We also lease office space in Irvine, California; New Haven, Connecticut; Ft. Lauderdale, Florida; Maitland, Florida; Atlanta, Georgia; Chicago, Illinois; Quincy, Massachusetts; Westborough, Massachusetts; Portland, Maine; Jersey City, New Jersey; Moorestown, New Jersey; Melville, New York; Williamsville, New York; Irving, Texas; Petaluma, California; Saint Louis, Missouri; Palm Springs, California; and Charlotte, North Carolina.
(3) The net underwriting expense ratio is calculated by dividing net underwriting expenses (consisting of direct commission expenses and other underwriting expenses net of policy billing fees and ceding commission revenue) by net premiums earned.
Our consolidated results of operations in 2012 reflect continued growth from our Assumed Reinsurance products as well as growth from acquisitions completed in prior years. Our consolidated revenues and expenses reflect the results of these acquired companies from their respective acquisition dates and this affects the comparability of our results between years.
See “Note 4 - Acquisitions” in the consolidated financial statements for more detail on each of the acquisitions discussed below.
On January 14, 2011, Tower obtained the renewal rights to the middle market commercial package and commercial automobile business underwritten through the NAV PAC division of Navigators Group, Inc. Tower pays Navigators Insurance Company a commission equal to 2% of the direct premiums written under this renewal rights arrangement. This business allowed us to expand our middle market commercial product offering into certain niche classes of business. This renewal rights acquisition represents the ability to write future insurance business and does not include the acquisition of any assets or liabilities of NAV PAC. Accordingly, this transaction was not accounted for as a business combination.
Loss ratio. The loss ratio is the ratio of losses and LAE incurred to premiums earned and measures the underwriting profitability 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 particular year, regardless of when they are reported, as a percentage of premiums earned during that particular accident year. A calendar year loss ratio measures losses and LAE for insured events occurring during a particular year and the changes in estimates in loss and LAE reserves from prior accident years as a percentage of premiums earned during that particular calendar year.
The following table provides a reconciliation of operating income to net income attributable to Tower Group, Inc. on a GAAP basis. The operating income is used to calculate operating earnings per share and operating return on average equity.
Our most critical accounting estimates involve the estimation of reserves for losses (including losses that have occurred but had not been reported by the financial statement date) and LAE, establishing fair value of losses and LAE for acquired businesses, net earned premiums, the reporting of ceding commissions earned, the amount and recoverability of reinsurance recoverable balances, deferred acquisition costs, investment impairments and potential impairments of goodwill and intangible assets.
Loss and loss adjustment expense reserves. The reserving process for loss and LAE reserves provides management’s best estimate at a particular point in time of the ultimate unpaid cost of all losses and LAE incurred, including settlement and administration of losses, and is based on facts and circumstances then known and including losses that have been incurred but not yet reported. The process includes using actuarial methodologies to assist in establishing these estimates, judgments relative to estimates of future claims severity and frequency, the length of time before losses will develop to their ultimate level and the possible changes in the law and other external factors that are often beyond our control. There are various actuarial methods that are appropriate for the different lines of business, and our actuaries’ use of a particular method or weighting of methods depends in part on the maturity of each accident year by line of business, the limits of liability covered under the policies, the presence or absence of large claims in the experience, and other considerations. In general, the various actuarial methods can be grouped into three categories: loss ratio projection, loss development methods, and the B-F method. For the most recent accident year, and especially for liability lines of business, the actuarial method given the most weight is usually the loss ratio method, since the percentage of ultimate claims reported to date is expected to be low and the immature reported claims experience is not a reliable indicator of ultimate losses for that accident year. For property lines of business for the most recent accident year, the B-F method is usually given the most weight, because experience typically shows that there is a small percentage of claims reported in the subsequent period due to normal lags in reporting and processing of claims in these lines of business that can be relatively reliably estimated as a percentage of premiums, which is reflected in the B-F method. For each line of business, the actuarial reserving method usually given the most weight shifts from the loss ratio projection to the B-F method to the incurred loss projection as each accident year matures. These methods are described in “Business-Loss and Loss Adjustment Expense Reserves.”
This process helps management set carried loss reserves based upon the actuaries’ best estimates, using estimates made by segment, product or line of business, territory, and accident year. The actuaries also separately estimate loss reserves from LAE reserves and within LAE reserves estimates are made for defense and cost containment expenses or Allocated Loss Adjustment Expenses (“ALAE”) and for other claims adjusting expenses or Unallocated Loss Adjustment Expenses (“ULAE”). The amount of loss and LAE reserves for reported claims is based primarily upon a case-by-case evaluation of coverage, liability, injury severity, and any other information considered pertinent to estimating the exposure presented by the claim. The amounts of loss and LAE reserves for unreported claims are determined using historical information by line of business as adjusted to current conditions. Due to the inherent uncertainty associated with the reserving process, the ultimate liability may differ, perhaps substantially, from the original estimate. Such estimates are regularly reviewed and updated, and any resulting adjustments are included in the current year’s results. Reserves are closely monitored and are recomputed periodically using the most recent information on reported claims and a variety of statistical techniques. Specifically, on at least a quarterly basis, we review, by line of business, existing reserves, new claims, changes to existing case reserves and paid losses with respect to the current and prior years. See “Business-Loss and Loss Adjustment Expense Reserves” for additional information regarding our loss and LAE reserves.
For claims that are defended by in-house attorneys, we estimate the defense cost per claim, and 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 determined actuarially based upon the projected number of litigated claims and expected closing patterns at the beginning of each year as well as the projected budget for our in-house attorneys, and these amounts are calibrated to reimburse our in-house legal department for all of their costs.
Net premiums earned. Insurance policies issued or reinsured by us are short-duration contracts. Accordingly, premium revenue, including direct writings and reinsurance assumed, net of premiums ceded to reinsurers, is recognized as earned in proportion to the amount of insurance protection provided, on a pro-rata basis over the terms of the underlying policies. Unearned premiums represent premiums applicable to the unexpired portions of in-force insurance contracts at the end of each year. Prepaid reinsurance premiums represent the unexpired portion of reinsurance premiums ceded.
Deferred acquisition costs, net. We defer certain expenses that vary with and are directly related to the successful acquisition of new and renewal insurance business, including commission expense on gross premiums written, premium taxes and certain other costs related to the acquisition of insurance contracts. These costs are capitalized and the resulting asset, DAC, is amortized and charged to expense or income in future periods as gross and ceded premiums written are earned. The method followed in computing deferred acquisition costs, net, limits the amount of such deferred amounts to its estimated realizable value. The ultimate recoverability of deferred acquisition costs is dependent on the continued profitability of our insurance underwriting. We also consider anticipated invested income in determining the recoverability of these costs. If our insurance underwriting becomes unprofitable, we may have to write off a portion of our deferred acquisition costs, resulting in a further charge to income in the period in which the underwriting losses are recognized. The value of business acquired (“VOBA”) is an intangible asset relating to the estimated fair value of the unexpired insurance policies acquired in a business combination. VOBA is determined at the time of a business combination and is reported on the consolidated balance sheet with DAC and is amortized in proportion to the timing of the estimated underwriting profit associated with the in force policies acquired. The cash flow or interest component of VOBA is amortized in proportion to the expected pattern of future cash flows. The Company considers anticipated investment income in determining the recoverability of these costs and believes they are fully recoverable.
Since total unrealized losses are a component of stockholders’ equity, the recognition of OTTI losses has no effect on our comprehensive income or stockholders’ equity.
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. No impairment losses were recognized on intangible assets with a finite useful life in 2012, 2011 or 2010.
Goodwill is not amortized. Rather, it is tested for recoverability at least annually or whenever events or changes in circumstances indicate that a carrying amount may not be recoverable. The Company completed its annual goodwill assessment as of September 301, 2012 for the two individual reporting units that carry goodwill, Commercial Insurance and Personal Insurance. Our Insurance Service reporting unit does not carry 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 each reporting unit and the level of the Company’s own share price. Fair value estimates we utilize both the market approach and income approach. Management considered valuation techniques such as peer company price-to-earnings and price-to-book multiples and an in-depth analysis of projected future cash flows and relevant discount rates, which considered market participant inputs. Other significant assumptions include levels of surplus available for distribution, future business growth and earnings projections for each reporting unit. Estimates of fair value are subject to assumptions that are sensitive to change and represent the Company’s reasonable expectation regarding future developments. Management also considers the implied control premium derived from its market capitalization and the implied fair value of the enterprise.
Of the assets and liabilities in Commercial Insurance, the value of business in the unearned premiums, the fair value of the distribution network and customer list and the reserve risk premium associated with losses and loss adjustment expense contain significant assumptions and judgment in estimating fair value. The second step of the impairment analysis for Commercial Insurance indicated that the implied goodwill for the reporting unit exceeded the carried value of goodwill. Accordingly, no impairment losses were recognized in 2012. Also, no impairment losses were recognized in 2011 or 2010.
Subsequent goodwill assessments could result in impairment due to the impact of a volatile financial market on earnings, discount assumptions, liquidity and market capitalization, as well as our assessment of segment organization upon the completion of the proposed merger with the Canopius Bermuda Operations. Slight changes in the factors we consider when evaluating our goodwill for impairment losses (such as forecasted future cash flows, changes in discount rates or market multiples derived from peer companies) could result in a significant charge for impairment losses reported in our consolidated financial statements. In addition, if our market capitalization decreases, we may be required to record goodwill impairment charges in future periods. Management will continue to monitor its goodwill for possible future impairments. See “Note 8 - Goodwill and Intangible Assets” in the notes to consolidated financial statements.
Premiums earned. Gross premiums earned for the years ended December 31, 2012 and 2011 were $1,943.3 million and $1,789.8 million, respectively. The increase of 8.6% year over year is primarily a result of increased premiums from Tower’s assumed reinsurance business in the Commercial Insurance segment.
Ceded premiums earned increased $25.9 million to $221.8 million for the year ended December 31, 2012 from $195.9 million in 2011. The Company reinsures certain of its program business through quota share treaties and purchases excess per risk and catastrophe reinsurance for all property lines. It also reinsures the homeowners and umbrella business obtained from the OBPL through a quota share treaty. The increase in ceded premium earned in 2012 is primarily attributable to the reinstatement premium on our catastrophe reinsurance program as a result of Superstorm Sandy.
For the Reciprocal Exchanges, the favorable development was $8.9 million, comprised of favorable development of $3.1 million for homeowners, $1.6 million for private passenger auto liability, $1.7 million for other lines, and $2.5 million for amortization of reserves risk premium.
The consolidated gross underwriting expense ratio increased to 34.0% for the year ended December 31, 2012 from 32.3% 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 17.4% 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 15.5% for the year ended December 31, 2012 compared to 14.9% in the prior year.
Income tax expense. Income tax expense was a benefit of $26.7 million in 2012 compared to an expense of $24.1 million in 2011 The change of $50.8 million in income tax expense is directly attributable to the change of pre-tax income from $95.6 million in 2011 to a pre-tax loss of $52.1 million in 2012. The effective income tax rate (including state and local taxes) was 51.3% for the year ended December 31, 2012, compared to 25.2% for the same period in 2011. The increase in the effective tax rate in 2012 is primarily related to tax exempt interest and the movement in the valuation allowance on the Reciprocal Exchanges in 2012, which increased the 2012 income tax benefit.
The net loss in 2012 is primarily due to the net adverse loss development and losses from Superstorm Sandy discussed above. 2012 net loss included losses of $80.1 million after-tax from Superstorm Sandy, as well as reserve adverse development of $50.8 million recorded in 2012 for accident years 2011 and prior.
Total revenues. Total revenues increased by 21.4% for the year ended December 31, 2011 as compared to 2010, primarily due to increased net premiums earned, net investment income and policy billing fees resulting from the acquisition of OBPL which was acquired on July 1, 2010 and was reflected in Tower’s consolidated results for twelve months in 2011 as compared to six months in 2010.
Commission and fee income. Commission and fee income decreased by $1.7 million in the year ended December 31, 2011 as compared to the year ended December 31, 2010. This decrease is primarily attributed to the decline in ceding commission revenue on a liability quota share reinsurance treaty that was effective only in 2010, offset by an increase in policy billing fees and ceding commission revenues associated with the OBPL acquired business.
Net investment income and net realized gains (losses). Net investment income increased 17.9% in the year ended December 31, 2011 compared to 2010. The increase in net investment income resulted from an increase in average cash and invested assets for the year ended December 31, 2011 as compared to 2010. The increase in average cash and invested assets resulted primarily from $365.1 million of invested assets from the OBPL acquisition (reduced by cash to finance such acquisition) and from operating cash flows of $85.0 million generated in 2011. The positive cash flow from operations was the result of an increase in premiums collected from a growing book of business. The tax equivalent investment yield of our fixed maturity portfolio at amortized cost was 4.8 % and 4.7% at December 31, 2011 and 2010, respectively. Operating cash invested in fixed income securities in 2011 and in 2010 has been affected by a low yield environment. We increased investments in high-yield securities and dividend paying equity securities to reduce the impact of this low interest rate environment.
The Company had net realized investment gains of $9.4 million for the year ended December 31, 2011 compared to gains of $14.7 million in 2010. OTTI losses recorded in earnings for the year ended December 31, 2011 were $3.2 million compared to $3.0 million of OTTI losses recorded in earnings for 2010.
Excluding the Reciprocal Exchanges, the 2011 net loss and loss adjustment expenses included $74.3 million from claims related to severe weather related events, including first quarter 2011 claims relating to heavy snow, Hurricane Irene in August 2011, and other severe winter storms and tornados that resulted in an unusual number of claims. Excluding these severe weather related events, the net loss ratio for Tower, excluding the Reciprocal Exchanges, was 62.3% for the year ended December 31, 2011. The net loss ratio for Tower would have been 59.0% for the year ended December 30, 2010, excluding the Reciprocal Exchanges and the impact of severe weather events.
Interest expense. Interest expense increased by $10.1 million for the year ended December 31, 2011 compared to 2010. Interest expense increased mainly due to the issuance of $150 million of convertible senior notes in September 2010 and increased borrowings under the credit facility in 2011. Interest on funds withheld was $3.6 million in 2011 as compared to $2.7 million in 2010.
The decline in the effective tax rate from 2010 to 2011 is primarily attributed to (i) the increase in tax exempt interest income and dividend received deductions of $7.2 million in 2011 as compared to $4.9 million in 2010, (ii) the decline in pre-tax income from 2010 to 2011, and (iii) the movement in the Reciprocal Exchange valuation allowance in 2011.
Net income and return on average equity. Net income and annualized return on average equity attributable to Tower Group, Inc. were $60.5 million and 5.8% for the year ended December 31, 2011 compared to $106.4 million and 10.3% for the year ended December 31, 2010. The return on average equity is calculated by dividing net income by average stockholders’ equity. Average stockholders’ equity was $1,041.1 million and $1,036.9 million at December 31, 2011 and 2010, respectively.
Premiums. Gross premiums written for the year ended December 31, 2012 were $1,327.9 million as compared to $1,225.3 million during the same period in 2011. The increase of $102.6 million is primarily attributed to our growth in assumed reinsurance which accounted for growth of $75.6 million in 2012 compared to 2011. Gross premiums earned were $1,321.7 million as compared to $1,178.6 million during the same period in 2011.
Net premiums written and earned increased $73.3 million and $136.4 million, respectively, in 2012 as compared to 2011. These changes are attributed to the gross and ceded premium changes discussed above.
The Company’s renewal retention rate excluding programs was 80.5% for the year ended December 31, 2012 compared to 77.1% during the same period in 2011. Premiums on renewed commercial business, other than programs, increased 4% in 2012. Excluding programs, policies in-force for our commercial business decreased 9% as of December 31, 2012 from 2011.
Net loss and loss adjustment expenses. The net calendar year loss ratios were 73.7% and 67.7% 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 67.7% and 63.5%, respectively.
Management’s estimates of prior years’ loss and loss expenses increased $74.2 million for the year ended December 31, 2012. This increase in prior accident year loss and loss expense was the result of a comprehensive review of its loss reserves completed in the second quarter of 2012 and an updated analysis during the third quarter as well as recent loss emergence that occurred during the fourth quarter.
The gross underwriting expense ratio was 32.3% compared to 30.3% in the same periods in 2011. The commission portion of the gross underwriting expense ratio, which is expressed as a percentage of gross premiums earned, was 18.8% for the year ended December 31, 2012 compared to 17.7% for the same periods in 2011. The increase is primarily due to the assumed reinsurance business which has a higher commission ratio. The OUE ratio, including boards, bureaus and taxes (“BB&T”), was 13.5% for the year ended December 31, 2012 compared 12.6% for the same period in 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 profit decreased $106.7 million and the combined ratio increased 8.8 percentage points for the year ended December 31, 2012 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 strengthening 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 $113.9 million and increased the calendar year loss ratio by 9.3 points. In the year ended December 31, 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 2.8 points in 2011. In addition, as discussed above, the expense ratio increased by 2.8 percentage points from 2011 to 2012.
Ceding commission revenue. Ceding commission revenue decreased for the year ended December 31, 2011 by $18.5 million compared to 2010. The decrease was a result of the non-renewal of our liability quota share contract.
Underwriting profit and combined ratio. The net combined ratios were 99.2% for the year ended December 31, 2011 and 95.7% for 2010. The increase in the combined ratio in 2011 resulted from an increase in the net loss ratio due to catastrophe losses and more competitive market conditions, partially offset by a decrease in the net expense ratios as described above.
The Company’s personal lines renewal retention was 84.9% and 86.0% for the years ended December 31, 2012 and 2011, respectively. Premiums on renewed personal business increased by 4.6% in 2012 compared to 2.5% in 2011. Policies-in-force decreased by 5.2% at December 31, 2012 as compared to December 31, 2011.
Net loss and loss adjustment expenses. For Personal Insurance, the net calendar year loss ratios were 70.6% and 63.0% for the year ended December 31, 2012 and 2011, respectively. The accident year loss ratios for the year ended December 31, 2012 and 2011 were 71.6% and 76.2%, respectively. Estimates of prior accident year loss and loss expenses decreased by $4.9 million for the year ended December 31, 2012.
For Tower personal lines, excluding the Reciprocal Exchanges, the net calendar year loss ratios were 72.5% and 67.2% for the year ended December 31, 2012 and 2011, respectively. The accident year loss ratios for the year ended December 31, 2012 and 2011 were 71.3% and 76.4%, respectively. There was net adverse loss development 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 and other severe storms.
The Reciprocal Exchanges’ net calendar year loss ratios were 66.7% and 55.8% for the year ended December 31, 2012 and 2011, respectively. The accident year loss ratios for the year ended December 31, 2012 and 2011 were 72.2% and 76.0%, respectively. Estimates of prior accident year loss and loss adjustment expenses decreased by $8.9 million for the year ended December 31, 2012. For the year ended December 31, 2012, the Reciprocal Exchanges recorded $9.0 million of losses relating to Superstorm Sandy.
Underwriting expenses. Underwriting expenses, which include direct commissions and other underwriting expenses, increased by $11.7 million, or 5.2% for the year ended December 31, 2012 as compared to the prior year. The net underwriting expense ratio increased 1.8 percentage points from 2011 to 2012.
The gross underwriting expense ratio was 37.2% compared to 36.1% in the same periods 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 same periods in 2011. 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 OUE ratio, including BB&T, was 16.3% for the year ended December 31, 2012 compared 16.6% for the same period in 2011.
Ceded premiums written for the year ended December 31, 2011 were $99.4 million, an increase of $13.7 million as compared to $85.7 million in 2010. Ceded premiums earned were $105.2 million compared to $71.3 million for the year ended December 31, 2011 compared to the same period in 2010. 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 associated with the OBPL acquisition
Ceding commission revenue. The increase in ceding commission revenue increased for the year ended December 31, 2011 by $13.1 compared to the prior year is attributed to the commission revenue earned on the previously mentioned homeowners and umbrella quota share treaties on the OBPL acquired business.
For Tower personal lines, excluding the Reciprocal Exchanges, the net calendar year loss ratios were 67.2% and 51.4% for the year ended December 31, 2011 and 2010, respectively. The accident year loss ratios for the year ended December 31, 2011 and 2010 were 76.4% and 60.0%, respectively. There was net favorable loss development of $29.1 million for the year ended December 31, 2011, and net favorable development of $22.3 million for the year ended December 31, 2010. For the year ended December 31, 2011, the Company recorded $243.4 million of incurred losses of which $42.8 million related to Hurricane Irene and other severe storms.
The Reciprocal Exchanges’ net calendar year loss ratios were 55.8% and 66.3% for the year ended December 31, 2011 and 2010, respectively. The accident year loss ratios for the year ended December 31, 2011 and 2010 were 76.0% and 76.8%, respectively. Estimates of prior accident year loss and loss adjustment expenses decreased by $37.8 million for the year ended December 31, 2011
Total revenue. The increase in total revenue for the year ended December 31, 2012 compared to 2011 was primarily due to fee income earned by our managing general agencies for business placed with other insurers. The management fee income is earned by Tower for underwriting, investment management and other services provided to the Reciprocal Exchanges for 2012 was consistent with the revenues earned for the year ended December 31, 2011. The effects of these management services agreements 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, Inc. and included in basic and diluted earnings per share.
Total revenue. The increase in total revenue for the year ended December 31, 2011 compared to 2010 was primarily due to the management fee income earned by Tower for underwriting, investment management and other services provided to the Reciprocal Exchanges pursuant to management services agreements with the Reciprocal Exchanges.
Total expenses. The increase in total expenses for the year ended December 31, 2011 compared to 2010 was primarily due to the costs incurred under the management services agreement between Tower and the Reciprocal Exchanges, which were in place for the twelve months in 2011 as compared to six months in 2010.
The average credit rating of our fixed-maturity securities, using ratings assigned to securities by Standard & Poor’s, was A+ at December 31, 2012 and December 31, 2011. The following table shows the ratings distribution of our fixed-maturity portfolio:
Under GAAP, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an “exit price”). GAAP establishes a fair value hierarchy that distinguishes between inputs based on market data from independent sources (“observable inputs”) and a reporting entity’s internal assumptions based upon the best information available when external market data are limited or unavailable (“unobservable inputs”). The fair value hierarchy in GAAP prioritizes fair value measurements into three levels based on the nature of the inputs. Quoted prices in active markets for identical assets have the highest priority (“Level 1”), followed by observable inputs other than quoted prices including prices for similar but not identical assets or liabilities (“Level 2”), and unobservable inputs, including the reporting entity’s estimates of the assumption that market participants would use, having the lowest priority (“Level 3”).
At December 31, 2012, two securities included in other invested assets were priced in Level 3 with a fair value of $25.0 million, which was also our cost basis.
“Note 7-Fair Value Measurements” to the consolidated financial statements provides a description of the valuation methodology utilized to value Level 3 assets, how the valuation methodology is validated and an analysis of the change in fair value of Level 3 assets. As of December 31, 2012, the fair value of Tower Level 3 assets as a percentage of Tower’s total assets carried at fair value was as follows (the Reciprocal Exchanges had no Level 3 assets):
For those fixed-maturity investments deemed not to be in an OTTI position, we believe that the gross unrealized investment loss was primarily caused by a spread widening in the capital markets. We expect cash flows from operations to be sufficient to meet our liquidity requirements and, therefore, we do not intend to sell these fixed maturity securities and we do not believe that we will be required to sell these securities before recovering their cost basis. For equity securities not considered OTTI, we believe we have the ability to hold these investments until a recovery of fair value to our cost basis. A substantial portion of the unrealized loss relating to the mortgage-backed securities is the result of a spread widening in the market that we believe to be temporary.
The following table presents information regarding our invested assets that were in an unrealized loss position at December 31, 2012 and December 31, 2011 by amount of time in a continuous unrealized loss position:
The following table stratifies the gross unrealized losses in the portfolio at December 31, 2012, 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 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, 2012:
Tower Insurance Company of New York (“TICNY”) is the Company’s largest insurance subsidiary. Under New York law, TICNY is limited to paying dividends to the Holding Company only from statutory earned surplus. In addition, the New York Insurance Department must approve any dividend declared or paid by TICNY that, together with all dividends declared or distributed by TICNY during the preceding twelve months, exceeds the lesser of (1) 10% of TICNY’s policyholders’ surplus as shown on its latest annual statutory financial statement filed with the New York State Insurance Department or (2) 100% of adjusted net investment income during the preceding twelve months. TICNY declared $2.5 million, $15.0 million and $4.7 million in dividends to the Holding Company in 2012, 2011 and 2010, respectively.
The other insurance subsidiaries are subject to similar restrictions, usually related to policyholders’ surplus, unassigned surplus or net income and notice requirements of their domiciliary state. As of December 31, 2012, the amount of distributions that our insurance subsidiaries could pay to Tower without approval of their domiciliary Insurance Departments was $33.5 million. In addition, we can return capital of $43.0 million from CastlePoint Re without permission from the Bermuda Monetary Authority.
We do not consolidate the statutory business trusts for which we hold 100% of the common trust securities because we are not the primary beneficiary of the trusts. Our $7.1 million investment in the common trust securities of the statutory business trusts are reported in Other Assets. We report as a liability the outstanding subordinated debentures issued to the statutory business trusts.
In May 2010, the Company entered into a $125.0 million credit facility agreement. The credit facility is a revolving credit facility with a letter of credit sublimit of $25.0 million. The credit facility is being used for general corporate purposes. The Company may request that the facility be increased by an amount not to exceed $50.0 million, and the facility expires May 2013. The Company has $70.0 million and $50.0 million outstanding under the credit facility as of December 31, 2012 and 2011, respectively.
Our capital resources consist of funds deployed or available to be deployed to support our business operations. At December 31, 2012 and December 31, 2011, our capital resources were as follows:
We may seek to raise additional capital or may seek to return additional capital to our stockholders through share repurchases, cash dividends or other methods (or a combination of such methods). Any such determination will be at the discretion of our Board of Directors and will be dependent upon our profits, financial requirements and other factors, including legal restrictions, rating agency requirements, credit facility limitations and such other factors as our Board of Directors deems relevant.
Net cash flows used in investing activities were $89.1 million for the year ended December 31, 2012 compared to $105.0 million used for the year ended December 31, 2011. The year ended December 31, 2012 and 2011 included an increase to fixed assets of
The net cash flows used in financing activities for the year ended December 31, 2012 are primarily the result of uses of cash for the repurchase of common stock for $21.0 million and dividends of $29.1 million partially offset by cash inflows from a $20.0 million drawdown of our line of credit. In 2011, the Company had uses of cash for the repurchase of common stock and dividend payments of $64.6 million and $27.9 million, respectively, offset by net cash inflows of $50.0 million from a drawdown on our line of credit and $39.8 million from capital lease financings.
The Company continued to direct excess cash balances to higher yielding investments to maximize investment income. Accordingly, Tower’s cash balances declined from December 31, 2010 to 2011.
Net cash flows used in investing activities were $105.0 million for the year ended December 31, 2011 compared to $260.1 million used for the year ended December 31, 2010. The year ended December 31, 2011 and 2010 included an increase to fixed assets of $53.6 million and $36.9 million, respectively, primarily related to the build out of new systems. The additional cash outflows in 2010 related to the purchase of OBPL on July 1, 2010. The remaining cash flows in both years relate to purchases and sales of fixed maturity and equity securities. The net cash flows used in financing activities for the year ended December 31, 2011 are primarily the result of uses of cash for the repurchase of common stock for $64.6 million and dividends of $27.9 million offset by cash inflows from a $50.0 million drawdown of our line of credit and $39.8 million from capital lease financings related to the aforementioned systems costs, and other fixtures and equipment. In 2010, the Company had uses of cash for the repurchase of common stock and dividend payments of $88.0 million and $16.6 million, respectively, offset by net cash inflows of $134.1 million for the issuance of the senior convertible notes, senior convertible noted hedge, and warrants.
The insurance subsidiaries maintain sufficient liquidity to pay claims, operating expenses and meet other obligations. We held $100.3 million and $114.1 million of cash and cash equivalents at December 31, 2012 and 2011, respectively. We monitor the expected claims payment needs and maintain a sufficient portion of our invested assets in cash and cash equivalents to enable us to fund the claims payments without having to sell longer-duration investments. As necessary, we adjust the holdings of short-term investments and cash and cash equivalents to provide sufficient liquidity to respond to changes in the anticipated pattern of claims payments. See “Business-Investments.”
As of December 31, 2012 and 2011, Tower’s insurance subsidiaries had $516.5 million and $340.8 million, respectively, of cash and investment balances held as collateral with counterparties or in New York Regulation 114 type compliant trust accounts to support letters of credit issued on behalf of the insurance subsidiaries, other reinsurance payable amounts and certain lease obligations. In addition, $351.1 million and $226.8 million of investment balances were on deposit with various states to comply with insurance laws of the states in which the Company’s insurance subsidiaries are licensed.
In 2012, 2011 and 2010, respectively, the Holding Company made no capital contributions to the insurance subsidiaries.
The insurance subsidiaries are required by law to maintain a certain minimum level of policyholders’ surplus on a statutory basis. Policyholders’ surplus is calculated by subtracting total liabilities from total assets. The NAIC maintains risk-based capital (“RBC”) requirements for property and casualty insurance companies. RBC is a formula that attempts to evaluate the adequacy of statutory capital and surplus in relation to investments and insurance risks. The formula is designed to allow the state Insurance Departments to identify potential weakly capitalized companies. Under the formula, a company determines its risk-based capital by taking into account certain risks related to the insurer’s assets (including risks related to its investment portfolio and ceded reinsurance) and the insurer’s liabilities (including underwriting risks related to the nature and experience of its insurance business). Applying the RBC requirements as of December 31, 2012, the insurance subsidiaries’ risk-based capital exceeded the minimum level that would trigger regulatory attention.
For a discussion of accounting standards, see “Note 2-Accounting Policies and Basis of Presentation” of Notes to Consolidated Financial Statements.
Consolidated Statements of Income and Comprehensive Income for the years ended December 31, 2012, 2011, and 2010
Consolidated Statements of Cash Flows for the years ended December 31, 2012, 2011, and
Tower Group, Inc. (the “Company” or “Tower”) offers a broad range of commercial, specialty and personal specialty property and casualty insurance products and services through its subsidiaries to businesses in various industries and to individuals. The Company’s common stock is publicly traded on the NASDAQ Global Select Market under the symbol “TWGP”.
Commercial Insurance (“Commercial”) Segment offers a broad range of standard and specialty commercial lines property and casualty insurance products to businesses distributed through a network of retail and wholesale agents and program underwriting agents on both an admitted and non-admitted basis. This segment also includes assumed reinsurance;
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All inter-company accounts and transactions have been eliminated in consolidation.
In the first quarter 2012, Tower transferred a licensed insurance subsidiary shell to the Reciprocal Exchanges and received cash for its statutory book value. At the date of the transfer, Tower’s GAAP carrying basis in this subsidiary exceeded the statutory book value and the transfer resulted in a loss to Tower of $1.8 million. Since this was a non-recurring transaction between entities under common control, assets are transferred at historical book value. Any difference in the consideration paid and the book value of the assets transferred is treated as an adjustment to equity. This transaction had no effect on consolidated stockholders’ equity.
The insurance policies issued or reinsured by the Company are short-duration contracts. Accordingly, premium revenue, including direct business and reinsurance assumed, net of business ceded to reinsurers, is recognized on a pro-rata basis over the terms of the underlying policies. Unearned premiums represent premium applicable to the unexpired risk of in-force insurance contracts at each balance sheet date. Prepaid reinsurance premiums represent the unexpired portion of reinsurance premiums on risks ceded and are earned consistent with premiums. Mandatory reinstatement premiums are recognized and earned at the time a loss event occurs.
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 reported as management fee income within the segment but are eliminated in consolidation.
Policy billing fees are earned on a pro-rata basis over the terms of the underlying policies. These fees include installment and other fees related to billing and collections.
The liability for loss and LAE represents management’s best estimate of the ultimate cost and expense of all reported and unreported losses that are unpaid as of the balance sheet date. The liability for loss and LAE is recorded net of a tabular reserve discount for workers’ compensation and excess workers’ compensation claims in the amount of $8.4 million and $3.7 million at December 31, 2012 and 2011, respectively. The 2012 discount relates to $381.6 million of total net reserves for workers’ compensation. The projection of future claims payments and reporting is based on an analysis of the Company’s historical experience, supplemented by analyses of industry loss data. Management believes that the liability for loss and LAE is adequate to cover the ultimate cost of losses and claims to date; however, because of the uncertainty from various sources, including changes in reporting patterns, claims settlement patterns, judicial decisions, legislation, and economic conditions, actual loss experience may not conform to the assumptions used in determining the estimated amounts for such liability at the balance sheet date. As adjustments to these estimates become necessary, such adjustments are reflected in expense for the period in which the estimates are changed.
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, 2012 or 2011. The Company did not write-off balances from reinsurers during the three year period ended December 31, 2012.
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 7 - 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 stockholders’ 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.
As management is responsible for the recorded fair values, the Company has processes in place to validate the market prices obtained from the outside pricing sources including, but not limited to, periodic evaluation of model pricing methodologies and analytical reviews of certain prices. The Company also periodically performs back-testing of selected sales activity to determine whether there are any significant differences between the market price used to value the security prior to sale and the actual sale price.
In business combinations, including the acquisition of a group of assets, the Company allocates the purchase price to the net tangible and intangible assets acquired based on their relative fair values. Any portion of the purchase price in excess of this amount results in goodwill. Identifiable intangible assets with a finite useful life are amortized over the period that the asset is expected to contribute directly or indirectly to the future cash flows of the Company. Intangible assets with an indefinite life and goodwill are not amortized and are subject to annual impairment testing at the reporting unit level. For purposes of goodwill impairment testing, the Company defined its two segments, Commercial Insurance and Personal Insurance as reporting units. The Insurance Services segment does not carry goodwill.
Furniture, leasehold improvements, computer equipment, and software, including internally developed software, are reported at cost less accumulated depreciation and amortization. Gross fixed assets were $194.0 million and $176.4 million as of December 31, 2012 and 2011, respectively. Capitalized leases of $44.0 million and $41.0 million were included in this amount as at December 31, 2012 and 2011, respectively. Accumulated depreciation and amortization of $54.7 million and $56.5 million were recorded as of December 31, 2012 and 2011, respectively. In 2012, the Company wrote off $21.5 million of fully depreciated fixed assets with no impact to net income. Depreciation and amortization is provided using the straight-line method over the estimated useful lives of the assets. The Company estimates the useful life for computer equipment to be three years, computer software, three to seven years, furniture and other equipment seven years and leasehold improvements is the term of the lease. Depreciation and amortization expense of $20.2 million, $22.0 million and $15.4 million were recorded for the years ended December 31, 2012, 2011 and 2010, respectively. Fixed assets are recorded in Other Assets on the balance sheet.
The Company measures earnings per share at two levels: basic earnings per share and diluted earnings per share. Basic earnings per share is calculated by dividing net income attributable to Tower common stockholders by the weighted average number of common shares outstanding during the year. This weighted average number of shares includes unvested share-based awards that contain nonforfeitable rights to dividends or dividend equivalents whether paid or unpaid (“participating securities”). Diluted earnings per share is calculated by dividing net income attributable to Tower common stockholders by the weighted average number of common shares outstanding during the year, as adjusted for the potentially dilutive effects of stock options, warrants, unvested restricted stock and/or preferred stock that are not participating securities, unless such items are not dilutive.
In May 2011, the Financial Accounting Standards Board (“FASB”) issued new guidance concerning fair value measurement and disclosure. This new guidance requires additional disclosure about fair value measurements categorized as Level 3. This guidance had no effect on the Company’s financial position, results of operations or cash flows. The Company’s fair value disclosures have been revised effective January 1, 2012 to comply with this guidance.
In June 2011 (and as amended in December 2011), the FASB issued new guidance concerning the presentation of comprehensive income. The Company adopted this new guidance retrospectively on January 1, 2012 and now reports its comprehensive income in a separate consolidated financial statement immediately following the statement of operations.
In September 2011, the FASB issued amended guidance on testing goodwill for impairment. This guidance was intended to reduce the cost and complexity of the annual goodwill impairment test by allowing an entity to utilize more qualitative factors. The Company considered this guidance in the performance of its goodwill impairment test in the fourth quarter as of September 30, 2012. See Note 8 - “Goodwill and Intangible Assets” for further discussion on goodwill impairment testing.
Tower accounts for its 10.7% investment in Canopius Group using the equity method of accounting on a one quarter lag. Management has concluded it exerts significant influence over Canopius Group due to the following: Tower has a board seat on Canopius Group’s Board of Directors, Tower assumes approximately 6% of premiums written by Canopius Group, and Tower has certain rights in accordance with the Merger Option and SPS Transaction Right and Acquisition Right to cause Canopius Group to assist Tower as defined in the Master Transaction Agreement. For the year ended December 31, 2012, Tower recorded a reduction in its investment in Canopius Group by $0.7 million, of which $2.5 million is related to losses recorded in the statement of operations offset by a $1.8 million foreign currency translation adjustment which is recorded in other comprehensive income.
Effective July 1, 2010, Tower entered into transition service agreements with OneBeacon whereby OneBeacon will provide certain information technology and operational support to Tower until such time that these processes are migrated to Tower. Expenses incurred under such transition service agreements were $20.3 million and $23.9 million for the years ended December 31, 2012 and 2011, respectively.
Tower consolidated OBPL as of July 1, 2010 and the purchase consideration has been allocated to the assets acquired and liabilities assumed, including separately identified intangible assets, based on their fair values as of the close of the acquisition, with the amounts exceeding the fair value recorded as goodwill. The goodwill consisted largely of the synergies and economies of scale expected from combining the operations of the Company and OBPL.
All goodwill associated with the OBPL acquisition has been allocated to the Personal Insurance segment.
In the event of dissolution, policyholders would share any residual unassigned surplus in the same proportion as the amount of insurance purchased but are not subject to assessment for any deficit in unassigned surplus of the Reciprocal Exchanges. Tower receives management fee income for the services provided to the Reciprocal Exchanges. The assets of the Reciprocal Exchanges can be used only to settle the obligations of the Reciprocal Exchanges and general creditors to their liabilities have no recourse to Tower as the primary beneficiary.
The cost or amortized cost and fair value of the Company’s investments in fixed maturity and equity securities, gross unrealized gains and losses, and other-than-temporary impairment losses as of December 31, 2012 and December 31, 2011 are summarized as follows:
(1) Represents the gross unrealized loss on other-than-temporarily impaired securities recognized in accumulated other comprehensive income (loss).
Proceeds from the sale of fixed-maturity securities were $1.8 billion, $2.0 billion and $1.4 billion for the year ended December 31, 2012, 2011 and 2010, respectively. Proceeds from the sale of equity securities were $1.4 billion, $793.9 million and $80.7 million for the year ended December 31, 2012, 2011 and 2010, respectively.
(1) Other gross realized gains and losses consists primarily of “debt and equity securities sold, not yet purchased,” which are reported with Other liabilities.
For all fixed-maturity securities in an unrealized loss position at December 31, 2012, the Company has received all contractual interest payments (and principal if applicable). Based on the continuing receipt of cash flow and the foregoing analyses, management expects continued timely payments of principal and interest and considers the losses to be temporary.
The following table presents information regarding invested assets that were in an unrealized loss position at December 31, 2012 and December 31, 2011 by amount of time in a continuous unrealized loss position:
Management evaluated the severity of the impairment in relation to the carrying values for the securities referred to above and considered all relevant factors in assessing whether the loss was other-than-temporary. Management does not intend to sell its fixed-maturity securities, and it is not more likely than not that fixed maturity and equity securities will be sold until there is a recovery of fair value to the original cost basis, which may be at maturity.
The following table shows the composition of the fixed-maturity portfolio by remaining time to maturity at December 31, 2012 and 2011. 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.
The following table shows the composition of the other invested assets as of December 31, 2012 and 2011:
As at December 31, 2012 and 2011, the Company’s financial instruments carried at fair value are allocated among levels as follows:
(1) $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, 2012, 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
Management is responsible for the determination of the value of the investments carried at fair value and the supporting methodologies and assumptions. Management has reviewed the pricing techniques and methodologies of the independent pricing sources and believes that their policies adequately consider market activity, either based on specific transactions for the issue valued or based on modeling of securities with similar credit quality, duration, yield and structure that were recently traded. Management monitors security-specific valuation trends and discusses material changes or the absence of expected changes with the portfolio managers to understand the underlying factors and inputs and to validate the reasonableness of pricing. Management also back-tests the prices on numerous sales of securities during the year to validate the previous pricing provided as well as utilizes other pricing sources to validate the pricing provided by our primary provider of the majority of the non-U.S. Treasury securities and non-agency securities included in Level 2.
The following table summarizes changes in Level 3 assets measured at fair value for the year ended December 31, 2012 and 2011 for Tower (the Reciprocal Exchanges have no Level 3 assets):
Goodwill is calculated as the excess of purchase price over the net fair value of assets acquired. See Note 4 - “Acquisitions” for information regarding the calculation of goodwill related to the recent acquisitions. The following is a summary of goodwill by reporting units:
(a) In 2012, the Company identified deferred tax assets that should have been recorded in purchase accounting for certain acquisitions. The Company increased deferred tax assets by $4,090 and reduced goodwill to properly report 2010 and prior items as of the earliest period presented.
The market multiples techniques are based on book value; tangible book value; and estimates of projected future results were derived from selected guideline companies, which write products similar to those issued by us and are of comparable size, and were adjusted for the return on equity and the return on tangible equity. The DCF valuation and market multiples are based on projected future results involve a number of estimates that require broad assumptions and significant judgment by management regarding future performance. The key assumptions used in these methods are as follows:
* In the determination of the terminal value we considered a combined ratio of 94% as reasonable for Commercial Insurance and Personal Insurance.
The Company also compared the aggregate fair value of the reporting units to Tower’s overall market capitalization. The aggregate fair value of the reporting units exceeded Tower’s book value by 1% and market capitalization by 42%; management believes that the implied premium of the aggregate fair value over market capitalization is a reasonable valuation for an acquisition control premium (the price in excess of a stock’s market price that investors would typically pay to gain control of an entity).
Subsequent goodwill assessments could result in impairment due to the impact of a volatile financial market on earnings, discount assumptions, liquidity and market capitalization, as well as our assessment of segment organization upon the completion of the proposed merger with the Canopius Bermuda Operations. Management will continue to monitor its goodwill for possible future impairments.
The activity in the components of intangible assets for the years ended December 31, 2012 and 2011 consisted of intangible assets acquired from business combinations and amortization expense as shown in the table below:
The Company performs an analysis annually as of September 30 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. No impairments have been identified in the years ended December 31, 2012, 2011 and 2010.
The Company recorded amortization expense related to intangible assets with definite lives of $8.2 million, $8.9 million and $6.6 million in the years ended December 31, 2012, 2011 and 2010, respectively. The estimated amortization expense associated with these intangible assets for each of the next five years is:
The Reciprocal Exchanges are not party to the reinsurance agreements discussed above, except for the homeowners quota share treaty whereby they cede 35.5% 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.
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 $189.6 million and $161.9 million at December 31, 2012 and 2011, 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.
The consolidated net loss ratio, which includes the Reciprocal Exchanges, was 72.8% and 66.2% for the years ended December 31, 2012 and 2011, respectively. Excluding the Reciprocal Exchanges, the net loss ratio was 73.5% and 67.6% for the years ended December 31, 2012 and 2011, respectively. The Reciprocal Exchanges’ net loss ratio was 66.7% and 55.8% for the years ended December 31, 2012 and 2011, respectively.
Excluding the Reciprocal Exchanges, the 2012 net loss and loss adjustment expenses included $101.0 million from claims related to Superstorm Sandy.
For the Reciprocal Exchanges, the favorable development was $8.9 million, comprised of favorable development of $3.1 million for homeowners, $1.6 million for private passenger automobile liability, $1.7 million for other lines, and $2.5 million for amortization of reserves risk premium.
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 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.
Loss and loss adjustment expense reserves. The reserving process for loss and LAE reserves provides management’s best estimate at a particular point in time of the ultimate unpaid cost of all losses and LAE incurred, including settlement and administration of losses, and is based on facts and circumstances then known and including losses that have been incurred but not yet reported. The process includes using actuarial methodologies to assist in establishing these estimates, judgments relative to estimates of future claims severity and frequency, the length of time before losses will develop to their ultimate level and the possible changes in the law and other external factors that are often beyond our control. There are various actuarial methods that are appropriate for the different lines of business, and our actuaries’ use of a particular method or weighting of methods depends in part on the maturity of each accident year by line of business, the limits of liability covered under the policies, the presence or absence of large claims in the experience, and other considerations. In general, the various actuarial methods can be grouped into three categories: loss ratio projection, loss development methods, and the Bornhuetter-Ferguson (“B-F”) method. For the most recent accident year, and especially for liability lines of business, the actuarial method given the most weight is usually the loss ratio method, since the percentage of ultimate claims reported to date is expected to be low and the immature reported claims experience is not a reliable indicator of ultimate losses for that accident year. For property lines of business for the most recent accident year, the B-F method is usually given the most weight, because experience typically shows that there is a small percentage of claims reported in the subsequent period due to normal lags in reporting and processing of claims in these lines of business that can be relatively reliably estimated as a percentage of premiums, which is reflected in the B-F method. For each line
On January 30, 2013, the Board of Directors approved a quarterly dividend of $0.1875 per share payable on February 28, 2013 to stockholders of record as of February 14, 2013.
Aggregate scheduled maturities of the Company’s borrowings at December 31, 2012 are:
(a) Amount reflected in balance sheet for convertible senior notes is net of unamortized original issue discount of $5.3 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 date to February 15, 2016, and resetting borrowing fees to more favorable current market terms. The credit facility is used for general corporate purposes. The original credit facility was entered into on May 14, 2010 and had an expiration date of May 14, 2013.
The credit facility contains customary covenants for facilities of this type, including restrictions on indebtedness and liens, limitations on mergers, dividends and the sale of assets, and requirements to maintain certain consolidated net worth, debt to capitalization ratios, minimum risk-based capital and minimum statutory surplus. The credit facility also provides for customary events of default, including failure to pay principal when due, failure to pay interest or fees within three days after becoming due, failure to comply with covenants, any representation or warranty made by the Company being false in any material respect, default under certain other indebtedness, certain insolvency or receivership events affecting the Company and its material subsidiaries, the occurrence of certain material judgments, or a change in control of the Company, and upon an event of default the administrative agent (subject to the consent of the requisite percentage of the lenders) may immediately terminate the obligations to make loans and to issue letters of credit, declare the Company’s obligations under the credit facility to become immediately due and payable, and require the Company to deposit in a collateral account cash collateral with a value equal to the then outstanding amount of the aggregate face amount of any outstanding letters of credit. The Company was in compliance with or has obtained waivers for all covenants under the credit facility at December 31, 2012.
The following table shows the amounts recorded for the Notes as of December 31, 2012 and 2011:
The Compensation Committee of the Board of Directors has established, beginning in 2013 and subject to stockholder approval, a new Long Term Incentive Plan (the “2013 LTIP”), to replace the Company’s existing 2008 Long Term Equity Compensation Plan.
All options outstanding as of December 31, 2012 are fully exercisable as shown on the following table:
The following table provides an analysis of stock based compensation expense for the years ended December 31, 2012, 2011 and 2010:
The provision for Federal, state and local income taxes consist of the following components for the years ended December 31, 2012, 2011 and 2010:
The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 provided benefits from 100% accelerated depreciation of fixed assets. As a result, the Company’s current Federal income tax benefit for the year ended December 31, 2011 includes a refund from prior year overpayments and benefits from the 100% acceleration of depreciation of
Section 382 imposes annual limitations on a corporation’s ability to utilize its NOLs if it experiences an “ownership change.” As a result of the acquisitions, PGI and CastlePoint’s NOLs are subject to annual limitations of $2.8 million and $11.1 million, respectively. Any unused annual limitation may be carried over to later years. The NOLs will expire in years 2019 through 2029.
Additionally, Tower and the Reciprocal Exchanges have an AMT credit of $6.5 million and $0.5 million, respectively, that can be carried over indefinitely.
The Company believes it is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax assets, including the NOLs, except for those associated with the Reciprocal Exchanges. The Company has recorded a valuation allowance of $4.7 million and $5.1 million at December 31, 2012 and 2011, respectively, to reflect the amount of the Reciprocal Exchanges’ deferred taxes that may not be realized.
As of December 31, 2012 and 2011, 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 is currently under an IRS excise tax examination for the 2011 tax year. We expect to close this examination in 2013 with no changes.
On May 28, 2009, Munich Reinsurance America, Inc. (“Munich”) commenced an action against Tower Insurance Company of New York (“TICNY”), a wholly-owned subsidiary of Tower Group, Inc., in the United States District Court for the District of New Jersey seeking, inter alia, to recover $6.1 million under various retrocessional contracts pursuant to which TICNY reinsures Munich. On June 22, 2009, TICNY filed its answer, in which it, inter alia, asserted two separate counterclaims seeking to recover $2.8 million under various reinsurance contracts pursuant to which Munich reinsures TICNY. (A separate action commenced by Munich against TICNY on June 17, 2009 in the United States District Court for the District of New Jersey seeking a declaratory judgment that Munich is entitled to access to TICNY’s books and records pertaining to various quota share agreements, to which TICNY filed its answer on July 7, 2009, was subsequently dismissed pursuant to the stipulation of the parties on March 17, 2010). On July 15, 2011, TICNY paid $3.3 million to Munich to resolve a portion of the dispute. On December 22, 2011, the court granted partial summary judgment with respect to certain of the claims and defenses in the litigation. On March 23, 2012, the Court ruled that Munich was entitled to approximately $168,000 from TICNY in pre-judgment interest on the amount of $3.3 million that TICNY had paid to Munich on July 15, 2011, which was expensed in the first quarter of 2012. Trial was scheduled for October 15, 2012, but during the third quarter of 2012, the parties have reached a settlement of the action for $2.9 million after-tax which is included as a charge in other operating expenses. On October 9, 2012, the Court entered an order dismissing certain claims with prejudice and other claims without prejudice.
On May 12, 2010, Mirabilis Ventures, Inc. (“Mirabilis”) commenced an action against Specialty Underwriters’ Alliance Insurance Co. (“SUA”, now known as CastlePoint National Insurance Company (“CNIC”), a subsidiary of Tower Group, Inc.) and Universal Reinsurance Co., Ltd., an unrelated entity, in the United States District Court for the Middle District of Florida. The Complaint is based upon a Worker’s Compensation/Employer’s Liability policy issued by SUA to AEM, Inc. (“AEM”), to whose legal rights Mirabilis is alleged to have succeeded as a result of the Chapter 11 bankruptcy of AEM. The Complaint, which includes claims against SUA for breach of contract and breach of the duty of good faith, alleges that SUA failed to properly audit AEM’s operations to determine AEM’s worker’s compensation exposure for two policy years, in order to compute the premium owed by AEM, such that SUA owes Mirabilis the principal sum of $3.4 million for one policy year and $0.6 million for the other policy year, plus interest and costs. On July 30, 2010, CNIC answered the Complaint and asserted nine separate counterclaims, to which Mirabilis responded on September 3, 2010. Since that time, Mirabilis has filed an amended complaint that failed to add any defenses against Mirabilis, and CNIC subsequently filed a motion for summary judgment on all of Mirabilis’ claims. On March 15, 2012, Mirabilis and CNIC entered into a settlement agreement and mutual release, pursuant to which Mirabilis agreed to withdraw all of its claims against CNIC and CNIC agreed to withdraw its counterclaims against Mirabilis. Neither party was required to pay any money under the terms of the settlement. On March 20, 2012, the Court ordered dismissal of the case. On March 26, 2012, CNIC filed a stipulation of final order and the case was dismissed with prejudice and terminated.
Tower’s insurance subsidiaries are also required to participate in various mandatory insurance facilities or in funding mandatory pools, which are generally designed to provide insurance coverage for consumers who are unable to obtain insurance in the voluntary insurance market. The insurance subsidiaries are subject to assessments in New York, Florida, New Jersey, Georgia, California and other states for various purposes, including the provision of funds necessary to fund the operations of the New York Insurance Department and the New York Property/Casualty Insurance Security Fund, which pays covered claims under certain policies provided by impaired, insolvent or failed insurance companies and various funds administered by the New York Workers’ Compensation Board, which pays covered claims under certain policies provided by impaired, insolvent or failed insurance companies.
The Company’s insurance subsidiaries paid $14.0 million, $35.0 million and $4.7 million in dividends and or return of capital to Tower in 2012, 2011 and 2010, respectively. As of December 31, 2012, the maximum distribution that Tower’s insurance subsidiaries could pay without prior regulatory approval was $33.5 million and the maximum return of capital available from CastlePoint Re without Bermuda regulatory permission was $43.0 million.
CastlePoint Re is registered as a Class 3 reinsurer under The Insurance Act 1978 (Bermuda), amendments thereto and related regulations (the “Insurance Act”). Under the Insurance Act, CastlePoint Re is required to prepare Statutory Financial Statements and to file a Statutory Financial Return. The Insurance Act also requires CastlePoint Re to maintain minimum share capital and surplus, and it has met these requirements as of December 31, 2012.
Other invested assets: The fair value of securities which are reported under the fair value option are included in “Note 7-Fair Value Measurements.
stock holders share in dividends on a 1:1 basis, the earnings per share on undistributed earnings is equivalent. 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 following table shows the computation of the earnings per share:
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, 2012, 2011 and 2010, 0, 166,700 and 193,000, 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.
Segment performance is evaluated based on segment profit, which excludes investment income, realized gains and losses, interest expense, income taxes and incidental corporate expenses. Assets, other than intangible assets and goodwill, are not allocated to segments because investments and assets other than intangible assets and goodwill are considered in total by management for decision-making purposes.