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Tower Group 10-Q 2011 Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended March 31, 2011
For the transition period from to
Commission file no. 000-50990
Tower Group, Inc.
(Exact
name of registrant as specified in its charter)
(212) 655-2000
(Registrant’s telephone number, including area code
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 and 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. þ Yes o No
Indicate by check mark whether the registrant has submitted electronically and posted on its
corporate Web site, if any, every Interactive Data File required to be submitted and posted
pursuant to Rule 405 of Regulation S-T ( § 232.405 of this chapter) during the preceding 12 months
(or for such shorter period that the registrant was required to submit and post such files). þ Yes o No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated
filer, non-accelerated filer or a smaller reporting company. See definitions of “large accelerated
filer”, “accelerated filer” and “smaller reporting company” 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 Exchange Act). o Yes þ No
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as
of the latest practicable date: 41,334,145 shares of common stock, par value $0.01 per share, as of May 5,
2011.
Tower Group, Inc.
Quarterly Report on Form 10-Q For the Period Ended March 31, 2011
Table of Contents
Part I — FINANCIAL INFORMATION
Item 1. Financial Statements
Tower Group, Inc.
Consolidated Balance Sheets
(Unaudited)
See accompanying notes to the consolidated financial statements.
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Tower Group, Inc.
Consolidated Statements of Income and Comprehensive Income
(Unaudited)
See accompanying notes to the consolidated financial statements.
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Tower Group, Inc.
Consolidated Statements of Changes in Stockholders’ Equity
(Unaudited)
See accompanying notes to the consolidated financial statements.
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Tower Group, Inc.
Consolidated Statements of Cash Flows
(Unaudited)
See accompanying notes to the consolidated financial statements.
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Note 1—Nature of Business
Tower Group, Inc. (the “Company” or “Tower”), through its subsidiaries, offers a broad range of
commercial, personal and specialty property and casualty insurance products and services to
businesses in various industries and to individuals. The Company’s common stock is publicly traded
on the NASDAQ Global Select Market under the symbol “TWGP”.
The Company operates three business segments: Commercial Insurance, Personal Insurance and
Insurance Services:
Note 2—Accounting Policies and Basis of Presentation
Basis of Presentation
The accompanying unaudited consolidated financial statements included in this report have been
prepared in accordance with accounting principles generally accepted in the United States of
America (“GAAP”) for interim financial information and with the instructions to Securities and
Exchange Commission (“SEC”) Form 10-Q and Article 10 of SEC Regulation S-X. The principles for
condensed interim financial information do not require the inclusion of all the information and
footnotes required by GAAP for complete financial statements. Therefore, these financial statements
should be read in conjunction with the consolidated financial statements as of and for the year
ended December 31, 2010 and notes thereto included in the Annual Report on Form 10-K filed on March
1, 2011. The accompanying consolidated financial statements have not been audited by an independent
registered public accounting firm in accordance with standards of the Public Company Accounting
Oversight Board (United States) but, in the opinion of management, such financial statements
include all adjustments, consisting only of normal recurring adjustments, necessary for a fair
statement of the Company’s financial position, results of operations and cash flows.
Effective January 1, 2011, the Company adopted new accounting guidance concerning the accounting
for costs associated with acquiring or renewing insurance contracts. This guidance was adopted
retrospectively and has been applied to all prior period financial information contained in these
consolidated financial statements.
The results of operations for the three months ended March 31, 2011 may not be indicative of the
results that may be expected for the year ending December 31, 2011. All significant inter-company
transactions have been eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make
estimates and assumptions that affect the reported amounts of assets and liabilities and the
disclosure of contingent assets and liabilities at the date of the financial statements and the
reported amounts of revenues and expenses during the reporting period. Actual results could differ
from those estimates.
Reclassifications
Certain amounts in the 2010 consolidated financial statements have been reclassified to conform to
the 2011 presentation. None of these reclassifications had an effect on consolidated net earnings,
total stockholders’ equity or cash flows.
Accounting Pronouncements
Accounting guidance adopted in 2011
Guidance issued by the Financial Accounting Standards Board (“FASB”) in January 2010 requires
additional disclosure about the gross activity within Level 3 of the fair value hierarchy within
GAAP as opposed to the net disclosure currently required. This disclosure is included in “Note 6 —
Fair Value Measurements”.
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited) In October 2010, the FASB issued new guidance concerning the accounting for costs associated with
acquiring or renewing insurance contracts. This guidance generally follows the model of that for
loan origination costs. Under the new guidance, only direct incremental costs associated with
successful insurance contract acquisitions or renewals are deferrable. The Company adopted this
guidance retrospectively effective January 1, 2011 and has adjusted its previously issued financial
information.
Adoption of this guidance affected the carrying value of the categories of acquisition costs
included within the 2010 caption “Deferred acquisition costs, net” as follows:
The effect of adoption of this new guidance on the consolidated balance sheet as of December
31, 2010 and on stockholders’ equity as of December 31, 2009 was as follows:
The effect of adoption of this new guidance on the consolidated income statement for the three
months ended March 31, 2010 was as follows:
Accounting guidance not yet effective
Guidance issued by the FASB in July 2010 requires additional disclosure on the income statement
impact of troubled debt restructurings (including loans and receivables). This guidance is
effective for interim and annual periods beginning after June 15, 2011. The Company will comply
with the required disclosures in its consolidated financial statements when it becomes effective.
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited) Note 3—Acquisitions
Acquisition of the Renewal Rights of AequiCap Program Administrators Inc. (“AequiCap”)
On November 2, 2010, Tower acquired the renewal rights to the commercial automobile liability and
physical damage business of AequiCap for $12 million (“AequiCap”). The business subject to the
agreement covers both trucking and taxi risks that are consistent with Tower’s current underwriting
guidelines. Most of the employees of AequiCap involved in the servicing of this commercial
liability and physical damage business became employees of the Company. The acquisition was
accounted for as a business combination under GAAP.
Acquisition of the OneBeacon Personal Lines Division (“OBPL”)
On July 1, 2010, Tower completed the OBPL acquisition pursuant to a definitive agreement (the
“Agreement”) dated February 2, 2010 by and among the Company and OneBeacon Insurance Group
(“OneBeacon”). This acquisition expanded Tower’s suite of personal lines insurance products to
include private passenger automobile, homeowners, umbrella, and the signature package product,
OneChoice CustomPac, which provides customers with one policy for all of their homeowners, auto and
umbrella needs.
Under the terms of the Agreement, the Company acquired Massachusetts Homeland Insurance Company
(“Homeland”), York Insurance Company of Maine (“York”) and two management companies (collectively
the “Stock Companies”). The management companies are the attorneys-in-fact for Adirondack Insurance
Exchange, a New York reciprocal insurer, and New Jersey Skylands Insurance Association, a New
Jersey reciprocal insurer (together, the “Reciprocal Exchanges”). Tower purchased $102 million
principal of surplus notes issued by the Reciprocal Exchanges (the “surplus notes”). In addition,
Tower reinsured the personal lines business written by other subsidiaries of OneBeacon not
acquired by Tower. The total consideration paid for OBPL was $167 million.
Effective July 1, 2010, Tower entered into transition service agreements with OneBeacon whereby
OneBeacon will provide certain information technology and operational support to Tower until such
time that these processes are migrated to Tower. Expenses incurred under such transition service
agreements were $6.6 million for the three months ended March 31, 2011.
Tower has consolidated OBPL as of July 1, 2010 and the purchase consideration has been allocated to
the assets acquired and liabilities assumed, including separately identified intangible assets,
based on their fair values as of the close of the acquisition, with the amounts exceeding the fair
value recorded as goodwill. The goodwill consists largely of the synergies and economies of scale
expected from combining the operations of the Company and OBPL.
Direct costs of the acquisition were accounted for separately from the business combination and
were expensed as incurred. As the values of certain assets and liabilities are preliminary in
nature, they are subject to adjustment as additional information is obtained, including, but not
limited to, valuation of separately identifiable intangibles, fixed assets, deferred taxes and loss
reserves. The valuations will be finalized within 12 months of the close of the acquisition. When
the valuations are finalized, any changes to the preliminary valuation of assets acquired or
liabilities assumed may result in adjustments to separately identifiable intangible assets and
goodwill.
For the three months ended March 31, 2011, OBPL contributed revenue and earnings to the Company
from its acquisition date as follows:
Note 4—Variable Interest Entities (“VIEs”)
Through its management companies, Tower is the attorney-in-fact for the Reciprocal Exchanges and
has the ability to direct their activities. The Reciprocal Exchanges are policyholder-owned
insurance carriers organized as unincorporated associations. Each policyholder insured by the
Reciprocal Exchanges shares risk with the other policyholders. In the event of dissolution,
policyholders would share any residual unassigned surplus in the same proportion as the amount of
insurance purchased but are not subject to assessment for any deficit in unassigned surplus of the
Reciprocal Exchanges. Tower receives management fee income for the services provided to the
Reciprocal Exchanges. The assets of the Reciprocal Exchanges can be used only to settle the
obligations of the Reciprocal Exchanges and general creditors to their liabilities have no recourse
with Tower as the primary beneficiary.
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited) In addition, Tower holds the surplus notes issued by the Reciprocal Exchanges when they were
originally capitalized. The obligation to repay principal and interest on the surplus notes is
subordinated to the Reciprocal Exchanges’ other liabilities including obligations to policyholders
and claimants for benefits under insurance policies. Principal and interest on the surplus notes
are repayable only with regulatory approval. The Company has no ownership interest in the
Reciprocal Exchanges.
The Company determined that each of the Reciprocal Exchanges qualifies as a VIE and that the
Company is the primary beneficiary as it has both the power to direct the activities of the
Reciprocal Exchanges that most significantly impact their economic performance and the obligation
to absorb losses or receive benefits from the management services provided to the Reciprocal
Exchanges. Accordingly, the Company consolidates these Reciprocal Exchanges and eliminates all
intercompany balances and transactions with Tower.
For the three months ended March 31, the Reciprocal Exchanges recognized total revenues and total
expenses of $47.6 million and $46.8 million, respectively, and had net income of $0.8 million.
Note 5—Investments
The cost or amortized cost and fair value of the Company’s invested assets, gross unrealized gains
and losses, and other-than-temporary impairment (“OTTI”) losses as of March 31, 2011 and December
31, 2010 are summarized as follows:
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited)
Major categories of net investment income are summarized as follows:
Proceeds from the sale and maturity of fixed-maturity securities were $611.1 million and $122.9
million for the three months ended March 31, 2011 and 2010, respectively. Proceeds from the sale of
equity securities were $82.9 million and $13.6 million for the three months ended March 31, 2011
and 2010, respectively.
Gross realized gains, losses and impairment write-downs on investments are summarized as follows:
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited) Management may dispose of a particular security due to changes in facts and circumstances
related to the invested asset that have arisen since the last analysis supporting management’s
determination whether or not it intended to sell the security, and if not, whether it is more
likely than not that the Company would be required to sell the security before recovery of its
amortized cost basis.
Impairment Review
Management regularly reviews the Company’s fixed-maturity and equity security portfolios in
accordance with its impairment policy to evaluate the necessity of recording impairment losses for
OTTI. The determination of OTTI is a subjective process and different judgments and assumptions
could affect the timing of loss realization.
Management, in conjunction with its outside portfolio managers, analyzes its non-agency residential
mortgage-backed securities (“RMBS”) using default loss models based on the performance of the
underlying loans. Performance metrics include delinquencies, defaults, foreclosures, prepayment
speeds and cumulative losses incurred. The expected losses for a mortgage pool are compared to the
break-even loss, which represents the point at which the Company’s tranche begins to experience
losses.
The commercial mortgage-backed securities (“CMBS”) holdings are evaluated using analytical
techniques and various metrics including the level of subordination, debt-service-coverage ratios,
loan-to-value ratios, delinquencies, defaults and foreclosures.
For the non-structured fixed-maturity securities (U.S. Treasury securities, obligations of U.S.
Government and government agencies and authorities, obligations of states, municipalities and
political subdivisions, and certain corporate debt), unrealized loss is reviewed to determine
whether full recovery of principal and interest will be received. The estimate of expected cash
flows is determined by projecting a recovery value and a recovery time frame and assessing whether
further principal and interest will be received. The determination of recovery value incorporates
an issuer valuation assumption utilizing one or a combination of valuation methods as deemed
appropriate by management. The present value of the cash flows is determined by applying the
effective yield of the security at the date of acquisition (or the most recent implied rate used to
accrete the security if the implied rate has changed as a result of a previous impairment) and an
estimated recovery time frame. For securities for which the issuer is financially troubled but not
in bankruptcy, that time frame is generally longer. Included in the present value calculation are
expected principal and interest payments; however, for securities for which the issuer is
classified as bankrupt or in default, the present value calculation assumes no interest payments
and a single recovery amount. In situations for which a present value of cash flows cannot be
estimated, a write-down to fair value is recorded.
In estimating the recovery value, significant judgment is involved in the development of
assumptions relating to a number of factors related to the issuer including, but not limited to,
revenue, margin and earnings projections, the likely market or liquidation values of assets,
potential additional debt to be incurred pre- or post- bankruptcy/restructuring, the ability to
shift existing or new debt to different priority layers, the amount of restructuring/bankruptcy
expenses, the size and priority of unfunded pension obligations, litigation or other contingent
claims, the treatment of intercompany claims and the likely outcome with respect to inter-creditor
conflicts.
The following table shows the amount of fixed-maturity and equity securities that were OTTI for the
three months ended March 31, 2011 and 2010. This resulted in recording impairment write-downs
included in net realized investment gains (losses), and reduced the unrealized loss in other
comprehensive net income:
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited)
The following table provides a rollforward of the cumulative amount of OTTI for Tower
securities still held showing the amounts that have been included in earnings on a pretax basis for
the three months ended March 31, 2011 and 2010 (none of such OTTI was included within the
Reciprocal Exchanges):
Unrealized Losses
There are 887 securities at March 31, 2011 that account for the gross unrealized loss, none of
which is deemed by management to be OTTI. Temporary losses on corporate and other bonds resulted
from purchases made in a lower interest rate environment or lower yield spread environment. In
addition, there have been some ratings downgrades on certain of these securities. After analyzing
the credit quality, balance sheet strength and company outlook, management believes these
securities will recover in value as liquidity and the economy continue to improve. The structured
securities that had significant unrealized losses resulted primarily from declines in both
residential and commercial real estate prices. To the extent projected cash flows on structured
securities change adversely, they would be considered OTTI, and an impairment loss would be
recognized. Management considered all relevant factors, including expected recoverability of cash
flows, in assessing whether the loss was other-than-temporary. The Company does not intend to sell
these fixed maturity securities, and it is not more likely than not that these securities will be
sold before recovering their cost basis.
For all securities in an unrealized loss position at March 31, 2011, the Company has received all
contractual interest payments (and principal if applicable). Based on the continuing receipt of
cash flow and the foregoing analyses, management expects continued timely payments of principal and
interest and considers the losses to be temporary.
For common stocks, there were 13 and 19 individual securities in a loss position at March 31, 2011
and December 31, 2010, respectively, totaling $1.5 million and $3.1 million. Management evaluated
the financial condition of the common stock issuers, the severity and duration of the impairment,
and our ability and intent to hold to recovery and determined these securities are not considered
OTTI.
The following table presents information regarding invested assets that were in an unrealized loss
position at March 31, 2011 and December 31, 2010 by amount of time in a continuous unrealized loss
position:
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited)
The unrealized loss position associated with the fixed-maturity portfolio was $12.0 million as
of March 31, 2011, consisting primarily of mortgage-backed and asset-backed securities representing
30.5% of the gross unrealized loss related to fixed-maturity securities. The total fixed-maturity
portfolio of gross unrealized losses included 828 securities which were, in aggregate,
approximately 1.7% below amortized cost. Of the 828 fixed maturity investments identified, 11 have
been in an unrealized loss position for more than 12 months. The total unrealized loss on these
investments at March 31, 2011 was $0.4 million. Management does not consider these investments to
be other-than-temporarily impaired.
All of the preferred securities that were in an unrealized loss position as of March 31, 2011 were
evaluated. The evaluation consisted of a detailed review, including but not limited to some or all
of the following factors for each security: the current S&P
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited) rating, analysts’ reports, past earning trends and analysts’ earnings expectations for the next 12
months, liquidity, near-term financing risk, and whether the company was currently paying dividends
on its equity securities. Management does not consider these investments to be
other-than-temporarily impaired.
The unrealized loss for the corporate and other bonds was $4.4 million with no securities in an
unrealized loss position over 12 months. These investments are not considered to be
other-than-temporarily impaired.
Management evaluated the severity of the impairments in relation to the carrying values for the
securities referred to above and considered all relevant factors in assessing whether the loss was
other-than-temporary. Management does not intend to sell its fixed-maturity securities, and it is
not more likely than not that these securities will be sold until there is a recovery of fair value
to the original cost basis, which may be at maturity.
Fixed-Maturity Investment—Time to Maturity
The following table shows the composition of the fixed-maturity portfolio by remaining time to
maturity at March 31, 2011 and December 31, 2010. For securities that are redeemable at the option
of the issuer and have a market price that is greater than 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.
Note 6—Fair Value Measurements
GAAP establishes a three-level hierarchy that prioritizes the inputs to valuation techniques used
to measure fair value. The fair value hierarchy gives the highest priority to quoted prices in
active markets for identical assets or liabilities (Level 1) and the lowest priority to
unobservable inputs (Level 3). If the inputs used to measure the assets or liabilities fall within
different levels of the hierarchy, the classification is based on the lowest level input that is
significant to the fair value measurement of the asset or liability. Classification of assets and
liabilities within the hierarchy considers the markets in which the assets and liabilities are
traded, including during periods of market disruption, and the reliability and transparency of the
assumptions used to determine fair value. The hierarchy requires the use of observable market data
when available. The levels of the hierarchy are as follows:
Level 1 — Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets
or liabilities traded in active markets. Included are those investments traded on an active
exchange, such as the NASDAQ Global Select Market.
Level 2 — Inputs to the valuation methodology include quoted prices for similar assets or
liabilities in active markets, quoted prices for identical or similar assets or liabilities in
markets that are not active, inputs other than quoted prices that are observable for the asset or
liability and market-corroborated inputs. Included are investments in U.S. Treasury securities and
obligations of
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited) U.S. government agencies, together with municipal bonds, corporate debt securities,
commercial mortgage and asset-backed securities, certain residential mortgage-backed securities
that are generally investment grade and certain equity securities. Additionally, interest-rate swap
contracts utilize Level 2 inputs in deriving fair values.
Level 3 — Inputs to the valuation methodology are unobservable for the asset or liability and are
significant to the fair value measurement. Material assumptions and factors considered in pricing
investment securities may include projected cash flows, collateral performance including
delinquencies, defaults and recoveries, and any market clearing activity or liquidity circumstances
in the security or similar securities that may have occurred since the prior pricing period.
Generally included in this valuation methodology are investments in certain mortgage-backed and
asset-backed securities.
The availability of observable inputs varies and is affected by a wide variety of factors. When the
valuation is based on models or inputs that are less observable or unobservable in the market, the
determination of fair value requires significantly more judgment. The degree of judgment exercised
by management in determining fair value is greatest for investments categorized as Level 3. For
investments in this category, management considers prices and inputs that are current as of the
measurement date. In periods of market dislocation, as characterized by current market conditions,
the ability to observe stable prices and inputs may be reduced for many instruments. This condition
could cause a security to be reclassified between levels.
As at March 31, 2011 and December 31, 2010, the Company’s fixed-maturities, equity investments and
short-term investments are allocated among levels as follows:
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited)
The fair values of the fixed-maturity, equity investments and short-term investments are
determined by management after taking into consideration available sources of data. Various factors
are considered that may indicate an inactive market, including levels of activity, source and
timeliness of quotes, abnormal liquidity risk premiums, unusually wide bid-ask spreads, and lack of
correlation between fair value of assets and relevant indices. If management believes that the
price provided from the pricing source is distressed, management will use a valuation method that
reflects an orderly transaction between market participants, generally a discounted cash flow
method that incorporates relevant interest rate, risk and liquidity factors.
Substantially all of the portfolio valuations at March 31, 2011 classified as Level 1 or Level 2 in
the above table is priced by utilizing the services of independent pricing services that provide
the Company with a price quote for each security. The remainder of the Level 1 and Level 2
portfolio valuations represents non-binding broker quotes. There were no adjustments made to the
prices obtained from the independent pricing sources and dealers on securities classified as Level
1 or Level 2.
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited) In 2011, there were no transfers of investments between Level 1 and Level 2. Approximately $1.0
million of securities were transferred from Level 3 to Level 2 when quoted market prices for
similar securities that were considered reliable and could be validated against an alternative
source became available in 2011.
The Level 3 classified securities in the investment portfolio consist of primarily non-agency
mortgage-backed and asset-backed securities that were either not traded or very thinly traded.
Management, in conjunction with its outside portfolio manager, has considered the various factors
that may indicate an inactive market and has concluded that prices provided by the pricing sources
represent an inactive or distressed market. As a result, prices from independent third party
pricing services, broker quotes or other observable inputs were not always available or were deemed
unrealistic, or, in the case of certain broker quotes, were non-binding. Therefore, the fair values
of these securities were determined using a model to develop a security price using future cash
flow expectations that were developed based on collateral composition and performance and
discounted at an estimated market rate (including estimated risk and liquidity premiums) taking
into account estimates of the rate of future prepayments, current credit spreads, credit
subordination protection, mortgage origination year, default rates, benchmark yields and time to
maturity. For certain securities, non-binding broker quotes were available and these were also
considered in determining the appropriateness of the security price.
Management has reviewed the pricing techniques and methodologies of the independent pricing sources
and believes that their policies adequately consider market activity, either based on specific
transactions for the issue valued or based on modeling of securities with similar credit quality,
duration, yield and structure that were recently traded. Management monitors security-specific
valuation trends and discusses material changes or the absence of expected changes with the pricing
sources to understand the underlying factors and inputs and to validate the reasonableness of
pricing.
The following table summarizes changes in Level 3 assets measured at fair value for the three
months ended March 31, 2011 and 2010 for Tower (the Reciprocal Exchanges have no Level 3 assets):
Note 7—Loss and Loss Adjustment Expense
The following table provides a reconciliation of the beginning and ending balances for unpaid
losses and LAE for the three months ended March 31, 2011 and 2010:
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited)
Incurred losses and loss adjustment expenses (“LAE”) for the three months ended March 31, 2011
were $240.2 million and include unfavorable development of $1.8 million relating to prior years.
The prior year development of $8.0 million for Tower, excluding the Reciprocal Exchanges, was
primarily in our property and personal automobile lines of business and resulted from winter
weather related claims. There was favorable prior year development of $6.2 million for the
Reciprocal Exchanges which was a result of lower than anticipated claims emergence for both
homeowners and private passenger lines of business.
Prior year development is based upon numerous estimates by line of business and accident year. No
additional premiums or return premiums have been accrued as a result of the prior year effects,
although we recorded changes in ceding commissions on reinsurance treaties that we purchase and for
which the commissions depend in part on loss experience. The Company’s management continually
monitors claims activity to assess the appropriateness of carried case and incurred but not
reported (“IBNR”) reserves, giving consideration to Company and industry trends.
Incurred losses and LAE as of March 31, 2011 included a reduction of $1.4 million pertaining to the
amortization of the reserve risk premium on loss reserves recorded in connection with the Company’s
acquisitions in prior years. Of this amount, $1.1 million and $0.3 million relate to Tower and the
Reciprocal Exchanges, respectively. As of March 31, 2011 the unamortized reserves risk premium was
$13.2 million, of which $9.8 million and $3.4 million, respectively, related to Tower and the
Reciprocal Exchanges.
Loss and loss adjustment expense reserves. The reserving process for loss and LAE reserves
provides for the Company’s best estimate as of the balance sheet date of the ultimate unpaid cost
of all losses and LAE incurred, including settlement and administration of losses, and is based on
facts and circumstances then known and including losses that have been incurred but not yet been
reported. The amount of loss and LAE reserves for reported claims is based primarily upon a
case-by-case evaluation of coverage, liability, injury severity, and any other information
considered pertinent to estimating the exposure presented by the claim. The amounts of loss and LAE
reserves for unreported claims are determined using historical information by line of insurance as
adjusted to current conditions. The difference between the paid claims and case outstanding loss
estimates and management’s best estimate of loss and LAE and reported losses is recorded in IBNR.
The process includes using actuarial methodologies to assist in establishing these estimates,
judgments relative to estimates of future claims severity and frequency, the length of time before
losses will develop to their ultimate level and considerations of other factors such as law
changes, economic conditions, and other external factors. The methods used to select the estimated
loss reserves include loss ratio projections, loss development projections, and
Bornhuetter-Ferguson (B-F) method projections. The actuaries’ estimates are the result of numerous
analyses made by line of business, accident year, and for loss, allocated LAE and unallocated LAE.
Management sets the carried reserves based upon the actuaries’ estimates of expected loss and LAE
and other considerations about the underlying business that are not reflected in the actuarial
indications.
There is no explicit or implicit risk premium provision for uncertainty in the carried loss and LAE
reserves, excluding the loss and LAE reserves assumed through business combinations in either 2010
or 2009. For business combinations after January 1, 2009, which included CastlePoint, Hermitage,
SUA and OBPL, the liability for loss and LAE includes the fair value adjustment related to those
acquisitions.
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited) Note 8—Stockholders’ Equity
Shares of Common Stock Issued
For the three months ended March 31, 2011 and 2010, 23,500 and 17,707 new common shares,
respectively, were issued as the result of employee stock option exercises and 613,502 and 341,406
new common shares, for the same periods, respectively, were issued as the result of restricted
stock grants.
For the three months ended March 31, 2011 and 2010, 58,418 and 54,080 shares, respectively, of
common stock were purchased from employees in connection with the vesting of restricted stock
issued under the 2004 Long Term Equity Compensation Plan (the “Plan”). The shares were withheld at
the direction of employees as permitted under the Plan in order to pay the expected amount of tax
liability owed by the employees from the vesting of those shares. In addition, for the three months
ended March 31, 2011 and 2010, 1,318 and 7,945 shares, respectively, of common stock were
surrendered as a result of restricted stock forfeitures.
Share Repurchase Program
The Board of Directors of Tower approved a $100 million share repurchase program on March 3, 2011.
This authorization is in addition to the $100 million share repurchase program approved on February
26, 2010. Purchases under both programs can be made from time to time in the open market or in
privately negotiated transactions in accordance with applicable laws and regulations. The new share
repurchase program will expire on March 4, 2013. In the three months ended March 31, 2011, 0.7
million shares of common stock were purchased under these programs at an aggregate consideration of
$17.6 million. As of March 31, 2011, the original $100 million share repurchase program had been
fully utilized and, $94.4 million remained available for future share repurchases under the new
program.
Dividends Declared
Dividends on common stock of $5.1 million and $3.1 million for the three months ended March 31,
2011 and 2010, respectively, were declared.
On May 5, 2011, the Board of Directors approved a quarterly dividend of $0.1875 per share payable on
June 24, 2011 to stockholders of record as of June 13, 2011.
Note 9—Debt
The Company’s borrowings consisted of the following at March 31, 2011 and December 31, 2010:
The fair values of the subordinated debentures and convertible senior notes were $250.4 million
and $164.8 million at March 31, 2011, respectively, as compared to $246.6 million and $168.4
million, respectively, at December 31, 2010.
Total interest expense incurred was $8.1 million and $4.9 million for the three months ended March
31, 2011 and 2010, respectively.
Credit Facility
On May 14, 2010, the Company entered into a $125 million credit facility agreement. The credit
facility will be used for general corporate purposes and expires on May 14, 2013.
The Company may request that the facility be increased by an amount not to exceed $50 million. The
credit facility contains customary covenants for facilities of this type, including restrictions on
indebtedness and liens, limitations on mergers, dividends
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited) and the sale of assets, and requirements to maintain certain consolidated net worth, debt to
capitalization ratios, minimum risk-based capital and minimum statutory surplus. The credit
facility also provides for customary events of default, including failure to pay principal when
due, failure to pay interest or fees within three days after becoming due, failure to comply with
covenants, any representation or warranty made by the Company being false in any material respect,
default under certain other indebtedness, certain insolvency or receivership events affecting the
Company and its material subsidiaries, the occurrence of certain material judgments, or a change in
control of the Company, and upon an event of default the administrative agent (subject to the
consent of the requisite percentage of the lenders) may immediately terminate the obligations to
make loans and to issue letters of credit, declare the Company’s obligations under the credit
facility to become immediately due and payable, and require the Company to deposit in a collateral
account cash collateral with a value equal to the then outstanding amount of the aggregate face
amount of any outstanding letters of credit. The Company was in compliance with all covenants under
the credit facility at March 31, 2011.
Fees payable by the Company under the credit facility include a fee on the daily unused portion of
each letter of credit, a letter of credit fronting fee with respect to each fronted letter of
credit and a commitment fee.
The Company had $17.0 million outstanding as of March 31, 2011. There was no balance outstanding as
of December 31, 2010.
Convertible Senior Notes
In September 2010, the Company issued $150.0 million principal amount of 5.0% convertible senior
notes (“the Notes”), which mature on September 15, 2014. Interest on the Notes is payable
semi-annually in arrears on March 15 and September 15 of each year, commencing March 15, 2011.
Holders may convert their Notes into cash or common shares, at the Company’s option, at any time on
or after March 15, 2014 or earlier under certain circumstances determined by: (i) the market price
of the Company’s stock, (ii) the trading price of the Notes, or (iii) the occurrence of specified
corporate transactions. Upon conversion, the Company intends to settle its obligation either
entirely or partially in cash. The initial conversion rate is 36.3782 shares of common stock per
$1,000 principal amount of the Notes (equivalent to an initial conversion price of $27.49 per
share), subject to adjustment upon the occurrence of certain events. Additionally, in the event of
a fundamental change, the holders may require the Company to repurchase the Notes for a cash price
equal to 100% of the principal plus any accrued and unpaid interest.
The proceeds from the issuance of the Notes were allocated to the liability component and the
embedded conversion option, or equity component. The equity component was reported as an adjustment
to paid-in-capital, net of tax, and is reflected as an original issue discount (“OID”). The OID of
$11.5 million and deferred origination costs relating to the liability component of $5.0 million
will be amortized into interest expense over the term of the Notes. After considering the
contractual interest payments and amortization of the original issue discount, the Notes’ effective
interest rate is 7.2%. Transaction costs of $0.4 million associated with the equity component were
netted with the equity component in paid-in-capital. Interest expense, including amortization of
deferred origination costs, recognized on the Notes was $2.8 million for the three months ended
March 31, 2011.
The following table shows the amounts recorded for the Notes as of March 31, 2011 and December 31,
2010:
To the extent the market value per share of the Company’s common stock exceeds the conversion
price, the Company will use the “treasury stock” method in calculating the dilutive effect on
earnings per share.
Interest Rate Swaps
In October 2010, the Company entered into interest rate swap contracts (the “Swaps”) with $190
million notional value to manage interest costs and cash flows associated with the floating rate
subordinated debentures. The Swaps have terms of five years. The majority of the Swaps is forward
starting and become effective when the respective subordinated debentures change from fixed rates
to floating rates and convert the subordinated debentures’ to rates ranging from 5.1% to 5.9%. As
of March 31, 2011 and December 31, 2010, the Swaps had fair
values of $4.1 million and $3.2 million, respectively, and are reported in Other Assets.
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited) The Company has designated and accounts for the Swaps as cash flow hedges. The Swaps are considered
to have no ineffectiveness, and, accordingly, changes in their fair values will be recorded in
Accumulated Other Comprehensive Income (“AOCI”), net of taxes. For the three months ended March 31,
2011, $72,407 was reclassified from AOCI to interest expense for the effects of the hedges.
Note 10—Stock Based Compensation
Restricted Stock
During the three months ended March 31, 2011 and 2010, restricted stock shares were granted to
senior officers, key employees and directors as shown in the table below. Restricted stock expense
recognized for the three months ended March 31, 2011 and 2010 was $1.2 million and $1.3 million net
of tax, respectively. The total value of restricted stock vesting was $4.4 million and $2.8 million
for the three months ended March 31, 2011 and 2010, respectively. The value of the unvested
restricted stock outstanding as of March 31, 2011 and 2010 was $24.4 million and $15.1 million,
respectively.
The following table provides an analysis of restricted stock activity for the three months ended
March 31, 2011 and 2010:
Stock Options
The following table provides an analysis of stock option activity for the three months ended March
31, 2011 and 2010:
Compensation expense (net of tax) related to stock options was $0.1 million for the three
months ended March 31, 2010. There was no expense for the three months ended March 31, 2011. The
intrinsic value of stock options outstanding as of March 31, 2011 was $3.8 million, of which $3.5
million was related to vested options.
The total remaining compensation cost related to non-vested stock options and restricted stock
awards not yet recognized in the income statement was $21.4 million of which $0.1 million was for
stock options and $21.3 million was for restricted stock as of March 31, 2011. The weighted average
period over which this compensation cost is expected to be recognized is 4.1 years.
Note 11—Earnings per Share
In accordance with the two-class method, undistributed net earnings (net income less dividends
declared during the period) are allocated to both common stock and unvested share-based payment
awards (“unvested restricted stock”). Because the common shareholders and share-based payment award
holders share in dividends on a 1:1 basis, the earnings per share on
undistributed earnings is equivalent. Undistributed earnings are allocated to all outstanding share-based payment
awards, including those for which the requisite service period is not expected to be rendered.
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited) The following table shows the computation of the earnings per share pursuant to the two-class
method:
The computation of diluted earnings per share excludes outstanding options and other common
stock equivalents in periods where inclusion of such potential common stock instruments would be
anti-dilutive. For the three months ended March 31, 2011, 193,000 options and other common
stock equivalents to purchase Tower shares were excluded from the computation of diluted earnings
per share because the exercise price of the options was greater than the average market price while
for the three months ended March 31, 2010, 392,500 options and other common stock equivalents were
excluded.
Note 12—Segment Information
The accounting policies of the segments are the same as those described in the summary of
significant accounting policies in the Annual Report on Form 10-K for the year ended December 31,
2010.
The Personal Insurance segment includes revenues and expenses associated with the Reciprocal
Exchanges, including fees paid to Tower for underwriting, claims, investment management and other
services provided pursuant to management services agreements with the Reciprocal Exchanges. The
Insurance Services segment reports revenues earned by Tower from the Reciprocal Exchanges as
management fee income, which is calculated as a percentage of the Reciprocal Exchanges’ gross
written premiums. The effects of these management services agreements between Tower and the
Reciprocal Exchanges are eliminated in consolidation to derive consolidated net income. However,
the management fee income is reported in net income attributable to Tower Group, Inc. and included
in basic and diluted earnings per share.
Segment performance is evaluated based on segment profit, which excludes investment income,
realized gains and losses, interest expense, income taxes and incidental corporate expenses. Assets
are not allocated to segments because assets, which consist primarily of investments and fixed
assets, other than intangibles and goodwill, are considered in total by management for
decision-making purposes.
Business segments results are as follows:
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited)
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited) The following table reconciles revenue by segment to consolidated revenues:
The following table reconciles the results of the Company’s individual segments to
consolidated income before income taxes:
Note 13—Contingencies
Legal Proceedings
On May 28, 2009, Munich Reinsurance America, Inc. (“Munich”) commenced an action against Tower
Insurance Company of New York (“TICNY”), a wholly-owned subsidiary of Tower Group, Inc., in the
United States District Court for the District of New Jersey seeking, among other things, to recover
$6.1 million under various retrocessional contracts pursuant to which TICNY reinsures Munich. On
June 22, 2009, TICNY filed its answer, in which it, inter alia, asserted two separate counterclaims
seeking to recover $2.8 million under various reinsurance contracts pursuant to which Munich
reinsures TICNY. A separate action commenced by Munich against TICNY on June 17, 2009 in the United
States District Court for the District of New Jersey seeking a declaratory judgment that Munich is
entitled to access TICNY’s books and records pertaining to various quota share agreements, to which
TICNY filed its answer on July 7, 2009, was subsequently dismissed pursuant to the stipulation of
the parties on March 17, 2010. The parties are currently engaged in discovery and the Company is
therefore unable to assess the likelihood of any particular outcome.
On May 12, 2010, Mirabilis Ventures, Inc. (“Mirabilis”) commenced an action against Specialty
Underwriters’ Alliance Insurance Co. (“SUA”, now known as CastlePoint National Insurance Company
(“CNIC”), a subsidiary of Tower Group, Inc.) and Universal Reinsurance Co., Ltd., an unrelated
entity, in the United States District Court for the Middle District of Florida. The Complaint is
based upon a Workers’ Compensation/Employer’s Liability policy issued by SUA to AEM, Inc. (“AEM”),
to whose legal rights Mirabilis is alleged to have succeeded as a result of the Chapter 11
bankruptcy of AEM. The Complaint, which includes claims against SUA for breach of contract and
breach of the duty of good faith, alleges that SUA failed to properly audit AEM’s operations to
determine AEM’s Workers’ Compensation exposure for two policy years, in order to compute the
premium owed by AEM, such that SUA owes Mirabilis the principal sum of $3.4 million for one policy
year and $0.6 million for the other policy year, plus interest and costs. On July 30, 2010, CNIC
answered the complaint and asserted nine separate counterclaims, to which Mirabilis responded on
September 3, 2010. Since that time, Mirabilis has filed an amended
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Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited) complaint that failed to add any new claims against CNIC, and CNIC has filed amended counterclaims
and affirmative defenses against Mirabilis. The litigation is only in its preliminary stage, and
the Company is therefore unable to assess the likelihood of any particular outcome.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Note on Forward-Looking Statements
The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking
statements. Some of the statements under “Management’s Discussion and Analysis of Financial
Condition and Results of Operations,” and elsewhere in this Form 10-Q may include forward-looking
statements that reflect our current views with respect to future events and financial performance.
Forward-looking statements can generally be identified by the use of forward-looking terminology
such as “may,” “will,” “plan,” “expect,” “project,” “intend,” “estimate,” “anticipate,” “believe”
and “continue” or their negative or variations and similar terminology. These statements include
forward-looking statements both with respect to us specifically and to the insurance sector in
general.
All forward-looking statements address matters that involve risks and uncertainties. Accordingly,
there are or will be important factors that could cause our actual results to differ materially
from those indicated in these statements. We believe that these factors include, but are not
limited to, the following:
The foregoing review of important factors should not be construed as exhaustive and should be read
in conjunction with the other cautionary statements that are included in this Form 10-Q. We
undertake no obligation to publicly update or review any forward-looking statement, whether as a
result of new information, future developments or otherwise.
Operating Income
Operating income excludes realized gains and losses and acquisition-related transaction costs and
the results of the reciprocal business, net of tax. This is a common measurement for property and
casualty insurance companies. We believe this presentation enhances the understanding of our
results of operations by highlighting the underlying profitability of our insurance business.
Additionally, these measures are a key internal management performance standard.
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The following table provides a reconciliation of operating income to net income on a GAAP basis.
Operating income is used to calculate operating earnings per share and operating return on average
equity:
Critical Accounting Estimates
As of March 31, 2011, except as discussed below, there were no material changes to our critical
accounting estimates; refer to the Company’s 2010 Annual Report on Form 10-K for a complete
discussion of critical accounting estimates.
In October 2010, the FASB issued new guidance concerning the accounting for costs associated with
acquiring or renewing insurance contracts. This guidance generally follows the model of that for
loan origination costs. Under the new guidance, only direct incremental costs associated with
successful insurance contract acquisitions or renewals are deferrable. The Company adopted this
guidance retrospectively effective January 1, 2011 and has adjusted its previously issued financial
information
Critical Accounting Policies
See Note 2—“Accounting Policies and Basis of Presentation” for information related to updated
accounting policies.
Consolidated Results of Operations
Our reported results for the period ended March 31, 2011 reflect the impact of acquisitions that we
made during 2010. On July 1, 2010, we closed on the acquisition of OBPL. In the fourth quarter of
2010, we closed on the acquisition of AequiCap. Our consolidated revenues and expenses for the
three months ended March 31, 2011 and 2010 reflect the results of these acquired companies from
their respective acquisition dates. This affects the comparability of our results between years.
The Company operates three business segments: Commercial Insurance, Personal Insurance and
Insurance Services:
Because we do not manage our invested assets by segments, our investment income is not allocated
among our segments. Operating expenses incurred by each segment are recorded in such segment
directly. General corporate overhead not incurred by an individual segment is allocated based upon
the methodology deemed to be most appropriate which may include employee head count, policy count
and premiums earned in each segment.
Our results of operations are discussed below in two parts. The first part discusses the
consolidated results of operations. The second part discusses the results of each of our three
segments. The comparison between quarters is affected by the acquisitions described above.
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Consolidated Results of Operations
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Consolidated Results of Operations for the Three Months Ended March 31, 2011 and 2010
Total revenues. Total revenues increased by 41.9% for the three months ended March 31, 2011 as
compared to the same period in 2010, primarily due to increased net premiums earned and net
investment income resulting from the acquisition of OBPL. In the first quarter of 2011, OBPL
accounted for $99.1 million of total revenues. Tower also acquired certain renewal rights which
increased written premiums in the first quarter of 2011 by $19.0 million. Net realized investment
gains increased $6.7 million in the first quarter of 2011 compared to the same period in 2010.
Premiums earned. Gross premiums earned in the three months ended March 31, 2011 increased 31.6%
compared to the same period in 2010, primarily as a result of the acquisition of OBPL. In addition
first quarter 2011 premiums increased resulting from renewal rights transactions entered into in
November 2010 and January 2011 for commercial automobile and physical damage business and workers’
compensation policies. Ceded premiums earned in the three months ended March 31, 2011 decreased by
$10.0 million, or 18.7%, from the same period in 2010 as Tower elected to cancel its liability
quota share reinsurance treaty. This decrease was somewhat offset by the Company’s reinsurance of
its OBPL homeowners business.
Overall, net premiums earned in the three months ended March 31, 2011 increased by $111.7 million
as compared to the same period in 2010.
Commission and fee income. Commission and fee income decreased by $2.0 million, or 19.7%, in the
three month period ended March 31, 2011 as compared to the same period in 2010, and this decline is
attributed to the changes in our reinsurance program described above.
Net investment income and net realized gains (losses). Net investment income increased 39.7% in the
three months ended March 31, 2011 as compared to the same period in 2010. The increase in net
investment income resulted from an increase in average cash and invested assets for the three
months ended March 31, 2011 as compared to the same period of 2010. The increase in cash and
invested assets resulted primarily from $365.1 million of invested assets acquired from the OBPL
acquisition (reduced by cash used to finance such acquisition) and due to operating cash flows of
$170.0 million generated during 2010 and $5.8 million generated during the first three months of
2011. The positive cash flow from operations was the result of an increase in premiums collected
from a growing book of business. The tax equivalent investment yield at amortized cost was 4.8% at
March 31, 2011 compared to 5.7% at March 31, 2010. Operating cash invested in 2011 and in 2010 has
been affected by a low-yield environment, as asset classes other than U.S. Treasuries have
experienced tightening spreads, the result of investors reaching for yield in a low interest rate
environment. We have increased our investment in high-yield securities and dividend paying equity
securities to reduce the impact of this low rate environment.
Net realized investment gains were $7.4 million for the three months ended March 31, 2011 compared
to gains of $0.7 million in the same period last year. Credit related OTTI losses in the three
months ended March 31, 2011 of $0.1 million were lower than the $2.9 million which were recorded
for the comparable period of 2010.
Loss
and loss adjustment expenses and loss ratio. The consolidated net loss ratio, which includes the Reciprocal
Exchanges, was 63.2% in the three months ended March 31, 2011 and 2010. Excluding the Reciprocal
Exchanges, the net loss and loss expense ratio was 64.7% for the
three months ended March 31, 2011. The Reciprocal Exchange’s net loss ratio
was 52.4% for the three months ended March 31, 2011.
Excluding the Reciprocal Exchanges, the net loss ratio included approximately $15 million from
claims related to winter storms while in the three months ended March 31, 2010, the net loss ratio included
approximately $17.5 million of winter related catastrophe losses. Excluding the
effects of the winter storms in 2011 and the catastrophe losses in 2010, the net loss ratios for
the three month periods ended March 31, 2011 and 2010 would have been approximately 59.3% and
56.7%, respectively. Excluding the Reciprocal Exchanges, prior year unfavorable
development on property losses was comprised of $4.3 million
from the Commercial Insurance segment and $3.6 million from
the Personal Insurance segment, primarily related to winter storms. Prior year development in liability lines was flat for the
quarter as $4.4 million of unfavorable development in the Commercial Insurance segment was offset by $4.3 million of
favorable development in the Personal Insurance segment.
The Reciprocal Exchanges had favorable prior year development of $6.2 million including both
homeowners’ and private passenger automobile lines of business.
Operating expenses. Operating expenses were $66.3 million for the three months ended March 31,
2011, an increase of 30.1% from the same period in 2010, primarily as a result of the OBPL
acquisition. In addition, the Company continued to amortize the
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value of business acquired (“VOBA”) asset recorded in the OBPL purchase accounting and has incurred
costs under the transaction services agreements with OneBeacon.
The commission portion of the gross underwriting expense ratio, which is expressed as a percentage
of gross premiums earned, was 18.0% for both the three months ended March 31, 2011 and March 31,
2010. The other underwriting expenses component of the underwriting expense ratio declined to
14.9% in the first quarter 2011 from 15.3% for the three months ended March 31, 2010. This
decrease was the result of lower New York State workers’ compensation assessments declining by $2.6
million in the first quarter of 2011 as compared to the same period in 2010.
The decline in the net underwriting expense ratio from 36.2% for the three months ended March 31,
2010 to 34.5% for the three months ended March 31, 2011 is due to the decline in New York State
workers’ compensation assessments in the first quarter of 2011, as well as the Company’s reduction
in ceded premiums in the first quarter of 2011. The Company cancelled its liability quota share
agreement in 2011.
Acquisition-related transaction costs. Acquisition-related transaction costs for the three months
ended March 31, 2011 were negligible. In the comparable period of the prior year, acquisition
related transaction costs were $0.9 million.
Interest expense. Interest expense increased by $3.2 million for the three months ended March 31,
2011 compared to the same period in 2010. Interest expense increased mainly due to the issuance of
the senior convertible notes in October 2010. In addition, the Company had borrowings outstanding
of $17.0 million as of March 31, 2011 under its credit facility which resulted in incremental
interest expense.
Income tax expense. Income tax expense for the three months ended March 31, 2011 increased compared
to the same period in 2010. The effective income tax rate (including state and local taxes) was
32.5% for the three months ended March 31, 2011, compared to 30.9% for the same period in 2010. The
2011 effective tax rate represents management’s best estimate and considers, among other things,
the tax exempt municipal investments and dividends received deductions to be incurred on our equity
securities portfolio. The increase of 1.6% is due to the Company’s permanent tax
differences as a percentage of income decreasing in the first quarter 2011 as compared to the same
period in the prior year.
Net income and return on average equity. Net income attributable to Tower Group, Inc. and
annualized return on average equity were $25.7 million and 9.9% for the three months ended March
31, 2011 compared to $13.1 million and 5.7% for the same period in 2010. The increase in the net
income and annualized return on equity in 2011 is primarily due to the net realized investment
gains and the earnings from the OBPL business described above.
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Commercial Insurance Segment Results of Operations
Commercial Insurance Segment Results of Operations for the Three Months Ended March 31, 2011
and 2010
Gross premiums. Commercial Insurance gross premiums written increased by $15.5 million for the
three months ended March 31, 2011 compared to the same period in 2010. The increase resulted from
renewal rights transactions of which $6.9 million of new business
written and $12.1 million of the portfolio transfer accounted for $19.0 million of the new premiums written. Gross
earned premiums declined slightly as only a small amount of the premium from the renewal rights
transaction was earned.
Renewal retention rate excluding programs was 74.8% for the three months ended March 31, 2011.
Premiums on renewed commercial business, other than programs, increased 1.0% for first quarter
2011. Excluding programs, policies in-force for our commercial business increased by 1.4% as of
March 31, 2010.
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Ceded premiums. Ceded premiums written and earned for the three months ended March 31, 2011 were
$11.9 million and $24.8 million, respectively compared to $28.1 million and $45.2 million,
respectively, for the three months ended March 31, 2010. The decrease in ceded premiums written for
the three ended March 31, 2011 compared to 2010 resulted from our decision to cancel our liability
quota share reinsurance treaty which was in effect in 2010. In addition, we reduced the ceded
premiums for our excess of loss reinsurance by raising our retention from $1.0 million to $5.0
million on all lines of business except workers compensation on which our retention was raised to
$2.5 million from $1.0 million. Catastrophe reinsurance ceded premiums were $2.4 million and $3.1
for the three months ended March 31, 2011 and 2010, respectively.
Net premiums. The change in net premiums written and earned results from the changes in gross and
ceded premiums discussed above.
Ceding commission revenue. Ceding commission revenue decreased for the three months ended March 31,
2011 by $5.1 million compared to the same period in 2010. The decrease was a result of the
cancellation of our liability quota share contract. In the fourth quarter of 2010 we lowered our
ceding percentage and cancelled the contract in 2011. Ceding commission revenue was not impacted in
the quarter ended March 31, 2011 as a result of change in loss ratios on prior year’s quota share
treaties compared to a decrease of $0.4 million for the same period in 2010.
Loss and loss adjustment expenses and loss ratio. The net loss ratio was 65.3% and 58.2% for the
three month periods ended March 31, 2011 and 2010, respectively.
The net loss ratio for the three months ended March 31, 2011 included $8.7 million attributable to prior years.
Commercial property lines, including fire, commercial packages and automobile physical damage,
experienced losses related to prior years of $4.3
million of which approximately $2.5 million related to winter storms.
Liability lines developed unfavorably in the first quarter of 2011 by approximately $4.4 million,
stemming primarily from program business unfavorable development of $6.2 million, offset in part by
favorable development of $1.2 million in our CastlePoint Re assumed business, and $0.6 million
amortization of the reserves risk premium.
Underwriting expenses and underwriting expense ratio. Underwriting expenses include direct
commissions and other underwriting expenses. The gross underwriting expense ratio was 31.3% for the
three months ended March 31, 2011 as compared to 32.4% for 2010. The net expense ratio was 32.7%
for the three months ended March 31, 2011 as compared to 34.9% for the same period in 2010.
The commission portion of the gross underwriting expense ratio, which is expressed as a percentage
of gross premiums earned, was 18.3% for the three months ended March 31, 2011 compared to 17.9% for
the same period in 2010. This increase is attributable to profit commission expense incurred in the
first quarter 2011. The other underwriting expense (“OUE”) ratio, including boards, bureaus and
taxes (“BB&T”), was 13.0% for the three months ended March 31, 2011 compared to 14.5% for the same
period in 2010. The OUE decreased in part because our New York State workers’ compensation
assessment declined by $2.6 million from the three months ended March 31, 2010 compared to the
three months ended March 31, 2011.
Underwriting profit and combined ratio. The net combined ratios were 98.0% for the three months
ended March 31, 2011 and 93.0% for the same period in 2010. The increase in the combined ratio in
2011 resulted from an increase in the net loss ratio partially offset by a decrease in the net
expense ratios as described above.
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Personal Insurance Segment Results of Operations
Personal Insurance Segment Results of Operations for the Three Months Ended March 31, 2011 and
2010
Gross premiums. Gross earned premium increased $104.1 million during the three months ended March
31, 2011 as compared to the same period in 2010, primarily due to the acquisition of OBPL which
added $95.2 million of gross earned premiums. Excluding the effect of the OBPL business, Tower’s
gross earned premiums increased by $8.9 million, or 20.6%, from the same period in 2010 due to
organic growth in homeowners business. Tower’s personal lines renewal retention was 83.8% for the
three months ended March 31, 2011, compared to 90.0% in the same period in 2010. Excluding the OBPL
business, policies-in-force for our personal business increased by 4.8% from March 31, 2010 to
March 31, 2011.
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Ceded premiums. Ceded premiums written
and earned were $17.7 million and $19.3 million,
respectively, for the three months ended March 31, 2011. This represents increases compared to same
period in the prior year of $9.8 million and $10.8 million, respectively, and is primarily
attributed to the acquisition of OBPL business. The Company reinsures the homeowners business
obtained from OBPL through a quota share program which resulted in $7.4 million of ceded earned
premiums for the first quarter of 2011.
Catastrophe ceded premiums written were $8.3 million for the first quarter in 2011 compared to $5.6
million for the first quarter in 2010. The increase in catastrophe ceded premiums includes $2.7
million for business acquired from OBPL acquisition and $1.2 million for the existing Tower
business.
Net premiums. Net premiums written for the three months ended March 31, 2010 were $108.8 million,
an increase of $81.0 million compared to the same period in the prior year. The acquisition of OBPL
accounted for $76.5 million of this growth. The remainder of this change results from the increases
in gross written premiums discussed above.
Ceding commission revenue. Ceding commission revenue for the three months ended March 31, 2011 was
$4.2 million, compared to $1.0 million in the first quarter of 2010. This increase was primarily
attributable to the commission revenue earned on the previously mentioned homeowners quota share
treaty.
Loss
and loss adjustment expenses and loss ratio. The net loss and LAE ratio for the first quarter of 2011 was
62.8% excluding the Reciprocal Exchanges, and 97.0% for the same period in the prior year. The net
loss ratio for the Reciprocal Exchanges was 52.4% for the first quarter 2011.
Excluding the Reciprocal Exchanges, there was $0.7 million in
favorable development attributable to prior years comprised of $3.6
million of unfavorable development in property lines offset by $4.3
million of favorable development in liability lines. In the Reciprocal Exchanges, there
was $6.2 million in favorable development attributable to prior years.
In the
first quarter of 2011, we incurred a large number of winter related claims totaling
approximately $12.5 million that primarily impacted our homeowners’ and automobile physical damage
lines. This included claims arising from the Northeast storm on
December 26, 2010 that were reported and developed during the first quarter of 2011. In the first quarter of 2010 we incurred a large number of
homeowners’ claims relating to Cat 96 that amounted to
approximately $12.5 million
The net loss and loss expense ratio for private passenger automobile in the first quarter of 2011
was 47.0% including $4.5 million of favorable prior year
development and the net accident year loss
and LAE ratio was 67.7%. This compares to the net loss and LAE ratio
for private passenger automobile for the three months ended March 31, 2010 of 122.2%. However
premiums in our private passenger automobile line were relatively small, $0.8 million, in the first
quarter of 2010 which was prior to our acquisition of OBPL.
Underwriting expenses and underwriting expense ratio. Underwriting expenses increased by $37.4
million to $54.4 million in the three months ended March 31, 2011 as compared to the same period in
2010. The increase in underwriting expenses is due to the increase in gross premiums earned, which
was primarily due to the OBPL acquisition. The gross underwriting expense ratio for the three
months ended March 31, 2011 was 35.9% as compared to 39.0% for the same period last year.
The commission portion of the gross underwriting expense ratio was 17.6% in 2011 compared to 18.3%
in 2010. This decrease reflects the impact of lower commission rates in the Reciprocal Exchanges.
The gross OUE ratio, which included BB&T, was 18.3% for the three months ended March 31, 2011
compared with 20.7% in the same period in 2010. The decrease in the OUE ratio resulted, in part,
from higher amortization of the value of business acquired (“VOBA”) asset and DAC as compared to
direct underwriting costs capitalized by the Company in 2010. In addition, increases in premiums
exceeded the increase in OUE in the first quarter of 2011 as compared to the same period in the
prior year which had the effect of lowering the OUE ratios.
The net underwriting expense ratio was 38.0% for the three months ended March 31, 2011 as compared
to 45.7% for the comparable 2010 period. This change results from the changes in commission expense
described above as well as the effects of the ceded commission earned on the homeowners quota share
treaty.
Underwriting profit and combined ratio. The underwriting gain for the three months ended March 31,
2011 as compared to the loss in the prior year primarily resulted from improvements in both the
loss ratios and underwriting expense ratio, as discussed above.
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Insurance Services Segment Results of Operations
Insurance Services Segment Results of Operations for the Three Months Ended March 31, 2011 and
2010
Total revenue. The increase in total revenue for the three months ended March 31, 2011 compared to
the same period in the prior year was primarily due to the management fee income earned by Tower
for underwriting, claims, investment management and other services provided to the Reciprocal
Exchanges pursuant to management services agreements with the Reciprocal Exchanges. The management
fee income is calculated as a percentage of the Reciprocal Exchanges’ gross written premiums. The
effects of these management services agreements between Tower and the Reciprocal Exchanges are
eliminated in consolidation to derive consolidated net income.
Total expenses. The increase in total expenses for the three months ended March 31, 2011 compared
to the same period in the prior year was primarily due to the costs incurred under the management
services agreement between Tower and the Reciprocal Exchanges.
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Investments
Portfolio Summary
The following table presents a breakdown of the amortized cost, aggregate fair value and unrealized
gains and losses by investment type as of March 31, 2011 and December 31, 2010:
Credit Rating of Fixed-Maturity Securities
The average credit rating of our fixed-maturity securities, using ratings assigned to securities by
Standard & Poor’s, was AA- at March 31, 2011 and December 31, 2010. The following table shows the
ratings distribution of our fixed-maturity portfolio:
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Fixed-Maturity Investments with Third Party Guarantees
At March 31, 2011, $192.4 million of our municipal bonds, at fair value, were guaranteed by third
parties from a total of $2.4 billion, at fair value, of all fixed-maturity securities held by us.
The amount of securities guaranteed by third parties along with the credit rating with and without
the guarantee is as follows:
The securities guaranteed, by guarantor, are as follows:
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Fair Value Consideration
Under GAAP, fair value is defined as the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants (an “exit price”). GAAP
establishes a fair value hierarchy that distinguishes between inputs based on market data from
independent sources (“observable inputs”) and a reporting entity’s internal assumptions based upon
the best information available when external market data is limited or unavailable (“unobservable
inputs”). The fair value hierarchy in GAAP prioritizes fair value measurements into three levels
based on the nature of the inputs. Quoted prices in active markets for identical assets have the
highest priority (“Level 1”), followed by observable inputs other than quoted prices including
prices for similar but not identical assets or liabilities (“Level 2”), and unobservable inputs,
including the reporting entity’s estimates of the assumption that market participants would use,
having the lowest priority (“Level 3”).
As of March 31, 2011, substantially all of the investment portfolio recorded at fair value was
priced based upon quoted market prices or other observable inputs. For investments in active
markets, we used the quoted market prices provided by the outside pricing services to determine
fair value. In circumstances where quoted market prices were unavailable, we used fair value
estimates based upon other observable inputs including matrix pricing, benchmark interest rates,
market comparables and other relevant inputs. When observable inputs were adjusted to reflect
management’s best estimate of fair value, such fair value measurements are considered a lower level
measurement in the GAAP fair value hierarchy.
Our process to validate the market prices obtained from the outside pricing sources includes, but
is not limited to, periodic evaluation of model pricing methodologies and analytical reviews of
certain prices. We also periodically perform testing of the market to determine trading activity,
or lack of trading activity, as well as market prices. Several securities sold during the quarter
were “back-tested” (i.e., the sales price is compared to the previous month end reported market
price to determine reasonableness of the reported market price).
In certain instances, we deemed it necessary to utilize Level 3 pricing over prices available
through pricing services used throughout 2011 and 2010. In the periods of market dislocation, the
ability to observe stable prices and inputs may be reduced for some instruments as currently is the
case for certain non-agency residential, commercial mortgage-backed securities and asset-backed
securities.
As more fully described in Note 5 to our Consolidated Financial Statements, “Investments,” we
completed a detailed review of all our securities in a continuous loss position, including but not
limited to residential and commercial mortgage-backed securities, and concluded that the unrealized
losses in these asset classes are the result of a decrease in value due to technical spread
widening and broader market sentiment, rather than fundamental collateral deterioration, and are
temporary in nature.
Unrealized Losses
Changes in interest rates and credit spreads directly impact the fair value of our fixed maturity
portfolio. We regularly review both our fixed-maturity and equity portfolios to evaluate the
necessity of recording impairment losses for other-than temporary declines in the fair value of
investments.
The following table presents information regarding our invested assets that were in an unrealized
loss position at March 31, 2011 and December 31, 2010 by amount of time in a continuous unrealized
loss position:
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At March 31, 2011, the unrealized losses for fixed-maturity securities were primarily in our
municipal bond and corporate bond portfolios.
The following table shows the number of securities, fair value, unrealized loss amount and
percentage below amortized cost and the ratio of fair value by security rating as of March 31,
2011:
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NR indicates that equity securities are not rated
See Note 5—“Investments” in our unaudited financial statements for further information about
impairment testing and other-than-temporary impairments.
Liquidity and Capital Resources
Tower is organized as a holding company (the “Holding Company”) with multiple intermediate holding
companies, 13 Insurance Subsidiaries and several management companies. The Holding Company’s
principal liquidity needs include interest on debt, stockholder dividends and share repurchases
under its share repurchase program. The Holding Company’s principal sources of liquidity include
dividends and other permitted payments from our subsidiaries, as well as financing through
borrowings and sales of securities.
As of December 31, 2010, the amount of distributions that our Insurance Subsidiaries could pay to
Tower without approval of their domiciliary Insurance Departments was $30.8 million. In addition,
we can return capital of $46.5 million from CastlePoint Re without permission from the Bermuda
Monetary Authority. No dividends or return of capital were paid from the Insurance Subsidiaries or
CastlePoint Re to the Holding Company during the three month period ended March 31, 2011. The
management companies paid dividends of $10.2 million to the Holding Company during the three months
ended March 31, 2011.
We believe that the cash flow generated by the operating activities of our subsidiaries, combined
with other available capital sources, will provide sufficient funds for us to meet our liquidity
needs over the next twelve months. Beyond the next twelve months, cash flow available to us may be
influenced by a variety of factors, including general economic conditions and conditions in the
insurance and reinsurance markets, as well as fluctuations from year-to-year in claims experience.
We have the intent and ability to hold any temporarily impaired fixed maturity securities until the
anticipated date that these temporary impairments are recovered.
Capital
Our capital resources consist of funds deployed or available to be deployed to support our business
operations. At March 31, 2011 and December 31, 2010, our capital resources were as follows:
We monitor our capital adequacy to support our business on a regular basis. The future capital
requirements of our business will depend on many factors, including our ability to write new
business successfully and to establish premium rates and reserves at levels sufficient to cover
losses. Our ability to underwrite is largely dependent upon the quality of our claims paying and
financial strength ratings as evaluated by independent rating agencies. In particular, we require
(1) sufficient capital to maintain our
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financial strength ratings, at a level considered necessary by management to enable our Insurance
Subsidiaries to compete, and (2) sufficient capital to enable our Insurance Subsidiaries to meet
the capital adequacy tests performed by statutory agencies in the United States and Bermuda.
In May 2010, the Company entered into a $125.0 million credit facility agreement. The credit
facility is a revolving credit facility with a letter of credit sublimit of $25.0 million. The
credit facility will be used for general corporate purposes. The Company may request that the
facility be increased by an amount not to exceed $50.0 million, and the facility expires May 2013.
The Company had $17.0 million outstanding under the credit facility as of March 31, 2011.
In September 2010, the Company issued $150 million principal amount of 5.0% convertible senior
notes (the “Notes”) due September 2015. Interest will be paid semi-annually commencing March 2011.
Holders may convert their Notes into cash or common shares, at the Company’s option, at any time on
or after March 14, 2014 or earlier under certain circumstances determined by: (i) the market price
of the Company’s stock, (ii) the trading price of the Notes, or (iii) the occurrence of specified
corporate transactions. Upon conversion, the Company intends to settle its obligation either
entirely or partially in cash. The initial conversion rate is 36.3782 shares of common stock per
$1,000 principal amount of the Notes (equivalent to an initial conversion price of $27.49 per
share), subject to adjustment upon the occurrence of certain events. Additionally, in the event of
a fundamental change, the holders may require the Company to repurchase the Notes for a cash price
equal to 100% of the principal plus any accrued and unpaid interest.
In October 2010, the Company effected interest rate swap contracts on $190 million notional amount
of the subordinated debentures. As described in the table above, certain of these subordinated
debentures are currently paying a variable interest rate and other subordinated debentures will
convert to variable rates over the next two years. The interest rate swaps will fix the variable
interest payments on the subordinated debentures to rates from 5.1% to 5.9%. The interest rate
swaps mature in 2015.
The Board of Directors of Tower approved a $100 million share repurchase program on March 3, 2011.
This authorization is in addition to the $100 million share repurchase program approved on February
26, 2010. Purchases under both programs can be made from time to time in the open market or in
privately negotiated transactions in accordance with applicable laws and regulations. The new share
repurchase program will expire on March 4, 2013. In the three months ended March 31, 2011, 0.7
million shares of common stock were purchased under these programs at an aggregate consideration of
$17.6 million. As of March 31, 2011, the original $100 million share repurchase program had been
fully utilized and $94.4 million remained available for future share repurchases under the new
program.
We may seek to raise additional capital or may seek to return additional capital to our
stockholders through share repurchases, cash dividends or other methods (or a combination of such
methods). Any such determination will be at the discretion of our Board of Directors and will be
dependent upon our profits, financial requirements and other factors, including legal restrictions,
rating agency requirements, credit facility limitations and such other factors as our board of
directors deems relevant.
Cash Flows
The primary sources of consolidated cash flows are from the Insurance Subsidiaries’ gross premiums
collected, ceding commissions from quota share reinsurers, loss payments by reinsurers, investment
income and proceeds from the sale or maturity of investments. Funds are used by the Insurance
Subsidiaries for loss payments and loss adjustment expenses. The Insurance Subsidiaries also use
funds for ceded premium payments to reinsurers, which are paid on a net basis after subtracting
losses paid on reinsured claims and reinsurance commissions on our net business, commissions to
producers, salaries and other underwriting expenses as well as to purchase investments, fixed
assets and to pay dividends to the Holding Company. The management companies’ primary sources of
cash are management fees for the attorneys-in-fact from the Reciprocal Exchanges and TRM’s
commissions and fees collected.
The reconciliation of net income to cash provided from operations is generally influenced by the
collection of premiums in advance of paid losses, the timing of reinsurance, issuing company
settlements and loss payments.
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Cash flow and liquidity are categorized into three sources: (1) operating activities; (2) investing
activities; and (3) financing activities, which are shown in the following table:
Comparison of Three Months Ended March 31, 2011 and 2010
For the three months ended March 31, 2011, net cash provided by operating activities was $5.8
million as compared to $36.8 million for the same period in 2010. The decrease in cash flow for the
three months ended March 31, 2011 primarily resulted from increased claims payments attributed to
the Northeast winter storms beginning on December 26, 2010. The catastrophe losses recorded in the
first quarter of 2010 were paid predominantly in the second quarter of 2010.
Net cash flows used in investing activities were $30.6 million for the three months ended March 31,
2011 compared to $33.3 million used for the three months ended March 31, 2010. The cash flows in
both years primarily related to purchases and sales of fixed-maturity securities and equity
securities. The purchases and sales of fixed-maturity securities in the first quarter of 2011 for
$630.4 million and $611.1 million, respectively, are attributable to the Company replacing its U.S.
Treasury securities with higher yielding Agency-backed RMBS, rebalancing of the corporate and other
bond portfolio and general maturities and repurchases within the portfolio.
The net cash flows used in financing activities for the three months ended March 31, 2011 are
primarily the result of borrowings of $17.0 million from our credit facility reduced by the
repurchase of common stock for $17.6 million and dividends of $5.1 million.
Cash flow needs at the holding company level are primarily for dividends to our stockholders and
interest payments on our outstanding debt.
Insurance Subsidiaries
The Insurance Subsidiaries maintain sufficient liquidity to pay claims, operating expenses and meet
other obligations. The Company held $71.0 million and $102.9 million of cash and cash equivalents
at March 31, 2011 and December 31, 2010, respectively. We monitor the expected claims payment needs
and maintain a sufficient portion of our invested assets in cash and cash equivalents to enable us
to fund the claims payments without having to sell longer-duration investments. As necessary, we
adjust the holdings of short-term investments and cash and cash equivalents to provide sufficient
liquidity to respond to changes in the anticipated pattern of claims payments. See
“Business—Investments.”
The Insurance Subsidiaries are required by law to maintain a certain minimum level of
policyholders’ surplus on a statutory basis. Policyholders’ surplus is calculated by subtracting
total liabilities from total assets. The NAIC maintains risk-based capital (“RBC”) requirements for
property and casualty insurance companies. RBC is a formula that attempts to evaluate the adequacy
of statutory capital and surplus in relation to investments and insurance risks. The formula is
designed to allow the state Insurance Departments to identify potential weakly capitalized
companies. Under the formula, a company determines its risk-based capital by taking into account
certain risks related to the insurer’s assets (including risks related to its investment portfolio
and ceded reinsurance) and the insurer’s liabilities (including underwriting risks related to the
nature and experience of its insurance business). Applying the RBC requirements as of December 31,
2010, the Insurance Subsidiaries’ risk-based capital exceeded the minimum level that would trigger
regulatory attention.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk is the risk that we will incur losses in our investments due to adverse changes in
market rates and prices. Market risk is directly influenced by the volatility and liquidity in the
market in which the related underlying assets are invested. We believe that we are principally
exposed to three types of market risk: changes in credit quality of issuers of investment
securities, changes in equity prices, and changes in interest rates.
Interest Rate Risk
Interest rate risk is the risk that we may incur economic losses due to adverse changes in interest
rates. The primary market risk to the investment portfolio is interest rate risk associated with
investments in fixed-maturity securities, although conditions affecting particular asset classes
(such as conditions in the commercial and housing markets that affect commercial and residential
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mortgage-backed securities) can also be significant sources of market risk. Fluctuations in
interest rates have a direct impact on the market valuation of these securities. The fair value of
our fixed-maturity securities as of March 31, 2011 was $2.4 billion.
For fixed-maturity securities, short-term liquidity needs and potential liquidity needs for our
business are key factors in managing our portfolio. We use modified duration analysis to measure
the sensitivity of the fixed income portfolio to changes in interest rates as discussed more fully
below under sensitivity analysis.
As of March 31, 2011, we had a total of $59.8 million of outstanding floating rate subordinated
debentures underlying our trust preferred securities issued by our wholly owned statutory business
trusts and carrying an interest rate that is determined by reference to market interest rates. An
additional $175.3 million of subordinated debentures will convert from fixed rate to floating rate
in 2011 and 2012. In order to reduce the interest rate risk on the subordinated debentures, the
Company entered into interest rate swap contracts with Keybank National Association that are
designed to convert $190 million of these outstanding borrowings from their respective floating
rates to fixed rates ranging from 5.1% to 5.9%. These swaps mature in 2015.
Sensitivity Analysis
Sensitivity analysis is a measurement of potential loss in future earnings, fair values or cash
flows of market sensitive instruments resulting from one or more selected hypothetical changes in
interest rates and other market rates or prices over a selected time. In our sensitivity analysis
model, we select a hypothetical change in market rates that reflects what we believe are reasonably
possible near-term changes in those rates. The term “near-term” means a period of up to one year from the date of the consolidated financial statements. Actual results may
differ from the hypothetical change in market rates assumed in this disclosure, especially since
this sensitivity analysis does not reflect the results of any action that we may take to mitigate
such hypothetical losses in fair value.
In this sensitivity analysis model, we use fair values to measure our potential loss. The
sensitivity analysis model includes fixed-maturities, preferred stocks and short-term investments.
For invested assets, we use modified duration modeling to calculate changes in fair values.
Durations on invested assets are adjusted for call, put and interest rate reset features. Durations
on tax-exempt securities are adjusted for the fact that the yield on such securities is less
sensitive to changes in interest rates compared to Treasury securities. Invested asset portfolio
durations are calculated on a market value weighted basis, including accrued investment income,
using holdings as of March 31, 2011.
The following table summarizes the estimated change in fair value on our fixed-maturity portfolio
including preferred stocks and short-term investments based on specific changes in interest rates
as of March 31, 2011:
The sensitivity analysis model used by us produces a predicted pre-tax loss in fair value of
market-sensitive instruments of $130.4 million or (5.3%) based on a 100 basis point increase in
interest rates as of March 31, 2011. This loss amount only reflects the impact of an interest rate
increase on the fair value of our fixed-maturity investments.
Interest expense would also be affected by a hypothetical change in interest rates. As of March 31,
2011 we had $59.8 million of floating rate debt obligations, of which $20 million are hedged
through our interest rate swaps. A 100 basis point increase in interest rates would increase annual
interest expense by $0.4 million, pre-tax, a 200 basis point increase would increase interest
expense by $0.8 million, pre-tax, and a 300 basis point increase would increase interest expense by
$1.2 million on the $39.8 million in non-hedged floating rate debt obligations.
With respect to investment income, the most significant assessment of the effects of hypothetical
changes in interest rates on investment income would be an adjustment to amortization for
mortgage-backed securities. The rates at which the mortgages underlying mortgage-backed securities
are prepaid, and therefore the average life of mortgage-backed securities, can vary
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depending on changes in interest rates (for example, mortgages are prepaid faster and the average
life of mortgage-backed securities falls when interest rates decline). The adjustments for changes
in amortization, which are based on revised average life assumptions, would have an impact on
investment income if a significant portion of our mortgage-backed securities holdings had been
purchased at significant discounts or premiums to par value. As of March 31, 2011, the par value of
our residential mortgage-backed securities holdings was $564.1 million and the amortized cost of
our residential mortgage-backed securities holdings was $562.3 million. This equates to an average
price of 99.7% of par. Historically, few of our mortgage-backed securities were purchased at more
than three points (below 97% and above 103%) from par, thus an adjustment in accordance with this
GAAP guidance would not have a significant effect on investment income. However, since many of our
non-investment grade mortgage-backed securities have been impaired as a result of adverse cash
flows, the required adjustment to book yield can have a significant effect on our future investment
income.
Furthermore, significant hypothetical changes in interest rates in either direction can affect
principal redemptions, and therefore investment income, because of the residual mortgage securities
in the portfolio. The residential mortgage-backed securities portion of the fixed-maturity
securities portfolio totaled 23.9% as of March 31, 2011. Of this total, 31.9% was in agency pass
through securities, which have the highest amount of prepayment risk from declining rates. The
remainder of our mortgage-backed securities portfolio is invested in agency planned amortization
class collateralized mortgage obligations, non-agency residential non-accelerating securities, and
commercial mortgage-backed securities.
The planned amortization class collateralized mortgage obligation securities maintain their average
life over a wide range of prepayment assumptions, while the non-agency residential non-accelerating
securities have five years of principal lock-out protection and the commercial mortgage-backed
securities have very onerous prepayment and yield maintenance provisions that greatly reduce the
exposure of these securities to prepayments.
Credit Risk
Our credit risk is the potential loss in market value resulting from adverse change in the
borrower’s ability to repay its obligations. Our investment objectives are to preserve capital,
generate investment income and maintain adequate liquidity for the payment of claims and debt
service. We seek to achieve these goals by investing in a diversified portfolio of securities. We
manage credit risk through regular review and analysis of the creditworthiness of all investments
and potential investments.
We bear credit risk on our reinsurance recoverables and premiums ceded to reinsurers. If any of
these reinsurers fails to pay its obligations to us, or substantially delays making payments on the
reinsurance recoverables, our financial condition and results of operations could be impaired. To
mitigate the credit risk associated with reinsurance recoverables, we secure certain of our
reinsurance recoverables by withholding ceded premium and requiring funds to be placed in trust as
well as monitoring our reinsurers’ financial condition and rating agency ratings and outlook.
We also bear credit risk on the premium deposits paid by our policyholders to our producers.
Producers collect such premiums and remit them to us within prescribed periods. After the initial
premium deposit is made to the producer, the Insurance Subsidiaries subsequently bill premiums
directly to insureds. In New York State and other jurisdictions, premiums paid to producers by an
insured may be considered to have been paid under applicable insurance laws and regulations and the
insured will no longer be liable to us for those amounts, whether or not we have actually received
the premium payment from the producer. Consequently, we assume a degree of credit risk associated
with producers. Due to the unsettled and fact specific nature of the law, we are unable to quantify
our exposure to this risk.
Our interest rate swap contracts contain credit support annex provisions which require Keybank
National Association to post collateral if the swap fair values exceed $5 million (asset position).
As of March 31, 2011, the swaps had a fair value of $4.1 million (asset position) and no collateral
has been posted.
Equity Risk
Equity risk is the risk that we may incur economic losses due to adverse changes in equity prices.
Our equity securities are classified as available for sale in accordance with GAAP and carried on
the balance sheet at fair value. Our outside investment managers are constantly reviewing the
financial health of these issuers. In addition, we perform periodic reviews of these issuers.
Item 4. Controls and Procedures
(a) Disclosure Controls and Procedures
The Company’s principal executive officer and its principal financial officer, based on their
evaluation of the Company’s disclosure controls and procedures (as defined in Exchange Act Rule
13a-15(e)), concluded that the Company’s disclosure
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controls and procedures were effective for the purposes set forth in the definition thereof in
Exchange Act Rule 13a-15(e) as of March 31, 2011.
Because of its inherent limitations, our disclosure controls and procedures and our internal
control over financial reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree or compliance with the policies or
procedures may deteriorate.
(b) Changes in internal control over financial reporting
On July 1, 2010, we completed the acquisition of OBPL. We are in the process of integrating OBPL’s
operations, including internal controls over financial reporting, and extending our Section 404
compliance program to this business.
Part II — OTHER INFORMATION
Item 1. Legal Proceedings
On May 28, 2009, Munich Reinsurance America, Inc. (“Munich”) commenced an action against Tower
Insurance Company of New York (“TICNY”), a wholly-owned subsidiary of Tower Group, Inc., in the
United States District Court for the District of New Jersey seeking, among other things, to recover
$6.1 million under various retrocessional contracts pursuant to which TICNY reinsures Munich. On
June 22, 2009, TICNY filed its answer, in which it, inter alia, asserted two separate counterclaims
seeking to recover $2.8 million under various reinsurance contracts pursuant to which Munich
reinsures TICNY. A separate action commenced by Munich against TICNY on June 17, 2009 in the United
States District Court for the District of New Jersey seeking a declaratory judgment that Munich is
entitled access to TICNY’s books and records pertaining to various quota share agreements, to which
TICNY filed its answer on July 7, 2009, was subsequently dismissed pursuant to the stipulation of
the parties on March 17, 2010. The parties are currently engaged in discovery and the Company is
therefore unable to assess the likelihood of any particular outcome.
On May 12, 2010, Mirabilis Ventures, Inc. (“Mirabilis”) commenced an action against Specialty
Underwriters’ Alliance Insurance Co. (“SUA”, now known as CastlePoint National Insurance Company
(“CNIC”), a subsidiary of Tower Group, Inc.) and Universal Reinsurance Co., Ltd., an unrelated
entity, in the United States District Court for the Middle District of Florida. The Complaint is
based upon a Workers’ Compensation/Employer’s Liability policy issued by SUA to AEM, Inc. (“AEM”),
to whose legal rights Mirabilis is alleged to have succeeded as a result of the Chapter 11
bankruptcy of AEM. The Complaint, which includes claims against SUA for breach of contract and
breach of the duty of good faith, alleges that SUA failed to properly audit AEM’s operations to
determine AEM’s Workers’ Compensation exposure for two policy years, in order to compute the
premium owed by AEM, such that SUA owes Mirabilis the principal sum of $3.4 million for one policy
year and $0.6 million for the other policy year, plus interest and costs. On July 30, 2010, CNIC
answered the complaint and asserted nine separate counterclaims, to which Mirabilis responded on
September 3, 2010. Since that time, Mirabilis has filed an amended complaint that failed to add any
new claims against CNIC, and CNIC has filed amended counterclaims and affirmative defenses against
Mirabilis. The litigation is only in its preliminary stage, and the Company is therefore unable to
assess the likelihood of any particular outcome.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
During the three months ended March 31, 2011, the Company purchased 58,418 shares of its common
stock from employees in connection with the vesting of restricted stock issued in connection with
its 2004 Long Term Equity Compensation Plan (the “Plan”). The shares were withheld at the direction
of the employees as permitted under the Plan in order to pay the minimum amount of tax liability
owed by the employee from the vesting of those shares.
The Board of Directors of Tower approved a $100 million share repurchase program on March 3, 2011.
This authorization is in addition to the $100 million share repurchase program approved on February
26, 2010. Purchases under both programs can be made from time to time in the open market or in
privately negotiated transactions in accordance with applicable laws and regulations. The new share
repurchase program will expire on March 4, 2013. In the three months ended March 31, 2011, 733,167
shares of common stock were purchased under these programs
The following table summarizes the Company’s stock repurchases for the three-month period ended
March 31, 2011, and represents employees’ withholding tax obligations on the vesting of restricted
stock and the share repurchase program:
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Item 6. Exhibits
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Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned thereunto duly authorized.
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