Tower Group 10-K 2007
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)
registered pursuant to Section 12(b) of the Act:
registered pursuant to Section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of Securities Act. Yes o No x
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, 2006 (based on the closing price on the Nasdaq National Market) on such date was approximately $515,117,298.
As of March 5, 2007, the registrant had 23,101,108 shares of common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE:
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), and Tower National Insurance Company (TNIC), Tower Indemnity Company of America (TICA) and its managing general agency, Tower Risk Management Corp. (TRM), unless the context suggests otherwise.
References to Preserver refer to Preserver Group, Inc. and its subsidiaries, including Preserver Insurance Company, Mountain Valley Indemnity Company and North East Insurance Company and any other direct or indirect subsidiary, unless the context suggests otherwise;
References to CastlePoint refer to CastlePoint Holdings, Ltd. and its subsidiaries, which include CastlePoint Management Corp., CastlePoint Bermuda Holdings, Ltd., CastlePoint Reinsurance Company, Ltd. and CastlePoint Insurance Company, unless the context suggests otherwise.
Through our subsidiaries, 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, New Jersey, Massachusetts and Pennsylvania. We provide coverage for many different market segments, including nonstandard risks that do not fit the underwriting criteria of standard risk carriers due to factors such as type of business, location and premium per policy. We provide commercial lines products comprised of commercial package, general liability, workers compensation and commercial auto policies to businesses such as retail and wholesale stores, grocery stores, restaurants, artisan contractors and residential and commercial buildings. We also provide personal lines products that currently insure modestly valued homes and dwellings. These products are distributed through approximately 800 retail agents that are serviced through our offices in New York City, Buffalo and Long Island. We also distribute our products through approximately 60 wholesale agents that are primarily located throughout the New York metropolitan area. TICNY and TNIC are currently rated A- (Excellent) by A.M. Best.
In March 2005, in an effort to expand our writings outside of New York as well as position our products in various market segments, we purchased the outstanding common stock of TNIC, a shell insurance company that had licenses in various states in the Northeast. A shell insurance company is a licensed insurance company that does not have any net liabilities and does not write any business. We have worked to increase the licensing of both TNIC and TICNY, which are licensed in 25 and 36 states, respectively. TNIC began writing business in New Jersey, Pennsylvania, Illinois, Massachusetts and New York in 2006.
In February 2006, we sponsored the formation of CastlePoint Holdings, Ltd., a Bermuda holding company organized to provide property and casualty insurance and reinsurance business solutions, products and services primarily to small insurance companies and program underwriting agents in the United States. We sponsored and entered into a long-term strategic relationship with CastlePoint to secure a stable source of traditional quota share reinsurance and insurance risk-sharing capability to support our anticipated future growth. We believe that the formation of CastlePoint and the agreements between our company and CastlePoint further enhance our hybrid business model by reducing certain risks of relying on other reinsurers and issuing carriers. These risks include cyclicality in demand for underwriting and availability of capacity, restrictions on business and underwriting classes and the high costs of utilizing issuing carriers. Our relationship with CastlePoint also generates commission and fee income which are an important component of our business. See Business - Strategic Relationship and Agreements with CastlePoint.
We have agreed to enter into various pooling arrangements with CastlePoint Insurance Company to be effective January 1, 2007 that are pending the approval of the New York State Department of Insurance. As a result of these pooling agreements and the reinsurance agreements that we already have in place with CastlePoint Reinsurance Company, Ltd. (CastlePoint Reinsurance), we expect to cede and/or pool a total of 49% of our brokerage business premium and to participate in 50% of the traditional program business premium with CastlePoint in 2007, and we expect to assume approximately 15% of the specialty program business premium written by CastlePoint Insurance Company in 2007. These pooling arrangements remain subject to regulatory approval. On December 4, 2006, we sold an unused shell insurance company, Tower Indemnity Company of America (which was renamed CastlePoint Insurance Company), to CastlePoint, in order to facilitate our pooling arrangements with CastlePoint. See Business-Strategic Relationship and Agreements with CastlePoint.
On November 13, 2006, we signed an agreement to acquire Preserver Group, Inc. (Preserver) for a base purchase price of $68.3 million (approximately $64.8 million after deduction for expenses incurred by Preserver, net of tax). A portion of the purchase price paid will be used to redeem $30.8 million of debt to Preservers shareholders at the closing. In addition, $12 million of Preservers trust preferred securities will remain outstanding. Preserver is a privately-held company that offers products similar to ours in the Northeast, particularly in New Jersey, Maine and Massachusetts. Preservers gross written premiums were $88.6 million in 2005 and $64.6 million for the nine months ended September 30, 2006. Preserver is rated B++ (Good) by A.M. Best. On December 7, 2006, A.M. Best placed the ratings of Preserver under review with positive implications. We believe this transaction will accelerate our regional expansion by allowing us to access Preservers approximately 300 agents that produce business in various Northeastern states. The acquisition is subject to regulatory approvals and is expected to close in the second quarter of 2007. See BusinessAcquisition of Preserver.
On November 13, 2006, we entered into the Stock Purchase Agreement with a subsidiary of CastlePoint pursuant to which we agreed to issue and sell 40,000 shares of perpetual preferred stock to the subsidiary for aggregate consideration of $40 million. The transaction closed on December 4, 2006. See BusinessStrategic Relationship and Agreements with CastlePoint.
On January 22, 2007, the Securities and Exchange Commission declared effective our registration statement on Form S-3 for the sale by the Company of an aggregate of 2,704,000 shares of common stock, par value $.01 per share, of the Company (common stock) and the grant of an option to the underwriters to purchase up to of 405,600 additional shares of common stock to cover over-allotments, if any, from the Company.
On January 25, 2007, Tower Group Statutory Trust VI (the Trust), an affiliated Delaware trust issued $20.0 million of fixed/floating rate capital securities (the Trust Preferred Securities) in a private placement. The Trust Preferred Securities mature in April 2036, are redeemable at the Companys option at par beginning April 7, 2011, and require quarterly distributions of interest by the Trust to the holder of the Trust Preferred Securities. Interest distributions are initially at a fixed rate of 8.155% for the first five years and will then reset quarterly for changes in the three-month London Interbank Offered Rate (LIBOR) plus 300 basis points. The Trust simultaneously issued 619 of the Trusts common securities to the Company for a purchase price of $0.6 million, which constitutes all of the issued and outstanding common securities of the Trust. The Trust used the proceeds from the sale of the Trust Preferred Securities and common securities to purchase for $20.6 million a Junior Subordinated Debt Security due 2037 issued by the Company. The Company does not consolidate interest in its statutory business trusts for which the Company holds 100% of the common trust securities because the Company is not the primary beneficiary of the trusts. The Companys investment in common trust securities of the statutory business trust are reported in investments as equity securities. The Company reports as a liability the outstanding
subordinated debentures owed to the statutory business trusts. The net proceeds were used to redeem $20.0 million of the perpetual preferred stock held by a subsidiary of CastlePoint on January 26, 2007.
On January 26, 2007, the Company closed on its sale of 2,704,000 shares of common stock at an offering price of $31.25 per share. The Companys gross proceeds of $84.5 million were reduced by $4.2 million for the underwriters discount and $1.0 million for other offering expenses resulting in approximately $79.3 million of net proceeds. The Company used $20.0 million of these net proceeds to redeem its remaining $20.0 million of perpetual preferred stock held by a subsidiary of CastlePoint. As of January 26, 2007 all of the Companys perpetual preferred stock was fully redeemed.
On February 5, 2007 the underwriters exercised their over-allotment option in part to purchase 340,600 shares of common stock at the offering price of $31.25 per shares. The Company received gross proceeds of $10.6 million from this exercise and net proceeds of $10.1 million after the underwriting discount. The partial exercise of the over-allotment option brought the Companys aggregate net proceeds from the offering and over-allotment option, after underwriting discounts, commissions and expenses, to approximately $89.4 million.
We believe our hybrid business model, high growth platform, underwriting and market segmentation expertise, low cost infrastructure and proven leadership and experienced management are competitive strengths, as described below. We plan to utilize these competitive strengths to continue our profitable growth through the following strategies:
· Hybrid Business Model. We utilize a business model under which we (i) retain premiums to generate investment and underwriting income through the use of our own capital and (ii) transfer premiums to reinsurers and produce business for other insurance companies to generate commission and fee income. Our business model allows us to create and support a much larger premium base and more highly developed infrastructure than otherwise would have been possible with our capital base. In doing so, we have been able to achieve a return on average equity (or ROAE) that we believe is higher than many other insurance companies with a traditional business model. From 2002 to 2006, our return on average equity averaged 21.6%. Through our strategic relationship with CastlePoint, we have reduced the risk of relying on other reinsurance and issuing companies and will be able to maintain and strengthen our hybrid business model as well as pursue our growth plans. Through reinsurance and pooling, we plan to transfer approximately 49% of our total premiums written and produced to CastlePoints reinsurance and insurance company subsidiaries in order to generate commission and fee income. We will continue to maintain the operational infrastructure that will market, originate, underwrite and service the total premiums written and produced.
· High Growth Platform and Territorial Expansion. We have established a track record of growth by expanding our product line offering, entering into new territories and acquiring books of business. Our gross premiums written and premiums produced increased 34.3% on a compounded annual basis from 2002 to 2006. Our acquisition of Preserver will allow us to increase our premium writings in the three states in which we are currently writing business, New York, New Jersey and Massachusetts, as well as expand into new states such as Maine, New Hampshire, Rhode Island, Vermont and Pennsylvania. Through this acquisition, we will also be able to expand our broad product line platform to include personal auto and businessowners policies. We also plan to expand into other parts of the United States by establishing offices and appointing retail agents in those areas as well as appointing wholesale agents throughout the country. We will continue to seek acquisitions of renewal rights, insurance companies and managing general agencies that will provide us with access to local markets throughout the United States.
· Underwriting and Market Segmentation Expertise. We have a strong track record of generating favorable underwriting results as demonstrated by our weighted average gross loss ratio of 57.0% during the period from 2002 to 2006. We have been able to achieve these underwriting results by focusing on customers that present low to moderate hazard risks and utilizing our in-house claims and legal defense capabilities to adjust and defend claims cost-effectively. We also have utilized our broad product line platform to allocate our capital to the most profitable lines of business in response to changing market conditions. In addition, we have been able to maintain pricing and coverage discipline in writing these policies by positioning our products in various market segments that tend to exhibit a reduced level of competition, including nonstandard risks that may be avoided by standard or preferred market carriers due to underwriting factors such as type of business, location and premium per policy.
· Entrance into Excess and Surplus Lines Market. At present, we generally write our insurance policies in the preferred and standard market through our retail agents and insurance policies in the non-standard market segments through our wholesale agents, all on an admitted basis. This means that we are licensed by the states in which we sell our policies, and we write our policies using premium rates and forms that are filed with state insurance regulators. However, we plan to enter the excess and surplus lines (or E&S) market segment by offering our products through TICNY, which is qualified as a non-admitted company to write E&S business in Florida and Texas, as well as through a separate non-admitted company that we plan to form and capitalize. Non-admitted carriers writing in the E&S market are not bound by most of the rate and form regulations imposed on standard market companies, allowing them the flexibility to change the coverage offered and the rate charged without the time constraints and financial costs associated with the filing process. Because we focus on providing products in underserved market segments through our wholesale distribution system, we believe we can distribute these products utilizing both the non-standard market segment on an admitted basis as well as the E&S market segment on a non-admitted basis. Having a non-admitted company will provide us with a means to quickly expand and distribute our products nationally through the wholesale distribution system.
· Low Cost Infrastructure. We have been able to gradually lower our expense ratio by realizing economies of scale resulting from our growth in total premiums produced and managed, and by improving our business processes and integrating technology to become more efficient. The commission and fee income that we generate from transferring premiums to reinsurers and other insurance companies also reduces our expense ratio. Our net expense ratio, which is calculated after offsetting our reinsurance commission, was 27.3% and 29.3% in 2006 and 2005, respectively. We also expect that acquisitions we may make will generate incremental reductions in our expense ratio as we apply our technology and business processes to the operations of the acquired business in order to realize economies of scale.
· Proven Leadership and Experienced Management. Our senior management team members average over 20 years of insurance industry experience. Michael H. Lee, our Chairman of the Board, President and Chief Executive Officer, was a founder of the company in 1990 and has an extensive knowledge and understanding of our business, having played a key role in building several aspects of our operations, including underwriting, finance, claims and systems.
We organized and sponsored CastlePoint, a Bermuda holding company, with an initial investment of $15.0 million on February 6, 2006. On April 4, 2006, CastlePoint raised $249.9 million, net of expenses, in a private placement offering of newly issued shares, which reduced our investment ownership from 100% to 8.6%. On April 6, 2006, we received a warrant from CastlePoint to purchase an additional 3.7% or
1,127,000 shares of common stock with a fair value of approximately $4.6 million using a Black-Scholes option pricing model.
As previously announced, Michael H. Lee serves as Chairman and Chief Executive Officer of CastlePoint Holdings, Ltd. and Tower Group, Inc.
CastlePoint is a Bermuda holding company organized to provide property and casualty insurance and reinsurance business solutions, products and services primarily to small insurance companies and program underwriting agents in the United States. Reinsurance is an arrangement by which one insurance company, called the reinsurer, agrees to indemnify another insurance (or reinsurance) company, called the ceding company, against all or a portion of the insurance (or reinsurance) risks underwritten by the ceding company under one or more policies. Program underwriting agents are insurance intermediaries that aggregate insurance business from retail and wholesale agents and manage business on behalf of insurance companies. Their functions may include some or all of risk selection, underwriting, premium collection, policy form and design, and client service.
CastlePoint operates through a number of subsidiaries, including CastlePoint Reinsurance, a Bermuda reinsurance company; CastlePoint Insurance Company, a New York domiciled insurance company; and CastlePoint Management Corp., which provides insurance services.
For your convenience, we have included below definitions of terms used in this Form 10-K in connection with our relationship with CastlePoint:
· brokerage business refers to broad classes of business that are underwritten on an individual policy basis by an insurance companys underwriting staff through wholesale and retail agents, and for which most or all of the services are provided by the insurance company as part of the overall product offering;
· program business refers to narrowly defined classes of business that are underwritten on an individual policy basis by program underwriting agents on behalf of insurance companies;
· traditional program business refers to blocks of program business in excess of $5 million in annual gross written premium that we historically have underwritten, consisting of non-auto related personal lines and the following commercial lines of business: retail stores and wholesale trades, commercial and residential real estate, restaurants, grocery stores, office and service industries and artisan contractors;
· specialty program business refers to (i) program business other than traditional program business and (ii) traditional program business that we and CastlePoint agree will be deemed to be specialty program business;
· insurance risk-sharing business refers to various risk sharing arrangements, such as (i) pooling or sharing of premiums and losses between our insurance companies and other insurance companies based upon their respective percentage allocations or (ii) appointing other insurance companies as our program underwriting agents and then having those insurance companies assume through reinsurance a portion of the business they produce as program underwriting agents;
· traditional quota share reinsurance refers to a type of reinsurance whereby a reinsurer provides reinsurance coverage to an insurance company on a pro-rata basis based on a ceding percentage without any provisions to limit meaningful losses within the contractual limits; and
· program underwriting agent refers to an insurance intermediary that aggregates business from retail and wholesale agents and manages business on behalf of insurance companies, including functions such as risk selection and underwriting, premium collection, policy form design and client service.
In April 2006, we entered into a master agreement with CastlePoint (the Master Agreement). Pursuant to the Master Agreement and as described more fully in BusinessReinsurance, we subsequently entered into the following agreements and arrangements with subsidiaries of CastlePoint:
· brokerage business quota share reinsurance agreement between CastlePoint Reinsurance and our subsidiaries, TICNY and TNIC, covering brokerage business historically written by us;
· traditional program business quota share reinsurance agreement between CastlePoint Reinsurance and our subsidiaries, TICNY and TNIC, covering program business historically written by us;
· specialty program business and insurance risk-sharing business quota share reinsurance agreement between CastlePoint Reinsurance and our subsidiaries, TICNY and TNIC, covering business not historically written by us;
· a service and expense sharing agreement with CastlePoint Management; and
· a program management agreement between CastlePoint Management and our subsidiaries, TICNY and TNIC.
The reinsurance agreements and pooling agreement are described in more detail under BusinessReinsuranceCastlePoint Reinsurance and Pooling. Under the service and expense sharing agreement, CastlePoint Management can purchase from us certain insurance company services, such as claims adjustment, policy administration, technology solutions, underwriting, and risk management services, at cost and market these services to program underwriting agents on an unbundled basis. The reimbursement for these charges have been recorded as Other administration revenues in our insurance services segment. CastlePoint Management shares with us 50% of the profits and losses generated from marketed services. We charged CastlePoint $0.7 million for such services in 2006. Under the program management agreement, CastlePoint Management was appointed by TICNY and TNIC to perform certain underwriting and claims services with respect to the specialty program business and insurance risk-sharing business, such as soliciting, underwriting, quoting, binding, issuing and servicing of insurance policies. In circumstances where CastlePoint Management cannot fully perform these functions on its own, CastlePoint Management plans to delegate authority to the program underwriting agents or to purchase services from us under the service and expense sharing agreement.
The program management agreements, the pooling agreements and the service and expense sharing agreement are subject to further review, approval and modification by the New York State Insurance Department. On December 4, 2006, we sold an unused shell insurance company, Tower Indemnity Company of America, to CastlePoint in order to facilitate these pooling arrangements. Tower Indemnity Company of America was renamed CastlePoint Insurance Company.
We believe that the formation of CastlePoint and the agreements between our company and CastlePoint further enhance our hybrid business model by reducing certain risks of relying on other reinsurers and issuing carriers. These risks include cyclicality in demand for underwriting and availability of capacity, restrictions on business and underwriting classes and the high costs of utilizing issuing carriers. Our relationship with CastlePoint also generates commission and fee income which are an important component of our business. Furthermore, we can continue to participate in program business though our pooling arrangements while operationally remaining focused on our core business which is distributed by retail and wholesale agencies.
On November 13, 2006, we entered into the Stock Purchase Agreement with a subsidiary of CastlePoint pursuant to which we agreed to issue and sell 40,000 shares of perpetual preferred stock to the subsidiary for aggregate consideration of $40 million. The transaction closed on December 4, 2006.
In connection with the issuance and sale of the preferred stock, we (i) paid a placement fee on December 28, 2006 to CastlePoints subsidiary in an amount of $400,000; (ii) agreed to provide to
CastlePoint a right of first refusal to enter into a loss portfolio transfer of existing reserves of any operating company we may acquire; and (iii) agreed to extend the Master Agreement for an additional year.
The preferred stock was redeemed on January 26, 2007 from the proceeds of the Companys placement of trust preferred securities and from a portion of the proceeds of its common stock offering.
We believe it is important to maintain and enhance our strategic relationship with CastlePoint as CastlePoint provides a reliable source of reinsurance capacity that will permit us to continue to implement our business strategy. We believe the relationship can be enhanced through mutually beneficial transactions, including investments. Our growth plans and business model will require additional capital or financing from time to time. These needs will likely occur in connection with the acquisition of a book of business or another company and could also occur in other circumstances. Assuming that CastlePoint would be willing to provide financing, any such transaction with CastlePoint will be made only after approval by a special committee of independent members of the Board of Directors after evaluating and comparing the proposed terms of such transactions with available alternatives.
On November 13, 2006, we entered into a Stock Purchase Agreement (the Preserver Purchase Agreement) to acquire all of the outstanding shares of stock of Preserver. The sellers are certain individuals and trusts and companies affiliated with them. We agreed to pay the sellers a base purchase price of $68,250,000, subject to adjustment as described below. This amount will be used to acquire the outstanding shares and to satisfy all of Preservers obligations with respect to Preservers direct transaction costs and the outstanding principal and accrued and unpaid interest on indebtedness of Preserver owed to the sellers (approximately $30.8 million principal amount as of November 13, 2006). Approximately $12 million of trust preferred securities issued by a subsidiary of Preserver will remain outstanding as a liability of Preserver.
Preserver is a privately-held holding company for a regional insurance company group specializing in small commercial and personal lines insurance in the Northeast. Preservers three insurance companies are rated B++ (Good) by A.M. Best. It is headquartered in Paramus, New Jersey, with offices in Maine, New Hampshire and New York, and currently has a staff of approximately 163 employees. Preserver offers similar products and has a similar risk appetite as ours. Upon closing, the acquisition will give us access to up to 300 retail agencies working with Preserver that have little overlap with our existing distribution. The transaction will accelerate our Northeast expansion plans by adding premium volume in New Jersey, Maine, New York, New Hampshire, Massachusetts, Vermont, Rhode Island and Pennsylvania.
Preserver fits our acquisition profile due to its access to local distribution systems in the Northeast, and focus on similar types of business as ours. Preserver writes all the lines of business that we currently write but also adds personal auto and a web-based program for writing business owners policies to our product portfolio. The acquisition will diversify our geographical footprint, with New Jersey and Maine being Preservers largest states in terms of premium volume. We believe Preservers business exhibits loss characteristics that are similar to our own, and would expect that the business produced by Preserver following the acquisition will generate loss ratios similar to our historical loss ratios. Following the acquisition of Preserver, we intend to cause all of our insurance subsidiaries (other than the E&S carrier that we plan to form and capitalize) to enter into a pooling agreement, subject to regulatory approvals, to apportion premium, loss and expense among those companies on a pro rata basis. If this pooling agreement and our proposed pooling agreement with CastlePoint Insurance Company are approved by insurance regulators, the effect will be that the premiums written by the Preserver companies will be subject to our reinsurance and pooling agreements with CastlePoint.
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, New Jersey, and Massachusetts. We also provide limited commercial lines policies in other Northeast states such as Pennsylvania. Towers commercial lines products include commercial multiple-peril, monoline general liability, commercial umbrella, monoline property, workers compensation and commercial automobile policies. The personal lines products consist of homeowners, dwelling and other liability policies. See BusinessInsurance Segment Products.
· Reinsurance. In our reinsurance segment in 2006, TICNY accepted or assumed reinsurance directly from TRMs issuing companies on a 100% quota share basis. Until December 31, 2005, as a reinsurer, TICNY assumed a modest amount of the risk on the premiums that TRM produced. While this reinsurance business was not profitable in certain prior periods, the commission income generated by TRM on the production of this business exceeded any underwriting losses from the reinsurance assumed on this business. See BusinessInsurance Services Segment Products and Services.
· Insurance 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. In order for us to obtain reinsurance for TRMs issuing companies, the reinsurers often required TICNY to assume reinsurance premiums directly from TRMs issuing companies or from reinsurers that reinsured the premiums written by these companies.
In our insurance services segment, we reflect administration service revenue received from CastlePoint for services provided by TICNY in addition to fees generated from services provided by TRM. In 2007, we will also reflect management fee income and related expenses which will result from the pooling agreements with CastlePoint, which are effective, January 1, 2007 and are pending New York State Department of Insurance approval. 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. Until December 31, 2005, all of the risk was 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 previously unavailable to TICNY due to its then 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. In 2006, the reinsurance on TRM business was ceded to TICNY. See BusinessInsurance Services Segment Products and Services.
Insurance Segment Products
Tower Group offers a broad array of commercial and personal lines products. Our insurance segment (TICNY and TNIC) products target low severity, low frequency risks. In 2006, our overall average annual premium was $5,130 per policy for commercial lines and $1,161 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 both urban and suburban areas of the
Northeastern United States, a market that we believe, in our lines of business, level of risk and premium size, has historically been underemphasized by regional and national insurance companies. With the OneBeacon Insurance Group LLC (OneBeacon) renewal rights agreement and our pending acquisition of Preserver, we have expanded our marketing territory to other areas outside of New York State, including New Jersey, Massachusetts, Maine, New Hampshire, Pennsylvania and Vermont and Rhode Island. However, we are 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, 2006, 2005 and 2004:
Our commercial multiple-peril products include commercial package policies, businessowners policies and landlord package policies. Our commercial package policies provide property and casualty coverage and focus on classes of business such as retail and wholesale stores, restaurants, residential and commercial buildings, and grocery stores. We have written commercial package policies since TICNY commenced operations in 1990. Our businessowners policies provide property and liability coverage to small businesses. We introduced this product in 1997 to provide broader built-in coverage for businesses in the standard and preferred pricing tiers. 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, 2006, approximately 40,107 commercial multiple-peril products were in force, including 23,616 commercial package policies and 11,799 landlord package policies and 4,692 business owners policies.
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. As of December 31, 2006 approximately 3,342 monoline commercial general liability policies were in force. We also write monoline personal liability policies as an addition to our dwelling fire policies and currently have 1,259 comprehensive personal liability policies in force. For commercial umbrella we have a small number of policies with a limit over $5 million.
We introduced our workers compensation product in 1995. Our underwriting focus is on businesses such as restaurants, retail stores, offices, and service risks that generally have a lower potential for severe injuries to workers from exposure to dangerous machines, elevated worksites and occupational diseases. For workers compensation policies, we use full administered rates provided by the New York Compensation Insurance Rating Board, the Rating and Inspection Bureau of New Jersey, the Workers Compensation Rating Bureau of Massachusetts and the NCCI in developing our pricing in other states. In New Jersey and Massachusetts we also offer premium credits based on scheduled criteria. As of December 31, 2006, we had approximately 12,106 workers compensation policies in force.
Our commercial automobile product focuses on non-fleet and 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, 2006, approximately 3,256 commercial automobile policies were in force.
Our homeowners policy is a multiple-peril policy providing property and liability coverage 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. In the first quarter of 2006 we started writing homeowners business in New Jersey and added homeowners business in Massachusetts in December 2006. We market both a standard and preferred homeowners product. As of December 31, 2006, approximately 64,987 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 coverage 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, 2006, we had approximately 19,325 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.
Reinsurance Segment Products
Until December 31, 2005, in order for TRM to obtain reinsurance support for the business it produced for its issuing companies, Virginia Surety Company Inc. (Virginia Surety) and State National Insurance Company Inc. (State National), TICNY was often required to assume through retrocession a limited amount of reinsurance on this business from the issuing companies or the issuing companies reinsurers. By assuming risk, we aligned our interests with the issuing companies and their reinsurers. While this assumed business was unprofitable in certain prior periods, the direct commission income generated by TRM historically offset assumed losses.
In 2006, TRM produced business through Virginia Surety from January 1 to August 31, and it produced business through State National beginning on November 1, 2006. In 2006, TICNY directly reinsured 100% of the TRM business written by Virginia Surety and State National.
Insurance Services Segment Products and Services
We reflect administration service revenue received from CastlePoint for services provided by TICNY in addition to fees generated from services provided by TRM. In 2007, we will also reflect management fee income and related expenses which will result from the pooling agreements with CastlePoint, which are effective, January 1, 2007 pending New York State Department of Insurance approval.
Other Administration Revenue
TICNY provides administrative services to CastlePoint, which represents the reimbursement of cost for services provided pursuant to its Service and Expense Sharing Agreement with CastlePoint. Its revenue for performing these services in 2006 was $0.7 million. See BusinessStrategic Relationship and Agreements with CastlePoint.
Managing General Agency
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 had 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 was 20.9% and 27.1% in 2006 and 2005, respectively. 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.
In 2005 and 2004 TRM produced business on behalf of Virginia Surety and State National. In 2006, TRM continued to produce business on behalf of Virginia Surety and State National on a limited basis, primarily to retain business in states where TICNY and TNIC are not yet licensed. 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.
TRMs business is primarily sourced through wholesale and retail brokers. See BusinessProduct Development and Marketing StrategyDistribution for further detail on our producers.
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 $3.2 million in 2006, $4.3 million in 2005 and $4.1 million in 2004.
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 generated 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 $0.6 in 2006, $0.7 million in 2005 and $0.7 million in 2004.
Product Development and Marketing Strategy
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 demand-driven 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 coverage 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.
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 began to expand territorially into New Jersey, Pennsylvania and the New England states.
In marketing our products, we segment the market based upon industry, location, pricing tiers, hazard grading 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 have also expanded our product offering to various lines of business within the preferred, standard and non-standard pricing segments and we plan to expand to the excess and surplus lines segment. Within the preferred, standard or non-standard and E&S market segments, we first developed different pricing, coverage and underwriting guidelines. For example, the pricing for the preferred risk segment is generally the lowest, followed by the standard, non-standard and E&S 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, non-standard and E&S risks. We currently write all of our insurance policies in the preferred, standard and non-standard market segments on an admitted basis, meaning that we are licensed by the states in which we sell our policies, and we write our policies using premium rates and forms that are filed with state insurance regulators. We generally distribute policies for risks with preferred and standard underwriting characteristics through our retail distribution system and policies for risks with non-standard underwriting characteristics through our wholesale distribution system. However, we plan to offer our products in the excess and surplus market through TICNY, which plans to write business on a non-admitted basis in Florida and Texas, as well as a separate non-admitted company that we plan to form and capitalize. Non-admitted carriers are not bound by most of the rate and form regulations imposed on companies writing on an admitted basis, allowing them the flexibility to change the coverage offered and the rate charged without time constraints and financial costs associated with the filing process. The E&S market allows insurers to tailor their rates and policy terms to the particular risk presented and provides an alternative market for customers with hard-to-place risks that admitted carriers may not cover. Because we focus on providing products in underserved market segments through our wholesale distribution system, we believe we can distribute these products utilizing both the non-standard pricing tier on an admitted basis as well an E&S pricing tier on a non-admitted basis. Having a non-admitted company will provide us with means to quickly expand and distribute our products nationally through the wholesale distribution system. In addition, we may be able to write more of our policies with non-standard underwriting characteristics in the E&S market rather than in the non-standard admitted market in the states where we currently conduct business.
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 middle market 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 814 producers appointed to generate business in 2006. This includes 299 former OneBeacon producers that we contracted with in connection with the renewal rights transaction that occurred in 2004.
As of December 31, 2006, approximately 80% of the 2006 gross premiums written, including premiums produced by TRM on behalf of its issuing companies, were produced by our top 142 producers representing 17% of our active agents and brokers. These producers have annual written premiums of $500,000 or more. As we build a broader territorial base, the number of producers with significant premium volumes with Tower is increasing. In 2005, producers with premium volumes of $500,000 or more numbered 121 and contributed 77% of gross premiums written.
Our largest producers in 2006 were Morstan General Agency, Northeast Agencies and Davis Agency Inc. through December 31, 2006, these producers accounted for 11%, 7% and 5%, respectively, of the total of our gross premiums written. No other producer was responsible for more than 5% of our gross premiums written.
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 $10,000,000. 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. Commissions paid to producers in 2006 for TICNY averaged 16.1% of gross premiums earned. 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, we have a profit sharing plan that added approximately ¼ to ½ of 1 percent to overall commission rates in 2006, 2005 and 2004.
We have increased marketing and business development efforts aimed at increasing premium volume in all areas of New York State as well as in New Jersey, Pennsylvania and Massachusetts. This has required the identification, appointment, orientation and training of over 80 newly appointed agents in New Jersey, Pennsylvania and Massachusetts. With the acquisition of additional state licenses and approval of our product filings, we have broadened our agency relationships and marketing capabilities.
Additionally, our proposed acquisition of Preserver will give us access to up to 300 retail agencies working with Preserver; no more than 14% of these agencies overlap with our existing retail agencies. The Preserver transaction accelerates our Northeast expansion plans by adding premium volume in New Jersey, Maine, New York, New Hampshire, Massachusetts, Vermont, Rhode Island and Pennsylvania.
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 monthly review to monitor premium volume and profitability. We have access to online premium and loss ratio reports on a producer basis. Annually we develop actuarial ultimate accident year factors in order to confirm the continuing profitability of our producers. We continuously monitor the producers in this manner so we can develop corrective action, if necessary, at any time throughout the year. Corrective action may be implemented based on the identified problem area, and may include joint and increasingly frequent business planning in the case of poor production or renewal retention, the monitoring of risk profiles and reduction of binding authority if there is a loss ratio issue or a review of the pertinent agency agreement requirements to address inadequate adherence to administrative duties and responsibilities. Noncompliance could lead to reduction of authority and potential termination.
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 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 coverage 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 50 employees in any one building. However, please see Risk Factors-Risks Related to Our Business-We may face substantial exposure to losses from terrorism and 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 26 years of industry experience in the property and casualty industry. We have the following four business units: small commercial, middle market, commercial auto and personal lines. 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 at levels that are projected to generate 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 full administered rates provided by the New York Compensation Insurance Rating Board, the Rating and Inspection Bureau of New Jersey, the Workers Compensation Rating Bureau of Massachusetts and the NCCI in developing our pricing in other states.
If a particular business line is not performing well, we may seek rate increases, which are subject to regulatory approval and market acceptance. Recently, we have been successful in achieving preliminary price increases. We increased premiums on our commercial renewals as measured against expiring premium by 3.3% in 2006 and by 5.5% in 2005. In personal lines we increased premiums by 9.3% in 2006 and by 7.6% in 2005.
Beginning in the latter half of 2004 and continuing throughout 2005 and 2006, 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 rate 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 2007 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 losses and loss adjustment expenses on the business ceded. 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 Managements Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies-Ceding 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 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, 2007 and our catastrophe reinsurance program was renewed July 1, 2006. On April 1, 2006, we entered into three multi-year quota share agreements with CastlePoint Reinsurancesee 2006 and 2007 Reinsurance ProgramsCastlePoint Reinsurance and Pooling. Before these agreements were in place, from January 1, to March 31, 2006, we retained 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 quota share treaty.
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. The hurricanes that struck Florida and the Gulf coast in 2004 and 2005 have contributed to this trend, particularly in regard to catastrophe reinsurance.
In an effort to maintain quota share capacity for our business with favorable commission levels, prior to our agreements with CastlePoint Reinsurance, we accepted 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 reinsurers. 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 were 95.0% in 2005, 95.0% in 2004, 92.0% in 2003, 97.5% in 2002 and 100.0% in 2001. The quota share agreements with CastlePoint Reinsurance effective April l, 2006, provide traditional reinsurance terms such as flat ceding commission or narrow sliding scale commission, and have no loss ratio caps.
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.
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 (PXRE). On February 16, 2006, A.M. Best downgraded PXREs financial strength rating to B++ (Good) from A- (Excellent) and issued a negative outlook. On February 24, 2006 A.M. Best downgraded PXRE to B+ (Good) with a negative outlook. On June 29, 2006, to eliminate our exposure to uncollateralized reinsurance recoverables from PXRE, we concluded, through commutation agreements, PXREs participation under various reinsurance agreements with TICNY covering the 2001, 2002 and a portion of the 2003 policy periods. Ceded loss and loss adjustment expense recoverables of $20.5 million, ceded paid losses of $2.4 million and ceding commissions receivable of $8.7 million, totaling $31.6 million of unsecured recoverables were settled with a payment from PXRE of $26.7 million, which represents an estimate of the present value of these recoverables. This resulted in a $4.8 million pre-tax charge, of which $1.6 million was recognized in loss and loss adjustment expenses and $3.2 million was recognized as a reduction to ceding commission income in the second quarter of 2006. In addition, on the same date, novation agreements were executed with PXRE relating to other reinsurance agreements covering business written in 2001, 2002 and 2003 by other insurance companies and managed on their behalf by TRM. As a result of the novation, TICNY assumed loss reserves of $12.2 million for which it received as consideration $11.4 million in cash and other assets and TRM recorded a reduction in commission liabilities of $0.2 million, the total of which resulted in a $0.6 million pre-tax charge. As a result of the commutation and novation agreements, which were effective as of June 29, 2006, PXRE was discharged from future obligations under the reinsurance agreements. There are no other agreements outstanding with PXRE.
To further minimize our exposure to reinsurance recoverables, our quota share reinsurance treaties, from October 1, 2003 to December 31, 2005, were, placed 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. Our reinsurance receivables from CastlePoint Reinsurance are collateralized in a New York Regulation 114 compliant trust account. We also used the proceeds from the IPO and the concurrent private placement to increase the capitalization of TICNY. As a result of this increase in capital, we have been able to retain more of the risk on the business we write, thereby reducing our need for quota share reinsurance.
The following table summarizes our reinsurance exposures by reinsurer as of December 31, 2006:
(1) Formerly American Re-Insurance Company.
2006 and 2007 Reinsurance Programs
Quota Share Reinsurance. From January 1 to March 31, 2006, we retained all of the risk for 2006 that would have been ceded to quota share reinsurers. Effective April 1, 2006, we entered into three multi-year
quota share reinsurance agreements with CastlePoint Reinsurance, which are described under CastlePoint Reinsurance and Pooling below.
Umbrella Quota Share Reinsurance. The Umbrella Quota Share Reinsurance Treaty, 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 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 Rueckversicherungs AG, rated A (Excellent) by A.M. Best, reinsures 50%. The Umbrella Quota Share Reinsurance Treaty was renewed on January 1, 2007, on terms similar to the 2006 terms. Of the premiums ceded, Hannover Rueckversicherung AG, rated A (Excellent) by A.M. Best, reinsures 40%, Platinum Underwriters Reinsurance, Inc., rated A (Excellent) by A.M. Best, reinsures 40% and AXIS Reinsurance Company, rated A (Excellent) by A.M. Best reinsures 20%.
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 Rueckversicherung 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. On May 1, 2006, CastlePoint Reinsurance became a participant of the Multi-line and the First Property Excess of Loss layers, on a new and renewal basis. Certain excess reinsurers agreed to reduce their percentage participation as of the same date to enable CastlePoint Reinsurance to participate in these two layers. The Excess of Loss Reinsurance Program was renewed on January 1, 2007, on terms similar to the 2006 program, and with the addition of a new Casualty Clash Excess of Loss layer and a new Workers Compensation Excess of Loss layer. The 2007 Excess of Loss Reinsurance Program was placed with Platinum Underwriters Reinsurance, Inc., 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 Rueckversicherung AG, rated A (Excellent) by A.M. Best and Aspen Insurance UK Limited, rated A (Excellent) by A.M. Best.
W.H. Greene Umbrella Quota Share and Excess Reinsurance. Effective December 1, 2005, we entered into a quota share agreement 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 we ceded 80% of premium written and retained the remaining 20%. The flat ceding commission under this treaty was 29% of ceded premium written. Of the premium ceded, Endurance Reinsurance Corporation of America, rated A- (Excellent) by A.M. Best, reinsured 50%, AXIS Reinsurance Company, rated A (Excellent) by A.M. Best, reinsured 20% and NGM Insurance Company, rated A (Excellent) by A.M. Best, reinsured 10%. Effective May 1, 2006, we entered into an excess of loss reinsurance agreement to cover losses in excess of $5 million up to $10 million per occurrence on the same book of commercial umbrella business. Under the terms of the agreement, we ceded 75% of premium written and retained the remaining 25%. The flat ceding commission under this agreement was 29% of ceded written premium. Of the premium ceded, Endurance Reinsurance Corporation of America, rated A- (Excellent) by A.M. Best, reinsured 30%, AXIS Reinsurance Company, rated A (Excellent) by A.M. Best, reinsured 40% and NGM Insurance Company, rated A (Excellent) by A.M. Best, reinsured 5%. Both agreements were renewed on December 1, 2006, with the same A rated reinsurers, at similar terms except that our retention under the excess of loss reinsurance agreement has been reduced from 25% to 20%.
Catastrophe Reinsurance. The 2006 Property Catastrophe Program provides coverage for events occurring through June 30, 2007 and is expected to be renewed on July 1, 2007 with a similar structure to
the expiring program. CastlePoint Reinsurance participates in the first three layers of the 2006 Property Catastrophe Program.
Terrorism Reinsurance. 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 Insurance Act (TRIA) was enacted. TRIA 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 and TNIC. Although TICNY and TNIC are protected by federally funded terrorism reinsurance as provided for by TRIA, 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 TRIA though December 31, 2007 with the passage of the Terrorism Risk Insurance Extension Act (TRIEA). Under the terms of TRIEA, the minimum size of the triggering event increased from $5 million to $50 million for 2006 and to $100 million in 2007. Towers deductible increased to 17.5% of direct earned premium in 2006 and will increase to 20% in 2007. If the program trigger is reached, the federal government will reimburse commercial insurers for 85% of their insured loses from the certified act of terrorism in excess of their statutory deductible. Under TRIEA, federal assistance for insured terrorism losses has been reduced as compared to the assistance previously available under TRIA. As a consequence of these changes, potential losses from a terrorist attack could be substantially larger than previously expected. The failure to extend TRIEA beyond December 31, 2007 or the extension of TRIEA on terms less favorable to insurers 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.
CastlePoint Reinsurance and Pooling. In April 2006, we entered into the following quota share reinsurance agreements with CastlePoint Reinsurance:
· Brokerage business quota share reinsurance agreement between TICNY and TNIC and CastlePoint Reinsurance, covering brokerage business historically written by Tower. Under this agreement we cede between 25% and 45% (with the percentage determined by us) of our brokerage business to CastlePoint Reinsurance and receive an initial ceding commission of 34%;
· Traditional program business quota share reinsurance agreement between TICNY and TNIC and CastlePoint Reinsurance, covering program business historically written by us. Under this agreement we cede 50% of our traditional program business to CastlePoint Reinsurance and share premium revenue and losses in proportion to the parties respective quota share of participation. Expenses will be deemed to be approximately 30% of business ceded. In the event that, after allowing for the ceding commissions, (1) the reinsurance premium is insufficient to cover losses, we will be required to make an additional premium payment; and (2) the reinsurance premium paid is in excess of the losses attributable to the business covered by the agreement, CastlePoint Reinsurance will be required to return to us a portion of the premium paid; and
· Specialty program business and insurance risk-sharing business quota share reinsurance agreement between TICNY and TNIC and CastlePoint Reinsurance and, covering business not historically written by us. Under this agreement we cede 85% of our net retention on specialty program business to CastlePoint Reinsurance and receive a ceding commission of 30%, subject to a minimum of 30% and a maximum of 36%.
In addition, CastlePoint Reinsurance participates as of May 1, 2006 as a reinsurer of our insurance companies, TICNY and TNIC, under certain layers of their existing property and casualty excess of loss reinsurance program. Further, CastlePoint Reinsurance participates as of July 1, 2006 as a reinsurer in the
property catastrophe excess of loss reinsurance program of our insurance companies, TICNY and TNIC, with a 30% participation in the first three layers.
We have agreed to enter into various pooling agreements with CastlePoint Insurance Company, to be effective January 1, 2007, pending New York State Department of Insurance approval, including (i) a brokerage business pooling agreement (covering business historically written by Tower), (ii) a traditional program business pooling agreement (covering program business historically written by Tower) and (iii) a specialty program business pooling agreement (covering business not historically written by Tower).
The Master Agreement provides that, subject to the receipt of any required regulatory approvals, CastlePoint will manage the traditional program business and the specialty program business pools, and we will manage the brokerage business pool. The pool managers are required to purchase property and casualty excess of loss reinsurance and property catastrophe excess of loss reinsurance from third party reinsurers to protect the net exposure of the pool participants. In purchasing the property catastrophe excess of loss reinsurance, the pool manager may retain risk equating to no more than 10% of the combined surplus of Tower and CastlePoint Insurance Company (referred to as the pooled catastrophe retention). Under the brokerage pooling agreement for 2007, CastlePoint Insurance Company has agreed to assume the greater of (i) its actual pooling percentage or (ii) 30% of property catastrophe premiums and risks. In addition, with respect to each of the pools, any of the participating companies will have the option to require the pool manager to increase the pooled catastrophe retention by an amount up to 10% of CastlePoint Reinsurances surplus provided that CastlePoint Reinsurance reinsures this increase to the pooled catastrophe retention.
The following chart is a summary of the percentage of business being ceded by us under the quota share reinsurance agreements with CastlePoint Reinsurance and the pooling agreements with CastlePoint, and the provisional ceding commissions and management fee percentages applicable under such agreements:
(1) Subject to adjustment based on the net loss ratio of the business covered by the applicable agreement.
The parties to the Master Agreement agreed to exercise good faith, and to cause their respective subsidiaries to exercise good faith, to carry out the intent of parties in the event the specific agreements contemplated by the Master Agreement must be revised to comply with regulatory requirements. For example, if the ceding commissions under the quota share reinsurance agreements or the management fee percentages under the pooling agreements must be adjusted to comply with regulatory requirements, each party will use its best good faith efforts to structure the transaction so that the ceding company cedes premiums at a combined ratio equal to 95% for the brokerage business and 93% for each of the traditional program business and the specialty program business. In addition, to the extent the transfers of any policies require regulatory review or approval, the Master Agreement requires the parties to cooperate fully and in good faith to take various actions with respect to the policies to be transferred by us to CastlePoint, including giving required notices and providing appropriate services relating to the policies, so as to implement such transfers in a timely and efficient manner.
The quota share reinsurance agreements and the pooling agreements have a term of four years (as extended by mutual agreement from the initial term of three years), subject to regulatory approval and certain early termination rights of the parties. In addition, each party to each of the pooling agreements may terminate its participation in the applicable pooling agreement upon 12 months notice. Further, we and CastlePoint have modified the program management agreements to provide that they can be terminated by any party upon 60 days notice. We and CastlePoint have also agreed that neither of us will cause nor permit our respective subsidiaries to exercise such annual termination right in the quota share reinsurance agreements and the pooling agreements or the 60 days notice termination right in the program management agreements. This agreement not to exercise the annual termination right or 60 days notice termination right does not affect the other early termination provisions.
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 ceded 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, reinsured 50% and Hannover Ruckversicherung 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 ceded 80% of its premium written and retained the remaining 20%. The flat ceding commission under this treaty is 29% of ceded premium written. 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 Munich Reinsurance America Inc (formerly known as American Re-Insurance Company), 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 Ruckversicherung 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.
We derive investment income from our invested assets. We invest our insurance companies statutory surplus and funds to support their loss and loss adjustment expense reserves and unearned premium reserves. Our investment income increased significantly beginning in 2004 as TICNYs invested assets increased due to increased net premiums written and surplus as well as the $98.0 million capital contribution of a portion of the IPO proceeds.
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, 2006, the fixed maturity securities represented approximately 89% of the fair market value of our investment portfolio and equity securities represented approximately 11%. 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, 2006, cash and cash equivalents represented approximately 17.8% of the total of fair market value of our investment portfolio and cash and cash equivalents. Our higher year end 2006 cash position was due to the relatively flat yield curve and managements decision to invest new funds short term and not taking on additional interest rate risk associated with longer term investments as well as the $39.6 million of new cash from the perpetual preferred stock offering. These funds will be reinvested longer term by our investment manager as we see advantages in the fixed maturity market.
Our investments are managed by an outside asset management company, Hyperion Brookfield Asset Management, Inc. (Hyperion), 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 83.0% of the fixed income portion of our investment portfolio is rated A or higher as of December 31, 2006. 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.
Our investment income was $23.0 million in 2006, compared to $15.0 million in 2005. Additionally, in 2006, invested assets increased as a result of $134.0 million of net cash flow from operations and an increase in the investment yield.
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:
For 2006, the principal change in allocations was an increase to common stocks, mortgage-backed securities and corporate bonds. During 2006 we allocated 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. During 2006 we used approximately $134.0 million of new cash flow from operations to purchase mortgage-backed securities, corporate bonds and equity securities. These new fixed maturity investments offered us favorable yields while maintaining fundamental credit quality. At December 31, 2006 the average credit quality of our fixed income investments was AA and the duration was 3.67 years.
The principal change in 2005 was an increase in the allocation to common stocks, municipal bonds, mortgage-backed securities and corporate bonds. During 2005 we allocated 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 that went public in 2006. 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 3.97 years.
The following table shows the composition of our fixed maturity portfolio by remaining time to maturity at December 31, 2006 and December 31, 2005. 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, 2006 and AA+ at December 31, 2005. The following table shows the ratings distribution of our fixed income portfolio as of the end of each of the past two years.
We account for our investments in accordance with Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (SFAS 115), which requires that fixed-maturity securities and equity securities that have readily determined fair values be segregated into categories based upon our intention for those securities. In accordance with SFAS 115, we classified our fixed-maturity and equity securities as available-for-sale. We may sell our available-for-sale securities in response to changes in interest rates, risk/reward characteristics, liquidity needs or other factors.
Fixed-maturity securities and equity securities are reported at their estimated fair values based on quoted market prices or a recognized pricing service. Changes in unrealized gains and losses on these securities are reported as a separate component of comprehensive net income, and accumulated unrealized gains and losses, net of tax effects, reported as a separate component of accumulated other comprehensive income in stockholders equity. During the third quarter of 2006, we reclassified our entire balance of equity securities at cost to equity securities at fair value in compliance with GAAP for insurance companies. Realized gains and losses are charged or credited to income in the period in which they are realized and are determined on the specific identification method.
On November 3, 2005, the FASB issued FSP FAS 115-1 and FAS 124-1, Other-Than-Temporary Impairment and Its Application to Certain Investments. The guidance in this FSP addresses the determination of when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. The FSP also includes accounting considerations subsequent to the recognition of an other than temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in this FSP applies to reporting periods beginning after December 15, 2005.
Impairment of investment securities results in a charge to operations when a market decline below cost is deemed to be other-than-temporary. As of December 31, 2006, we reviewed our fixed-maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments in accordance with the provisions of this FSP. We determined that we did not hold any investments that we considered other-than-temporarily impaired. As of December 31, 2006, and December 31, 2005, cumulative net unrealized losses on our fixed maturity portfolio were $2.1 million and $4.4 million, respectively. There were no other than temporary declines in the fair value of our securities at December 31, 2006 and December 31, 2005.
The aggregate fair market value of our invested assets excluding cash and cash equivalents as of December 31, 2006 was $464.0 million. As of that date, our fixed maturity securities had a fair market value of $414.6 million and amortized cost of $416.6 million. Equity securities, available for sale, at fair value were $49.5 million as of December 31, 2006 with a cost of $48.0 million.
The following table provides a breakdown of the amortized cost, aggregate fair value and unrealized gains and losses by investment type as of December 31, 2006 and December 31, 2005.
The following table presents information regarding our invested assets that were in an unrealized loss position at December 31, 2006 by amount of time in a continuous unrealized loss position.
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.
Loss Reserve Development
Shown below is the loss reserve development for business written each year from 1996 through 2006. 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, 2000 we estimated that $7,901,000 would be a sufficient reserve to settle all claims not already settled that had occurred prior to December 31, 2000 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 $7,901,000 as of December 31, 2000, by December 31, 2006 (six years later) $8,736,000 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 $7,901,000 was re-estimated to be $12,666,000 at December 31, 2006. 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, 2000 than had occurred prior to that date.
The cumulative redundancy/ (deficiency) represents, as of December 31, 2006, 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, 2006 and based upon updated information, we re-estimated that the reserves which were established as of December 31, 2005 were $738,000 redundant, and excluding the PXRE commutation were $2,340,000 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.