Tower Group 10-K 2006
Documents found in this filing:
Washington, D.C. 20549
For the transition period from to .
Commission File Number: 000-50990
Tower Group, Inc.
(Exact name of registrant as specified in its charter)
(Registrants telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.0l par value per share
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of Securities Act. Yes x No o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer: in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x
The aggregate market value of the registrants common stock held by non-affiliates on June 30, 2005 (based on the closing price on the Nasdaq National Market) on such date was approximately $264,037,653.
As of March 10, 2006, the registrant had 19,855,841 shares of common stock outstanding.
Part III of this Form 10-K incorporates by reference certain information from the registrants definitive Proxy Statement with respect to the registrants 2006 Annual Meeting of Shareholders, to be filed not later than 120 days after the close of the registrants fiscal year (the Proxy Statement).
As used in this Form 10-K, references to the Company, we, us, or our refer to Tower Group, Inc. and its subsidiaries, including its insurance companies, Tower Insurance Company of New York (TICNY), Tower National Insurance Company (TNIC) and its managing general agency, Tower Risk Management Corporation (TRM), unless the context suggests otherwise.
Through our subsidiaries Tower Insurance Company of New York, Tower National Insurance Company and Tower Risk Management Corporation, we offer a broad range of specialized property and casualty insurance products and services to small to mid-sized businesses and to individuals in New York State and the surrounding areas. By targeting select underserved market segments and expeditiously delivering needed products and services, we position ourselves to obtain favorable policy terms, conditions and pricing, thereby creating opportunities for favorable underwriting results. Our commercial lines products provide insurance coverage to businesses such as retail and wholesale stores, grocery stores, restaurants, artisan contractors and residential and commercial buildings, while our personal lines products currently focus on modestly valued homes and dwellings.
We provide coverage for many different market segments, including nonstandard risks that do not fit the underwriting criteria of standard carriers due to factors such as type of business, location and premium per policy. As of December 31, 2005 TICNY is licensed in fifteen states and TNIC is licensed in sixteen states. TRM, through its managing general agency, produces business on behalf of other insurance companies, referred to as issuing companies, and primarily focuses on commercial risks with higher per policy premium, including risks that TICNY had not been able to target due to, among other things, licensing and surplus limitations. TICNY also reinsures a modest amount of the premiums written by TRMs issuing companies. In addition, TRM earns fee revenues by providing claims administration and reinsurance intermediary services to its issuing companies and to other insurance companies.
The business model that we have developed in the 16 years since we began our operations has allowed us to create and support a much larger premium base and insurance company infrastructure than otherwise would have been possible with the limited pre-IPO capital base. Through retained earnings generated from our operations in 2005 and the infusion of the proceeds from our IPO and the concurrent private placement in October 2004, we increased the statutory surplus in our insurance company and are pursuing continued profitable growth through the following strategies:
· Reducing our Dependence on Reinsurance and Other Insurance Companies. The additional capital from the IPO and the concurrent private placement has allowed us to retain a greater percentage of our premium writings and thereby reduce our use of quota share reinsurance in TICNY. It has also provided us with greater flexibility to selectively retain a larger portion of the business previously placed with other insurance companies while continuing to utilize TRM to generate commissions on premiums placed with other insurance companies and non-risk bearing, service income.
· Improving our Rating to Attract Customers in Other Market Segments. As a result of the infusion of $98.0 million of the proceeds of the IPO and concurrent private placement into our insurance company operation, on October 26, 2004, TICNY received a rating upgrade from A.M. Best to A- (Excellent) from B++ (Very Good). Our A.M. Best rating reflects A.M. Bests opinion of TICNYs financial strength and is not an evaluation directed to investors in neither our common stock nor a recommendation to buy, sell or hold our common stock. Ratings are an increasingly important factor in establishing the competitive position of insurance companies.
There is no guarantee that TICNY will maintain the improved rating. An increase in rating positions us to write policies in rating-sensitive market segments that TICNY was not previously able to access, especially policies written by TRMs issuing companies. Tower National Insurance Company is also rated A- (Excellent) by A.M. Best.
· Expanding Territorially. TICNY is presently licensed in fifteen states including New York State as of December 31, 2005. We believe that the insurance products and services that we currently offer carry strong market demand. On March 25, 2005, Tower Group, Inc. closed on its purchase of the outstanding common stock of North American Lumber Insurance Company and renamed it Tower National Insurance Company. This acquisition will allow us to continue executing our plan to expand territorially first in New Jersey, followed by expansion into other states. On August 5, 2005, following our shell acquisition strategy, we announced our execution of an agreement to acquire MIIX Insurance Company of New York (MIIX), an insurance company with licenses in New York and New Jersey. Closing of the transaction is expected to occur during early 2006 and is contingent upon a variety of conditions including approval of the transaction by the New York State Insurance Department. In the event of closing, we will pay $225,000 in cash as well as an amount equal to MIIXs statutory surplus which was approximately $7.8 million as of December 31, 2004. MIIX has no liabilities for insurance losses. MIIXs assets consist of U.S. Treasuries and cash. We also expect to make similar shell acquisitions in the future in order to offer products in various market segments in the same territory. In addition, we formed a Program Underwriting Unit to expand on our regional distribution approach and allow us greater access to established, highly focused and narrowly defined industry classes of business with which we are familiar but which are typically distributed over a broader geographical area.
· Acquiring Books of Business. We intend to continue to acquire books of business that fit our underwriting competencies from competitors, managing agents and other producers. In September 2004, the Company entered into a Commercial Renewal Rights Agreement with OneBeacon Insurance Group LLC and some of its insurance company subsidiaries pursuant to which we have acquired OneBeacons rights to seek to renew a block of commercial lines insurance policies in New York State. Through the OneBeacon renewal rights transaction, we were able to add approximately 363 retail agents throughout New York State to expand our number of appointed agents. As we enter other states, we will continue to expand our distribution capability by appointing quality wholesale and retail agents. As of December 31, 2005, on an inception to date basis, the premiums written or produced subject to the OneBeacon Renewal Rights agreement were $39.6 million and the new business written or produced through former OneBeacon producers that we appointed in connection with the renewal rights transaction were $22.1 million.
· Expanding Non-Risk-Bearing Fee-Generating Services. We plan to continue to generate commission and fee income through our insurance services operation by offering managing general underwriting, reinsurance intermediary and claims administration services.
· Continuing Implementation of Technological Improvements. We plan to continue our implementation of technology-based initiatives such as WebPlus, our web-based platform for quoting and capturing policy submissions from our agents, in order to improve customer service and further lower our underwriting expense ratio.
We operate in three business segments:
· Insurance. In our insurance segment, TICNY and TNIC provide commercial lines policies to businesses and personal lines policies to individuals in New York State. TICNYs commercial lines
products include commercial multiple-peril, monoline general liability, commercial umbrella, monoline property, workers compensation and commercial automobile policies. Its personal lines products consist of homeowners, dwelling and other liability policies. See Item 1.Insurance Segment Products.
· Reinsurance. In our reinsurance segment, TICNY accepts or assumes reinsurance directly from TRMs issuing companies or indirectly from reinsurers that provide reinsurance coverage directly to these issuing companies. As a reinsurer, TICNY assumes a modest amount of the risk on the premiums that TRM produces. While this reinsurance business historically has not been profitable, the commission income generated by TRM on the production of this business has exceeded any underwriting losses from the reinsurance assumed on this business. See Item 1.Insurance Services Segment Products and Services.
· Insurance Services. In our insurance services segment, TRM, as a managing general agency, generates commission income by producing premiums on behalf of its issuing companies and generates fees by providing claims administration and reinsurance intermediary services. TRM does not assume any risk on business produced by it. All of the risk is written by the issuing companies and ceded to a variety of reinsurers pursuant to reinsurance programs arranged by TRM working with outside reinsurance intermediaries. Placing risks through TRMs issuing companies allowed us to underwrite larger policies and gain exposure to market segments unavailable to TICNY due to rating, financial size, geographical licensing limitations, or other factors. Through its issuing companies, TRM produces commercial package, monoline general liability, monoline property, commercial automobile and commercial umbrella products. See Item 1.Insurance Services Segment Products and Services.
Prior to our IPO, TICNYs limited capital, rating and licensing constrained its ability to write and retain large premium volume. Consequently, TICNY made extensive use of quota share reinsurance to manage the level of risk it retains in relation to its capital. In 1995, we formed TRM in order to produce business for other insurance companies that TICNY was precluded from writing due to TICNYs limited capital, rating and licensing. TRM also enabled us to earn fee revenue and to lower our underwriting expense ratio by creating economies of scale and sharing some of the cost of developing and maintaining a full insurance infrastructure. In order for us to obtain reinsurance for TRMs issuing companies, the reinsurers often require TICNY to assume reinsurance premiums directly from TRMs issuing companies or from reinsurers that reinsure the premiums written by these companies.
The following table summarizes the focus of our three segments:
Insurance Segment Products
In our insurance segment, TICNY offers a broad array of commercial and personal lines products. Our insurance segment products currently target low severity, low frequency risks with an overall average annual premium in 2005 of $4,359 policy for commercial lines and $1,043 per policy for personal lines. Typically, the liability coverage on these classes of business is not exposed to long-tailed (i.e., many years may pass before claims are reported or settled), complex or contingent risks, such as products liability, asbestos or environmental claims. These risks are located in New York City and the adjacent areas of New York State, a market that we feel, in our lines of business, level of risk and premium size, has historically been overlooked by regional and national insurance companies. With the OneBeacon Renewal Rights Agreement, TICNY has expanded its marketing territory to other areas of New York State, including Long Island, the Hudson River Valley and Western New York. However, TICNY is maintaining a targeted approach to underwriting; focusing on underserved markets that we believe will permit us to achieve favorable premium rates.
The following table shows our gross premiums earned and loss ratio for the insurance segments products for the years ended December 31, 2005 and December 31, 2004.
Commercial Multiple-peril. Our commercial multiple-peril products include commercial package policies, businessowners policies and landlord package policies. Our commercial package policies provide property and casualty coverages and focus on classes of business such as retail and wholesale stores, grocery stores, restaurants and residential and commercial buildings. We have written commercial package policies since TICNY commenced operations in 1990. Our businessowners policies provide property and liability coverages to small businesses. We introduced this product in 1997 to provide broader built-in coverages for businesses in the standard and preferred pricing tiers at lower rates than on commercial package policies. Our landlord package policy provides property and casualty coverage for three- and four-family dwellings with a maximum coverage limit of $700,000. As of December 31, 2005, approximately 38,656 commercial multiple-peril products were in place, including 22,741 commercial package policies and 11,179 landlord package policies and 4,736 businessowners policies.
Other Liability. We offer other liability products in personal and commercial lines. Our commercial products are comprised of monoline commercial general liability and commercial umbrella policies. We write commercial general liability policies for risks that do not have property exposure or whose property exposure is insured elsewhere. Primarily, we target residential and commercial buildings, as well as artisan contractors for monoline general liability. Our commercial umbrella policy, introduced in 2002, provides additional liability coverage with limits of $1,000,000 to $5,000,000 to policyholders who insure their primary general liability exposure with TICNY through a business owners, commercial package policy, or commercial general liability policy. We have the ability to offer limits of up to $10,000,000 with facultative reinsurance. As of December 31, 2005, approximately 1,774 monoline commercial general liability policies and 342 commercial umbrella policies were in force. We also write monoline personal liability policies as an addition to our dwelling fire policies. As of December 31, 2005, TICNY had approximately 1,447 comprehensive personal liability policies in force. We also write personal lines excess liability or umbrella policies covering personal liability in excess of the amounts covered under our homeowners and dwelling policies. We offer this policy with a $1,000,000 limit. We do not market excess liability policies to individuals unless we also write the underlying homeowners policy. Further, the excess liability is usually handled as an endorsement to the homeowners policy. Also, due to the upgrade in TICNYs rating from A.M. Best to A- (Excellent) from B++ (Very Good), other liability premiums that were formerly produced through TRM are now being written and earned in TICNY.
Workers Compensation. We introduced our workers compensation product in 1995. Our underwriting focus is on businesses such as restaurants, retail stores, offices, and clothing manufacturers that generally have a lower potential for severe injuries to workers from exposure to dangerous machines, elevated worksites and occupational diseases. This product is currently offered on a guaranteed cost basis
at the rates published by the New York State Workers Compensation Bureau. As of December 31, 2005, we had approximately 9,517 workers compensation policies in force.
Commercial Automobile. Our commercial automobile product focuses on non-fleet business such as contractor and wholesale food delivery vehicles. We underwrite primarily medium and lightweight trucks (under 30,000 lbs. gross vehicular weight). Historically unprofitable accounts for this segment of the insurance industry such as livery, trucking for hire or long-haul trucking operations are presently excluded under our underwriting guidelines. We commenced writing commercial automobile business in 1998. As of December 31, 2005, approximately 2,173 commercial automobile policies were in force.
Homeowners. Our homeowners policy is a multiple-peril policy providing property and liability coverages for one- and two-family owner-occupied residences. While we are expanding our marketing territories throughout New York State, the homes we currently insure are located predominantly in the greater New York City area. We market both a standard and preferred homeowners product. As of December 31, 2005, approximately 51,225 homeowners policies were in force.
Fire and Allied Lines. Our fire and allied lines policies consist of dwelling policies and monoline commercial property policies. Our dwelling product targets owner-occupied dwellings of no more than two families. The dwelling policy provides optional coverages for personal property and can be combined with an optional endorsement for liability insurance. This provides an alternative to the homeowners policy for the personal lines customer. As of December 31, 2005, we had approximately 16,457 dwelling policies in force. We also write monoline commercial property policies for insureds that do not meet our underwriting criteria for the liability portion of our commercial package policies. The classes of business are the same as those utilized for commercial package property risks. Generally, the rates charged on these policies are higher than those for the same property exposure written on a commercial package policy. As of December 31, 2005, approximately 232 monoline commercial property policies were in force.
Reinsurance Segment Products
In order for TRM to obtain reinsurance support for the business it produces for its issuing companies, Virginia Surety Company Inc. and State National Insurance Company Inc., TICNY is often required to assume a limited amount of reinsurance on this business from the issuing companies or the issuing companies reinsurers. By assuming risk, we align our interests with the issuing companies and their reinsurers. While this assumed business had historically been unprofitable, the direct commission income generated by TRM has historically offset assumed losses. In 2005, TICNY assumed 4.2% of the business produced by TRM, with gross written premiums assumed of $1.5 million, representing 0.5% of TICNYs total gross premiums written and 1.0% of its net premiums earned.
With respect to Virginia Surety, TICNY also assumed 100% of the liability above the loss ratio caps under the 2004 Multiple Lines Quota Share Reinsurance Agreement. These loss ratio caps were 95% for the small business program, 115% for the middle market program and 125% for the large lines general liability real estate program. TICNY also assumed from Virginia Surety the liability for losses not covered under the original quota share reinsurance treaties between Virginia Surety and its other reinsurers. Pursuant to an aggregate excess of loss reinsurance agreement, TICNY also assumed from two Virginia Suretys quota share reinsurers 10.25% of losses in excess of a loss ratio of 68.0% under the small market program, 15.25% of losses in excess of a loss ratio of 68.0% under the middle market program and 19.0% of losses in excess of a loss ratio of 63.0% for the large lines general liability real estate program. The Virginia Surety Multiple Lines Quota Share Reinsurance Agreement was renewed as of January 1, 2006.
In 2005, TICNY assumed from State National 100% of the liability above the loss ratio caps under the 2005 State National Combined Quota Share Reinsurance Agreement. These loss ratio caps were 95% for the small business overflow program, 115% for the middle market program and 125% for the large lines general liability real estate program. TICNY also assumed from State National the liability for losses not covered under the original quota share reinsurance treaties between State National and its other
reinsurers. Pursuant to an aggregate excess of loss reinsurance agreement, TICNY also assumed from State Nationals quota share reinsurers 10.25% of losses in excess of a loss ratio of 68.0% under the small market program, 15.25% in excess of 68.0% under the middle market program and 19.0% of losses in excess of a loss ratio of 63.0 % for the large lines general liability real estate program.
Effective August 1, 2005, TICNY agreed to be the quota share reinsurer for a book of business covering artisan contractors and general contractors written by Accident Insurance Company (AIC). Under the terms of the treaty, AIC cedes to TICNY 65% of the premiums written and TICNY allows AIC a 25% ceding commission. In addition, the terms provide for TICNY to pay AIC a contingent commission equal to 30% of any profit accruing to TICNY during each accounting period, where profit is calculated as earned premiums, less commission, less 15% of ceded earned premiums for reinsurersexpenses, less incurred losses, less any loss carried forward from the previous accounting period. TICNYs limit of liability under the treaty is capped at 150% of ceded gross earned premium, i.e. earned premium gross of ceding commission and after deduction of any return premiums and cancellations.
Insurance Services Segment Products and Services
TRM provides non-risk bearing managing general agency, reinsurance intermediary and claims administration services that generate commission and fee income for us. TRM also provides us with additional market capability to produce business in other states, product lines and pricing tiers that TICNY cannot currently access. TRM produces this business on behalf of its issuing companies, which have higher ratings, greater financial resources and more licenses than TICNY.
TRM provides underwriting, claims administration and reinsurance intermediary services to its issuing companies by utilizing TICNYs staff, facilities and insurance knowledge and skills. All of the business produced by TRM for its issuing companies is ceded to reinsurers. TRM earns a commission, equal to a specified percentage of ceded net premiums written, which is deducted from the premiums paid to the issuing insurance companies. TRMs commission rate varies from year to year depending on the loss experience of the business produced by TRM. The commission rate in 2005 was 27.1%. TRM also performs claims administration services on behalf of other insurance companies, including companies for which TRM produced business in the past, but as to which it may no longer act as an underwriting agent.
While TICNY had incurred underwriting losses from its assumed premiums to support TRMs business, those losses were based upon assumed premiums that represented only a small portion of TRMs issuing companies. TRM, as a managing general agency, however, generated commissions on all of the premiums produced. As result, TRM has contributed to both the profitability and the growth of our organization while at the same time reducing TICNYs underwriting expense ratio through economies of scale and the sharing of TICNY operating costs. As consideration for the use of TICNYs staff, equipment and facilities, TRM reimburses a portion of TICNY underwriting expenses through an expense sharing agreement. These reimbursements were $2.0 million, $3.0 million and $2.2 million in 2005, 2004 and 2003, respectively, representing 5.6%, 13.2% and 13.7%, respectively, of TICNYs total other underwriting expenses in those years. TRM also reimburses TICNY for the use of TICNYs claims and legal defense staff based upon the hourly billing rates charged by TRM to its issuing companies. These reimbursements were $4.3 million, $4.0 million and $3.6 million in 2005, 2004 and 2003, respectively, representing 3.1%, 4.8% and 4.9%, respectively, of TICNYs gross loss and loss adjustment expenses in those periods. In addition to lowering TICNYs underwriting expenses through expense reimbursement, TRM also contributes the balance of its revenues after these expense reimbursements to our overall pre-tax income. Those contributions were $2.8 million, $2.0 million and $1.5 million in 2005, 2004 and 2003, respectively.
In 2005 and 2004 TRM underwrote business on behalf of Virginia Surety and State National. Virginia Surety is rated A- (Excellent) and State National is rated A (Excellent) by A.M. Best. Virginia Surety and State National are each licensed in all 50 states and the District of Columbia. Virginia Surety is expected to be TRMs only issuing company in 2006.
TRMs business is primarily sourced through wholesale and retail brokers. See Item 1.Product Development and Marketing StrategyDistribution for further detail on our producers. The business TRM writes for its issuing companies is reinsured 100% to various reinsurers in addition to TICNY, including Tokio Millennium Re Ltd., Hannover Reinsurance (Ireland) Ltd. and E+S Reinsurance (Ireland) Ltd. TRM acts as a reinsurance intermediary for its issuing companies and arranges for all of the reinsurance ceded. For 2005, all of the reinsurers providing reinsurance for TRMs issuing companies are rated A- (Excellent) or better by A.M. Best
Managing General Agency
TRM produces business for its issuing companies through various programs, as follows:
TRM Small Business Overflow Program. TRMs small business overflow program, created in 2003, provides additional capacity and the ability to write risks outside of New York for commercial lines products of the kind written by TICNY (other than workers compensation and landlord package policies), generating annual premiums per policy of less than $25,000. All the rates, forms and underwriting guidelines for this program are identical to those used by TICNY.
TRM Middle Market Program. TRMs middle market program enables us to access commercial lines business for the same classifications of risk written by TICNY, but having annual premiums per policy in excess of $25,000. The middle market program also enables us to serve accounts that require a larger insurer than TICNY or are located outside of New York. For risks that would otherwise qualify for a commercial package policy, this program can offer monoline property or general liability coverages where one of the coverage parts does not qualify due to overly competitive pricing, lack of capacity, insufficient underwriting expertise or a restricted underwriting classification. Due to the upgrade in TICNYs A.M. Best rating to A- (Excellent) in late 2004, certain policies in the more rating sensitive middle market program were renewed in the insurance segment in 2005.
This program focuses on mercantile, residential and commercial building risks and offers property limits up to $30.0 million per location. Most of the business is located in New York City, with some accounts in other areas of New York State and New Jersey. Prior to 2001, the premium rates for the middle market program were significantly lower than the rates offered by TICNY. Beginning in 2001, the rates in this program were significantly increased, and in 2004 and 2005 they were not substantially different from those offered by TICNY.
TRM Large Lines General Liability Real Estate Program. This program, which we began in 1996, provides monoline general liability policies for mercantile, residential and commercial building risks primarily in New York City, generating annual general liability premiums in excess of $100,000. From 2001 through 2003, premium rates increased significantly on a cumulative basis from 2000 levels and we re-underwrote this program. While the rate levels stabilized in 2004 and 2005, we continued to obtain modest premium changes. Due to the upgrade in TICNYs A.M. Best rating to A- (Excellent) in late 2004, certain policies in the more rating sensitive large lines program were renewed in the insurance segment in 2005.
TRM Claims Service
TRMs claims service division provides complete claims adjusting and litigation management service for all commercial and personal property and casualty lines of business to TRMs issuing insurance companies, reinsurers and self-insureds. TRM presently bills its claims administration cost as a value added service to its issuing companies and is reimbursed by the issuing companies for the amounts billed. The fees earned by TRM help offset the total expenses incurred by TICNYs claims staff and allow TICNY to maintain a larger claims infrastructure than it would otherwise be able to support with its own premium base. The amount of claims administration fees reimbursed by the issuing companies was $4.3 million in 2005, $4.0 million in 2004 and $3.6 million in 2003.
In addition, TRM generates fees for a profit by providing claims administration, audit and consulting services to self-insureds and other insurance companies. While TRM has not actively marketed its claims service division, its reputation in claims administration and litigation management has brought several opportunities to act as a third-party claims administrator. We plan to expand our claims administration services for profit in the future.
Tower Risk Reinsurance Intermediary Services
TRMs reinsurance intermediary services division provides reinsurance intermediary services to TICNY and to TRMs issuing companies. Its revenue is derived from a fee sharing agreement with an outside reinsurance intermediary on the premium ceded to various reinsurers that reinsure TICNY and TRMs issuing companies. Its revenue for performing these services was $0.7 million in 2005, $0.7 million in 2004 and $1.1 million in 2003
We believe that many insurance companies develop and market their products based on an underwriting focused approach in which they define products based upon their underwriting guidelines and subsequently market those products to producers whose needs fit within the bounds of their underwriting criteria. Conversely, while we are a disciplined underwriting organization, our product development and marketing strategy is to first identify needed products and services from our producers and then to develop profitable products in response to those needs. After positioning our products in this manner, we focus on developing underwriting guidelines that enable us to make an underwriting profit. This approach has allowed our organization to gain the reputation of being responsive to market needs with a highly service oriented approach to our producer base.
When we first began operations in 1990, our producers confirmed the need for us to underwrite small commercial risks, such as apartment buildings, restaurants and retail stores in urban areas such as New York City that other insurance companies avoided due to a perceived lack of underwriting profitability. In response to this need, we developed commercial package policies that provided limited property and liability coverage customized to meet the needs of this nonstandard market segment, as well as underwriting and claims approaches that enabled us to achieve underwriting profitability. Since then, we have continued to develop other commercial lines products such as business owners, workers compensation and commercial automobile policies, and introduced personal lines products such as homeowners and dwelling policies, to respond to the needs of our customers in other nonstandard segments as well as customers in the preferred and standard market segments where we generally offer lower rates and broader coverages for risks that we perceive to have more desirable underwriting characteristics.
With the development of our broad product line offering, we have been able to access markets with significant premium volume and opportunity for market penetration. We have increased our market share in each of these lines of business. We have been able to achieve profitable premium growth by keeping our annual premium volume objectives in the various lines of business low relative to the overall size of the market in those lines. This approach allows us to remain selective in our underwriting and to avoid sacrificing profitability for the sake of volume.
In marketing our products, we segment the market based upon industry, location, pricing tiers and premium size. For commercial lines products, we have generally focused on specific classes of business in the real estate, retail, wholesale and service industries such as retail and wholesale stores, residential and commercial buildings, restaurants and artisan contractors. We target these underserved classes of business because we believe that they are less complex, have reduced potential for loss severity and can be easily screened and verified through physical or telephonic inspection.
We also have historically targeted risks located in urban areas such as New York City that require special underwriting expertise and have generally been avoided by other insurance companies. We have
had success targeting markets in geographical areas outside of New York City by focusing on classes of business such as residential real estate buildings that other companies have avoided. In 2006 we plan to expand territorially into New Jersey, Pennsylvania and the New England states.
We have also expanded our product offering to various lines of business within the preferred, standard and non-standard pricing segments. Within the preferred, standard or non-standard market segment, we first developed different pricing, coverages and underwriting guidelines. For example, the pricing for the preferred risk segment is generally the lowest, followed by the standard and non-standard risk segments. The underwriting guidelines are correspondingly stricter for preferred risks in order to justify the lower premium rates charged for these risks. Underwriting standards become progressively less restrictive for standard and non-standard risks.
In addition to segmenting our products by industry, location and pricing tiers, we further classify our products into the following premium size segments: under $25,000 (small), $25,000 to $150,000 (medium) and over $150,000 (large). We have historically had more success in the small premium size segment due to our focus on reducing our underwriting expenses by realizing economies of scale, utilizing technology and developing efficient business processes. We believe that due to the higher cost of underwriting small policies, other insurance companies have not been able to price competitively in this premium size segment. Our expense advantage has allowed us to maintain adequate rates through industry cycles. With improved market conditions in recent years, we have seen adequate pricing in the medium and large premium size segments as reflected by improved operating performance by TRM and in 2005 by TICNY, which has focused on these premium size segments.
Each year, we analyze various market segments and deliver products for each line of business in those segments that present the best opportunity to earn an underwriting profit based on the prevailing market conditions. As a result, the segments on which we focus will vary from year to year as market conditions change. We expand our product offerings in segments where we believe that we have established the appropriate price, coverage and commission rate to generate the desired underwriting profit. Conversely, we aim to reduce our product offerings in market segments where competition has reduced opportunities for us to earn an underwriting profit.
We generate business through independent wholesale and retail agents and brokers, whom we refer to collectively as producers. These producers sell policies for us as well as for other insurance companies. We had approximately 808 producers appointed to generate business in 2005, including 363 former OneBeacon producers.
Approximately 40% of the total of TICNYs gross premiums written and premiums produced by TRM on behalf of its issuing companies in 2005 were derived from our top 10 producers. In 2005, Morstan General Agency, CRC Insurance and Davis Agency Inc., produced, 11%, 5% and 5%, respectively, of the total of TICNYs gross premiums written and premiums produced by TRM on behalf of its issuing companies. No other producer was responsible for more than 5% of TICNYs gross premiums written and premiums produced by TRM for its issuing companies in 2005.
We carefully select our producers by evaluating several factors such as their need for our products, premium production potential, and loss history with other insurance companies that they represent, product and market knowledge and the size of the agency. We generally appoint producers with a total annual premium volume greater than $5,000,000. We expect a new producer to be able to produce at least $250,000 in annual premiums for us during the first year and $500,000 in annual premiums after three years. The newly appointed producers that were part of the OneBeacon transaction are providing access to the expiring OneBeacon renewal policies, as well as producing new business within our established underwriting guidelines and marketing appetite.
Commissions paid to producers in 2005 for TICNY averaged 16.4% of gross premiums earned. For TRM business, average commissions in 2005 were 14.4%. Our commission schedules are 1 to 1.5 points higher for wholesalers as compared to retailers in recognition of the additional duties that wholesalers perform. Also, TICNY has a profit sharing plan that added less than ½% to overall commission rates in 2005.
Prior to the IPO, we were able to generate as much premium volume as TICNYs surplus would support consistent with its A.M. Best rating. With the additional capital infusion resulting from the IPO we have increased marketing and business development efforts aimed at increasing premium volume in New York City as well as other areas in New York State. This has been directed at the orientation and training of the newly appointed agents. Additionally, with the acquisition of additional state licenses, our focus has increased in developing marketing capabilities and agency relationships in other northeastern states. Currently, our activities are directed toward constructing a producer network in New Jersey. In March 2005 we completed the acquisition of North American Lumber Insurance Company, a shell company and renamed it Tower National Insurance Company that is now licensed in sixteen states as of December 31, 2005. Additionally on March 1, 2005 we announced the formation of a Programs Underwriting Unit to compliment our regional distribution approach. The Program Underwriting Unit will allow us to gain access to established highly focused and narrowly defined books of business that are distributed over a broader geographical area not accessible through our regional distribution approach. It will also enable us to add greater value to our existing agents by developing new program opportunities for classes of business that we do not currently underwrite or in which we have a limited market penetration.
To ensure that we obtain profitable business from our producers, we attempt to position ourselves as our producers primary provider of the products that we offer. We manage the results of our producers through a quarterly review to monitor premium volume and profitability. At the end of each quarter, we produce premium and loss history reports and develop actuarial ultimate accident year factors in order to project the profitability of the producers. We continuously monitor the producers in this manner so we can develop corrective action, if necessary, at any time throughout the year.
The underwriting strategy for controlling our loss ratio is to seek diversification in our products and an appropriate business mix for any given year, emphasizing profitable lines of business and de-emphasizing unprofitable lines. At the beginning of each year, we establish the target loss ratios for each line of business. We monitor the actual loss ratio throughout the year on a monthly basis. If any line of business fails to meet its target loss ratio, a cross-functional team comprised of personnel from the underwriting teams and the corporate underwriting, actuarial, claims and loss control departments meets to develop a corrective action plan that may involve revising underwriting guidelines, non-renewing unprofitable segments or entire lines of business and/or rate increases.
During the period of time that a corrective action plan is being implemented with respect to any product line that fails to meet its target loss ratio, premium for that product line is reduced or maintained depending upon its effect on our total loss ratio. To offset the reduction or lack of growth in premium volume for the products that are undergoing corrective action, we seek to expand our premium writings in existing profitable lines of business or add new lines of business with better underwriting profit potential.
We establish underwriting guidelines for all the products that we underwrite to ensure a uniform approach to risk selection, pricing and risk evaluation among our underwriters and to achieve underwriting profitability. Our underwriting process involves securing an adequate level of underwriting information from our producers, identifying and evaluating risk exposures and then pricing the risks we choose to accept. For certain approved classes of commercial risks and most personal lines policies, we allow our producers to initially bind these risks utilizing rating criteria that we provide to them. Also, our web-based platform WebPlus provides our producers with the capability to submit and receive quotes over the Internet and contains our risk selection and pricing logic, thereby enabling us to streamline our initial
submission and screening process. If the individual risk does not meet the initial submission and screening parameters contained within WebPlus, the risk is automatically referred to our assigned underwriter for specific offline review. See Item 1.Technology.
Once a risk is bound by our underwriter or producers, our internal or outside loss control representatives conduct physical inspections of substantially all of the insured premises to validate the information provided by our producers and provide a loss control report to our underwriters to make a final evaluation of the risk. With the exception of a few typically low risk classes of business such as beauty parlors and offices, all of the new risks that are bound are physically inspected or subject to a telephone survey, generally within 60 days from the effective date of the policy. If the inspection reveals that the risk insured under the policy does not meet our established underwriting guidelines, the policy is generally cancelled within the first 60 days from its effective date. If the inspection reveals that the risk meets our established underwriting guidelines but the policy was bound with incorrect rating information, the policy is amended through an endorsement based upon the correct information. We supplement the inspection by using online data sources to further evaluate the building value, claim experience, financial history and catastrophe exposures of the insured. In addition, we specifically tailor coverages to match the insureds exposure and premium requirements. We complete internal file reviews and audits on a monthly, quarterly and annual basis to confirm that underwriting standards and pricing programs are being consistently followed. Our property risks are generally comprised of residential buildings, retail stores and restaurants covered under policies with low building and content limits. We carefully underwrite potential catastrophe exposures to terrorism losses. Our underwriting guidelines are designed to avoid properties designated as, or in close proximity to, high profile or target risks, individual buildings over 25 stories and any site within 500 feet of major transportation centers, bridges, tunnels and other governmental or institutional buildings. In addition, we monitor the concentration of employees insured under our workers compensation policies and avoid writing risks with more than 40 employees in any one building. However, please see Item 1A.Risks Related to Our Businesswe may face substantial exposure to losses from terrorism, we are currently required by law to provide coverage against such losses. Our property limits profile and the premium size of our policies in TICNY have risen as a result of the increase in TICNYs statutory surplus due to the capital contribution of $98 million of the proceeds from the IPO and the rating upgrade to A- (Excellent) by A.M. Best.
We underwrite our products through four underwriting teams that are each headed by an underwriting manager having an average of approximately 16 years of industry experience in the property and casualty industry. We have the following five business units: small commercial, middle market, commercial auto, personal lines and programs. These business units perform underwriting functions and are supported by professionals in the corporate underwriting, actuarial, operations, business development and loss control departments. The corporate underwriting department is responsible for managing and analyzing the profitability of our entire book of business, supporting line underwriting with technical assistance, developing underwriting guidelines, granting underwriting authority, training, developing new products and monitoring underwriting quality control through audits. The actuarial department is responsible for monitoring rate adequacy on all of our products and analyzing loss data on a monthly basis. The underwriting operations department is responsible for developing workflows, conducting operational audits and providing technical assistance to the underwriting teams. The loss control department conducts loss control inspections on nearly all new commercial and personal lines business written, utilizing in-house loss control representatives and outside vendors. The business development department works with the underwriting teams to manage relationships with our producers.
We price our products to make an acceptable underwriting profit. In situations where rates for a particular line become insufficient to produce satisfactory results, we control growth and reduce our premium volume in that line.
We generally use actuarial loss costs promulgated by the Insurance Services Office, a company providing statistical, actuarial and underwriting claims information and related services to insurers, as a benchmark in the development of pricing for our products. We further tailor pricing to each specific product we underwrite (other than workers compensation), taking into account our historical loss experience and individual risk and coverage characteristics. For workers compensation policies, we use statistical information provided by the New York Compensation Insurance Rating Board (NYCRIB) as a benchmark in developing our pricing.
If a particular business line is not performing well, we may seek rate increases, which are subject to regulatory approval (See Item 1.Regulation) and market acceptance. Recently, we have been successful in increasing our rates. We increased premiums on our commercial renewals as measured against expiring premium by 5.5% in 2005 and 9.0% in 2004 and 9.0% in 2003. In personal lines we increased premiums by 7.6% in 2005, 9.5% in 2004 and 2.6% in 2003.
Beginning in the latter half of 2004 and continuing throughout 2005, the rates for property and casualty insurance products began to moderate, and for certain products, rates began to decrease due to an increased level of competition. The softening in the personal lines market for both primary and reinsurance was interrupted by effects of hurricanes Katrina, Rita and Wilma on the insurance industry. We did not have any exposure to these hurricanes. However, these changes may still signal the start of a soft market cycle that could restrict or diminish our ability to obtain rate increases as in the recent past. We cannot predict with any certainty the direction the market will take during 2006 or thereafter.
We purchase reinsurance to reduce our net liability on individual risks, to protect against possible catastrophes, to achieve a target ratio of net premiums written to policyholders surplus and to expand our underwriting capacity. Reinsurance coverage can be purchased on a facultative basis, where individual risks are reinsured, or on a treaty basis, where a class or type of business is reinsured. We purchase facultative reinsurance to provide limits in excess of the limits provided by our treaty reinsurance. Treaty reinsurance falls into three categories: quota share (also called pro rata), excess of loss and catastrophe treaty reinsurance. Under our quota share reinsurance contracts, we cede a predetermined percentage of each risk for a class of business to the reinsurer and recover the same percentage of each loss and loss adjustment expenses. We pay the reinsurer the same percentage of the original premium, less a ceding commission. The ceding commission rate is based upon the ceded loss ratio on the ceded quota share premiums earned. See Item 7.Critical Accounting PoliciesCeding commissions earned. Under our excess of loss treaty reinsurance, we cede all or a portion of the liability in excess of a predetermined deductible or retention. We also purchase catastrophe treaty reinsurance on an excess of loss basis to protect ourselves from an accumulation of net loss exposures from a catastrophic event or series of events such as terrorist acts, riots, windstorms, hailstorms, tornadoes, hurricanes, earthquakes, blizzards and freezing temperatures. We do not receive any commission for ceding business under excess of loss or catastrophe reinsurance agreements.
The type, cost and limits of reinsurance we purchase can vary from year to year based upon our desired retention levels and the availability of quality reinsurance at an acceptable price. Our excess of loss reinsurance program was renewed on January 1, 2006 and Tower Group, Inc. is in discussions with a Bermuda reinsurance company in formation to enter into a multi-year quota share reinsurance agreement. Until this agreement is in place we are retaining all of the risk for 2006 that would have been ceded to quota share reinsurers. In 2005, we ceded 25% of its net premiums written to reinsurers in accordance with its quota share treaty. Our 2005 Property Catastrophe Program warrants that a minimum 25% quota share cession be in place. If a loss to the Property Catastrophe Program occurs after January 1, 2006 but before the inception of the proposed multi-year quota share agreement we would be required to retain 25% of the loss as if a 25% quota share cession was in place. Our Property Catastrophe Reinsurance Program renewed on July 1, 2005.
In recent years, the reinsurance industry has undergone very dramatic changes. Soft market conditions created by years of inadequate pricing brought poor results, which were exacerbated by the events of September 11, 2001. As a result, market capacity was reduced significantly. Reinsurers exited lines of business, significantly raised rates and imposed much tighter terms and conditions where coverage was offered, to limit or reduce their exposure to loss.
In an effort to maintain quota share capacity for our business with favorable commission levels, we have been accepting loss ratio caps in our reinsurance treaties. Loss ratio caps cut off the reinsurers liability for losses above a specified loss ratio. These provisions have been structured to provide reinsurers with some limit on the amount of potential loss being assumed, while maintaining the transfer of significant insurance risk with the possibility of a significant loss to the reinsurer. We believe our reinsurance arrangements qualify for reinsurance accounting in accordance with SFAS 113, Accounting for Reinsurance Contracts. The loss ratio caps for our quota share treaties are 95.0% for 2005, and were 95.0% in 2004, 92.0% in 2003, 97.5% in 2002 and 100.0% in 2001.
Recently, regulators and other governmental authorities have been investigating certain types of insurance and reinsurance arrangements that they allege are intended only to smooth an insured company or ceding insurers earnings rather than to transfer insurance risk. As noted above, we believe our quota share reinsurance meets all requirements pertaining to risk transfer. However, these investigations, the related legal actions and the accompanying increased scrutiny of non-traditional reinsurance arrangements may lead to a change in the applicable accounting standards or a reduction in the availability of some types of reinsurance. In turn, these developments could produce higher prices for reinsurance, an increase in the amount of risk we retain, reduced ceding commission revenue, or other potentially adverse developments. In that event, we may be required to restructure or reduce use of quota share reinsurance or reduce our premium writings. See Item 1.RegulationIndustry Investigations.
Regardless of type, reinsurance does not legally discharge the ceding insurer from primary liability for the full amount due under the reinsured policies. However, the assuming reinsurer is obligated to indemnify the ceding company to the extent of the coverage ceded. To protect our Company from the possibility of a reinsurer becoming unable to fulfill its obligations under the reinsurance contracts, we attempt to select financially strong reinsurers with an A.M. Best rating of A- (Excellent) or better and continue to evaluate their financial condition and monitor various credit risks to minimize our exposure to losses from reinsurer insolvencies.
As of December 31, 2005, we had unsecured reinsurance recoverables and ceding commissions receivable totaling $33.2 million owed by PXRE Reinsurance Company. On February 16, 2006, A.M. Best downgraded to B++(Very Good) its former A-(Excellent) financial strength rating on PXRE and issued a negative outlook. On February 24, 2006 A.M. Best downgraded PXRE to B+(Very Good) with a negative outlook. We believe that the unsecured reinsurance recoverables and ceding commission receivables from PXRE, none of which are past due nor in dispute, are fully collectible. Our judgment is based primarily on PXREs capital position as a result of its recent capital raising initiatives.
To further minimize our exposure to reinsurance recoverables, effective October 1, 2003, we have placed our quota share reinsurance treaty on a funds withheld basis under which ceded premiums written are deposited in segregated trust funds from which we receive payments for losses and ceding commission adjustments. We also used the proceeds from the IPO and the concurrent private placement to increase the capitalization of our insurance subsidiary. As a result of this increase in capital, our insurance subsidiary has been able to retain more of the risk on the business it writes, thereby reducing our need for quota share reinsurance.
The following table summarizes our reinsurance exposures by reinsurer as of December 31, 2005.
(1) Downgraded to B+ (Very Good) in February 2006.
2006 Reinsurance Program
Quota Share Reinsurance. We are in discussion with a Bermuda reinsurance company in formation to enter into a multi-year quota share reinsurance agreement. Until this agreement is in place we are retaining all of the risk for 2006 that would have been ceded to quota share reinsurers. In 2005, we ceded 25% of its net premiums written to reinsurers in accordance with its quota share treaty. Our 2005 Property Catastrophe Program warrants that a minimum 25% quota share cession be in place. If a loss to the Property Catastrophe Program occurs after January 1, 2006 but before the inception of the proposed multi-year quota share agreement we would be required to retain 25% of the loss as if a 25% quota share cession was in place.
Umbrella Quota Share Reinsurance. The Umbrella Quota Share Reinsurance, originally effective January 1, 2005, was renewed on January 1, 2006, at terms similar to the 2005 terms. The treaty reinsures against umbrella losses up to $5.0 million per occurrence. We cede 95% of its premiums written and retain the remaining 5%. The provisional ceding commission under this treaty is 30% of ceded premium written. Of the premium ceded, Platinum Underwriters Reinsurance, Inc., rated A (Excellent) by A.M. Best, reinsures 50% and Hannover Ruckversicherungs AG, rated A (Excellent) by A.M. Best, reinsures 50%.
Excess of Loss Reinsurance. Effective January 1, 2006 we entered into an Excess of Loss Reinsurance Program with similar terms as the 2005 Excess of Loss Reinsurance Program. The 2006 Excess of Loss Reinsurance Program was placed with Platinum Underwriters Reinsurance, Inc., rated A (Excellent) by A.M. Best, Endurance Reinsurance Corporation of America, rated A- (Excellent) by A.M. Best, QBE Reinsurance Corporation, rated A (Excellent) by A.M. Best, Syndicates from Lloyds of London, rated A (Excellent) by A.M. Best, Hannover Ruckversicherungs AG, rated A (Excellent) by A.M. Best, Aspen Insurance UK limited, rated A (Excellent) by A.M. Best and ACE European Group Ltd., rated A (Excellent) by A.M. Best.
Catastrophe Reinsurance. The 2005 Property Catastrophe Program provides coverage for events occurring through June 30, 2006 and is expected to be renewed on July 1, 2006 with a similar structure to the expiring program.
Terrorism Reinsurance. Pursuant to the Terrorism Risk Insurance Act of 2002 (Terrorism Act), TICNY must offer insureds the option to purchase coverage for certified acts of terrorism for an additional premium or decline such coverage. When the coverage is not purchased, we endorse the policy to exclude coverage for certified acts of terrorism, but losses from an act of terrorism that is not a certified event may be covered in any case. Also, even for certified acts of terrorism, losses from fire following the act of terrorism are covered.
The Terrorism Act reimburses up to 90% of the losses to commercial insurers due to certified acts of terrorism in excess of a deductible. Our deductible in 2004 was 10% of our 2003 direct earned premium on commercial lines. Our deductible in 2005 is 15% of our 2004 direct earned premiums on commercial lines
On December 17, 2005, Congress passed a two-year extension of the Terrorism Act though December 31, 2007 with the passage of the Terrorism Risk Insurance Extension Act of 2005 (TRIEA). Under the terms of the extension, TICNYs deductible will increase to 17.5% of direct earned premium in 2006 and 20% in 2007. The minimum size of the triggering event will be increased from the current $5 million to $50 million for the last nine months of 2006 and $100 million for 2007. As a consequence of these changes, potential losses from a terrorist attack could be substantially larger than previously expected. Potential future changes to TRIEA could also adversely affect our ability to obtain reinsurance on favorable terms, including pricing, and may affect our underwriting strategy, rating, and other elements of our operation.
2005 Reinsurance Program
Quota Share Reinsurance. Effective January 1, 2005, TICNY entered into a quota share treaty to reinsure against losses up to $1.0 million per occurrence on the gross premiums written in the insurance segment. Under the terms of the treaty, TICNY cedes 25% of its net premiums written and retains the remaining 75%. The provisional ceding commission under this treaty is 39.1% of ceded net premiums written. Of the premium ceded, Tokio Millennium Re Ltd. (Tokio Millennium), rated A+ (Superior) by A.M. Best, reinsures 50%, Hannover Reinsurance (Ireland) Ltd., rated A (Excellent) by A.M. Best, reinsures 40% and E+S Reinsurance (Ireland) Ltd. (collectively Hannover), rated A (Excellent) by A.M. Best, reinsures the remaining 10%. The 2005 quota share treaty contains various exclusions and provides coverage for 100% of extra-contractual obligations and losses in excess of policy limits. To reduce TICNYs credit exposure to reinsurance, the quota share reinsurance has been placed on a funds withheld basis. Under the terms of the reinsurance treaty, TICNY guarantees to credit the reinsurers with a 3% annual effective yield on the monthly balance of this account.
Effective January 1, 2005, TICNY entered into a quota share treaty to reinsure against umbrella losses up to $5.0 million per occurrence. Under the terms of the treaty TICNY cedes 95% of its premiums written and retained the remaining 5%. The provisional ceding commission under this treaty is 30% of ceded premium written. Of the premium ceded, Platinum Underwriters Reinsurance, Inc., rated A
(Excellent) by A.M. Best, reinsures 50% and Hannover Ruckversicherungs AG, rated A (Excellent) by A.M. Best, reinsures 50%.
Effective December 1, 2005, TICNY entered into a quota share treaty to reinsure against umbrella losses up to $5 million per occurrence on a book of commercial umbrella business produced by a third party managing general agent, W. H. Greene. Under the terms of the treaty TICNY cedes 80% of its premium written and retains the remaining 20%. The flat ceding commission under this treaty is 29% of ceded written premium. Of the premium ceded, Endurance Reinsurance Corporation of America, rated A- (Excellent) by A.M. Best, reinsures 50%, AXIS Reinsurance Company, rated A (Excellent) by A.M. Best, reinsures 20% and NGM Insurance Company, rated A (Excellent) by A.M. Best, reinsures 10%.
Excess of Loss Reinsurance. Effective January 1, 2005 TICNY entered into an Excess of Loss Reinsurance Program with the same terms as the 2004 Excess of Loss Reinsurance Treaty. The 2005 Excess of Loss Reinsurance Program was placed with American Re-Insurance Company (Am Re), rated A (Excellent) by A.M. Best, Platinum Underwriters Reinsurance, Inc., rated A (Excellent) by A.M. Best, Endurance Specialty Insurance, Ltd., rated A- (Excellent) by A.M. Best, syndicates from Lloyds of London, rated A (Excellent) by A.M. Best, and Hannover Ruckversicherungs AG, rated A (Excellent) by A.M. Best.
Catastrophe Reinsurance. The 2004 Property Catastrophe Program provided coverage for events occurring through June 30, 2005 and was renewed on July 1, 2005 with a similar structure to the expiring program.
2004 Reinsurance Program
Quota Share Reinsurance. Effective January 1, 2004, TICNY entered into a quota share treaty to reinsure against losses up to $1.0 million per occurrence on the gross premiums written in the insurance segment. Under the terms of the treaty, TICNY ceded 60% of its net premiums written and retained the remaining 40%. In accordance with treaty terms, TICNY elected to reduce the quota share cession from 60% to 25% on October 1, 2004. The provisional ceding commission under this treaty was 39.1% of ceded net premiums written. Of the premium ceded, Tokio Millennium, rated A+ (Superior), reinsured 331¤3%; Converium Reinsurance (North America) Inc. (Converium), rated B- (Fair) by A.M. Best, reinsured 331¤3%; Hannover Reinsurance (Ireland) Ltd., rated A (Excellent) by A.M. Best, reinsured 262¤3% and E+S Reinsurance (Ireland) Ltd., rated A (Excellent), reinsured the remaining 62¤3%. The 2004 quota share treaty contained various exclusions and provided coverage for 100% of extra-contractual obligations and losses in excess of policy limits. To reduce TICNYs credit exposure to reinsurance, the quota share reinsurance was placed on a funds withheld basis. Under the terms of the reinsurance treaty, TICNY guaranteed to credit the reinsurers with a 2.5% annual effective yield on the monthly balance of this account.
In September 2004, A.M. Best downgraded the rating of Converium to B- (Fair) and Converium was placed into run-off by its parent company. As a result, on September 2, 2004, we delivered notice to Converium under our quota share treaty of our intent to terminate their participation under the quota share treaty on a cut-off basis effective November 1, 2004 (subsequently extended to December 31, 2004). Subsequently we reached an agreement with Converium, Tokio Millennium and Hannover to effect a novation of Converiums quota share treaty to those other reinsurers effective January 1, 2004, as a result of which Tokio and Hannover agreed to each take 50% of Converiums share under the quota share treaty. In connection with the agreement, Tokio, Hannover and TICNY agreed to fully release Converium for any liabilities under the quota share treaty. In addition, we decided to retain the unearned premiums and risks as of December 31, 2004 that would have been ceded to Converium absent the novation.
Effective October 1, 2004, TICNY entered into a quota share treaty to reinsure against equipment breakdown losses up to $35 million per occurrence. Under the terms of the treaty, TICNY cedes 100% of its premium written to The Hartford Steam Boiler Inspection and Insurance Company, rated A++ (Superior) by A.M. Best. The flat ceding commission under this treaty is 30%. A nominal amount of premium was ceded to this treaty in 2004. The treaty is placed on a continuous basis, therefore the above terms were in effect during 2005 and will be in effect in 2006.
Excess of Loss Reinsurance. Effective January 1, 2004 TICNY entered into an Excess of Loss Reinsurance Program whereby our reinsurers were liable for 100% of the ultimate net losses in excess of $1 million for all lines of business we write, up to $10 million of limit. The program provided coverage in several layers. The first layer, which applied to multiple lines of business, afforded coverage for property business up to $1 million in excess of $1 million for each risk, with a per occurrence limit of $3 million, and for casualty business and for workers compensation losses, up to $1 million in excess of $1 million per occurrence. The excess of loss program then bifurcated into separate workers compensation and property layers. The workers compensation layers afforded coverage for workers compensation business up to $3 million in excess of $2 million for each occurrence, and for up to $5 million in excess of $5 million for each occurrence, with a maximum of $5 million for any one life. The property layers afforded coverage for property business up to $3 million in excess of $2 million for each risk, subject to a per occurrence limit of $6 million, and for up to $5 million in excess of $5 million for each risk, with a maximum of $5 million for each occurrence. The excess of loss treaties contained various sub-limits or exclusions for specific lines of business, provided coverage for 90% of extra-contractual obligations and losses in excess of policy limits, and allowed TICNY to recover allocated loss adjustment expenses on a pro rata basis in proportion to net loss. The 2004 excess of loss reinsurance treaties were placed with Am Re, rated A (Excellent) by A.M. Best, Platinum Underwriters Reinsurance, Inc., rated A (Excellent) by A.M. Best, Endurance Specialty Insurance, Ltd., rated A- (Excellent) by A.M. Best, syndicates from Lloyds of London, rated A (Excellent) by A.M. Best, Hannover Ruckversicherungs AG, rated A (Excellent) by A.M. Best, and Aspen Insurance UK Limited, rated A (Excellent) by A.M. Best.
Catastrophe Reinsurance. Effective July 1, 2004, the 2003 Property Catastrophe Program described below was extended until August 31, 2004 and provided coverage in four layers on a per occurrence basis for losses up to $55 million, less our net retention of the first $5 million of losses. Effective September 1, 2004, we entered into a property catastrophe reinsurance program that provides coverage in five layers for losses up to $75 million, less our retention of the first $15 million of losses through June 30, 2005. The program covered aggregations of net exposures on our in force, new, renewal and assumed personal and commercial property as well as auto physical damage and inland marine business, subject to certain exclusions, including mold claims, terrorists events and nuclear, chemical and biochemical attacks. In the event of a catastrophic event that results in a loss under this program, we must reinstate the amount of cover exhausted by the loss on a one-time basis by paying an additional premium to the reinsurers. Each year we select the amount of catastrophic reinsurance that we believe will be necessary to protect our Company against catastrophic events. We believe the amount of catastrophic coverage is sufficient to cover our probable maximum loss from a once in a one hundred year catastrophic event. Our catastrophic reinsurers include American Agricultural Insurance Company, rated A (Excellent) by A.M. Best, Folksamerica Reinsurance Company, rated A (Excellent) by A.M. Best, Odyssey America Reinsurance Corporation, rated A (Excellent) by A.M. Best, PXRE Reinsurance Company, rated B+ (in 2006) (Very Good) by A.M. Best, and syndicates from Lloyds of London, rated A (Excellent) by A.M. Best.
We derive investment income from our invested assets. We invest TICNYs statutory surplus and funds to support its loss and loss adjustment expense reserves and its unearned premium reserves. Due to historically limited amounts of statutory surplus and net retention by TICNY, our net investment income
had not been significant. Our investment income, however, has increased beginning in 2002 as TICNYs invested assets increased due to TICNYs increased net premiums written and surplus as well as from its $98.0 million of new investments as a direct result of a capital contribution of a portion of the IPO proceeds. Our net investment income was $15.0 million in 2005, compared to $5.1 million in 2004.
Our primary investment objectives are to preserve capital and maximize after-tax investment income. Our strategy is to purchase debt securities in sectors that represent the most attractive relative value and to maintain a moderate equity exposure. As of December 31, 2005, the fixed maturity securities represented approximately 91% of the fair market value of our investment portfolio and equity securities represented approximately 9%. Historically, we have emphasized liquidity to meet our claims obligations and debt service and to support our obligation to remit ceded premium (less ceding commission and claims payments) to our quota share reinsurers on a quarterly basis. Accordingly we have traditionally maintained between 8% and 10% of our portfolio in cash and cash equivalents. As of December 31, 2005, cash and cash equivalents represented approximately 9.8% of the total of fair market value of our investment portfolio and cash and cash equivalents.
Our investments are managed by an outside asset management company, Hyperion Capital Management, Inc., a New York based investment management firm. Hyperion has authority and discretion to buy and sell securities for us, subject to guidelines established by our Board of Directors. We may terminate our agreement with Hyperion upon 30 days notice. Our investment policy is conservative, as approximately 88.4% of the fixed income portion of our investment portfolio is rated A or higher as of December 31, 2005. The current equity target is 10% of the investment portfolio. The maximum allocation to equities, which results from market appreciation, is 20% of the investment portfolio. We monitor our investment results on a monthly basis to review the performance of our investments, determine whether any investments have been impaired and monitor market conditions for investments that would warrant any revision to our investment guidelines. Hyperion also provides us with a comprehensive quarterly report providing detailed information on our investment results as well as prevailing market conditions. Our investment results are also reviewed quarterly by the Board of Directors.
See Item 7.Investments for further information on the composition and results of our investment portfolio.
The following table shows the market values of various categories of invested assets, the percentage of the total market value of our invested assets represented by each category and the book yield based on market value of each type as of the dates and for the periods indicated:
The principal change in allocations in 2005 was an increase in the allocation to common stocks, municipal bonds, mortgage-backed securities and corporate bonds. During 2005 we reallocated a portion of the investment portfolio to higher yielding investments in equity securities. This includes common shares of a closed-end management investment company investing predominantly in asset-backed securities and mortgage-backed securities. We also invested in publicly traded real estate investment trusts (REITs) and one private placement REIT scheduled for an early 2006 IPO. During 2005 we had net purchases of mortgage-backed securities, municipal bonds and corporate bonds of approximately $108.6 million from investing new cash flow from operations. These new fixed maturity investments offered us favorable yields and fundamental credit quality. At December 31, 2005, the average credit quality of our fixed income investments was AA+ and the duration was 3.96 years.
During 2004, the most significant portfolio activity came during the fourth quarter with the investment of the IPO proceeds of $98.0 million. In order to increase the portfolios overall tax-exempt allocation, approximately 60% of the proceeds were invested into tax-exempt securities. Due to the steeper yield curve in the tax-exempt market compared to the taxable market, the tax-exempt purchases were focused in longer duration securities averaging approximately six years. To offset these longer duration securities, the taxable bond purchases were concentrated in short durations averaging two to three years.
In addition, during the fourth quarter of 2004, the effective duration of the portfolio decreased to 4.17 years compared to 4.41 years as of September 30, 2004. The lower duration was primarily due to the significant cash increase from the net proceeds from the issuance of $26.8 million of subordinated debentures underlying trust preferred securities in December 2004.
The following table shows the composition of our investment portfolio by remaining time to maturity at December 31, 2005 and December 31, 2004. For securities that are redeemable at the option of the issuer and have a market price that is greater than par 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 par value, the maturity used for the table below is the final maturity date.
The average credit rating of our fixed maturity portfolio, using ratings assigned to securities by Standard and Poors, was AA+ at December 31, 2005 and AA+ at December 31, 2004. The following table shows the ratings distribution of our fixed income portfolio as of the end of each of the past two years.
We regularly review our portfolio for declines in value. If a decline in value is deemed temporary, we record the decline as an unrealized loss in other comprehensive net income on our consolidated statement of income and accumulated other comprehensive net income on our consolidated balance sheet. If the decline is deemed other than temporary, we write down the carrying value of the investment and record a realized loss in our consolidated statements of income. As of December 31, 2005 and December 31, 2004, we had cumulative net unrealized (losses)/gains on our fixed maturity portfolio of $(4.4) million and $1.0 million, respectively. There were no other than temporary declines in the fair value of our securities at December 31, 2005 and 2004.
We maintain reserves for the payment of claims (incurred losses) and expenses related to adjusting those claims (loss adjustment expenses or LAE). Our loss reserves consist of case reserves, which are reserves for reported claims, and reserves for claims that have been incurred but have not yet been reported (sometimes referred to as IBNR). The amount of loss reserves for reported claims is based primarily upon a claim-by-claim evaluation of coverage, liability, injury severity or scope of property
damage, and any other information considered pertinent to estimating the exposure presented by the claim. The amounts of loss reserves for unreported claims and loss adjustment expense reserves are determined using historical information by line of business as adjusted to current conditions. Reserves for LAE are intended to cover the ultimate cost of settling claims, including investigation and defense of lawsuits resulting from such claims. The amount of loss and LAE reserves is determined by us on the basis of industry information, the development to date of losses on the relevant line of business and anticipated future conditions. Because loss reserves are an estimate of the ultimate cost of settling claims, they are closely monitored by us and recomputed at least quarterly based on updated information on reported claims and a variety of statistical techniques. Furthermore, an independent actuary prepares a report each year concerning the adequacy of the loss reserves.
Reconciliation of Loss and Loss Adjustment Expense Reserves
The table below shows the reconciliation of reserves on a gross and net basis for each of the last three calendar years, reflecting changes in losses incurred and paid losses.
Our claims reserving practices are designed to set reserves that in the aggregate are adequate to pay all claims at their ultimate settlement value. Thus, our reserves are not discounted for inflation or other factors.
Shown below is the loss development for business written each year from 1995 through 2005. The table portrays the changes in our loss and LAE reserves in subsequent years from the prior loss estimates based on experience as of the end of each succeeding year on the basis of GAAP.
The first line of the table shows, for the years indicated, our net reserve liability including the reserve for incurred but not reported losses as originally estimated. For example, as of December 31, 2002 we estimated that $15.476 million would be a sufficient reserve to settle all claims not already settled that had occurred prior to December 31, 2002 whether reported or unreported to us. The next section of the table shows, by year, the cumulative amounts of losses and loss adjustment expenses paid as of the end of each succeeding year. For example, with respect to the net losses and loss expense reserve of $15.476 million as of December 31, 2002, by the end of 2005 (three years later) $9.090 million had actually been paid in settlement of the claims.
The next section of the table sets forth the re-estimates in later years of incurred losses, including payments, for the years indicated. For example, as reflected in that section of the table, the original reserve of $15.476 million was re-estimated to be $16.461 million at December 31, 2005. The increase from the original estimate is caused by a combination of factors, including: (1) reserves being settled for amounts different than originally estimated, (2) reserves being increased or decreased for claims remaining open as more information becomes known about those individual claims and (3) more or fewer claims being reported after December 31, 2002 than had occurred prior to that date.
The cumulative redundancy/ (deficiency) represents, as of December 31, 2005, the difference between the latest re-estimated liability and the reserves as originally estimated. A redundancy means the original estimate was higher than the current estimate; a deficiency means that the current estimate is higher than the original estimate. For example, as of December 31, 2005 and based upon updated information, we re-estimated that the reserves which were established as of December 31, 2004 were $392,000 redundant.
The bottom part of the table shows the impact of reinsurance reconciling the net reserves shown in the upper portion of the table to gross reserves.
Analysis of Reserves
The following table shows our net outstanding case loss reserves and IBNR by line of business as of December 31, 2005.
In 2004 and 2005 we had favorable development in our net losses from prior accident years of $199,000 and $392,000, respectively.
We carefully monitor our gross, ceded and net loss reserves by segment and line of business to ensure that they are adequate, since a deficiency in reserves will indicate inadequate pricing on our products and may impact our financial condition.
Our actuaries utilize several methodologies to project losses and corresponding reserves. These methodologies generally are classified into three types:
· Loss development projections. Loss development projection methods are characterized by determination of loss development factors utilizing patterns of loss development from incurred and paid losses for prior accident years. This is the main methodology utilized for each accident year except for the most current accident year.
· Loss ratio projections. There also is significant weight given to the loss ratio projections. Loss ratio projections determine the loss ratio for the current year based upon applying inflation, or trend, and the effect of rate changes to the loss ratios from the prior years. This method is given weight for the current accident year when there is high volatility in the reported development patterns at early ages.
· Frequency and severity projections. Frequency and severity projections are characterized by development of numbers of claims reported and average claims severity, and these methods are utilized as a check on the other methods.
Based upon these methods our actuaries determine a best estimate of the loss reserves. All of these methods are standard actuarial approaches and have been utilized consistently since 2003.
We are not aware of any claims trends that have emerged or that would cause future adverse development that have not already been considered in existing case reserves and in our current loss development factors.
Also, in New York State, lawsuits for negligence, subject to certain limitations, must be commenced within three years from the date of the accident or are otherwise barred. Accordingly, our exposure to IBNR for accident years 2003 and prior is limited although there remains the possibility of adverse development on reported claims. Due to the reserve strengthening in 2002 and close monitoring and analysis of reserves, we believe our loss reserves are adequate. This is reflected by the loss development as of December 31, 2005 showing developed redundancies since 2003. However, there are no assurances that future loss development and trends will be consistent with our past loss development history, and so
adverse loss reserves development remains a risk factor to our business. See Item 1A.Risks Related to Our BusinessIf our actual loss and loss adjustment expenses exceed our loss reserves, our financial condition and results of operations could be significantly adversely affected.
The net loss reserves for the most recent accident years on a consolidated basis as of December 31, 2005 were $76.1 million for accident year 2005 and $12.7 million for accident year 2004. A redundancy or (deficiency) in net reserves for these years would impact our income before income taxes by the following :
Our claims division combines the services of our staff defense, coverage and appellate attorneys with a traditional multi-line insurance claims adjusting staff. See Item 1.Business SegmentsInsurance Services Segment Products and Services for a description of TRMs claim service fee-based operations.
The claims division seeks to provide expedient, fair and consistent claims handling, while controlling loss adjustment expenses. Handling the claims adjustment and defense of insureds in-house enables us to accurately evaluate coverage, promptly post accurate loss and loss adjustment expense reserves, maintain the highest policyholders service standards and aggressively defend against liability claims. In addition, through the use of a claims database that captures detailed statistics and information on every claim, our underwriting and loss control departments are able to access information to assist them in the monitoring of the various lines of business and identifying adverse loss trends, giving them the ability to make informed underwriting and pricing decisions.
The claims division is divided into eight units: auto claims, workers compensation claims, property claims, liability claims, coverage, in-house defense, administration and processing, and subrogation and recovery. Our in-house legal staff consists of approximately 16 attorneys who are managed by two co-managing attorneys reporting to the Senior Vice President Claims.
The continued development of in-house expertise in all areas remains a primary goal of the claims division. We have continued to build an in-house defense team in order to handle a substantial percentage of lawsuits in New York State and vigorously defend against fraudulent and frivolous lawsuits. Given the high cost of coverage counsel in those instances where coverage may be an issue, we formed an in-house coverage law firm. Our claims staff and in-house attorneys handle all of our claims and the majority of our lawsuits internally. Approximately 75% of all lawsuits arising from our insurance company operation are currently handled in-house. This approach enables us to maintain a high level of service to our policyholders and vigorously defend non-meritorious and frivolous claims while controlling loss adjustment expenses. We have also formed a full time staff of in-house liability field investigators to replace a traditionally outsourced claims function. We have also built an experienced team of field property adjusters to push down costs and to ensure high quality claims experience for our commercial and personal lines property policyholders.
Ultimately, the claims division endeavors to provide a prompt response to the needs of policyholders in all first-party losses. Rapid review of the loss, confirmation of coverage and speedy payment to the insured is the ongoing commitment of our claims division. With respect to third-party claims, our approach is the thorough investigation of all claims as soon as reported, in order to separate those that should be
resolved through settlement from those that should be denied and/or defended. Suspicious or fraudulent first- and third-party claims are always aggressively investigated and defended.
We seek to leverage technology and make use of business process redesign in order to gain operating efficiencies and effectiveness. For example, we were able to eliminate redundant keying of policy information by upgrading our policy data entry system. This has enabled us to control the growth of our clerical staff and improve our customer service. We have implemented a number of technology improvements and redesign of business processes, including an on-line imaging system, a data warehouse that houses both claims and underwriting data to provide management reporting and a web-based platform (WebPlus) for quoting and capturing policy submissions directly from our producers.
We utilize Hewlett Packard/Compaq servers that run the Microsoft Windows Server 2000 operating system. Backups of server data and programs are made to tape daily and are taken to an off-site facility by an outside vendor. We have begun migrating our production servers to an offsite location. This secure facility will provide fully redundant power, air conditioning, communications and 24-hour support. With this off site premise, we will have two operational data centers, one primary and one secondary, to handle disaster recovery needs.
Since April 2003, we have been using WebPlus, our web-based software platform for quoting and capturing policy submissions directly from our producers. WebPlus allows our producers to submit, rate and, where permitted by the program, bind small premium accounts. Through a rules based engine, we have implemented our underwriting guidelines within WebPlus. Through an ongoing monthly, quarterly and annual management review and analysis of the book of business, we confirm the risk quality and loss ratio profile of policies processed in WebPlus. We utilize WebPlus for all of our personal lines business and landlord package policies. We started using WebPlus in April 2003 and within twelve months approximately 94% of our personal lines policies were being processed through WebPlus. We believe that this technology reduces underwriter involvement in each policy application, as well as improves our ability to validate and capture all relevant policy information early in the submission process and at a single point. We believe that WebPlus has significantly reduced our expense associated with processing business, improved customer service and made it easier for our producers to do business with us. In 2004, we added workers compensation and automobile to the suite of products that can be submitted to us through WebPlus, and we are now developing commercial package and automobile policies capability.
WebPlus was developed for us by AgencyPort Insurance Services, Inc. (AgencyPort), a technology Company specializing in the property and casualty insurance industry, in exchange for our commitment to invest $1 million in AgencyPort. In addition, we licensed AgencyPorts KeyOnce software development kit (SDK), which AgencyPort utilized to develop WebPlus. We also obtained a warrant to acquire common shares in AgencyPort. On January 7, 2004 TICNY exercised this warrant in full for 1,072,525 common shares of AgencyPort, for $1 million less $663,000 paid towards the development of WebPlus resulting in a payment of $337,000. These payments have been capitalized as software and are being amortized over three years. The 1,072,525 shares represented approximately 25% of the outstanding shares of AgencyPort as of December 31, 2005. We do not exercise significant influence over AgencyPort and we do not have any representation on the Board of Directors of AgencyPort. The relationship is primarily one of AgencyPort as a licensor and developer of software for our benefit. Accordingly, we do not account for our investment in AgencyPort on the equity method. We have assigned no value to the shares acquired as AgencyPort as of December 31, 2005. As of December 31, 2003, we held another warrant to acquire an additional 30% of the outstanding shares of AgencyPort. On August 31, 2004, we entered into an agreement with AgencyPort to eliminate this warrant in consideration for certain rights granted to us including access to certain software source code. We received the source code upon execution of the agreement.
Our technology plan currently envisions that we will expand our use of WebPlus to additional products and other business functions (such as claims submission and reporting). We also intend to exploit technological improvements and economies of scale realized through premium growth to continue to lower our underwriting expense ratio while offering a strong value proposition to our producer base.
We compete with a large number of other companies in our selected lines of business, including major U.S. and non-U.S. insurers and other regional companies, as well as mutual companies, specialty insurance companies, underwriting agencies and diversified financial services companies. We compete for business on the basis of a number of factors, including price, coverages offered, customer service, relationship with producers (including ease of doing business, service provided and commission rates paid), financial strength and size and rating by independent rating agencies.
As our territorial expansion has progressed within New York State, we have developed an increased number of competitors. In our commercial lines business, our competitors include The St. Paul Travelers Insurance Company, Hartford Insurance Company, Safeco, Hannover Insurance Companies, Magna Carta Companies, Greater New York Mutual Insurance Company, OneBeacon Insurance Company, Selective, Utica First Insurance Company, Middlesex Mutual and Erie Insurance Company. In our personal lines business, we compete against companies such as Allstate Insurance Company, State Farm Companies, The St. Paul Travelers Companies, Inc., Hartford Insurance Company, OneBeacon Insurance Group, New York Central Insurance Company, Commercial Mutual Insurance Company, Preferred Mutual Insurance Company and Otsego Mutual Fire Insurance Company.
The soft market that existed until sometime in 2001 was characterized by pricing based competition, with a number of competitors attempting to gain or retain market share by charging premium rates that ultimately proved to be inadequate. The losses suffered by many of these companies have resulted in their insolvencies or exit from our chosen markets. The pricing environment in the hard market prevalent in 2004 was such that competition tends to focus more on the non-pricing factors listed above. During the last quarter of 2004 and continuing throughout 2005 a moderation of the pricing environment within the commercial insurance marketplace became evident as pricing increases on renewing policies lessened.
We seek to distinguish ourselves from our competitors by providing a broad product line offering and targeting those market segments that we believe are underserved and therefore provide us with the best opportunity to obtain favorable policy terms, conditions and pricing. We believe that by offering several different lines of business, we are able to compete effectively against insurance companies that offer limited products. We also seek to limit the extent to which we must directly compete with the companies listed above by positioning our products in underserved market segments and adjusting our premium volume in these market segments depending upon the level of competition. We have historically targeted risks located in New York City and adjacent areas, as we feel this is a market that historically has not been emphasized by regional and national insurance companies. As our territorial expansion has encompassed all of New York State and other northeastern states, we have maintained our marketing approach. We will continue to compete with other companies by quickly and opportunistically delivering products that respond to our producers needs, which may be determined by other companies insolvencies or voluntary withdrawals from particular market segments. Our ability to quickly develop and replace various products that had previously been offered by Empire Insurance Group when we purchased the renewal rights to the Empire business in 2001 is an example of this capability. In addition to being responsive to market needs, we also focus on assisting our producers with placing business by offering rating and submission capability through WebPlus and rating disks, as well as by providing our producers with clear and concise underwriting guidelines. We also compete by focusing on reducing our producers costs of doing business with us. For example, we directly bill our policyholders on most of our policies with a per policy premium below $10,000 and provide customer service support to policyholders on behalf of our producers. This
increased service allows us to deliver value to our producers other than through higher commission rates. Finally, our success in reducing liability claims costs through cost effective and aggressive claims handling has reduced the cost of liability insurance premiums for our policyholders. This capability also helps us compete with other insurance companies. Notwithstanding the positive competitive factors discussed above, many of our competitors have greater financial and marketing resources and higher ratings from rating agencies than we do, which may have an adverse effect on our ability to compete with them.
Many insurance buyers, agents and brokers use the ratings assigned by A.M. Best and other rating agencies to assist them in assessing the financial strength and overall quality of the companies from which they are considering purchasing insurance. TICNY was assigned a letter rating of B+ (Very Good) by A.M. Best in 1997 and was upgraded to B++ (Very Good) in 2003. In October 2004, TICNY was upgraded to A- (Excellent) by A.M. Best, the 4th highest of 15 rating categories used by A.M. Best. In evaluating a companys financial strength, A.M. Best reviews the companys profitability, leverage and liquidity, as well as its book of business, the adequacy and soundness of its reinsurance, the quality and estimated market value of its assets, the adequacy of its loss and loss expense reserves, the adequacy of its surplus, its capital structure, the experience and competence of its management and its market presence. This rating is intended to provide an independent opinion of an insurers financial strength and is not an evaluation directed at investors. There is no guarantee that TICNY will maintain the improved rating. In addition during 2005 TNIC, a newly acquired shell company, was also rated A- (Excellent) by A.M. Best.
In April 2003, in connection with the issuance of subordinated debentures underlying trust preferred securities, TICNY also received an insurer financial strength rating from Standard & Poors. This rating provides an assessment of the financial strength of an insurance company and its capacity to meet obligations to policyholders on a timely basis. TICNYs most recent rating from Standard & Poors is BB+ with a stable outlook.
With the rating upgrade from A.M. Best, TICNY is positioned to enter into new market segments that will provide additional premium growth opportunities. Some segments of the insurance market are rating sensitive. This means that customers in those segments require that their insurance company have a minimum financial strength and/or a minimum rating. Additional rating sensitivity is created by some insurance companies writing umbrella policies, who will not issue a policy unless the underlying primary carrier has a minimum rating. We believe that the A- (Excellent) rating will allow TICNY to participate in rating sensitive markets such as the middle market segment described in Item 1.Business SegmentsInsurance Services Segment Products and Services, currently served by TRM through the use of TRMs issuing companies. Likewise, with the higher rating, we believe TICNY will be able to attract many large premium accounts in the monoline liability and preferred property lines of business, where insureds also tend to be rating sensitive.
All of our employees are employed directly by TICNY. As of December 31, 2005, the total number of full-time equivalent employees of TICNY was 360 of which 286 are in New York City, 48 are in the Long Island, New York branch and 26 are in the Buffalo, New York branch. None of these employees are covered by a collective bargaining agreement. We have employment agreements with our senior executive officers. The remainder of our employees are at-will employees.
U.S. Insurance Holding Company Regulation of Tower
Tower, as the parent of TICNY and TNIC, is subject to the insurance holding company laws of New York. These laws generally require TICNY and TNIC to register with the New York Insurance Department and to furnish annually financial and other information about the operations of companies within the holding company system. Generally under these laws, all material transactions among companies in the holding company system to which TICNY or TNIC is a party, including sales, loans, reinsurance agreements and service agreements, must be fair and reasonable and, if material or of a specified category, require prior notice and approval or non-disapproval by the New York Insurance Department.
Changes of Control
Before a person can acquire control of a New York insurance company, prior written approval must be obtained from the Superintendent of Insurance of the State of New York. Prior to granting approval of an application to acquire control of a New York insurer, the Superintendent of Insurance of the State of New York will consider such factors as: the financial strength of the applicant, the integrity and management of the applicants Board of Directors and executive officers, the acquirers plans for the management of the applicants Board of Directors and executive officers, the acquirers plans for the future operations of the domestic insurer and any anti-competitive results that may arise from the consummation of the acquisition of control. Pursuant to the New York insurance holding company statute, control means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of the company, whether through the ownership of voting securities, by contract (except a commercial contract for goods or non-management services) or otherwise. Control is presumed to exist if any person directly or indirectly owns, controls or holds with the power to vote 10% or more of the voting securities of the company; however, the New York State Insurance Department, after notice and a hearing, may determine that a person or entity which directly or indirectly owns, controls or holds with the power to vote less than 10% of the voting securities of the company, controls the company. Because a person acquiring 10% or more of our common stock would indirectly control the same percentage of the stock of the TICNY, the insurance change of control laws of New York would likely apply to such a transaction.
These laws may discourage potential acquisition proposals and may delay, deter or prevent a change of control of Tower, including through transactions, and in particular unsolicited transactions, that some or all of the stockholders of Tower might consider to be desirable.
From time to time, various regulatory and legislative changes have been proposed in the insurance industry. Among the proposals that have in the past been or are at present being considered are the possible introduction of Federal regulation in addition to, or in lieu of, the current system of state regulation of insurers and proposals in various state legislatures (some of which proposals have been enacted) to conform portions of their insurance laws and regulations to various model acts adopted by the National Association of Insurance Commissioners (NAIC). We are unable to predict whether any of these laws and regulations will be adopted, the form in which any such laws and regulations would be adopted, or the effect, if any, these developments would have on our operations and financial condition.
In 2002, in response to the tightening of supply in certain insurance and reinsurance markets resulting from, among other things, the September 11, 2001 terrorist attacks, the Terrorism Act was enacted. The Terrorism Act is designed to ensure the availability of insurance coverage for foreign terrorist acts in the United States of America. This law established a Federal assistance program through the end of 2005 to
help the commercial property and casualty insurance industry cover claims related to future terrorism-related losses and requires such companies to offer coverage for certain acts of terrorism. As a result, we are prohibited from adding certain terrorism exclusions to the policies written by TICNY. Although TICNY is protected by federally funded terrorism reinsurance as provided for in the Terrorism Act, there is a substantial deductible that must be met, the payment of which could have an adverse effect on our results of operations. On December 17, 2005, Congress passed a two-year extension of the Terrorism Act though December 31, 2007, under the terms of the extension, Tower deductible will increase to 17.5% of direct earned premium in 2006 and 20% in 2007. The minimum size of the triggering event will be increased from the current $5 million to $50 million for the last nine months of 2006 and $100 million in 2007. As a consequence of these changes, potential losses from a terrorist attack could be substantially larger than previously expected. Potential future changes to the Terrorism Act could also adversely affect our ability to obtain reinsurance on favorable terms, including pricing, and may affect our underwriting strategy, rating, and other elements of our operation.
In October 2003, New York State enacted a version of the NAIC Producer Licensing Model Act (the Act), which provides uniform procedures and guidelines for the licensing of insurance brokers and agents. The applicable provisions of the Act took effect January 1, 2004. The Act is primarily directed toward assisting New York insurance agents and brokers to transact business in other states on a non-resident basis. The law includes provisions to increase uniformity among states in regard to producer licensing. We do not anticipate that this law will have a material impact on us.
State Insurance Regulation
State insurance authorities have broad regulatory powers with respect to various aspects of the business of U.S. insurance companies. The primary purpose of such regulatory powers is to protect individual policyholders. The extent of such regulation varies, but generally has its source in statutes that delegate regulatory, supervisory and administrative power to state insurance departments. Such powers relate to, among other things, licensing to transact business, accreditation of reinsurers, admittance of assets to statutory surplus, regulating unfair trade and claims practices, establishing reserve requirements and solvency standards, regulating investments and dividends, approving policy forms and related materials in certain instances and approving premium rates in certain instances. State insurance laws and regulations require TICNY and TNIC to file financial statements with insurance departments everywhere it will be licensed to conduct insurance business, and its operations are subject to examination by those departments.
TICNY and TNIC prepare statutory financial statements in accordance with statutory accounting principles (SAP) and procedures prescribed or permitted by the New York Insurance Department and the Massachusetts Department of Insurance, respectively. As part of their regulatory oversight process, state insurance departments conduct periodic detailed examinations of the books and records, financial reporting, policy filings and market conduct of insurance companies domiciled in their states, generally once every three to five years. Examinations are generally carried out in cooperation with the insurance departments of other states under guidelines promulgated by the NAIC.
The terms and conditions of reinsurance agreements generally are not subject to regulation by any U.S. state insurance department with respect to rates or policy terms. As a practical matter, however, the rates charged by primary insurers do have an effect on the rates that can be charged by reinsurers.
Insurance Regulatory Information System Ratios
The Insurance Regulatory Information System, or IRIS, was developed by the NAIC and is intended primarily to assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. IRIS identifies thirteen industry ratios and specifies usual values for each ratio. Departure from the usual values on four or more
of the ratios can lead to inquiries from individual state insurance commissioners as to certain aspects of an insurers business. For 2005 TICNYs results were outside the usual values for two IRIS ratios and within the usual values for eleven IRIS ratios. In 2005, the change in net writings ratio was affected by the 116% increase in net premiums written due to the reduction in our quota share ceding percentage effective October 1, 2004 which continued throughout 2005 as well as growth in gross premiums written. The estimated current reserve deficiency to policyholders surplus was affected by the 261% increase in net premiums earned due to the reduction in our quota share ceding percentage effective October 1, 2004 which continued throughout 2005 as well as growth in gross premiums earned. For 2005 TNICs results were outside the usual values for two IRIS ratios and within the usual values for eleven IRIS rations. The two IRIS ratios that were outside the usual values were gross change in policyholders surplus and net change in adjusted policyholders surplus. Both ratios were outside of the usual values as a result of the beginning surplus of zero and an ending surplus of $10.1 million from our capital contribution.
New York State Dividend Limitations
TICNYs ability to pay dividends is subject to restrictions contained in the insurance laws and related regulations of New York. Under New York law, TICNY may pay dividends out of 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 12 months, exceeds the lesser of (1) 10% of TICNYs policyholders surplus as shown on its latest statutory financial statement filed with the New York Insurance Department or (2) 100% of adjusted net investment income during the preceding twelve months. TICNY declared approximately $2,050,000, $850,000 and $363,000 in dividends to Tower in 2005, 2004, and 2003, respectively. As of December 31, 2005, the maximum distribution that TICNY could pay without prior regulatory approval was approximately $4.0 million.
Massachusetts Dividend Limitations
TNIC my not pay any dividend that, together with all dividends declared or distributed by TNIC during the preceding twelve months, excluding pro rata distributions of any class of the TNICs own securities, exceeds the greater of (1) 10% of TNICs policyholders surplus as of the end of the preceding calendar year or (2) TNICs net income for the next preceding calendar year, until thirty days after the Commissioner has received notice of the intended dividend and not objected in such time. Because TNIC has not yet commenced insurance operations it has no positive unassigned surplus. Therefore, it may not pay dividends at this time without the approval of the Massachusetts Commissioner of Insurance.
Risk-Based Capital Regulations
The New York Insurance Department requires domestic property and casualty insurers to report their risk-based capital based on a formula developed and adopted by the NAIC that attempts to measure statutory capital and surplus needs based on the risks in the insurers mix of products and investment portfolio. The formula is designed to allow the New York Insurance Department 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 insurers assets (including risks related to its investment portfolio and ceded reinsurance) and the insurers liabilities (including underwriting risks related to the nature and experience of its insurance business). At December 31, 2005 TICNY and TNICs risk-based capital levels exceeded the minimum level that would trigger regulatory attention. In their 2005 statutory statements, TICNY and TNIC have both complied with the NAICs risk-based capital reporting requirements.
Statutory Accounting Principles
SAP is a basis of accounting developed to assist insurance regulators in monitoring and regulating the solvency of insurance companies. It is primarily concerned with measuring an insurers surplus to policyholders. Accordingly, statutory accounting focuses on valuing assets and liabilities of insurers at financial reporting dates in accordance with appropriate insurance law and regulatory provisions applicable in each insurers domiciliary state.
GAAP is concerned with a companys solvency, but it is also concerned with other financial measurements, such as income and cash flows. Accordingly, GAAP gives more consideration to appropriate matching of revenue and expenses and accounting for managements stewardship of assets than does SAP. As a direct result, different assets and liabilities and different amounts of assets and liabilities will be reflected in financial statements prepared in accordance with GAAP as opposed to SAP.
Statutory accounting practices established by the NAIC and adopted, in part, by the New York and Massachusetts regulators determine, among other things, the amount of statutory surplus and statutory net income of TICNY and TNIC and thus determine, in part, the amount of funds that are available to pay dividends to us.
In New York and in the Commonwealth of Massachusetts and in most of the jurisdictions where TICNY and TNIC are currently licensed to transact business there is a requirement that property and casualty insurers doing business within the jurisdiction participate in guaranty associations, which are organized to pay contractual benefits owed pursuant to insurance policies issued by impaired, insolvent or failed insurers. These associations levy assessments, up to prescribed limits, on all member insurers in a particular state on the basis of the proportionate share of the premium written by member insurers in the lines of business in which the impaired, insolvent or failed insurer is engaged. Some states permit member insurers to recover assessments paid through full or partial premium tax offsets.
In none of the past five years has the assessment in any year levied against TICNY been material. Property and casualty insurance company insolvencies or failures may result in additional security fund assessments to TICNY and TNIC at some future date. At this time we are unable to determine the impact, if any; such assessments may have on the consolidated financial position or results of operations. We have established liabilities for guaranty fund assessments with respect to insurers that are currently subject to insolvency proceedings and assessments by the various workers compensation funds. See Note 13. Commitments and Contingencies.
The activities of TRM are subject to licensing requirements and regulation under the laws of New York and New Jersey. TRMs business depends on the validity of, and continued good standing under, the licenses and approvals pursuant to which it operates, as well as compliance with pertinent regulations. TRM therefore devotes significant effort toward maintaining its licenses to ensure compliance with a diverse and complex regulatory structure.
Licensing laws and regulations vary from jurisdiction to jurisdiction. In all jurisdictions, the applicable licensing laws and regulations are subject to amendment or interpretation by regulatory authorities. Generally such authorities are vested with relatively broad and general discretion as to the granting, renewing and revoking of licenses and approvals. Licenses may be denied or revoked for various reasons, including the violation of such regulations, conviction of crimes and the like. Possible sanctions which may be imposed include the suspension of individual employees, limitations on engaging in a particular business for specified periods of time, revocation of licenses, censures, redress to clients and fines. In some
instances, TRM follows practices based on interpretations of laws and regulations generally followed by the industry, which may prove to be different from the interpretations of regulatory authorities.
The insurance industry recently has become the subject of increasing scrutiny with respect to insurance broker and agent compensation arrangements and sales practices. The New York State Attorney General and other state and Federal regulators have commenced investigations and other proceedings relating to compensation and bidding arrangements between producers and issuers of insurance products and unsuitable sales practices by producers on behalf of either the issuer or the purchaser. The practices currently under investigation include, among other things, allegations that so-called contingent commission arrangements may conflict with a brokers duties to its customers that certain brokers and insurers may have engaged in anti-competitive practices in connection with insurance premium quotes. The New York State Attorney General has recently entered into a settlement agreement with two large insurance brokers. These investigations and proceedings are expected to continue, and new investigative proceedings may be commenced, in the future. These investigations and proceedings could result in legal precedents and new industry-wide practices or legislation, rules or regulations that could significantly affect our industry and may also cause stock price volatility for companies in the insurance industry. Contingent commissions under our producers profit sharing plan amounted to less than ¼% of our overall commission expense in 2004 and less than ½% in 2005.
Recently, regulators and other governmental authorities have been investigating certain types of insurance and reinsurance arrangements that they allege are intended only to smooth an insured company or ceding insurers earnings rather than to transfer insurance risk. We believe our quota share reinsurance meets all requirements pertaining to risk transfer. However, these investigations, the related legal actions and the accompanying increased scrutiny of non-traditional reinsurance arrangements may lead to a change in the applicable accounting standards or a reduction in the availability of some types of reinsurance. In turn, these developments could produce higher prices for reinsurance, an increase in the amount of risk we retain, reduced ceding commission revenue, or other potentially adverse developments. In that event, we may be required to restructure or reduce our use of quota share reinsurance or reduce our premium writings.
The Company received an inquiry from the New York Insurance Department on April 15, 2005 relating to risk transfer under its 2004 quota share reinsurance agreement effective January 1, 2004. The Company provided information in response to this inquiry and on August 8, 2005 the New York Insurance Department concluded that, based upon its review of the additional information provided by the Company, the 2004 quota share treaty complies with the risk transfer provisions.
Some of the statements under Item 1A Risk Factors, Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations, Item 1 Business and elsewhere in this Form 10-K 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 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 Item 1A.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 worlds financial and capital markets that adversely affect the performance of our investments;
· changes in regulations or laws applicable to us, our subsidiaries, brokers or customers;
· 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 ceded 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 and divestitures;
· changes in rating agency policies or practices;
· changes in legal theories of liability under our insurance policies;
· changes in accounting policies or practices; and
· changes in general economic conditions, including inflation, interest rates and other factors.
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-K. 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-K reflect our views as of the date of this Form 10-K 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-K that could cause actual results to differ.
An investment in our common stock involves a number of risks. You should carefully consider the following information about these risks, together with the other information contained in this Form 10-K, in considering whether to invest in or hold our common stock. Additional risks not presently known to us,
or that we currently deem immaterial may also impair our business or results of operations. Any of the risks described below could result in a significant or material adverse effect on our financial condition or results of operations, and a corresponding decline in the market price of our common stock. You could lose all or part of your investment.
This Form 10-K also contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of certain factors, including the risks described below and elsewhere in this Form 10-K. See Item 1.Note on Forward-Looking Statements.
If our actual loss and loss adjustment expenses exceed our loss reserves, our financial condition and results of operations could be significantly adversely affected.
Our results of operations and financial condition depend upon our ability to assess accurately the potential losses associated with the risks that we insure and reinsure. We establish loss reserves to cover our estimated liability for the payment of all losses and loss adjustment expenses incurred under the policies that we write. Loss reserves include case reserves, which are established for specific claims that have been reported to us, and reserves for claims that have been incurred but not reported (or IBNR). To the extent that loss and loss adjustment expenses exceed our estimates, we will be required to immediately recognize the less favorable experience and increase loss reserves, with a corresponding reduction in our net income in the period in which the deficiency is identified. For example, over the past ten years we have experienced adverse development of reserves for losses and loss adjustment expenses incurred in prior years. In 2002, following an annual review by an outside actuarial consulting company of TICNYs net loss and loss adjustment reserves, we increased such reserves by $2.9 million.
With respect to losses on the property coverage portion of our commercial and personal lines policies, the primary component of our loss reserve is a case reserve, which is posted by the assigned examiner shortly after the loss is reported. The extent of the damage is evaluated through a primarily fact-based loss assessment process. Property losses are typically reported within days of occurrence and case reserves are posted promptly. While this case reserving process is not free of errors in determining the scope of the loss or deviations at the time the loss is paid, major deviations are infrequent. Consequently, commercial and personal property lines of business generally do not require significant IBNR nor are they difficult to predict with a relative amount of certainty. Absent significant changes by underwriting personnel in risk selection and coverage offered and assuming examiners are properly trained with the requisite experience, loss reserves on property lines of business remain relatively predictable from an actuarial standpoint.
With respect to losses on the liability coverage portions of our commercial and personal lines policies, the reserving process possesses characteristics that make case and IBNR reserving inherently less susceptible to accurate actuarial estimation. Unlike property losses, liability losses are claims made by third parties of which the policyholder may not be aware and therefore may be reported a significant time after the occurrence, sometimes years. In addition, as liability claims most often involve claims of bodily injury, assessment of the proper case reserve is a far more subjective process than claims involving property damages. In addition, the determination of a case reserve for a liability claim is often without the benefit of information, which develops slowly over the life of the claim and can subject the case reserve to substantial modification well after the claim was first reported. Numerous factors impact the liability case reserving process, such as venue, the amount of monetary damage, the permanence of the injury, the age of the claimant and many others.
Estimating an appropriate level of loss and loss adjustment expense reserves is an inherently uncertain process. Accordingly, actual loss and loss adjustment expenses paid will likely deviate, perhaps substantially, from the reserve estimates reflected in our consolidated financial statements. It is possible
that claims could exceed our loss and loss adjustment expense reserves and have a material adverse effect on our financial condition or results of operations.
TICNY and TRM conduct business in a concentrated geographical area. Any single catastrophe or other condition affecting losses in this area could adversely affect our results of operations.
TICNY currently writes business in concentrated geographic areas, primarily in the southern and western portions of New York State, and reinsures business produced by TRM in New York and to a lesser extent in New Jersey and Pennsylvania. As a result, a single catastrophe occurrence, destructive weather pattern, terrorist attack, regulatory development or other condition or general economic trend affecting the region within which TICNY and TRM conduct their business could adversely affect our financial condition or results of operations more significantly than other insurance companies that conduct business across a broader geographical area. During our history, we have not experienced any single event that materially affected our results of operations. The most significant single event was the terrorist attacks of September 11, 2001, as a result of which we suffered $391,000 in net losses.
The incidence and severity of catastrophes are inherently unpredictable and our losses from catastrophes could be substantial. The occurrence of claims from catastrophic events is likely to result in substantial volatility in our financial condition or results of operations for any fiscal quarter or year and could have a material adverse effect on our financial condition or results of operations and our ability to write new business. Increases in the values and concentrations of insured property may increase the severity of such occurrences in the future. Although we attempt to manage our exposure to such events, including through the use of reinsurance, the frequency or severity of catastrophic events could exceed our estimates. As a result, the occurrence of one or more catastrophic events could have a material adverse effect on our financial condition or results of operations.
We have not yet arranged quota share insurance for 2006. If we cannot obtain adequate reinsurance protection for the risks we have underwritten, we may be exposed to greater losses from these risks or we may reduce the amount of business we underwrite, which will reduce our revenues.
Under state insurance law, insurance companies are required to maintain a certain level of capital in support of the policies they issue. In addition, rating agencies will reduce an insurance companys ratings if the companys premiums exceed specified multiples of its capital. As a result, the level of TICNYs statutory surplus and capital limits the amount of premiums that it can write and retain risk on. Historically, we have utilized reinsurance to expand our capacity to write more business than TICNYs surplus would have otherwise supported. As a result of the increase in TICNYs surplus with proceeds contributed from the IPO, the quota share ceding percentage was reduced from 60% to 25% on October 1, 2004 and was maintained at 25% throughout 2005.
From time to time, market conditions have limited, and in some cases have prevented, insurers from obtaining the types and amounts of reinsurance that they consider adequate for their business needs. For example, beginning in 2001, terms and conditions in the reinsurance market generally became less attractive for insurers seeking reinsurance. In addition, recent investigations by the New York State Attorney General, the SEC and other regulatory and government bodies into the use of non-traditional reinsurance by certain reinsurers may lead to the re-examination of applicable accounting standards or a reduction in the availability of some types of reinsurance. In turn, these developments could produce unfavorable changes in prices, reduced ceding commission revenue or other potentially adverse changes in the terms of reinsurance. Accordingly, we may not be able to obtain our desired amounts of reinsurance. In addition, even if we are able to obtain such reinsurance, we may not be able to obtain such reinsurance from entities with satisfactory creditworthiness or negotiate terms that we deem appropriate or acceptable.
We do not currently have in place quota share reinsurance for 2006. We are currently in discussions with a Bermuda reinsurance company in formation to enter into a multi-year quota share reinsurance agreement and in discussions with the Bermuda reinsurers parent holding company with respect to a
potential pooling or other risk sharing agreements between our insurance companies and one or more U.S. insurance companies that may be acquired by the Bermuda holding company, which could provide additional capacity to write business through an insurance risk sharing or pooling agreement. The Bermuda reinsurance company in formation is not yet able to engage in the reinsurance and insurance business because it has not received all of the necessary regulatory approvals or completed its capitalization. There can be no assurance that the capitalization will be completed or that the necessary regulatory approvals will be granted or that any approval granted will not be subject to conditions that restrict operations.
Furthermore, the Bermuda holding companys acquisition of the U.S. insurance companies will require the approval of insurance regulators in the respective states of domicile of such companies, and also may need the approval of insurance regulators in states where such companies are admitted. There can be no assurance that the necessary regulatory approvals will be received.
We have made an investment in the Bermuda holding company and our Chairman and Chief Executive Officer, Michael H. Lee, is also expected to serve as the Chairman and Chief Executive Officer of that company. Because we may be deemed to control the Bermuda reinsurance company and any U.S. insurance companies that the Bermuda holding company may acquire under the provisions of the New York State Insurance Department and applicable regulations, we cannot enter into the reinsurance agreements or pooling agreements unless 30 days advance notice is provided to the New York State Insurance Department proposing our intention to enter into such agreements, and the New York State Insurance Department does not disapprove of these agreements within such period. Accordingly, it is possible that the New York State Insurance Department may not approve the terms and conditions of these agreements or it may determine that certain terms and conditions may not be fair or equitable or reasonable and must be revised.
If the Bermuda reinsurance company and the U.S. insurance companies are not formed or acquired or our discussions with respect to the multi-year reinsurance agreement and the risk sharing or pooling agreements do no result in reaching acceptable terms and execution, we will seek reinsurance protection and additional capacity elsewhere. However, if we cannot obtain adequate reinsurance protection for the risks we have underwritten, we may be exposed to greater losses from these risks, which could have a material adverse effect on our financial condition or results of operation. It we cannot obtain our desired amount of reinsurance or addition capacity to write business through risk sharing or pooling agreements, we may be forced to reduce the amount of business that we underwrite, which will reduce our revenues.
Until the multi-year reinsurance agreement is in place we are retaining all of the risk for 2006 that would have been ceded to quota share reinsurers. In 2005, we ceded 25% of our net premiums written to reinsurers in accordance with our 2005 quota share treaty. The 2005 Property Catastrophe Program, which expires on June 30, 2006, requires that a minimum of 25% quota share cession be in place for the program. If a loss that is ceded to the Property Catastrophe Program occurs after January 1, 2006 but before the inception of the proposed multi-year quota share agreement, we would be required to retain 25% of the loss as if the quota share cession was in place.
If we are able to obtain reinsurance, our reinsurers may not pay losses in a timely fashion, or at all, which may cause a substantial loss and increase our costs.
As of December 31, 2005, we had a net balance due in our favor from our reinsurers of $148.1 million, consisting of $104.8 million in reinsurance recoverables and $43.3 million in prepaid reinsurance premiums. This amount is $15.7 million higher than TICNYs statutory capital and surplus at that date. Since October 1, 2003, we have sought to manage our exposure to our reinsurers by placing our quota share reinsurance on a funds withheld basis and requiring any non-admitted reinsurers to collateralize their share of unearned premium and loss reserves. However, we have substantial recoverables from our pre-October 1, 2003 reinsurance arrangements that are uncollateralized, in that they are not supported by letters of credit, trust accounts, funds withheld arrangements or similar mechanisms intended to protect us against a reinsurers inability or unwillingness to pay. Our net exposure to our reinsurers totaled $58.8 million as of December 31, 2005 (representing 8.9% of our total assets on that date), including $33.2 million due from PXRE Reinsurance Company which received a ratings downgrade to B+ (Very Good) by A.M. Best on February 24, 2006. See Item 1.Reinsurance for a detailed discussion of our reinsurance exposures. Because we remain primarily liable to our policyholders for the payment of their claims, in the event that one of our reinsurers under an uncollateralized treaty became insolvent or refused to reimburse us for losses paid, or delayed in reimbursing us for losses paid, our cash flow and financial results overall could be materially and adversely affected.
Our insurance company subsidiaries are rated A- (Excellent) by A.M. Best, and a decline in this rating or the ratings assigned by other rating agencies could affect our standing among brokers, agents and insured and cause our sales and earnings to decrease.
Ratings have become an increasingly important factor in establishing the competitive position of insurance companies. A.M. Best maintains a letter scale rating system ranging from A++ (Superior) to F (In Liquidation). TICNY was upgraded to A- (Excellent) by A.M. Best, which is the 4th highest of 15 rating levels. There is no guarantee that TICNY will maintain this rating that is subject to, among other things, A.M. Bests evaluation of our capitalization and performance on an ongoing basis including our management of terrorism risks, loss reserves and expenses.
In April 2003, in connection with the issuance of subordinated debentures underlying trust preferred securities, TICNY also received an insurer financial strength rating from Standard & Poors Rating Services, a division of The McGraw-Hill Companies, Inc. (Standard & Poors). The most recent rating from Standard & Poors is BB+ with a stable outlook. A BB+ rating is the 11th highest of 21 rating levels used by Standard & Poors.
Our ratings are subject to periodic review by, and may be revised downward or revoked at the sole discretion of A.M. Best or Standard & Poors. A decline in a companys ratings indicating a reduced financial strength or other adverse financial developments can cause concern about the viability of the downgraded insurer among its agents, brokers and policyholders, resulting in a movement of business away from the downgraded carrier to other stronger or more highly rated carriers. Because many of our agents and brokers (whom we refer to as producers) and policyholders purchase our policies on the basis of our current ratings, the loss or reduction of any of our ratings will adversely impact our ability to retain or expand our policyholder base. The objective of the rating agencies rating systems is to provide an opinion of an insurers financial strength and ability to meet ongoing obligations to its policyholders. Our ratings reflect the rating agencies opinion of our financial strength and are not evaluations directed to investors in neither common stock nor recommendations to buy, sell or hold our common stock.
The failure of any of the loss limitation methods we employ could have a material adverse effect on our financial condition or our results of operations.
Various provisions of our policies, such as limitations or exclusions from coverage or choice of forum, which have been negotiated to limit our risks, may not be enforceable in the manner we intend. At the
present time we employ a variety of endorsements to our policies that limit exposure to known risks, including but not limited to exclusions relating to coverage for lead paint poisoning, asbestos and most claims for bodily injury or property damage resulting from the release of pollutants.
In addition, the policies we issue contain conditions requiring the prompt reporting of claims to us and our right to decline coverage in the event of a violation of that condition. Our policies also include limitations restricting the period in which a policyholder may bring a breach of contract or other claim against the company, which in many cases is shorter than the statutory limitations for such claims in the states in which we write business. While these exclusions and limitations reduce the loss exposure to us and help eliminate known exposures to certain risks, it is possible that a court or regulatory authority could nullify or void an exclusion or legislation could be enacted modifying or barring the use of such endorsements and limitations in a way that would adversely effect our loss experience, which could have a material adverse effect on our financial condition or results of operations.
We may face substantial exposure to losses from terrorism and we are currently required by law to provide coverage against such losses.
Our location and concentration of business written in New York City and adjacent areas by our insurance company subsidiaries may expose us to losses from terrorism. U.S. insurers are required by state and Federal law to offer coverage for terrorism in certain commercial lines.
In response to the September 11, 2001 terrorist attacks, the United States Congress enacted legislation designed to ensure, among other things, the availability of insurance coverage for foreign terrorist acts, including the requirement that insurers offer such coverage in certain commercial lines. The Terrorism Risk Insurance Act of 2002 (TRIA) requires commercial property and casualty insurance companies to offer coverage for certain acts of terrorism and established a Federal assistance program through the end of 2005 to help such insurers cover claims related to future terrorism-related losses. The Terrorism Risk Insurance Extension Act of 2005 (TRIEA) extends the Federal assistance program through 2007, but it also has set a per-event threshold that must be met before the federal program becomes applicable and also increases the insurers statutory deductibles.
Pursuant to TRIA, our insurance company subsidiaries must offer insureds the option to purchase coverage for acts of terrorism that are certified as such by the U.S. Secretary of the Treasury, in concurrence with the Secretary of State and the Attorney General, for an additional premium or decline such coverage. When the coverage is not purchased, the policy is endorsed to exclude coverage for certified acts of terrorism, but losses from an act of terrorism that is not a certified event may be covered in any case. Also, even if coverage for certified acts of terrorism is excluded, losses from fire following the act of terrorism are covered. Under TRIA, the Federal government agreed to reimburse commercial insurers for up to 90% of the losses due to certified acts of terrorism in excess of a deductible which, for 2005, was set at 15% of the insurers direct earned commercial lines premiums for the immediately preceding calendar year, i.e., 2004.
Under TRIEA, the Federal government now agrees to reimburse commercial insurers only after a per-event threshold, referred to as the program trigger, has been reached. In the case of certified acts of terrorism taking place after March 31, 2006, the program trigger has been set at $50 million for industry-wide insured losses occurring in 2006 and $100 million for industry-wide insured losses occurring in 2007. The amount of the Federal governments reimbursement drops from 90% to 85% for insured losses in 2007. In addition, each insurers deductible amount is set at 17.5% of certain of the insurers direct earned commercial lines premiums for 2006 and 20% for 2007. These changes reduce the federal assistance and increase the costs of terrorism risk insurance program for our insurance company subsidiaries.
A terrorist attack or series of attacks in New York City or the surrounding areas could have a material adverse effect on our results of operations and financial condition. In addition, terrorist attacks in these areas could depress economic activity in our core market, which could hurt our business.
The effects of emerging claim and coverage issues on our business are uncertain.
As industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to claims and coverage may emerge. These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until some time after we have issued insurance or reinsurance contracts that are affected by the changes. As a result, the full extent of liability under our insurance or reinsurance contracts may not be known for many years after a contract is issued.
One recent example of an emerging claim and coverage issue is New York City sidewalk liability. Effective as of September 14, 2003, a new law enacted by the New York City Council allows an injured party to sue the owner of a commercial building located in the five boroughs of New York City for any property damage or personal injury that was caused by the failure of the owner to maintain the sidewalk abutting the owners building in a reasonably safe condition. Previously, the City of New York, and not the building owner, was responsible for the maintenance of city sidewalks. We have adjusted our underwriting guidelines to attempt to screen out exposures that present a heightened risk from this new law.
Since we depend on a few producers for a large portion of our revenues, loss of business provided by any one of them could adversely affect us.
Our products are marketed by independent producers. Other insurance companies compete with us for the services and allegiance of these producers. These producers may choose to direct business to our competitors, or may direct less desirable risks to us. For the twelve months ended December 31, 2005, approximately 40% of the total of TICNYs gross premiums written and premiums produced by TRM on behalf of its issuing companies was derived from our top 10 producers. For the twelve months ended December 31, 2005, Morstan General Agency, CRC Insurance Inc. and Davis Agency Inc produced 11%, 5%, and 5%, respectively, of the total of TICNYs gross premiums written and the premiums produced by TRM on behalf of its issuing companies. A significant decrease in business from, or the entire loss of, our largest producer or several of our other large producers would cause us to lose premium and require us to seek alternative producers or to increase submissions from existing producers. In the event we are unable to find replacement producers or increase business produced by our existing producers, our premium revenues would decrease and our business and results of operations would be materially and adversely affected.
Our reliance on producers subjects us to their credit risk.
With respect to the premiums produced by TRM for its issuing companies and a limited amount of premium volume written by TICNY, producers collect premium from the policyholders and forward them to TRM and TICNY. In certain jurisdictions, including New York, when the insured pays premiums for these policies to producers for payment over to TRM and TICNY, the premiums might be considered to have been paid under applicable insurance laws and regulations and the insured will no longer be liable to us for those amounts, whether or not we have actually received the premiums from the producer. Consequently, we assume a degree of credit risk associated with producers. Although producers failures to remit premiums to us have not caused a material adverse impact on us to date, there have been instances where producers collected premium but did not remit it to us and we were nonetheless required under applicable law to provide the coverage set forth in the policy despite the absence of premium. Because the possibility of these events is dependent in large part upon the financial condition and internal operations of our producers, which in most cases are not public information, we are not able to quantify the exposure presented by this risk. If we are unable to collect premiums from our producers in the future, our financial condition and results of operations could be materially and adversely affected.
We operate in a highly competitive environment. If we are unsuccessful in competing against larger or more well-established rivals, our results of operations and financial condition could be adversely affected.
The property and casualty insurance industry is highly competitive and has historically been characterized by periods of significant pricing competition alternating with periods of greater pricing discipline, during which competition focuses upon other factors. In recent years the market environment was favorable in that rates increased significantly. During the latter part of 2004 and throughout 2005, increased competition in the marketplace became evident and, as a result, rate increases have become moderate. A softening of the market could lead to reduced growth or a reduction in premium volume, adverse effects on profitability and, ultimately, dislocation in the insurance industry. A.M. Best estimates that the industry wide change in net premiums written in the property casualty industry was 0.7% in 2005 compared to 4.7% in 2004 and is estimated to be 3.3% in 2006. The change in industry policyholders surplus as estimated by A.M. Best was 6.2% in 2005 compared to 13.6% in 2004 and is estimated to be 8.0% in 2006. In addition, in 2005, A.M. Best estimated new capital or capacity of $20 billion was raised by the property casualty insurance and reinsurance industry. This additional underwriting capacity may result in increased competition from other insurers seeking to expand the types or amount of business they write or cause a shift in focus by some insurers to maintaining market share at the expense of underwriting discipline. We attempt to compete based primarily on products offered, service, experience, the strength of our client relationships, reputation, speed of claims payment, perceived financial strength, ratings, scope of business, commissions paid and policy and contract terms and conditions. There are no assurances that in the future we will be able to retain or attract customers at prices which we consider to be adequate.
We compete with major U.S. insurers and certain underwriting syndicates, including large national companies such as The St. Paul Travelers Companies, Inc., Allstate Insurance Company and State Farm Fire and Casualty Company; regional insurers such as OneBeacon Insurance Company; and smaller, more local competitors such as Magna Carta Companies, Utica First Insurance Company, Greater New York Mutual Insurance Company, Commercial Mutual Insurance Company and Otsego Mutual Fire Insurance Company. Many of these companies have greater financial, marketing and management resources than we do. Many of these competitors also have more experience, better ratings and more market recognition than we do. We seek to distinguish ourselves from our competitors by providing a broad product line offering and targeting those market segments that provide us with the best opportunity to earn an underwriting profit. We also compete with other companies by quickly and opportunistically delivering products that respond to our producers needs.
In addition to competition in the operation of our business, we face competition from a variety of sources in attracting and retaining qualified employees. We also face competition because of entities that self-insure, primarily in the commercial insurance market. From time to time, established and potential customers may examine the benefits and risks of self-insurance and other alternatives to traditional insurance. See Item 1.Competition.
We may experience difficulty in expanding our
business, which could adversely affect our results of
We plan to expand our licensing or acquire other insurance companies with multi-state property and casualty licensing in order to expand our product and service offerings geographically. We also intend to continue to acquire books of business that fit our underwriting competencies from competitors, managing agents and other producers and to acquire other insurance companies. This expansion strategy may present special risks:
· We have achieved our prior success by applying a disciplined approach to underwriting and pricing in select markets that are not well served by our competitors. We may not be able to successfully implement our underwriting, pricing and product strategies in companies or books of business we acquire or over a larger operating region;
· We may not be successful in obtaining the required regulatory approvals to offer additional insurance products or expand into additional states;
· We have limited acquisition experience and may not be able to efficiently combine an acquired company or block of business with our present financial, operational and management information systems; and
· An acquisition could dilute the book value and earnings per share of our common stock.
We cannot assure you that we will be successful in expanding our business or that any new business will be profitable. If we are unable to expand our business or to manage our expansion effectively, our results of operations and financial condition could be adversely affected.
We could be adversely affected by the loss of one or more principal employees or by an inability to attract and retain staff.
Our success will depend in substantial part upon our ability to attract and retain qualified executive officers, experienced underwriting talent and other skilled employees who are knowledgeable about our business. We rely substantially upon the services of our executive management team. Although we are not aware of any planned departures or retirements, if we were to lose the services of members of our management team, our business could be adversely affected. We believe we have been successful in attracting and retaining key personnel throughout our history. We have employment agreements with Michael H. Lee, our Chairman of the Board, President and Chief Executive Officer, and other members of our senior management team. We do not currently maintain key man life insurance policies with respect to our employees except for Michael H. Lee.
Our business relationship with the Bermuda reinsurance company that may provide our 2006 quota share reinsurance and its affiliates may present, and make us vulnerable to, difficult conflicts of interest, related party transactions, business opportunity issues and legal challenges.
As noted elsewhere (see Item 1A.Risk FactorsWe have not yet arranged quota share insurance for 2006.), we are in discussions with a Bermuda reinsurance company in formation with respect to a multi-year quota share reinsurance agreement among other matters. We have made a $15 million investment in the reinsurers parent holding company and expect to own a substantial interest in the holding company. In addition, Michael H. Lee, our Chairman of the Board, President and Chief Executive Officer, is expected to hold the same positions at the Bermuda holding company and, as such, will not serve our company on a full-time basis. Furthermore, members of our executive management are expected to resign their positions with us and become executive managers of the Bermuda holding company and its subsidiaries. Conflicts of interest could arise with respect to business opportunities that could be advantageous to the Bermuda company or its subsidiaries, on the one hand, and us or any of our subsidiaries, on the other hand.
Because Mr. Lee will hold leadership positions at both Tower and the Bermuda company following the closing of this offering, potential conflicts of interest may arise should the interests of Tower, the Bermuda company and Mr. Lee diverge. While we expect that initially our interests and the Bermuda company should be aligned, they may diverge as the Bermuda company develops additional business.
Mr. Lees service as Chairman of the Board, President and Chief Executive Officer of both the Bermuda holding company and Tower could also raise a potential challenge under anti-trust laws. Section 8 of the Clayton Antitrust Act, or the Clayton Act, prohibits a person from serving as a director or officer in any two competing corporations under certain circumstances. If the Bermuda holding company and Tower are in the future deemed to be competitors with the meaning of the Clayton Act, certain thresholds relating to direct competition between Tower and the Bermuda holding company are met, and the Department of Justice and Federal Trade Commission challenge the arrangement, Mr. Lee may be required to resign his positions with one of the companies, and/or fines or other penalties could be assessed against Mr. Lee and us. To alleviate any potential for direct competition between the Bermuda
holding company and us, proposed arrangements between us and the Bermuda holding company will provide for a division of responsibilities. However, it is possible that the potential for direct competition with respect to certain classes of business may exist with respect to the business we and the Bermuda holding companys subsidiaries may pursue.
If issuing companies or reinsurers are unwilling to participate in insurance arranged by TRM, our financial condition or results of operations could be materially adversely affected.
TRM produces insurance for other insurance companies, which we call TRMs issuing companies that in turn cede 100% of the business to reinsurers, including TICNY. TRM receives commissions and fees for producing the insurance and arranging the reinsurance. TRMs ability to generate fee income therefore depends upon the willingness of issuing companies to write the business produced by TRM, which depends upon the willingness of reinsurers, including TICNY, to assume the risk on the business produced by TRM. Prior to 2006, all of the premiums produced by TRM were written through two issuing insurance companies, Virginia Surety Company, Inc. (Virginia Surety) and State National Insurance Company, Inc. (State National). Starting in 2006, all of TRMs premiums produced will be issued through Virginia Surety. The contract with this company is terminable by either party upon 90 days notice. If we are unable to successfully structure a reinsurance transaction that would be satisfactory to this issuing company or if the issuing company is otherwise unwilling to do business with us, and we are unable to find an additional or replacement issuing company, we would have to rely on our own insurance company to write the premium currently produced by TRM for these issuing company or else forego some or all of this business and the associated fee revenues. Writing this business in our own insurance company would require us to bear additional insurance risk. Depending on our insurance companys statutory surplus and our premium growth, we may not be able to write some or all of this business. Accordingly, the inability to retain or replace a TRM issuing company or to obtain reinsurance acceptable to us or the issuing company could have an adverse effect on our financial condition or results of operations.
An issuing companys insolvency or weakened financial condition may have an adverse impact on TRMs revenues.
In the event of the insolvency or liquidation of an issuing company or other event having a negative impact on the financial strength of an issuing company, TRM may be unable to collect commissions due on policies written through that issuing company and may be unable to collect other fees due such as claims administration fees. Commission revenue on policies written through TRMs issuing companies represented 4.2% of consolidated revenues in 2005 and 10.7% in 2004 and in 2003.
Our investment performance may suffer as a result of adverse capital market developments or other factors, which may affect our financial results and ability to conduct business.
We invest the premium we receive from policyholders until it is needed to pay policyholder claims or other expenses. At December 31, 2005, our invested assets consisted of $326.7 million in fixed maturity securities, $5.9 million in equity securities at fair value, $24.6 million of equity securities at cost and $1.4 million in common trust securitiesstatutory business trusts. Additionally, we held $38.8 million in cash and cash equivalents. In 2005, we earned $15.0 million of net investment income representing 6.8% of our total revenues and 47.1% of our pre-tax income. Our funds are invested by a professional investment advisory management firm under the direction of our management team in accordance with detailed investment guidelines set by us. See Item 1.Investments. Although our investment policies stress diversification of risks, conservation of principal and liquidity, our investments are subject to a variety of investment risks, including risks relating to general economic conditions, market volatility, interest rate fluctuations, liquidity risk and credit and default risk. (Interest rate risk is discussed below under the heading, We may be adversely affected by interest rate changes). In particular, the volatility of our claims may force us to liquidate securities, which may cause us to incur capital losses. If we do not structure our investment portfolio so that it is appropriately matched with our insurance and reinsurance liabilities, we may be forced to liquidate investments prior to maturity at a significant loss to cover such liabilities.
Investment losses could significantly decrease our asset base and statutory surplus, thereby affecting our ability to conduct business.
We may be adversely affected by interest rate changes.
Our operating results are affected, in part, by the performance of our investment portfolio. Our investment portfolio contains interest rate sensitive instruments, such as bonds, which may be adversely affected by changes in interest rates. A significant increase in interest rates could have a material adverse effect on our financial condition or results of operations. Generally, bond prices decrease as interest rates rise. Changes in interest rates could also have an adverse effect on our investment income and results of operations. For example, if interest rates decline, investment of new premiums received and funds reinvested will earn less than expected.
In addition, our investment portfolio includes mortgage-backed securities. As of December 31, 2005, mortgage-backed securities constituted approximately 27.0% of our invested assets. As with other fixed income investments, the fair market value of these securities fluctuates depending on market and other general economic conditions and the interest rate environment. Changes in interest rates can expose us to prepayment risks on these investments. When interest rates fall, mortgage-backed securities are prepaid more quickly than expected and the holder must reinvest the proceeds at lower interest rates. Our mortgage-backed securities currently consist of securities with features that reduce the risk of prepayment, but there is no guarantee that we will not invest in other mortgage-backed securities that lack this protection. In periods of increasing interest rates, mortgage-backed securities are prepaid more slowly, which may require us to receive interest payments that are below the interest rates then prevailing for longer than expected.
Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control.
We may require additional capital in the future, which may not be available or only available on unfavorable terms.
Our future capital requirements 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. To the extent that our present capital is insufficient to meet future operating requirements and/or cover losses, we may need to raise additional funds through financings or curtail our growth. Based on our current operating plan, we believe current capital together with our anticipated retained earnings, will support our operations without the need to raise additional capital. However, we cannot provide any assurance in that regard, since many factors will affect our capital needs and their amount and timing, including our growth and profitability, our claims experience, and the availability of reinsurance, as well as possible acquisition opportunities, market disruptions and other unforeseeable developments. If we had to raise additional capital, equity or debt financing may not be available at all or may be available only on terms that are not favorable to us. In the case of equity financings, dilution to our stockholders could result, and in any case such securities may have rights, preferences and privileges that are senior to those of the shares offered hereby. If we cannot obtain adequate capital on favorable terms or at all, our business, financial condition or results of operations could be materially adversely affected.
The regulatory system under which we operate, and potential changes thereto, could have a material adverse effect on our business.
TICNY and TNIC are subject to comprehensive regulation and supervision in their respective states of domicile. The purpose of the insurance laws and regulations are to protect insureds, not our stockholders. These regulations are generally administered by the insurance departments in which the individual insurance companies are domiciled and relate to, among other things:
· standards of solvency, including risk based capital measurements;
· restrictions on the nature, quality and concentration of investments;
· required methods of accounting;
· rate and form regulation pertaining to certain of our insurance businesses; and
· potential assessments for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies.
Significant changes in these laws and regulations could make it more expensive to conduct our business. The New York Insurance Department for TICNY and the Massachusetts Department of Insurance for TNIC also conduct periodic examinations of the affairs of their domiciled insurance companies and require the filing of annual and other reports relating to financial condition, holding company issues and other matters. These regulatory requirements may adversely affect or inhibit our ability to achieve some or all of our business objectives.
TICNY and TNIC may not be able to obtain or maintain necessary licenses, permits, authorizations or accreditations in new states we intend to enter, or may be able to do so only at significant cost. In addition, we may not be able to comply fully with or obtain appropriate exemptions from, the wide variety of laws and regulations applicable to insurance companies or holding companies. Failure to comply with or to obtain appropriate authorizations and/or exemptions under any applicable laws could result in restrictions on our ability to do business or engage in certain activities that are regulated in one or more of the jurisdictions in which we operate and could subject us to fines and other sanctions, which could have a material adverse effect on our business. In addition, changes in the laws or regulations to which our operating subsidiaries are subject could adversely affect our ability to operate and expand our business or could have a material adverse effect on our financial condition or results of operations.
In recent years, the U.S. insurance regulatory framework has come under increased Federal scrutiny, and some state legislators have considered or enacted laws that may alter or increase state regulation of insurance and reinsurance companies and holding companies. Moreover, the National Association of Insurance Commissioners (NAIC), which is an association of the insurance commissioners of all 50 states and the District of Columbia, and state insurance regulators regularly re-examine existing laws and regulations, often focusing on modifications to holding company regulations, interpretations of existing laws and the development of new laws. Changes in these laws and regulations or the interpretation of these laws and regulations could have a material adverse effect on our financial condition or results of operations. The recent highly publicized investigations of the insurance industry by the New York State Attorney General and other regulators and government officials have led to, and may continue to lead to, additional legislative and regulatory requirements for the insurance industry and may increase the costs of doing business.
The activities of TRM are subject to licensing requirements and regulation under the laws of New York and New Jersey. TRMs business depends on the validity of, and continued good standing under, the licenses and approvals pursuant to which it operates, as well as compliance with pertinent regulations.
Licensing laws and regulations vary from jurisdiction to jurisdiction. In all jurisdictions, the applicable licensing laws and regulations are subject to amendment or interpretation by regulatory authorities. Generally such authorities are vested with relatively broad and general discretion as to the granting, renewing and revoking of licenses and approvals. Licenses may be denied or revoked for various reasons, including the violation of such regulations, conviction of crimes and the like. Possible sanctions which may be imposed include the suspension of individual employees, limitations on engaging in a particular business for specified periods of time, revocation of licenses, censures, redress to clients and fines. In some instances, TRM follows practices based on its or its counsels interpretations of laws and regulations, or those generally followed by the industry, which may prove to be different from those of regulatory authorities.
If the assessments we are required to pay are increased drastically our results of operations and financial condition will suffer.
TICNY is subject to assessments in New York for various purposes, including the provision of funds necessary to fund the operations of the New York Insurance Department and the New York Security Fund, which pays covered claims under certain policies provided by impaired, insolvent or failed insurance companies. In 2005, the assessment for the New York Insurance Department was $589,000 and the New York Security Fund assessment was $941,000. These assessments are generally set based on an insurers percentage of the total premiums written in New York State within a particular line of business. The Company is permitted to assess premium surcharges on workers compensation policies that are based on statutorily enacted rates. However, assessments by the various workers compensation funds have recently exceeded the permitted surcharges resulting in additional expenses of $1,143,000 in 2004 and none in 2005. As of December 31, 2005 the liability for the various workers compensation funds, which includes amounts assessed on workers compensation policies was $2,776,000. This amount is expected to be paid over an eighteen month period ending June 30, 2007. As our company grows, our share of any assessments may increase. However, we cannot predict with certainty the amount of future assessments because they depend on factors outside our control, such as insolvencies of other insurance companies. Significant assessments could have a material adverse effect on our financial condition or results of operations. TNIC did not write or assume premiums in 2005. As TNIC writes or assumes premiums it will be subject to regulatory assessments.
Our ability to meet ongoing cash requirements and pay dividends may be limited by our holding company structure and regulatory constraints.
Tower is a holding company and, as such, has no direct operations of its own. Tower does not expect to have any significant operations or assets other than its ownership of the shares of its operating subsidiaries. Dividends and other permitted payments from our operating subsidiaries are expected to be our primary source of funds to meet ongoing cash requirements, including any future debt service payments and other expenses, and to pay dividends, if any, to our stockholders. TICNY is subject to significant regulatory restrictions limiting its ability to declare and pay dividends. As of December 31, 2005, the maximum amount of distributions that TICNY could pay to Tower without approval of the New York Insurance Department was $4.0 million. The inability of TICNY to pay dividends and other permitted payments in an amount sufficient to enable us to meet our cash requirements at the holding company level would have a material adverse effect on our operations and our ability to pay dividends to our stockholders. Because TNIC has not yet commenced insurance operations it has no positive unassigned surplus and, therefore, it may not pay dividends at this time without the approval of the Massachusetts Commissioner of Insurance. While we currently intend to pay dividends, if you require dividend income you should carefully consider these risks before relying on an investment in our company. For more information regarding restrictions on the payment of dividends. See Item 5.Dividend Policy and Item 1.Regulation.
Although we have paid cash dividends in the past, we may not pay cash dividends in the future.
We have a history of paying dividends to our stockholders when sufficient cash is available, and we currently intend to pay dividends in each quarter of 2006. However, future cash dividends will depend upon our results of operations, financial condition, cash requirements and other factors, including the ability of our subsidiaries to make distributions to us, which ability is restricted in the manner previously discussed in this section. Also, there can be no assurance that we will continue to pay dividends even if the necessary financial conditions are met and if sufficient cash is available for distribution. See Item 5.Dividend Policy.
Risks Related to Our Industry
The threat of terrorism and military and other actions may adversely affect our investment portfolio and may result in decreases in our net income, revenue and assets under management.
The threat of terrorism, both within the United States and abroad, and military and other actions and heightened security measures in response to these types of threats, may cause significant volatility and declines in the equity markets in the United States, Europe and elsewhere, as well as loss of life, property damage, additional disruptions to commerce and reduced economic activity. Some of the assets in our investment portfolio may be adversely affected by declines in the equity markets and economic activity caused by the continued threat of terrorism, ongoing military and other actions and heightened security measures.
We cannot predict at this time whether and the extent to which industry sectors in which we maintain investments may suffer losses as a result of potential decreased commercial and economic activity, or how any such decrease might impact the ability of companies within the affected industry sectors to pay interest or principal on their securities, or how the value of any underlying collateral might be affected.
We can offer no assurances that terrorist attacks or the threat of future terrorist events in the United States and abroad or military actions by the United States will not have a material adverse effect on our business, financial condition or results of operations.
Our results of operations and revenues may fluctuate as a result of many factors, including cyclical changes in the insurance industry, which may cause the price of our securities to be volatile.
The results of operations of companies in the property and casualty insurance industry historically have been subject to significant fluctuations and uncertainties. Our profitability can be affected significantly by:
· rising levels of loss costs that we cannot anticipate at the time we price our products;
· volatile and unpredictable developments, including man-made, weather-related and other natural catastrophes or terrorist attacks;
· changes in the level of reinsurance capacity and capital capacity;
· changes in the amount of loss and loss adjustment expense reserves resulting from new types of claims and new or changing judicial interpretations relating to the scope of insurers liabilities; and