million. Management concluded these corrections were not material to the 2012 or 2011 consolidated statements of cash flows.
Direct commission revenue from the Company’s managing general underwriting services is recognized and earned as insurance policies are placed with the issuing companies of its managing general agencies. Fees relating to the provision of reinsurance intermediary services are earned when the Company’s insurance subsidiaries or the issuing companies of its managing general agencies cede premiums to reinsurers. Management fees earned by the management companies for services provided to the Reciprocal Exchanges are eliminated in consolidation.
Tower estimates reserves separately for losses, allocated loss adjustment expenses, and unallocated loss adjustment expenses. Allocated loss adjustment expenses (“ALAE”) refers to costs of attorneys as well as miscellaneous costs such as investigators, witness fees and court costs attributable to specific claims that generally are in various stages of litigation. Unallocated loss adjustment expenses (“ULAE”) refers to costs for administering claims that are not related to attorney fees and miscellaneous costs associated with litigated claims. Tower estimates the ALAE liability separately for claims that are defended by in-house attorneys, claims that are handled by other attorneys that are not employees, and miscellaneous ALAE costs such as witness fees and court costs. Similarly, Tower estimates the ULAE liability separately for claims which are handled internally by our employees and for claims which are handled by third party administrators.
We determine ULAE reserves by applying a paid-to-paid ratio to the case and IBNR reserves by line of business. The paid-to-paid ratio is based on ratios of ULAE payments to loss and ALAE payments for last three calendar years.
Management estimates uncollectible amounts receivable from reinsurers based on an assessment of a number of factors. The Company recorded no allowance for uncollectible reinsurance at December 31, 2013 or 2012. The Company did not write-off balances from reinsurers during the three year period ended December 31, 2013.
Deposit assets arise from ceded reinsurance contracts purchased that do not transfer significant underwriting or timing risk. Under deposit accounting, consideration received or paid, excluding non-refundable fees, is recorded as a deposit asset or liability in the balance sheet as opposed to recording premiums and losses in the statement of operations. At December 31, 2013, deposit assets of $28.7 million are included in Other Assets.
Fair value for fixed-maturity securities and equity securities is primarily based on quoted market prices or a matrix pricing using observable inputs, with limited exceptions as discussed in “Note 6 - Fair Value Measurements”. Changes in unrealized gains and losses, net of tax effects, are reported as a separate component of other comprehensive income while cumulative unrealized gains and losses are reported net of tax effects within accumulated other comprehensive income in shareholders’ equity. Realized gains and losses are determined on the specific identification method. Investment income is recorded when earned and includes the amortization of premium and discount on investments.
The Company, along with its outside portfolio managers, regularly reviews its fixed-maturity and equity security portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. In evaluating potential impairment, management considers, among other criteria: (i) the overall financial condition of the issuer, (ii) the current fair value compared to amortized cost or cost, as appropriate; (iii) the length of time the security’s fair value has been below amortized cost or cost; (iv) specific credit issues related to the issuer such as changes in credit rating, reduction or elimination of dividends or non-payment of scheduled interest payments; (v) whether management intends to sell the security and, if not, whether it is not more likely than not that the Company will be required to sell the security before recovery of its cost or amortized cost basis; (vi) specific cash flow estimations for fixed-maturity securities and (vii) current economic conditions. If an other-than-temporary-impairment (“OTTI”) loss is determined for a fixed-maturity security (and management does not intend to sell the security or it is not more likely than not that the Company will be required to sell the security), the credit portion is recorded in the statement of income as net realized losses on investments and the non-credit portion is recorded in accumulated other comprehensive income. The credit portion results in a permanent reduction of the cost basis of the underlying investment. OTTI losses on fixed-maturity securities management has the intent to sell or it is more likely than not that the Company will be required to sell and on equity securities are reported in realized losses for the entire impairment.
The value of business acquired (“VOBA”) is an intangible asset relating to the estimated fair value of the unexpired insurance policies acquired in a business combination. VOBA is determined at the time of a business combination and is reported on the consolidated balance sheet with DAC and is amortized in proportion to the timing of the estimated underwriting profit associated with the in force policies acquired. The Company fully amortized the VOBA in the year ended December 31, 2011 and,
accordingly, does not have any VOBA recorded on its balance sheet as of December 31, 2013 or 2012. The Company considers anticipated investment income in determining the recoverability of these costs and believes they are fully recoverable. See “Note 8 - Deferred Acquisition Costs” for additional information regarding deferred acquisition costs.
In business combinations, including the acquisition of a group of assets, the Company allocates the purchase price to the net tangible and intangible assets acquired based on their relative fair values. Any portion of the purchase price in excess of this amount results in goodwill. Identifiable intangible assets with a finite useful life are amortized over the period that the asset is expected to contribute directly or indirectly to the future cash flows of the Company and are tested for impairment when impairment indicators are present. Intangible assets with an indefinite life and goodwill are not amortized and are subject to annual impairment testing at the reporting unit level or more frequently if circumstances indicate that the value of goodwill may be impaired.
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 amortized over their useful lives and 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 are not amortized. Rather, they are tested for recoverability at least annually or whenever events or changes in circumstances indicate that a carrying amount may not be recoverable. Management performed its impairment analysis on its intangible assets with a finite useful life in 2013 and concluded impairment charges of $21.9 million were required to reduce its customer relationship intangible assets. These charges are reported in Other Operating Expenses in the consolidated statements of operations. No impairment losses were recognized on intangible assets with a finite useful life in 2012 or 2011.
result of the reserve increases, rating downgrades and the expected significant declines in net written premiums and the orders and restrictions placed by various insurance departments, management tested fixed assets for recoverability in 2013 and recorded a non-cash charge to earnings of $125.8 million in 2013. Gross fixed assets and accumulated depreciation (after the effects of the impairment) were $20.7 million and $1.0 million as of December 31, 2013.
Tower’s other liabilities balances are comprised primarily of accrued operating expenses, payables for securities purchased, accrued boards, bureaus and tax expenses, and capital lease obligations.
Although the Company owned less than 20% of the outstanding common stock of Canopius Group at December 31, 2012, it recorded its investment in Canopius Group under the equity method of accounting as it was able to significantly influence the operating and financial policies and decisions of Canopius Group. In the twelve months ended December 31, 2013 and December 31, 2012, the change in the value of the Company’s investment in Canopius was a gain of $6.9 million and a loss of $1.5 million, respectively. Changes in the value were recognized in Equity in income (loss) of unconsolidated affiliate in the consolidated statement of operations. On December 13, 2013, Tower sold its 10.7% ownership in Canopius Group.
The Company measures earnings (loss) per share at two levels: basic earnings (loss) per share and diluted earnings (loss) per share. Basic earnings per share is calculated by dividing net income (loss) attributable to Tower common shareholders by the weighted average number of common shares outstanding during the year. Undistributed net earnings (loss) (net income less dividends declared during the period) are allocated to both common stock and unvested share-based payment awards (“unvested restricted stock”). Because the common shareholders and unvested restricted stock holders share in dividends on a 1:1 basis, the earnings per share on undistributed earnings is equivalent; however, undistributed losses are allocated only to common shareholders. Undistributed earnings are allocated to all outstanding share-based payment awards, including those for which the requisite service period is not expected to be rendered. The computation of diluted earnings (loss) per share excludes outstanding options and other common stock equivalents in periods where inclusion of such potential common stock instruments would be anti-dilutive.
The Company’s insurance subsidiaries are required to prepare statutory basis financial statements in accordance with practices prescribed or permitted by the state or country in which they are domiciled. See “Note 18 - Statutory Financial Information and Accounting Policies” for more details.
In February 2013, the FASB issued amended guidance on the presentation of amounts reclassified out of accumulated other comprehensive income in one place, either on the face of the income statement or in the footnotes to the financial statements. The Company adopted this guidance effective January 1, 2013 on a prospective basis as prescribed by the amended guidance. As all of the information that this guidance requires to be disclosed is already presented elsewhere in the Company’s financial statements under existing GAAP, and it does not affect the classification, recognition or measurement of items within other comprehensive income, the adoption will not affect the Company’s financial position, results of operations or cash flows.
On March 13, 2013, Canopius Bermuda and TGI consummated the Canopius Merger Transaction contemplated by the Merger Agreement. Canopius Bermuda was re-named Tower Group International, Ltd. and became the ultimate parent company of TGI, with TGI becoming its indirect wholly-owned subsidiary. Pursuant to the terms of the Merger Agreement, among other things, (i) 100% of the issued and outstanding shares of TGI common stock were cancelled and automatically converted into the right to receive 1.1330 common shares of the Company, par value $0.01 per share (the “ Common Shares”), (ii) each outstanding option to acquire TGI common stock, whether vested or unvested and whether granted under TGI’s 2008 Long-Term Equity Compensation Plan or otherwise, automatically vested, free of any forfeiture conditions, and constituted a fully vested option to acquire that number of Common Shares (rounded down to the nearest whole number) equal to the number of shares of TGI common stock subject to such option multiplied by 1.1330, on the same terms and conditions (other than vesting and performance conditions) as were applicable to such TGI stock option immediately prior to the Canopius Merger Transaction, with the exercise price of such option adjusted to be the original exercise price divided by 1.1330, and (iii) substantially all issued and outstanding shares of TGI restricted stock, whether granted under TGI’s 2008 Long-Term Equity Compensation Plan or otherwise, automatically vested, free of any forfeiture conditions, and were converted into the right to receive, as soon as reasonably practicable after the effective time, 1.1330 Common Shares.
On December 13, 2013, Tower closed a sale to an investment fund managed by Bregal Capital LLP (“Bregal”) of all of the shares of the capital stock of Canopius Group owned by Tower. The initial purchase price for the Canopius shares is $69.7 million (£42.5 million), which has been paid in full to Tower. In addition, if a legally binding contract for the sale or other transfer of shares representing a majority of the voting power of Canopius Group is entered into within six months after the date of Tower’s stock purchase agreement with Bregal, a further cash payment would be made by Bregal to Tower. This additional cash payment would be equivalent to the excess, if any, of (1) one-third of the difference between the amount in British pound sterling paid for the shares previously owned by Tower in such sale and £40.6 million (plus Tower’s share of expenses of such sale), minus (2) £1.95 million (the “Additional Payment”). On December 18, 2013, NKSJ Holdings announced that it had entered into an agreement, through its insurance subsidiary Sompo Japan Insurance, Inc. to purchase 100% of the shares of Canopius Group. This Additional Payment meets the definition of a derivative as of December 31, 2013. Management in its judgment concluded that the initial fair value of this derivative is $7.2 million and has included it in other assets on the balance sheet. In addition, $2.1 million has been recorded in realized gains on the income statement, reflecting the increase in fair value of the derivative from its inception date of December 13, 2013 to the reporting date of December 31, 2013.
The Company has accounted for the Canopius Merger Transaction as a reverse acquisition in which TGI, the legal acquiree, was identified and treated as the accounting acquirer and Tower Group International, Ltd., the legal acquirer, was identified and treated as the accounting acquiree. The identification of the accounting acquirer and acquiree in the Canopius Merger Transaction was primarily based on the fact that immediately following the close of the Canopius Merger Transaction there was a change in control of the Company with TGI designees to the Company’s Board of Directors comprising all of its directors and TGI’s former senior management comprising the Company’s entire senior management team. In accordance with accounting guidance for reverse acquisitions, the unaudited consolidated financial statements of the Company following the Canopius Merger Transaction have been issued under the name of the Company, as the legal parent, but reflect a continuation of the financial statements of TGI, as the accounting acquirer, with one exception, which was the retroactive adjustment of TGI’s historical legal capital to reflect the transaction as a recapitalization of TGI’s historical capital accounts. On the effective date of the Canopius Merger Transaction, the assets and liabilities of Tower Group International, Ltd. were accounted for under the acquisition method, under which they have been reflected at their respective acquisition date fair values.
Prior to the Canopius Merger Transaction, Canopius Bermuda restructured its insurance operations as contemplated in the Master Transaction Agreement. This restructuring occurred primarily through the execution of retrocession agreements with Canopius Reinsurance Limited (“CRL”), an indirectly wholly-owned subsidiary of Canopius Group, to retrocede a percentage of Lloyd’s of
In addition, effective January 1, 2013, pursuant to the terms of the Master Transaction Agreement, prior to the Canopius Merger Transaction, TGI entered into a commutation agreement whereby TGI commuted Syndicate 4444 YOA 2012 and YOA 2011 business TGI previously reinsured from Canopius Group in prior years. There was no gain or loss recognized on this commutation.
The following provides details of the purchase consideration, the fair values of the respective assets acquired and liabilities assumed and the resulting amount of goodwill recorded in connection with the Canopius Merger Transaction on March 13, 2013.
The September 30, 2013 commutation of the Syndicate 4444 YOA 2012 and YOA 2011 and prior years retrocession agreements with CRL and the novation of the assumed reinsurance with Canopius Group on these same contracts provided the Company access to $30.3 million of assets that were previously restricted as “Funds at Lloyd’s” assets. No commutation gain or loss was recognized on these transactions.
The following unaudited pro forma financial information presents the consolidated revenues and net income (loss) of the Company for years ended December 31, 2013 and 2012, as if the Canopius Merger Transaction had been completed as of January 1, 2012.
These pro forma amounts exclude any pro forma impacts to the Company’s effective federal income tax rates.
For the year ended December 31, 2013, the Reciprocal Exchanges recognized total revenues, total expenses and net loss of $190.2 million, $211.0 million and $(20.4) million, respectively. For the year ended December 31, 2012, the Reciprocal Exchanges recognized total revenues, total expenses and net income of $204.7 million, $202.4 million and $2.3 million, respectively.
(1) Other gross realized gains and losses consists primarily of foreign exchange and “debt and equity securities sold, not yet purchased,” which are reported in Other liabilities. The Company recorded a $4.3 million gain from translation of foreign currency transactions to the functional currency.
The following table provides a rollforward of the cumulative amount of credit related OTTI for securities still held showing the amounts that have been included in earnings on a pretax basis for the years ended 2013 and 2012 (none of such OTTI was included within the Reciprocal Exchanges):
The following table presents information regarding invested assets that were in an unrealized loss position at December 31, 2013 and December 31, 2012 by amount of time in a continuous unrealized loss position:
The following table shows the composition of the fixed-maturity portfolio by remaining time to maturity at December 31, 2013 and 2012. For securities that are redeemable at the option of the issuer and have a market price that is greater than par value, the maturity used for the table below is the earliest redemption date. For securities that are redeemable at the option of the issuer and have a market price that is less than par value, the maturity used for the table below is the final maturity date.
Level 3 - Inputs to the valuation methodology are unobservable in the market for the asset or liability and are significant to the fair value measurement. Material assumptions and factors considered in pricing investment securities may include projected cash flows, collateral performance including delinquencies, defaults and recoveries, and any market clearing activity or liquidity circumstances in the security or similar securities that may have occurred since the prior pricing period. Generally included in this valuation methodology are investments in certain mortgage-backed and asset-backed securities and securities the Company is reporting under the fair value option.
(1) $43.6 million of the $96.2 million Other invested assets reported on the consolidated balance sheet at December 31, 2013 is reported at fair value. The remaining $52.6 million of Other invested assets is reported under the equity method of accounting.
(2) $25.0 million of the $57.8 million Other invested assets reported on the consolidated balance sheet at December 31, 2012 is reported at fair value. The remaining $32.8 million of Other invested assets is reported under the equity method of accounting or at amortized cost.
As of December 31, 2013, substantially all of the investment portfolio recorded at fair value was priced based upon quoted market prices or other observable inputs. For investments in active markets, we used the quoted market prices provided by the outside pricing services to determine fair value. In circumstances where quoted market prices were unavailable, we used fair value estimates based upon other observable inputs including matrix pricing, benchmark interest rates, market comparables and other relevant inputs. When observable inputs were adjusted to reflect management’s best estimate of fair value, such fair value measurements are considered a lower level measurement in the GAAP fair value hierarchy.
The fair values of the debt and equity securities sold, not yet purchased were derived by using quoted prices for similar securities in active markets. These instruments resulted in net realized gains of $.6 million for the year ended December 31, 2013.
The Company holds seven securities which are reported in other invested assets and have been classified as Level 3 of the fair value hierarchy. Management utilizes a discounted cash flow analysis to derive the fair values. Two of the seven securities, START VII CLO and HONDIUS CRAFT CLO, are credit linked notes which will mature in 2015 and 2017, respectively, and whose cash flows are supported by underlying short-term loans, the significant unobservable inputs include the underlying short-term loans’ probability of default and loss severity, and a discount for the security’s lack of marketability. Increases in the probability of default and loss severity assumptions (which generally move directionally with each other) would have the effect of decreasing the fair value of this security. The Company obtains credit ratings on the underlying short-term loans quarterly and considers these ratings when updating its assumptions. A third security, Aeolus CHIAT SAC, is an equity instrument which entitles the Company to residual interests of a finite life special purpose vehicle. The significant unobservable inputs include the estimated losses to be incurred by the vehicle and the equity instrument’s lack of marketability. The Company obtains quarterly financial data from the vehicle and evaluates the estimated incurred loss figure. An increase in the vehicle’s estimated incurred losses would have the effect of decreasing the instrument’s fair value. The remaining four securities are preferred equity interests in limited partnerships that invest in leisure hotels. The preferred interests pay a stated quarterly dividend with residual equity incentives payable after the General Partner’s minimum return thresholds are met. The significant unobservable inputs include the market discount rate and the instruments’ lack of marketability. The three of the four preferred equity interest investments closed in the latter part of June 2013 (and the fourth investment closed on July 1, 2013). These four preferred equity interest investments are carried at fair value with changes recorded in the statement of operations.
Goodwill is calculated as the excess of purchase price over the net fair value of assets acquired. Under GAAP, the Company is required to allocate goodwill to each of its reporting units. On March 13, 2013, the Company recorded $28.1 million of goodwill in connection with the Canopius Merger Transaction (See “Note 3 - Canopius Merger Transaction”), which was mainly derived from synergies and economies of scale expected to result from the combined operations of the Company. Management allocated the goodwill recognized in the Canopius Merger Transaction to the Commercial Insurance reporting unit.
In the second quarter of 2013, the Company changed the way it presented its results by segment. Following the reorganization, based on information reviewed by the Company’s chief operating decision maker, the Company concluded it had three reporting units corresponding to it each of the business segments: (i) Commercial Insurance, (ii) Specialty Insurance and Assumed Reinsurance and (iii) Personal Insurance. (Each of the reporting units corresponds with the Company’s reporting segments).
The Company tests goodwill balances for impairment annually in the fourth quarter of each year using a September 30 measurement date, or more frequently if circumstances indicate that the value of goodwill may be impaired. Goodwill impairment is performed at the reporting unit level and the test requires a two-step process. In performing Step 1 of the impairment test, management compared the estimated fair values of the applicable reporting units to their aggregate carrying values, including goodwill. If the carrying amount of a reporting unit including goodwill were to exceed the fair value of the reporting unit, Step 2 of the goodwill impairment would be performed. Step 2 of the goodwill impairment test requires comparing the implied fair value of the affected reporting unit’s goodwill against the carrying value of that goodwill.
The process of evaluating goodwill for impairment requires judgments and assumptions to be made to determine the fair value of each reporting unit, including discounted cash flow calculations, assumptions that market participants would make in valuing
In the third quarter of 2013, the Company accounted for the Marine and Energy Acquisition as a business combination and recorded $1.9 million of goodwill in the Commercial Insurance reporting unit. As of September 30, 2013, in response to the significant business developments discussed in “Note 1 - Nature of Business,” management in its judgment concluded this goodwill was fully impaired.
The following table reflects the changes to goodwill during the years ended December 31, 2013 and 2012 and is presented using the reporting units prior to the reorganizations.
(a) In 2012, Tower transferred a licensed insurance subsidiary shell to the Reciprocal Exchanges, as discussed in Note 2-Accounting Policies and Procedures. This resulted in classifying $2.6 million insurance licenses out of Tower and into the Reciprocal Exchange.
The Company performs an analysis at least annually to identify potential impairment of intangible assets with both definite and indefinite lives and measures the amount of any impairment loss that may need to be recognized. Intangible asset impairment testing requires an evaluation of the estimated fair value of each identified intangible asset to its carrying value. An impairment charge could be recorded if the estimated fair value is less than the carrying amount of the intangible asset. Management assessed the carrying value of its intangible assets in the second quarter of 2013, and concluded an impairment charge of $3.8 million was required to reduce its customer relationship intangible assets. These charges are reported in Other Operating Expenses in the consolidated statements of operations. In addition, after further reserve increases and A.M. Best rating downgrades in the third quarter of 2013, management in its judgment concluded an impairment charge of another $18.1 million was required to further reduce the customer relationship intangible asset.
As a result of ratings downgrades and the expected significant declines in net written premiums and other items more fully discussed in Significant Business Developments and Risks and Uncertainties in “Note 1 - Nature of Business”, management tested fixed assets for recoverability in 2013.
Management determined the fair value of fixed assets by (i) calculating an estimated software charge (i.e. fee for use of software) a market participant would pay the owner of the asset in return for the ability to use the Company’s software and (ii) performing an orderly liquidation value analysis ranging from 0%-15% for furniture, leasehold improvements and computer equipment, and concluded the fixed assets were impaired as of September 30, 2013. The Company recorded a non-cash charge to earnings of $125.8 million in 2013. This charge is recorded within Goodwill and fixed-assets impairment in the statement of operations. As of December 31, 2013, the Company has recorded $19.7 million of fixed assets in Other Assets on the consolidated balance sheet.
Acquisition costs incurred and policy-related ceding commission revenue are deferred and amortized to income on property and casualty business for the year ended December 31, 2013, 2012 and 2011 as follows:
The Company utilizes various excess of loss, quota share and catastrophe reinsurance programs to limit its exposure to a maximum loss on any one risk. In addition, as disclosed in “Note 1 - Nature of the Business,” as a result of the 2013 significant business developments, Tower entered into reinsurance agreements with Arch, Hannover and Southport Re.
Under the terms of the excess of loss programs in 2013, Tower was at risk for $5.0 million on property, $3.5 million on workers’ compensation and $2.5 million on umbrella. The Company then had reinsurance coverage up to $30 million for property, $60 million for workers’ compensation, and $5 million for umbrella. In addition the Company also had “clash coverage” in effect for 2013 for a limit of $5 million in excess of $5 million which applies to the aggregate liability for liability losses from multiple insureds involved in the same occurrence.
The Company also purchases property catastrophe reinsurance on an excess of loss basis above a specified retention to protect itself from an accumulation of losses resulting from a catastrophic event. At the July 1, 2013 renewal of its property catastrophe program, the Company maintained a retention of $75 million per catastrophe, had 100% catastrophe protection for the next $925 million of loss above the $75 million.
At the July 1, 2012 renewal of its property catastrophe program, the Company maintained a retention of $75 million per catastrophe, had 100% catastrophe protection for the next $75 million of loss above the $75 million, 70% catastrophe protection for the next $75 million of loss over $150 million and 100% catastrophe protection for the next $700 million of loss in excess of $225 million.
The Company maintains funds held liabilities under the liability quota share reinsurance agreements written in 2010 and prior years and is required to credit interest to the reinsurers with annual effective yields ranging from 2.5% to 4.0% on the monthly balance in the funds held liability accounts. The amounts credited for 2012, 2011 and 2010 were $3.9 million, $3.6 million and $2.7 million, respectively, and have been recorded as interest expense. The funds held under reinsurance agreements liability increased from $98.1 million as of December 31, 2012 to $222.1 million as of December 31, 2013 as a result of reinsurance treaties executed in the third and fourth quarters of 2013.
The Reciprocal Exchanges are not party to the reinsurance agreements discussed above, except for the homeowners quota share treaty whereby in 2013 they ceded 40.0% of homeowners business written. The Reciprocal Exchanges were covered under this treaty in 2012, 2011 and 2010. The Reciprocal Exchanges are also protected under a property catastrophe reinsurance cover placed on an excess of loss basis. In 2012, 2011 and 2010, this coverage was for 100% of $150 million in excess of a $10 million retention and in 2013 it was for $170 million in excess of $10 million.
The Company did not record any modifications of its reinsurance recoverables on paid or unpaid losses in the years ended December 31, 2013, 2012 or 2011. The Company recorded no allowance for credit losses on its reinsurance recoverables on paid or unpaid losses as of December 31, 2013 or 2012. The Company did not consider that any of its undisputed reinsurance recoverables on paid or unpaid losses as of years ended December 31, 2013 and 2012 to be past due. As discussed in “Note 17 - Contingencies”, certain reinsurance agreements are subject to legal proceedings.
Under certain reinsurance agreements, collateral and letters of credit (“collateral”) are held to secure performance of reinsurers in meeting their obligations. The amount of such collateral was $540.7 million and $189.6 million at December 31, 2013 and 2012, respectively. The collateral we hold does not apply to our entire outstanding reinsurance recoverable. Rather, collateral is provided on an individual basis. For each individual reinsurer, the collateral held may exceed or fall below the total outstanding recoverable from that individual reinsurer.
(i) In the third quarter of 2013, Tower executed the Southport Re ADCs (see “Note 1 - Nature of the Business” for further description). The Southport Re ADCs resulted in a direct reduction to net loss reserves. A deferred gain of $12.5 million was recorded on the Southport Re ADCs and is reported in Other Liabilities. In addition, Tower executed the Southport Re Quota Share in the third quarter of 2013. This treaty is accounted for using deposit accounting and reduced the net reserves by $7.2 million.
Incurred losses and LAE for the year ended December 31, 2013 attributable to insured events of prior years increased by $538.1 million. Excluding the Reciprocal Exchanges the incurred losses and LAE increased by $533.0 million.
Prior year development is based upon numerous estimates by line of business and accident year. No additional premiums or return premiums have been accrued as a result of the prior year effects, although we recorded changes in ceding commissions on reinsurance treaties of $9.8 million for which the ceding commissions depend in part on loss experience. The Company’s management continually monitors claims activity to assess the appropriateness of carried case and incurred but not reported (“IBNR”) reserves, giving consideration to Company and industry trends.
We segregate our data for estimating loss reserves. The property lines include Fire and Allied Lines, Homeowners-property, Commercial Multi-peril Property and Automobile Physical Damage. The casualty lines include Homeowners-liability, Commercial Multi-peril Liability, Other Liability, Workers’ Compensation, Commercial Automobile Liability, and Personal
As previously discussed in “Note 3 - Canopius Merger Transaction”, the Canopius Merger Transaction was accounted for as a reverse acquisition with TGI treated as the accounting acquirer. Accordingly, Tower’s historical common stock balance immediately prior to the Merger is the historical common stock of TGI adjusted for the number of shares issued in the Canopius Merger Transaction by the Company to TGI shareholders (i.e., TGI’s outstanding shares immediately prior to the Canopius Merger Transaction multiplied by the conversion ratio of 1.1330).
Tower’s Board of Directors approved a $50 million share repurchase program on May 7, 2013. Purchases under this program can be made from time to time in the open market or in privately negotiated transactions in accordance with applicable laws and regulations. In 2013 no shares of common stock were purchased under this program.
On November 14, 2013, the Company announced that its Board of Directors determined that it would not declare and pay a dividend to shareholders in the fourth quarter of 2013. The Company paid quarterly dividends of $0.165 per share on February 28, 2013, June 21, 2013 and September 20, 2013.
The following table provides a summary of changes in accumulated other comprehensive income, by component, for year ended December 31, 2013, with all amounts reflected net of income taxes and noncontrolling interest:
The following provides a summary of the items that have been reclassified from accumulated other comprehensive income to net income in their entirety during the year ended December 31, 2013, including the line item on the consolidated statement of operations on which the impact is reflected. Unrealized gains (losses) on available for sale securities are reclassified from accumulated other comprehensive income when a security is sold or when a non-credit impairment is recorded. Gains (losses) on cash flow hedges are reclassified from accumulated other comprehensive income when the related hedged item (subordinated debentures floating rate interest payments) are recorded in the statement of operations.
(a) Amount reflected in balance sheet for convertible senior notes is net of unamortized original issue discount of $2.3 million
Total interest expense incurred, including interest expense on the funds held liabilities disclosed in “Note 9 - Reinsurance”, was $33.6 million, $32.6 million and $34.3 million for the years ended December 31, 2013, 2012 and 2011, respectively.
Under the terms for all of the subordinated debentures, an event of default may occur upon:
The Company has designated and accounts for the Swaps as cash flow hedges. The Swaps are considered to have no ineffectiveness and changes in their fair values will be recorded in Accumulated Other Comprehensive Income (“AOCI”), net of tax. For the years ended December 31, 2013, 2012 and 2011, $3.4 million, $1.6 million and $0.4 million, respectively, was reclassified from AOCI to interest expense for the effects of the hedges. As of December 31, 2013 and 2012, the Company had collateral on deposit with the counterparty amounting to $6.3 million and $9.1 million, respectively, pursuant to its Credit Support Annex.
On April 3, 2013, an increase in borrowing capacity up to $220 million became effective pursuant to the second amendment to the credit agreement and consent by and between TGI and Bank of America, N.A., as administrative agent for the lenders party to the credit agreement, dated as of November 26, 2012, and the limited waiver and amendment agreement, dated as of March 3, 2013. The increase in the Credit Facility was negotiated in the event that holders of the convertible senior notes put their bonds to Tower as a result of the Canopius Merger Transaction. This put option expired on April 26, 2013. This second amendment and consent also included (i) TGIL as a guarantor of TGI’s obligations under the credit facility and (ii) consent by the lenders to the change in control triggered by the completion of the Canopius Merger Transaction. The maturity date and borrowing fees were not changed in this amendment.
On December 13, 2013, TGI paid in full the $70.0 million outstanding on the bank credit facility and the bank credit facility has been terminated.
In September 2010, TGI issued $150.0 million principal amount of 5.0% convertible senior notes (“the Notes”), which mature on September 15, 2014. Interest on the Notes is payable semi-annually in arrears on March 15 and September 15 of each year, commencing March 15, 2011. Holders may convert their Notes into cash or common shares, at TGI’s option, at any time on or after March 15, 2014 or earlier under certain circumstances determined by: (i) the market price of TGI’s stock, (ii) the trading price of the Notes, or (iii) the occurrence of specified corporate transactions. Upon conversion, the Company intends to settle its obligation either entirely or partially in cash.
All options outstanding as of December 31, 2013 are fully exercisable as shown on the following table:
TGI files a consolidated Federal income tax return. The Reciprocal Exchanges are not included in TGI’s consolidated tax return as TGI does not have an ownership interest in the Reciprocal Exchanges, and they are not a part of the consolidated tax sharing agreement.
During the year ended December 31, 2013, Tower’s U.S. taxed subsidiaries (excluding the Reciprocal Exchanges) recognized pre-tax losses of approximately $901.4 million. This resulted in $161.9 million of net operating loss carryforwards in ($161.2 million federal NOL and $0.7 million state NOL) the deferred tax inventory and a net deferred tax asset, before any valuation allowance, of $265.0 million (excluding the Reciprocal Exchanges) as of December 31, 2013. Including the Reciprocal Exchanges, the net deferred tax asset, before any valuation allowance, was $263.4 million.
Management in its judgment concluded that a full valuation allowance was required for Tower’s U.S. taxed subsidiaries after its consideration of the cumulative three-year pre-tax loss in its U.S. taxed subsidiaries resulting from certain second quarter 2013 events and the 2012 pre-tax loss of $61.3 million. In the second quarter of 2013, the following items contributed significantly to pre-tax losses in Tower’s U.S. taxed subsidiaries: (i) $325.6 million of prior year reserve increases were recorded, of which $149.7 million related to Tower’s U.S. taxed subsidiaries, and (ii) a $214.0 million goodwill impairment charge, of which $185.9 million related to Tower’s U.S. taxed subsidiaries. Management believes that the negative evidence associated with the realizability of its net deferred tax asset, including the cumulative three-year pre-tax loss, the prior year adverse reserve development recorded in 2012 and 2013, and the effects of Hurricane Irene in 2011 and Superstorm Sandy in 2012 outweighed the positive evidence that the deferred tax assets, including the net operating loss carryforward, would be realized, and recorded the full valuation allowance. As of December 31, 2013, management continues to believe the negative evidence outweighs the positive evidence.
As of December 31, 2013 and 2012, the Company had no material uncertain tax positions and no adjustments to liabilities or operations were required.
The Internal Revenue Service performed an audit of The Company’s 2006 and 2007 tax years and closed these audits in 2011 with no changes. Additionally, in 2011 the IRS performed an audit of CastlePoint and subsidiary’s federal income tax return for the period ended February 2009 and closed this audit with no changes. CastlePoint’s federal excise tax for the 2009 and 2010 tax years were examined by the IRS in 2012. This audit was closed in 2012 with no changes. One of the Reciprocal Exchanges was under an IRS excise tax examination for the 2011 tax year. This audit closed in 2013 with no changes. The 2008 and 2009 years closed by statute. At the end of March 2014, the IRS notified the Company that its 2010, 2011 and 2012 tax returns were selected for examination.
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 $3.9 million, $3.6 million, and $3.2 million of expense in 2013, 2012 and 2011, respectively, related to the 401(k) Plan.
The SERP is a non-qualified defined contribution plan that was established effective as of January 1, 2009 and is intended to enhance retirement benefits for the Company’s most senior executives and certain other key employees. Eligibility to participate in the SERP generally requires three years of prior employment with the Company for Executive Vice Presidents and Senior Vice Presidents and between five and 10 years of prior employment with the Company for other key employees. In 2013, all of the Named Executive Officers (“NEOs”), as well as certain other key executives selected at the discretion of the Compensation Committee, participated in the SERP. Subject to the approval of the Compensation Committee, the Company may make annual contributions to the SERP on behalf of each participant. The SERP is a defined contribution plan and a target benefit level cannot be guaranteed. For all participants, the amount of the annual contribution is presently equal to 5.0% of their annual cash compensation. In general, Company contributions for each participant remain unvested until such participant has completed 10 years of service with the Company, and vest in full upon completion of 10 years of service. However, as a result of the change in control provision as part of the Canopius Merger Transaction in Q1 2013, all previous Company contributions vested at that time. The Compensation Committee has discretion to terminate the SERP at any time or to adjust upward or downward the level of the Company’s contribution each year.
On August 20, 2013, Robert P. Lang, a purported shareholder of Tower Group International Ltd. (“Tower”), filed a purported class action complaint (the “Lang Complaint”) against Tower and certain of its current and former officers in the United States District Court for the Southern District of New York. The Lang Complaint purports to be asserted on behalf of a class of persons who purchased Tower stock between July 30, 2012 and August 8, 2013. The Lang Complaint alleges that Tower and certain of its current and former officers violated federal securities laws and seeks unspecified damages. On September 3, 2013, a second purported shareholder class action complaint was filed by Dennis Feighay, another purported Tower shareholder, containing similar allegations to those set forth in the Lang Complaint (the “Feighay Complaint”). The Feighay Complaint purports to be
asserted on behalf of a class of persons who purchased Tower stock between May 9, 2011 and August 7, 2013. On October 4, 2013, a third complaint was filed by Sanju Sharma (the “Sharma Complaint”). The Sharma Complaint names as defendants Tower and certain of its current and former officers, and purports to be asserted on behalf of a plaintiff class who purchased Tower stock between May 10, 2011 and September 17, 2013. On October 18, 2013, an amended complaint was filed in the Sharma case (the “Sharma Amended Complaint”). The Sharma Amended Complaint alleges additional false and misleading statements, and purports to be asserted on behalf of a plaintiff class who purchased Tower stock between March 1, 2011 and October 7, 2013. On October 21, 2013, a number of motions were filed seeking to consolidate the shareholder class actions into one matter and for appointment of a lead plaintiff. The Company believes that it is not probable that the Lang and Feighay Complaints and the Sharma Amended Complaint will result in a loss, and if they would result in a loss, that the amount of any such loss cannot reasonably be estimated.
On October 18, 2013, Cinium Financial Services Corporation (“Cinium”) and certain other affiliated parties (collectively, “Plaintiffs”) commenced an action against, among others, Tower, CastlePoint Insurance Company (“CastlePoint”), an indirect wholly owned subsidiary of Tower, and certain officers of Tower (the “New York Action”) in New York State Supreme Court. CastlePoint is a party to a Securityholders’ Agreement, dated as of June 14, 2012 (the “Securityholders’ Agreement”), among certain parties including Plaintiffs, and is also the holder of a senior note issued by Cinium dated May 15, 2012 that is convertible into shares of Cinium common stock (the “Senior Note”). On October 29, 2013, Plaintiffs filed a complaint which revised their initial pleading (the “Complaint”). Plaintiffs seek, among other things, (i) a declaratory judgment that CastlePoint has no right to exercise any control over Cinium under the Securityholders’ Agreement or to convert the Senior Note without prior regulatory approval; (ii) rescission of the Senior Note and Securityholders’ Agreement based on alleged fraudulent misrepresentations by Tower at the time these agreements were entered into; and (iii) damages of $150 million for alleged breach of fiduciary duties to Cinium and its shareholders by certain directors, and for alleged lender liability and fraudulent misrepresentation by the Company.
On April 22, 2014, counsel for Plaintiffs notified counsel for Defendants of its intent to file a stipulation of discontinuance without prejudice of the New York Action within thirty days.
The Company believes that it is not probable that the Merger Complaints will result in a loss, and if they would result in a loss, that the amount of any such loss cannot reasonably be estimated.
From time to time, the Company is involved in other various legal proceedings in the ordinary course of business. The Company does not believe that the resolution of any currently pending legal proceedings, either individually or taken as a whole, will have a material adverse effect on its business, results of operations or financial condition.
The Company has various lease agreements for office space, furniture and equipment. The terms of the office space lease agreements provide for annual rental increases and certain lease incentives including initial free rent periods and cash allowances for leasehold improvements.
In 2013, the NYDFS issued orders for seven of Tower’s insurance subsidiaries, subjecting them to heightened regulatory oversight, which includes providing the NYDFS with increased information with respect to the insurance subsidiaries’ business, operations and financial condition. In addition, the NYDFS has placed limitations on payments and transactions outside the ordinary course of business and material changes in the insurance subsidiaries’ management and related matters. Tower’s management and Board of Directors have held discussions with the NYDFS, and Tower has been complying with the orders and oversight.
U.S. state insurance regulations restrict the ability of our insurance subsidiaries to pay dividends to Tower Group International, Ltd. as their ultimate parent (the “Holding Company”). Generally dividends may only be paid out of earned surplus, and the amount of an insurer’s surplus following payment of any dividends must be reasonable in relation to the insurer’s outstanding liabilities and adequate to meet its financial needs. As of December 31, 2013, no dividends may be paid to the Holding Company without the approval of the state regulators or BMA, as appropriate.
For Bermuda registered companies, there are some differences between financial statements prepared in accordance with GAAP and those prepared on a Bermuda statutory basis. The more significant Bermuda SAP variances from GAAP are as follows:
Investments in fixed-maturity securities are carried at amortized cost. GAAP requires investments in fixed-maturity securities classified as available for sale to be reported at fair value.
Deferred income taxes, intangible assets and goodwill are not included in the Bermuda statutory capital and surplus balances.
For the year ended December 31, 2013, the Bermuda based insurers had statutory net income (loss) of $ (198.6) million and at December 31, 2013, had statutory surplus of $60.3 million. The statutory capital surplus amounts as of December 31, 2013 include $26.5 million from U.S.-based insurance subsidiaries that are owned by CastlePoint Re.
The Reciprocal Exchanges are required to maintain minimum capital and surplus. The minimum capital and surplus requirements were determined to be above Company Action Level. As of December 31, 2013 and 2012, the combined Company Action Level capital and surplus requirement for Adirondack was $34.5 million and $38.1 million, respectively. As of December 31, 2013 and 2012, the combined Company Action Level capital and surplus requirement for New Jersey Skylands was $11.2 million and $10.2 million, respectively.
The Reciprocal Exchanges are not owned by the Company, but managed through management agreements. Accordingly, the Reciprocal Exchanges’ net assets are not available to the Company. In addition, no dividends can be paid from the Reciprocal Exchanges to Tower.
Other invested assets: The fair value of securities which are reported under the fair value option are included in “Note 6-Fair Value Measurements.
Premiums receivable and reinsurance recoverable: The carrying values reported in the accompanying balance sheets for these financial instruments approximate their fair values. Premiums receivable and reinsurance recoverable are considered Level 3 pursuant to the fair value hierarchy due to the lack of available observable inputs for their valuation in the market.
Debt: Fair value disclosures for debt are included in “Note 13-Debt.” The Company uses a discounted cash flow model to fair value the subordinated debentures. Market quotes are used to fair value the senior convertible notes.
Reinsurance balances payable and funds held under reinsurance contracts: The carrying value reported in the balance sheet for these financial instruments approximates fair value. Reinsurance balances payable and funds held under reinsurance contracts are considered Level 3 pursuant to the fair value hierarchy due to the lack of available observable inputs for their valuation in the market.
The following table shows the computation of the earnings per share (historical earnings per share amounts have been adjusted for the 1.1330 share conversion ratio in connection with the Canopius Merger Transaction):
The computation of diluted earnings (loss) per share excludes outstanding options and other common stock equivalents in periods where inclusion of such potential common stock instruments would be anti-dilutive. For the years ended December 31, 2013, 2012 and 2011, 955,800, zero and 166,700, respectively, options and other common stock equivalents to purchase Tower shares were excluded from the computation of diluted earnings (loss) per share because the exercise price of the options was greater than the average market price.
The Personal Insurance segment, which includes the Reciprocal Exchanges and the management companies, reports the management fees earned by Tower from the Reciprocal Exchanges for underwriting, investment management and other services as a reduction to other underwriting expenses. The effects of these management fees between Tower and the Reciprocal Exchanges are eliminated in consolidation to derive consolidated net income. However, the management fee income is reported in net income attributable to Tower Group International, Ltd. and included in basic and diluted earnings (loss) per share.
(3) Revenues have been revised from amounts previously reported to adjust for a correction in accounting for the Southport Quota Share. In the third quarter of 2013, management should have used deposit accounting. This correction resulted in greater net earned premiums of $46.1 million and less ceded commission revenue of $10.1 million, and additional loss and loss adjustment expense of $36.0 million. This correction had no impact to net income (loss). This correction also resulted in an adjustment to decrease total assets and total liabilities by $23.9 million. Cash flows provided by (used in) operating activities increased and Cash flows provided by (used in) financing activities decreased by $35.1 million in the third quarter of 2013. Management concluded these revisions were not material to the previously reported financial statements.
Concurrently with the execution of the ACP Re Merger Agreement, several subsidiaries of Tower have entered into two Cut-Through Reinsurance Agreements, pursuant to which a subsidiary of AmTrust and a subsidiary of NGHC agreed to provide 100% quota share reinsurance and a cut-through endorsement to cover all eligible new and renewal commercial and personal lines business, respectively, and at their option, losses incurred on or after January 1, 2014 on not less than 60% of the in-force business. Tower received confirmation on January 16, 2014 from AmTrust and NGHC that they would exercise such option to reinsure on a cut-through basis losses incurred on or after January 1, 2014 under in-force policies with respect to (1) in the case of AmTrust, approximately 65.7% of Tower’s unearned premium reserves as of December 31, 2013 with respect to its ongoing commercial lines business, and (2) in the case of NGHC, 100% of Tower’s unearned premium reserves as of December 31, 2013 with respect to its personal lines segment business. Tower received a 20% ceding commission from AmTrust or NGHC on all Tower unearned premiums that are subject to the Cut-Through Reinsurance Agreements and a 22% ceding commission on 2014 ceded premiums.
Michael H. Lee, the former Chairman, President and Chief Executive Officer of Tower, who beneficially owned approximately 4.2% of the issued and outstanding common stock of Tower as of January 3, 2014, has entered into a support agreement pursuant to which he has agreed to vote his shares in favor of the merger.
Following the announcement of the ACP Re merger, on January 10, 2014 A.M. Best maintained the under review status of Tower’s financial strength and issuer credit ratings and revised the implications from “negative” to “developing” for all of these ratings. A.M. Best stated that, “[t]he under review status with developing implications reflects the potential benefits to be garnered from the transaction as well as the potential downside from any additional adverse reserve development and/or any unforeseen events that might transpire up until the close of the transaction.”
Jan R. Van Gorder, who is the lead independent director of the Board and a member of the Board’s Audit Committee, Compensation Committee and Corporate Governance and Nominating Committee, was appointed on February 9, 2014 to succeed Mr. Lee as Chairman of the Board. William W. Fox, Jr., who had served as a member of the Board and of the Board’s Audit Committee and Corporate Governance and Nominating Committee until his resignation from the Board on December 31, 2013, succeeded Mr. Lee as President and Chief Executive Officer of Tower, effective as of February 14, 2014.
On April 7, 2014, the Company and a lessor mutually agreed to enter into a final settlement agreement to terminate a lease agreement for IT systems supporting certain personal lines business. Under the terms of the settlement agreement, the Company paid the lessor $10.4 million from a pledged collateral account funded by the Company for the benefit of the lessor. The final settlement agreement and payment were approved by the NYDFS.