TOWER GROUP, INC. – 10-K – Management’s Discussion and Analysis of Financial Condition and Results of Operations

Edgar Online, Inc.

 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. 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, particularly under the headings "Business-Risk Factors" and "Business-Note on Forward-Looking Statements."  

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. 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.  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                                           44 

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  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 3 - 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.                                           45

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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.                                           46

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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.  

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.

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  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                               $ 56,048      $  97,155      $ 107,288   Net realized gains (losses) on investments        6,980         13,740          1,501   Acquisition-related transaction costs              (360 )       (2,369 )      (14,038 )   Income tax                                       (2,470 )       (4,636 )        2,047    Net income attributable to Tower Group, Inc.   $ 60,198      $ 103,890      $  96,798   

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."  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                                           48 

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  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.  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.                                           49

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  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, $2.7 million and $2.2 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.                                           50 

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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, $16.1 million and $44.2 million in 2011, 2010, and 2009, respectively, of which $3.2 million, $4.2 million and $23.5 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 5 - 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 7 - Goodwill and Intangible Assets" in the notes to consolidated financial statements.                                           51

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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                      $     8.7      $ (31.2)         

-78% $ 39.9$ (44.2) -53% $ 84.1 Personal insurance segment underwriting profit (loss) (1)

               (13.7)       (21.2)        -283%           7.5         11.1         -308%          (3.6) Insurance services segment pretax income (2)                                    11.5         (2.7)         -19%          14.2         13.3           NM            0.9 Net investment income                        127.6         21.5           20%         106.1         31.2           42%          74.9 Net realized gains on investments, including other-than-temporary impairments                                    9.4         (4.1)         -30%          13.5         12.0           NM            1.5 Corporate expenses                           (11.4)        (7.2)         178%          (4.2)        (0.3)           5%          (3.9) Acquisition-related transaction costs         (0.4)         2.0          -83%          (2.4)        11.6          -83%         (14.0) Interest expense                             (34.4)        (9.8)          40%         (24.6)        (6.5)          36%         (18.1) Other income (expense)                           -          0.4        

-100% (0.4) (20.2) -103% 19.8 Income before income taxes

                    97.3        (52.3)         -35%         149.6          8.0            6%         141.6 Income tax expense                            25.2        (25.2)         -50%          50.4          5.6           13%          44.8  Net income                               $    72.1      $ (27.1)         -27%     $    99.2      $   2.4            2%     $    96.8  Less net income (loss) attributable to Reciprocal Exchanges                          11.9         16.6         -353%          (4.7)           -            -              -  Net income attributable to Tower Group, Inc.                              $    60.2      $ (43.7)         -42%     $   103.9      $   7.1            7%     $    96.8  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      $  314.6          21%     $  1,496.4     $ 425.7           40%     $ 1,070.7 Produced by Insurance Services segment           -            -            -              -        (11.7)        -100%          11.7  Total                                    $ 1,810.9      $  314.6          21%     $ 1,496.4      $ 413.9          -60%     $ 1,082.4                                                                        Year Ended December 31,                                                                 2011        2010        2009  Percent of total revenues: Net premiums earned                                              89.7%       88.7%       86.9% Commission and fee income (3)                                     2.6%        3.1%        5.3% Net investment income                                             7.2%        7.3%        7.6% Net realized investment gains(losses)                             0.5%      

0.9% 0.2%

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%       35.0% Net Combined Ratios                                             100.3%       96.4%       90.6%  Return on average equity (5)                                      5.8%       10.0%       12.7%   

(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.                                           52

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  (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 21.8% 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 $0.4 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 20.3% 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 $13.5 million in 2010. OTTI losses recorded in earnings for the year ended December 31, 2011 were $3.2 million, a decline from $4.2 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.  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.                                           53

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  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 $589.6 million for the year ended December 31, 2011, an increase of 18.5% 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 $9.9 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 25.9% for the year ended December 31, 2011, compared to 33.7% 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 reversal of a $1.3 million 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 to $7.2 million in 2011 as compared to $4.9 million in 2010, and (ii) the decline in pre-tax income from 2010 to 2011. Also, the Company reduced the valuation allowance for the Reciprocal Exchanges in by $1.3 million in 2011, whereas no change to the valuation allowance was recorded in 2010.  Net income and return on average equity. Net income and annualized return on average equity attributable to Tower Group, Inc. were $60.2 million and 5.8% for the year ended December 31, 2011 compared to $103.9 million and 10.0% for the year ended December 31, 2010. The return on average equity is calculated by dividing net income by average stockholders' equity. Average stockholders' equity was $1,041.7 million and $1,039.1 million at December 31, 2011 and 2010, respectively.  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.                                           54

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Consolidated Results of Operations 2010 Compared to 2009

  Total revenues. Total revenues increased by 48.4% 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 $5.5 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 41.7% 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 $13.5 million for the year ended December 31, 2010 compared to gains of $1.5 million in the same period last year. This increase is due in part to a $19.3 million decline in OTTI losses recognized in earnings from $23.5 million in 2009 to $4.2 million in 2010, offset by a $7.3 decline in capital realized gains from sales of securities from $25.0 million in 2009 to $17.7 million in 2010.  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.                                           55

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  Operating expenses. Operating expenses were $497.7 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 $6.5 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 $19.8 million whereas in 2010, we recorded other expenses of $0.4 million. The other income in 2009 consisted of $13.2 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. Other expenses in 2010 were not significant at $0.4 million.  Income tax expense. Income tax expense increased in 2010 compared to 2009. The increase in the income tax expense is attributable to the higher income before taxes in the current year, a higher effective tax rate in 2010 and an increase in state taxes from fee income associated with managing the Reciprocal Exchanges. The effective income tax rate (including state and local taxes) was 33.7% for the year ended December 31, 2010, compared to 31.6% 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 $ 103.9 million and 10.0% for the year ended December 31, 2010 compared to $96.8 million and 12.7% 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 $1,039.1 million and $761.9 million at December 31, 2010 and 2009, respectively.                                           56

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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       (17.2)       -53.9%        32.0        (7.4)       -18.5%        39.4 Policy billing fees                           4.3         1.5         58.5%         2.8         0.6         22.7%         2.2  Total revenue                             1,107.0       131.2         13.5%       975.8       196.0         25.1%       779.8   Expenses

Net loss and loss adjustment expenses 736.5 147.2 25.0%

       589.3       182.6         44.9%       406.7 Underwriting expenses Direct commission expenses                  209.9        18.5          9.6%       191.4        17.1          9.8%       174.3 Other underwriting expenses                 151.9        (3.3)        -2.1% 

155.2 40.5 35.3% 114.7

  Total underwriting expenses                 361.8        15.2          4.4%       346.6        57.6         19.9%       289.0  Underwriting profit                     $     8.7     $ (31.2)       -78.3%     $  39.9     $ (44.2)       -52.6%     $  84.1                                                       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%       33.5%             Net combined                        99.2%       95.7%       88.6%   

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 $17.2 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</chron> 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.                                           57

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  Underwriting expenses and underwriting expense ratio. Underwriting expenses, which include direct commissions and other underwriting expenses, increased by $15.2 million, or 4.4%, 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 31.3% in 2010. The commission portion of the gross underwriting expense ratio, which is expressed as a percentage of gross premiums earned, was 17.8% for the year ended December 31, 2011 compared to 17.4% 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 12.5% 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 $1,083.8 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 $7.4 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.                                           58 

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  We increased reserves for prior years by approximately <money>$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 $57.6 million from 2009 to 2010. The increase in underwriting expenses resulted from the increase in gross premiums earned, which was primarily due to the acquisitions discussed above. The gross underwriting expense ratio was 31.3% for the year ended December 31, 2010 as compared to 32.3% for 2009. The net expense ratio was 33.1% for the year ended December 31, 2010 as compared to 33.5% for 2009.  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, was 17.4% for the year ended December 31, 2010 compared to 19.6% 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 88.6% 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 describe above.                                           59

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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                 68.9             32.5        101.4         26.6          35.7%        56.4             18.4         74.8 Other underwriting expenses                73.1             51.7        124.8         40.6          48.2%        59.9             24.3         84.2  Total underwriting expenses               142.0             84.2        226.2         67.2          42.2%       116.3             42.7        159.0  Underwriting profit (loss)              $ (19.6)     $       5.9      $ (13.7)     $ (21.2)       -281.7%     $   16.2     $      (8.7)     $    7.5   Ratios Net calendar year loss and LAE             67.2%            55.8%        63.0%                                   51.4%            66.3%        55.4% Net underwriting expenses                  38.9%            41.0%        39.7%                                   42.3%            43.0%        42.5% Net combined                              106.1%            96.8%       102.7%                                   93.7%           109.3%        97.9%                                                                         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         32.5%         4.6 Policy billing fees                         3.1              0.3          3.4          2.7        381.9%         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        183.1%        68.8 Underwriting expenses Direct commission expenses                 56.4             18.4         74.8         46.1        160.0%        28.7 Other underwriting expenses                59.9             24.3         

84.2 56.3 177.7% 27.9

  Total underwriting expenses               116.3             42.7        

159.0 102.4 180.6% 56.6

  Underwriting profit (loss)              $  16.2      $      (8.7)     $   

7.5 $ 11.1 306.5% $ (3.6)

Ratios

 Net calendar year loss and LAE             51.4%            66.3%        55.4%                                  59.1% Net underwriting expenses                  42.3%            43.0%        42.5%                                  44.1% Net combined                               93.7%           109.3%        97.9%                                 103.2%   

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.                                           60 

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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 $67.2 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 36.0% in 2011 from 36.8% in 2010. The commission portion of the gross underwriting expense ratio was 16.6% 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 19.4% and 19.1% 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.  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.                                           61 

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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 $102.4 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 1.6 percentage points from 44.1% in 2009 to 42.5% in 2010.

  The gross underwriting expense ratio for 2010 was 36.8%, as compared to 35.3% 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 19.1% compared with 17.2% in 2009. The increase in the OUE expense ratio relates primarily to increases in expenses attributed to OBPL, including the transition service agreements Tower entered into with OneBeacon whereby OneBeacon will provide certain information technology and operational support to Tower.  Underwriting profit and combined ratio. The net combined ratio for the Personal Insurance segment was 97.9% in 2010, 5.3 points better than prior year. Underwriting income of $7.5 million was $11.1 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.                                           62 

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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            1.4          33.3%            4.2  Total expenses                                19.4           13.7        240.4%            5.7            1.4          33.3%            4.2 

Insurance services pre-tax income $ 11.5$ (2.7) -19.0% $ 14.2$ 13.4

            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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  Table of Contents  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                    852,287          36,059           (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            2,307,164          90,097          (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                                  $   2,399,942     $    92,584     $    (16,677)     $      (1,361)     $   2,474,488       100.0%  Tower                                  $   2,061,448     $    87,879     $    (14,532)     $      (1,361)     $   2,133,434 Reciprocal Exchanges                         338,494           4,705           (2,145)                 -            341,054  Total, December 31, 2010               $   2,399,942     $    92,584     $    (16,677)     $      (1,361)     $   2,474,488   

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:                                           64 

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  Table of Contents                                            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                            512,102           526,746          65,993          66,771           578,095           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                                  $   1,968,670     $   2,041,557     $   338,494     $   341,054     $   2,307,164     $   2,382,611                                             65 

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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.                                           66

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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 $25.0 million, which was also our cost basis.  As more fully described in Note 5 to our consolidated financial statements, "Investments-Impairment Review," we completed a detailed review of all our securities in a continuous loss position, including but not limited to residential and commercial mortgage-backed securities, and concluded that the unrealized losses in these asset classes are the result of a decrease in value due to technical spread widening and broader market sentiment.  "Note 6-Fair Value Measurements" to the consolidated financial statements provides a description of the valuation methodology utilized to value Level 3 assets, how the valuation methodology is validated and an analysis of the change in fair value of Level 3 assets. As of December 31, 2011, the fair value of Tower Level 3 assets as a percentage of Tower's total assets carried at fair value was as follows (the Reciprocal Exchanges had no Level 3 assets):                                                                                                 Level 3 Assets                                           Assets Carried at                                as a Percentage of                                             Fair Value at           Fair Value of         Total Assets Carried ($ 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%    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.

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  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)   

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:                                           68

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   Table of Contents                                                                 Total               Decline of Investment Value                                                             Gross                                             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 5-Investments" in our consolidated financial statements for further information about impairment testing and other-than-temporary impairments.

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:

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  Table of Contents  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%)                                             70 

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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.

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:

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  Table of Contents                                                                      Payments due by period                                                         Less than 1                                      After 5 ($ in millions)                            Total           Year           1-3 Years       4-5 Years       Years  Subordinated Debentures                  $   235.1     $           -     $         -     $         -     $  235.1 Interest on subordinated debentures and interest rate swaps                      406.1              16.4            32.9            32.9        323.9 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            $ 2,630.1     $       771.9     $  

821.9 $ 311.9$ 724.4

    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.                                           72 

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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     1,034,142        1,045,001          Total capitalization                     $ 1,461,043      $ 1,419,267          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.                                           73 

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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                                   $   85,028      $  197,025      $  214,711 Investing activities                                     (107,224)       (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         

164,882 146,595

  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 $74.3 million as compared to $170.0 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 $107.2 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 2-Accounting Policies and Basis of Presentation" of Notes to Consolidated Financial Statements.

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