Note on Forward-Looking Statements
Some of the statements under "Risk Factors," "Management's Discussion and
Analysis of Financial Condition and Results of Operations," "Business" and
elsewhere in this Form 10-Q may include forward-looking statements that reflect
our current views with respect to future events and financial performance. These
statements include forward-looking statements both with respect to us
specifically and to the insurance sector in general. Statements that include the
words "expect," "intend," "plan," "believe," "project," "estimate," "may,"
"should," "anticipate," "will" and similar statements of a future or
forward-looking nature identify forward-looking statements for purposes of the
Federal securities laws or otherwise.
All forward-looking statements address matters that involve risks and
uncertainties. Accordingly, there are or will be important factors that could
cause our actual results to differ materially from those indicated in these
statements. We believe that these factors include, but are not limited to, those
described under "Risk Factors" and the following:
• ineffectiveness or obsolescence of our business strategy due to changes in
current or future market conditions;
• developments that may delay or limit our ability to enter new markets as
quickly as we anticipate;
• increased competition on the basis of pricing, capacity, coverage terms or
other factors;
• greater frequency or severity of claims and loss activity, including as a
result of natural or man-made catastrophic events, than our underwriting,
reserving or investment practices anticipate based on historical experience
or industry data;
• the effects of acts of terrorism or war;
• developments in the world's financial and capital markets that could adversely affect the performance of our investments;
• changes in regulations or laws applicable to us, our subsidiaries, brokers or
customers;
• changes in acceptance of our products and services, including new products
and services;
• changes in the availability, cost or quality of reinsurance and failure of
our reinsurers to pay claims timely or at all;
• changes in the percentage of our premiums written that we cede to reinsurers;
• decreased demand for our insurance or reinsurance products;
• loss of the services of any of our executive officers or other key personnel;
• the effects of mergers, acquisitions or divestitures;
• changes in rating agency policies or practices;
• changes in legal theories of liability under our insurance policies;
• changes in accounting policies or practices;
• changes in general economic conditions, including inflation, interest rates
and other factors;
• disruptions in Tower's business arising from the integration of acquired
businesses into Tower and the anticipation of potential or pending
acquisitions or mergers; and
• currently pending or future litigation or governmental proceedings.
The foregoing review of important factors should not be construed as exhaustive
and should be read in conjunction with the other cautionary statements that are
included in this Form 10-Q. We undertake no obligation to publicly update or
review any forward-looking statement, whether as a result of new information,
future developments or otherwise.
If one or more of these or other risks or uncertainties materialize, or if our
underlying assumptions prove to be incorrect, actual results may vary materially
from what we project. Any forward-looking statements you read in this Form 10-Q
reflect our views as of the date of this Form 10-Q with respect to future events
and are subject to these and other risks, uncertainties and assumptions relating
to our operations, results of operations, growth strategy and liquidity. All
subsequent written and oral forward-looking statements attributable to us or
individuals acting on our behalf are expressly qualified in their entirety by
this paragraph. Before making an investment decision, you should specifically
consider all of the factors identified in this Form 10-Q that could cause actual
results to differ.
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Overview
Tower, through its subsidiaries, offers a broad range of commercial, specialty
and personal property and casualty insurance products and services to businesses
in various industries and to individuals throughout the United States. We
provide coverage for many different market sectors, including non-standard risks
that do not fit the underwriting criteria of standard risk carriers due to
factors such as type of business, location and premium per policy. We provide
these products on both an admitted and excess and surplus ("E&S") basis.
The Company operates three business segments: Commercial Insurance, Personal
Insurance and Insurance Services. Each of these segments is described below.
Our Commercial Insurance segment offers property and casualty insurance products
through several business units that serve customers in general commercial and
specialty markets. Our commercial lines products include commercial
multiple-peril (provides both property and liability insurance), monoline
general liability (insures bodily injury or property damage liability),
commercial umbrella, monoline property (insures buildings, contents or business
income), workers' compensation, fire and allied lines, inland marine, commercial
automobile policies and assumed reinsurance.
Our Personal Insurance segment offers a broad range of products designed to fit
the insurance needs of most personal lines customers. This segment includes the
business written in the Reciprocal Exchanges. Our personal lines products
consist of homeowners, personal automobile, package and umbrella policies. In
the first quarter of 2012, Tower sold one of its insurance subsidiaries to the
Reciprocal Exchanges. As a result, the Reciprocal Exchanges have expanded their
licensing and increased their capacity to write business.
In our Insurance Services segment, we generate management fees primarily from
the services provided to the Reciprocal Exchanges and other fees generated by
our managing general agencies.
Investment in Canopius Group Limited and Exercise of Merger Option
On August 20, 2012, Tower closed on its $74.9 million acquisition of a 10.7%
stake in Canopius Group Limited ("Canopius Group"), a privately owned Lloyd's
insurance holding company domiciled in Guernsey, Channel Islands. In connection
with this acquisition, which was agreed to on April 25, 2012, Tower also entered
into an agreement dated April 25, 2012 (the "Master Transaction Agreement")
under which Canopius Group committed to assist Tower with the establishment of a
presence at Lloyd's of London through a special purpose syndicate ("SPS
Transaction Right and Acquisition Right"), subject to required approvals and
granted Tower an option (the "Merger Option") to combine with Canopius Holdings
Bermuda Limited ("Canopius Bermuda"). On July 30, 2012, Tower announced that it
had exercised the Merger Option and executed an Agreement and Plan of Merger
(the "Original Merger Agreement") with Canopius Bermuda pursuant to which a
wholly-owned subsidiary of Canopius Bermuda will acquire all of Tower's common
stock. Under applicable accounting principles Tower will be regarded as the
acquiring entity. Tower paid Canopius Group a fee of $1,000,000 to exercise the
Merger Option. On November 8, 2012, the Original Merger Agreement was amended by
Amendment No. 1 to the Agreement and Plan of Merger to reflect changes to the
merger consideration to be received by Tower stockholders (the Original Merger
Agreement as so amended, the "Merger Agreement").
Under the Merger Agreement, Tower stockholders will receive, in exchange for
each share of Tower's common stock, a certain number of Canopius Bermuda common
shares equal to a Stock Conversion Number (defined below). Canopius Group
intends to sell its shares in Canopius Bermuda prior to the consummation of the
merger in a private placement of those shares (the "Canopius Secondary
Offering") to a group of yet-to-be-identified institutional third party
investors (the "Third Party Investors"). The "Stock Conversion Number" will be
equal to the quotient obtained by dividing (x) the price per share of Tower
common stock at the market close on the date of the pricing of the Canopius
Secondary Offering by (y) the Adjusted Canopius Bermuda Price Per Share (defined
below).
The "Adjusted Canopius Bermuda Price Per Share" will be equal to the quotient
obtained by dividing (i) the sum of (a) the Target TNAV Amount, which is the
amount that Tower specifies in a written notice delivered to Canopius Group
prior to the signing date of the purchase and sale agreements for the Canopius
Secondary Offering, as the target amount of the tangible net asset value of
Canopius Bermuda as of the closing date of the Canopius Secondary Offering, (b)
the value of the retained business of Canopius Bermuda following its
restructuring, (c) the aggregate amount of the placement fees received by the
placement agents in connection with the Canopius Secondary Offering and (d) the
aggregate amount, expressed in dollars, equal to the absolute value of the
discount from the closing price of Tower's common stock on the pricing date of
the Canopius Secondary Offering, or on another reasonably current date (as
agreed by Tower, Canopius Bermuda and the Third Party Investors), that Tower,
Canopius Bermuda and the Third Party Investors have agreed is necessary in order
to effect the Canopius Secondary Offering, by (ii) the aggregate number of
Canopius Bermuda common shares sold in the Canopius Secondary Offering.
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Because neither the restructuring of Canopius Bermuda nor the Canopius Secondary
Offering is likely to occur until the fourth quarter of this year at the
earliest, no assurances can be given as to the Target TNAV Amount or the
Adjusted Canopius Bermuda Price Per Share. In determining the Target TNAV
Amount, Tower will principally consider the amount of capital that it believes
will be required to maintain its ratings and to operate the combined business.
Tower believes this capital amount to be between $150 million and $180 million.
Although the Merger Agreement contains no conditions precedent to Tower's
obligations to consummate the merger, Tower will not proceed with the merger in
the event that (1) the Canopius Secondary Offering cannot be effected, or can
only be effected on terms that would make the Stock Conversion Number, and
therefore the merger, unattractive to Tower, (2) the Adjusted Canopius Bermuda
Price Per Share declines to a point that the Third Party Investors would own 20%
or less of the merged entity's fully diluted capital stock immediately following
the closing of the merger, (3) Tower stockholders and optionholders, as well as
holders of Tower's convertible senior notes, would own less than 76% of the
fully diluted capital stock of Tower Ltd. immediately following the closing of
the merger, (4) the parties to the Merger Agreement fail to obtain the necessary
regulatory approvals on terms acceptable to Tower, (5) Tower's stockholders fail
to adopt the Merger Agreement and approve the merger, (6) Tower's Board of
Directors determines that the transactions contemplated by the Merger Agreement
are not favorable to Tower or its stockholders and (7) Tower has not received an
opinion of a nationally recognized law firm, in form and substance satisfactory
to Tower, to the effect that the merger should not cause Tower Ltd. to be
treated as a domestic corporation under Section 7874(b) of the Internal Revenue
Code of 1986, as amended.
Tower has the explicit right in the Merger Agreement to terminate that agreement
and not complete the merger at any time and for any or no reason prior to the
effective time of the merger. In the event that Tower exercises its right to
terminate the Merger Agreement, it will nonetheless be obligated to reimburse
affiliates of Canopius Bermuda for costs actually incurred in connection with
negotiating, documenting and implementing the Merger Agreement and the
transactions contemplated thereby to the extent that such costs exceed the
$1,000,000 Merger Option exercise fee paid by Tower.
Operating Income
Operating income excludes realized gains and losses and acquisition-related
transaction costs, net of tax. This is a common measurement for property and
casualty insurance companies. We believe this presentation enhances the
understanding of our results of operations by highlighting the underlying
profitability of our insurance business. Additionally, these measures are a key
internal management performance standard.
The following table provides a reconciliation of operating income to net income
on a GAAP basis. The operating income is used to calculate operating earnings
per share and operating return on average equity:
Three Months Ended Nine Months Ended
September 30, September 30,
($ in thousands) 2012 2011 2012 2011
Operating income (loss) $ 23,772 $ (15,307 ) $ 30,242 $ 31,013
Net realized gains (losses) on investments,
excluding gains (losses) attributable to
Reciprocal Exchanges 80 (1,135 ) 1,108 4,245
Acquisition-related transaction costs (2,679 ) (425 ) (4,661 ) (437 )
Income tax 456 428 461 (1,454 )
Net income (loss) attributable to Tower
Group, Inc. $ 21,629 $ (16,439 ) $ 27,150$ 33,367
Critical Accounting Estimates
As of September 30, 2012, there were no material changes to our critical
accounting estimates; refer to the Company's 2011 Annual Report on Form 10-K for
a complete discussion of critical accounting estimates.
Critical Accounting Policies
See "Note 2-Accounting Policies and Basis of Presentation" for information
related to updated accounting policies.
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Consolidating Supplemental Information
The following tables present the consolidating financial statements as of
September 30, 2012 and December 31, 2011 and for the three and nine months ended
September 30, 2012 and 2011:
September 30, 2012
Reciprocal Elimin-
($ in thousands) Tower Exchanges ations Total
Assets
Investments
Available-for-sale investments, at
fair value:
Fixed-maturity securities $ 2,133,676 $ 303,172 $ - $ 2,436,848
Equity securities 123,614 5,654 - 129,268
Short-term investments 4,748 - - 4,748
Other invested assets 131,565 - (77,200 ) 54,365
Total investments 2,393,603 308,826 (77,200 ) 2,625,229
Cash and cash equivalents 168,031 11,383 - 179,414
Investment income receivable 41,786 3,443 (15,041 ) 30,188
Investment in unconsolidated affiliate 71,512 - - 71,512
Premiums receivable 327,089 42,800 (2,400 ) 367,489
Reinsurance recoverable on paid losses 20,753 2,248 (3,128 ) 19,873
Reinsurance recoverable on unpaid
losses 294,488 23,524 (4,386 ) 313,626
Prepaid reinsurance premiums 44,876 19,910 (1,966 ) 62,820
Deferred acquisition costs, net 177,086 12,503 - 189,589
Intangible assets 101,806 7,000 - 108,806
Goodwill 250,103 - - 250,103
Funds held by reinsured companies 124,353 - - 124,353
Other assets 336,138 4,086 (19,057 ) 321,167
Total assets $ 4,351,624 $ 435,772 $ (123,178 ) $ 4,664,169
Liabilities
Loss and loss adjustment expenses $ 1,571,593 $ 127,459 $ (4,386 ) $ 1,694,666
Unearned premium 823,155 106,106 (1,966 ) 927,295
Reinsurance balances payable 17,165 9,213 (5,528 ) 20,850
Funds held under reinsurance
agreements 88,810 - - 88,810
Other liabilities 303,054 46,889 (34,298 ) 315,645
Deferred income taxes 41,451 7,445 - 48,896
Debt 449,005 77,000 (77,000 ) 449,005
Total liabilities 3,294,661 374,111 (123,178 ) 3,545,595
Stockholders' equity
Common stock 468 - - 468
Treasury stock (181,432 ) - - (181,432 )
Paid-in-capital 777,864 27,647 (27,647 ) 777,864
Accumulated other comprehensive income 96,125 17,090 (17,090 ) 96,125
Retained earnings 361,956 16,874 (16,874 ) 361,956
Noncontrolling interests 1,982 - 61,611 63,593
Total stockholders' equity 1,056,963 61,611 - 1,118,574
Total liabilities and stockholders'
equity $ 4,351,624 $ 435,722 $ (123,178 ) $ 4,664,169
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December 31, 2011
Reciprocal Elimin-
($ in thousands) Tower Exchanges ations Total
Assets
Investments
Available-for-sale investments, at
fair value:
Fixed-maturity securities $ 2,153,620 $ 300,054 $ - $ 2,453,674
Equity securities 87,479 1,866 - 89,345
Short-term investments - - - -
Other invested assets 121,547 - (77,200 ) 44,347
Total investments 2,362,646 301,920 (77,200 ) 2,587,366
Cash and cash equivalents 113,432 666 - 114,098
Investment income receivable 33,842 2,978 (10,038 ) 26,782
Premiums receivable 367,336 41,290 - 408,626
Reinsurance recoverable on paid losses 18,233 6,326 (656 ) 23,903
Reinsurance recoverable on unpaid
losses 308,411 20,134 (8,881 ) 319,664
Prepaid reinsurance premiums 39,352 14,685 - 54,037
Deferred acquisition costs, net 156,992 11,866 - 168,858
Intangible assets 110,081 4,839 - 114,920
Goodwill 250,103 - - 250,103
Funds held by reinsured companies 69,755 - - 69,755
Other assets 317,173 2,485 (15,575 ) 304,083
Total assets $ 4,147,356 $ 407,189 $ (112,350 ) $ 4,442,195
Liabilities
Loss and loss adjustment expenses $ 1,495,839 $ 145,155 $ (8,881 ) $ 1,632,113
Unearned premium 790,185 102,991 - 893,176
Reinsurance balances payable 17,328 4,122 (656 ) 20,794
Funds held under reinsurance
agreements 96,726 - - 96,726
Other liabilities 259,408 32,560 (25,813 ) 266,155
Deferred income taxes 24,826 4,511 - 29,337
Debt 426,901 77,000 (77,000 ) 426,901
Total liabilities 3,111,213 366,339 (112,350 ) 3,365,202
Stockholders' equity
Common stock 465 - - 465
Treasury stock (158,185 ) - - (158,185 )
Paid-in-capital 772,938 25,851 (25,851 ) 772,938
Accumulated other comprehensive income 62,244 7,771 (7,771 ) 62,244
Retained earnings 356,680 7,228 (7,228 ) 356,680
Noncontrolling interests 2,001 - 40,850 42,851
Total stockholders' equity 1,036,143 40,850 - 1,076,993
Total liabilities and stockholders'
equity $ 4,147,356 $ 407,189 $ (112,350 ) $ 4,442,195
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Three Months Ended September 30,
2012 2011
Reciprocal Elimina- Reciprocal Elimina-
($ in thousands) Tower Exchanges tions Total Tower Exchanges tions Total
Revenues
Net premiums earned $ 388,090 $ 42,623 $ - $ 430,713 $ 366,874 $ 46,573 $ - $ 413,447
Ceding commission revenue 4,990 3,190 (477 ) 7,703 4,956 2,011 - 6,967
Insurance services revenue 8,678 - (7,870 ) 808 8,057 - (7,644 ) 413
Policy billing fees 2,980 153 - 3,133 2,688 142 - 2,830
Net investment income 29,924 3,141 (1,676 ) 31,389 29,817 3,268 (1,674 ) 31,411
Total net realized investment gains
(losses) 80 1,065 - 1,145 (1,135 ) 1,362 - 227
Total revenues 434,742 50,172 (10,023 ) 474,891 411,257 53,356 (9,318 ) 455,295
Expenses
Loss and loss adjustment expenses 235,782 20,314 - 256,096 284,661 25,376 - 310,037
Direct and ceding commission expense 79,637 8,367 (477 ) 87,527 73,066 7,188 - 80,254
Other operating expenses 78,760 14,514 (7,870 ) 85,404 68,498 13,029 (7,644 ) 73,883
Acquisition-related transaction costs 2,679 - - 2,679 425 - - 425
Interest expense 8,224 1,676 (1,676 ) 8,224 8,633 1,674 (1,674 ) 8,633
Total expenses 405,082 44,871 (10,023 ) 439,930 435,283 47,267 (9,318 ) 473,232
Income (loss) before income taxes 29,660 5,301 - 34,961 (24,026 ) 6,089 - (17,937 )
Income tax expense (benefit) 8,031 1,469 - 9,500 (7,587 ) 1,606 - (5,981 )
Net income (loss) $ 21,629 $ 3,832 $ - $ 25,461 $ (16,439 ) $ 4,483 $ - $ (11,956 )
Ratios
Net calendar year loss and LAE 60.8 % 47.7 % 59.5 % 77.6 % 54.5 % 75.0 %
Net underwriting expenses 35.5 % 45.8 % 36.5 % 34.4 % 38.8 % 34.9 %
Net Combined 96.3 % 93.5 % 96.0 % 112.0 % 93.3 % 109.9 %
Return on Average Equity 8.4 % -6.3 %
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Nine Months Ended September 30,
2012 2011
Reciprocal Elimina- Reciprocal Elimina-
($ in thousands) Tower Exchanges tions Total Tower Exchanges tions Total
Revenues
Net premiums earned $ 1,184,371 $ 126,653 $ - $ 1,311,024 $ 1,044,201 $ 142,571 $ - $ 1,186,772
Ceding commission revenue 13,923 9,500 (477 ) 22,946 20,898 4,905 - 25,803
Insurance services revenue 25,361 - (22,697 ) 2,664 22,985 - (22,043 ) 942
Policy billing fees 8,853 414 - 9,267 7,234 433 - 7,667
Net investment income 92,448 9,668 (5,003 ) 97,113 90,924 9,663 (5,000 ) 95,587
Total net realized investment gains
(losses) 1,108 3,384 - 4,492 4,245 1,028 - 5,273
Total revenues 1,326,064 149,619 (28,177 ) 1,447,506 1,190,487 158,600 (27,043 ) 1,322,044
Expenses
Loss and loss adjustment expenses 801,873 71,491 - 873,364 715,080 75,979 - 791,059
Direct and ceding commission expense 238,573 24,302 (477 ) 262,398 208,840 24,227 - 233,067
Other operating expenses 223,114 42,058 (22,697 ) 242,475 192,311 39,703 (22,043 ) 209,971
Acquisition-related transaction costs 4,661 - - 4,661 437 - - 437
Interest expense 23,702 5,003 (5,003 ) 23,702 24,990 5,000 (5,000 ) 24,990
Total expenses 1,291,923 142,854 (28,177 ) 1,406,600 1,141,658 144,909 (27,043 ) 1,259,524
Income (loss) before income taxes 34,141 6,765 - 40,906 48,829 13,691 - 62,520
Income tax expense (benefit) 6,991 (2,880 ) - 4,111 15,462 4,192 - 19,654
Net income (loss) $ 27,150 $ 9,645 $ - $ 36,795 $ 33,367 $ 9,499 $ - $ 42,866
Ratios
Net calendar year loss and LAE 67.7 % 56.4 % 66.6 % 68.5 % 53.3 % 66.7 %
Net underwriting expenses 34.7 % 44.6 % 35.6 % 33.5 % 41.1 % 34.4 %
Net Combined 102.4 % 101.0 % 102.2 % 102.0 % 94.4 % 101.1 %
Return on Average Equity 3.5 % 4.3 %
Consolidated Results of Operations
Our results of operations are discussed below in two parts, consolidated results
of operations and the results of each of our three segments.
Consolidated Results of Operations for the Three and Nine Months Ended
September 30, 2012 and 2011
The comparison of financial results for the three and nine months ended
September 30, 2012 as compared to the same periods in the prior year were
particularly affected by two items (i) severe weather events including Hurricane
Irene in 2011and (ii) the reserve strengthening recorded in the second quarter
of 2012. The severe weather events including Hurricane Irene increased net
losses and loss adjustment expense by $60.1 million and $82.3 million for the
three and nine months ended September 30, 2011. The reserve strengthening
recorded in the second quarter of 2012 increased net losses and loss adjustment
expense by $65.0 million. Year to year comparisons must be considered carefully
because of these two events. The following discussion will note the specific
influences from these two events when applicable.
Total revenues. Total revenues increased by 4.3% and 9.5%, respectively for the
three and nine months ended September 30, 2012 compared to the same periods in
2011. These increases are primarily attributable to increases in earned
premiums.
Premiums earned. Gross premiums earned for the three and nine months ended
September 30, 2012 were $483.9 million and $1,455.7 million, respectively, and
$459.2 million and $1,329.0 million for the same periods in 2011, respectively.
The increase of 5.4% for the three months ended September 30, 2012 was primarily
due to the earnings from the assumed reinsurance business written in later half
of 2011 and 2012 in the Commercial Insurance Segment. The increase of 9.5% for
the nine month period is primarily a result of increased business in Tower's
continuing programs and assumed reinsurance lines in the Commercial Insurance
segment.
Ceded premiums earned increased $7.4 million to $53.2 million for the three
months ended September 30, 2012 from $45.8 million in 2011. For the nine months
ended September 30, 2012, ceded premiums earned were $144.6 million compared to
$142.2 million for the same period in the prior year. The Company reinsures
premiums written on certain of its program business through quota share treaties
and purchases excess per risk and catastrophe reinsurance for all property
lines.
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Overall, net premiums earned increased $17.3 million and $124.3 million,
respectively for the three and nine months ended September 30, 2012 compared to
the same periods in 2011.
Commission and fee income. Commission and fee income, comprised of ceding
commission revenue, insurance services revenue and policy billing fees,
increased by $1.4 million and $0.5 million in the three and nine months ended
September 30, 2012, respectively, compared to the same periods in 2011. The
increases for the three and nine months ended September 30, 2012 are due to
additional fees earned by our managing general agencies.
Net investment income and net realized gains (losses).For the three months ended
September 30, 2012, net investment income remained relatively constant when
compared with the same period in 2011. For the nine month period ended
September 30, 2012, net investment income increased $1.5 million, or 1.6%, due
to an increase in average cash and invested assets from the comparative period
in 2011. Operating cash invested in fixed income securities in 2012 and in 2011
has been affected by an extended low interest rate environment. Investments in
high-yield securities and dividend paying equity securities continue to be made
to help maintain overall portfolio yield and to partially mitigate the impact of
the lower interest rate environment.
For the three months ended September 30, 2012 and 2011, OTTI losses of $1.7
million and $2.8 million were primarily in the equity portfolio. Net realized
investment gains for the three months ended September 30, 2012 and 2011 remained
relatively constant. Net realized gains for the nine months ended September 30,
2012 increased $2.8 million on the sale of securities. These gains and losses
are a function of individual securities selected for sale when cash needs arise
in the ordinary course of business or when market dictates disposals pursuant to
our investment policy.
Loss and loss adjustment expenses. The consolidated net loss ratio, which
includes the Reciprocal Exchanges, was 59.5% and 75.0% for the three months
ended September 30, 2012 and 2011, respectively. Excluding the Reciprocal
Exchanges, the net loss ratio was 60.8% and 77.6% for the three months ended
September 30, 2012 and 2011, respectively. The Reciprocal Exchanges' net loss
ratio was 47.7% and 54.5% for the three months ended September 30, 2012 and
2011, respectively.
Incurred losses and LAE for the three months ended September 30, 2012
attributable to insured events of prior years were favorable by $1.1 million.
Excluding the Reciprocal Exchanges, the incurred losses and LAE from prior
accident years were nil. Excluding the Reciprocal Exchanges, there was net
adverse loss development of $0.2 million in the Commercial Insurance segment
offset by $0.2 million favorable development in the Personal Insurance segment
for the three months ended September 30, 2012.
Incurred losses and LAE for the nine months ended September 30, 2012 excluding
the Reciprocal Exchanges and attributable to insured events of prior years were
$78.2 million, comprised of $74.2 million adverse development in Commercial
Insurance and $4.0 million in Personal Insurance. Tower's commercial business
includes some programs that we acquired as part of our acquisition of Specialty
Underwriters' Alliance. Inc. ("SUA") in 2009. Certain of these programs
generated very poor loss experience and the experience got worse as time
elapsed. We have discontinued all but one of these programs with respect to new
premium; however, we still must run off the losses. Most of the reserve
strengthening arose from the need to increase reserves on these programs.
Commission and Operating expenses. Operating expenses, which include direct and
ceding commission expenses and other operating expenses, were $172.9 million for
the three months ended September 30, 2012, an increase of 12.2% compared to the
same period in the prior year. This increase is primarily due to: (i) increased
business production, including more assumed premiums written which have a higher
commission rate compared to direct premiums written, (ii) the Company's ongoing
efforts to build-out our information technology infrastructure to support our
policy administration and claims processing needs, and (iii) the aforementioned
charge attributable to the Munich legal settlement.
The consolidated gross underwriting expense ratio increased to 34.1% for the
three months ended September 30, 2012 from 33.0% in the same period in 2011. The
commission portion of the gross underwriting expense ratio increased to 18.1%
for the three month period September 30, 2012 compared to 17.5% in 2011. This
increase is attributed to the increase in assumed reinsurance business written,
as noted above. The gross OUE ratio was 12.6% for the three months ended
September 30, 2012 compared to 12.3% in the prior year. The change in the gross
OUE ratio is attributable to the change in estimate for the allocation between
ULAE and OUE as noted above.
For the nine months ended September 30, 2012, operating expenses were $504.9
million compared to $443.0 million for the nine months ended September 30, 2011,
for an increase of $61.9 million or 14.0%. This increase is due to increased
business production and our ongoing efforts to build-out our information
technology infrastructure to support our policy administration and claims
processing needs.
The consolidated gross underwriting expense ratio increased to 33.7% for the
nine months ended September 30, 2012 from 32.6% in the same period in 2011. The
commission portion of the gross underwriting expense ratio increased to 18.0%
for the
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nine month period September 30, 2012 compared to 17.5% in 2011. This increase is
attributed to the increase in assumed reinsurance business written, which
charges a higher commission rate. In 2012, management revised its estimates in
the allocation of operating expenses between unallocated loss adjustment expense
and OUE which resulted in a greater percentage assigned to OUE. The gross OUE
ratio was 12.3% for the nine months ended September 30, 2012 compared to 11.9%
for the same period in the prior year.
Acquisition-related transaction costs. Acquisition-related transaction costs for
the three and nine months ended September 30, 2012 were $2.7 million and $4.7
million, respectively, primarily attributed to the acquisition of our equity
interest in Canopius Group and expenses associated with the Merger Option, as
described on page 7. These costs were negligible for the same periods in 2011.
Interest expense. Interest expense decreased by $0.4 million and $1.3 million
for the three and nine months ended September 30, 2012, respectively, compared
to the same periods in 2011.
Income tax expense. Tower uses the effective tax rate method in computing its
interim tax provision. The effective tax rate was 27.2% and 33.3% for the three
months ended September 30, 2012 and 2011, respectively. Excluding the Reciprocal
exchanges, Tower's effective tax rate was 27.1% and 31.6% for the three months
ended September 30, 2012 and 2011, respectively.
In the nine months ended September 30, 2012, the income tax expense of $4.1
million includes a $7.1 million out-of-period adjustment in the first quarter of
2012 to correct the Company's deferred income tax liability as reported at
December 31, 2011. Excluding the out-of-period adjustment, the effective tax
rate would have been 27.3% for the nine months ended September 30, 2012 compared
to 31.4% for the same period in the prior year. Excluding the Reciprocal
Exchanges and out-of-period adjustment, Tower's effective tax rate would have
been 28.0% for the nine months ended September 30, 2012 compared to 31.7% for
the same period in 2011.
Net income (loss) and return on average equity. Net income/(loss) attributable
to Tower Group, Inc. and annualized return on average equity were $21.6 million
and 8.3% for the three months ended September 30, 2012 compared to $(16.4)
million and annualized return on average equity of (6.3)% for the same period in
2011. The return on average equity is calculated by dividing annualized net
income by average stockholders' equity. Average stockholders' equity was
$1,035.9 million and $1,045.5 million at September 30, 2012 and 2011,
respectively. The net income and improvement in annualized return on equity for
the three months ended September 30, 2012 is primarily due to effects of
Hurricane Irene which increased incurred losses in the third quarter of 2011.
Net income attributable to Tower Group, Inc. and annualized return on average
equity were $27.1 million and 3.5% for the nine months ended September 30, 2012
compared to net income of $33.4 million and annualized return on average equity
of 4.3% for the nine months ended September 30, 2011. The decline in net income
and annualized return on equity is primarily due to reserve strengthening
recorded for Tower Group, Inc. in the second quarter of 2012, which was higher
than the incurred losses recorded in 2011 attributable to Hurricane Irene.
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Commercial Insurance Segment Results of Operations
Three Months Ended September 30, Nine Months Ended September 30,
($ in thousands) 2012 2011 Change Percent 2012 2011 Change Percent
Net premiums written $ 286,393 $ 350,207 $ (63,815 ) -18.2 % $ 950,346 $ 896,850 $ 53,496 6.0%
Revenues
Net premiums earned $ 296,606 $ 290,113 $ 6,493 2.2 % $ 932,091 $ 805,616 $ 126,475 15.7%
Ceding commission revenue 2,446 1,455 991 68.1 % 6,350 10,183 (3,833 ) -37.6%
Policy billing fees 1,358 1,195 163 13.6 % 4,261 3,073 1,188 38.7%
Total revenue 300,410 292,763 7,647 2.6 % 942,702 818,872 123,830 15.1%
Expenses
Net loss and loss adjustment expenses 180,053 221,540
(41,487 ) -18.7 % 662,700 552,627 110,073 19.9%
Underwriting expenses
Direct commission expenses 61,142 57,146 3,996 7.0 % 183,230 157,394 25,836 16.4%
Other underwriting expenses 45,213 39,854 5,359 13.4 % 140,875 113,467 27,408 24.2%
Total underwriting expenses 106,355 97,000 9,355 9.6 % 324,105 270,861 53,244 19.7%
Underwriting profit (loss) $ 14,002 $ (25,777 ) $ 39,779 -154.3 % $ (44,103 ) $ (4,616 ) $
(39,487 ) NM
Ratios
Net calendar year loss and LAE 60.7 % 76.4 % 71.1 % 68.6 %
Net underwriting expenses 34.6 % 32.5 % 33.6 % 32.0 %
Net combined 95.3 % 108.9 % 104.7 % 100.6 %
Commercial Insurance Segment Results of Operations for the Three and Nine Months
Ended September 30, 2012 and 2011
Premiums. Gross premiums written for the three months ended September 30, 2012
were $312.0 million compared to $366.7 million during the same period in 2011.
The decrease in the three months ended September 30, 2012 of $54.7 million is
primarily attributable to the non renewal of one program that generated $51.7
million of gross written premium in the third quarter in 2011. Gross premiums
earned were $322.6 million for the three month period ended September 30, 2012
as compared to $310.0 million during the same period in 2011. The increase in
gross premiums earned is a result of the increased writings in our assumed
reinsurance over the last twelve months.
Gross premiums written for the nine months ended September 30, 2012 were
$1,018.7 million compared to $945.6 million during the same period in 2011. The
increase in the nine months ended September 30, 2012 of $72.49 million is
primarily attributed to growth in assumed reinsurance which accounted for $84.8
million compared to the same period in 2011. Gross premiums earned were $997.2
million for the nine month period ended September 30, 2012 as compared to $872.6
million during the same period in 2011.
Ceded premiums written for the three months ended September 30, 2012 increased
to $25.6 million from $16.5 million for the three months ended September 30,
2011. The Company reinsures through quota share treaties premiums written on
certain of its program business. In addition, we also purchase excess per risk
and catastrophe reinsurance for all property lines. Ceded earned premiums were
$26.0 million and $19.9 million for the three month periods ended September 30,
2012 and 2011, respectively. The increase in ceded premiums in 2012 is
attributable primarily to increased written premiums on certain program business
which is then reinsured through the quota share treaties. In addition, the
Company's catastrophe reinsurance premiums increased in 2012 compared to 2011.
Ceded premiums written for the nine months ended September 30, 2012 were $68.4
million compared to $48.8 million for the nine months ended September 30, 2011.
Ceded premiums earned were $65.1 million compared to $66.9 million for the nine
month periods ended September 30, 2012. The Company reinsures through quota
share treaties premiums written on certain of its program business. In addition,
we also purchase excess per risk and catastrophe reinsurance for all property
lines. The increase in ceded premiums in 2012 is attributable primarily to
increased written premiums on certain program business which is then reinsured
through the quota share treaties. In addition, the Company's catastrophe
reinsurance premiums increased in 2012 compared to 2011.
Net premiums written for the three months ended September 30, 2012 decreased
$63.8 million and net premiums earned for the three months ended September 30,
2012 increased $6.5 million compared to the same periods in 2011. These changes
are attributed to the gross and ceded premium changes discussed above.
Net premiums written and earned for the nine months ended September 30, 2012
increased $53.5 million and $126.5 compared to the same periods in 2011. These
changes are attributed to the gross and ceded premium changes discussed above.
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Our renewal retention rate excluding programs was 83.7% and 79.5% for the three
and nine months ended September 30, 2012 compared to 76.8% and 76.3% during the
same periods in 2011 as we saw a better pricing environment in 2012. Premiums on
renewed commercial business, other than programs, increased 4.0% and 3.2% for
the three and nine months ended September 30, 2012. Excluding programs,
policies-in-force for our commercial business, which is predominantly small
business, decreased 9.6% as of September 30, 2012.
Ceding commission revenue. Ceding commission revenue increased for the three
months ended September 30, 2012 by $1.0 million compared to the same period in
2011. The increase was a result of increased premium on programs with specific
quota share reinsurance. We also recognized a change in loss ratio on a prior
year's quota share treaty which reduced ceding commission revenue by $1.8
million during the three month period ended September 30, 2012 compared to $2.0
million during the same period in 2011.
Ceding commission revenue decreased for the nine months ended September 30, 2012
by $3.8 million compared to the same period in 2011, primarily due to a change
in loss ratio on a prior year's quota share treaty which reduced ceding
commission revenue by $4.2 million during the nine month period ended
September 30, 2012 compared to $1.1 million charge attributable to the change in
loss ratio for the same quota share treaty in the nine month period ended
September 30, 2011.
Net loss and loss adjustment expenses. The net calendar year loss ratios were
60.7% and 76.4% for the three months ended September 30, 2012 and 2011,
respectively. The accident year loss ratios for the three months ended
September 30, 2012 and 2011 were 60.6% and 68.3%, respectively.
In the three month period ended September 30, 2011, the Company incurred net
losses of $32.5 million relating to Hurricane Irene and other severe weather
events. Excluding the effects of these storms, the net loss ratio would have
been 65.2% for the three months ended September 30, 2011.
The net calendar year loss ratios were 71.1% and 68.6% for the nine months ended
September 30, 2012 and 2011, respectively. The accident year loss ratios for the
nine months ended September 30, 2012 and 2011 were 63.1% and 64.0%,
respectively.
Management's estimates of prior years' loss and loss expenses increased $74.0
million for the nine months ended September 30, 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 analysis of
recent loss emergence that occurred during the second quarter.
The reserve strengthening related primarily to unfavorable development in the
company's Commercial Insurance segment arising from changes in estimated
ultimate losses for accident years 2011 and prior. During the second quarter
Tower conducted detailed reserve studies for all lines using loss data through
the first quarter of 2012 as well as reported claims during the second quarter,
including analysis of the source of unusually high reported loss emergence for
certain casualty lines, primarily workers' compensation and commercial
automobile, observed during the first quarter of 2012. The increase in prior
accident year ultimate loss and loss expense was largely comprised of $39
million in workers compensation and $22 million in commercial automobile
liability. The reserve development was attributable mostly to programs, many of
which are terminated and in runoff.
The Commercial Insurance segment incurred losses included $41.6 million relating
to Hurricane Irene and other severe storms during the nine month period ending
September 30, 2011.
Underwriting expenses. Underwriting expenses, which include direct commissions
and other underwriting expenses, increased by $9.4 million and $53.2 million, or
9.6% and 19.7%, for the three and nine months ended September 30, 2012,
respectively, compared to the same periods in 2011. The net underwriting expense
ratio increased 2.1 and 1.6 percentage points for the three and nine months
ended September 30, 2012 from 2011.
The gross underwriting expense ratio was 32.5% and 32.1% for the three and nine
months ended September 30, 2012 compared to 30.9% and 30.7% 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 19.0% and 18.4% for
the three and nine months ended September 30, 2012 compared to 18.4% and 18.0%
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 BB&T, was 13.6% and 13.7% for the three and nine months ended
September 30, 2012 compared to 12.5% and 12.7% for the same periods 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 loss and combined ratio. Commercial Insurance segment underwriting
profit increased $39.8 million and the combined ratio improved by 13.6
percentage points for the three months ended September 30, 2012 compared to the
three months ended September 30, 2011. The improvement in the combined ratio is
directly attributable to Hurricane Irene and other
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severe storms in the prior year. The Company recorded $32.5 million of net
incurred losses for the three month period ended September 30, 2012 relating to
these storms.
Underwriting profit decreased $39.5 million and the combined ratio increased 4.1
percentage points from the nine months ended September 30, 2011 to September 30,
2012. The increase in the combined ratio for the nine months ended September 30,
2012 resulted primarily from the $74.0 million reserve strengthening the Company
recorded in the first and second quarters of 2012. In the nine month period
ended September 30, 2011, the Company recorded $41.6 million in catastrophe and
other severe storm losses. In addition, as discussed above, the Commercial
Segment expense ratio increased by 1.6 percentage points from 2011 to 2012.
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Personal Insurance Segment Results of Operations
Three Months Ended September 30,
2012 2011
Reciprocal Reciprocal
($ in thousands) Tower Exchanges Total Tower Exchanges Total Change Percent
Net premiums written $ 96,262 $ 41,831 $ 138,093 $ 73,605 $ 44,891 $ 118,496 $ 19,597 16.5 %
Revenues
Net premiums earned $ 91,484 $ 42,623 $ 134,107 $ 76,761 $ 46,573 $ 123,334 $ 10,773 8.7 %
Ceding commission revenue 2,067 3,190 5,257 3,501 2,011 5,512 (255 ) -4.6 %
Policy billing fees 1,622 153 1,775 1,493 142 1,635 140 8.6 %
Total revenue 95,173 45,966 141,139 81,755 48,726 130,481 10,658 8.2 %
Expenses
Net loss and loss adjustment expenses 55,729 20,314 76,043 63,122 25,375 88,497 (12,454 ) -14.1 %
Underwriting expenses
Direct commission expenses 18,018 8,367 26,385 15,816 7,188 23,004 3,381 14.7 %
Other underwriting expenses 20,714 14,513 35,227 21,166 13,030 34,196 1,031 3.0 %
Total underwriting expenses 38,732 22,880 61,612 36,982 20,218 57,200 4,412 7.7 %
Underwriting profit (loss) $ 712 $ 2,772 $ 3,484 $ (18,349 ) $ 3,133 $ (15,216 ) $ 18,700
-122.9 %
Ratios
Net calendar year loss and LAE 60.9 % 47.7 % 56.7 % 82.2 % 54.5 % 71.8 %
Net underwriting expenses 38.3 % 45.8 % 40.7 % 41.7 % 38.8 % 40.6 %
Net combined 99.2 % 93.5 % 97.4 % 123.9 % 93.3 % 112.4 %
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Personal Insurance Segment Results of Operations (continued)
Nine Months Ended September 30,
2012 2011
Reciprocal Reciprocal
($ in millions) Tower Exchanges Total Tower Exchanges Total Change Percent
Net premiums written $ 261,513 $ 124,544 $ 386,057 $ 230,218 $ 130,649 $ 360,867 25,190 7.0 %
Revenues
Net premiums earned $ 252,280 $ 126,653 $ 378,933 $ 238,585 $ 142,571 $ 381,156 (2,223 ) -0.6 %
Ceding commission revenue 7,096 9,500 16,596 10,715 4,905 15,620 976 6.2 %
Policy billing fees 4,592 414 5,006 4,161 433 4,594 412 9.0 %
Total revenue 263,968 136,567 400,535 253,461 147,909 401,370 (835 ) -0.2 %
Expenses
Net loss and loss adjustment expenses 139,173 71,491 210,664 162,453 75,979 238,432 (27,768 ) -11.6 %
Underwriting expenses
Direct commission expenses 54,866 24,302 79,168 51,445 24,227 75,672 3,496 4.6 %
Other underwriting expenses 53,844 42,057 95,901 55,348 39,703 95,051 850 0.9 %
Total underwriting expenses 108,710 66,359 175,069 106,793 63,930 170,723 4,346 2.5 %
Underwriting profit (loss) $ 16,085 $ (1,283 ) $ 14,802 $ (15,785 ) $ 8,000 $ (7,785 ) $ 22,587
-290.1 %
Ratios
Net calendar year loss and LAE 55.2 % 56.4 % 55.6 % 68.1 % 53.3 % 62.6 %
Net underwriting expenses 38.5 % 44.6 % 40.5 % 38.5 % 41.1 % 39.5 %
Net combined 93.7 % 101.0 % 96.1 % 106.6 % 94.4 % 102.1 %
Personal Insurance Segment Results of Operations for the Three and Nine Months
Ended September 30, 2012 and 2011
Premiums. Gross premiums written for the three months ended September 30, 2012
were $172.9 million compared to $152.4 million in 2011, an increase of $20.5
million, or 13.5%. Gross premiums earned increased $12.2 million to $161.4
million for the three months ended September 30, 2012 from $149.2 million for
the same period in the prior year. This increase is primarily attributed to an
increase in homeowners business offset by a decline in mono-line automobile
policies.
Gross premiums written for the nine months ended September 30, 2012 were $471.1
million compared to $431.0 million in 2011, for an increase of $40.1 million, or
9.3%. This increase is attributed to the acquisition of personal lines renewal
rights resulting in $20.0 million of written premium in the second and third
quarter of 2012 and an increase in homeowners business offset by a decline in
mono-line automobile policies. Gross premiums earned increased $2.1 million to
$458.5 million for the nine months ended September 30, 2012 from $456.4 million
for the same period in 2011. This increase is due primarily to the renewal
rights premiums and increase in homeowners business discussed above offset by a
decline in mono-line automobile policies.
Ceded premiums written for the three months ended September 30, 2012 were $34.8
million, an increase of $0.9 million compared to $33.9 million in 2011. The
Company reinsures a portion of its homeowners and umbrella business through
quota share reinsurance treaties. The Company also purchased catastrophe
reinsurance for certain property business. The increase in 2012 is attributed to
increasing the percentage of business ceded pursuant to the homeowners quota
share treaty. Ceded premiums earned increased $1.4 million to $27.3 million for
the three months ended September 30, 2012 from $25.9 million for the same period
in the prior year.
Ceded premiums written for the nine months ended September 30, 2012 were $85.0
million, an increase of $14.8 million compared to $70.2 million in 2011. The
Company reinsures the majority of its homeowners and umbrella business through
quota share reinsurance treaties. The Company also purchased catastrophe
reinsurance for certain property business. The increase in 2012 is attributed to
increasing the percentage of business ceded pursuant to the homeowners quota
share treaty. Ceded premiums earned increased $4.3 million to $79.6 million for
the nine months ended September 30, 2012 from $75.3 million for the same period
in the prior year.
Net premiums written for the three and nine months ended September 30, 2012
increased $19.6 million and $25.2 million compared to the same periods in 2011.
Net premiums earned for the three months ended September 30, 2012 increased
$10.8 million and decreased $2.2 million for the nine months ended September 30,
2012 compared to the same periods in 2011. These changes are attributed to the
gross and ceded premium changes discussed above.
Our personal lines renewal retention was 88.9% and 89.8% for the three months
ended September 30, 2012 and 2011, respectively. Personal lines renewal
retention was 89.4% and 84.6% for the nine months ended September 30, 2012 and
2011,
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respectively. Written premiums on renewed business increased by 4.5% and 3.4%
during the three and nine months ended September 30, 2012, respectively.
Policies-in-force decreased 2.1% from December 31, 2011 to September 30, 2012.
Ceding commission revenue. Ceding commission revenue remained stable from the
three and nine months ended September 30, 2011 to the three months ended
September 30, 2012, increasing only $0.3 million and $1.0 million, respectively.
Net loss and loss adjustment expenses. For Personal Insurance, the net calendar
year loss ratios were 56.7% and 71.8% for the three months ended September 30,
2012 and 2011, respectively. The accident year loss ratios for the three months
ended September 30, 2012 and 2011 were 57.6% and 103.8%, respectively. The net
calendar year loss ratios were 55.6% and 62.6% for the nine months ended
September 30, 2012 and 2011, respectively. The accident year loss ratios for the
nine months ended September 30, 2012 and 2011 were 56.5% and 77.3%,
respectively. Estimates of prior accident year loss and loss expenses decreased
by $1.3 million and $3.2 million for the three and nine months ended
September 30, 2012, respectively.
For Tower personal lines, excluding the Reciprocal Exchanges, the net calendar
year loss ratios were 60.9% and 82.2% for the three months ended September 30,
2012 and 2011, respectively. The accident year loss ratios for the three months
ended September 30, 2012 and 2011 were 61.1% and 100.2%, respectively. The net
calendar year loss ratios were 55.2% and 68.1% for the nine months ended
September 30, 2012 and 2011, respectively. The accident year loss ratios for the
nine months ended September 30, 2012 and 2011 were 53.6% and 76.3%,
respectively. There was net adverse loss development of $4.0 million for the
nine months ended September 30, 2012, and net favorable development of $0.2
million for the three months ended September 30, 2012. The adverse development
for the nine months ended September 30, 2012 was comprised primarily of $3.6
million in Homeowners, and $0.3 million in Private Passenger Automobile. In the
three and nine month periods ended September 30, 2011, the Company recorded
$27.6 million and $40.7 million of incurred losses relating to Hurricane Irene
and other severe storms.
The Reciprocal Exchanges' net calendar year loss ratios were 47.7% and 54.5% for
the three months ended September 30, 2012 and 2011, respectively. The accident
year loss ratios for the three months ended September 30, 2012 and 2011 were
50.2% and 92.8%, respectively. The net calendar year loss ratios were 56.4% and
53.3% for the nine months ended September 30, 2012 and 2011, respectively. The
accident year loss ratios for the nine months ended September 30, 2012 and 2011
were 62.2% and 73.4%, respectively. Estimates of prior accident year loss and
loss adjustment expenses decreased by $1.0 million and $7.3 million for the
three and nine months ended September 30, 2012, respectively.
Underwriting expenses. Underwriting expenses, which include direct commissions
and other underwriting expenses, increased $4.4 million and $4.4 million, or
7.7% and 2.5%, for the three and nine months ended ending September 30, 2012,
respectively, compared to the same periods in 2011. The net underwriting expense
ratio increased 0.1 percentage points in the three month period ended
September 30, 2011 compared to the same period in 2012. The net underwriting
expense ratio increased 1.0 percentage points from the nine month period ended
September 30, 2011 to 2012.
The gross underwriting expense ratio was 37.1% and 37.2% for the three months
ended September 30, 2012 and 2011, respectively. The commission portion of the
gross underwriting expense ratio was 16.4% and 15.4% for the three months ended
September 30, 2012 and 2011, respectively. The gross OUE ratio, which includes
BB&T, was 20.7% and 21.8% for the three months ended September 30, 2012 and
2011, respectively.
The gross underwriting expense ratio was 37.1% and 36.4% for the nine months
ended September 30, 2012 and 2011, respectively. The commission portion of the
gross underwriting expense ratio was 17.3% and 16.6% for the nine months ended
September 30, 2012 and 2011, respectively. The gross OUE ratio, which includes
BB&T, was 19.8% and 19.8% for the nine months ended September 30, 2012 and 2011,
respectively.
Underwriting profit and combined ratio. Personal Insurance segment underwriting
profit improved $18.7 million and the combined ratio improved by 15.0 percentage
points for the three months ended September 30, 2012 compared to the same period
in 2011 as a result of the improved net loss ratio. The improvement in the net
loss ratio is directly attributable to Hurricane Irene and other severe storms
in the prior year. The Company recorded $27.6 million of net incurred losses for
the three month period ended September 30, 2012 relating to these storms.
Underwriting profit improved $22.6 million and the combined ratio improved 6.0
percentage points from the nine months ended September 30, 2011 to September 30,
2012 as a result of an improved net loss ratio offset by a slightly worse net
expense ratio. The net loss ratio improvement is due to the Company recording
$27.6 million of incurred losses attributable to Hurricane Irene and other
severe storms for the nine month period ended September 30, 2011.
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Insurance Services Segment Results of Operations
Three Months Ended September 30, Nine Months Ended September 30,
($ in thousands) 2012 2011 Change Percent 2012 2011 Change Percent
Revenue
Management fee income $ 7,870 $ 7,644 $ 226 3.0 % $ 22,697 $ 22,043 $ 654 3.0 %
Other revenue 808 413 395 95.6 % 2,664 942 1,722 182.8 %
Total revenue 8,678 8,057 621 7.7 % 25,361 22,985 2,376 10.3 %
Expenses -
Other expenses 9,578 4,986 4,592 92.1 % 19,120 15,004 4,116 27.4 %
Total expenses 9,578 4,986 4,592 92.1 % 19,120 15,004 4,116 27.4 %
Insurance services pre-tax income (loss) $ (900 ) $ 3,071 $ (3,971 ) -129.3 % $ 6,241$ 7,981 $ (1,740 )
-21.8 %
NM is shown where percentage change
exceeds 500%
Insurance Services Segment Results of Operations for the Three and Nine Months
Ended September 30, 2012 and 2011
Total revenue. Total revenues for the three months ended September 30, 2012
increased $.6 million, or 7.7%, from the Insurance Services revenues compared to
the same period in the prior year. This increase is primarily related to certain
fee income earned by our managing general agencies for business placed with
other insurers. The management fee income for the nine months ended
September 30, 2012 was consistent with the revenues earned for the nine months
ended September 30, 2011.
Total expenses. Insurance Services segment expenses for the three and nine
months ended September 30, 2012 increased by $4.6 million and $4.1 million,
respectively, compared to the expenses for the same period ended September 30,
2011. The increase is primarily due to a settlement reached with Munich
Reinsurance America, Inc. ("Munich") to resolve a legal action commenced by
Munich in 2009. See Legal Proceedings for additional details on the settlement.
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Investments
Portfolio Summary
The following table presents a breakdown of the amortized cost, aggregate fair
value and unrealized gains and losses by investment type as of September 30,
2012 and December 31, 2011:
Cost or Gross Gross Unrealized Losses % of
Amortized Unrealized Less than 12 More than 12 Fair Fair
($ in thousands) Cost Gains Months Months Value Value
September 30, 2012
U.S. Treasury securities $ 114,209 $ 1,636 $ (1 ) $ - $ 115,844 4.5 %
U.S. Agency securities 74,623 4,474 - - 79,097 3.1 %
Municipal bonds 739,201 65,028 (37 ) - 804,192 31.2 %
Corporate and other bonds 700,181 55,571 (875 ) (54 ) 754,823 29.4 %
Commercial, residential and
asset-backed securities 628,197 54,904 (91 ) (118 ) 682,892 26.6 %
Total fixed-maturity securities 2,256,411 181,613 (1,004 ) (172 ) 2,436,848 94.8 %
Equity securities 126,483 4,584 (1,570 ) (229 ) 129,268 5.0 %
Short-term investments 4,748 - - - 4,748 0.2 %
Total, September 30, 2012 $ 2,387,642 $ 186,197 $ (2,574 ) $ (401 ) $ 2,570,864 100.0 %
Tower $ 2,104,711 $ 160,051 $ (2,348 ) $ (376 ) $ 2,262,038
Reciprocal Exchanges 282,931 26,146 (226 ) (25 ) 308,826
Total, September 30, 2012 $ 2,387,642 $ 186,197 $ (2,574 ) $ (401 ) $ 2,570,864
December 31, 2011
U.S. Treasury securities $ 154,430 $ 1,725 $ (13 ) $ - $ 156,142 6.1 %
U.S. Agency securities 114,411 2,779 - - 117,190 4.6 %
Municipal bonds 688,192 48,777 (255 ) - 736,714 29.0 %
Corporate and other bonds 750,220 34,466 (6,813 ) (150 ) 777,723 30.6 %
Commercial, residential and
asset-backed securities 627,859 42,167 (3,529 ) (592 ) 665,905 26.2 %
Total fixed-maturity securities 2,335,112 129,914 (10,610 ) (742 ) 2,453,674 96.5 %
Equity securities 93,034 1,395 (4,838 ) (246 ) 89,345 3.5 %
Total $ 2,428,146 $ 131,309 $ (15,448 ) $ (988 ) $ 2,543,019 100.0 %
Tower $ 2,138,001 $ 118,173 $ (14,160 ) $ (915 ) $ 2,241,099
Reciprocal Exchanges 290,145 13,136 (1,288 ) (73 ) 301,920
Total, December 31, 2011 $ 2,428,146 $ 131,309 $ (15,448 ) $ (988 ) $ 2,543,019
Credit Rating of Fixed-Maturity Securities
The average credit rating of our fixed-maturity securities, using ratings
assigned to securities by Standard & Poor's, was A+ at September 30, 2012 and
December 31, 2011. The following table shows the ratings distribution of our
fixed-maturity portfolio:
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Tower Reciprocal Exchanges
Percentage Percentage
of Fair of Fair
($ in thousands) Fair Value Value Fair Value Value
September 30, 2012
Rating
U.S. Treasury securities $ 109,456 5.1 % $ 6,388 2.1 %
AAA 185,581 8.7 % 48,202 15.9 %
AA 946,195 44.4 % 91,981 30.3 %
A 446,460 20.9 % 99,334 32.8 %
BBB 199,003 9.3 % 25,347 8.4 %
Below BBB 246,982 11.6 % 31,919 10.5 %
Total $ 2,133,677 100.0 % $ 303,171 100.0 %
December 31, 2011
Rating
U.S. Treasury securities $ 151,621 7.0 % $ 4,521 1.5 %
AAA 189,431 8.8 % 49,316 16.4 %
AA 930,436 43.3 % 98,017 32.8 %
A 459,353 21.3 % 105,696 35.2 %
BBB 208,552 9.7 % 12,728 4.2 %
Below BBB 214,227 9.9 % 29,776 9.9 %
Total $ 2,153,620 100.0 % $ 300,054 100.0 %
Fixed-Maturity Investments with Third Party Guarantees
At September 30, 2012, $212.9 million of our municipal bonds, at fair value,
were guaranteed by third parties from a total of $2.4 billion, at fair value, of
all fixed-maturity securities held by us. The amount of securities guaranteed by
third parties along with the credit rating with and without the guarantee is as
follows:
With Without
($ in thousands) Guarantee Guarantee
AA $ 163,098 $ 145,324
A 40,746 56,365
BBB 9,069 3,413
BB - 3,098
No underlying rating - 4,713
Total $ 212,913 212,913
Tower $ 207,385 $ 207,385
Reciprocal Exchanges 5,528 5,528
Total $ 212,913 $ 212,913
The guaranteed securities, by guarantor, are as follows:
Guaranteed Percent
($ in thousands) Amount of TotalNational Public Finance Guarantee Corp$ 81,131 38.1 %
Assured Guaranty Municipal Corp 78,626
36.9 %
Ambac Financial Corp 37,639
17.7 %
Berkshire Hathaway Assurance Corp 6,818
3.2 %
Others 8,699 4.1 %
Total $ 212,913 100.0 %
Tower $ 207,385 97.4 %
Reciprocal Exchanges 5,528 2.6 %
Total $ 212,913 100.0 %
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Municipal Bonds
As of September 30, 2012, our municipal bonds consisted of state general
obligations, municipal general obligations and special revenue bonds. Municipal
bonds by state at September 30, 2012 are as follows:
State General Municipal General Special
Obligations Obligations Revenue Bonds Total
Amortized Fair Amortized Fair Amortized Fair Amortized Fair
($ in thousands) Cost Value Cost Value Cost Value Cost Value
Texas $ 22,065 $ 23,848 $ 8,540 $ 9,424 $ 92,861 $ 102,123 $ 123,466 $ 135,395
New York 11,535 12,672 7,743 8,376 66,066 72,335 85,344 93,383
Florida 7,596 8,327 1,800 1,799 35,298 38,974 44,694 49,100
Washington 19,041 20,795 7,585 7,995 13,717 14,875 40,343 43,665
California 11,872 13,202 6,068 6,405 14,194 15,673 32,134 35,280
Arizona 4,862 5,475 - - 26,709 28,818 31,571 34,293
Massachusetts 2,966 3,369 255 264 25,635 27,823 28,856 31,456
Indiana - - 1,005 1,011 27,285 29,973 28,290 30,984
Illinois 10,691 11,662 3,350 3,665 10,782 12,017 24,823 27,344
Wisconsin 14,809 15,371 5,184 5,663 5,333 6,194 25,326 27,228
Other 58,848 62,455 32,075 34,358 183,431 199,251 274,354 296,064
Total $ 164,285 $ 177,176 $ 73,605 $ 78,960 $ 501,311 $ 548,056 $ 739,201 $ 804,192
No one jurisdiction within "Other" in the table above exceeded 3% of the total
fair value of municipal bonds. As of September 30, 2012, the special revenue
bonds are supported primarily by water and sewer utilities, electric utilities,
college revenues and highway tolls.
Fair Value Consideration
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").
As of September 30, 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 value
estimates based upon other observable inputs including matrix pricing, benchmark
interest rates, market comparables and other relevant inputs. When observable
inputs were adjusted to reflect management's best estimate of fair value, such
fair value measurements are considered a lower level measurement in the GAAP
fair value hierarchy.
Our process to validate the market prices obtained from the outside pricing
sources includes, but is not limited to, periodic evaluation of model pricing
methodologies and analytical reviews of certain prices. We also periodically
perform testing of the market to determine trading activity, or lack of trading
activity, as well as market prices. Several securities sold during the quarter
were "back-tested" (i.e., the sales price is compared to the previous month end
reported market price to determine reasonableness of the reported market price).
The ability to observe stable prices and inputs may be reduced for
highly-customized and illiquid instruments which had been the case for certain
non-agency residential and commercial mortgage-backed securities and
asset-backed securities in previous periods. At September 30, 2012, two
securities included in other invested assets were priced in Level 3 with a fair
value of $25.0 million.
As more fully described in "Note 5 - Investments" to our consolidated financial
statements, "Investments-Impairment Review," we completed a detailed review of
all our securities in a continuous loss position, including but not limited to
residential and
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commercial mortgage-backed securities, and concluded that the unrealized losses
in these asset classes are the result of a decrease in value due to technical
spread widening and broader market sentiment.
"Note 6 - Fair Value Measurements" to the consolidated financial statements
provides a description of the valuation methodology utilized to value Level 3
assets, how the valuation methodology is validated and an analysis of the change
in fair value of Level 3 assets. As of September 30, 2012, the fair value of
Tower Level 3 assets as a percentage of Tower's total assets carried at fair
value was as follows (the Reciprocal Exchanges had no Level 3 assets):
Level 3 Assets
Assets Carried at as a Percentage of
Fair Value at Fair Value of Total Assets Carried
($ in thousands) September 30, 2012 Level 3 Assets at Fair Value
Fixed-maturity investments $ 2,436,848 $ - 0%
Equity investments 129,268 - 0%
Short-term investments 4,748 - 0%
Total investments available for sale $ 2,570,864 $
- 0%
Other invested assets 25,000 25,000 100%
Cash and cash equivalents 179,414 - 0%
Total $ 2,775,278 $ 25,000 0.9%
Unrealized Losses
The fair value of our fixed maturity portfolio is directly affected by changes
in interest rates and credit spreads. We regularly review both our
fixed-maturity and equity portfolios to evaluate the necessity of recording
impairment losses for other-than temporary declines in the fair value of
investments.
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
purchases made in a lower yield environment. 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.
The following table presents information regarding our invested assets that were
in an unrealized loss position at September 30, 2012 and December 31, 2011 by
amount of time in a continuous unrealized loss position:
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Less than 12 Months 12 Months or Longer Total
Fair Unrealized Fair Unrealized Aggregate Unrealized
($ in thousands) Value Losses Value Losses Fair Value Losses
September 30, 2012
U.S. Treasury securities $ 4,195 $ (1 ) $ - $ - $ 4,195 $ (1 )
Municipal bonds 6,003 (37 ) 500 - 6,503 (37 )
Corporate and other bonds
Finance 8,298 (147 ) 786 (13 ) 9,084 (160 )
Industrial 27,579 (708 ) 3,785 (41 ) 31,364 (749 )
Utilities 7,053 (21 ) 6 - 7,059 (21 )
Commercial mortgage-backed securities 888 (10 ) 132 - 1,020 (10 )
Residential mortgage-backed securities
Agency backed 21,499 (79 ) 22 - 21,521 (79 )
Non-agency backed - - 749 (28 ) 749 (28 )
Asset-backed securities 1,499 (1 ) 4,145 (90 ) 5,644 (91 )
Total fixed-maturity securities 77,014 (1,004 ) 10,125 (172 ) 87,139 (1,176 )
Preferred stocks 10,030 (95 ) 5,530 (229 ) 15,560 (324 )
Common stocks 39,724 (1,475 ) - - 39,724 (1,475 )
Total, September 30, 2012 $ 126,768 $ (2,574 ) $ 15,655 $ (401 ) $ 142,423 $ (2,975 )
Tower $ 118,809 $ (2,348 ) $ 14,950 $ (376 ) $ 133,759 $ (2,724 )
Reciprocal Exchanges 7,959 (226 ) 705 (25 ) 8,664 (251 )
Total, September 30, 2012 $ 126,768 $ (2,574 ) $ 15,655 $ (401 ) $ 142,423 $ (2,975 )
December 31, 2011
U.S. Treasury securities $ 92,001 $ (13 ) $ - $ - $ 92,001 $ (13 )
Municipal bonds 13,449 (255 ) - - 13,449 (255 )
Corporate and other bonds
Finance 138,986 (4,610 ) 251 (5 ) 139,237 (4,615 )
Industrial 57,357 (2,141 ) 3,519 (146 ) 60,876 (2,287 )
Utilities 1,902 (61 ) - - 1,902 (61 )
Commercial mortgage-backed securities 26,130 (2,564 ) - - 26,130 (2,564 )
Residential mortgage-backed securities
Agency backed 19 (1 ) 12 - 31 (1 )
Non-agency backed 13,294 (318 ) 4,609 (583 ) 17,903 (901 )
Asset-backed securities 29,624 (647 ) 610 (8 ) 30,234 (655 )
Total fixed-maturity securities 372,762 (10,610 ) 9,001 (742 ) 381,763 (11,352 )
Preferred stocks 17,773 (644 ) 1,303 (246 ) 19,076 (890 )
Common stocks 44,132 (4,194 ) - - 44,132 (4,194 )
Total, December 31, 2011 $ 434,667 $ (15,448 ) $ 10,304 $ (988 ) $ 444,971 $ (16,436 )
Tower $ 398,989 $ (14,160 ) $ 8,264 $ (915 ) $ 407,253 $ (15,075 )
Reciprocal Exchanges 35,678 (1,288 ) 2,040 (73 ) 37,718 (1,361 )
Total, December 31, 2011 $ 434,667 $ (15,448 ) $ 10,304 $ (988 ) $ 444,971 $ (16,436 )
The following table shows the fair value, unrealized loss amount and percentage
below amortized cost and the ratio of fair value by security rating as of
September 30, 2012:
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Unrealized Loss
Percent of Fair Value by Security Rating
Fair Amortized BB or
($ in thousands) Value Amount Cost AAA AA A BBB Lower
U.S. Treasury securities $ 4,195 $ (1) 0 % 0 % 100 % 0 % 0 % 0 %
Municipal bonds
6,503 (37)
-1 % 18 % 73 % 1 % 8 % 0 %
Corporate and other bonds
47,507 (930)
-2 % 0 % 0 % 12 % 9 % 79 %
Commercial mortgage-backed securities 1,020
(10)
-1 % 100 % 0 % 0 % 0 % 0 %
Residential mortgage-backed securities 22,270
(107) -1 % 2 % 97 % 0 % 0 % 1 %
Asset-backed securities 5,644 (91) -2 % 27 % 73 % 0 % 0 % 0 %
Equities 55,284 (1,799) -4 % NR
NR indicates that equity securities are not rated
See "Note 5-Investments" in our consolidated financial statements for further
information about impairment testing and other-than-temporary impairments.
Liquidity and Capital Resources
Tower is organized as a holding company (the "Holding Company") with multiple
intermediate holding companies, 12 insurance subsidiaries and several management
companies. The Holding Company's principal liquidity needs include interest on
debt, stockholder dividends and share repurchases under its share repurchase
program. The Holding Company's principal sources of liquidity include dividends
and other permitted payments from our subsidiaries, as well as financing through
borrowings under our bank credit facility and sales of securities. Cash flows
from the management companies are not subject to restrictions.
As of September 30, 2012, the amount of distributions that our Insurance
Subsidiaries could pay to Tower without approval of their domiciliary Insurance
Departments was $22.1 million. In addition, we can return capital of $48.9
million from CastlePoint Re without permission from the Bermuda Monetary
Authority. During the nine months ended September 30, 2012, $14.0 million in
dividends were paid from the Insurance Subsidiaries. CastlePoint Re made $2.5
million of payments to the Holding Company during the nine month period ended
September 30, 2012.
The management companies are not subject to any statutory limitations on their
dividends to the Holding Company. The management companies paid no dividends to
the Holding Company during the nine month period ended September 30, 2012.
We believe that the cash flow generated by the operating activities of our
subsidiaries, combined with other available capital sources, will provide
sufficient funds for us to meet our liquidity needs over the next twelve months.
Beyond the next twelve months, cash flow available to us may be influenced by a
variety of factors, including general economic conditions and conditions in the
insurance and reinsurance markets, as well as fluctuations from year-to-year in
claims experience.
We have the intent and ability to hold any temporarily impaired fixed maturity
securities until the anticipated date that these temporary impairments are
recovered.
Book Value per Common Share
Book value per common share represents Tower Group Inc. stockholders' equity
divided by the number of common shares outstanding. Management uses growth in
book value per common share as a key measure of the value generated for our
common shareholders each period and believes that book value per common share is
a key driver of TWGP's share price over time. Book value per common share is
impacted by, among other factors, our underwriting results, investment returns
and share repurchase activity, which has an accretive or dilutive impact on book
value per common share depending on the purchase price.
September 30,
December 31,
(in thousands, except per share data) 2012
2011
Calculation of book value per common share:
Tower Group, Inc. stockholders' equity $ 1,054,981$ 1,034,142
Common shares outstanding 38,377
39,221
Book value per common share $ 27.49 $ 26.37
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Capital
Our capital resources consist of funds deployed or available to be deployed to
support our business operations. At September 30, 2012 and December 31, 2011,
our capital resources were as follows:
September 30, December 31,
($ in thousands) 2012 2011
Outstanding under credit facility $ 70,000 $ 50,000
Convertible Senior Notes 143,947 141,843
Subordinated debentures 235,058 235,058
Tower Group, Inc. stockholders' equity 1,054,981 1,034,142
Total capitalization $ 1,503,986 $ 1,461,043
Ratio of debt to total capitalization 29.9 %
29.2 %
We monitor our capital adequacy to support our business on a regular basis. The
future capital requirements of our business will depend on many factors,
including our ability to write new business successfully and to establish
premium rates and reserves at levels sufficient to cover losses. Our ability to
underwrite is largely dependent upon the quality of our claims paying and
financial strength ratings as evaluated by independent rating agencies. In
particular, we require (1) sufficient capital to maintain our financial strength
ratings, at a level considered necessary by management to enable our insurance
subsidiaries to compete, and (2) sufficient capital to enable our insurance
subsidiaries to meet the capital adequacy tests performed by statutory agencies
in the United States and Bermuda.
On February 15, 2012, we amended our $125.0 million credit facility by
increasing borrowing capacity up to $150 million, extending the maturity date
out 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.
As part of Tower's capital management strategy, the Board of Directors of Tower
approved a $100 million share repurchase program on March 3, 2011. This
authorization is in addition to the $100 million share repurchase program
approved on February 26, 2010. Purchases under both programs can be made from
time to time in the open market or in privately negotiated transactions in
accordance with applicable laws and regulations. The new share repurchase
program will expire on March 4, 2013. The timing and amount of purchases under
the programs depend on a variety of factors, including the trading price of the
stock, market conditions and corporate and regulatory considerations. For the
three and nine months ended September 30, 2012, no shares and 1.1 million shares
of common stock, respectively, were purchased under this program. As of
September 30, 2012, $26.4 million remained available for future share
repurchases under the new program.
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.
Stock Based Compensation Expense
The actual restricted stock expense that the Company has incurred for the nine
months ended September 30, 2012 and the future restricted stock expense that the
Company expects to incur for grants made as of September 30, 2012 assuming no
forfeitures is shown in the table below:
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Restricted Stock Restricted Stock
Expense Expense(in $ thousands) Before Tax Tax Benefit After Tax
2012
First Quarter (1) $ 2,253 $ (789 ) $ 1,464
Second Quarter (1) 2,360 (826 ) 1,534
Third Quarter (1) 2,378 (832 ) 1,546
Fourth Quarter (2) 2,279 (798 ) 1,481
Subtotal - 2012 9,270 (3,245 ) 6,025
2013 (2)
First Quarter 1,971 (690 ) 1,281
Second Quarter 1,266 (443 ) 823
Third Quarter 1,272 (445 ) 827
Fourth Quarter 1,262 (442 ) 820
Subtotal - 2013 5,771 (2,020 ) 3,751
2014 (2) 3,777 (1,322 ) 2,455
2015 (2) 2,165 (758 ) 1,407
2016 (2) 450 (158 ) 292
2017 (2) 30 (11 ) 19
Total actual and expected future
restricted stock expense $ 21,463 $ (7,514 ) $ 13,949
(1) Actual expense incurred
(2) Expected restricted stock expense to be incurred
Cash Flows
The primary sources of consolidated cash flows are from the insurance
subsidiaries' gross premiums collected, ceding commissions from quota share
reinsurers, loss payments by reinsurers, investment income and proceeds from the
sale or maturity of investments. Funds are used by the insurance subsidiaries
for loss payments and loss adjustment expenses. The insurance subsidiaries also
use funds for ceded premium payments to reinsurers, which are paid on a net
basis after subtracting losses paid on reinsured claims and reinsurance
commissions on our net business, commissions to producers, salaries and other
underwriting expenses as well as to purchase investments, fixed assets and to
pay dividends to the Holding Company. The management companies' primary sources
of cash are management fees for acting as the attorneys-in-fact for the
Reciprocal Exchanges.
The reconciliation of net income to cash provided from operations is generally
influenced by the collection of premiums in advance of paid losses, the timing
of reinsurance, issuing company settlements and loss payments.
Cash flow and liquidity are categorized into three sources: (1) operating
activities; (2) investing activities; and (3) financing activities, which are
shown in the following table:
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Nine Months Ended September 30,
($ in thousands) 2012 2011
Cash provided by (used in):
Operating activities $ 126,596 $ 123,979
Investing activities (36,447) (91,435)
Financing activities (24,833) (25,236)
Net increase (decrease) in cash and cash equivalents 65,316 7,308
Cash and cash equivalents, beginning of year 114,098 140,221
Cash and cash equivalents, end of period $ 179,414
$ 147,529
Comparison of Nine Months Ended September 30, 2012 and 2011
For the nine months ended September 30, 2012, net cash inflows provided by
operating activities were $126.6 million compared to $124.0 million for 2011.
The operating cash flow for the nine months ended September 30, 2012 is largely
unchanged.
Net cash flows used in investing activities were $36.5 million for the nine
months ended September 30, 2012 compared to $91.4 million used for the nine
months ended September 30, 2011. The reduction in cash flows used in investing
activities in 2012 is due to the Company keeping more liquidity in its cash and
investment portfolio. Accordingly, the Company had increase in cash and cash
equivalents for the nine months ended September 30, 2012 of $65.3 million.
The net cash flows used in financing activities for the nine months ended
September 30, 2012 are primarily the result of use of cash for dividends of
$21.9 million and the repurchase of common stock of $21.0 million, offset by
increased borrowings on our credit facility of $20.0 million. In 2011, we used
cash for the repurchase of common stock and dividend payments of $50.4 million
and $20.5 million, respectively.
Cash flow needs at the holding company level are primarily for dividends to our
stockholders, interest and principal payments on our outstanding debt and
payments under the credit facility.
Insurance Subsidiaries
The insurance subsidiaries maintain sufficient liquidity to pay claims,
operating expenses and meet other obligations. 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.
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 September 30, 2012, the insurance subsidiaries' risk-based
capital exceeded the minimum level that would trigger regulatory attention.
Inflation
Property and casualty loss and loss adjustment expense reserves are established
before we know the amount of losses and LAE or the extent to which inflation may
affect such amounts. We attempt to anticipate the potential impact of inflation
in establishing our loss and LAE reserves. Inflation in excess of the levels we
have assumed could cause loss and LAE to be higher than we anticipated.
Substantial future increases in inflation could also result in future increases
in interest rates, which in turn are likely to result in a decline in the market
value of the investment portfolio and cause unrealized losses or reductions in
stockholders' equity.
Adoption of New Accounting Pronouncements
For a discussion of accounting standards, see "Note 2 - Accounting Policies and
Basis of Presentation" of Notes to Consolidated Financial Statements.
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