Interest expense. We pay interest on our loans, on our subordinated debentures and on segregated assets placed in trust accounts on a “funds withheld” basis in order to collateralize reinsurance recoverables. In addition, interest expense includes amortization of any debt issuance costs over the remaining term of our subordinated debentures.
Income taxes. We pay Federal, state and local income taxes and other taxes.
In preparing our consolidated financial statements, management is required to make estimates and assumptions that affect reported assets, liabilities, revenues and expenses and the related disclosures as of the date of the financial statements. Management considers an accounting estimate to be critical if it requires assumptions to be made that involve uncertainty at the time the estimate is made and, had different assumptions been selected, the changes in the outcome could have a significant effect on our financial statements. We review our critical accounting estimates and assumptions quarterly. Actual results may differ, perhaps substantially, from the estimates.
The accident year loss ratio increased slightly by 0.9 points on a gross basis and by 0.8 points on a net basis as compared to the prior year. The increase in the accident year loss ratio reflects softer market conditions, although we mitigated some of the weaker insurance pricing by shifting our business mix towards small policies and more profitable lines of business, especially homeowners. We further mitigated the net accident year loss ratio through a quota share reinsurance contract in the fourth quarter of 2009 to cede 50% of our new and renewal premiums on liability lines. In addition, the net accident year loss ratio was favorably impacted by 0.6 percentage points due to the amortization of the reserve risk premium on loss reserves in accordance with GAAP for the business combinations occurring during 2009.
The commission portion of the gross underwriting expense ratio was 18.5% for 2009 compared to 16.9 % for the prior year. Our producer commissions did not vary significantly in 2009. The increase in the commission ratio resulted from the amortization of CastlePoint’s VOBA which was based on CastlePoint’s higher commission ratio. See “Note 3 - Acquisitions” to the financial statements elsewhere in this Form 10-K for information on VOBA.
The following tables show the fair value and unrealized loss by credit quality rating and deal origination year of our commercial, residential non-agency-backed and asset-backed securities in an unrealized loss position at December 31, 2009:
Our 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, 2009, our Insurance Subsidiaries’ risk-based capital exceeded the minimum level that would trigger regulatory attention.
The property and casualty insurance industry is affected by naturally occurring industry cycles known as “hard” and “soft” markets. For the first ten years after our company began, we operated in a soft market, generally considered an adverse industry condition in the property and casualty insurance industry. A soft market is characterized by intense competition that results in inadequate pricing, expanded coverage terms and increased commissions paid to distribution sources in order to compete for business. A hard market, generally considered a beneficial industry trend, is characterized by reduced competition that results in
We have audited the accompanying consolidated balance sheets of Tower Group, Inc. (“the Company”) as of December 31, 2009 and 2008, and the related consolidated statements of income and comprehensive net income, changes in stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2009. Our audits also included the financial statement schedules listed in Item 15. We also have audited the Company’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and the financial statement schedules and an opinion on the Company’s internal control over financial reporting based on our audits.
As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for other-than-temporary impairments of debt securities as of January 1, 2009 due to the adoption of new FASB guidance.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect reported assets, liabilities, revenues and expenses and the related disclosures as of the date of the financial statements. As more information becomes available, actual results could differ, perhaps substantially, from those estimates.
Tower estimates reserves separately for losses, allocated loss adjustment expenses, and unallocated loss adjustment expenses. Allocated loss adjustment expenses (“ALAE”) refers to costs of attorneys as well as miscellaneous costs such as witness fees and court costs attributable to specific claims that
For ALAE stemming from defense by in-house attorneys the Company determines a fixed fee per in-house litigated claim, and allocates to each of these litigated claims 50% of this 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 the Company’s in-house attorneys, and these amounts are subject to adjustment each quarter based upon actual experience.
The line of business that subjects the Company to concentration risk is primarily the commercial multiple-peril line. For the years ended December 31, 2009, 2008 and 2007, 33%, 42% and 42%, respectively, of gross premiums earned were for the commercial multiple-peril line.
In April, 2009, the FASB issued new guidance regarding requirements for disclosures relating to fair value of financial instruments. This guidance specifies that after reporting periods ended June 15, 2009, all interim, as well as annual, financial statements must contain the additional disclosures regarding fair value of financial instruments. Early adoption was permitted for periods ending after March 15, 2009. The Company adopted this guidance on January 1, 2009. As this guidance relates to disclosure rather than measurement of assets and liabilities, there will be no effect on the financial results or position of the Company.
The non-agency RMBS holdings include securities with underlying prime mortgages. Sub-prime and Alt-A mortgages are included in Agency backed Securities. The Company analyzes certain of its RMBS on a quarterly basis using default loss models based on the performance of the underlying loans. Performance metrics include delinquencies, defaults, foreclosures, prepayment speeds and cumulative losses incurred. The expected losses for a mortgage pool are compared to the break-even loss, which represents the point at which the Company’s tranche begins to experience losses. The timing of projected cash flows on these securities has changed as economic conditions have prevented the underlying borrowers from refinancing the mortgages underlying these securities, thereby reducing the amount of projected prepayments. Additionally, for certain of the non-agency RMBS holdings, the estimated cash flows have continued to decline throughout the year. This is primarily attributable to the continued decline in home prices during the first half of the year, but which seems to have stabilized during the second half of 2009. Additionally, unemployment has steadily risen throughout 2009 from 7.4% at December 2008 to 10.0% at December 2009. These are critical factors impacting future projected losses. As a result, the default and loss severity estimates have increased based on these home price change estimates and the increase in unemployment. See the table below for a summary of OTTI losses recorded in 2009. The OTTI charges are recognized and recorded in the period when there are adverse changes in projected cash flows, which the Company tests on a quarterly basis.
In addition, the Company entered into two aggregate excess of loss reinsurance agreements for the brokerage business with CastlePoint effective October 1, 2007. The purpose of the two aggregate excess of loss reinsurance agreements was to equalize the loss ratios for the brokerage business written by CastlePoint Insurance Company (“CPIC”) and the Company. Under the first agreement, TICNY reinsured approximately 85% (which percentage to be adjusted to equal Tower’s actual percentage of the total brokerage business written by the Company and CPIC) of CPIC’s brokerage business losses above a loss ratio of 52.5%. Under the second agreement, CPIC reinsured approximately 15% (which percentage to be adjusted to equal CastlePoint’s actual percentage of the total brokerage business written by the Company and CPIC) of the Company’s brokerage business losses above a loss ratio of 52.5%. For the years ended December 31, 2008 and 2007, the Company paid $3.0 million and $0.8 million to CPIC for reinsurance brokerage business written by the Company and received $3.0 million and $0.8 million from CPIC for business assumed which was produced by TRM as part of the brokerage business pool, respectively. The Company recorded $2.7 million and $0 million in net loss recoveries from the aggregate stop loss agreements with CPIC for the years ended December 31, 2008 and 2007, respectively. The aggregate excess of loss agreements were terminated effective December 31, 2008.
Based on the amount of ceded premiums earned, the maximum potential reduction to ceding commissions earned related to an increase in the Company’s estimated ultimate loss ratios is $33.5 million for all treaties for all five years. The ceded premiums for the 2004, 2005, 2006, 2007 and 2008 treaty years have been fully earned as of December 31, 2009. As of December 31, 2009, the ceded premium earned and prepaid reinsurance premiums for the 2009 treaty year were $27.2 million and $59.7 million, respectively.
As of December 31, 2009, there are 122,580 shares of common stock options outstanding that are fully vested. With the adoption of the 2004 Long-Term Incentive Compensation Plan, no further awards may be granted under the 2001 Stock Award Plan.
The following table provides an analysis of stock option activity during the three years ended December 31, 2009, 2008 and 2007:
Options outstanding and excercisable as of December 31, 2009 are shown on the following table:
Total rental expense charged to operations was approximately $7.9 million, $3.8 million and $4.3 million in 2009, 2008 and 2007, respectively.
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, New Jersey 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 was assessed $0 in 2009 and 2008 and $624,000 in 2007 for its proportional share of the total assessment for the Property/Casualty Security Fund and approximately $4.0 million, $2.0 million and $1.4 million in 2009, 2008 and 2007, respectively, for its proportional share of the operating expenses of the New York Insurance Department. Property casualty insurance company insolvencies or failures may result in additional security fund assessments to the Company at some future date. At this time the Company is unable to estimate the possible amounts, if any, of such assessments. Accordingly, the Company is unable to determine the impact, if any; such assessments may have on financial position or results of operations of the Company. The Company is permitted to assess premium surcharges on workers’ compensation policies that are based on statutorily enacted rates. Actual assessments have resulted in differences to the original estimates based on permitted surcharges of $2.2 million, $0 and ($2.2 million) in 2009, 2008 and 2007, respectively. The Company estimates its liability for future assessments based on actual written premiums and historical rates and available information. As of December 31, 2009 the liability for the various workers’ compensation funds, which includes amounts assessed on workers’ compensation policies was $11.6 million. This amount is expected to be paid over an eighteen month period ending June 30, 2011. As of December 31, 2008, the liability for the various workers’ compensation funds was $1.0 million.
Tower Group, Inc.’s Board of Directors approved a quarterly dividend on February 5, 2010 of $0.07 per share payable March 26, 2010 to stockholders of record as of March 15, 2010.