On April 6, 2006, we received a warrant from CastlePoint to purchase an additional 3.1% (adjusted for initial public offering) or 1,127,000 shares of common stock with a fair value of approximately $4.6 million using a Black-Scholes option pricing model. The warrant is exercisable in whole or in part at any time up to April 6, 2016, and the exercise price is $10 per share. Shares acquired through the exercise of the warrant may not be sold prior to April 9, 2009. The warrant was received in exchange for sponsorship services, which included management, operational and industry expertise to establish the CastlePoint organization and prepare for a private placement offering. Accordingly, we recognized $4.6 million in income before taxes in the twelve months ending December 31, 2006 relating to non-recurring sponsorship services. The warrant has been recorded as an equity instrument at cost, which was determined to be the fair value of the warrant on the date it was received and will be subject to impairment testing.
Deferred acquisition costs/commission revenues. We defer certain expenses and commission revenues related to producing and reinsuring insurance business, including commission expense on gross premiums written, commission income on ceded premiums written, premium taxes and certain other costs related to the acquisition of insurance contracts. These costs and revenues are capitalized and the resulting asset or liability, deferred acquisition costs/revenues, 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/income 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 ceases to be profitable, 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.
Operating expenses. Operating expenses increased by 56.1% to $178.4 million for 2007 from $114.2 million for 2006. The increase was due primarily to the increase in underwriting expenses resulting from the growth in premiums earned and additional staffing and facility expenses. The acquisition of Preserver added $22.0 million of operating expenses in 2007. The integration of Preserver is on target with our expectations and Preserver’s gross expense ratio was reduced to 33.6% in the portion of 2007 subsequent to the acquisition and to 31.2% in the fourth quarter of 2007.
Interest expense. Our interest expense increased in 2006 to $6.9 million compared to $4.9 million in 2005. The increase resulted from $1.3 million of interest expense from the $20.6 million of subordinated debentures issued on March 31, 2006, $0.4 million resulting from an increase in interest rates on the floating rate portions of our subordinated debentures and $0.3 million as a result of crediting reinsurers on funds withheld in segregated trusts as collateral for reinsurance recoverables.
Direct commission expense. TRM’s direct commission expense rate was 16.5% for 2007 compared to 14.9% for 2006. The direct commission expense rate increased in 2007 as a result of the change in the mix of business TRM produced on behalf of CPIC in comparison to what TRM produced in 2006 for other issuing carriers. The CPIC book of business is produced through the same agents who produce business written through our insurance segment and TRM’s commission rates are similar to the commission rates in the insurance segment.
As of December 31, 2007, the maximum dividend distribututions that our Insurance Subsidiaries could pay to Tower without approval of their domiciliary Insurance Departments was approximately $17.0 million.
The following table presents information regarding the Company’s invested assets that were in an unrealized loss position at December 31, 2007 and 2006 by amount of time in a continuous unrealized loss position.
The Company has made only minor changes to the key assumptions used during the last three annual reserve estimates. In 2005 and 2006 the Company had favorable development in its net losses from prior accident
In an effort to manage the cost of quota share reinsurance in the time of rising cost and limited availability, the Company implemented provisions for loss ratio caps to provide the reinsurers with some limit on the amount of potential loss being assumed, while maintaining the transfer of significant insurance risk with the possibility of a significant loss to the reinsurer, and thereby to reduce the cost of reinsurance. Loss ratio caps cut off the reinsurers’ liability for losses above a specified loss ratio. The loss ratio caps in the 2005, 2004 and 2003 quota share agreements were 95.0%, 95.0% and 92.0%, respectively, and there was no loss ratio cap in 2007 and 2006.
The Company issued 40,000 Perpetual Series A Preferred Shares on December 4, 2006 with a $0.01 par value per share and a $1,000 liquidation preference per share to CastlePoint Management Corp. which were potentially convertible into common stock upon a public offering of common shares by the Company. The carrying value of this stock is $40 million less issuing cost of $0.4 million or $39.6 million at December 31, 2006. The preferred stock paid a fixed 8.66% annual dividend that is not cumulative. On January 10, 2007, the Company exchanged its outstanding Series A Perpetual Preferred stock for 40,000 shares of Series A-1 Perpetual Preferred Stock. On January 26, 2007, the Company fully redeemed all 40,000 shares of the Series A-1 stock for $40.0 million using $20.0 million of the net proceeds from its trust preferred securities issued on January 25, 2007 and $20.0 million of the net proceeds from its common stock offering (described in the next paragraph).
to generate sufficient taxable income to use the benefits before the expiration of the applicable carryforward periods.
Section 382 imposes limitations on a corporation’s ability to utilize its net operating loss carry forwards (NOL) if it experiences an “ownership change.” In general terms, an ownership change results from transactions increasing the ownership of certain stockholders in the stock of a corporation by more than 50 percentage points over a three-year period. As a result of the acquisition, Preserver underwent an ownership change. Use of Preserver’s NOL of $40.3 million is subject to an annual limitation under Section 382 determined by multiplying the value of Preserver’s stock at the time of purchase by the applicable long-term rate resulting in an annual limitation amount of approximately $2.8 million. Any unused annual limitation may be carried over to later years.
information from the NYBFU on the Fire Patrol assessment. The Company has not recorded any liability for this assessment as of December 31, 2007 and 2006. The NYBFU has informed the Company that the Fire Patrol ceased operations on October 15, 2006. The Company cannot predict what action, if any, the NYBFU will take in this matter and whether the Company may ultimately be liable for some amount of the assessment.