The following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our consolidated audited financial
statements and accompanying notes which appear elsewhere in this Form 10-K/A. It
contains forward-looking statements that involve risks and uncertainties. See
"Business-Note on Forward-Looking Statements" for more information. Our actual
results could differ materially from those anticipated in these forward-looking
statements as a result of various factors, including those discussed below and
elsewhere in this Form 10-K/A, particularly under the headings "Business-Risk
Factors" and "Business-Note on Forward-Looking Statements." particularly under
the heading "Forward Looking Statements" and the Original Form 10-K under the
heading "Risk Factors."
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.
Our consolidated results of operations in 2011 reflect organic growth from our
Customized Solutions and Assumed Reinsurance products as well as growth from
acquisitions completed in the current and prior years. Our consolidated revenues
and expenses reflect the results of these acquired companies from their
respective acquisition dates and this affects the comparability of our results
between years.
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Subsequent to the acquisition of OBPL on July 1, 2010, the Company changed the
presentation of its business results, by allocating the personal insurance
business previously reported in the Brokerage Insurance segment along with the
newly acquired OBPL business to a new Personal Insurance segment and merged the
commercial business previously reported in either the Brokerage Insurance or
Specialty Business segments in a new Commercial Insurance segment. The Company
has retained its Insurance Services segment which includes fees earned by the
management companies. This change in presentation reflects the way management
organizes the Company for making operating decisions and assessing
profitability. In developing cost allocations between the commercial and
personal lines segments, management has made significant assumptions regarding
costs of reinsurance and internal services provided on behalf of such segments.
As management receives additional facts which enhance its ability to apportion
such costs, it may modify such allocation. If modifications are made, such
adjustments will be made to all reporting periods disclosed.
Because we do not manage our invested assets by segments, our investment income
is not allocated among our segments. Operating expenses incurred by each segment
are recorded in such segment directly. Our home office related expenses not
directly allocable to an individual segment (for example, accounting, finance
and general legal costs) are allocated based upon the methodology deemed to be
most appropriate which may include employee head count, policy count and
premiums earned in each segment.
We offer our products and services through our insurance subsidiaries, managing
general agencies and management companies. Results for our insurance
subsidiaries are reported in our Commercial and Personal Insurance segments.
Results for our managing general agencies and management companies are reported
in our Insurance Services segment.
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 lines products consist of homeowners, personal
automobile and umbrella policies.
In our Insurance Services segment, we generate management fees primarily from
the services provided by management companies to the Reciprocal Exchanges and
other fees generated by the managing general agencies.
Acquisitions
See "Note 4 - Acquisitions" in the consolidated financial statements for more
detail on each of the acquisitions discussed below.
NAV PAC Division of Navigators Group, Inc. ("NAV PAC")
On January 14, 2011, Tower obtained the renewal rights to the middle market
commercial package and commercial automobile business underwritten through the
NAV PAC division of Navigators Group, Inc. This business will allow us to
continue to expand our middle market commercial product offering into certain
niche classes of business. The underwriting personnel from NAV PAC became part
of our recently formed Customized Solutions business unit focused on developing
customized products for our key partner agents.
One Beacon Personal Lines Division ("OBPL")
On July 1, 2010, Tower completed the OBPL acquisition pursuant to a definitive
agreement (the "Agreement") dated February 2, 2010 by and among the Company and
OneBeacon Insurance Group, LLC ("OneBeacon"). This acquisition expanded Tower's
suite of personal lines insurance products to include private passenger
automobile, homeowners, umbrella, and the signature package product, OneChoice
CustomPac, which provides customers with one policy for all of their homeowners,
automobile and umbrella needs.
Specialty Underwriters' Alliance, Inc ("SUA").
On November 13, 2009, the Company completed the acquisition of SUA, a specialty
property and casualty insurance company. SUA offers specialty commercial
property and casualty insurance products through independent program
underwriting agents that serve niche groups of insureds. The acquisition of SUA
expands the Company's Commercial Insurance segment and its regional presence in
the Midwest.
Renewal Rights of AequiCap Program Administrators, Inc. ("AequiCap")
On November 2, 2010, Tower acquired the renewal rights to the commercial
automobile liability and physical damage business of AequiCap ("AequiCap II"),
an underwriting agency based in Fort Lauderdale, Florida. The business subject
to the agreement
covers both trucking and taxi risks that are consistent with Tower's current
underwriting guidelines. Most of the employees of AequiCap II involved in the
servicing of this commercial liability and physical damage business became
employees of the Company.
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On October 14, 2009, the Company completed the acquisition of the renewal rights
to the workers' compensation business of AequiCap ("AequiCap I"). The acquired
business primarily consists of small, low to moderate hazard workers'
compensation policies in Florida. Most of the employees of AequiCap I involved
in the servicing of the workers' compensation business became employees of the
Company. The acquisition of this business expands the Company's regional
presence in the Southeast.
HIG, Inc. ("Hermitage")
On February 27, 2009, the Company completed the acquisition of Hermitage, a
property and casualty insurance holding company, pursuant to a stock purchase
agreement, from a subsidiary of Brookfield Asset Management Inc. Hermitage
offers both admitted and E&S lines products. This transaction further expanded
the Company's wholesale distribution system nationally and established a network
of retail agents in the Southeast.
CastlePoint Holdings, Ltd. ("CastlePoint")
On February 5, 2009 the acquisition of 100% of the issued and outstanding common
stock of CastlePoint, a Bermuda exempted corporation, was completed. This
transaction has expanded and diversified revenues by accessing CastlePoint's
programs and risk sharing businesses.
Principal Revenue and Expense Items
We generate revenue from four primary sources:
• Net premiums earned;
• Ceding commission revenue;
• Insurance Service revenue; and
• Net investment income and realized gains and losses on investments.
We incur expenses from four primary sources:
• Losses and loss adjustment expenses;
• Operating expenses;
• Interest expense; and
• Income taxes.
Each of these is discussed below.
Net premiums earned. Premiums written include all policies produced in an
accounting period. Premiums are earned over the term of the related policy. The
portion of the premium that relates to the policy term that has not yet expired
is included on the balance sheet as unearned premium to be earned in subsequent
accounting periods. Premiums can be assumed from or ceded to reinsurers. Direct
premiums combined with assumed premiums are referred to as gross premiums and
subtracting premiums ceded to reinsurers results in net premiums.
Ceding commission revenue. We earn ceding commission revenue (generally a
percentage of the premiums ceded) on the gross premiums written that we cede to
reinsurers under quota share reinsurance agreements. We typically do not earn
ceding commission revenue on property catastrophe or excess of loss reinsurance
that we purchase.
Insurance Service revenue. We earn fee income primarily from services provided
to the Reciprocal Exchanges for underwriting, claims, investment management and
other services. Additional commission and fee income is generated on premiums
produced by the managing general agencies on behalf of third-party reinsurance
companies.
Net investment income and realized gains and losses on investments. We invest
our available funds in cash, cash equivalents, securities and investment
partnerships. Our investment income includes interest and dividends earned on
our invested assets. Realized gains and losses on invested assets are reported
separately from net investment income. We earn realized gains when invested
assets are sold for an amount greater than their amortized cost, in the case of
fixed maturity securities, and cost, in the
case of equity securities, and we recognize realized losses when invested assets
are written down or sold for an amount less than their amortized cost or actual
cost, as applicable.
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Losses and loss adjustment expenses. We establish loss and loss adjustment
expense ("LAE") reserves in an amount equal to our estimate of the ultimate
liability for claims under our insurance policies and the cost of adjusting and
settling those claims. Loss and LAE recorded in a period include estimates for
losses incurred during the period and changes in estimates for prior periods.
Operating expenses. In our Commercial Insurance and Personal Insurance segments,
we refer to the operating expenses that we incur to underwrite risks as
underwriting expenses. These include direct and ceding commission expenses
(payments to our producers for the premiums that they generate for us) and other
underwriting expenses. In our Insurance Services segment, operating expenses
consist of costs incurred to manage the Reciprocal Exchanges and other insurance
service expenses.
Interest expense. We pay interest on our subordinated debentures, convertible
senior notes, credit facility 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 debt origination costs
and original issue discounts over the remaining term of our debt instruments.
Income taxes. We pay Federal, state and local income taxes and other taxes.
Measurement of Results
We use various measures to analyze the growth and profitability of our business
segments. In our Commercial Insurance and Personal Insurance segments, we
measure growth in terms of gross, ceded and net premiums written, and we measure
underwriting profitability by examining our loss, expense and combined ratios.
We also measure our gross and net written premiums to surplus ratios to measure
the adequacy of capital in relation to premiums written. In the Insurance
Services segment, we measure growth in terms of fee income generated from the
Reciprocal Exchanges and, to a lesser extent, fee and commission revenue
received. We measure profitability in terms of net income attributable to Tower
Group, Inc. and return on average equity related to Tower Group, Inc..
Premiums written. We use gross premiums written to measure our sales of
insurance products and, in turn, our ability to generate ceding commission
revenues from premiums that we cede to reinsurers. Gross premiums written also
correlates to our ability to generate net premiums earned.
Loss ratio. The loss ratio is the ratio of losses and LAE incurred to premiums
earned and measures the underwriting profitability of a company's insurance
business. We measure our loss ratio on a gross (before reinsurance) and net
(after reinsurance) basis. We also measure the loss ratio on the ceded portion
(the difference between gross and net premiums) for our Commercial Insurance and
Personal Insurance segments. We use the gross loss ratio as a measure of the
overall underwriting profitability of the insurance business we write and to
assess the adequacy of our pricing. We use the loss ratio on the ceded portion
of our insurance business to measure the experience on the premiums that we cede
to reinsurers, including the premiums ceded under our quota share treaties. In
some cases, the loss ratio on such ceded business is considered in determining
the ceding commission rate that we earn on ceded premiums. Our net loss ratio is
meaningful in evaluating our financial results, which are net of ceded
reinsurance, as reflected in our consolidated financial statements. In addition,
we use accident year and calendar year loss ratios to measure our underwriting
profitability. An accident year loss ratio measures losses and LAE for insured
events occurring in a particular year, regardless of when they are reported, as
a percentage of premiums earned during that particular accident year. A calendar
year loss ratio measures losses and LAE for insured events occurring during a
particular year and the changes in estimates in loss and LAE reserves from prior
accident years as a percentage of premiums earned during that particular
calendar year.
Underwriting expense ratio. The gross underwriting expense ratio is the ratio of
direct commission expenses and other underwriting expenses less policy billing
fees to gross premiums earned. The gross underwriting expense ratio measures a
company's operational efficiency in producing, underwriting and administering
its insurance business. Due to our historically high levels of reinsurance, we
also calculate our underwriting expense ratio after the effect of ceded
reinsurance. Ceding commission revenue is applied to reduce our underwriting
expenses in our insurance company operation.
Combined ratio. We use the combined ratio to measure our underwriting
performance. The combined ratio is the sum of the loss ratio and the
underwriting expense ratio. We analyze the combined ratio on a gross (before the
effect of reinsurance) and net (after the effect of reinsurance) basis. If the
combined ratio is at or above 100%, an insurance company is not underwriting
profitably and may not be profitable unless investment income is sufficient to
offset underwriting losses.
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Management fee income earned by the management companies. Our management
companies provide various underwriting, claims, investment management and other
services to the Reciprocal Exchanges. We receive a percentage of the gross
written premiums issued by the Reciprocal Exchanges.
Net income and return on average equity. We use net income to measure our
profits and return on average equity to measure our effectiveness in utilizing
our stockholders' equity to generate net income on a consolidated basis. In
determining return on average equity for a given year, net income is divided by
the average of stockholders' equity for that year.
Book value per share. Book value per share is calculated as Tower Group, Inc,
stockholders' equity over the number of shares outstanding. We use this as a
measure of value per share of the Company independent from the market price per
share.
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.
Year Ended December 31,
($ in thousands) 2011 2010 2009
Operating income $ 56,331 $ 98,861 $ 105,975
Net realized gains (losses) on investments 6,980 14,910 331
Acquisition-related transaction costs (360 ) (2,369 ) (14,038 )
Income tax (2,470 ) (5,046 ) 2,456
Net income attributable to Tower Group, Inc. $ 60,481 $ 106,356 $ 94,724
Critical Accounting Estimates
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.
Our most critical accounting estimates involve the reporting of reserves for
losses (including losses that have occurred but had not been reported by the
financial statement date) and LAE, establishing fair value of losses and LAE for
acquired businesses, net earned premiums, the reporting of ceding commissions
earned, the amount and recoverability of reinsurance recoverable balances,
deferred acquisition costs, investment impairments and potential impairments of
goodwill and intangible assets.
Loss and loss adjustment expense reserves. The reserving process for loss and
LAE reserves provides our best estimate at a particular point in time of the
ultimate unpaid cost of all losses and LAE incurred, including settlement and
administration of losses, and is based on facts and circumstances then known and
including losses that have been incurred but not yet reported. The process
includes using actuarial methodologies to assist in establishing these
estimates, judgments relative to estimates of future claims severity and
frequency, the length of time before losses will develop to their ultimate level
and the possible changes in the law and other external factors that are often
beyond our control. There are various actuarial methods that are appropriate for
the different lines of business, and our actuaries' use of a particular method
or weighting of methods depends in part on the maturity of each accident year by
line of business, the limits of liability covered under the policies, the
presence or absence of large claims in the experience, and other considerations.
In general, the various actuarial methods can be grouped into three categories:
loss ratio projection, loss development methods, and the B-F method. For the
most recent accident year, and especially for liability lines of business, the
actuarial method given the most weight is usually the loss ratio method, since
the percentage of ultimate claims reported to date is expected to be low and the
immature reported claims experience is not a reliable indicator of ultimate
losses for that accident year. For property lines of business for the most
recent accident year, the B-F method is usually given the most weight, because
experience typically shows that there is a small percentage of claims reported
in the subsequent period due to normal lags in reporting and processing of
claims in these lines of business that can be relatively reliably estimated as a
percentage of premiums, which is reflected in the B-F method. For each line of
business, the actuarial reserving method usually given the most weight shifts
from the loss ratio projection to the B-F method to the incurred loss projection
as each accident year matures. These methods are described in "Business-Loss and
Loss Adjustment Expense Reserves."
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This process helps management set carried loss reserves based upon the
actuaries' best estimates, using estimates made by segment, product or line of
business, territory, and accident year. The actuaries also separately estimate
loss reserves from LAE reserves and within LAE reserves estimates are made for
defense and cost containment expenses or Allocated Loss Adjustment Expenses
("ALAE") and for other claims adjusting expenses or Unallocated Loss Adjustment
Expenses ("ULAE"). The amount of loss and LAE reserves for reported claims is
based primarily upon a case-by-case evaluation of coverage, liability, injury
severity, and any other information considered pertinent to estimating the
exposure presented by the claim. The amounts of loss and LAE reserves for
unreported claims are determined using historical information by line of
business as adjusted to current conditions. Since our process produces loss
reserves set by management based upon the actuaries' best estimate, there is no
explicit or implicit provision for uncertainty in the carried loss reserves,
except for required provisions in connection with acquisitions which are
separately determined.
Due to the inherent uncertainty associated with the reserving process, the
ultimate liability may differ, perhaps substantially, from the original
estimate. Such estimates are regularly reviewed and updated, and any resulting
adjustments are included in the current year's results. Reserves are closely
monitored and are recomputed periodically using the most recent information on
reported claims and a variety of statistical techniques. Specifically, on at
least a quarterly basis, we review, by line of business, existing reserves, new
claims, changes to existing case reserves and paid losses with respect to the
current and prior years. See "Business-Loss and Loss Adjustment Expense
Reserves" for additional information regarding our loss and LAE reserves.
We segregate our data for estimating loss reserves. The property lines include
Fire and Allied Lines, Homeowners-property, Commercial Multi-peril Property,
Multi-Family Dwellings, Inland Marine and Automobile Physical Damage. The
casualty lines include Homeowners-liability, Commercial Multi-peril Liability,
Other Liability, Workers' Compensation, Commercial Automobile Liability, and
Personal Automobile Liability. Commercial Insurance segment reserves are
estimated separately from Personal Insurance segment reserves. For the
Commercial Insurance segment we analyze reserves by line of business and, where
appropriate, we further segregate the data for analysis purposes between small,
middle and large policies sizes and by state or region. We also analyze various
producers' business separately where the volume of business from those producers
is considered significant and the characteristics of the business from those
particular producers are perceived to be different. Within the Personal
Insurance segment, we estimate loss and loss expenses reserves separately for
the Reciprocal Exchanges, which we manage, and for our owned companies. We
utilize line of business breakdowns and, where appropriate, analyze results
separately by state.
Two key assumptions that materially impact the estimate of loss reserves are the
loss ratio estimate for the current accident year and the loss development
factor selections for all accident years. The loss ratio estimate for the
current accident year is selected after reviewing historical accident year loss
ratios adjusted for rate and price changes, trend, mix of business, and other
factors. In addition, as the year matures and, depending upon the line of
business, we utilize B-F methods or loss development methods for the current
accident year.
In most cases, our data is sufficiently credible to determine loss development
factors utilizing our own data. In some cases, we supplement our own loss
development experience with industry data and utilize historical loss
development experience for particular books of business, programs or treaties
obtained from our sources. The loss development factors are reviewed at least
annually, and whenever there is a significant change in the underlying business.
Each quarter we test the loss development by analyzing actual emerging claims
compared to expected development.
Because of the nature of the business historically written, the Company's
management believes that the Company has limited exposure to environmental claim
liabilities.
We estimate ALAE reserves separately for claims that are defended by in-house
attorneys, claims that are handled by other attorneys that are not employees,
and miscellaneous ALAE costs such as investigators, witness fees and court
costs.
For claims that are defended by in-house attorneys, we estimate the defense cost
per claim, and we attribute to each of these claims a fixed fee for defense
work. We allocate to each of these litigated claims 50% of the fixed fee when
litigation on a particular claim begins and 50% of the fee when the litigation
is closed. The fee is determined actuarially based upon the projected number of
litigated claims and expected closing patterns at the beginning of each year as
well as the projected budget for our in-house attorneys, and these amounts are
calibrated to reimburse our in-house legal department for all of their costs.
ULAE for claims that are handled in-house by our claims adjusters utilize a
similar process to that described above for ALAE. We determine fixed fees per
claim by line of business, and assign these costs to line of business and
accident year. For property lines, 50% of the fixed fee is attributed to claims
when a claim is opened and 50% is attributed to claims when they are closed. For
casualty lines, 75% of the fixed fee is attributed to the claim when a claim is
opened and 25% is attributed to the claims when the claim is closed. The IBNR
portion of ULAE for these claims is based upon 50% of the fixed fee per claims
for in-house ULAE multiplied by the number of claims open and by 100% of the
fixed fee multiplied by the estimated number of claims to be reported for prior
accident dates.
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For some types of claims and for some programs where we utilize third-party
administrators ("TPA") to adjust claims, we pay them fees which are included in
ULAE. In some cases, we arrange for fixed percentages of premiums earned to be
the fee for claims administration, and in other cases we arrange for fixed fees
per claim or hourly charges for ULAE services. The reserves for ULAE for these
situations is estimated based upon the particular arrangement for these types of
claims by product or program.
Establishing fair value of loss and LAE reserves for acquired companies. At
acquisition date, loss and LAE reserves must be set to fair value. As there are
no readily observable markets for these liabilities, we use a valuation model
that estimates net nominal future cash flows related to the loss and LAE
reserve. This valuation is adjusted for the time value of money and a risk
margin to compensate the Company for bearing the risk associated with the
liabilities. This adjustment is referred to as the "reserve risk premium", which
is amortized over the expected payout pattern of the claims.
Net premiums earned. Insurance policies issued or reinsured by us are
short-duration contracts. Accordingly, premium revenue, including direct
writings and reinsurance assumed, net of premiums ceded to reinsurers, is
recognized as earned in proportion to the amount of insurance protection
provided, on a pro-rata basis over the terms of the underlying policies.
Unearned premiums represent premiums applicable to the unexpired portions of
in-force insurance contracts at the end of each year. Prepaid reinsurance
premiums represent the unexpired portion of reinsurance premiums ceded.
Ceding commissions earned. We have historically relied on quota share, excess of
loss and catastrophe reinsurance to manage our regulatory capital requirements
and limit our exposure to loss.
Ceding commissions under a quota share reinsurance agreement are based on the
agreed-upon commission rate applied to the amount of ceded premiums written.
Ceding commissions are realized as income as ceded premiums written are earned.
The ultimate commission rate earned on our quota share reinsurance contracts is
determined by the loss ratio on the ceded premiums earned. If the estimated loss
ratio decreases from the level currently in effect, the commission rate
increases and additional ceding commissions are earned in the period in which
the decrease is recognized. If the estimated loss ratio increases, the
commission rate decreases, which reduces ceding commissions earned. As a result,
the same uncertainties associated with estimating loss and LAE reserves affect
the estimates of ceding commissions earned. We monitor the ceded ultimate loss
ratio on a quarterly basis to determine the effect on the commission rate of the
ceded premiums earned that we accrued during prior accounting periods. The
estimated ceding commission income relating to prior years recorded in 2011,
2010, and 2009 was a decrease of $0.1 million, $2.2 million and $2.7 million,
respectively. These decreases are attributed to prior year reserve development
that was not initially anticipated.
Reinsurance recoverables. Reinsurance recoverable balances are established for
the portion of paid and unpaid loss and LAE that is assumed by reinsurers.
Prepaid reinsurance premiums represent unearned premiums that are ceded to
reinsurers. Reinsurance recoverables and prepaid reinsurance premiums are
reported on our balance sheet separately as assets, instead of netted against
the related liabilities, since reinsurance does not relieve us of our legal
liability to policyholders and ceding companies. We are required to pay losses
even if a reinsurer fails to meet its obligations under the applicable
reinsurance agreement. Consequently, we bear credit risk with respect to our
individual reinsurers and may be required to make judgments as to the ultimate
recoverability of our reinsurance recoverables. Additionally, the same
uncertainties associated with estimating loss and LAE reserves affect the
estimates of the amount of ceded reinsurance recoverables. We continually
monitor the financial condition and rating agency ratings of our reinsurers.
Non-admitted reinsurers are required to collateralize their share of unearned
premium and loss reserves either by placing funds in a trust account meeting the
requirements of New York Regulation 114 or by providing a letter of credit. In
addition, from October 2003 to December 31, 2005, we placed our quota share
treaties on a "funds withheld" basis, under which we retained the ceded premiums
written and placed that amount in segregated trust accounts from which we may
withdraw amounts due to it from the reinsurers.
Deferred acquisition costs, net. We have retrospectively adopted updated
guidance issued by the Financial Accounting Standards Board ("FASB") on the
accounting for deferred acquisition costs ("DAC") effective January 1, 2011. Our
prior period results have been restated for the impact of this accounting
change. We defer certain expenses that vary with and are directly related to the
successful acquisition of new and renewal insurance business, including
commission expense on gross premiums written, premium taxes and certain other
costs related to the acquisition of insurance contracts. These costs are
capitalized and the resulting asset, DAC, is amortized and charged to expense or
income in future periods as gross and ceded premiums written are earned. The
method followed in computing deferred acquisition costs, net, limits the amount
of such deferred amounts to its estimated realizable value. The ultimate
recoverability of deferred acquisition costs is dependent on the continued
profitability of our insurance underwriting. We also consider anticipated
invested income in determining the recoverability of these costs. If our
insurance underwriting becomes unprofitable, we may have to write off a portion
of our deferred acquisition costs, resulting in a further charge to income in
the period in which the underwriting losses are recognized. The value of
business acquired ("VOBA") is an intangible asset relating to the estimated fair
value of the unexpired insurance policies acquired in a business combination.
VOBA is determined at the time of a business combination and is reported on the
consolidated balance sheet with DAC and is amortized in proportion to the timing
of the estimated underwriting profit associated with the in force policies
acquired. The cash flow or interest component of VOBA is amortized in proportion
to the expected pattern of future cash flows. The Company considers anticipated
investment income in determining the recoverability of these costs and believes
they are fully recoverable.
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Impairment of invested assets. Impairment of investment securities results in a
charge to operations when a market decline below cost is deemed to be
other-than-temporary. We regularly review our fixed-maturity and equity
securities portfolios to evaluate the necessity of recording impairment losses
for other-than-temporary declines in the fair value of investments. In
evaluating potential impairment, we consider, among other criteria:
• the overall financial condition of the issuer;
• the current fair value compared to amortized cost or cost, as appropriate;
• the length of time the security's fair value has been below amortized cost or
cost;
• specific credit issues related to the issuer such as changes in credit
rating, reduction or elimination of dividends or non-payment of scheduled
interest payments;
• whether management intends to sell the security and, if not, whether it is more likely than not that the Company will be required to sell the security
before recovery of its amortized cost basis;
• specific cash flow estimations for fixed-income securities; and
• current economic conditions.
If an other-than-temporary-impairment ("OTTI") loss is determined for a
fixed-maturity security (for which we do not have the intent to sell or it is
not more likely than not we would be required to sell), the credit portion is
recorded in the income statement as realized investment losses and the
non-credit portion is recorded in accumulated other comprehensive income. The
credit portion results in a permanent reduction in the cost basis of the
underlying investment. For all other fixed-maturity security and equity security
impairments, the entire impairment is reflected as a realized investment loss
and reduces the cost basis of the security. The determination of OTTI is a
subjective process and different judgments and assumptions could affect the
timing of loss realization. We recorded OTTI losses on our fixed maturity and
equity securities in the amounts of $3.5 million, $14.9 million and
$45.4 million in 2011, 2010, and 2009, respectively, of which $3.2 million, $3.0
million and $24.7 million were recorded in earnings in 2011, 2010, and 2009,
respectively.
Since total unrealized losses are a component of stockholders' equity, the
recognition of OTTI losses have no effect on our comprehensive income or
stockholders' equity.
See "Business-Investments" and "Note 6 - Investments" in the notes to
consolidated financial statements for additional detail regarding our investment
portfolio at December 31, 2011, including disclosures regarding OTTI.
Goodwill and intangible assets and potential impairment. The costs associated
with a group of assets acquired in a transaction are allocated to the individual
assets, including identifiable intangible assets, based on their relative fair
values. Purchase consideration in excess of the fair value of tangible and
intangible assets is recorded as goodwill.
Identifiable intangible assets with a finite useful life are amortized over the
period in which the asset is expected to contribute directly or indirectly to
our future cash flows. Identifiable intangible assets with finite useful lives
are tested for recoverability whenever events or changes in circumstances
indicate that a carrying amount may not be recoverable. Identifiable intangible
assets with indefinite useful lives and goodwill are not amortized. Rather, they
are tested for recoverability at least annually or whenever events or changes in
circumstances indicate that a carrying amount may not be recoverable.
An impairment loss is recognized if the carrying value of an intangible asset or
goodwill is not recoverable and its carrying amount exceeds its fair value. No
impairment losses were recognized in 2011, 2010 and 2009. Significant changes in
the factors we consider when evaluating our intangible assets and goodwill for
impairment losses could result in a significant charge for impairment losses
reported in our consolidated financial statements. See "Note 8 - Goodwill and
Intangible Assets" in the notes to consolidated financial statements.
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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. The comparison
between quarters is affected by the acquisitions described above.
Year Ended December 31,
($ in millions) 2011 Change Percent 2010 Change Percent 2009
Commercial insurance segment
underwriting profit
$ 8.6 $ (31.6 )
-79 % $ 40.2 $ (42.1 ) -51 % $ 82.3
Personal insurance segment underwriting
profit (loss)(1)
(14.3 ) (21.2 ) -307 % 6.9 10.8 -277 % (3.9 )
Insurance services segment pretax
income(2) 11.5 (2.7 ) -19 % 14.2 13.3 NM 0.9
Net investment income 126.5 19.2 18 % 107.3 32.4 43 % 74.9
Net realized gains on investments,
including other-than-temporary
impairments 9.4 (5.3 ) -36 % 14.7 14.4 NM 0.3
Corporate expenses (11.5 ) (7.4 ) 172 % (4.3 ) (0.5 ) 13 % (3.8 )
-83 %
Acquisition-related transaction costs (0.3 ) 2.1 -88 % (2.4 ) 11.6 -83 % (14.0 )
Interest expense (34.3 ) (10.1 ) 42 % (24.2 ) (6.6 ) 38 % (17.6 )
Other income (expense) - - 0 % - (19.3 ) -100 % 19.3
Income before income taxes 95.6 (56.8 ) -37 % 152.4 14.0 10 % 138.4
Income tax expense 24.1 (28.0 ) 53 % 52.1 9.8 22 % 43.7
Net income $ 71.5 $ (28.8 ) 89 % $ 100.3 $ 4.2 4 % $ 94.7
Less net income (loss) attributable to
Reciprocal Exchanges 11.0 17.1 NM (6.1 ) (7.4 ) - -
Net income attributable to Tower Group,
Inc. $ 60.5 $ 45.9 43.1 % $ 106.4 $ 11.6 12 % $ 94.7
NM is shown where percentage change
exceeds 500%
Key Measures
Gross premiums written and produced:
Written by Commercial and Personal
Insurance segments $ 1,810.9 $ 314.5 21 % $ 1,496.4 $ 425.7 40 % $ 1,070.7
Produced by Insurance Services segment - - - - (11.7 ) -100 % 11.7
Total $ 1,810.9 $ 314.5 21 % $ 1,496.4 $ 413.9 -60 % $ 1,082.4
Year Ended December 31,
2011 2010 2009
Percent of total revenues:
Net premiums earned 89.8 % 88.4 % 87.2 %
Commission and fee income (3) 2.6 % 3.3 % 5.2 %
Net investment income 7.1 % 7.3 % 7.6 %
Net realized investment gains (losses) 0.5 % 1.0 % 0.0 %
Underwriting Ratios for Commercial and Personal
Insurance Segments Combined
Net Calendar Year Loss Ratios 66.2 % 60.7 % 55.6 %
Net Underwriting Expense Ratios (4) 34.1 % 35.7 % 35.2 %
Net Combined Ratios 100.3 % 96.4 % 90.8 %
Return on average equity (5) 5.8 % 10.3 % 12.4 %
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(1) Personal Insurance segment underwriting profit includes underwriting results
of the Reciprocal Exchanges for the years ended December 31, 2011 and 2010.
(2) Insurance Services segment pretax income for the years ended December 31,
2011 and 2010 includes results related to Tower's management services
agreements with the Reciprocal Exchanges.
(3) Commission and fee income for the years ended December 31, 2011 and 2010
excludes management fee income earned by Tower from the Reciprocal Exchanges.
These amounts are eliminated in reporting consolidated net income.
(4) The net underwriting expense ratios include fees paid by the Reciprocal
Exchanges to Tower in excess of Tower's direct costs to service the
management services agreement. These fees increased the gross and net expense
ratios by 0.6% and 1.0%, respectively, for the years ended December 31, 2011
and 2010.
(5) For the years ended December 31, 2011, 2010 and 2009, the after-tax impact of
net realized investment gains offset by acquisition-related transaction
costs, increased (lowered) return on average equity by 0.4%, 0.7% and (1.4)%,
respectively.
Consolidated Results of Operations 2011 Compared to 2010
Total revenues. Total revenues increased by 21.4% for the year ended
December 31, 2011 as compared to 2010, primarily due to increased net premiums
earned, net investment income and policy billing fees resulting from the
acquisition of OBPL which was acquired on July 1, 2010 and was reflected in
Tower's consolidated results for twelve months in 2011 as compared to six months
in 2010.
Premiums earned. Gross premiums earned for the years ended December 31, 2011 and
2010 were $1,789.8 million and $1,519.6 million, respectively, for an increase
of 17.8%. This increase is primarily a result of OBPL and to a lesser extent the
AequiCap II and Navigators renewal rights transactions and the customized
solutions and assumed reinsurance initiatives. Ceded premiums earned declined
$31.1 million to $195.9 million in 2011 from $227.0 million in 2010. Ceded
premiums earned declined as Tower elected to cancel its liability quota share
reinsurance treaty in 2011. This decrease was somewhat offset by the Company's
quota share reinsurance on the OBPL homeowners business, which was in effect for
twelve months in 2011 as compared to six months in 2010.
Overall, the Company's net earned premiums increased $301.2 million, or 23.3%,
to $1,593.9 million in 2011 from $1,292.7 million in 2010.
Commission and fee income. Commission and fee income decreased by $1.7 million
in the year ended December 31, 2011 as compared to the year ended December 31,
2010. This decrease is primarily attributed to the decline in ceding commission
revenue on a liability quota share reinsurance treaty that was effective only in
2010, offset by an increase in policy billing fees and ceding commission
revenues associated with the OBPL acquired business.
Net investment income and net realized gains (losses). Net investment income
increased 17.9% in the year ended December 31, 2011 compared to 2010. The
increase in net investment income resulted from an increase in average cash and
invested assets for the year ended December 31, 2011 as compared to 2010. The
increase in average cash and invested assets resulted primarily from $365.1
million of invested assets from the OBPL acquisition (reduced by cash to finance
such acquisition) and from operating cash flows of $85.0 million generated in
2011. The positive cash flow from operations was the result of an increase in
premiums collected from a growing book of business. The tax equivalent
investment yield of our fixed maturity portfolio at amortized cost was 4.8 % and
4.7% at December 31, 2011 and 2010, respectively. Operating cash invested in
fixed income securities in 2011 and in 2010 has been affected by a low yield
environment. We increased investments in high-yield securities and dividend
paying equity securities to reduce the impact of this low interest rate
environment.
The Company had net realized investment gains of $9.4 million for the year ended
December 31, 2011 compared to gains of $14.7 million in 2010. OTTI losses
recorded in earnings for the year ended December 31, 2011 were $3.2 million, a
decline from $3.0 million of OTTI losses recorded for 2010.
Loss and loss adjustment expenses. The consolidated net loss ratio, which
includes the Reciprocal Exchanges, was 66.2% and 60.7% for the years ended
December 31, 2011 and 2010, respectively. Excluding the Reciprocal Exchanges,
the net loss ratio was 67.6% and 60.2% for the years ended December 31, 2011 and
2010, respectively. The Reciprocal Exchanges' net loss ratio was 55.8% and 66.3%
for the years ended December 31, 2011 and 2010, respectively.
Excluding the Reciprocal Exchanges, the 2011 net loss and loss adjustment
expenses included $74.3 million from claims related to severe weather related
events, including first quarter of 2011 claims relating to heavy snow, Hurricane
Irene in August 2011, and other severe winter storms and tornados that resulted
in an unusual number of claims. Excluding these severe weather related events,
the net loss ratio for Tower, excluding the Reciprocal Exchanges, would have
been 62.3% for the year ended December 31, 2011.
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Excluding the Reciprocal Exchanges, there was net adverse loss development of
$17.0 million for the year ended December 31, 2011 comprised of favorable
development in Personal Insurance of $29.1 million and unfavorable development
in Commercial Insurance of $46.1 million.
The net unfavorable development in Commercial Insurance included $26.4 million
for other liability, $30.5 million for workers compensation, and $7.9 million
for commercial automobile. This was offset in part by favorable development on
commercial packages and monoline property totaling $6.4 million, by favorable
development in CPRE of $10.4 million, and $1.9 million for amortization of
reserves risk premium that was established in 2009 as part of fair value
accounting for the acquisitions made that year. The favorable development in
Personal Insurance, was comprised primarily of $22.2 million for private
passenger automobile liability, $13.1 million for homeowners and $1.9 million
for amortization of reserves risk premium, principally relating to reserves
acquired in the OBPL transaction developing more favorably than anticipated at
the time of the acquisition, offset by unfavorable development of $4.2 million
in discontinued personal lines business, $3.1 million in involuntary plans and
$0.8 million in other lines.
For the Reciprocal Exchanges, the favorable development was $37.8 million,
comprised of favorable development of $29.0 million for private passenger
automobile liability, $7.6 million for homeowners and other lines, and $1.2
million for amortization of reserves risk premium.
Operating expenses. Operating expenses, which include direct and ceding
commission expenses and other operating expenses, were $590.5 million for the
year ended December 31, 2011, an increase of 18.3% over the prior year,
primarily as a result of the OBPL acquisition, which was not included in the
Company's results for the first six months of 2010. In addition, the Company
amortized the value of business acquired ("VOBA") asset recorded on July 1, 2010
in connection with the OBPL purchase accounting. This resulted in $10.2 million
of expense recorded in 2011 and exceeded the amount of acquisition costs that
were capitalized in 2011as DAC. The VOBA was fully amortized as of June 30,
2011. In addition, the Company incurred $23.9 million in 2011 compared to $13.3
million in 2010, under the transition services agreements with OneBeacon. The
net underwriting expense ratio improved to 34.1% in 2011 from 35.7% in 2010.
The consolidated gross underwriting expense ratio improved slightly to 32.3% in
2011 from 32.9% in 2010. The commission portion of the gross underwriting
expense ratio was 17.4% and 17.6% for years ended December 31, 2011 and 2010,
respectively. The improvement in the commission ratio reflects the impact of
lower commission rates in the Reciprocal Exchanges. The gross other underwriting
expense ("OUE") ratio, which includes boards, bureaus and taxes ("BB&T"),
improved to 14.9% in 2011 from 15.3% in 2010.
Acquisition-related transaction costs. Acquisition-related transaction costs for
the year ended December 31, 2010 were $2.4 million and relate to the acquisition
of OBPL. These costs were negligible in 2011.
Interest expense.Interest expense increased by $10.1 million for the year ended
December 31, 2011 compared to 2010. Interest expense increased mainly due to the
issuance of $150 million of convertible senior notes in September 2010 and
increased borrowings under the credit facility in 2011. Interest on funds
withheld was $3.6 million in 2011 as compared to $2.7 million in 2010.
Income tax expense. Income tax expense decreased in 2011 compared to 2010 due to
the decrease in pre-tax income. The effective income tax rate (including state
and local taxes) was 25.2% for the year ended December 31, 2011, compared to
34.2% for the same period in 2010. The effective rate is lower than the
statutory rate due to, among other things, our tax exempt municipal investment
and dividends received deductions related to our equity securities portfolio, as
well as the release of a valuation allowance at the Reciprocal Exchanges.
The decline in the effective tax rate from 2010 to 2011 is primarily attributed
to (i) the increase in tax exempt interest income and dividend received
deductions of $7.2 million in 2011 as compared to $4.9 million in 2010, (ii) the
decline in pre-tax income from 2010 to 2011, and (iii) the release of the
Reciprocal Exchange valuation allowance in 2011.
Net income and return on average equity. Net income and annualized return on
average equity attributable to Tower Group, Inc. were $60.5 million and 5.8% for
the year ended December 31, 2011 compared to $106.4 million and 10.3% for the
year ended December 31, 2010. The return on average equity is calculated by
dividing net income by average stockholders' equity. Average stockholders'
equity was $1,041.1 million and $1,036.9 million at December 31, 2011 and 2010,
respectively.
The decrease in the net income and annualized return on equity in 2011 is
primarily due to an increase of $48.3 million in after-tax losses from severe
weather related events in 2011. These losses were partially offset by increased
net income attributed to the acquisition of OBPL.
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Consolidated Results of Operations 2010 Compared to 2009
Total revenues. Total revenues increased by 49.1% for the year ended
December 31, 2010 as compared to 2009, primarily due to increased net premiums
earned and net investment income resulting from the acquisition of OBPL at the
beginning of the third quarter of 2010 and the full year results of SUA in 2010
compared to only one month of results in 2009. The following table shows the
effects of the various acquisitions on our gross premiums written in 2010:
($ in millions) Amount
% Change
Gross premiums written for the year ended December 31, 2009$ 1,070.7
Gross premiums written from acquired companies
397.7 37 %
Organic growth during year 28.0 3 %
Gross premiums written for the year ended December 31, 2010$ 1,496.4
40 %
Premiums earned. Gross premiums earned in the year ended December 31, 2010
increased 45.2% compared to the prior year, primarily as a result of the
aforementioned acquisitions. Ceded premiums earned increased by a lower
percentage than the gross growth percentage as we retained a larger percentage
of our gross premiums because of our increased capital base. Accordingly, net
premiums earned in the year ended December 31, 2010 increased by $438.0 million
compared to 2009.
Commission and fee income. Commission and fee income decreased by $3.1 million
in the year ended December 31, 2010. This decrease is due to our decision to use
less quota share reinsurance in 2010 compared to 2009 leading to reduced ceding
commission revenue. Insurance services revenue declined for the year ended
December 31, 2010 compared to 2009 caused by our managing general agency ceasing
to produce business on behalf of CastlePoint's insurance companies subsequent to
the CastlePoint acquisition in 2009. Partially offsetting these decreases was a
$3.3 million increase in policy billing fees generated in connection with the
OBPL business for the last six months of 2010.
Net investment income and net realized gains (losses). Net investment income
increased 43.3% in the year ended December 31, 2010 compared to 2009. The
increase in net investment income resulted from an increase in average cash and
invested assets for the year ended December 31, 2010 that resulted primarily
from invested assets acquired from OBPL and SUA. The tax equivalent investment
yield at amortized cost was 4.7% at December 31, 2010 compared to 5.5% for 2009.
Operating cash invested in 2009 and in 2010 has been affected by a low yield
environment, as asset classes other than US Treasuries have experienced
tightening spreads, the result of investors reaching for yield in a low interest
rate environment. We have increased our investment in high-yield securities to
partially reduce the impact of this low rate environment and in the fourth
quarter of 2010. We made investments in dividend paying common equities starting
in the fourth quarter of 2010, as a further strategy to mitigate the current low
interest rate environment.
Net realized investment gains were $14.7 million for the year ended December 31,
2010 compared to gains of $0.3 million in the same period last year. This
increase is due in part to a $19.3 million decline in OTTI losses recognized in
earnings from $23.5 million in 2009 to $4.2 million in 2010, offset by a $7.3
decline in capital realized gains from sales of securities from $25.0 million in
2009 to $17.7 million in 2010.
Loss and loss adjustment expenses. For the year ended December 31, 2010 the net
loss ratio increased 5.1 percentage points due to the impact of changing
business mix, price competition and losses from the storms in the northeastern
U.S. occurring in March 2010 which increased the loss ratio by 1.2 points. These
impacts were partially offset during the second half of the year by lower
property losses.
The amortization of the reserves risk premium, which was established in
connection with the acquisitions completed in 2010 and 2009, reduced
consolidated losses by $7.1 million, comprised of $6.3 million excluding the
Reciprocal Exchanges and $0.8 million for the Reciprocal Exchanges. The
amortization of reserves risk premium lowered the loss ratio, excluding the
Reciprocal Exchanges by 0.5 loss ratio points for the year ended December 31,
2010 as compared to 0.6 loss points for 2009.
We had favorable loss development related to prior years of $12.3 million,
comprised of unfavorable development of $19.8 million in the Commercial
Insurance segment and favorable development of $32.1 million in the Personal
Insurance segment, of which $9.9 million related to the Reciprocal Exchanges.
LAE improved during the year by approximately $10 million as a result of
bringing in-house the defense of a large portion of our third-party liability
claims, and by approximately $14 million as a result of a revised study of the
costs of settling claims. The improvement in litigation loss adjustment expenses
favorably impacted our Commercial Insurance segment. See "Commercial Insurance
Segment Results of Operations" for more details.
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Operating expenses. Operating expenses were $499.0 million for the year ended
December 31, 2010, an increase of 40.7% over the prior year, primarily as a
result of the aforementioned acquisitions. Also contributing to the increase
were investments in technology and restructuring, primarily in our Commercial
Insurance segment, following the various acquisitions over the past eighteen
months.
Acquisition-related transaction costs. Acquisition-related transaction costs for
the year ended December 31, 2010 were $2.4 million and relate to the acquisition
of OBPL. In the prior year, we recorded acquisition related transaction costs of
$14.0 million, primarily related to the CastlePoint and SUA acquisitions.
Interest expense. Interest expense increased by $6.6 million for the year ended
December 31, 2010 compared to 2009. Interest expense increased mainly due to the
issuance of $150 million of convertible senior notes in September 2010, interest
expense on subordinated debentures which were assumed as a result of the merger
with CastlePoint, and, to a much lesser extent, interest of $0.1 million on the
$56.0 million draw-down under our credit facility entered into on May 24, 2010.
The credit facility draw-down was repaid in September 2010. Interest on funds
withheld was $2.7 million in 2010 as compared to $0.7 million in 2009.
Other income (expense). Other income for the year ended 2009 was $19.3 million
whereas in 2010, we recorded no other income and other expenses. The other
income in 2009 consisted of $12.7 million gain on bargain purchase related to
the acquisition of SUA in the fourth quarter of 2009 and a gain of $7.4 million
on the revaluation of the shares owned in CastlePoint at the time of the
acquisition offset by the Company's $0.8 million equity in the net loss of
CastlePoint prior to its acquisition on February 5, 2009.
Income tax expense. Income tax expense increased by $8.5 million in 2010
compared to 2009. The increase in the income tax expense is attributable to the
higher income before taxes in the current year. The effective income tax rate
(including state and local taxes) was 34.2% for the year ended December 31,
2010, compared to 31.5% for the same period in 2009. The gain on bargain
purchase of SUA in 2009 decreased the effective tax rate in that year as this
gain was not subject to tax.
Net income and return on average equity. Net income and annualized return on
average equity were $ 106.3 million and 10.3% for the year ended December 31,
2010 compared to $94.7 million and 12.4% for the 2009. The decline in the
annualized return on equity in 2010 is primarily due to the reduced earnings
resulting from higher incurred loss and LAE, including the $17.5 million pre-tax
charge for the northeast U.S. Storm occurring during March 13 to March 15, 2010.
The return on average equity is calculated by dividing net income by average
stockholders' equity. Average stockholders' equity was $1,036.9 million and
$764.7 million at December 31, 2010 and 2009, respectively.
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Commercial Insurance Segment Results of Operations
Year Ended December 31,
($ in millions) 2011 Change Percent 2010 Change Percent 2009
Net premiums written $ 1,152.3 $ 165.0 16.7 % $ 987.3 $ 256.4 35.1 % $ 730.9
Revenues
Net premiums earned $ 1,087.9 $ 146.9 15.6 % $ 941.0 $ 202.8 27.5 % $ 738.2
Ceding commission revenue 14.8 (18.5 ) -55.6 % 33.3 (4.8 ) -12.6 % 38.1
Policy billing fees 4.3 1.5 53.6 % 2.8 0.6 27.3 % 2.2
Total revenue 1,107.0 129.9 13.3 % 977.1 198.6 25.5 % 778.5
ExpensesNet loss and loss adjustment expenses 736.5 147.2 25.0 % 589.3 182.6 44.9 % 406.7
Underwriting expenses
Direct commission expenses
208.7 16.7 8.7
% 192.0 17.6 10.1 % 174.4
Other underwriting expenses
153.2 (2.4 ) -1.5
% 155.6 40.5 35.2 % 115.1
Total underwriting expenses 361.9 14.3 4.1
% 347.6 58.1 20.1 % 289.5
Underwriting profit $ 8.6 $ (31.6 ) -78.6 % $ 40.2 $ (42.1 ) -51.2 % $ 82.3
Year Ended December 31,
Ratios 2011 2010 2009
Net calendar year loss and LAE 67.7 % 62.6 % 55.1 %
Net underwriting expenses 31.5 % 33.1 % 33.8 %
Net combined 99.2 % 95.7 % 88.9 %
Commercial Insurance Segment Results of Operations 2011 Compared to 2010
Premiums. Gross premiums written for the year ended December 31, 2011 were
$1,225.3 million as compared to $1,083.9 million during the same period in 2010.
The increase of $141.4 million is primarily attributed to our new initiatives
with customized solutions and assumed reinsurance which accounted for growth of
$85.7 million and $72.8 million in 2011 compared to 2010, respectively.
Ceded premiums written for the year ended December 31, 2011 were $73.0 million
compared to $96.6 million for the year ended December 31, 2010. The decrease in
ceded premiums written resulted from our decision to not renew our liability
quota share reinsurance treaty which was in effect in 2010. In addition, we
reduced the ceded premiums for our excess of loss reinsurance by raising our
retention from $1.5 million to $5.0 million on all lines of business except
workers' compensation on which our retention was raised from $1.5 million to
$2.5 million. The company also purchased catastrophe reinsurance for all
property lines.
The increases in net premiums written and earned are attributed to both the
increase in gross written premiums and decline in ceded written premiums, as
discussed above.
Renewal retention rate excluding programs was 77.1% for the year ended
December 31, 2011 compared to 77.0% during the same period in 2010. Premiums on
renewed commercial business, other than programs, increased 1.5%. Excluding
programs, policies in-force for our commercial business remained flat as of
December 31, 2011.
Ceding commission revenue. Ceding commission revenue decreased for the year
ended December 31, 2011 by $18.5 million compared to 2010. The decrease was a
result of the non-renewal of our liability quota share contract.
Loss and loss adjustment expenses and loss ratio. The net loss ratios were 67.7%
and 62.6% for the years ended December 31, 2011 and 2010, respectively. The loss
ratios increased in the current calendar year by 5.1 points in total, which is
attributable to 2.9 points primarily due to severe weather related events losses
and 2.2 points as a result of revised estimates of losses from prior years. The
2011 severe weather related losses, which include Hurricane Irene, were $31.5
million.
We increased reserves for prior years by approximately $46.1 million comprised
of $26.4 million for other liability, $30.5 for workers compensation, and $7.9
million for commercial automobile. This was offset in part by favorable
development on commercial packages and monoline property totaling $6.4 million,
by favorable development in CPRE of $10.4 million, and $1.9 million for
amortization of reserves risk premium that was established in 2009 as part of
fair value accounting for the acquisitions made that year. Other liability
unfavorable development included $8.1 million unfavorable related to excess
liability coverage pertaining to one of our specialty programs. The unfavorable
development in workers compensation included $8.3 million for programs and $10.3
million for transactional business.
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Underwriting expenses and underwriting expense ratio. Underwriting expenses,
which include direct commissions and other underwriting expenses, increased by
$14.3 million, or 4.1%, for the year ended December 31, 2011 as compared to the
2010. The net underwriting expense ratio improved 1.6 percentage points from
2010 to 2011.
The gross underwriting expense ratio was 30.3% for the year ended December 31,
2011 as compared to 31.4% in 2010. The commission portion of the gross
underwriting expense ratio, which is expressed as a percentage of gross premiums
earned, was 17.7% for the year ended December 31, 2011 compared to 17.5% for the
same periods in 2010. This increase is attributable to the assumed reinsurance
which has a higher commission. The OUE ratio, including BB&T, was 12.6% for the
year ended December 31, 2011 compared 13.9% for the same period in 2010. The
improvement in OUE in 2011 resulted from of our continued efforts to reduce
expenses through integration, with many functions consolidated into one office.
Underwriting profit and combined ratio. The net combined ratios were 99.2% for
the year ended December 31, 2011 and 95.7% for 2010. The increase in the
combined ratio in 2011 resulted from an increase in the net loss ratio due to
catastrophe losses and more competitive market conditions, partially offset by a
decrease in the net expense ratios as described above.
Commercial Insurance Segment Results of Operations 2010 Compared to 2009
Premiums. Gross premium written for the year ended December 31, 2010 were
$1,083.9 million compared to $884.7 million in 2009. The increase in gross
premiums written was primarily the result of the acquisitions of CastlePoint and
Hermitage in February 2009 and the acquisition of SUA in November 2009.
Ceded premiums written for the year ended December 31, 2010 were $96.6 million
compared to $153.8 million for the year ended December 31, 2009. The decrease in
ceded premiums written resulted from our decision to lower the ceded percentage
on our liability quota share reinsurance treaty during 2010.
Catastrophe reinsurance ceded premiums were $11.4 million for the years ended
December 31, 2010 and 2009. Catastrophe costs remained flat because there were
no significant changes in commercial property exposure that we reinsure.
The change in net premiums written and earned increased in line with increases
in gross premiums that were driven primarily by the acquisitions described above
and the aforementioned decrease in ceded premiums.
Renewal retention, particularly for small policies, continued to offset a
challenging market environment for new business. We restricted underwriting in
some of our programs and for middle market and larger accounts, which resulted
in a decline in premiums from these customer types. Excluding programs, the
renewal retention rate was 77% for the year ended December 31, 2010. Premiums on
renewed commercial business, other than programs, increased 0.6%. Excluding
programs, policies in-force for our commercial business increased by 0.2% as of
December 31, 2010.
Ceding commission revenue. Ceding commission revenue decreased for the year
ended December 31, 2010 by $4.8 million compared to 2009. The decrease was a
result of a lower ceded commission rate on our liability quota share treaty
earned in 2010 compared to the ceded commission rate on our multi-line quota
share which was earned in 2009. Ceding commission revenue decreased by $2.3
million for the year ended December 31, 2010 as a result of increases in ceded
loss ratios on prior year's quota share treaties compared to a decrease of $1.8
million for 2009.
Loss and loss adjustment expenses and loss ratio. Our gross and net loss ratios
increased by 6.7 points and 7.5 points, respectively, from 2009 to 2010. The
loss ratios increased mostly as a result of more competitive market conditions
and revised estimates of losses from prior years. These increases were partially
offset by improvements in loss adjustment expenses impacting both ALAE and ULAE
as well as by amortization of reserves risk premiums that were established in
connection with fair value accounting for acquisitions made in 2009.
More competitive market conditions contributed to the increase in loss ratio
despite small increases in premiums for renewed commercial business. We
cancelled several of our workers' compensation and commercial automobile
programs early in the year due to poor performance, but the runoff for these
cancelled programs was relatively poor. We also increased loss development
factors for commercial lines which impacted reserves for prior years, described
below, and also caused us to increase our loss ratio estimates for the current
year.
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We increased reserves for prior years by approximately $19.8 million comprised
of $18.7 million for commercial automobile and $6.6 million for commercial
multi-peril, which was offset in part by favorable development on workers'
compensation of $10.1 million and amortization of reserves risk premium of $4.6
million that was established in 2009 as part of fair value accounting for the
acquisitions of CastlePoint, Hermitage, and SUA in that year. The unfavorable
development in commercial automobile and commercial packages resulted from
higher loss development factors based upon detailed studies of our business that
we completed in the fourth quarter. The favorable development in workers'
compensation included lower estimates of incurred losses for small workers'
compensation policies as well as higher estimated ceded losses for excess of
loss reinsurance that we purchase. We also had adverse development of $8.0
million in assumed reinsurance that resulted from participation on quota share
business written by CastlePoint prior to its acquisition by Tower.
The adverse development was reduced as a result of lowering estimated costs for
litigation defense claims in our commercial multi-peril and other liability
business of approximately $10 million. Since 2009 we have been increasing the
number of staff attorneys defending third-party liability claims defense
in-house, which we believe results in better loss ratios as well as
significantly lower ALAE. As part of our acquisition of OBPL on July 1, 2010 we
hired additional defense attorneys that we were able to reassign, in part, to
commercial lines.
Underwriting expenses and underwriting expense ratio. Underwriting expenses,
which include direct commissions and other underwriting expenses, increased
$58.1 million from 2009 to 2010. The increase in underwriting expenses resulted
from the increase in gross premiums earned, which was primarily due to the
acquisitions discussed above. The gross underwriting expense ratio was 31.4% for
the year ended December 31, 2010 as compared to 32.4% for 2009. The net expense
ratio was 33.1% for the year ended December 31, 2010 as compared to 33.8% for
2009.
The other underwriting expense ("OUE") ratio, including BB&T, was 13.9% for the
year ended December 31, 2010 compared to 12.7% for 2009. This increase is
attributed to: (i) the increase in gross premiums written which impact our BB&T;
(ii) our investment in technology and overall integration efforts have increased
due to the previously mentioned acquisitions over the past eighteen months that
were mainly commercial lines focused; and (iii) compensation-related costs of
$2.9 million were incurred in connection with staff reductions related to
ongoing restructuring and closing of certain offices associated with acquired
businesses.
The commission portion of the gross underwriting expense ratio, which is
expressed as a percentage of gross premiums earned, was17.5% for the year ended
December 31, 2010 compared to 19.7% for 2009. The decrease in commission rate
for 2010 resulted from significantly higher amortization costs in 2009 for the
value of business acquired ("VOBA") of CastlePoint.
Underwriting profit and combined ratio. The net combined ratios were 95.7% for
the year ended December 31, 2010 and 88.9% for 2009. The increase in the
combined ratio in 2010 resulted from an increase in the net loss ratio due to
catastrophe losses, softer market conditions and from increases in the net
expense ratios as described above.
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Personal Insurance Segment Results of Operations
Year Ended December 31,
2011 2010
Reciprocal Reciprocal
($ in millions) Tower Exchanges Total Change Percent Tower Exchanges Total
Net premiums written $ 316.9 $ 169.4 $ 486.3 $ 159.5 48.8 % $ 223.6 $ 103.2 $ 326.8
Revenues
Net premiums earned $ 318.7 $ 187.2 $ 505.9 $ 154.2 43.9 % $ 257.9 $ 93.8 $ 351.7
Ceding commission revenue 12.5 6.7 19.2 13.1 216.0 % 4.0 2.1 6.1
Policy billing fees 5.6 0.6 6.2 2.8 76.2 % 3.1 0.3 3.4
Total revenue 336.8 194.5 531.3 170.1 47.1 % 265.0 96.2 361.2
Expenses
Net loss and loss adjustment expenses 214.4 104.4 318.8 124.1 63.7 % 132.5 62.2 194.7
Underwriting expenses
Direct commission expenses 68.6 32.5 101.1 26.2 35.0 % 56.5 18.4
74.9
Other underwriting expenses 73.5 52.3 125.8 41.2 48.7 % 59.8 24.8
84.6
Total underwriting expenses 142.1 84.8 226.9 67.4 42.3 % 116.3 43.2
159.5
Underwriting profit (loss) $ (19.7 ) $ 5.3 $ (14.4 ) $ (21.4 ) -305.7 % $ 16.2 $ (9.2 ) $ 7.0
Ratios
Net calendar year loss and LAE 67.2 % 55.8 % 63.0 % 51.4 % 66.3 % 55.4 %
Net underwriting expenses 38.9 % 41.4 % 39.8 % 42.3 % 43.5 % 42.6 %
Net combined 106.1 % 97.2 % 102.8 % 93.7 % 109.8 % 98.0 %
Year Ended December 31,
2010
Reciprocal
($ in millions) Tower Exchanges Total Change Percent 2009
Net premiums written $ 223.6 $ 103.2 $ 326.8 $ 171.5 110.4 % $ 155.3
Revenues
Net premiums earned $ 257.9 $ 93.8 $ 351.7 $ 235.2 201.9 % $ 116.5
Ceding commission revenue 4.0 2.1 6.1 1.5 32.6 % 4.6
Policy billing fees 3.1 0.3 3.4 2.7 385.7 % 0.7
Total revenue 265.0 96.2 361.2 239.4 196.6 % 121.8
Expenses
Net loss and loss adjustment expenses 132.5 62.2 194.7 125.9 183.0 % 68.8
Underwriting expenses
Direct commission expenses 56.5 18.4 74.9 46.1 160.1 % 28.8
Other underwriting expenses 59.8 24.8 84.6 56.5 201.1 % 28.1
Total underwriting expenses 116.3 43.2
159.5 102.6 180.3 % 56.9
Underwriting profit (loss) $ 16.2 $ (9.2 ) $
7.0 $ 10.9 -279.5 % $ (3.9 )
Ratios
Net calendar year loss and LAE 51.4 % 66.3 % 55.4 % 59.1 %
Net underwriting expenses 42.3 % 43.5 % 42.6 % 44.3 %
Net combined 93.7 % 109.8 % 98.0 % 103.4 %
Personal Insurance Segment Results of Operations 2011 Compared to 2010
Premiums. Gross premiums written for the year ended December 31, 2011 were
$585.6 million as compared to $412.5 million in 2010. The increase of $173.1
million is primarily attributable to OBPL which was acquired on July 1, 2010,
and was reflected in Tower's consolidated results for twelve months in 2011 as
compared to six months in 2010. Excluding the effects of OBPL, Tower's other
personal lines gross premiums written increased $7.7 million from $201.0 million
in 2010 to $208.7 million in 2011 due principally to organic growth in the
homeowners business.
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Ceded premiums written for the year ended December 31, 2011 were $99.4 million,
an increase of $13.7 million as compared to $85.7 million in 2010. The Company
reinsures the homeowners and umbrella business obtained from OBPL through a
quota share program. The Company also purchased catastrophe reinsurance for
certain property business. The increase in ceded premiums written is due to the
increase in gross premiums written associated with the OBPL acquisition
Net premiums written and earned increased $159.5 million and $154.2 million,
respectively, in 2011 as compared to 2010. The increase in net premiums written
and earned is a result of the OBPL acquisition, as discussed above. Net premiums
written and earned associated with the OBPL business were $311.6 million and
$335.2 million, respectively, in 2011 compared to $170.0 million and $191.8
million, respectively, in 2010.
The Company's personal lines renewal retention was 86% and 83% for the years
ended December 31, 2011 and 2010, respectively. The increase in 2011 is
attributed to the change in business mix as a result of the OBPL acquisition.
Premiums on renewed business increased by 2.5% and 5.0% in 2011 and 2010,
respectively. Policies-in-force decreased by 2.5% as of December 31, 2011 from
December 31, 2010.
Ceding commission revenue. The increase in ceding commission revenue for the
year ended December 31, 2011 compared to the prior year is attributed to the
commission revenue earned on the previously mentioned homeowners and umbrella
quota share treaties on the OBPL acquired business.
Net loss and loss adjustment expenses. Our net loss and loss adjustment expense
ratio for 2011 compared to 2010 increased by 7.6 percentage points to 63.0% and,
excluding the Reciprocal Exchanges, increased by 15.8 points to 67.2%.
Excluding the Reciprocal Exchanges, the increase in the loss ratio as compared
to 2010 was primarily due to winter storms and property catastrophes, the most
significant of which was Hurricane Irene. These storms, together, added $42.8
million in losses and 13.4 points to the net loss ratio. Excluding these storms
the loss ratio would have been 53.8% in 2011.
The favorable development in Personal Insurance, excluding the Reciprocal
Exchanges, of $29.1 million was comprised primarily of $22.2 million for private
passenger automobile liability, $13.1 million for homeowners and $1.9 million
for amortization of reserves risk premium, principally relating to reserves
acquired in the OBPL transaction developing more favorably than anticipated at
the time of the acquisition, offset by unfavorable development of $4.2 million
in discontinued personal lines business, $3.1 million in involuntary plans and
$0.8 million in other lines.
The Reciprocal Exchanges loss ratio included $6.5 million from winter storms and
property catastrophes that amounted to 3.5 loss ratio percentage points.
Excluding these storms the loss ratio would have been 52.3% in 2011.
Underwriting expenses. Underwriting expenses increased by $67.4 million for the
year ended December 31, 2011 as compared to the prior year. Nearly all of the
increase is related to the OBPL acquisition. The net underwriting expense ratio
improved 2.8 percentage points from 2010 to 2011.
The gross underwriting expense ratio improved to 36.1% in 2011 from 36.9% in
2010. The commission portion of the gross underwriting expense ratio was 16.5%
and 17.7% for years ended December 31, 2011 and 2010, respectively. The
improvement in the commission ratio reflects the impact of lower commission
rates in the Reciprocal Exchanges. The gross OUE ratio, which includes BB&T, was
19.6% and 19.2% for the years ended December 31, 2011 and 2010, respectively.
The costs of the transition services agreements with OneBeacon have the effect
of increasing the gross OUE ratios.
Underwriting profit and combined ratio. The increase in Personal Insurance
segment underwriting loss and combined ratio for the year ended December 31,
2011 as compared to the underwriting profit and combined ratio in 2010 are due
primarily to the catastrophe and severe storms that affected the northeastern
United States in 2011, partially offset by favorable prior year loss development
of $48.3 million in 2011.Of this amount, $10.5 million of the favorable loss
development related to Tower, excluding the Reciprocal Exchanges. The Reciprocal
Exchanges' favorable loss development in 2011 was $37.8 million.
Personal Insurance Segment Results of Operations 2010 Compared to 2009
Premiums. Gross premiums written for the year ended December 31, 2010 were
$412.5 million, an increase of $226.5 million over the 2009 gross premiums
written of $186.0 million. The acquisition of OBPL accounted for $224.3 million
of the increase. The remaining growth from the existing business was
predominately from our California homeowners book. Immediately following the
OBPL acquisition, actions were taken to shed unprofitable business and to reduce
coastal exposures.
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Ceded premiums written for 2010 were $85.7 million as compared to $30.7 million
in 2009. The increase in ceded premiums is principally due to the acquisition of
OBPL which generated $41.5 million in ceded premiums. The Company reinsures the
homeowners and umbrella business obtained from OBPL through a quota share
program. The Company also purchases catastrophe reinsurance for all property
business.
Net premiums written for the year ended December 31, 2010 was $326.8 million, an
increase of $171.5 million over 2009. The acquisition of OBPL accounted for
$167.8 million of the increase.
Ceding commission revenue. Ceding commission revenue for 2010 was $6.1 million,
an increase of $1.5 million over 2009. The increase was primarily attributable
to the commission revenue associated with the previously mentioned homeowner and
umbrella quota share treaties.
Loss and loss adjustment expenses. Our gross and net loss ratios for 2010
decreased by 0.8 and of 3.7 percentage points, respectively, compared to 2009.
The net loss ratio excluding the Reciprocal Exchanges was 51.4%. The improvement
in loss ratio resulted from lower than expected losses in 2010 and favorable
reserve development, which was offset in part by winter storm losses that
occurred in March 2010. Winter storm losses were $15.5 million in 2010, which
represented 4.4 loss ratio points overall. Third and fourth quarter 2010
homeowners losses were better than expected for the current accident year due to
relatively mild winter weather even considering the snow storm that occurred in
the Northeast on December 26, 2010.
Prior year losses developed favorably by $32.1 million, comprised of $22.3
million favorable development in our stock companies and $9.9 million favorable
development in the Reciprocal Exchanges. For the OBPL business we recorded
favorable development that we experienced relative to expected patterns only for
the third and fourth quarters of 2010 after our acquisition of this business.
Underwriting expenses. Underwriting expenses increased by $102.6 million for the
year ended December 31, 2010 as compared to 2009. This increase is related
predominantly to the OBPL acquisition. The net underwriting expense ratio
improved 1.7 percentage points from 44.3% in 2009 to 42.6% in 2010.
The gross underwriting expense ratio for 2010 was 36.9%, as compared to 35.4% in
2009. The commission portion of the gross underwriting expense ratio was 17.7%,
compared to 18.1% for the prior year. The improvement in the commission ratio
reflects the impact of lower commission rates in the Reciprocal Exchanges. The
gross OUE ratio, including BB&T, was 19.2% compared with 17.3% in 2009. The
increase in the OUE expense ratio relates primarily to increases in expenses
attributed to OBPL, including the transition services agreements Tower entered
into with OneBeacon whereby OneBeacon will provide certain information
technology and operation support to Tower.
Underwriting profit and combined ratio. The net combined ratio for the Personal
Insurance segment was 98.0% in 2010, 5.4 points better than prior year.
Underwriting income of $7.0 million was $10.9 million better than 2009 and was
largely driven by the addition of the OBPL business. Changes in combined ratio
reflect the changes in the loss ratio and the expense ratio for reasons
described above.
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Insurance Services Segment Results of Operations
Year Ended December 31,
($ in millions) 2011 Change Percent 2010 Change Percent 2009
Revenue
Management fee income $ 29.3 $ 11.5 64.6 % $ 17.8 $ 17.8 - $ -
Other revenue 1.6 (0.5 ) -23.8 % 2.1 (3.0 ) -57.7 % 5.1
Total revenue 30.9 11.0 55.0 % 19.9 14.8 284.6 % 5.1
Expenses
Other expenses 19.4 13.7 240.4 % 5.7 1.5 32.1 % 4.2
Total expenses 19.4 13.7 240.4 % 5.7 1.5 32.1 % 4.2
Insurance services pre-tax income $ 11.5 $ (2.7 ) -19.0 % $ 14.2$ 13.3
NM $ 0.9
Premiums produced on behalf of
issuing companies $ - $ - -
$ - $ (11.7 ) -100.0 % $ 11.7
NM is shown where percentage change exceeds 500%
Insurance Services Segment Results of Operations 2011 Compared to 2010
Total revenue. The increase in total revenue for the year ended December 31,
2011 compared to 2010 was primarily due to the management fee income earned by
Tower for underwriting, claims, investment management and other services
provided to the Reciprocal Exchanges pursuant to management services agreements
with the Reciprocal Exchanges. The management fee income is calculated as a
percentage of the Reciprocal Exchanges' gross written premiums of $209.3 million
and $126.8 million in 2011 and 2010, respectively. The effects of these
management services agreements between Tower and the Reciprocal Exchanges are
eliminated in consolidation to derive consolidated net income. However, the
management fee income is reported in net income attributable to Tower Group,
Inc. and included in basic and diluted earnings per share. We had no premiums
managed by our managing general agencies in 2011 and 2010.
Total expenses. The increase in total expenses for the year ended December 31,
2011 compared to 2010 was primarily due to the costs incurred under the
management services agreement between Tower and the Reciprocal Exchanges, which
were in place for the twelve months in 2011 as compared to six months in 2010.
Insurance Services Segment Results of Operations 2010 Compared to 2009
Total revenue. The increase in total revenue for the year ended December 31,
2010 compared to 2009 was primarily due to the management fee income earned by
Tower for underwriting, claims, investment management and other services
provided to the Reciprocal Exchanges pursuant to a management services agreement
with the Reciprocal Exchanges. The management fee income is calculated as a
percentage of the Reciprocal Exchanges' gross written premiums of $126.8 million
in 2010. The increase in management fee income was offset by modest declines in
revenue generated from our managing general agencies.
Total expenses. The increase in total expenses for the year ended December 31,
2010 compared to 2009 was primarily due to the costs incurred under the
management services agreements between Tower and the Reciprocal Exchanges.
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Investments
Portfolio Summary
The following table presents a breakdown of the amortized cost, aggregate fair
value and unrealized gains and losses by investment type as of December 31, 2011
and December 31, 2010:
Cost or Gross Gross Unrealized Losses % of
Amortized Unrealized Less than 12 More than 12 Fair Fair
($ in thousands) Cost Gains Months Months Value Value
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 %
Short-term investments - - - - - 0.0 %
Total, December 31, 2011 $ 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
December 31, 2010
U.S. Treasury securities $ 177,060 $ 1,258 $ (64 ) $ - $ 178,254 7.2 %
U.S. Agency securities 26,504 758 (34 ) - 27,228 1.1 %
Municipal bonds 544,019 14,357 (4,635 ) (35 ) 553,706 22.4 %
Corporate and other bonds 853,154 35,192 (4,766 ) (10 ) 883,570 35.7 %
Commercial, residential and 0.0 %
asset-backed securities 707,294 37,665 (3,986 ) (1,120 ) 739,853 29.9 %
Total fixed-maturity securities 2,308,031 89,230 (13,485 ) (1,165 ) 2,382,611 96.3 %
Equity securities 91,218 2,487 (3,192 ) (196 ) 90,317 3.6 %
Short-term investments 1,560 - - - 1,560 0.1 %
Total $ 2,400,809 $ 91,717 $ (16,677 ) $ (1,361 ) $ 2,474,488 100.0 %
Tower $ 2,062,315 $ 87,012 $ (14,532 ) $ (1,361 ) $ 2,133,434
Reciprocal Exchanges 338,494 4,705 (2,145 ) - 341,054
Total, December 31, 2010 $ 2,400,809 $ 91,717 $ (16,677 ) $ (1,361 ) $ 2,474,488
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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 December 31, 2011 and
December 31, 2010. The following table shows the ratings distribution of our
fixed-maturity portfolio:
Tower Reciprocal Exchanges
Percentage Percentage
of Fair of Fair
($ in thousands) Fair Value Value Fair Value Value
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 %
December 31, 2010
Rating
U.S. Treasury securities $ 148,018 7.3 % $ 30,236 8.9 %
AAA 620,281 30.4 % 100,566 29.5 %
AA 412,414 20.2 % 46,015 13.5 %
A 445,498 21.8 % 111,064 32.6 %
BBB 161,474 7.9 % 32,932 9.7 %
Below BBB 253,872 12.4 % 20,241 5.8 %
Total $ 2,041,557 100.0 % $ 341,054 100.0 %
Fixed Maturity Investments-Time to Maturity
The following table shows the composition of our fixed maturity portfolio by
remaining time to maturity at December 31, 2011 and December 31, 2010. For
securities that are redeemable at the option of the issuer and have a market
price that is greater than redemption value, the maturity used for the table
below is the earliest redemption date. For securities that are redeemable at the
option of the issuer and have a market price that is less than redemption value,
the maturity used for the table below is the final maturity date:
Tower Reciprocal Exchanges Total
Amortized Fair Amortized Fair Amortized Fair
($ in thousands) Cost Value Cost Value Cost Value
December 31, 2011
Remaining Time to Maturity
Less than one year $ 40,201 $ 40,529 $ 44,238 $ 44,942 $ 84,439 $ 85,471
One to five years 479,721 491,904 81,566 83,743 561,287 575,647
Five to ten years 563,830 593,838 21,522 22,797 585,352 616,635
More than 10 years 427,357 458,536 48,818 51,480 476,175 510,016
Mortgage and asset-backed securities 535,823 568,813 92,036 97,092 627,859 665,905
Total $ 2,046,932 $ 2,153,620 $ 288,180 $ 300,054 $ 2,335,112 $ 2,453,674
December 31, 2010
Remaining Time to Maturity
Less than one year $ 28,408 $ 28,665 $ - $ - $ 28,408 $ 28,665
One to five years 512,969 526,746 65,993 66,771 578,962 593,517
Five to ten years 501,324 521,138 110,463 111,166 611,787 632,304
More than 10 years 351,093 358,445 30,487 29,826 381,580 388,271
Mortgage and asset-backed securities 575,743 606,563 131,551 133,291 707,294 739,854
Total $ 1,969,537 $ 2,041,557 $ 338,494 $ 341,054 $ 2,308,031 $ 2,382,611
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Fixed-Maturity Investments with Third Party Guarantees
At December 31, 2011, $237.9 million of our municipal bonds, at fair value, were
guaranteed by third parties from a total of $2.5 billion, at fair value, of all
fixed-maturity securities held by us. The amount of securities guaranteed by
third parties along with the credit rating with and without the guarantee is as
follows:
With Without
($ in thousands) Guarantee Guarantee
AA $ 180,996 $ 161,584
A 46,722 65,829
BBB 10,151 2,203
BB - 3,097
No underlying rating - 5,156
Total $ 237,869 237,869
Tower $ 232,115 $ 232,115
Reciprocal Exchanges 5,754 5,754
Total $ 237,869 $ 237,869
The securities guaranteed, by guarantor, are as follows:
Guaranteed Percent
($ in thousands) Amount of Total
National Public Finance Guarantee Corp $ 89,129 37.5 %
Assured Guaranty Municipal Corp 86,828 36.5 %
Ambac Financial Corp 47,611 20.0 %
Berkshire Hathaway Assurance Corp 6,796 2.9 %
FGIC Corp 4,153 1.7 %
Others 3,352 1.4 %
Total $ 237,869 100.0 %
Tower $ 232,115 97.6 %
Reciprocal Exchanges 5,754 2.4 %
Total $ 237,869 100.0 %
Municipal Bonds
As of December 31, 2011, our municipal bonds consisted of state general
obligations, municipal general obligations and special revenue bonds. Municipal
bonds by state at December 31, 2011 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 $ 17,326 $ 18,585 $ 4,916 $ 5,585 $ 86,424 $ 91,931 $ 108,666 $ 116,101
New York 12,169 13,262 7,206 7,376 42,148 45,626 61,523 66,264
California 15,303 16,613 12,363 13,593 19,855 21,691 47,521 51,897
Florida 7,649 8,026 1,802 1,822 36,603 39,934 46,054 49,782
Washington 14,866 15,688 5,602 5,991 12,852 13,615 33,320 35,294
Indiana - - 1,018 1,036 27,972 30,149 28,990 31,185
Illinois 14,715 15,513 3,350 3,541 10,960 11,745 29,025 30,799
Arizona 6,269 7,047 2,677 2,676 19,263 20,566 28,209 30,289
Other 64,053 68,715 36,596 38,667 204,235 217,721 304,884 325,103
Total $ 152,350 $ 163,449 $ 75,530 $ 80,287 $ 460,312 $ 492,978 $ 688,192 $ 736,714
No one jurisdiction within "Other" in the table above exceeded 4% of the total
fair value of municipal bonds. As of December 31, 2011, the special revenue
bonds are supported primarily by water and sewer utilities, electric utilities,
college revenues and highway tolls.
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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 December 31, 2011, 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).
In certain instances, we deemed it necessary to utilize Level 3 pricing over
prices available through pricing services used throughout 2011 and 2010. The
ability to observe stable prices and inputs may be reduced for highly-customized
an illiquid instruments as currently is the case for certain non-agency
residential and commercial mortgage-backed securities and asset-backed
securities.
A number of our Level 3 investments have also been written down as a result of
our impairment analysis. At December 31, 2011, two securities included in other
invested assets were priced in Level 3 with a fair value of $25.0 million, which
was also our cost basis.
As more fully described in Note 6 to our consolidated financial statements,
"Investments-Impairment Review," we completed a detailed review of all our
securities in a continuous loss position, including but not limited to
residential and commercial mortgage-backed securities, and concluded that the
unrealized losses in these asset classes are the result of a decrease in value
due to technical spread widening and broader market sentiment.
"Note 7 - Fair Value Measurements" to the consolidated financial statements
provides a description of the valuation methodology utilized to value Level 3
assets, how the valuation methodology is validated and an analysis of the change
in fair value of Level 3 assets. As of December 31, 2011, the fair value of
Tower Level 3 assets as a percentage of Tower's total assets carried at fair
value was as follows (the Reciprocal Exchanges had no Level 3 assets):
Level 3 Assets
Assets Carried at as a Percentage of
Fair Value at Fair Value of Total Assets Carried
($ in thousands) December 31, 2011 Level 3 Assets at Fair Value
Fixed-maturity investments $ 2,453,674 $ - 0 %
Equity investments 89,345 - 0 %
Total investments available for sale $ 2,543,019 $
- 0 %
Other invested assets 25,000 25,000 100 %
Cash and cash equivalents 114,098 - 0 %
Total $ 2,682,117 $ 25,000 0.9 %
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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 a
spread widening in the capital markets. We expect cash flows from operations to
be sufficient to meet our liquidity requirements and, therefore, we do not
intend to sell these fixed maturity securities and we do not believe that we
will be required to sell these securities before recovering their cost basis.
For equity securities not considered OTTI, we believe we have the ability to
hold these investments until a recovery of fair value to our cost basis. A
substantial portion of the unrealized loss relating to the mortgage-backed
securities is the result of a spread widening in the market that we believe to
be temporary.
The following table presents information regarding our invested assets that were
in an unrealized loss position at December 31, 2011 and December 31, 2010 by
amount of time in a continuous unrealized loss position:
Less than 12 Months 12 Months or Longer Total
Fair Unrealized Fair Unrealized Aggregate Unrealized
($ in thousands) Value Losses Value Losses Fair Value Losses
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 (145 ) 60,876 (2,286 )
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 (9 ) 30,234 (656 )
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 )
December 31, 2010
U.S. Treasury securities $ 2,641 $ (64 ) $ - $ - $ 2,641 $ (64 )
U.S. Agency securities 4,643 (34 ) - - 4,643 (34 )
Municipal bonds 146,947 (4,635 ) 215 (35 ) 147,162 (4,670 )
Corporate and other bonds
Finance 45,542 (618 ) - - 45,542 (618 )
Industrial 172,305 (3,526 ) 241 (9 ) 172,546 (3,535 )
Utilities 24,567 (622 ) 243 (1 ) 24,810 (623 )
Commercial mortgage-backed securities 35,362 (892 ) 2,315 (658 ) 37,677 (1,550 )
Residential mortgage-backed securities
Agency backed 210,770 (2,750 ) - - 210,770 (2,750 )
Non-agency backed 2,416 (209 ) 8,112 (462 ) 10,528 (671 )
Asset-backed securities 9,958 (135 ) - - 9,958 (135 )
Total fixed-maturity securities 655,151 (13,485 ) 11,126 (1,165 ) 666,277 (14,650 )
Preferred stocks 9,507 (72 ) 5,356 (196 ) 14,863 (268 )
Common stocks 38,516 (3,120 ) - - 38,516 (3,120 )
Total, December 31, 2010 $ 703,174 $ (16,677 ) $ 16,482 $ (1,361 ) $ 719,656 $ (18,038 )
Tower $ 530,401 $ (14,533 ) $ 16,482 $ (1,361 ) $ 546,883 $ (15,894 )
Reciprocal Exchanges 172,773 (2,144 ) - - 172,773 (2,144 )
Total, December 31, 2010 $ 703,174 $ (16,677 ) $ 16,482 $ (1,361 ) $ 719,656 $ (18,038 )
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At December 31, 2011, the fixed-maturity securities in an unrealized loss
position for twelve months or greater were primarily in our residential
non-agency mortgage-backed securities.
The following table stratifies the gross unrealized losses in the portfolio at
December 31, 2011, by duration in a loss position and magnitude of the loss as a
percentage of the cost or amortized cost of the security:
Total Gross Decline of Investment Value
Fair Unrealized >15% >25% >50%
($ in thousands) Value Losses Amount Amount Amount
Unrealized loss for less than 6 months $ 359,522 $ (10,035 ) $ (1,750 ) $ (65 ) $ (49 )
Unrealized loss for over 6 months 74,486 (5,380 ) (2,072 ) (48 ) (89 )
Unrealized loss for over 12 months 5,844 (288 ) (68 ) - -
Unrealized loss for over 18 months 12 - - - -
Unrealized loss for over 2 years 5,107 (733 )
(418 ) (179 ) -
Total unrealized loss $ 444,971 $ (16,436 )
$ (4,308 ) $ (292 ) $ (138 )
Tower $ 407,253 $ (15,075 ) $ (4,030 ) $ (285 ) $ (138 )
Reciprocal Exchanges 37,718 (1,361 )
(278 ) (7 ) -
Total unrealized loss $ 444,971 $ (16,436 )
$ (4,308 ) $ (292 ) $ (138 )
The following table shows the number of securities, fair value, unrealized loss
amount and percentage below amortized cost and the ratio of fair value by
security rating as of December 31, 2011:
Unrealized Loss
Percent of Fair Value by Security Rating
Fair Amortized BB or
($ in thousands) Count Value Amount Cost AAA AA A BBB Lower
U.S. Treasury securities 4 $ 92,001 $ (13 ) 0 % 0 % 100 % 0 % 0 % 0 %
Municipal bonds 17 13,449 (255 ) -2 % 6 % 55 % 27 % 9 % 3 %
Corporate and other bonds 273 202,015 (6,962 ) -3 % 2 % 3 % 35 % 18 % 42 %
Commercial mortgage-backed securities 12 26,130 (2,564 )
-9 % 17 % 2 % 48 % 14 % 19 %
Residential mortgage-backed securities 36 17,934 (902 ) -5 % 15 % 2 % 30 % 0 % 53 %
Asset-backed securities 18 30,234 (656 ) -2 % 12 % 74 % 12 % 2 % 0 %
Equities 25 63,208 (5,084 ) -7 % 0 % 0 % 0 % 0 % 100 %
See "Note 6-Investments" in our consolidated financial statements for further
information about impairment testing and other-than-temporary impairments.
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Corporate and other bonds
The following tables show the fair value and unrealized loss by sector and
credit quality rating of our corporate and other bonds in an unrealized loss
position at December 31, 2011:
Fair Value Rating
BB or Fair
($ in thousands) AAA AA A BBB lower value
Sector
Financial $ 6,971 $ 70,402 $ 22,563 $ 18,201 $ 21,100 $ 139,237
Industrial - 1,010 12,808 15,591 31,467 60,876
Utilities - - - 947 955 1,902
Total fair value $ 6,971 $ 71,412 $ 35,371 $ 34,739 $ 53,522 $ 202,015
% of fair value 3 % 35 % 18 % 17 % 26 % 100 %
Unrealized Loss Rating
BB or Unrealized
($ in thousands) AAA AA A BBB lower Loss
Sector
Financial $ (71 ) $ (2,974 ) $ (422 ) $ (232 ) $ (916 ) $ (4,615 )
Industrial - (22 ) (545 ) (376 ) (1,343 ) (2,286 )
Utilities - - - (13 ) (48 ) (61 )
Total unrealized loss $ (71 ) $ (2,996 ) $ (967 ) $ (621 ) $ (2,307 ) $ (6,962 )
% of book value (1 %) (4 %) (3 %) (2 %) (4 %) (3 %)
The majority of our corporate bonds that are in an unrealized loss position are
rated below AA. Based on our analysis of these securities and current market
conditions, we expect price recovery on these over time, and we have determined
that these securities are not other than temporarily impaired as of December 31,
2011.
Total securitized assets
The following tables show the fair value and unrealized loss by credit quality
rating and deal origination year of our commercial mortgage-backed, non-agency
residential mortgage-backed and asset-backed securities in an unrealized loss
position at December 31, 2011:
Fair Value Rating
($ in thousands) BB or Fair
Deal Origination Year AAA AA A BBB Lower Value
2001-2004 $ 3,484 $ 857 $ 253 $ - $ 1,554 $ 6,148
2005-2007 307 15,735 13,398 4,348 13,056 46,844
2008-2010 2,203 948 1,778 - - 4,929
2011 4,482 5,629 6,235 - - 16,346
Total fair value $ 10,476 $ 23,169 $ 21,664 $ 4,348 $ 14,610 $ 74,267
% of fair value 14 % 31 % 29 % 6 % 20 % 100 %
Unrealized losses
Rating
($ in thousands) BB or Unrealized
Deal Origination Year AAA AA A BBB Lower Loss
1998-2004 $ (140 ) $ (67 ) $ (44 ) $ - $ (341 ) $ (592 )
2005-2007 - (356 ) (438 ) (877 ) (704 ) (2,375 )
2008-2010 (110 ) (50 ) (8 ) - - (168 )
2011 (18 ) (154 ) (814 ) - - (986 )
Total unrealized loss $ (268 ) $ (627 ) $ (1,304 ) $ (877 ) $ (1,045 ) $ (4,121 )
% of book value (2 %) (3 %) (6 %) (17 %) (7 %) (5 %)
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Liquidity and Capital Resources
Tower is organized as a holding company (the "Holding Company") with multiple
intermediate holding companies, 13 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 and sales of securities.
Tower Insurance Company of New York ("TICNY") is the Company's largest insurance
subsidiary. Under New York law, TICNY is limited to paying dividends to the
Holding Company only from statutory earned surplus. In addition, the New York
Insurance Department must approve any dividend declared or paid by TICNY that,
together with all dividends declared or distributed by TICNY during the
preceding twelve months, exceeds the lesser of (1) 10% of TICNY's policyholders'
surplus as shown on its latest annual statutory financial statement filed with
the New York State Insurance Department or (2) 100% of adjusted net investment
income during the preceding twelve months. TICNY declared $15.0 million, $4.7
million and $2.0 million in dividends to the Holding Company in 2011, 2010 and
2009, respectively.
CastlePoint Re is another of Tower's significant insurance subsidiaries. Under
the Insurance Act 1978 of Bermuda, as amended (the "Insurance Act"), CastlePoint
Re is required to maintain a specified solvency margin and a minimum liquidity
ratio and is prohibited from declaring or paying any dividends if doing so would
cause CastlePoint Re to fail to meet its solvency margin and its minimum
liquidity ratio. Under the Insurance Act, CastlePoint Re is prohibited from
declaring or paying dividends without the approval of the Bermuda Monetary
Authority ("BMA"), if CastlePoint Re failed to meet its solvency margin and
minimum liquidity ratio on the last day of the previous fiscal year. Under the
Insurance Act, CastlePoint Re is prohibited, without the approval of the BMA,
from reducing by 15% or more its total statutory capital as set forth on its
audited statutory financial statements for the previous year.
CastlePoint Re is also subject to dividend limitations imposed by Bermuda. Under
the Companies Act 1981 of Bermuda, as amended (the "Companies Act"), we may
declare or pay a dividend out of distributable reserves only if we have
reasonable grounds for believing that we are, or would after the payment, be
able to pay our liabilities as they become due and if the realizable value of
our assets would thereby not be less than the aggregate of our liabilities and
issued share capital and share premium accounts.
The other insurance subsidiaries are subject to similar restrictions, usually
related to policyholders' surplus, unassigned surplus or net income and notice
requirements of their domiciliary state. As of December 31, 2011, the amount of
distributions that our insurance subsidiaries could pay to Tower without
approval of their domiciliary Insurance Departments was $29.3 million. In
addition, we can return capital of $61.0 million from CastlePoint Re without
permission from the Bermuda Monetary Authority.
The management companies are not subject to any statutory limitations on their
dividends to the Holding Company. The management companies declared dividends of
$19.9 million, $7.5 million and $ 6.0 million in 2011, 2010 and 2009,
respectively.
Pursuant to a tax allocation agreement, we compute and pay Federal income taxes
on a consolidated basis. At the end of each consolidated return year, each
entity must compute and pay to the Holding Company its share of the Federal
income tax liability primarily based on separate return calculations. The tax
allocation agreement allows the Holding Company to make certain Code elections
in the consolidated Federal tax return. In the event such Code elections are
made, any benefit or liability is accrued or paid by each entity. If a unitary
or combined state income tax return is filed, each entity's share of the
liability is based on the methodology required or established by state income
tax law or, if none, the percentage equal to each entity's separate income or
tax divided by the total separate income or tax reported on the return.
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.
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Commitments
The following table summarizes information about contractual obligations and
commercial commitments. The minimum payments under these agreements as of
December 31, 2011 were as follows:
Payments due by period
Less than After 5
($ in millions) Total 1 Year 1-3 Years 4-5 Years Years
Subordinated Debentures $ 235.1 $ - $ - $ - $ 235.1
Interest on subordinated debentures and
interest rate swaps 405.1 16.4 32.9 32.9 322.9
Convertible senior notes 150.0 - 150.0 - -
Interest on convertible senior notes 30.0 7.5 15.0 7.5 -
Credit facility 50.0 50.0 - - -
Operating lease obligations 68.6 9.5 17.0 14.4 27.7
Capital lease obligation 39.9 7.8 17.7 14.4 -
Gross loss reserves 1,635.7 666.0 589.3 242.7 137.7
Limited partnership funding commitments 14.7 14.7 - - -
Total contractual obligations $ 2,629.1 $ 771.9 $ 821.9 $ 311.9$ 723.4
At various times over the past nine years we have issued trust preferred
securities through wholly-owned Delaware statutory business trusts. The trusts
used the proceeds of the sale of the trust preferred securities to third-party
investors and common trust securities to Tower to purchase junior subordinated
debentures from the Company. The terms of the junior subordinated debentures
match the terms of the trust preferred securities. Interest on the junior
subordinated debentures and the trust preferred securities is payable quarterly.
In some cases, the interest rate is fixed for an initial period of five years
after issuance and then floats with changes in the London Interbank Offered Rate
("LIBOR"). In other cases the interest rate floats with LIBOR without any
initial fixed-rate period. See "Note 12 - Debt" for the principal terms of the
subordinated debentures. The interest on the subordinated debentures is
calculated using interest rates in effect at December 31, 2011 for variable rate
debentures.
We do not consolidate the statutory business trusts for which we hold 100% of
the common trust securities because we are not the primary beneficiary of the
trusts. Our investments in common trust securities of the statutory business
trusts are reported in Other Assets. We report as a liability the outstanding
subordinated debentures issued to the statutory business trusts.
Under the terms for all of the trust preferred securities, an event of default
may occur upon:
• non-payment of interest on the trust preferred securities, unless such
non-payment is due to a valid extension of an interest payment period;
• non-payment of all or any part of the principal of the trust preferred
securities;
• our failure to comply with the covenants or other provisions of the
indentures or the trust preferred securities; or
• bankruptcy or liquidation of us or the trusts.
If an event of default occurs and is continuing, the entire principal and the
interest accrued on the affected trust preferred securities and junior
subordinated debentures may be declared to be due and payable immediately.
Pursuant to the terms of our subordinated debentures, we and our subsidiaries
cannot declare or pay any dividends if we are in default or have elected to
defer payments of interest on the subordinated debentures.
In October 2010, the Company effected interest rate swap contracts with $190
million notional on the subordinated debentures. Certain of these subordinated
debentures are currently paying a variable interest rate and other subordinated
debentures will convert to variable rates over the next year. The interest rate
swaps will fix the variable interest payments on the subordinated debentures to
rates from 5.1% to 5.9%. The interest rate swaps mature in 2015.
In September 2010, the Company issued $150 million principal amount of 5.0%
convertible senior notes (the "Notes") due September 2014. Interest is being
paid semi-annually commencing March 2011. Holders may convert their Notes into
cash or common shares, at the Company's option, at any time on or after
March 15, 2014 or earlier under certain circumstances determined by: (i) the
market price of the Company's stock, (ii) the trading price of the Notes, or
(iii) the occurrence of specified corporate transactions. Upon conversion, the
Company intends to settle its obligation either entirely or partially in cash.
The Company has been adjusting the conversion rate quarterly as the Company pays
its quarterly dividend. At December 31, 2011 the conversion rate is 36.6865
shares of common stock per $1,000 principal amount of the Notes (equivalent to a
conversion price of $27.26 per share), subject to further adjustment upon the
occurrence of certain events, including future dividend payments. Additionally,
in the event of a fundamental change, the holders may require the Company to
repurchase the Notes for a cash price equal to 100% of the principal plus any
accrued and unpaid interest.
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In May 2010, the Company entered into a $125.0 million credit facility
agreement. The credit facility is a revolving credit facility with a letter of
credit sublimit of $25.0 million. The credit facility is being used for general
corporate purposes. The Company may request that the facility be increased by an
amount not to exceed $50.0 million, and the facility expires May 2013. The
Company has $50.0 million outstanding under the credit facility as of
December 31, 2011. The Company had no balance outstanding under the credit
facility as of December 31, 2010.
On February 15, 2012, the Company amended its $125.0 million credit facility by
increasing borrowing capacity up to $150 million, extending the maturity out to
February 2016, and resetting borrowing fees to more favorable current market
terms.
The gross loss reserve payments due by period in the table above are based upon
the loss and loss expense reserves estimates as of December 31, 2011 and
actuarial estimates of expected payout patterns by line of business. As a
result, our calculation of loss reserve payments due by period is subject to the
same uncertainties associated with determining the level of reserves and to the
additional uncertainties arising from the difficulty of predicting when claims
(including claims that have not yet been reported to us) will be paid. The
projected gross loss payments presented do not include the estimated amounts
recoverable from reinsurers that amounted to $319.7 million, which are estimated
to be recovered as follows: less than one year, $130.2 million; one to three
years, $115.2 million; four to five years, $47.4 million; and after five years,
$26.9 million. The interest on the subordinated debentures is calculated using
interest rates in effect at December 31, 2011 for variable rate debentures.
For a discussion of our loss and LAE reserving process, see "Critical Accounting
Policies-Loss and LAE Reserves." Actual payments of losses and loss adjustment
expenses by period will vary, perhaps materially, from the above table to the
extent that current estimates of loss reserves vary from actual ultimate claims
amounts and as a result of variations between expected and actual payout
patterns. See "Risk Factors-Risks Related to Our Business-If our actual loss and
loss adjustment expense reserves exceed our loss and loss adjustment expense
reserves, our financial condition and results of operations could be
significantly adversely affected," for a discussion of the uncertainties
associated with estimating loss and LAE expense reserves. The estimated ceded
reserves recoverable referred to above also assumes timely reimbursement from
our reinsurers. If our reinsurers do not meet their contractual obligations on a
timely basis, the payment assumptions presented above could vary materially.
Capital
Our capital resources consist of funds deployed or available to be deployed to
support our business operations. At December 31, 2011 and December 31, 2010, our
capital resources were as follows:
December 31,
($ in thousands) 2011 2010
Outstanding under credit facility $ 50,000 $ -
Subordinated debentures 235,058
235,058
Convertible Senior Notes 141,843 139,208
Tower Group, Inc. stockholders' equity 1,033,799 1,042,962
Total capitalization $ 1,460,700 $ 1,417,228
Ratio of debt to total capitalization 29.2 % 26.4 %
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.
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
year ended December 31, 2011, 2.9 million shares of common stock were purchased
under this program at an aggregate consideration of $64.6 million. In the year
ended December 31, 2010, 4.0 million shares were purchased under this program at
an aggregate consideration of $88.0 million. As of December 31, 2011, $47.4
million remained available for future share repurchases under the new program.
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We may seek to raise additional capital or may seek to return additional capital
to our stockholders through share repurchases, cash dividends or other methods
(or a combination of such methods). Any such determination will be at the
discretion of our Board of Directors and will be dependent upon our profits,
financial requirements and other factors, including legal restrictions, rating
agency requirements, credit facility limitations and such other factors as our
Board of Directors deems relevant.
Cash Flows
The primary sources of consolidated cash flows are from the insurance
subsidiaries' gross premiums collected, ceding commissions from quota share
reinsurers, loss payments by reinsurers, investment income and proceeds from the
sale or maturity of investments. Funds are used by the insurance subsidiaries
for loss payments and loss adjustment expenses. The insurance subsidiaries also
use funds for ceded premium payments to reinsurers, which are paid on a net
basis after subtracting losses paid on reinsured claims and reinsurance
commissions on our net business, commissions to producers, salaries and other
underwriting expenses as well as to purchase investments, fixed assets and to
pay dividends to the Holding Company. The management companies' primary sources
of cash are management fees for acting as the attorneys-in-fact for the
Reciprocal Exchanges.
The reconciliation of net income to cash provided from operations is generally
influenced by the collection of premiums in advance of paid losses, the timing
of reinsurance, issuing company settlements and loss payments.
Cash flow and liquidity are categorized into three sources: (1) operating
activities; (2) investing activities; and (3) financing activities, which are
shown in the following table:
Year Ended December 31,
($ in thousands) 2011 2010 2009
Cash provided by (used in):
Operating activities $ 82,754 $ 197,025 $ 214,711
Investing activities (104,950 ) (260,115 ) (175,216 )
Financing activities (3,927 ) 28,087 (10,866 )
Net increase (decrease) in cash and cash equivalents (26,123 ) (35,003 ) 28,629
Cash and cash equivalents, beginning of year
140,221
175,224 146,595
Cash and cash equivalents, end of period $ 114,098 $
140,221 $ 175,224
Comparison of Years Ended December 31, 2011 and 2010
The Company continues to direct excess cash balances to higher yielding
investments to maximize investment income. Accordingly, Tower's cash balances
declined from December 31, 2010 to 2011.
For the year ended December 31, 2011, net cash provided by operating activities
was $82.8 million as compared to $197.0 million for 2010. The decrease in cash
flow for the year ended December 31, 2011 primarily resulted from a
$66.2 million cash transfer to provide collateral support for business written
on our behalf, claims payments on third quarter 2011 catastrophes and severe
storms, tornado losses in the second quarter of 2011 and winter storms in late
December 2010. These were partially offset by the receipt of a $22.0 million
Federal income tax refund in 2011.
Net cash flows used in investing activities were $105.0 million for the year
ended December 31, 2011 compared to $260.1 million used for the year ended
December 31, 2010. The year ended December 31, 2011 and 2010 included an
increase to fixed assets of $53.6 million and $36.9 million, respectively,
primarily related to the build out of new systems. The additional cash outflows
in 2010 related to the purchase of OBPL on July 1, 2010. The remaining cash
flows in both years relates to purchases and sales of fixed-maturity and equity
securities.
The net cash flows used in financing activities for the year ended December 31,
2011 are primarily the result of uses of cash for the repurchase of common stock
for $64.6 million and dividends of $27.9 million offset by cash inflows from a
$50.0 million drawdown of our line of credit and $39.8 million from capital
lease financings related to the aforementioned systems costs, and other fixtures
and equipment. In 2010, the Company had uses of cash for the repurchase of
common stock and dividend payments of $88.0 million and $16.6 million,
respectively, offset by net cash inflows of $134.1 million for the issuance of
the senior convertible notes, senior convertible noted hedge, and warrants.
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.
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Comparison of Years Ended December 31, 2010 and 2009
For the year ended December 31, 2010, net cash provided by operating activities
was $197.0 million as compared to $214.7 million for 2009. The decrease in cash
flow for the year ended December 31, 2010 primarily resulted from increased
claims payments offset by reductions in cash paid for income taxes attributed to
2009 tax overpayments and increased tax deductions in 2010 relating to capital
losses from the sale of certain fixed income securities.
Net cash flows used in investing activities were $260.1 million for the year
ended December 31, 2010 compared to $175.2 million used for the year ended
December 31, 2009. The year ended December 31, 2009 included net cash acquired
of $226.7 million with the acquisitions of CastlePoint and Hermitage whereas for
the year ended December 31, 2010 we used $171.9 million net cash to acquire OBPL
and AequiCap. The remaining cash flows in both years primarily related to
purchases and sales of fixed-maturity securities and preferred stock.
The net cash flows provided by financing activities for the year ended
December 31, 2010 primarily result from net cash inflows of $134.1 million for
the issuance of the senior convertible notes, senior convertible noted hedge,
and warrants offset by uses of cash for the repurchase of common stock and
dividend payments of $88.0 million and $16.6 million, respectively.
Cash flow needs at the holding company level are primarily for dividends to our
stockholders and interest payments on our outstanding debt.
Insurance Subsidiaries
The insurance subsidiaries maintain sufficient liquidity to pay claims,
operating expenses and meet other obligations. We held $114.1 million and
$140.2 million of cash and cash equivalents at December 31, 2011 and 2010,
respectively. We monitor the expected claims payment needs and maintain a
sufficient portion of our invested assets in cash and cash equivalents to enable
us to fund the claims payments without having to sell longer-duration
investments. As necessary, we adjust the holdings of short-term investments and
cash and cash equivalents to provide sufficient liquidity to respond to changes
in the anticipated pattern of claims payments. See "Business-Investments."
As of December 31, 2011 and 2010, Tower's insurance subsidiaries had $340.8
million and $261.1 million, respectively, of cash and investment balances held
as collateral with counterparties or in New York Regulation 114 type compliant
trust accounts to support letters of credit issued on behalf of the insurance
subsidiaries, other reinsurance payable amounts and certain lease obligations.
In addition, $226.8 million and $188.5 million of investment balances were on
deposit with various states to comply with insurance laws of the states in which
the Company's insurance subsidiaries are licensed.
In 2011 and 2010, the Holding Company made no capital contributions to the
insurance subsidiaries. In 2009, the Holding Company contributed $6.6 million to
two separate insurance subsidiaries.
The insurance subsidiaries are required by law to maintain a certain minimum
level of policyholders' surplus on a statutory basis. Policyholders' surplus is
calculated by subtracting total liabilities from total assets. The NAIC
maintains risk-based capital ("RBC") requirements for property and casualty
insurance companies. RBC is a formula that attempts to evaluate the adequacy of
statutory capital and surplus in relation to investments and insurance risks.
The formula is designed to allow the state Insurance Departments to identify
potential weakly capitalized companies. Under the formula, a company determines
its risk-based capital by taking into account certain risks related to the
insurer's assets (including risks related to its investment portfolio and ceded
reinsurance) and the insurer's liabilities (including underwriting risks related
to the nature and experience of its insurance business). Applying the RBC
requirements as of December 31, 2011, 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 loss adjustment expenses 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
expenses 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 3 - Accounting Policies and
Basis of Presentation" of Notes to Consolidated Financial Statements.
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