On October 14, 2009, the Company completed the acquisition of the renewal rights to the workers’ compensation business of AequiCap (“AequiCap I”). The acquired business primarily consists of small, low to moderate hazard workers’ compensation policies in Florida. Most of the employees of AequiCap I involved in the servicing of the workers’ compensation business became employees of the Company. The acquisition of this business expands the Company’s regional presence in the Southeast.
In most cases, our data is sufficiently credible to determine loss development factors utilizing our own data. In some cases, we supplement our own loss development experience with industry data and utilize historical loss development experience for particular books of business, programs or treaties obtained from our sources. The loss development factors are reviewed at least annually, and whenever there is a significant change in the underlying business. Each quarter we test the loss development by analyzing actual emerging claims compared to expected development.
ULAE for claims that are handled in-house by our claims adjusters utilize a similar process to that described above for ALAE. We determine fixed fees per claim by line of business, and assign these costs to line of business and accident year. For property lines, 50% of the fixed fee is attributed to claims when a claim is opened and 50% is attributed to claims when they are closed. For casualty lines, 75% of the fixed fee is attributed to the claim when a claim is opened and 25% is attributed to the claims when the claim is closed. The IBNR portion of ULAE for these claims is based upon 50% of the fixed fee per claims for in-house ULAE multiplied by the number of claims open and by 100% of the fixed fee multiplied by the estimated number of claims to be reported for prior accident dates.
Net income and return on average equity. Net income and annualized return on average equity attributable to Tower Group, Inc. were $60.2 million and 5.8% for the year ended December 31, 2011 compared to $103.9 million and 10.0% 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 $1,041.7 million and $1,039.1 million at December 31, 2011 and 2010, respectively.
Net realized investment gains were $13.5 million for the year ended December 31, 2010 compared to gains of $1.5 million in the same period last year. This increase is due in part to a $19.3 million decline in OTTI losses recognized in earnings from $23.5 million in 2009 to $4.2 million in 2010, offset by a $7.3 decline in capital realized gains from sales of securities from $25.0 million in 2009 to $17.7 million in 2010.
Underwriting expenses and underwriting expense ratio. Underwriting expenses, which include direct commissions and other underwriting expenses, increased $57.6 million from 2009 to 2010. The increase in underwriting expenses resulted from the increase in gross premiums earned, which was primarily due to the acquisitions discussed above. The gross underwriting expense ratio was 31.3% for the year ended December 31, 2010 as compared to 32.3% for 2009. The net expense ratio was 33.1% for the year ended December 31, 2010 as compared to 33.5% for 2009.
In September 2010, the Company issued $150 million principal amount of 5.0% convertible senior notes (the “Notes”) due September 2014. Interest is being paid semi-annually commencing March 2011. Holders may convert their Notes into cash or common shares, at the Company’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, the Company intends to settle its obligation either entirely or partially in cash. The Company has been adjusting the conversion rate quarterly as the Company pays its quarterly dividend. At December 31, 2011 the conversion rate is 36.6865 shares of common stock per $1,000 principal amount of the Notes (equivalent to a conversion price of $27.26 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 the Company 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 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 $50.0 million outstanding under the credit facility as of December 31, 2011. The Company had no balance outstanding under the credit facility as of December 31, 2010.
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.
As of December 31, 2011 and 2010, Tower’s insurance subsidiaries had $340.8 million and $261.1 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, $226.8 million and $188.5 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.
On July 1, 2010, Tower completed the OBPL acquisition pursuant to a definitive agreement (the “Agreement”) dated February 2, 2010 by and among the Company and OneBeacon Insurance Group (“OneBeacon”). This acquisition expanded Tower’s suite of personal lines insurance products to include private passenger automobile, homeowners, umbrella, and the signature package product, OneChoice CustomPac, which provides customers with one policy for all of their homeowners, auto and umbrella needs.
The following table shows the amount of fixed-maturity and equity securities that were OTTI for the years ended December 31, 2011, 2010 and 2009. This resulted in recording impairment write-downs included in net realized investment gains (losses), and reduced the unrealized loss in other comprehensive net income:
The fair values of the interest rate swaps were derived by using an industry standard swap valuation model with market based inputs for swaps having similar characteristics.
(a) Relates to the acquisition of OBPL and AequiCap II in 2010.
The Company recorded amortization expense related to intangibles of $8.9 million, $6.6 million and $3.2 million in the years ended December 31, 2011, 2010 and 2009, respectively. The estimated amortization expense for each of the next five years is:
On May 14, 2010, the Company entered into a $125 million credit facility agreement. The credit facility is being used for general corporate purposes and expires on May 14, 2013
In connection with the offering of the Notes, the Company also entered into convertible senior notes hedge transactions (the “Note Hedges” or “purchased call options”) and warrant transactions (the “Warrants”) with respect to its common stock with
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.) The parties have now concluded discovery. 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. The Company is unable to estimate a possible loss or range of loss.
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, California, New Jersey and other states for various purposes, including the provision of funds necessary to fund the operations of the New York Insurance