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TOWER GROUP, INC. – 10-Q/A – Management’s Discussion and Analysis of Financial Condition and Results of Operations
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Note on Forward-Looking Statements
Some of the statements under "Risk Factors," "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Business" and elsewhere in this Form 10-Q may include forward-looking statements that reflect our current views with respect to future events and financial performance. These statements include forward-looking statements both with respect to us specifically and to the insurance sector in general. Statements that include the words "expect," "intend," "plan," "believe," "project," "estimate," "may," "should," "anticipate," "will" and similar statements of a future or forward-looking nature identify forward-looking statements for purposes of the Federal securities laws or otherwise. All forward-looking statements address matters that involve risks and uncertainties. Accordingly, there are or will be important factors that could cause our actual results to differ materially from those indicated in these statements. We believe that these factors include, but are not limited to, those described under "Risk Factors" and the following:
• ineffectiveness or obsolescence of our business strategy due to changes in
current or future market conditions;
• developments that may delay or limit our ability to enter new markets as
quickly as we anticipate;
• increased competition on the basis of pricing, capacity, coverage terms or
other factors; • greater frequency or severity of claims and loss activity, including as a
result of natural or man-made catastrophic events, than our underwriting,
reserving or investment practices anticipate based on historical experience
or industry data; • the effects of acts of terrorism or war; • developments in the world's financial and capital markets that could adversely affect the performance of our investments;
• changes in regulations or laws applicable to us, our subsidiaries, brokers or
customers;
• changes in acceptance of our products and services, including new products
and services;
• changes in the availability, cost or quality of reinsurance and failure of
our reinsurers to pay claims timely or at all;
• changes in the percentage of our premiums written that we cede to reinsurers;
• decreased demand for our insurance or reinsurance products;
• loss of the services of any of our executive officers or other key personnel;
• the effects of mergers, acquisitions or divestitures; • changes in rating agency policies or practices; • changes in legal theories of liability under our insurance policies; • changes in accounting policies or practices;
• changes in general economic conditions, including inflation, interest rates
and other factors;
• disruptions in Tower's business arising from the integration of acquired
businesses into Tower and the anticipation of potential or pending acquisitions or mergers; and
• currently pending or future litigation or governmental proceedings.
The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included in this Form 10-Q. We undertake no obligation to publicly update or review any forward-looking statement, whether as a result of new information, future developments or otherwise. If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may vary materially from what we project. Any forward-looking statements you read in this Form 10-Q reflect our views as of the date of this Form 10-Q with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, growth strategy and liquidity. All subsequent written and oral forward-looking statements attributable to us or individuals acting on our behalf are expressly qualified in their entirety by this paragraph. Before making an investment decision, you should specifically consider all of the factors identified in this Form 10-Q that could cause actual results to differ. 34
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Overview
Tower, through its subsidiaries, offers a broad range of commercial, specialty and personal property and casualty insurance products and services to businesses in various industries and to individuals throughoutthe United States . We provide coverage for many different market sectors, including non-standard risks that do not fit the underwriting criteria of standard risk carriers due to factors such as type of business, location and premium per policy. We provide these products on both an admitted and excess and surplus ("E&S") basis (under NAIC rules).
The Company operates three business segments:
OurCommercial Insurance segment offers property and casualty insurance products through several business units that serve customers in general commercial and specialty markets. Our commercial lines products include commercial multiple-peril (provides both property and liability insurance), monoline general liability (insures bodily injury or property damage liability), commercial umbrella, monoline property (insures buildings, contents or business income), workers' compensation, fire and allied lines, inland marine, commercial automobile policies and assumed reinsurance. OurPersonal Insurance segment offers a broad range of products designed to fit the insurance needs of most personal lines customers. This segment includes the business written in the Reciprocal Exchanges. Our personal lines products consist of homeowners, personal automobile and umbrella policies. In the first quarter of 2012, Tower sold one of its insurance subsidiaries to the Reciprocal Exchanges. As a result, the Reciprocal Exchanges have expanded their licensing and increased their capacity to write business. In our Insurance Services segment, we generate management fees primarily from the services provided by management companies to the Reciprocal Exchanges and other fees generated by the managing general agencies.
Operating Income
Operating income excludes realized gains and losses and acquisition-related transaction costs, net of tax. This is a common measurement for property and casualty insurance companies. We believe this presentation enhances the understanding of our results of operations by highlighting the underlying profitability of our insurance business. Additionally, these measures are a key internal management performance standard. The following table provides a reconciliation of operating income to net income on a GAAP basis. The operating income is used to calculate operating earnings per share and operating return on average equity: Three Months Ended Six Months Ended June 30, June 30, 2012 2012 ($ in thousands) (restated) 2011 (restated) 2011 Operating income $ (17,313 ) $ 25,692 $ 3,305 $ 45,198 Net realized gains (losses) on investments, excluding gains (losses) attributable to Reciprocal Exchanges 1,676 (2,857 ) 1,028 5,380 Acquisition-related transaction costs (720 ) - (1,982 ) (12 ) Income tax (452 ) 1,572 5 (1,882 ) Net income attributable to Tower Group, Inc. $ (16,809 ) $ 24,407 $ 2,356 $ 50,928
Critical Accounting Estimates
As ofJune 30, 2012 , there were no material changes to our critical accounting estimates; refer to the Company's 2011 Annual Report on Form 10-K for a complete discussion of critical accounting estimates.
Critical Accounting Policies
See "Note 3-Accounting Policies and Basis of Presentation" for information related to updated accounting policies.
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Consolidating Supplemental Information
The following tables present the consolidating financial statements as ofJune 30, 2012 andDecember 31, 2011 and for the three and six months endedJune 30, 2012 and 2011: June 30, 2012, as restated Reciprocal Elimin- ($ in thousands) Tower Exchanges ations Total Assets Investments Available-for-sale investments, at fair value: Fixed-maturity securities $ 2,060,802 $ 299,172 $ - $ 2,359,974 Equity securities 128,490 7,903 - 136,393 Short-term investments - - - - Other invested assets 129,533 - (77,200 ) 52,333 Total investments 2,318,825 307,075 (77,200 ) 2,548,700 Cash and cash equivalents 192,099 6,906 - 199,005 Investment income receivable 37,519 3,078 (13,364 ) 27,233 Premiums receivable 363,432 42,791 (808 ) 405,415 Reinsurance recoverable on paid losses 21,503 1,799 (4,226 ) 19,076 Reinsurance recoverable on unpaid losses 281,959 28,979 (9,318 ) 301,620 Prepaid reinsurance premiums 39,272 16,611 (192 ) 55,691 Deferred acquisition costs, net 172,749 12,758 - 185,507 Intangible assets 103,772 7,146 - 110,918 Goodwill 245,548 - - 245,548 Funds held by reinsured companies 133,968 - - 133,968 Other assets 297,622 2,981 (16,344 ) 284,259 Total assets $ 4,208,268 $ 430,124 $ (121,452 ) $ 4,516,940 Liabilities - - - -
Loss and loss adjustment expenses
$ (9,318 ) $ 1,701,833 Unearned premium 823,048 103,600 (192 ) 926,456 Reinsurance balances payable 9,543 9,909 (5,034 ) 14,418 Funds held under reinsurance agreements 91,142 - - 91,142 Other liabilities 224,846 40,929 (29,908 ) 235,867 Deferred income taxes 26,546 19,287 - 45,833 Debt 448,291 77,000 (77,000 ) 448,291 Total liabilities 3,191,702 393,590 (121,452 ) 3,463,840 Stockholders' equity Common stock 468 - - 468 Treasury stock (181,324 ) - - (181,324 ) Paid-in-capital 775,542 8,826 8,826 775,542 Accumulated other comprehensive income 76,675 18,769 (18,769 ) 76,675 Retained earnings 343,204 8,939 (8,939 ) 343,204 Noncontrolling interests 2,001 0 36,534 38,535 Total stockholders' equity 1,016,566 36,534 - 1,053,100 Total liabilities and stockholders' equity $ 4,208,268 $ 430,124 $ (121,452 ) $ 4,516,940 36
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Table of Contents December 31, 2011 Reciprocal Elimin- ($ in thousands) Tower Exchanges ations Total Assets Investments Available-for-sale investments, at fair value: Fixed-maturity securities $ 2,153,620 $ 300,054 $ - $ 2,453,674 Equity securities 87,479 1,866 - 89,345 Short-term investments - - - - Other invested assets 121,547 - (77,200 ) 44,347 Total investments 2,362,646 301,920 (77,200 ) 2,587,366 Cash and cash equivalents 113,432 666 - 114,098 Investment income receivable 33,842 2,978 (10,038 ) 26,782 Premiums receivable 382,261 44,171 - 426,432 Reinsurance recoverable on paid losses 18,233 6,326 (656 ) 23,903 Reinsurance recoverable on unpaid losses 308,411 20,134 (8,881 ) 319,664 Prepaid reinsurance premiums 39,352 14,685 - 54,037 Deferred acquisition costs, net 156,992 11,866 - 168,858 Intangible assets 110,081 4,839 - 114,920 Goodwill 245,548 - - 245,548 Funds held by reinsured companies 69,755 - - 69,755 Other assets 320,460 1,410 (15,575 ) 306,295 Total assets $ 4,161,013 $ 408,995 $ (112,350 ) $ 4,457,658 Liabilities Loss and loss adjustment expenses $ 1,495,839 $ 145,155 $ (8,881 ) $ 1,632,113 Unearned premium 790,185 102,991 - 893,176 Reinsurance balances payable 17,328 4,122 (656 ) 20,794 Funds held under reinsurance agreements 96,726 - - 96,726 Other liabilities 279,766 35,441 (25,813 ) 289,394 Deferred income taxes 18,468 18,907 - 37,375 Debt 426,901 77,000 (77,000 ) 426,901 Total liabilities 3,125,213 383,616 (112,350 ) 3,396,479 Stockholders' equity Common stock 465 - - 465 Treasury stock (158,185 ) - - (158,185 ) Paid-in-capital 772,938 7,048 (7,048 ) 772,938 Accumulated other comprehensive income 63,053 12,840 (12,840 ) 63,053 Retained earnings 355,528 5,491 (5,491 ) 355,528 Noncontrolling interests 2,001 - 25,379 27,380 Total stockholders' equity 1,035,800 25,379 - 1,061,179 Total liabilities and stockholders' equity $ 4,161,013 $ 408,995 $ (112,350 ) $ 4,457,658 37
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Three Months Ended June 30, 2012 (restated) 2011 Reciprocal Elimina- Reciprocal Elimina- ($ in thousands) Tower Exchanges tions Total Tower Exchanges tions Total Revenues Net premiums earned $ 417,612 $ 42,541
$ -
- $ 393,530 Ceding commission revenue 6,855 3,225 - 10,080 7,707 1,548 - 9,255 Insurance services revenue 9,324 - (7,965 ) 1,359 7,631 - (7,704 ) (73 ) Policy billing fees 2,871 129 - 3,000 2,512 147 - 2,659 Net investment income 30,268 3,177 (1,664 ) 31,781 30,419 3,051 (1,672 ) 31,798 Total net realized investment gains (losses) 110 129 - 19 (2,857 ) 543 - (2,314 ) Total revenues 466,820 49,201 (9,629 ) 506,392 388,201 56,030 (9,376 ) 434,855 Expenses Loss and loss adjustment expenses 322,842 26,933 - 349,775 213,680 26,876 - 240,556 Direct and ceding commission expense 87,024 8,162 - 95,186 69,413 6,484 - 75,897 Other operating expenses 72,533 13,532 (7,965 ) 78,100 63,303 14,761 (7,704 ) 70,360 Acquisition-related transaction costs 720 - - 720 - - - - Interest expense 7,902 1,664 (1,664 ) 7,902 8,225 1,672 (1,672 ) 8,225 Total expenses 491,021 50,291 (9,629 ) 531,683 354,621 49,793 (9,376 ) 395,038 Income (loss) before income taxes (24,201 ) (1,090 ) - (25,291 ) 33,580 6,237 - 39,817 Income tax expense (benefit) (7,392 ) (1,527 ) - (8,919 ) 9,173 3,538 - 12,711 Net income (loss) $ (16,809 ) $ 437
$ - $ (16,372 )
- $ 27,106 Ratios Net calendar year loss and LAE 77.3 % 63.3 % 76.0 % 62.3 % 53.0 % 61.1 % Net underwriting expenses 33.9 % 43.1 % 34.8 % 33.1 % 38.5 % 33.8 % Net Combined 111.2 % 106.4 % 110.8 % 95.4 % 91.5 % 94.9 % Return on Average Equity -6.5 % 9.3 % 38
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Table of Contents Six Months Ended June 30, 2012 (restated) 2011 Reciprocal Elimina- Reciprocal Elimina- ($ in thousands) Tower Exchanges tions Total Tower Exchanges tions Total Revenues Net premiums earned $ 796,281 $
84,030 $ -
8,933 6,310 - 15,243 15,924 2,912 - 18,836 Insurance services revenue 16,683 - (14,827 ) 1,856 14,928 - (14,399 ) 529 Policy billing fees 5,873 261 - 6,134 4,546 291 - 4,837 Net investment income 62,525 6,526 (3,327 ) 65,724 59,932 6,395 (3,326 ) 63,001 Total net realized investment gains (losses) 1,028 2,319 - 3,347 5,380 (334 ) - 5,046 Total revenues 891,323 99,446 (18,154 ) 972,615 778,036 105,263 (17,725 ) 865,574 Expenses Loss and loss adjustment expenses 566,091 51,177 - 617,268 430,418 50,604 - 481,022 Direct and ceding commission expense 159,636 15,935 - 175,571 134,953 17,058 - 152,011 Other operating expenses 143,529 26,469 (14,827 ) 155,171 123,832 26,927 (14,399 ) 136,360 Acquisition-related transaction costs 1,982 - - 1,982 12 - - 12 Interest expense 16,513 3,327 (3,327 ) 16,513 16,325 3,326 (3,326 ) 16,325 Total expenses 887,751 96,908 (18,154 ) 966,505 705,540 97,915 (17,725 ) 785,730 Income (loss) before income taxes 3,572 2,538 - 6,110 72,496 7,348 - 79,844 Income tax expense (benefit) 1,216 (910 ) - 306 21,568 321 - 21,889 Net income (loss) $ 2,356 $ 3,448 $ - $ 5,804 $ 50,928 $ 7,027 $ - $ 57,955 Ratios Net calendar year loss and LAE 71.1 % 60.9 % 70.1 % 63.5 % 52.7 % 62.2 % Net underwriting expenses 34.3 % 42.6 % 35.1 % 32.9 % 42.5 % 34.1 % Net Combined 105.4 % 103.5 % 105.2 % 96.4 % 95.2 % 96.3 % Return on Average Equity 0.5 % 9.7 %
Consolidated Results of Operations
Our results of operations are discussed below in two parts, consolidated results of operations and the results of each of our three segments.
Consolidated Results of Operations for the Three and Six Months Ended
Total revenues. Total revenues increased by 16.5% and 12.4%, respectively for the three and six months endedJune 30, 2012 compared to the same periods in 2011. This increase is primarily attributed to the increases in earned premiums. Premiums earned. Gross premiums earned for the three and six months endedJune 30, 2012 were$508.6 million and$971.7 million , respectively, and$445.8 million and$869.8 million for the same periods in 2011, respectively. These increases of 14.1 % and 11.7 %, respectively, for the three and six month periods are primarily a result of increased business in Tower's continuing programs and assumed reinsurance lines in theCommercial Insurance segment. Ceded premiums earned declined$3.9 million to$48.4 million for the three months endedJune 30, 2012 from$52.3 million in 2011. For the six months endedJune 30, 2012 , ceded premiums earned were$91.4 million compared to$96.4 million for the same period in the prior year. Ceded premiums earned declined from the prior year as Tower elected to not renew its liability quota share reinsurance treaty in 2011. In 2011, we recorded earnings on the business ceded in 2010. This decrease was offset by an increase in the percentage of homeowners business ceded pursuant to the Company's homeowners quota share reinsurance treaty in 2012. We also purchase excess per risk and catastrophe reinsurance for all property lines.
Overall, net premiums earned increased
Commission and fee income. Commission and fee income, comprised of ceding commission revenue, insurance services revenue and policy billing fees, increased by$2.6 million and decreased by$1.0 million in the three and six months endedJune 30, 2012 , respectively, compared to the same periods in 2011. The increase for the three months endedJune 30, 2012 is due to additional fees earned by our managing general agencies. The decrease for the six months endedJune 30, 2012 is attributed to a reduction in the ceding commission revenue in the first quarter 2012 resulting from a change in loss ratio on a prior year's quota share treaties. The change in loss ratio resulted in a$2.9 million reduction in our ceding commission revenue. 39
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Net investment income and net realized gains (losses). For the three months endedJune 30, 2012 , net investment income remained relatively constant when compared with the same period in 2011. For the six-month period endedJune 30, 2012 , net investment income increased$2.7 million , or 4.3%, due to an increase in average cash and invested assets from the comparative period in 2011. Operating cash invested in fixed income securities in 2012 and in 2011 has been affected by an extended low interest rate environment. Investments in high-yield securities and dividend paying equity securities continue to be made to help maintain overall portfolio yield and to partially mitigate the impact of the lower interest rate environment. For the three months endedJune 30, 2012 and 2011, the net realized investment gains (losses) included OTTI of$2.2 million and$0.2 million , respectively. The OTTI in the second quarter of 2012 is driven primarily from the impairment of one equity security for$1.5 million and one fixed-maturity security for$0.7 million . Net realized investment gains for the three months endedJune 30, 2012 and 2011 also include net gains (losses) on the sale of securities for$19 thousand and$(2.3) million respectively. These gains and losses are a function of individual securities selected for sale when cash needs arise in the ordinary course of business or when market dictates disposals pursuant to our investment policy. For the six months endedJune 30, 2012 and 2011, the net realized investment gains (losses) included OTTI of$5.0 million and$0.4 million , respectively. The OTTI for the six months endedJune 30, 2012 is related mostly to securities in the Company's equity security portfolio. Net realized investment gains for the six months endedJune 30, 2012 and 2011 included net gains on the sale of securities for$3.3 million and$5.0 million respectively. Loss and loss adjustment expenses. The consolidated net loss ratio, which includes the Reciprocal Exchanges, was 76.0% and 61.1% for the three months endedJune 30, 2012 and 2011, respectively. Excluding the Reciprocal Exchanges, the net loss ratio was 77.3% and 62.3% for the three months endedJune 30, 2012</chron> and 2011, respectively. The Reciprocal Exchanges' net loss ratio was 63.3% and 53.0% for the three months ended June 30, 2012 and 2011, respectively. Incurred losses and LAE for the three months endedJune 30, 2012 attributable to insured events of prior years were$59.0 million . Excluding the Reciprocal Exchanges, the incurred losses and LAE from prior accident years were$65.0 million . Excluding the Reciprocal Exchanges, there was net adverse loss development of$62.1 million in theCommercial Insurance segment and$2.9 million in thePersonal Insurance segment for the three months endedJune 30, 2012 . The increase in estimates of prior years' loss and loss expenses was the result of a comprehensive review of its loss reserves in the second quarter and strengthened prior accident year reserves by$65 million following an analysis of recent loss emergence that occurred during the first and second quarters of 2012. The reserve strengthening in the second quarter represents 4% of the company's consolidated loss reserves (excluding the reserves that are carried by the Reciprocal Exchanges). The reserve strengthening relates primarily to unfavorable development in the company'sCommercial Insurance segment arising from changes in estimated ultimate losses for accident years 2011 and prior. During the quarter Tower conducted detailed reserve studies for all lines using loss data through the first quarter of 2012 as well as reported claims during the second quarter, including analysis of the source of unusually high reported loss emergence for certain casualty lines, primarily workers' compensation and commercial automobile, observed during the first quarter of 2012.
The Reciprocal Exchanges reported favorable development on prior accident years of
Commission and Operating expenses. Operating expenses, which include direct and ceding commission expenses and other operating expenses, were$173.3 million for the three months endedJune 30, 2012 , an increase of 18.5% over the prior year, primarily due to increased business production and our ongoing efforts to build-out our information technology infrastructure to support our policy administration and claims processing needs. The net underwriting expense ratio increased to 34.8% for the three months endedJune 30, 2012 from 33.8% in 2011. The consolidated gross underwriting expense ratio increased to 33.4% for the three months endedJune 30, 2012 from 32.3% in the same period in 2011. The commission portion of the gross underwriting expense ratio increased to 18.7% for the three month periodJune 30, 2012 compared to 17.2% in 2011. This increase is attributed to the increase in assumed reinsurance business written, which charges a higher commission rate. In addition, in 2012 management revised its estimates in the allocation of operating expenses between unallocated loss adjustment expense and other underwriting expenses ("OUE") which resulted in a greater percentage assigned to OUE. The gross OUE ratio, which includes boards, bureaus and taxes ("BB&T"), was 14.7% for the three months endedJune 30, 2012 compared to 15.1% in the prior year. For the six months endedJune 30, 2012 , operating expenses were$330.7 million compared to$288.4 million for the six months endedJune 30, 2011 , for an increase of$42.3 million or 14.7%. This change is due to increased business production and our 40
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ongoing efforts to build-out our information technology infrastructure to support our policy administration and claims processing needs. The net underwriting expense ratio increased to 35.1% for the six months ended
The consolidated gross underwriting expense ratio increased to 33.3% for the six months endedJune 30, 2012 from 32.6% in the same period in 2011. The commission portion of the gross underwriting expense ratio increased to 18.0% for the six month periodJune 30, 2012 compared to 17.6% in 2011. This increase is attributed to the increase in assumed reinsurance business written, which charges a higher commission rate. In addition, in 2012 management revised its estimates in the allocation of operating expenses between unallocated loss adjustment expense and OUE which resulted in a greater percentage assigned to OUE. The gross OUE ratio was 15.3% for the six months endedJune 30, 2012 compared to 15.0% in the prior year.
Acquisition-related transaction costs. Acquisition-related transaction costs for the three and six months ended
Interest expense. Interest expense decreased by$0.3 million and increased by$0.2 million for the three and six months endedJune 30, 2012 , respectively, compared to the same periods in 2011. Income tax expense. Tower uses the effective tax rate method in computing its interim tax provision. For the three months endedJune 30, 2012 , the effective tax rate on net income (loss) before income taxes was 30.7%, which resulted in an income tax benefit for the period of$8.9 million , compared to an income tax expense of$11.0 million and related effective tax rate of 28.4% for the same period in 2011. In the six months endedJune 30, 2012 , the consolidated effective tax rate for the six months endedJune 30, 2012 was 29.6% compared to 30.1% for the same period in 2011. The change in effective tax rate from 2011 to 2012 is due to the relatively small amount of pre-tax income in 2012. Net income (loss) and return on average equity. Net (loss) attributable toTower Group, Inc. and annualized return on average equity were$(16.8) million and (6.5)% for the three months endedJune 30, 2012 compared to net income of$24.4 million and annualized return on average equity of 9.3% for the same period in 2011. The return on average equity is calculated by dividing net income by average stockholders' equity. Average stockholders' equity was$1,038.0 million and$1,044.8 million atJune 30, 2012 and 2011, respectively. The net loss and decline in annualized return on equity for the three months endedJune 30, 2012 is primarily due to reserve strengthening in the second quarter of 2012. Net income attributable toTower Group, Inc. and annualized return on average equity were$2.4 million and 0.5% for the six months endedJune 30, 2012 compared to net income of$50.9 million and annualized return on average equity of 9.7% for the six months endedJune 30, 2011 . The decline in net income and annualized return on equity is primarily due to reserve strengthening of$78.3 million recorded forTower Group, Inc. in 2012 compared to prior year strengthening of$7.6 million recorded in 2011. 41
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Commercial Insurance Segment Results of Operations
Three Months Ended June 30, Six Months Ended June 30, 2012 ($ in thousands) 2012 2011 Change Percent (restated) 2011 Change Percent Net premiums written $ 343,748 $ 295,521 $ 48,227 16.3 % $ 663,953 $ 546,642 $ 117,311 21.5 % Revenues Net premiums earned $ 337,650 $ 263,735 $ 73,915 28.0 % $ 635,485 $ 515,503 $ 119,982 23.3 % Ceding commission revenue 3,894 3,310 584 17.6 % 3,904 8,728 (4,824 ) -55.3 % Policy billing fees 1,390 1,114 276 24.8 % 2,903 1,878 1,025 54.6 % Total revenue 342,934 268,159 74,775 27.9 % 642,292 526,109 116,183 22.1 % Expenses Net loss and loss adjustment expenses 281,209 166,307
114,902 69.1 % 482,647 331,087 151,560
45.8 % Underwriting expenses Direct commission expenses 66,539 49,457 17,082 34.5 % 122,669 99,446 23,223 23.4 % Other underwriting expenses 47,415 37,255 10,160 27.3 % 94,427 73,849 20,578 27.9 % Total underwriting expenses 113,954 86,712 27,242 31.4 % 217,096 173,295 43,801 25.3 % Underwriting profit (loss) $ (52,229 ) $ 15,140 $
(67,369 ) -445.0 % $ (57,451 )
Ratios
Net calendar year loss and LAE 83.3 % 63.1 % 75.9 % 64.2 % Net underwriting expenses 32.2 % 31.2 % 33.1 % 31.6 % Net combined 115.5 % 94.3 % 109.0 % 95.8 %
Commercial Insurance Segment Results of Operations for the Three and Six Months Ended
Premiums. Gross premiums written for the three months endedJune 30, 2012 were$369.8 million compared to$315.9 million during the same period in 2011. The increase in the three months endedJune 30, 2012 of$53.9 million is primarily attributable to growth in our assumed reinsurance business which accounted for$27.0 million of the increase compared to the same period in 2011. Gross premiums earned were$358.6 million for the three month period endedJune 30, 2012 as compared to$286.0 million during the same period 2011. The increase in gross premiums earned is a result of the increased writings in our assumed reinsurance and customized solutions products over the last twelve months. Gross premiums written for the six months endedJune 30, 2012 were$706.8 million compared to$578.9 million during the same period in 2011. The increase in the six months endedJune 30, 2012 of$127.9 million is primarily attributed to growth in our continuing programs and assumed reinsurance which accounted for$51.0 million and$68.8 million of the increase compared to the same period 2011. Gross premiums earned were$674.6 million for the six month period endedJune 30, 2012 as compared to$562.5 million during the same period 2011. Ceded premiums written for the three months endedJune 30, 2012 increased to$26.0 million from$20.3 million for the three months endedJune 31, 2011 . The Company reinsures through quota share treaties premiums written on certain of its program business. In addition, we also purchase excess per risk and catastrophe reinsurance for all property lines. Ceded earned premiums were$20.9 million and$22.2 million for the three month periods endedJune 30, 2012 and 2011, respectively. Ceded premiums written for the six months endedJune 30, 2012 were$42.8 million compared to$32.2 million for the six months endedJune 30, 2011 . Ceded premiums earned were$39.1 million compared to$47.0 million for the six month periods endedJune 30, 2012 . The Company reinsures through quota share treaties premiums written on certain of its program business. In addition, we also purchase excess per risk and catastrophe reinsurance for all property lines. The increases in net premiums written and earned for the three and six months endedJune 30, 2012 compared to the same periods in 2011 are attributable to both the increase in gross written premiums offset set slightly by the effects in ceded premiums, as discussed above. Renewal retention rate excluding programs was 78.4% and 77.9% for the three and six months endedJune 30, 2012 compared to 77.4% and 77.4% during the same period in 2011. Premiums on renewed commercial business, other than programs, increased 4.2% and 3.5% for the three and six months endedJune 30, 2012 . Excluding programs, policies-in-force for our commercial business, which is predominantly small business, increased 1.3% as ofJune 30, 2012 . Ceding commission revenue. Ceding commission revenue increased by$0.6 million and decreased by$4.8 million , respectively for the three and six months endedJune 30, 2012 compared to the same periods in 2011, primarily due to the non-renewal of the liability quota share program in 2011. The three and six month periods in 2011 had earned ceded commission revenue on some of the business ceded in 2010 under this treaty. There were no such ceded commissions earned in 2012. In addition, we recognized a change in loss ratio on a prior year's quota share treaty which reduced ceding commission revenue by$2.4 million during the six month period 42
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ended
Net loss and loss adjustment expenses. The net calendar year loss ratios were 83.3% and 63.1% for the three months endedJune 30, 2012 and 2011, respectively. The accident year loss ratios for the three months endedJune 30, 2012 and 2011 were 64.9% and 61.3%, respectively. The net calendar year loss ratios were 75.9% and 64.2% for the six months endedJune 30, 2012 and 2011, respectively. The accident year loss ratios for the six months endedJune 30, 2012 and 2011 were 64.3% and 61.7%, respectively. Management's estimates of prior years' loss and loss expenses were increased by$62.1 million for the three months and$74.0 million for the six months endedJune 30, 2012 . The increase in prior accident year loss and LAE in the quarter was the result of a comprehensive review of its loss reserves in the first and second quarters of 2012 and strengthened prior accident year reserves following an analysis of recent loss emergence that occurred during the quarter. The reserve strengthening relates primarily to unfavorable development in the company'sCommercial Insurance segment arising from changes in estimated ultimate losses for accident years 2011 and prior. During the quarter Tower conducted detailed reserve studies for all lines using loss data through the first quarter of 2012 as well as reported claims during the second quarter, including analysis of the source of unusually high reported loss emergence for certain casualty lines, primarily workers' compensation and commercial automobile, observed during the first quarter of 2012. The increase in prior accident year ultimate loss and LAE was comprised of$39 million in workers compensation and$22 million in commercial automobile liability. The reserve development was attributable mostly to programs, many of which are terminated and in runoff. Underwriting expenses. Underwriting expenses, which include direct commissions and other underwriting expenses, increased by$27.2 million and$43.8 million , or 31.4% and 25.3%, for the three and six months endedJune 30, 2012 , respectively, compared to the same period in 2011. The net underwriting expense ratio increased 1.0 and 1.5 percentage points for the three and six months endedJune 30, 2012 and 2011. The gross underwriting expense ratio was 31.4% and 31.8% for the three and six months endedJune 30, 2012 compared to 29.9% and 30.5% in the same periods in 2011. The commission portion of the gross underwriting expense ratio, which is expressed as a percentage of gross premiums earned, was 18.6% and 18.2% for the three and six months endedJune 30, 2012 compared to 17.3% and 17.7% for the same periods in 2011. The increase is primarily due to the assumed reinsurance business which has a higher commission ratio. The OUE ratio, including BB&T, was 12.8% and 13.6% for the three and six months endedJune 30, 2012 compared to 12.6% and 12.8% for the same periods in 2011. The increase in the OUE ratio is primarily a result of ongoing efforts by us to build-out our information technology infrastructure to support our policy administration and claims processing needs.
Underwriting loss and combined ratio. The underwriting loss and combined ratio for the three and six months ended
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Personal Insurance Segment Results of Operations
Three Months Ended June 30, 2012 2011 Reciprocal Reciprocal ($ in thousands) Tower Exchanges Total Tower Exchanges Total Change Percent Net premiums written $ 97,865 $ 44,620
6.8 %
Revenues
Net premiums earned $ 79,962 $ 42,541
2,961 3,225 6,186 4,414 1,531 5,945 241 4.1 % Policy billing fees 1,481 129 1,610 1,398 147 1,545 65 4.2 % Total revenue 84,404 45,895 130,299 84,867 52,418 137,285 (6,986 ) -5.1 % Expenses Net loss and loss adjustment expenses 41,633 26,933 68,566 47,373 26,876 74,249 (5,683 ) -7.7 % Underwriting expenses Direct commission expenses 20,486 8,162 28,648 20,333 6,465 26,798 1,850 6.9 % Other underwriting expenses 15,804 14,607 30,411 18,062 14,641 32,703 (2,292 ) -7.0 % Total underwriting expenses 36,290 22,769 59,059 38,395 21,106 59,501 (442 ) -0.7 % Underwriting profit (loss) $ 6,481 $ (3,807
)
Ratios
Net calendar year loss and LAE 52.1 % 63.3 % 56.0 % 59.9 % 53.0 % 57.2 % Net underwriting expenses 39.8 % 45.6 % 41.8 % 41.2 % 38.3 % 40.1 % Net combined 91.9 % 108.9 % 97.8 % 101.1 % 91.3 % 97.3 % 44
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Personal Insurance Segment Results of Operations (continued)
Six Months Ended June 30, 2012 (restated) 2011 Reciprocal Reciprocal ($ in millions) Tower Exchanges Total Tower Exchanges Total Change Percent Net premiums written $ 165,251 $ 82,713 $ 247,964 $ 156,613 $ 85,758 $ 242,371 5,593 2.3 % Revenues Net premiums earned $ 160,796 $ 84,030 $ 244,826 $ 161,824 $ 95,998 $ 257,822 (12,996 ) -5.0 % Ceding commission revenue 5,029 6,310 11,339 7,214 2,894 10,108 1,231 12.2 % Policy billing fees 2,970 261 3,231 2,668 291 2,959 272 9.2 % Total revenue 168,795 90,601 259,396 171,706 99,183 270,889 (11,493 ) -4.2 % Expenses Net loss and loss adjustment expenses 83,444 51,177 134,621 99,331 50,604 149,935 (15,314 ) -10.2 % Underwriting expenses Direct commission expenses 36,967 15,935 52,902 35,629 17,039 52,668 234 0.4 % Other underwriting expenses 32,465 27,544 60,009 33,982 26,673 60,655 (646 ) -1.1 % Total underwriting expenses 69,432 43,479 112,911 69,614 43,712 113,323 (412 ) -0.4 % Underwriting profit (loss) $ 15,919 $
(4,055 )
Ratios
Net calendar year loss and LAE 51.9 % 60.9 % 55.0 % 61.4 % 52.7 % 58.2 % Net underwriting expenses 38.2 % 43.9 % 40.2 % 37.0 % 42.4 % 39.0 % Net combined 90.1 % 104.8 % 95.2 % 98.4 % 95.1 % 97.2 %
Personal Insurance Segment Results of Operations for the Three and Six Months Ended
Premiums. Gross premiums written for the three months endedJune 30, 2012 were$167.9 million compared to$152.1 million in 2011, an increase of$15.8 million , or 10.4%. This increase is primarily attributed to the acquisition of personal lines renewal rights resulting in$15.2 million of written premium in the second quarter of 2012 and an increase in homeowners business offset by a decline in monoline automobile policies. Gross premiums earned declined$9.9 million to$150.0 million for the three months endedJune 30, 2012 from$159.9 million for the same period in the prior year. This decline is due primarily to the reduction from certain monoline automobile policies the Company has elected to not renew during the last year. This decline was offset by earnings of$2.5 million from the renewal rights premiums discussed above. Gross premiums written for the six months endedJune 30, 2012 were$298.2 million compared to$278.7 million in 2011, for an increase of$19.5 million , or 7.0%. This increase is primarily attributed to the acquisition of personal lines renewal rights resulting in$15.2 million of written premium in the second quarter of 2012 and an increase in homeowners business offset by a decline in monoline automobile policies. Gross premiums earned declined$10.1 million to$297.1 million for the six months endedJune 30, 2012 from$307.2 million for the same period in the prior year. This decline is due primarily to the reduction certain monoline automobile policies the Company has elected to not renew during the last year. This decline was offset by earnings of$2.5 million of the renewal rights premiums discussed above. Ceded premiums written for the three months endedJune 30, 2012 were$25.4 million , an increase of$6.8 million compared to$18.6 million in 2011. The Company reinsures a portion of its homeowners and umbrella business through quota share reinsurance treaties. The Company also purchased catastrophe reinsurance for certain property business. The increase in 2012 is attributed to increasing the percentage of business ceded pursuant to the homeowners quota share treaty. Ceded premiums earned decreased$2.5 million to$27.5 million for the three months endedJune 30, 2012 from$30.1 million for the same period in the prior year. Ceded premiums written for the six months endedJune 30, 2012 were$50.2 million , an increase of$13.9 million compared to$36.3 million in 2011. The Company reinsures the majority of its homeowners and umbrella business through quota share reinsurance treaties. The Company also purchased catastrophe reinsurance for certain property business. The increase in 2012 is attributed to increasing the percentage of business ceded pursuant to the homeowners quota share treaty. Ceded premiums earned increased$2.9 million to$52.3 million for the six months endedJune 30, 2012 from$49.4 million for the same period in the prior year. Net premiums written for the three and six months endedJune 30, 2012 increased$9.0 million and$5.6 million net premiums earned for the three and six months endedJune 30, 2012 decreased$7.3 million and$13.0 million compared to the same periods in 2011. These changes are attributed to the gross and ceded premium changes discussed above. 45
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Our personal lines renewal retention was 92.0% and 86.5% for the three months endedJune 30, 2012 and 2011, respectively. Personal lines renewal retention was 91.0% and 84.2% for the six months endedJune 30, 2012 and 2011, respectively. Written premiums on renewed business increased by 2.6% and 2.8% during the three and six months endedJune 30, 2012 , respectively. Policies-in-force remained relatively constant fromDecember 31, 2011 toJune 30, 2012 , decreasing by only 0.5%.
Ceding commission revenue. Ceding commission revenue remained stable from the three and six months ended
Net loss and loss adjustment expenses. ForPersonal Insurance , the net calendar year loss ratios were 56.0% and 57.2% for the three months endedJune 30, 2012 and 2011, respectively. The accident year loss ratios for the three months endedJune 30, 2012 and 2011 were 58.5% and 64.7%, respectively. The net calendar year loss ratios were 55.0% and 58.2% for the six months endedJune 30, 2012 and 2011, respectively. The accident year loss ratios for the six months endedJune 30, 2012 and 2011 were 55.8% and 64.5%, respectively. Estimates of prior accident year loss and loss adjustment expenses decreased by$3.0 million and$2.0 million for the three and six months endedJune 30, 2012 , respectively. For Tower personal lines, excluding the Reciprocal Exchanges, the net calendar year loss ratios were 52.1% and 59.9% for the three months endedJune 30, 2012 and 2011, respectively. The accident year loss ratios for the three months endedJune 30, 2012 and 2011 were 48.4% and 66.5%, respectively. The net calendar year loss ratios were 51.9% and 61.4% for the six months endedJune 30, 2012 and 2011, respectively. The accident year loss ratios for the six months endedJune 30, 2012 and 2011 were 49.2% and 64.9%, respectively. There was net adverse loss development of$2.9 million and$4.3 million for the three and six months endedJune 30, 2012 , respectively. The adverse development for the six months endedJune 30, 2012 was comprised of$3.6 million in Homeowners, and$0.3 million in Private Passenger Automobile. The Reciprocal Exchanges' net calendar year loss ratios were 63.3% and 53.0% for the three months endedJune 30, 2012 and 2011, respectively. The accident year loss ratios for the three months endedJune 30, 2012 and 2011 were 77.3% and 62.0%, respectively. The net calendar year loss ratios were 60.9% and 52.7% for the six months endedJune 30, 2012 and 2011, respectively. The accident year loss ratios for the six months endedJune 30, 2012 and 2011 were 68.3% and 64.0%, respectively. Estimates of prior accident year loss and loss adjustment expenses decreased by$6.0 million and$6.3 million for the three and six months endedJune 30, 2012 , respectively. Underwriting expenses. Underwriting expenses, which include direct commissions and other underwriting expenses, decreased$0.4 million and$0.4 million , or 0.7% and 0.4%, for the three and six months ended endingJune 30, 2012 , respectively, compared to the same period in 2011. The net underwriting expense ratio increased 1.7 percentage points from the three month period endedJune 30, 2011 to 2012. The net underwriting expense ratio increased 1.2 percentage points from the six month period endedJune 30, 2011 to 2012. The gross underwriting expense ratio was 38.3% and 36.3% for the three months endedJune 30, 2012 and 2011, respectively. The commission portion of the gross underwriting expense ratio was 19.1% and 16.8% for the three months endedJune 30, 2012 and 2011, respectively. The gross OUE ratio, which includes BB&T, was 19.2% and 19.5% for the three months endedJune 30, 2012 and 2011, respectively. The gross underwriting expense ratio was 36.9% and 36.0% for the six months endedJune 30, 2012 and 2011, respectively. The commission portion of the gross underwriting expense ratio was 17.8% and 17.1% for the six months endedJune 30, 2012 and 2011, respectively. The gross OUE ratio, which includes BB&T, was 19.1% and 18.9% for the six months endedJune 30, 2012 and 2011, respectively. Underwriting profit and combined ratio.Personal Insurance segment underwriting profit declined$0.9 million and the combined ratio increased by 0.5 percentage points for the three months endedJune 30, 2012 compared toJune 30, 2011 due to reserve strengthening in the second quarter of 2012. Underwriting profit increased$4.2 million and the combined ratio improved 2.0 percentage points from the six months endedJune 30, 2011 toJune 30, 2012 due to 2011 severe storms. 46
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Insurance Services Segment Results of Operations
Three Months Ended June 30, Six Months Ended June 30, ($ in thousands) 2012 2011 Change Percent 2012 2011 Change Percent Revenue Management fee income $ 7,965 $ 7,704 $ 261 3.4 % $ 14,827 $ 14,399 $ 428 3.0 % Other revenue 1,359 (73 ) 1,432 NM 1,856 529 1,327 250.9 % Total revenue 9,324 7,631 1,693 22.2 % 16,683 14,928 1,755 11.8 % Expenses - Other expenses 5,079 4,977 102 2.0 % 9,542 10,018 (476 ) -4.8 % Total expenses 5,079 4,977 102 2.0 % 9,542 10,018 (476 ) -4.8 %
Insurance services pre-tax income
NM is shown where percentage change exceeds 500%
Insurance Services Segment Results of Operations for the Three and Six Months Ended
Total revenue. Total revenues for the three months endedJune 30, 2012 increased$1.7 million , or 22.2%, from the Insurance Services revenues compared to the same period in the prior year. This increase is primarily related to certain fee income earned by our managing general agencies for business placed with other insurers. The management fee income for the six months endedJune 30, 2012 was consistent with the revenues earned for the six months endedJune 30, 2011 . Total expenses. Insurance Services segment expenses for the three and six months endedJune 30, 2012 remained relatively constant compared to the expenses for the same period endedJune 30, 2011 . Most of these expenses are associated with providing services pursuant to the management services agreement between Tower and the Reciprocal Exchanges. 47
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Table of Contents Investments Portfolio Summary The following table presents a breakdown of the amortized cost, aggregate fair value and unrealized gains and losses by investment type as ofJune 30, 2012 andDecember 31, 2011 : Cost or Gross Gross Unrealized Losses % of Amortized Unrealized Less than 12 More than 12 Fair Fair ($ in thousands) Cost Gains Months Months Value ValueJune 30, 2012 U.S. Treasury securities $ 120,783 $ 1,591 $ (7 ) $ - $ 122,367 4.9 % U.S. Agency securities 77,690 3,592 - - 81,282 3.3 % Municipal bonds 742,736 54,076 (431 ) (4 ) 796,377 31.8 % Corporate and other bonds 681,114 41,198 (1,183 ) (239 ) 720,890 28.9 % Commercial, residential and asset-backed securities 595,694 44,360 (392 ) (604 ) 639,058 25.6 % Total fixed-maturity securities 2,218,017 144,817 (2,013 ) (847 ) 2,359,974 94.5 % Equity securities 133,525 6,263 (3,228 ) (167 ) 136,393 5.5 % Total, June 30, 2012 $ 2,351,542 $ 151,080 $ (5,241 ) $ (1,014 ) $ 2,496,367 100.0 % Tower $ 2,063,859 $ 131,351 $ (4,959 ) $ (959 ) $ 2,189,292 Reciprocal Exchanges 287,683 19,729 (282 ) (55 ) 307,075 Total, June 30, 2012 $ 2,351,542 $ 151,080 $ (5,241 ) $ (1,014 ) $ 2,496,367 December 31, 2011 U.S. Treasury securities $ 154,430 $ 1,725 $ (13 ) $ - $ 156,142 6.1 % U.S. Agency securities 114,411 2,779 - - 117,190 4.6 % Municipal bonds 688,192 48,777 (255 ) - 736,714 29.0 % Corporate and other bonds 750,220 34,466 (6,813 ) (150 ) 777,723 30.6 % Commercial, residential and asset-backed securities 627,859 42,167 (3,529 ) (592 ) 665,905 26.2 % Total fixed-maturity securities 2,335,112 129,914 (10,610 ) (742 ) 2,453,674 96.5 % Equity securities 93,034 1,395 (4,838 ) (246 ) 89,345 3.5 % Total $ 2,428,146 $ 131,309 $ (15,448 ) $ (988 ) $ 2,543,019 100.0 % Tower $ 2,138,001 $ 118,173 $ (14,160 ) $ (915 ) $ 2,241,099 Reciprocal Exchanges 290,145 13,136 (1,288 ) (73 ) 301,920 Total, December 31, 2011 $ 2,428,146 $ 131,309 $ (15,448 ) $ (988 ) $ 2,543,019
Credit Rating of
The average credit rating of our fixed-maturity securities, using ratings assigned to securities by Standard & Poor's, was A+ at
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Table of Contents Tower Reciprocal Exchanges Percentage Percentage of Fair of Fair ($ in thousands) Fair Value Value Fair Value ValueJune 30, 2012 Rating U.S. Treasury securities $ 113,905 5.5 % $ 8,462 2.8 % AAA 190,072 9.2 % 47,907 16.0 % AA 934,512 45.5 % 95,042 31.8 % A 412,453 20.0 % 94,596 31.6 % BBB 190,418 9.2 % 25,109 8.4 % Below BBB 219,442 10.6 % 28,056 9.4 % Total $ 2,060,802 100.0 % $ 299,172 100.0 % December 31, 2011 Rating U.S. Treasury securities $ 151,621 7.0 % $ 4,521 1.5 % AAA 189,431 8.8 % 49,316 16.4 % AA 930,436 43.3 % 98,017 32.8 % A 459,353 21.3 % 105,696 35.2 % BBB 208,552 9.7 % 12,728 4.2 % Below BBB 214,227 9.9 % 29,776 9.9 % Total $ 2,153,620 100.0 % $ 300,054 100.0 %
Fixed-Maturity Investments with Third Party Guarantees
AtJune 30, 2012 ,$214.6 million of our municipal bonds, at fair value, were guaranteed by third parties from a total of$2.4 billion , at fair value, of all fixed-maturity securities held by us. The amount of securities guaranteed by third parties along with the credit rating with and without the guarantee is as follows: With Without ($ in thousands) Guarantee Guarantee AA $ 164,954 $ 147,310 A 40,485 56,000 BBB 8,436 3,398 BB 677 3,098 No underlying rating - 4,746 Total $ 214,552 214,552 Tower $ 208,662 $ 208,662 Reciprocal Exchanges 5,890 5,890 Total $ 214,552 $ 214,552
The guaranteed securities, by guarantor, are as follows:
Guaranteed Percent of ($ in thousands) Amount Total
National Public Finance Guarantee Corp $ 83,124
38.7 %
Assured Guaranty Municipal Corp 77,853
36.3 %
Ambac Financial Corp 38,294
17.8 %
Berkshire Hathaway Assurance Corp 6,701
3.1 % Others 8,580 4.1 % Total $ 214,552 100.0 % Tower $ 208,662 97.3 % Reciprocal Exchanges 5,890 2.7 % Total $ 214,552 100.0 % 49
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Municipal Bonds
As of
State General Municipal General Obligations Obligations Special Revenue Bonds Total Amortized Fair Amortized Fair Amortized Fair Amortized Fair ($ in thousands) Cost Value Cost Value Cost Value Cost Value Texas $ 25,010 $ 26,557 $ 7,013 $ 7,853 $ 99,006 $ 106,335 $ 131,029 $ 140,745 New York 11,553 12,608 7,758 8,318 63,908 68,557 83,219 89,483 California 7,614 8,091 1,800 1,807 36,013 39,416 45,427 49,314 Florida 14,827 16,129 7,600 8,058 17,258 18,075 39,685 42,262 Washington 11,888 13,103 5,823 6,179 15,031 16,239 32,742 35,521 Arizona 4,867 5,436 - - 25,597 27,230 30,464 32,666 Indiana 2,966 3,330 1,760 1,771 25,695 27,298 30,421 32,399 Massachusetts - - 1,009 1,020 27,331 29,785 28,340 30,805 Illinois 10,399 11,231 3,350 3,611 10,802 11,824 24,551 26,666 Wisconsin 11,955 12,309 5,195 5,704 5,338 6,128 22,488 24,141 Other 62,205 65,611 28,722 30,378 183,443 196,386 274,370 292,375 Total $ 163,284 $ 174,405 $ 70,030 $ 74,699 $ 509,422 $ 547,273 $ 742,736 $ 796,377 No one jurisdiction within "Other" in the table above exceeded 3% of the total fair value of municipal bonds. As ofJune 30, 2012 , the special revenue bonds are supported primarily by water and sewer utilities, electric utilities, college revenues and highway tolls.
Fair Value Consideration
Under GAAP, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an "exit price"). GAAP establishes a fair value hierarchy that distinguishes between inputs based on market data from independent sources ("observable inputs") and a reporting entity's internal assumptions based upon the best information available when external market data are limited or unavailable ("unobservable inputs"). The fair value hierarchy in GAAP prioritizes fair value measurements into three levels based on the nature of the inputs. Quoted prices in active markets for identical assets have the highest priority ("Level 1"), followed by observable inputs other than quoted prices including prices for similar but not identical assets or liabilities ("Level 2"), and unobservable inputs, including the reporting entity's estimates of the assumption that market participants would use, having the lowest priority ("Level 3"). As of June 30, 2012 , substantially all of the investment portfolio recorded at fair value was priced based upon quoted market prices or other observable inputs. For investments in active markets, we used the quoted market prices provided by the outside pricing services to determine fair value. In circumstances where quoted market prices were unavailable, we used fair value estimates based upon other observable inputs including matrix pricing, benchmark interest rates, market comparables and other relevant inputs. When observable inputs were adjusted to reflect management's best estimate of fair value, such fair value measurements are considered a lower level measurement in the GAAP fair value hierarchy. Our process to validate the market prices obtained from the outside pricing sources includes, but is not limited to, periodic evaluation of model pricing methodologies and analytical reviews of certain prices. We also periodically perform testing of the market to determine trading activity, or lack of trading activity, as well as market prices. Several securities sold during the quarter were "back-tested" (i.e., the sales price is compared to the previous month end reported market price to determine reasonableness of the reported market price). The ability to observe stable prices and inputs may be reduced for highly-customized and illiquid instruments which had been the case for certain non-agency residential and commercial mortgage-backed securities and asset-backed securities in previous periods. At June 30, 2012 , two securities included in other invested assets were priced in Level 3 with a fair value of $25.0 million . As more fully described in "Note 5 - Investments" to our consolidated financial statements, "Investments-Impairment Review," we completed a detailed review of all our securities in a continuous loss position, including but not limited to residential and 50
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commercial mortgage-backed securities, and concluded that the unrealized losses in these asset classes are the result of a decrease in value due to technical spread widening and broader market sentiment. "Note 6 - Fair Value Measurements" to the consolidated financial statements provides a description of the valuation methodology utilized to value Level 3 assets, how the valuation methodology is validated and an analysis of the change in fair value of Level 3 assets. As ofJune 30, 2012 , the fair value of Tower Level 3 assets as a percentage of Tower's total assets carried at fair value was as follows (the Reciprocal Exchanges had no Level 3 assets): Level 3 Assets Assets Carried at as a Percentage of Fair Value at Fair Value of Total Assets Carried ($ in thousands) June 30, 2012 Level 3 Assets at Fair Value Fixed-maturity investments $ 2,359,974 $ - 0 % Equity investments 136,393 - 0 %
Total investments available for sale $ 2,496,367 $
- 0 % Other invested assets 25,000 25,000 100 % Cash and cash equivalents 199,005 - 0 % Total $ 2,720,372 $ 25,000 0.9 % Unrealized Losses
The fair value of our fixed maturity portfolio is directly affected by changes in interest rates and credit spreads. We regularly review both our fixed-maturity and equity portfolios to evaluate the necessity of recording impairment losses for other-than temporary declines in the fair value of investments.
For those fixed-maturity investments deemed not to be in an OTTI position, we believe that the gross unrealized investment loss was primarily caused by purchases made in a lower yield environment. We expect cash flows from operations to be sufficient to meet our liquidity requirements and, therefore, we do not intend to sell these fixed maturity securities and we do not believe that we will be required to sell these securities before recovering their cost basis. For equity securities not considered OTTI, we believe we have the ability to hold these investments until a recovery of fair value to our cost basis. The following table presents information regarding our invested assets that were in an unrealized loss position atJune 30, 2012 andDecember 31, 2011 by amount of time in a continuous unrealized loss position: 51
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Table of Contents Less than 12 Months 12 Months or Longer Total Fair Unrealized Fair Unrealized Aggregate Unrealized ($ in thousands) Value Losses Value Losses Fair Value LossesJune 30, 2012 U.S. Treasury securities $ 65,714 $ (7 ) $ - $ - $ 65,714 $ (7 ) Municipal bonds 41,456 (431 ) 990 (4 ) 42,446 (435 ) Corporate and other bonds Finance 22,784 (169 ) 752 (46 ) 23,536 (215 ) Industrial 46,687 (990 ) 6,465 (191 ) 53,152 (1,181 ) Utilities 3,425 (24 ) 394 (2 ) 3,819 (26 ) Commercial mortgage-backed securities 16,036 (138 ) 16,053 (438 ) 32,089 (576 ) Residential mortgage-backed securities Agency backed 21,134 (134 ) 21 - 21,155 (134 ) Non-agency backed 6 (3 ) 2,666 (121 ) 2,672 (124 ) Asset-backed securities 12,333 (117 ) 1,680 (45 ) 14,013 (162 ) Total fixed-maturity securities 229,575 (2,013 ) 29,021 (847 ) 258,596 (2,860 ) Preferred stocks 6,263 (45 ) 6,019 (112 ) 12,282 (157 ) Common stocks 39,868 (3,183 ) 913 (55 ) 40,781 (3,238 ) Total, June 30, 2012 $ 275,706 $ (5,241 ) $ 35,953 $ (1,014 ) $ 311,659 $ (6,255 ) Tower $ 254,853 $ (4,959 ) $ 34,232 $ (959 ) $ 289,085 $ (5,918 ) Reciprocal Exchanges 20,853 (282 ) 1,721 (55 ) 22,574 (337 ) Total, June 30, 2012 $ 275,706 $ (5,241 ) $ 35,953 $ (1,014 ) $ 311,659 $ (6,255 ) 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 )
The following table shows the fair value, unrealized loss amount and percentage below amortized cost and the ratio of fair value by security rating as of
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Table of Contents Unrealized Loss Percent of Fair Value by Security Rating Fair Amortized BB or ($ in thousands) Value Amount Cost AAA AA A BBB Lower U.S. Treasury securities $ 65,714 $ (7 )
0 % 0% 100 % 0 % 0 % 0 % Municipal bonds
42,446 (435 )
-1 % 27% 68 % 3 % 1 % 1 % Corporate and other bonds
80,507 (1,422 )
-2 % 1% 0 % 15 % 26 % 58 % Commercial mortgage-backed securities 32,089
(576 )
-2 % 17% 17 % 37 % 14 % 15 % Residential mortgage-backed securities 23,827
(258 ) -1 % 5% 90 % 1 % 0 % 4 % Asset-backed securities 14,013 (162 ) -1 % 4% 96 % 0 % 0 % 0 % Equities 53,063 (3,395 ) -7 % NR
NR indicates that equity securities are not rated
See "Note 5 - Investments" in our consolidated financial statements for further information about impairment testing and other-than-temporary impairments.
Liquidity and Capital Resources
Tower is organized as a holding company (the "Holding Company") with multiple intermediate holding companies, 12 insurance subsidiaries and several management companies.The Holding Company's principal liquidity needs include interest on debt, stockholder dividends and share repurchases under its share repurchase program.The Holding Company's principal sources of liquidity include dividends and other permitted payments from our subsidiaries, as well as financing through borrowings under our bank credit facility and sales of securities. Cash flows from the management companies are not subject to restrictions. As ofJune 30, 2012 , the amount of distributions that our Insurance Subsidiaries could pay to Tower without approval of their domiciliary Insurance Departments was$25.9 million . In addition, we can return capital of$63.5 million from CastlePoint Re without permission from theBermuda Monetary Authority . No dividends were paid from the Insurance Subsidiaries during the six months endedJune 30, 2012 . CastlePoint Re made no payments to the Holding Company during the six month period endedJune 30, 2012 . The management companies are not subject to any statutory limitations on their dividends to the Holding Company. The management companies paid no dividends to the Holding Company during the six month period endedJune 30, 2012 . We believe that the cash flow generated by the operating activities of our subsidiaries, combined with other available capital sources, will provide sufficient funds for us to meet our liquidity needs over the next twelve months. Beyond the next twelve months, cash flow available to us may be influenced by a variety of factors, including general economic conditions and conditions in the insurance and reinsurance markets, as well as fluctuations from year-to-year in claims experience.
We have the intent and ability to hold any temporarily impaired fixed maturity securities until the anticipated date that these temporary impairments are recovered.
Book Value per Common Share
Book value per common share representsTower Group Inc. stockholders' equity divided by the number of common shares outstanding. Management uses growth in book value per common share as a key measure of the value generated for our common shareholders each period and believes that book value per common share is a key driver of TWGP's share price over time. Book value per common share is impacted by, among other factors, our underwriting results, investment returns and share repurchase activity, which has an accretive or dilutive impact on book value per common share depending on the purchase price.June 30, 2012 December 31 ,
(in thousands, except per share data) (restated) 2011
Calculation of book value per common share:
Common shares outstanding 38,377
39,221
Book value per common share $ 26.44 $
26.36 53
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Table of Contents
Capital
Our capital resources consist of funds deployed or available to be deployed to support our business operations. AtJune 30, 2012 andDecember 31, 2011 , our capital resources were as follows: June 30, 2012 December 31, ($ in thousands) (restated) 2011
Outstanding under credit facility $ 70,000 $ 50,000
Convertible Senior Notes 143,233
141,843
Subordinated debentures 235,058
235,058
Total capitalization $ 1,520,505 $
1,460,700
Ratio of debt to total capitalization 30.6 %
29.2 %
We monitor our capital adequacy to support our business on a regular basis. The future capital requirements of our business will depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. Our ability to underwrite is largely dependent upon the quality of our claims paying and financial strength ratings as evaluated by independent rating agencies. In particular, we require (1) sufficient capital to maintain our financial strength ratings, at a level considered necessary by management to enable our insurance subsidiaries to compete, and (2) sufficient capital to enable our insurance subsidiaries to meet the capital adequacy tests performed by statutory agencies inthe United States andBermuda . OnFebruary 15, 2012 , we amended our$125.0 million credit facility by increasing borrowing capacity up to$150 million , extending the maturity date out toFebruary 15, 2016 , and resetting borrowing fees to more favorable current market terms. The credit facility is used for general corporate purposes. The original credit facility was entered into onMay 14, 2010 and had an expiration date ofMay 14, 2013 As part of Tower's capital management strategy, the Board of Directors of Tower approved a$100 million share repurchase program onMarch 3, 2011 . This authorization is in addition to the$100 million share repurchase program approved onFebruary 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 onMarch 4, 2013 . The timing and amount of purchases under the programs depend on a variety of factors, including the trading price of the stock, market conditions and corporate and regulatory considerations. For the three months endedJune 30, 2012 , there were 1.1 million shares of common stock purchased under this program. As of 2012,$26.4 million remained available for future share repurchases under the new program. We may seek to raise additional capital or may seek to return additional capital to our stockholders through share repurchases, cash dividends or other methods (or a combination of such methods). Any such determination will be at the discretion of our Board of Directors and will be dependent upon our profits, financial requirements and other factors, including legal restrictions, rating agency requirements, credit facility limitations and such other factors as our Board of Directors deems relevant.
Cash Flows
The primary sources of consolidated cash flows are from the insurance subsidiaries' gross premiums collected, ceding commissions from quota share reinsurers, loss payments by reinsurers, investment income and proceeds from the sale or maturity of investments. Funds are used by the insurance subsidiaries for loss payments and loss adjustment expenses. The insurance subsidiaries also use funds for ceded premium payments to reinsurers, which are paid on a net basis after subtracting losses paid on reinsured claims and reinsurance commissions on our net business, commissions to producers, salaries and other underwriting expenses as well as to purchase investments, fixed assets and to pay dividends to the Holding Company. The management companies' primary sources of cash are management fees for acting as the attorneys-in-fact for the Reciprocal Exchanges. The reconciliation of net income to cash provided from operations is generally influenced by the collection of premiums in advance of paid losses, the timing of reinsurance, issuing company settlements and loss payments.
Cash flow and liquidity are categorized into three sources: (1) operating activities; (2) investing activities; and (3) financing activities, which are shown in the following table:
54
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Table of Contents Six Months Ended June 30, ($ in thousands) 2012 2011 Cash provided by (used in): Operating activities $ 72,437 $ 53,462 Investing activities 30,058 (46,043 ) Financing activities (17,588 ) (34,289 )
Net increase (decrease) in cash and cash equivalents 84,907
(26,870 )
Cash and cash equivalents, beginning of year 114,098
140,221
Cash and cash equivalents, end of period $ 199,005 $
113,351
Comparison of Six Months Ended
For the six months endedJune 30, 2012 , net cash inflows provided by operating activities were$72.4 million compared to$53.5 million for 2011. The increase in cash flow for the six months endedJune 30, 2012 is primarily due to operating cash flow in 2011 being unusually low because of increased claim payments resulting from the Northeast winter storms in the first quarter of 2011. Net cash flows provided by investing activities were$30.1 million for the six months endedJune 30, 2012 compared to$46.0 million used for the six months endedJune 30, 2011 . The increase in investing cash flows of$76.1 million is almost entirely related to the liquidation of securities in anticipation of our investment inCanopius Group, Ltd. of approximately$75 million . Additionally, the six months endedJune 30, 2012 and 2011 include an increase to fixed assets of$19.4 million and$11.7 million , respectively, primarily related to the build out of new systems. Other cash inflows and outflows in both years relates to purchases and sales and maturities of fixed-maturity and equity securities. The net cash flows used in financing activities for the six months endedJune 30, 2012 are primarily the result of use of cash for dividends of$14.7 million and the repurchase of common stock of$21.0 million , offset by increased borrowings on our credit facility of$20.0 million . In 2011, we used cash for the repurchase of common stock and dividend payments of$20.0 million and$12.9 million , respectively.
Cash flow needs at the holding company level are primarily for dividends to our stockholders, interest and principal payments on our outstanding debt and payments under the credit facility.
Insurance Subsidiaries
The insurance subsidiaries maintain sufficient liquidity to pay claims, operating expenses and meet other obligations. We monitor the expected claims payment needs and maintain a sufficient portion of our invested assets in cash and cash equivalents to enable us to fund the claims payments without having to sell longer-duration investments. As necessary, we adjust the holdings of short-term investments and cash and cash equivalents to provide sufficient liquidity to respond to changes in the anticipated pattern of claims payments. The insurance subsidiaries are required by law to maintain a certain minimum level of policyholders' surplus on a statutory basis. Policyholders' surplus is calculated by subtracting total liabilities from total assets. The NAIC maintains risk-based capital ("RBC") requirements for property and casualty insurance companies. RBC is a formula that attempts to evaluate the adequacy of statutory capital and surplus in relation to investments and insurance risks. The formula is designed to allow the state Insurance Departments to identify potential weakly capitalized companies. Under the formula, a company determines its risk-based capital by taking into account certain risks related to the insurer's assets (including risks related to its investment portfolio and ceded reinsurance) and the insurer's liabilities (including underwriting risks related to the nature and experience of its insurance business). Applying the RBC requirements as of June 30, 2012 , the insurance subsidiaries' risk-based capital exceeded the minimum level that would trigger regulatory attention.
Inflation
Property and casualty loss and loss adjustment expense reserves are established before we know the amount of losses and 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. 55
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Table of Contents
Adoption of New Accounting Pronouncements
For a discussion of accounting standards, see "Note 3 - Accounting Policies and Basis of Presentation" of Notes to Consolidated Financial Statements.
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