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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(MARK ONE) ANNUAL REPORT PRUSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
[X] EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 000-50990
TOWER GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 13-3894120
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
120 BROADWAY, 14TH FLOOR
NEW YORK, NEW YORK 10271
(Address of principal executive offices) (Zip Code)
(212) 655-2000
(Registrant's telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, $0.0I PAR VALUE PER SHARE
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes [ ] No [X]
As of March 14, 2005, the registrant had 19,737,168 shares of common stock
outstanding. The aggregate market value of the voting and non-voting common
equity held by non-affiliates as of December 31, 2004 was $202,602,672. This
value as of June 30, 2004 was not applicable as the registrant was not publicly
traded as of June 30, 2004.
DOCUMENTS INCORPORATED BY REFERENCE:
Part III of this Form 10-K incorporates by reference certain information
form the registrant's definitive Proxy Statement with respect to the
registrant's 2005 Annual Meeting of Shareholders, to be filed not later than 120
days after the close of the registrant's fiscal year (the "Proxy Statement").
TABLE OF CONTENTS
PAGE
PART I
Item 1. Business 3
Item 2. Properties 47
Item 3. Legal Proceedings 47
Item 4. Submission of Matters to a Vote of Security-Holders 47
PART II
Item 5. Market for The Registrant's Common Equity and Related Stockholder Matters 47
Item 6. Selected Consolidated Financial Data 49
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations 51
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 75
Item 8. Financial Statements and Supplementary Data 79
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure 116
Item 9A. Controls and Procedures 116
Item 9B. Other Information 116
PART III
Item 10. Directors and Executive Officers of the Registrant 117
Item 11. Executive Compensation 117
Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters 117
Item 13. Certain Relationships and Related Transactions 117
Item 14. Principal Accounting Fees and Services 117
PART IV
Item 15. Exhibits, Financial Statement 118
2
PART I
ITEM 1. BUSINESS
OVERVIEW
As used in this Form 10-K, references to the "Company", "we", "us", or
"our" refer to Tower Group, Inc. and its subsidiaries, including its insurance
company, Tower Insurance Company of New York ("TICNY"), and its managing general
agency, Tower Risk Management Corporation ("TRM"), unless the context suggests
otherwise.
Through our subsidiaries Tower Insurance Company of New York and Tower Risk
Management Corporation, we offer a broad range of specialized property and
casualty insurance products and services to small to mid-sized businesses and to
individuals in New York State and the surrounding areas. By targeting select
underserved market segments and expeditiously delivering needed products and
services, we position ourselves to obtain favorable policy terms, conditions and
pricing, thereby creating opportunities for favorable underwriting results.
TICNY provides coverage for many different market segments, including
nonstandard risks that do not fit the underwriting criteria of standard carriers
due to factors such as type of business, location and premium per policy. TRM,
through its managing general agency, produces business on behalf of other
insurance companies, referred to as "issuing companies", and primarily focuses
on commercial risks with higher per policy premium, including risks that TICNY
has not been able to target due to, among other things, licensing and surplus
limitations. TICNY also reinsures a modest amount of the premiums written by
TRM's issuing companies. Our commercial lines products provide insurance
coverage to businesses such as retail and wholesale stores, grocery stores,
restaurants, artisan contractors and residential and commercial buildings, while
our personal lines products currently focus on modestly valued homes and
dwellings.
Through the use of reinsurance in TICNY and other issuing companies that we
access through TRM's managing general agency, we have been able to create and
support a much larger premium base and insurance company infrastructure than
otherwise would have been possible given TICNY's pre-initial public offering
("IPO") surplus base. In addition, TRM earns fee revenues by providing claims
administration and reinsurance intermediary services to its issuing companies
and to other insurance companies.
On October 20, 2004, the Company sold 13,000,000 shares in its IPO at $8.50
per share. On the same date, the Company also effected a concurrent private
placement of 500,000 shares of its common stock to an affiliate of Friedman,
Billings, Ramsey & Co., Inc., the lead underwriter for the Company's IPO, at a
price of $8.50 per share. On November 10, 2004 the underwriters exercised their
30-day over-allotment option after the Company's IPO. Pursuant to this exercise,
the underwriters purchased 629,007 additional shares of common stock from the
Company and 1,320,993 shares of common stock from selling shareholders. The
Company received net cash proceeds of $107,845,000 from the offering and
concurrent private placement after the underwriting discounts, commissions and
offering expenses.
COMPETITIVE STRENGTHS
We believe that our competitive strengths position us to continue to expand
our business profitably. These strengths include:
o PROVEN PRODUCT DEVELOPMENT AND MARKETING EXPERTISE. We have
accomplished profitable growth by developing and expanding our product
line offering over time. Throughout our history, we have successfully
developed and positioned several commercial lines products that provide
property, liability, workers' compensation and auto insurance and
personal lines products such as homeowner's policies in response to
specific insurance needs in targeted market segments.
o OPPORTUNISTIC UNDERWRITING AND CAPITAL ALLOCATION. We target market
segments that we identify as underserved by other insurance companies
and allocate our capital and other resources opportunistically among
various market segments in response to changing market conditions. In
the five years ended December 31, 2004, TICNY's average net combined
ratio was 79.5%, and its average gross combined ratio over the same
period was 91.8%.
3
o COST-EFFECTIVE UNDERWRITING AND PROCESSING CAPABILITY. We believe our
systems and technology have resulted in a cost-effective underwriting
and processing capability that enables us to efficiently underwrite a
large number of small policies in urban areas such as New York City,
providing a competitive advantage over other insurance companies
lacking this capability. Despite the operational challenges of
underwriting and processing these policies, TICNY's gross underwriting
expense ratio was 31.0% in 2004.
o GENERATION OF COMMISSION AND FEE REVENUE. Our use of reinsurance
enables us to generate reinsurance ceding commission income on premiums
that we cede to our reinsurers, while access to issuing companies
through our managing general agency has expanded our capacity to
underwrite and produce premiums on which we earn fee income. This
strategy has enabled us to augment our return on equity. Our return on
average equity was 23.7% in 2004 and averaged 31.8% for the five years
ended December 31, 2004. The lower return on average equity in 2004
resulted from the significant increase in average shareholders' equity
as the IPO was completed in the fourth quarter.
o CLAIMS AND LEGAL DEFENSE APPROACH. Our claims staff and in-house
attorneys handle all of our claims and the majority of our lawsuits
internally. This enables us to maintain a high level of service to our
property policyholders and reduce the cost of claims to our casualty
policyholders by vigorously defending non-meritorious and frivolous
claims.
o PROVEN LEADERSHIP AND EXPERIENCED MANAGEMENT. Our senior management
team members have an average of over 20 years of insurance industry
experience. Michael H. Lee, our Chairman of the Board, President and
Chief Executive Officer, was a founder of the company in 1990 and has
an extensive knowledge and understanding of our business, having played
a key role in building several aspects of our operations, including
underwriting, finance, claims and systems.
STRATEGY
The business model that we have developed in the 14 years since we began
our operations has allowed us to succeed despite a limited pre-IPO capital base.
This model has enabled us to support a much larger premium base and create an
insurance company infrastructure otherwise not possible, ultimately leading to
the present stage of our development. With the infusion of the proceeds from our
IPO and the concurrent private placement in October 2004, we increased the
statutory surplus in our insurance company and are pursuing continued profitable
growth through the following strategies:
o REDUCING OUR DEPENDENCE ON REINSURANCE AND OTHER INSURANCE COMPANIES.
The additional capital from the IPO and the concurrent private
placement has allowed us to retain a greater percentage of our premium
writings and thereby reduce our use of quota share reinsurance in our
insurance company. It has also provided us with greater flexibility to
selectively retain a larger portion of the business previously placed
with other insurance companies while continuing to utilize TRM to
generate commissions on premiums placed with other insurance companies
and non-risk bearing, service income. Depending on our capital and
changing quota share reinsurance market conditions, we may ultimately
eliminate our use of quota share reinsurance.
o IMPROVING OUR RATING TO ATTRACT CUSTOMERS IN OTHER MARKET SEGMENTS. As
a result of the infusion of $98.0 million of the proceeds of the IPO
and concurrent private placement into our insurance company operation,
on October 26, 2004, TICNY received a rating upgrade from A.M. Best to
"A-" (Excellent) from "B++" (Very Good). Our A.M. Best rating reflects
A.M. Best's opinion of TICNY's financial strength and is not an
evaluation directed to investors in our common stock nor a
recommendation to buy, sell or hold our common stock. Ratings are an
increasingly important factor in establishing the competitive position
of insurance companies. There is no guarantee that TICNY will maintain
the improved rating. An increase in rating positions us to write
policies in rating-sensitive market segments that TICNY was not
previously able to access, especially policies written by TRM's issuing
companies. This rating increase should also enable TICNY to reinsure
other insurance companies, including TRM's issuing companies, and
assume a greater portion of profitable reinsurance business. By writing
these larger policies that TRM currently produces, TICNY also will be
able to lower its expense ratio since these larger policies entail
lower direct commission expense (13.9% in 2004 for TRM's business
compared with 16.7% for TICNY's business) as well as lower underwriting
cost relative to the premium per policy.
4
o EXPANDING TERRITORIALLY. Our insurance company subsidiary is presently
licensed in New York State. We believe that the insurance products and
services that we currently offer carry strong market demand beyond our
current core market of New York City and the adjacent areas of New York
State to areas of upstate New York and the surrounding states in the
Northeast. In January 2005, we entered into a stock purchase agreement
to acquire North American Lumber Insurance Company ("NALIC"), a shell
company with active licenses in the following nine states: New Jersey,
Connecticut, Massachusetts, Rhode Island, Vermont, Maryland, Delaware,
South Carolina and Wisconsin. While there is no guarantee this
transaction will close, in the event it does, this acquisition will
allow us to continue executing our plan to expand territorially first
in New Jersey after the close of the transaction, followed by expansion
into other states. We also expect to make similar shell acquisitions in
the future in order to offer products in various market segments in the
same territory. In addition, we recently formed a Program Underwriting
Unit to expand on our regional distribution approach and allow us
greater access to established, highly focused and narrowly defined
books of business with which we are familiar but which are typically
distributed over a broader geographical area. This program capability
should enable us to add greater value to our extensive network of
wholesale and retail agents by developing new program opportunities for
classes of businesses which we do not currently underwrite or in which
we have limited market penetration. See "Shell Acquisition" below.
o ACQUIRING BOOKS OF BUSINESS. We intend to continue to acquire books of
business that fit our underwriting competencies from competitors,
managing agents and other producers. In September 2004, the Company
entered into a Commercial Renewal Rights Agreement with OneBeacon
Insurance Group LLC and some of its insurance company subsidiaries
pursuant to which we have acquired OneBeacon's rights to seek to renew
a block of commercial lines insurance policies in New York State. See
"OneBeacon Renewal Rights Transaction" below.
o EXPANDING NON-RISK-BEARING FEE-GENERATING SERVICES. We plan to continue
to generate commission and fee income through our insurance services
operation by offering managing general underwriting, reinsurance
intermediary and claims administration services.
o CONTINUING IMPLEMENTATION OF TECHNOLOGICAL IMPROVEMENTS. We plan to
continue our implementation of technology-based initiatives such as
WebPlus, our web-based platform for quoting and capturing policy
submissions from our agents, in order to improve customer service and
further lower our underwriting expense ratio.
ONEBEACON RENEWAL RIGHTS TRANSACTION
In September 2004, we entered into a Commercial Renewal Rights Agreement
with OneBeacon Insurance Group LLC ("OneBeacon") and some of its insurance
company subsidiaries pursuant to which we have acquired OneBeacon's rights to
seek to renew a block of commercial lines insurance policies in New York State.
The subject policies consist of commercial multiple-peril, workers compensation,
commercial umbrella, commercial inland marine, commercial auto, fire and allied
lines and general liability coverages and generated more than $100 million in
gross written premiums for OneBeacon in 2003.
Under the terms of the agreement, we did not acquire any in-force business
or historical liabilities associated with the policies. In addition, we are not
obligated to renew any particular policies, but are free to seek to renew those
policies that meet our underwriting guidelines and on which we can charge a
satisfactory premium. The agents who produced the subject policies for OneBeacon
generally control the renewals; they are not obligated to produce the renewals
for us and can direct the renewals to other carriers if they choose. We have
appointed over 280 agencies located throughout New York State who have been
producing this business for OneBeacon. Based upon our initial review of the
subject policies and our current underwriting guidelines, we are seeking to
renew policies generating approximately $30 million to $40 million in annual
gross written premiums for the twelve months commencing December 1, 2004, but
there is no guarantee that we will be able to write any particular level of
renewals. Our estimate may change depending on agents' behavior and as we learn
more about the subject policies and apply our underwriting and pricing
guidelines to policies that are up for renewal.
5
We have agreed to pay OneBeacon a commission on the policies we renew, in
an amount equal to 5% of the direct premiums written resulting from our renewal
of any subject policies in the first year, 4% in the second year and 1% in the
third year, with no payments due after the third year. However, we are obligated
to pay OneBeacon a minimum commission of $2 million for policies we renew in the
first year, $2 million in the second year and $1 million in the third year. We
have posted letters of credit with OneBeacon to secure our minimum commission
obligations. OneBeacon has agreed not to compete with us until December 2006 in
writing the policies that are subject to the agreement.
We determined that two intangible assets were acquired in this transaction:
renewal rights and valuable agent contractual relationships with 280 new agents,
both of which were determined to be intangible assets with a finite useful life.
The renewal rights were recorded at $1,250,000 and will be amortized over ten
years in proportion to anticipated renewal premiums to be written during this
time period. The new agent contractual relationships have been recorded at
$3,750,000 and will be amortized over twenty years on a straight-line basis.
SHELL ACQUISITION
In January 2005, we entered into a stock purchase agreement to acquire
North American Lumber Insurance Company ("NALIC"), a shell company with active
licenses in the following nine states: New Jersey, Connecticut, Massachusetts,
Rhode Island, Vermont, Maryland, Delaware, South Carolina and Wisconsin. NALIC
will be initially capitalized with part of the $26.0 million raised through two
offerings of trust preferred securities in December 2004. According to the terms
of the agreement, all liabilities and assets of NALIC (which will be renamed)
will be transferred to a liquidating trust prior to closing with the exception
of its charter and insurance licenses. The transaction has received court
approval in Massachusetts and is expected to close in March or April 2005.
INDUSTRY BACKGROUND
Property and casualty insurance provides protection to insured parties from
damage to property (for example, damage to a building and its contents from
fire) and from claims by third parties (for example, injuries suffered by a
person on insured premises or as a result of actions or omissions by the insured
or its agents) arising from specified events. Property and casualty insurance
can be broadly classified into commercial lines, in which insurance is provided
to business enterprises, and personal lines, in which insurance is provided to
individuals.
The property and casualty insurance business has historically been subject
to cyclical fluctuations in pricing and availability of property and casualty
insurance. "Soft" markets are characterized by excess capital and underwriting
capacity, as well as pricing and policy terms and conditions generally being
less favorable to insurers, resulting in intense premium rate competition, an
erosion of underwriting discipline and poor operating performance. This market
condition is eventually followed by a period of diminished underwriting capacity
and greater underwriting discipline with insurance companies exiting
unprofitable areas of business and/or increasing their premium rates in order to
improve operating performance. This phase of the cycle is generally referred to
as a "hard" market.
Since we began operations in 1990 and continuing into 2000, the property
and casualty industry experienced a prolonged soft market characterized by
excess capacity as well as undisciplined underwriting. During this period, many
primary insurance companies and reinsurers lowered their rates, increased
coverage, increased commission rates paid and relaxed their underwriting
standards in order to compete for business.
We first began to notice the beginning of a hard market in late 2000, when
reinsurers began non-renewing unprofitable business, charging significantly
higher excess reinsurance rates and reducing ceding commissions paid on quota
share reinsurance business. The changes in the reinsurance market that began in
late 2000 were followed immediately by changes in the primary insurance market
in 2001, with many insurance companies and managing general agencies increasing
their rates, limiting policy terms and conditions and reducing commissions paid
to their producers. The September 11, 2001 terrorist attacks provided the
property and casualty industry with its single largest loss in its history,
estimated by A.M. Best to be between $30 and $40 billion. Despite our
geographical focus in New York City and the significant industry loss, our gross
and net losses from this catastrophe were limited to $1.2 million and $0.4
million, respectively. See "Item 1.--Underwriting" for further details. The
substantial loss of insurance and reinsurance capacity caused by these attacks
and by the downturn in global equity markets triggered an acceleration of the
rate increases and tightening of policy terms and conditions that began in late
2000. The industry combined ratio was 100.1% in 2003 and is estimated by A.M.
Best to decline to 97.6% in 2004 as a consequence of the compounded effects of
annual rate increases and tighter policy terms. However, beginning in the latter
half of 2004, the rates for property and casualty insurance products began to
moderate, and for certain products, rates began to decrease due to an increased
level of competition. A.M. Best estimates that industry wide growth in net
premiums written in the homeowner's line slowed in 2003 and 2004, and is
expected to slow further in 2005, while industry wide net premiums written in
commercial lines grew significantly less in 2004 than in 2003 and are projected
to decline slightly in 2005. These changes may signal the start of a "soft
market" cycle that could restrict or diminish our ability to obtain rate
increases as in the recent past. We cannot predict with any certainty the
direction the market will take during 2005 or thereafter. See "Item 1.-Risks
Related to Our Industry" and "Item 7.- Marketplace Conditions and Trends" for
further discussion on market conditions.
6
BUSINESS SEGMENTS
We operate in three business segments:
o Insurance. In our insurance segment, TICNY provides commercial lines
policies to businesses and personal lines policies to individuals in
New York State. TICNY's commercial lines products include commercial
multiple-peril, monoline general liability, commercial umbrella,
monoline property, workers' compensation and commercial automobile
policies. Its personal lines products consist of homeowners, dwelling
and other liability policies. See "Item 1.-Insurance Segment Products".
o Reinsurance. In our reinsurance segment, TICNY accepts or assumes
reinsurance directly from TRM's issuing companies or indirectly from
reinsurers that provide reinsurance coverage directly to these issuing
companies. As a reinsurer, TICNY assumes a modest amount of the risk on
the premiums that TRM produces. While this reinsurance business
historically has not been profitable, the commission income generated
by TRM on the production of this business has exceeded any underwriting
losses from the reinsurance assumed on this business. See "Item
1.-Insurance Services Segment Products and Services".
o Insurance Services. In our insurance services segment, TRM, as a
managing general agency, generates commission income by producing
premiums on behalf of its issuing companies and generates fees by
providing claims administration and reinsurance intermediary services.
TRM does not assume any risk on business produced by it. All of the
risk is written by the issuing companies and ceded to a variety of
reinsurers pursuant to reinsurance programs arranged by TRM working
with outside reinsurance intermediaries. Placing risks through TRM's
issuing companies allowed us to underwrite larger policies and gain
exposure to market segments unavailable to TICNY due to rating,
financial size or geographical licensing limitations, or other factors.
Through its issuing companies, TRM produces commercial package,
monoline general liability, monoline property, commercial automobile
and commercial umbrella products. See "Item 1.-Insurance Services
Segment Products and Services".
Prior to our IPO, TICNY's limited capital, rating and licensing constrained
its ability to write and retain large premium volume. Consequently, TICNY made
extensive use of quota share reinsurance to manage the level of risk it retains
in relation to its capital. In 1995, we formed TRM in order to produce business
for other insurance companies that TICNY was precluded from writing due to
TICNY's limited capital, rating and licensing. TRM also enabled us to earn fee
revenue and to lower our underwriting expense ratio by creating economies of
scale and sharing some of the cost of developing and maintaining a full
insurance infrastructure. In order for us to obtain reinsurance for TRM's
issuing companies, the reinsurers often require TICNY to assume reinsurance
premiums directly from TRM's issuing companies or from reinsurers that reinsure
the premiums written by these companies.
7
The following table summarizes the focus of our three segments:
INSURANCE (TICNY) REINSURANCE (TICNY) INSURANCE SERVICES (TRM)
----------------------- ------------------------- ------------------------
RISK BEARING RISK BEARING NON-RISK BEARING
PREMIUM SIZE Small (under $25,000 TICNY assumes a modest Small (under $25,000
premium per policy) portion of the premiums premium per policy)
written by TRM's issuing Medium ($25,000 to
companies on all business $100,000 premium per
produced by TRM. policy)
Large (over $100,000 per
policy)
PRICING TIER Standard and Non-Standard Preferred, Standard and
Non-Standard
EMPHASIZED CLASSES OF Retail and wholesale stores, Residential and
BUSINESS grocery stores, restaurants, commercial buildings
artisan contractors, apartment
buildings
Homeowners, dwelling and
other non-auto related
personal lines products
TERRITORY New York State New York, New Jersey,
Pennsylvania and
incidental locations
throughout the country,
but primarily in the
Northeast
COVERAGES Businessowners Policy Commercial Package Policy
Commercial Package Policy Monoline Commercial
Monoline Commercial Property
Property Monoline General Liability
Monoline General Liability Commercial Auto
Commercial Umbrella
Commercial Auto
Workers' Compensation
Homeowners and Dwelling
SERVICES Reinsurance intermediary
Claims administration
INSURANCE SEGMENT PRODUCTS
In our insurance segment, TICNY offers a broad array of commercial and
personal lines products. Our insurance segment products currently target low
severity, low frequency risks with an overall average annual premium in 2004 of
$3,091 per policy for commercial lines and $899 per policy for personal lines.
Typically, the liability coverage on these classes of business is not exposed to
long-tailed (i.e., many years may pass before claims are reported or settled),
complex or contingent risks, such as products liability, asbestos or
environmental claims. These risks are located in New York City and the adjacent
areas of New York State, a market that we feel, in our lines of business, level
of risk and premium size, has historically been overlooked by regional and
national insurance companies. With the OneBeacon renewal rights agreement, TICNY
is expanding its marketing territory to other areas of New York State, including
Long Island, the Hudson River Valley and Western New York. However, TICNY is
maintaining a targeted approach to underwriting, focusing on underserved markets
that we believe will permit us to achieve favorable premium rates.
8
The following table shows our gross premiums earned and loss ratio for the
insurance segment's products for the years ended December 31, 2004 and December
31, 2003.
YEAR ENDED DECEMBER 31, 2004 YEAR ENDED DECEMBER 31, 2003
GROSS GROSS GROSS GROSS
PREMIUMS LOSS PREMIUMS LOSS
EARNED RATIO EARNED RATIO
--------------- ------------ -------------- ------------
($ in thousands)
Commercial multiple-peril $ 77,917 63.1% $ 55,015 58.4%
Other liability 7,525 55.5% 5,728 60.8%
Workers compensation 14,101 61.8% 12,133 50.6%
Commercial auto 10,432 31.7% 8,133 65.4%
Homeowners 34,526 45.6% 33,809 67.3%
Fire and allied lines 6,709 55.2% 5,723 61.4%
-------- ---- -------- ----
ALL LINES $151,210 56.1% $120,541 60.9%
======== ==== ======== ====
Commercial Multiple-peril. Our commercial multiple-peril products include
commercial package policies, businessowners policies and landlord package
policies. Our commercial package policies provide property and casualty
coverages and focus on classes of business such as retail and wholesale stores,
grocery stores, restaurants and residential and commercial buildings. We have
written commercial package policies since TICNY commenced operations in 1990.
Our businessowners policies provide property and liability coverages to small
businesses. We introduced this product in 1997 to provide broader built-in
coverages for businesses in the standard and preferred pricing tiers at lower
rates than on commercial package policies. Our landlord package policy provides
property and casualty coverage for three- and four-family dwellings with a
maximum coverage limit of $700,000. As of December 31, 2004, approximately
32,126 commercial multiple-peril products were in place, including 16,746
commercial package policies and 11,477 landlord package policies and 3,903
businessowners policies.
Other Liability. We offer other liability products in personal and
commercial lines. Our commercial products are comprised of monoline commercial
general liability and commercial umbrella policies. We write commercial general
liability policies for risks that do not have property exposure or whose
property exposure is insured elsewhere. Primarily, we target residential and
commercial buildings, as well as artisan contractors for monoline general
liability. Our commercial umbrella policy, introduced in 2002, provides
additional liability coverage with limits of $1,000,000 to $5,000,000 to
policyholders who insure their primary general liability exposure with TICNY
through a business owners, commercial package policy, or commercial general
liability policy. We have the ability to offer limits of up to $10,000,000 with
facultative reinsurance. As of December 31, 2004, approximately 1,023 monoline
commercial general liability policies and 476 commercial umbrella policies were
in force. We also write monoline personal liability policies as an addition to
our dwelling fire policies. In addition, we acquired the renewal rights to a
block of comprehensive personal liability policies in the Empire renewal rights
transaction, but we are not currently issuing new comprehensive personal
liability policies. As of December 31, 2004, TICNY had approximately 1,636
comprehensive personal liability policies in force. We also write personal lines
excess liability or umbrella policies covering personal liability in excess of
the amounts covered under our homeowners and dwelling policies. We offer this
policy with a $1,000,000 limit. We do not market excess liability policies to
individuals unless we also write the underlying homeowner's policy. Further, the
excess liability is usually handled as an endorsement to the homeowner's policy.
Workers' Compensation. We introduced our workers' compensation product in
1995. Our underwriting focus is on businesses such as restaurants, retail
stores, offices, and clothing manufacturers that generally have a lower
potential for severe injuries to workers from exposure to dangerous machines,
elevated worksites and occupational diseases. This product is currently offered
on a guaranteed cost basis at the rates published by the New York State Workers'
Compensation Bureau. As of December 31, 2004, we had approximately 5,904
workers' compensation policies in force.
Commercial Automobile. Our commercial automobile product focuses on
non-fleet business such as contractor and wholesale food delivery vehicles. We
underwrite primarily medium and lightweight trucks (under 30,000 lbs. gross
vehicular weight). Historically unprofitable accounts for this segment of the
insurance industry such as livery, trucking for hire or long-haul trucking
operations are presently excluded under our underwriting guidelines. We
commenced writing commercial automobile business in 1998. As of December 31,
2004, approximately 1,032 commercial automobile policies were in force.
9
Homeowners. Our homeowner's policy is a multiple-peril policy providing
property and liability coverages for one- and two-family owner-occupied
residences. While we are expanding our marketing territories throughout New York
State, the homes we currently insure are located predominantly in the greater
New York City area. We market both a standard and preferred homeowner's product.
As of December 31, 2004, TICNY had approximately 38,237 homeowner's policies in
force.
Fire and Allied Lines. Our fire and allied lines policies consist of
dwelling policies and monoline commercial property policies. Our dwelling
product targets owner- occupied dwellings of no more than two families. The
dwelling policy provides optional coverages for personal property and can be
combined with an optional endorsement for liability insurance. This provides an
alternative to the homeowner's policy for the personal lines customer. As of
December 31, 2004, TICNY had approximately 13,724 dwelling policies in force. We
also write monoline commercial property policies for insureds that do not meet
our underwriting criteria for the liability portion of our commercial package
policies. The classes of business are the same as those utilized for commercial
package property risks. Generally, the rates charged on these policies are
higher than those for the same property exposure written on a commercial package
policy. As of December 31, 2004, approximately 84 monoline commercial property
policies were in force.
REINSURANCE SEGMENT PRODUCTS
In order for TRM to obtain reinsurance support for the business it produces
for its issuing companies, TICNY is often required to assume a limited amount of
reinsurance on this business from the issuing companies or the issuing
companies' reinsurers. By assuming risk, we align our interests with the issuing
companies and their reinsurers. While this assumed business has historically
been unprofitable, the direct commission income generated by TRM has
historically offset assumed losses. In 2004, TICNY assumed 3% of the business
produced by TRM, with gross written premiums assumed of $1.6 million,
representing 0.9% of TICNY's total gross premiums written and 2.9% of its net
premiums earned.
The profitability of the underlying assumed business improved in 2003 due
to re-underwriting and pricing increases that began in 2001. Prior to 2001,
assumed business was reinsured on a quota share basis, which required TICNY to
reinsure TRM's business on a proportional basis on any losses incurred up to a
certain limit of loss. For a part of 2001 and all of 2002, 2003 and 2004 TICNY
reinsured the assumed business on an excess of loss basis, which required TICNY
to assume losses in excess of specified loss ratio amounts as described in more
detail below. In addition to the change in the assumed reinsurance structure, we
also secured reinsurance protection on this assumed business by including this
business in the TICNY quota share reinsurance agreement from 2001 through 2002.
Assumed Reinsurance Coverage Terms. In 2003, TICNY assumed from State
National Insurance Company, Inc. ("State National") and Virginia Surety Company
("Virginia Surety") 100% of their liability above loss ratio caps of 92% for the
small business overflow program, 115% for the middle market and 125% for the
large lines general liability real estate program. TICNY also provided coverage
on a first dollar basis for losses arising out of excluded perils and coverage
in excess of certain sub-limits for perils such as terrorism, lead, mold, fungi,
and other microbes. Under an aggregate excess of loss retrocession agreement
relating to the large lines general liability real estate program, TICNY also
assumed from State National's and Virginia Surety's quota share reinsurer, PXRE
Reinsurance Company ("PXRE"), varying amounts of ultimate net loss based on
amounts of subject net premiums earned. With respect to Virginia Surety, the
large lines general liability real estate program began on August 1, 2003 and
expired on December 31, 2004, and the middle market program began on December 1,
2003 and expired on November 30, 2004. Therefore, the reinsurance terms
described above for 2003 were in effect during 2004.
In 2004, TICNY assumed from State National 100% of the liability above the
loss ratio caps under the 2004 State National Combined Quota Share Reinsurance
Agreement. These loss ratio caps were 95% for the small business overflow
program, 115% for the middle market program and 125% for the large lines general
liability real estate program. TICNY also assumed from State National the
liability for losses not covered under the original quota share reinsurance
treaties between State National and its other reinsurers. Pursuant to an
aggregate excess of loss reinsurance agreement, TICNY also assumed from two of
State National's quota share reinsurers 12.5% of losses in excess of a loss
ratio of 75% up to 115% under the middle market program and 12.5% of losses in
excess of a loss ratio of 60% up to 125% for the large lines general liability
real estate program.
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With respect to Virginia Surety, TICNY also assumed 100% of the liability
above the loss ratio caps under the 2004 Multiple Lines Quota Share Reinsurance
Agreement. These loss ratio caps were 95% for the small business program, 115%
for the middle market program and 125% for the large lines general liability
real estate program. TICNY also assumed from Virginia Surety the liability for
losses not covered under the original quota share reinsurance treaties between
Virginia Surety and its other reinsurers. Pursuant to an aggregate excess of
loss reinsurance agreement, TICNY also assumed from the two Virginia Surety's
quota share reinsurers 10.25% of losses in excess of a loss ratio of 68% under
the small market program, 15.25% of losses in excess of a loss ratio of 68%
under the middle market program and 19% of losses in excess of a loss ratio of
63% for the large lines general liability real estate program. The Virginia
Surety Multiple Lines Quota Share Reinsurance agreement began on December 1,
2004 and will expire on December 31, 2005.
INSURANCE SERVICES SEGMENT PRODUCTS AND SERVICES
TRM provides non-risk bearing managing general agency, reinsurance
intermediary and claims administration services that generate commission and fee
income for us. TRM also provides us with additional market capability to produce
business in other states, product lines and pricing tiers that TICNY cannot
currently access. TRM produces this business on behalf of its issuing companies,
which have higher ratings, greater financial resources and more licenses than
TICNY.
TRM provides underwriting, claims administration and reinsurance
intermediary services to its issuing companies by utilizing TICNY's staff,
facilities and insurance knowledge and skills. All of the business produced by
TRM for its issuing companies is ceded to reinsurers. TRM earns a commission,
equal to a specified percentage of ceded net premiums written, which is deducted
from the premiums paid to the issuing insurance companies. TRM's commission rate
varies from year to year depending on the loss experience of the business
produced by TRM. The commission rate in 2004 was 21.6%. TRM also performs claims
administration services on behalf of other insurance companies, including
companies for which TRM produced business in the past, but as to which it may no
longer act as an underwriting agent.
While TICNY has incurred underwriting losses from its assumed premiums to
support TRM's business, these losses were based upon assumed premiums that
represented only 3% of the total premiums produced by TRM on behalf of TRM's
issuing companies in 2004. TRM, as a managing general agency, however, generated
commissions on all of the premiums produced. As result, TRM has contributed to
both the profitability and the growth of our organization while at the same time
reducing TICNY's underwriting expense ratio through economies of scale and the
sharing of TICNY's operating costs. As consideration for the use of TICNY's
staff, equipment and facilities, TRM reimburses a portion of TICNY's
underwriting expenses through an expense sharing agreement. These reimbursements
were $3.0 million, $2.2 million and $1.6 million in 2004, 2003 and 2002,
respectively, representing 13.2%, 13.7% and 14.3%, respectively, of TICNY's
total other underwriting expenses in those years. TRM also reimburses TICNY for
the use of TICNY's claims and legal defense staff based upon the hourly billing
rates charged by TRM to its issuing companies. These reimbursements were $4.0
million, $3.6 million and $4.4 million in 2004, 2003 and 2002, respectively,
representing 4.8%, 4.9% and 8.0%, respectively, of TICNY's gross loss and loss
adjustment expenses in those periods. In addition to lowering TICNY's
underwriting expenses through expense reimbursement, TRM also contributes the
balance of its revenues after these expense reimbursements to our overall
pre-tax income. Those contributions were $2.0 million, $1.5 million and $3.0
million in 2004, 2003 and 2002, respectively.
In 2004 and 2003 TRM underwrote business on behalf of Virginia Surety and
State National. Virginia Surety is rated "A-" (Excellent) and State National is
rated "A" (Excellent) by A.M. Best. Virginia Surety and State National are each
licensed in all 50 states and the District of Columbia. Virginia Surety and
State National are expected to be TRM's issuing companies in 2005.
TRM's business is primarily sourced through wholesale and retail brokers.
See "Item 1.-Product Development and Marketing Strategy-Distribution" for
further detail on our producers. The business TRM writes for its issuing
companies is reinsured 100% to various reinsurers in addition to TICNY,
including Tokio Millennium Re Ltd., Hannover Reinsurance (Ireland) Ltd. and E+S
Reinsurance (Ireland) Ltd.. TRM acts as a reinsurance intermediary for its
issuing companies and arranges for all of the reinsurance ceded. For 2004, all
of the reinsurers providing reinsurance for TRM's issuing companies are rated
"A-" (Excellent) or better by A.M. Best. After A.M. Best downgraded the rating
of Converium Reinsurance (North America) Inc. to "B-" (Fair) and that company
was placed into runoff by its parent company in September 2004, Converium's
participation under our quota share treaty was novated to Tokio Millenium Re
Ltd., Hannover Reinsurance (Ireland) Ltd. and E+S Reinsurance (Ireland) Ltd.
effective January 1, 2004. See "Item 1.-Reinsurance-2004 Reinsurance Program"
for further detail.
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Managing General Agency
TRM produces business for its issuing companies through various programs,
as follows:
TRM Small Business Overflow Program. TRM's small business overflow program,
created in 2003, provides additional capacity and the ability to write risks
outside of New York for commercial lines products of the kind written by TICNY
(other than workers' compensation and landlord package policies), generating
annual premiums per policy of less than $25,000. All the rates, forms and
underwriting guidelines for this program are identical to those used by TICNY.
TRM Middle Market Program. TRM's middle market program enables us to access
commercial lines business for the same classifications of risk written by TICNY,
but having annual premiums per policy in excess of $25,000. The middle market
program also enables us to serve accounts that require a larger insurer than
TICNY or are located outside of New York. For risks that would otherwise qualify
for a commercial package policy, this program can offer monoline property or
general liability coverages where one of the coverage parts does not qualify due
to overly competitive pricing, lack of capacity, insufficient underwriting
expertise or a restricted underwriting classification.
This program focuses on mercantile, residential and commercial building
risks and offers property limits up to $30.0 million per location. Most of the
business is located in New York City, with some accounts in other areas of New
York State and New Jersey. Prior to 2001, the premium rates for the middle
market program were significantly lower than the rates offered by TICNY.
Beginning in 2001, the rates in this program were significantly increased, and
in 2004 they were not substantially different from those offered by TICNY.
TRM Large Lines General Liability Real Estate Program. This program, which
we began in 1996, provides monoline general liability policies for mercantile,
residential and commercial building risks primarily in New York City, generating
annual general liability premiums in excess of $100,000. From 2001 through 2003,
premium rates increased significantly on a cumulative basis from 2000 levels and
we re-underwrote this program. While the rate levels stabilized in 2004, we
continued to obtain modest premium changes.
TRM Claims Service
TRM's claims service division provides complete claims adjusting and
litigation management service for all commercial and personal property and
casualty lines of business to TRM's issuing insurance companies, reinsurers and
self-insureds. TRM presently bills its claims administration cost as a value
added service to its issuing companies and is reimbursed by the issuing
companies for the amounts billed. The fees earned by TRM help offset the total
expenses incurred by TICNY's claims staff and allow TICNY to maintain a larger
claims infrastructure than it would otherwise be able to support with its own
premium base. The amount of claims administration fees reimbursed by the issuing
companies was $4.0 million in 2004, $3.6 million in 2003 and $4.4 million in
2002.
In addition, TRM generates fees for a profit by providing claims
administration, audit and consulting services to self-insureds and other
insurance companies. While TRM has not actively marketed its claims service
division, its reputation in claims administration and litigation management has
brought several opportunities to act as a third-party claims administrator. For
this reason, we plan to expand our claims administration services for profit in
the future.
Tower Risk Reinsurance Intermediary Services
TRM's reinsurance intermediary services division provides reinsurance
intermediary services to TICNY and to TRM's issuing companies. Its revenue is
derived from a fee sharing agreement with an outside reinsurance intermediary on
the premium ceded to various reinsurers that reinsure TICNY and TRM's issuing
companies. Its revenue for performing these services was $0.7 million in 2004,
$1.1 million in 2003 and $3.2 million in 2002. Revenue in 2002 was higher due to
additional intermediary fees that we negotiated in that year in lieu of
commission for placing reinsurance on behalf of TICNY and TRM's issuing
companies.
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PRODUCT DEVELOPMENT AND MARKETING STRATEGY
We believe that many insurance companies develop and market their products
based on an underwriting focused approach in which they define products based
upon their underwriting guidelines and subsequently market those products to
producers whose needs fit within the bounds of their underwriting criteria.
Conversely, while we are a disciplined underwriting organization, our product
development and marketing strategy is to first identify needed products and
services from our producers and then to develop profitable products in response
to those needs. After positioning our products in this manner, we focus on
developing underwriting guidelines that enable us to make an underwriting
profit. This approach has allowed our organization to gain the reputation of
being responsive to market needs with a highly service oriented approach to our
producer base.
When we first began operations in 1990, our producers confirmed the need
for us to underwrite small commercial risks, such as apartment buildings,
restaurants and retail stores in urban areas such as New York City that other
insurance companies avoided due to a perceived lack of underwriting
profitability. In response to this need, we developed commercial package
policies that provided limited property and liability coverage customized to
meet the needs of this nonstandard market segment, as well as underwriting and
claims approaches that enabled us to achieve underwriting profitability. Since
then, we have continued to develop other commercial lines products such as
business owners, workers' compensation and commercial automobile policies, and
introduced personal lines products such as homeowners and dwelling policies, to
respond to the needs of our customers in other nonstandard segments as well as
customers in the preferred and standard market segments where we generally offer
lower rates and broader coverages for risks that we perceive to have more
desirable underwriting characteristics.
With the development of our broad product line offering, we have been able
to access markets with significant premium volume and opportunity for market
penetration. We have increased our market share in each of these lines of
business. We have been able to achieve profitable premium growth by keeping our
annual premium volume objectives in the various lines of business low relative
to the overall size of the market in those lines. This approach allows us to
remain selective in our underwriting and to avoid sacrificing profitability for
the sake of volume.
In marketing our products, we segment the market based upon industry,
location, pricing tiers and premium size. For commercial lines products, we have
generally focused on specific classes of business in the real estate, retail,
wholesale and service industries such as retail and wholesale stores,
residential and commercial buildings, restaurants and artisan contractors. We
target these underserved classes of business because we believe that they are
less complex, have reduced potential for loss severity and can be easily
screened and verified through physical or telephonic inspection.
We also have historically targeted risks located in urban areas such as New
York City that require special underwriting expertise and have generally been
avoided by other insurance companies. We have had success targeting markets in
geographical areas outside of New York City by focusing on classes of business
such as residential real estate buildings that other companies have avoided.
We have also expanded our product offering to various lines of business
within the preferred, standard and non-standard pricing segments. Within the
preferred, standard or non-standard market segment, we first develop different
pricing, coverages and underwriting guidelines. For example, the pricing for the
preferred risk segment is generally the lowest, followed by the standard and
non-standard risk segments. The underwriting guidelines are correspondingly
stricter for preferred risks in order to justify the lower premium rates charged
for these risks. Underwriting standards become progressively less restrictive
for standard and non-standard risks.
In addition to segmenting our products by industry, location and pricing
tiers, we further classify our products into the following premium size segments
under $25,000 (small), $25,000 to $100,000 (medium) and over $100,000 (large).
We have historically had more success in the small premium size segment due to
our focus on reducing our underwriting expenses by realizing economies of scale,
utilizing technology and developing efficient business processes. We believe
that due to the higher cost of underwriting small policies, other insurance
companies have not been able to price competitively in this premium size
segment. Our expense advantage has allowed us to maintain adequate rates through
industry cycles. With improved market conditions in recent years, we have seen
adequate pricing in the medium and large premium size segments as reflected by
improved underwriting performance by TRM, which has focused on these premium
size segments.
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Each year, we analyze various market segments and deliver products for each
line of business in those segments that present the best opportunity to earn an
underwriting profit based on the prevailing market conditions. As a result, the
segments on which we focus will vary from year to year as market conditions
change. We expand our product offerings in segments where we believe that we
have established the appropriate price, coverage and commission rate to generate
the desired underwriting profit. Conversely, we aim to reduce our product
offerings in market segments where competition has reduced opportunities for us
to earn an underwriting profit.
With the financial strength upgrade to "A-" (Excellent) we believe we are
positioned to expand our insurance product offering and marketing capability to
write policies generating premiums in excess of $25,000 within the preferred
tier. Prior to the upgrade, these risks were written only through TRM's issuing
companies. In addition, we believe we will be able to write preferred risks with
higher property limits than we have been able to write in TICNY prior to the
upgrade to an "A-" (Excellent) as well as products in other market segments.
There is no guarantee that TICNY will maintain the improved rating.
DISTRIBUTION
We generate business through independent wholesale and retail agents and
brokers who we refer to collectively as producers. These producers sell policies
for us as well as for other insurance companies. Prior to the renewal rights
agreement with OneBeacon, we had approximately 300 producers appointed to
generate new business. We also had approximately 400 producers who are
authorized to place only renewals of the business that we acquired in the Empire
renewal rights transaction in 2001. With the acquisition of the OneBeacon
business, we established agency agreements with an additional 280 agents
throughout New York State.
Approximately 49% of the total of TICNY's gross premiums written and
premiums produced by TRM on behalf of its issuing companies in 2004 were derived
from our top 10 producers. In 2004, Morstan General Agency, Davis Agency Inc.,
CRC Insurance and Simon Agency, Inc. produced 14%, 7%, 7% and 5%, respectively,
of the total of TICNY's gross premiums written and premiums produced by TRM on
behalf of its issuing companies. No other producer was responsible for more than
5% of TICNY's gross premiums written and premiums produced by TRM for its
issuing companies in 2004.
We carefully select our producers by evaluating several factors such as
their need for our products, premium production potential, loss history with
other insurance companies that they represent, product and market knowledge and
the size of the agency. We generally appoint producers with a total annual
premium volume greater than $5,000,000. We expect a new producer to be able to
produce at least $250,000 in annual premiums for us during the first year and
$500,000 in annual premiums after three years. The newly appointed producers
that were part of the OneBeacon transaction are providing access to the expiring
OneBeacon renewal policies, as well as producing new business within our
established underwriting guidelines and marketing appetite.
Commissions paid to producers in 2004 for TICNY averaged 16.7% of gross
premiums earned. For TRM business, average commissions in 2004 were 13.9%. Our
commission schedules are 1 to 1.5 points higher for wholesalers as compared to
retailers in recognition of the additional duties that wholesalers perform.
Also, TICNY has a profit sharing plan that added less than 1/4% to overall
commission rates in 2004.
Prior to the IPO, we were able to generate as much premium volume as
TICNY's surplus would support consistent with its A.M. Best rating. With the
additional capital infusion resulting from the IPO we have increased marketing
and business development efforts aimed at increasing premium volume in New York
City as well as other areas in New York State. This has been directed at the
orientation and training of the newly appointed agents. Additionally, with the
acquisition of additional state licenses, our focus has increased in developing
marketing capabilities and agency relationships in other northeastern states.
Currently, our activities are directed toward constructing a producer network in
New Jersey. In January 2005 we entered into a stock purchase agreement to
acquire North American Lumber Insurance Company, a shell company with active
licenses in nine states mostly on the east coast, including New Jersey,
Connecticut and various New England states. Additionally on March 1, 2005 we
announced the formation of a Programs Underwriting Unit to compliment our
regional distribution approach. The Program Underwriting Unit will allow us to
gain access to established highly focused and narrowly defined books of business
that are distributed over a broader geographical area not accessible through our
regional distribution approach. It will also enable us to add greater value to
our existing agents by developing new program opportunities for classes of
business that we do not currently underwrite or in which we have a limited
market penetration.
14
To ensure that we obtain profitable business from our producers, we attempt
to position ourselves as our producers' primary provider of the products that we
offer. We manage the results of our producers through a quarterly review to
monitor premium volume and profitability. At the end of each quarter, we produce
premium and loss history reports and develop actuarial ultimate accident year
factors in order to project the profitability of the producers. We continuously
monitor the producers in this manner so we can develop corrective action, if
necessary, at any time throughout the year.
UNDERWRITING
The underwriting strategy for controlling our loss ratio is to seek
diversification in our products and an appropriate business mix for any given
year, emphasizing profitable lines of business and de-emphasizing unprofitable
lines. At the beginning of each year, we establish the target loss ratios for
each line of business. We monitor the actual loss ratio throughout the year on a
monthly basis. If any line of business fails to meet its target loss ratio, a
cross-functional team comprised of personnel from the underwriting teams and the
corporate underwriting, actuarial, claims and loss control departments meets to
develop a corrective action plan that may involve revising underwriting
guidelines, non-renewing unprofitable segments or entire lines of business
and/or rate increases.
During the period of time that a corrective action plan is being
implemented with respect to any product line that fails to meet its target loss
ratio, premium for that product line is reduced or maintained depending upon its
effect on our total loss ratio. To offset the reduction or lack of growth in
premium volume for the products that are undergoing corrective action, we seek
to expand our premium writings in existing profitable lines of business or add
new lines of business with better underwriting profit potential.
We establish underwriting guidelines for all the products that we
underwrite to ensure a uniform approach to risk selection, pricing and risk
evaluation among our underwriters and to achieve underwriting profitability. Our
underwriting process involves securing an adequate level of underwriting
information from our producers, identifying and evaluating risk exposures and
then pricing the risks we choose to accept. For certain approved classes of
commercial risks and most personal lines policies, we allow our producers to
initially bind these risks utilizing rating criteria that we provide to them.
Also, our web-based platform WebPlus provides our producers with the capability
to submit and receive quotes over the Internet and contains our risk selection
and pricing logic, thereby enabling us to streamline our initial submission and
screening process. If the individual risk does not meet the initial submission
and screening parameters contained within WebPlus, the risk is automatically
referred to our assigned underwriter for specific offline review. See "Item
1.-Technology".
Once a risk is bound by our underwriter or producers, our internal or
outside loss control representatives conduct physical inspections of
substantially all of the insured premises to validate the information provided
by our producers and provide a loss control report to our underwriters to make a
final evaluation of the risk. With the exception of a few typically low risk
classes of business such as beauty parlors and offices, all of the new risks
that are bound are physically inspected or subject to a telephone survey,
generally within 60 days from the effective date of the policy. If the
inspection reveals that the risk insured under the policy does not meet our
established underwriting guidelines, the policy is generally cancelled within
the first 60 days from its effective date. If the inspection reveals that the
risk meets our established underwriting guidelines but the policy was bound with
incorrect rating information, the policy is amended through an endorsement based
upon the correct information. We supplement the inspection by using online data
sources to further evaluate the building value, claim experience, financial
history and catastrophe exposures of the insured. In addition, we specifically
tailor coverages to match the insured's exposure and premium requirements. We
complete internal file reviews and audits on a monthly, quarterly and annual
basis to confirm that underwriting standards and pricing programs are being
consistently followed.
Our gross and net losses from the World Trade Center terrorist attack of
September 11, 2001 were $1.2 million and $0.4 million, respectively. We believe
we avoided significant losses from this catastrophe due to the typical profile
of our property risks, which are generally comprised of residential buildings,
retail stores and restaurants covered under policies with low building and
content limits. We carefully underwrite potential catastrophe exposures to
terrorism losses. Our underwriting guidelines are designed to avoid properties
designated as or in close proximity to high profile or target risks, individual
buildings over 25 stories and any site within 500 feet of major transportation
centers, bridges, tunnels and other governmental or institutional buildings. In
addition, we monitor the concentration of employees insured under our workers'
compensation policies and avoid writing risks with more than 40 employees in any
one building. However, please see "Item 1.-Risks Related to Our Business-We may
face substantial exposure to losses from terrorism, we are currently required by
law to provide coverage against such losses, and the Terrorism Risk Insurance
Act of 2002 may expire on December 31, 2005", regarding the possible impact of
the scheduled expiration of the Terrorism Risk Insurance Act of 2002 on December
31, 2005. Our property limits profile and the premium size of our policies in
TICNY may, rise as a result of the increase in TICNY's statutory surplus due to
the capital contribution of $98 million of the proceeds from the IPO and the
rating upgrade to "A-" (Excellent) by A.M. Best.
15
We underwrite our products through four underwriting teams that are each
headed by an underwriting manager having an average of approximately 15 years of
industry experience in the property and casualty industry. We have the following
five business units: small commercial, middle market, commercial auto, personal
lines and programs. These business units perform underwriting functions and are
supported by professionals in the corporate underwriting, actuarial, operations,
business development and loss control departments. The corporate underwriting
department is responsible for managing and analyzing the profitability of our
entire book of business, supporting line underwriting with technical assistance,
developing underwriting guidelines, granting underwriting authority, training,
developing new products and monitoring underwriting quality control through
audits. The actuarial department is responsible for monitoring rate adequacy on
all of our products and analyzing loss data on a monthly basis. The underwriting
operations department is responsible for developing workflows, conducting
operational audits and providing technical assistance to the underwriting teams.
The loss control department conducts loss control inspections on nearly all new
commercial and personal lines business written, utilizing in-house loss control
representatives and outside vendors. The business development department works
with the underwriting teams to manage relationships with our producers.
PRICING
We price our products to make an acceptable underwriting profit. In
situations where rates for a particular line become insufficient to produce
satisfactory results, we control growth and reduce our premium volume in that
line.
We generally use actuarial loss costs promulgated by the Insurance Services
Office, a company providing statistical, actuarial and underwriting claims
information and related services to insurers, as a benchmark in the development
of pricing for our products. We further tailor pricing to each specific product
we underwrite (other than workers' compensation), taking into account our
historical loss experience and individual risk and coverage characteristics. For
workers' compensation policies, we use statistical information provided by the
New York Compensation Insurance Rating Board ("NYCRIB") as a benchmark in
developing our pricing.
If a particular business line is not performing well, we may seek rate
increases, which are subject to regulatory approval (See "Item 1.-Regulation")
and market acceptance. Recently, we have been successful in increasing our
rates. We increased our premiums on our commercial renewals as measured against
expiring premium by 6% in 2002, 9% in 2003 and 9% in 2004. In personal lines, we
increased premium by 2.6% in both 2002 and 2003, and 9.5% in 2004.
Beginning in the latter half of 2004, the rates for property and casualty
insurance products began to moderate, and for certain products, rates began to
decrease due to an increased level of competition. These changes may signal the
start of a "soft market" cycle that could restrict or diminish our ability to
obtain rate increases as in the recent past. We cannot predict with any
certainty the direction the market will take during 2005 or thereafter.
REINSURANCE
We purchase reinsurance to reduce our net liability on individual risks, to
protect against possible catastrophes, to achieve a target ratio of net premiums
written to policyholders' surplus and to expand our underwriting capacity.
Reinsurance coverage can be purchased on a facultative basis, where individual
risks are reinsured, or on a treaty basis, where a class or type of business is
reinsured. We purchase facultative reinsurance to provide limits in excess of
the limits provided by our treaty reinsurance. Treaty reinsurance falls into
three categories: quota share (also called pro rata), excess of loss and
catastrophe treaty reinsurance. Under our quota share reinsurance contracts, we
cede a predetermined percentage of each risk for a class of business to the
reinsurer and recover the same percentage of each loss and loss adjustment
expenses. We pay the reinsurer the same percentage of the original premium, less
a ceding commission. The ceding commission rate is based upon the ceded loss
ratio on the ceded quota share premiums earned. See "Item 7.-Critical Accounting
Policies-Ceding commissions earned". Under our excess of loss treaty
reinsurance, we cede all or a portion of the liability in excess of a
predetermined deductible or retention. We also purchase catastrophe treaty
reinsurance on an excess of loss basis to protect ourselves from an accumulation
of net loss exposures from a catastrophic event or series of events such as
terrorist acts, riots, windstorms, hailstorms, tornadoes, hurricanes,
earthquakes, blizzards and freezing temperatures. We do not receive any
commission for ceding business under excess of loss or catastrophe reinsurance
agreements.
16
The type, cost and limits of reinsurance we purchase can vary from year to
year based upon our desired retention levels and the availability of quality
reinsurance at an acceptable price. Our quota share contracts and excess of loss
reinsurance programs were renewed on January 1, 2005. Our catastrophe treaty
reinsurance was extended for two months through August 31, 2004 and renewed on
September 1, 2004 through June 30, 2005.
In recent years, the reinsurance industry has undergone very dramatic
changes. Soft market conditions created by years of inadequate pricing brought
poor results, which were exacerbated by the events of September 11, 2001. As a
result, market capacity was reduced significantly. Reinsurers exited lines of
business, significantly raised rates and imposed much tighter terms and
conditions where coverage was offered, to limit or reduce their exposure to
loss.
In an effort to maintain quota share capacity for our business with
favorable commission levels, we have been accepting loss ratio caps in our
reinsurance treaties. Loss ratio caps cut off the reinsurer's liability for
losses above a specified loss ratio. These provisions have been structured to
provide reinsurers with some limit on the amount of potential loss being
assumed, while maintaining the transfer of significant insurance risk with the
possibility of a significant loss to the reinsurer. We believe our reinsurance
arrangements qualify for reinsurance accounting in accordance with SFAS 113,
Accounting for Reinsurance Contracts. The loss ratio caps for our quota share
treaties are 95.0% for 2005, and were 95.0% in 2004, 92.0% in 2003, 97.5% in
2002 and 100.0% in 2001.
Recently, regulators and other governmental authorities have been
investigating certain types of insurance and reinsurance arrangements that they
allege are intended only to smooth an insured company or ceding insurer's
earnings rather than to transfer insurance risk. As noted above, we believe our
quota share reinsurance meets all requirements pertaining to risk transfer.
However, these investigations, the related legal actions and the accompanying
increased scrutiny of "non-traditional" reinsurance arrangements may lead to a
change in the applicable accounting standards or a reduction in the availability
of some types of reinsurance. In turn, these developments could produce higher
prices for reinsurance, an increase in the amount of risk we retain, reduced
ceding commission revenue, or other potentially adverse developments. In that
event, we may be required to restructure or reduce our use of quota share
reinsurance or reduce our premium writings. See "Item 1.-Regulation-Industry
Investigations".
Regardless of type, reinsurance does not legally discharge the ceding
insurer from primary liability for the full amount due under the reinsured
policies. However, the assuming reinsurer is obligated to indemnify the ceding
company to the extent of the coverage ceded. To protect our company from the
possibility of a reinsurer becoming unable to fulfill its obligations under the
reinsurance contracts, we attempt to select financially strong reinsurers with
an A.M. Best rating of "A-" (Excellent) or better and continue to evaluate their
financial condition and monitor various credit risks to minimize our exposure to
losses from reinsurer insolvencies.
To further minimize our exposure to reinsurance recoverables, effective
October 1, 2003, we have placed our quota share reinsurance treaty on a "funds
withheld" basis under which ceded premiums written are deposited in segregated
trust funds from which we receive payments for losses and ceding commission
adjustments. We also used the proceeds from the IPO and the concurrent private
placement to increase the capitalization of our insurance subsidiary. As a
result of this increase in capital, our insurance subsidiary has been able to
retain more of the risk on the business it writes, thereby reducing our need for
quota share reinsurance.
17
The following table summarizes our reinsurance exposures by reinsurer as of
December 31, 2004.
AMOUNTS
IN
TRUST
FUNDS HELD, ACCOUNTS
CEDED OR
RECOVERABLE ON PREPAID AND PAYABLE AND SECURED NET
A.M. ------------------- RETURN DEFERRED BY EXPOSURE
BEST PAID REINSURANCE COMMISSIONS CEDING LETTERS TO
REINSURER RATING LOSSES RESERVES PREMIUM RECEIVABLE COMMISSIONS OF CREDIT REINSURER
- ----------------------------------- ------ ------ -------- ----------- ----------- ----------- --------- ---------
($ in thousands)
PXRE Reinsurance Company A $3,804 $33,852 $ -- $ 8,329 $ (804) $ -- $ 46,789
American Re-Insurance Company(1) A 1,175 13,301 1,376 -- 278 -- 15,574
Platinum Underwriters Reinsurance,
Inc. A -- 659 250 -- 33 -- 876
SCOR Reinsurance Company B++ 9 1,322 -- -- -- -- 1,331
Lloyd's of London A -- -- -- -- (125) -- 125
Folksamerica Reinsurance Company A -- -- -- -- (41) -- 41
Odyssey America Reinsurance
Corporation A -- -- -- -- (34) -- 34
Erie Insurance Exchange A+ -- -- -- -- -- -- --
American Agricultural Insurance
Company A -- -- -- -- (14) -- 14
Endurance Specialty Insurance, Ltd. A 33 686 77 -- -- 796 --
Tokio Millenium Re Ltd. A++ 3,317 31,278 13,093 -- 44,520 3,168 --
Hannover Reinsurance (Ireland) Ltd. A 850 7,750 10,474 -- 17,814 1,260 --
E+S Reinsurance (Ireland) Ltd. A 212 1,937 2,619 -- 4,454 314 --
Hannover Rueckversicherungs AG A -- 988 502 -- 42 -- 1,448
------ ------- ------- ------- ------- ------ --------
Total $9,400 $91,773 $28,391 $ 8,329 $66,123 $5,538 $ 66,232
====== ======= ======= ======= ======= ====== ========
(1) Downgraded to "A" (Excellent) in January 2005.
2005 REINSURANCE PROGRAM
Quota Share Reinsurance. Effective January 1, 2005, TICNY entered into a
quota share treaty to reinsure against losses up to $1.0 million per occurrence
on the gross premiums written in the insurance segment. Under the terms of the
treaty, TICNY cedes 25% of its net premiums written and retains the remaining
75%. The provisional ceding commission under this treaty is 39.1% of ceded net
premiums written. Of the premium ceded, Tokio Millennium Re Ltd. ("Tokio
Millennium"), rated "A++" (Superior) by A.M. Best, reinsures 50%, Hannover
Reinsurance (Ireland) Ltd., rated "A" (Excellent) by A.M. Best, reinsures 40%
and E+S Reinsurance (Ireland) Ltd. (collectively "Hannover"), rated "A"
(Excellent) by A.M. Best, reinsures the remaining 10%. The 2005 quota share
treaty contains various exclusions and provides coverage for 100% of
extra-contractual obligations and losses in excess of policy limits. To reduce
TICNY's credit exposure to reinsurance, the quota share reinsurance has been
placed on a "funds withheld" basis. Under the terms of the reinsurance treaty,
TICNY guarantees to credit the reinsurers with a 3% annual effective yield on
the monthly balance of this account.
Effective January 1, 2005, TICNY entered into a quota share treaty to
reinsure against umbrella losses up to $5.0 million per occurrence. Under the
terms of the treaty TICNY cedes 95% of its premiums written and retains the
remaining 5%. The provisional ceding commission under this treaty is 30% of
ceded premium written. Of the premium ceded, Platinum Underwriters Reinsurance,
Inc., rated "A" (Excellent) by A.M. Best, reinsures 50% and Hannover
Ruckversicherungs AG, rated "A" (Excellent) by A.M. Best, reinsures 50%.
Excess of Loss Reinsurance. Effective January 1, 2005 we entered into an
excess of loss reinsurance treaty program with the same terms as the 2004 Excess
of Loss Reinsurance Treaty. The 2005 excess of loss reinsurance treaties were
placed with American Re-Insurance Company ("Am Re"), rated "A" (Excellent) by
A.M. Best, Platinum Underwriters Reinsurance, Inc., rated "A" (Excellent) by
A.M. Best, Endurance Specialty Insurance, Ltd., rated "A" (Excellent) by A.M.
Best, syndicates from Lloyd's of London, rated "A" (Excellent) by A.M. Best, and
Hannover Ruckversicherungs AG, rated "A" (Excellent) by A.M. Best.
Catastrophe Reinsurance. The 2004 Property Catastrophe Program provides
coverage for events occurring through June 30, 2005 and is expected to be
renewed on July 1, 2005 with a similar structure to the expiring program.
Terrorism Reinsurance. Pursuant to the Terrorism Risk Insurance Act of 2002
("The Terrorism Act"), TICNY must offer insureds the option to purchase coverage
for certified acts of terrorism for an additional premium or decline such
coverage. When the coverage is not purchased, we endorse the policy to exclude
coverage for certified acts of terrorism, but losses from an act of terrorism
that is not a certified event may be covered in any case. Also, even for
certified acts of terrorism, losses from fire following the act of terrorism are
covered.
18
The Terrorism Act reimburses up to 90% of the losses to commercial insurers
due to certified acts of terrorism in excess of a deductible. Our deductible in
2004 was 10% of our 2003 direct earned premium on commercial lines. Our
deductible in 2005 is 15% of our 2004 direct earned premiums on commercial
lines. Our quota share reinsurance treaty specifically provides terrorism
coverage. The amount of coverage is limited to 10% of the ceded earned premiums
for the applicable treaty year. Excess of loss reinsurance treaties for
multiple-line and workers' compensation contain various sublimits for terrorism
coverage.
The Federal assistance under the Terrorism Act is scheduled to expire at
the end of 2005 unless Congress extends it. Legislation has been introduced to
extend the Terrorism Act but we cannot predict whether or when any such
extension may be enacted and what the final terms of such legislation would be.
In the event that the Federal assistance under the Terrorism Act is not extended
or is altered (e.g., by increasing the deductible or reducing the amount of loss
that is reimbursed), our potential losses from a terrorist attack could be
substantially larger than previously expected. Policies we write in 2005 will
cover periods after the scheduled expiration of the Terrorism Act, and we are
taking the uncertainty regarding renewal of The Terrorism Act into account in
our pricing. Potential future changes to the Terrorism Act could also adversely
affect our ability to obtain reinsurance on favorable terms, including pricing,
and may affect our underwriting strategy, rating, and other elements of our
operation. See "Item 1.-Risks Related to Our Business-We may face substantial
exposure to losses from terrorism, we are currently required by law to provide
coverage against such losses, and the Terrorism Risk Insurance Act of 2002 may
expire on December 31, 2005".
In addition, in the event that the Terrorism Act is not extended, while we
would no longer be required to offer the insured the ability to purchase
coverage for Certified Acts of Terrorism the New York State Insurance Department
has not approved a terrorism exclusion so it is possible that we would not be
permitted to exclude losses resulting from terrorist acts in New York State for
accounts under $100,000 premium size.
2004 REINSURANCE PROGRAM
Quota Share Reinsurance. Effective January 1, 2004, TICNY entered into a
quota share treaty to reinsure against losses up to $1.0 million per occurrence
on the gross premiums written in the insurance segment. Under the terms of the
treaty, TICNY ceded 60% of its net premiums written and retained the remaining
40%. In accordance with treaty terms, TICNY elected to reduce the quota share
cession from 60% to 25% on October 1, 2004. The provisional ceding commission
under this treaty was 39.1% of ceded net premiums written. Of the premium ceded,
Tokio Millennium, rated "A++" (Superior), reinsured 33 1/3%; Converium
Reinsurance (North America) Inc. ("Converium), rated "A-" (Excellent) by A.M.
Best, reinsured 33 1/3%; Hannover Reinsurance (Ireland) Ltd., rated "A"
(Excellent) by A.M. Best, reinsured 26 2/3% and E+S Reinsurance (Ireland) Ltd.,
rated "A" (Excellent), reinsured the remaining 6 2/3%. The 2004 quota share
treaty contained various exclusions and provided coverage for 100% of
extra-contractual obligations and losses in excess of policy limits. To reduce
TICNY's credit exposure to reinsurance, the quota share reinsurance was placed
on a "funds withheld" basis. Under the terms of the reinsurance treaty, TICNY
guaranteed to credit the reinsurers with a 2.5% annual effective yield on the
monthly balance of this account.
In September 2004, A.M. Best downgraded the rating of Converium to "B-"
(Fair) and Converium was placed into run-off by its parent company. As a result,
on September 2, 2004, we delivered notice to Converium under our quota share
treaty of our intent to terminate their participation under the quota share
treaty on a cut-off basis effective November 1, 2004 (subsequently extended to
December 31, 2004). Subsequently we reached an agreement with Converium, Tokio
Millenium and Hannover to effect a novation of Converium's quota share treaty to
those other reinsurers effective January 1, 2004, as a result of which Tokio and
Hannover agreed to each take 50% of Converium's share under the quota share
treaty. In connection with the agreement, Tokio, Hannover and TICNY agreed to
fully release Converium for any liabilities under the quota share treaty. In
addition, we decided to retain the unearned premiums and risks as of December
31, 2004 that would have been ceded to Converium absent the novation.
Effective October 1, 2004, TICNY entered into a quota share treaty to
reinsure against equipment breakdown losses up to $35 million per occurrence.
Under the terms of the treaty, TICNY cedes 100% of its premium written to The
Hartford Steam Boiler Inspection and Insurance Company, rated "A++" (Superior)
by A.M. Best. The flat ceding commission under this treaty is 30%. A nominal
amount of premium was ceded to this treaty in 2004. The treaty is placed on a
continuous basis, therefore the above terms will be in effect during 2005.
19
Excess of Loss Reinsurance. Effective January 1, 2004 we entered into an
excess of loss reinsurance treaty program whereby our reinsurers were liable for
100% of the ultimate net losses in excess of $1 million for all lines of
business we write, up to $10 million of limit. The program provided coverage in
several layers. The first layer, which applied to multiple lines of business,
afforded coverage for property business up to $1 million in excess of $1 million
for each risk, with a per occurrence limit of $3 million, and for casualty
business and for workers' compensation losses, up to $1 million in excess of $1
million per occurrence. The excess of loss program then bifurcated into separate
workers' compensation and property layers. The workers' compensation layers
afforded coverage for workers' compensation business up to $3 million in excess
of $2 million for each occurrence, and for up to $5 million in excess of $5
million for each occurrence, with a maximum of $5 million for any one life. The
property layers afforded coverage for property business up to $3 million in
excess of $2 million for each risk, subject to a per occurrence limit of $6
million, and for up to $5 million in excess of $5 million for each risk, with a
maximum of $5 million for each occurrence. The excess of loss treaties contained
various sub-limits or exclusions for specific lines of business, provided
coverage for 90% of extra-contractual obligations and losses in excess of policy
limits, and allowed TICNY to recover allocated loss adjustment expenses on a pro
rata basis in proportion to net loss. The 2004 excess of loss reinsurance
treaties were placed with Am Re, rated "A" (Excellent) by A.M. Best, Platinum
Underwriters Reinsurance, Inc., rated "A" (Excellent) by A.M. Best, Endurance
Specialty Insurance, Ltd., rated "A" (Excellent) by A.M. Best, syndicates from
Lloyd's of London, rated "A" (Excellent) by A.M. Best, Hannover
Ruckversicherungs AG, rated "A" (Excellent) by A.M. Best, and Aspen Insurance UK
Limited, rated "A" (Excellent) by A.M. Best.
Catastrophe Reinsurance. Effective July 1, 2004, the 2003 Property
Catastrophe Program described below was extended until August 31, 2004 and
provided coverage in four layers on a per occurrence basis for losses up to $55
million, less our net retention of the first $5 million of losses. Effective
September 1, 2004, we entered into a property catastrophe reinsurance program
that provides coverage in five layers for losses up to $75 million, less our
retention of the first $15 million of losses through June 30, 2005. The program
covers aggregations of net exposures on our in force, new, renewal and assumed
personal and commercial property as well as auto physical damage and inland
marine business, subject to certain exclusions, including mold claims,
terrorists events and nuclear, chemical and biochemical attacks. In the event of
a catastrophic event that results in a loss under this program, we must
reinstate the amount of cover exhausted by the loss on a one-time basis by
paying an additional premium to the reinsurers. Each year we select the amount
of catastrophic reinsurance that we believe will be necessary to protect our
company against catastrophic events. We believe the amount of catastrophic
coverage is sufficient to cover our probable maximum loss from a once in a one
hundred year catastrophic event. Our catastrophic reinsurers include American
Agricultural Insurance Company, rated "A" (Excellent) by A.M. Best, Folksamerica
Reinsurance Company, rated "A" (Excellent) by A.M. Best, Odyssey America
Reinsurance Corporation, rated "A" (Excellent) by A.M. Best, PXRE Reinsurance
Company, rated "A" (Excellent) by A.M. Best, and syndicates from Lloyd's of
London, rated "A" (Excellent) by A.M. Best.
2003 REINSURANCE PROGRAM
Quota Share Reinsurance. In 2003, TICNY entered into two quota share
treaties to reinsure against losses and loss adjustment expenses up to $500,000
per occurrence incurred on the gross premiums written in the insurance segment.
The treaties contain provisions that reduce the obligations of the reinsurers at
certain loss ratios. Effective January 1, 2003, TICNY ceded 70.0% of the risks
it underwrote to PXRE Reinsurance Company ("PXRE New Jersey") and PMA
Reinsurance Company ("PMA"), with PXRE New Jersey reinsuring 75% and PMA 25% of
such cession.
In connection with the quota share treaty with PXRE New Jersey, we also
entered into an aggregate excess of loss reinsurance agreement with an affiliate
of PXRE New Jersey, PXRE Reinsurance (Barbados) Ltd. ("PXRE Barbados"), and
remitted $10,000,000 as deposit premium to PXRE Barbados as called for by the
contract. This aggregate excess of loss agreement covered 52.5% of the layer,
consisting of 18.48% of "ultimate net loss" (as defined in the contract) in
excess of 69.02% of ultimate net loss, and it inured solely to the benefit of
PXRE New Jersey (in that premiums and losses we paid to or received from PXRE
Barbados were deducted from premiums and losses we would have paid to or
received from PXRE New Jersey) in connection with its participation in the 2003
quota share agreement with TICNY.
20
After we entered into the quota share treaty, PMA's rating was lowered by
A.M. Best from "A" (Excellent) to "A-" (Excellent) and then to "B++" (Very
Good). Effective October 1, 2003, we commuted PMA's participation under the
reinsurance treaty. The effect of this commutation was to conclude PMA's
participation in the quota share treaty and to discharge PMA from future related
liabilities effective October 1, 2003. Loss related amounts recoverable from PMA
at the commutation date including ceded loss and loss adjustment expense reserve
liabilities of $2.7 million and ceded paid losses of $0.4 million that had not
yet been recovered from PMA were settled with a payment received from PMA of
$3.1 million. We also received $2.5 million for ceded unearned premium at the
commutation date resulting in a total cash settlement of $5.6 million. In
addition to commuting the treaty with PMA, we cancelled PXRE New Jersey's
participation under the quota share treaty on a cut-off basis effective October
1, 2003, to reduce the credit risk associated with having a significant amount
of reinsurance recoverables with PXRE New Jersey. As a result, PXRE New Jersey
is not obligated to indemnify us for losses occurring after September 30, 2003.
Effective October 1, 2003, we also commuted the aggregate excess of loss
reinsurance treaty with PXRE Barbados. As a result of the commutation of the
aggregate excess of loss treaty agreement, we recorded $1.5 million in ceding
commission income.
As a result of the commutation with PMA, we assumed exposure to a total of
$3.2 million in losses on earned premium that had previously been ceded to PMA.
In addition, TICNY's net exposure to any individual or catastrophe losses
incurred up to the $500,000 quota share limit increased from 30% prior to the
commutation to 47.5% on any business written during the period from January 1,
2003 to September 30, 2003 and premiums earned during this period. This
commutation also increased our leverage ratios, including net premiums written
to surplus, which potentially could have affected TICNY's rating with various
rating agencies. To replace PMA and PXRE New Jersey as quota share reinsurers
and to mitigate our net exposure, we entered into a new quota share treaty with
Tokio Millennium, which is rated "A++" (Superior) by A.M. Best. In the new quota
share treaty (the "October 1, 2003 Treaty"), we ceded 80% of the in force
business (premium unearned by TICNY on business written in the first nine months
of 2003 - i.e., Tokio Millennium is obligated to indemnify us for 80% of losses
occurring after September 30, 2003 with respect to the in force business ceded
to them), and 80% of the new and renewal business written by TICNY during
October, November and December of 2003, up to a maximum net premiums written of
$92.25 million, to Tokio Millennium, which will indemnify us for losses
occurring on or after October 1, 2003. If the net premiums written exceed $92.25
million, then the pro rata cession is subject to adjustment according to the
terms of the October 1, 2003 Treaty. The change in the reinsurance treaty
limited TICNY's net exposure to individual and catastrophe losses to 20% of
individual and catastrophe losses up to the $500,000 quota share limit in
respect of premiums earned after September 30, 2003 for business written during
the period January 1, 2003 to September 30, 2003 and all business written during
the period October 1, 2003 to December 31, 2003. This change in the reinsurance
treaty also reduced TICNY's financial ratios, including net premiums written to
surplus. Under our agreements with PXRE New Jersey and PMA, we earned a
provisional ceding commission of 34.2% of ceded premiums written in 2003. This
provisional ceding commission could increase or decrease depending upon a
sliding scale formula that links the commission rate with the loss ratio
incurred on the ceded premium. Under the October 1, 2003 Treaty with Tokio
Millennium, we earned a provisional ceding commission of 38.5% of ceded premiums
written, subject to the same sliding scale adjustments. The quota share treaty
with Tokio Millennium was placed on a "funds withheld" basis. Tokio Millennium
posted a letter of credit at December 31, 2003 and replaced it with a Regulation
114 trust during the first quarter of 2004. Under the terms of the reinsurance
treaty, TICNY guarantees to credit the reinsurers with a 2.5% annual effective
yield on the monthly balance of this account. TICNY's 2003 quota share treaties
contain various exclusions and provide coverage for 100% of extra-contractual
obligations and losses in excess of policy limits.
Excess of Loss Reinsurance. In 2003, we entered into an excess of loss
reinsurance treaty program that provides coverage in six layers by line of
business for losses up to $10 million net of our $712,500 net retention. The
program indemnifies us on a "per risk" basis, on property business and on a "per
occurrence" basis on casualty and workers' compensation. The first layer, which
applies to multiple lines of business, affords coverage up to $500,000 in
losses, and our retention, before the effect of the quota share reinsurance,
consists of 100% of the first $500,000 of losses and 42.5% of the next $500,000
of losses. The second layer, which applies to multiple lines of business,
affords coverage for the next $1 million in property losses on a per risk basis
and $1 million in casualty clash and workers' compensation losses on a per
occurrence basis. The excess of loss program then bifurcates into separate
property and workers' compensation layers that afford coverage at $3 million in
losses excess $2 million, and $5 million in losses excess $5 million. The excess
of loss treaties contain various sub-limits or exclusions for specific lines of
business, provide coverage for 90% of extra-contractual obligations and losses
in excess of policy limits, and allow TICNY to recover allocated loss adjustment
expenses on a pro rata basis in proportion to net loss. The 2003 excess of loss
reinsurance treaties were placed with Am Re, rated "A" (Excellent) by A.M. Best,
Endurance Specialty Insurance, Ltd., rated "A" (Excellent) by A.M. Best,
syndicates from Lloyd's of London, rated "A" (Excellent) by A.M. Best, SCOR
Reinsurance Company, rated "B++" (Very Good) by A.M. Best, and Aspen Insurance
UK Ltd., rated "A" (Excellent) by A.M. Best (formerly known as Wellington
Reinsurance Limited, U.K.).
21
Catastrophe Reinsurance. Effective July 1, 2003, we entered into a property
catastrophe reinsurance program that provides coverage in four layers on a per
occurrence excess of loss basis for losses up to $35 million, less our $3.5
million net retention. Our retention consists of 100% of the first $2.5 million
of losses and 40% of the next $2.5 million of losses. The contract covers
aggregations of net exposures on our in force, new, renewal and assumed personal
and commercial property as well as auto physical damage and inland marine
business, subject to certain exclusions, including mold claims, terrorists
events and nuclear, chemical and biochemical attacks. In the event of a
catastrophic event that results in a loss under this program, we must reinstate
the amount of cover exhausted by the loss on a one-time basis by paying an
additional premium to the reinsurers. Each year we select the amount of
catastrophe reinsurance that we believe will be necessary to protect our company
against catastrophic events. Based on this consultant's analysis, we believe the
amount of catastrophe coverage we purchased for 2003 is sufficient to cover our
probable maximum loss from a once in a one hundred year catastrophic event. Our
catastrophe reinsurers for 2003 included American Agricultural Insurance
Company, rated "A" (Excellent) by A.M. Best, Erie Insurance Exchange, rated "A+"
(Superior) by A.M. Best, Folksamerica Reinsurance Company, rated "A" (Excellent)
by A.M. Best, Odyssey America Reinsurance Corporation, rated "A" (Excellent) by
A.M. Best, PXRE Reinsurance Company, rated "A" (Excellent) by A.M. Best, and
syndicates from Lloyd's of London, rated "A" (Excellent) by A.M. Best.
INVESTMENTS
We derive investment income from our invested assets. We invest TICNY's
statutory surplus and funds to support its loss and loss adjustment expense
reserves and its unearned premium reserves. Due to historically limited amounts
of statutory surplus and net retention by TICNY, our net investment income has
not been significant. Our investment income, however, has increased beginning in
2002 as TICNY's invested assets increased due to TICNY's increased net premiums
written and surplus as well as from its $98.0 million of new investments as a
direct result of a capital contribution of a portion of the IPO proceeds. Our
net investment income was $5.1 million in 2004, compared to $2.3 million in
2003.
Our primary investment objectives are to preserve capital and maximize
after-tax investment income. Our strategy is to purchase debt securities in
sectors that represent the most attractive relative value and to maintain a
moderate equity exposure. As of December 31, 2004, the fixed maturity securities
represented approximately 98% of the fair market value of our investment
portfolio, equity securities represented approximately 1% and common trust
securities - statutory business trusts represented approximately 1%.
Historically, we have emphasized liquidity to meet our claims obligations and
debt service and to support our obligation to remit ceded premium (less ceding
commission and claims payments) to our quota share reinsurers on a quarterly
basis. Accordingly we have traditionally maintained between 8% and 10% of our
portfolio in cash and cash equivalents. As of December 31, 2004, cash and cash
equivalents represented approximately 19.0% of the total of fair market value of
our investment portfolio and cash and cash equivalents. The higher percentage
over what we traditionally maintain was due to the net proceeds from the
issuance of $26.8 million of subordinated debentures underlying trust preferred
securities in December 2004.
Our investments are managed by an outside asset management company,
Hyperion Capital Management, Inc., a New York based investment management firm.
Hyperion has authority and discretion to buy and sell securities for us, subject
to guidelines established by our Board of Directors. We may terminate our
agreement with Hyperion upon 30 days notice. Our investment policy is
conservative, as approximately 93.5% of the fixed income portion of our
investment portfolio is rated A or higher as of December 31, 2004 and up to 10%
of the investment portfolio may be invested in equities. The maximum allocation
to equities, which includes market appreciation, is 20% of the investment
portfolio. We monitor our investment results on a monthly basis to review the
performance of our investments, determine whether any investments have been
impaired and monitor market conditions for investments that would warrant any
revision to our investment guidelines. Hyperion also provides us with a
comprehensive quarterly report providing detailed information on our investment
results as well as prevailing market conditions. Our investment results are also
reviewed quarterly by the Board of Directors.
22
See "Item 7.-Investments" for further information on the composition and
results of our investment portfolio.
The following table shows the market values of various categories of
invested assets, the percentage of the total market value of our invested assets
represented by each category and the book yield based on market value of each
type as of the dates and for the periods indicated:
AS OF AND FOR THE YEAR ENDED DECEMBER 31,
2004 2003
----------------------------------- ----------------------------------
MARKET PERCENT MARKET PERCENT
VALUE OF TOTAL YIELD VALUE OF TOTAL YIELD
----------- ---------- -------- ---------- ----------- --------
CATEGORY ($ in thousands)
- --------
U.S. Treasury Securities $ 1,784 0.8% 4.05% $ 1,783 3.1% 3.75%
U.S. agency securities 19,636 8.6% 4.22% 5,738 10.0% 5.38%
Corporate fixed maturity securities 49,381 21.6% 4.60% 14,415 25.1% 5.71%
Mortgage-backed securities 64,159 28.1% 4.52% 19,756 34.4% 6.03%
Asset-backed securities 12,473 5.5% 4.92% 2,242 3.9% 5.56%
Other taxable fixed maturity securities 243 0.1% 4.96% 236 0.4% 4.96%
Municipal securities 76,847 33.6% 3.64% 10,375 18.1% 4.10%
Common stocks 2,368 1.0% 2,017 3.5%
Preferred stocks 117 0.1% 7.27% 167 0.3% 9.23%
Common trust securities - statutory
business trusts 1,426 0.6% 620 1.1%
The principal change in allocations in 2004 and 2003 was an increase in the
allocation to municipal bonds. The tax-equivalent yield on these securities was
more attractive than the yield on taxable securities and the allocation added
diversification to our portfolio. We also increased our allocation to
mortgage-backed securities due to favorable yield and fundamental credit quality
and reduced our allocation to corporate securities due to much tighter yield
spreads and less favorable total return opportunities.
During 2004, the most significant portfolio activity came during the fourth
quarter with the investment of the IPO proceeds of $98.0 million. In order to
increase the portfolio's overall tax-exempt allocation, approximately 60% of the
proceeds were invested into tax-exempt securities. Due to the steeper yield
curve in the tax-exempt market compared to the taxable market, the tax-exempt
purchases were focused in longer duration securities averaging approximately six
years. To offset these longer duration securities, the taxable bond purchases
were concentrated in short durations averaging two to three years.
In addition, during the fourth quarter of 2004, the effective duration of
the portfolio decreased to 4.17 years compared to 4.41 years as of September 30,
2004. The lower duration was primarily due to the significant cash increase from
the net proceeds from the issuance of $26.8 million of subordinated debentures
underlying trust preferred securities in December 2004. Therefore, the portfolio
duration is currently shorter than the Benchmark duration of 4.30 years as of
December 31, 2004. The total return on our fixed income and short-term duration
invested assets during 2004 was 4.9% on a pre-tax basis.
During 2003, our portfolio benefited from the increase in the weighted
average duration to approximately 5.1 years effected in late 2002. With interest
rates declining significantly during the first half of 2003, the longer duration
increased our total returns. During the first half of 2003, we reduced the
weighted average duration to approximately 4.4 years at June 30, 2003. This
change helped to protect the portfolio and reduced the impact of the sharp rise
in rates during the second half of the year. The total return on our fixed
income and short-term invested assets during 2003 was 6.5% on a pre-tax basis.
The following table shows the composition of our investment portfolio by
remaining time to maturity at December 31, 2004 and December 31, 2003. 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. For mortgage-backed
securities, mortgage prepayment assumptions are utilized to project the expected
principal redemptions for each security, and the maturity used in the table
below is the average life based on those projected redemptions.
23
AS OF DECEMBER 31, AS OF DECEMBER 31,
2004 2003
------------------------------------- -------------------------------------
PERCENTAGE OF PERCENTAGE OF
REMAINING TIME TO MATURITY FAIR MARKET VALUE FAIR MARKET VALUE FAIR MARKET VALUE FAIR MARKET VALUE
- -------------------------- ----------------- ----------------- ----------------- -----------------
($ in thousands)
Less than one year $ 8,243 3.7% $ 1,931 3.5%
One to five years 54,924 24.5% 6,866 12.6%
Five to ten years 92,094 41.0% 9,356 17.2%
More than ten years 5,103 2.3% 14,394 26.4%
Mortgage-backed securities 64,159 28.5% 21,998 40.3%
-------- ----- -------- ---
TOTAL $224,523 100.0% $ 54,545 100%
======== ===== ======== ===
The average credit rating of our fixed maturity portfolio, using ratings
assigned to securities by Standard and Poor's, was AA+ at December 31, 2004 and
AA+ at December 31, 2003. The following table shows the ratings distribution of
our fixed income portfolio as of the end of each of the past two years.
AS OF DECEMBER 31, AS OF DECEMBER 31,
2004 2003
--------------------------------------- --------------------------------
PERCENTAGE OF FAIR FAIR MARKET PERCENTAGE OF
RATING FAIR MARKET VALUE MARKET VALUE VALUE FAIR MARKET VALUE
- ------------------------ ----------------- ------------------ ----------- -----------------
($ in thousands)
U.S. Treasury securities $ 1,784 0.8% $ 1,783 3.3%
AAA 140,460 62.6% 31,421 57.6%
AA 31,641 14.1% 6,143 11.3%
A 35,850 16.0% 7,755 14.2%
BBB 13,979 6.2% 4,581 8.4%
Below BBB 809 0.3% 2,862 5.2%
-------- ----- -------- -----
TOTAL $224,523 100.0% $ 54,545 100.0%
======== ===== ======== =====
We regularly review our portfolio for declines in value. If a decline in
value is deemed temporary, we record the decline as an unrealized loss in other
comprehensive net income on our consolidated statement of income and accumulated
other comprehensive net income on our consolidated balance sheet. If the decline
is deemed "other than temporary," we write down the carrying value of the
investment and record a realized loss in our consolidated statements of income.
As of December 31, 2004 and December 31, 2003, we had cumulative unrealized
gains/(losses) on our fixed maturity portfolio of $1.0 million and $1.3 million,
respectively. There were no other than temporary declines in the fair value of
our securities at December 31, 2004 and 2003.
LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
We maintain reserves for the payment of claims (incurred losses) and
expenses related to adjusting those claims (loss adjustment expenses or LAE).
Our loss reserves consist of case reserves, which are reserves for reported
claims, and reserves for claims that have been incurred but have not yet been
reported (sometimes referred to as IBNR). The amount of loss reserves for
reported claims is based primarily upon a claim-by-claim evaluation of coverage,
liability, injury severity or scope of property damage, and any other
information considered pertinent to estimating the exposure presented by the
claim. The amounts of loss reserves for unreported claims and loss adjustment
expense reserves are determined using historical information by line of business
as adjusted to current conditions. Reserves for LAE are intended to cover the
ultimate cost of settling claims, including investigation and defense of
lawsuits resulting from such claims. The amount of loss and LAE reserves is
determined by us on the basis of industry information, the development to date
of losses on the relevant line of business and anticipated future conditions.
Because loss reserves are an estimate of the ultimate cost of settling claims,
they are closely monitored by us and recomputed at least quarterly based on
updated information on reported claims and a variety of statistical techniques.
Furthermore, an independent actuary prepares a report each year concerning the
adequacy of the loss reserves.
24
RECONCILIATION OF LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
The table below shows the reconciliation of reserves on a gross and net
basis for each of the last three calendar years, reflecting changes in losses
incurred and paid losses.
2004 2003 2002
--------- ---------- ----------
($ in thousands)
Balance at January 1, $ 99,475 $ 65,688 $ 37,637
Less reinsurance recoverables (75,114) (50,212) (29,017)
--------- --------- ---------
24,361 15,476 8,620
Incurred related to:
Current year 27,259 14,996 13,416
Prior years (199) 75 2,940
--------- --------- ---------
TOTAL INCURRED 27,060 15,071 16,356
--------- --------- ---------
Paid related to:
Current year 6,991 2,084 6,585
Prior years 7,481 4,102 2,915
--------- --------- ---------
TOTAL PAID 14,472 6,186 9,500
--------- --------- ---------
Net balance at December 31, 36,949 24,361 15,476
Add reinsurance recoverables 91,773 75,114 50,212
--------- --------- ---------
BALANCE AT DECEMBER 31, $ 128,722 $ 99,475 $ 65,688
========= ========= =========
Our claims reserving practices are designed to set reserves that in the
aggregate are adequate to pay all claims at their ultimate settlement value.
Thus, our reserves are not discounted for inflation or other factors.
LOSS DEVELOPMENT
Shown below is the loss development for business written each year from
1994 through 2004. The table portrays the changes in our loss and LAE reserves
in subsequent years from the prior loss estimates based on experience as of the
end of each succeeding year on the basis of GAAP.
The first line of the table shows, for the years indicated, our net reserve
liability including the reserve for incurred but not reported losses as
originally estimated. For example, as of December 31, 1995 we estimated that
$2.239 million would be a sufficient reserve to settle all claims not already
settled that had occurred prior to December 31, 1995, whether reported or
unreported to us. The next section of the table shows, by year, the cumulative
amounts of losses and loss adjustment expenses paid as of the end of each
succeeding year. For example, with respect to the net losses and loss expense
reserve of $2.239 million as of December 31, 1995, by the end of 2004 (nine
years later) $3.266 million had actually been paid in settlement of the claims.
The next section of the table sets forth the re-estimates in later years of
incurred losses, including payments, for the years indicated. For example, as
reflected in that section of the table, the original reserve of $2.239 million
was re-estimated to be $3.453 million at December 31, 2004. The increase from
the original estimate is caused by a combination of factors, including: (1)
reserves being settled for amounts different than originally estimated, (2)
reserves being increased or decreased for claims remaining open as more
information becomes known about those individual claims and (3) more or fewer
claims being reported after December 31, 1995 than had occurred prior to that
date.
The "cumulative redundancy/ (deficiency)" represents, as of December 31,
2004, the difference between the latest re-estimated liability and the reserves
as originally estimated. A redundancy means the original estimate was higher
than the current estimate; a deficiency means that the current estimate is
higher than the original estimate. For example, as of December 31, 2004 and
based upon updated information we re-estimated that the reserves which were
established as of December 31, 2003 were $199,000 redundant.
25
The bottom part of the table shows the impact of reinsurance reconciling
the net reserves shown in the upper portion of the table to gross reserves.
ANALYSIS OF LOSS AND LOSS ADJUSTMENT RESERVE DEVELOPMENT
YEAR ENDED DECEMBER 31,
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
----------------------------------------------------------------------------------------------------
($ in thousands)
Original Net Liability $1,394 $ 2,239 $ 3,361 $ 5,005 $ 6,184 $ 6,810 $ 7,901 $ 8,620 $15,476 $24,361 $ 36,949
Cumulative payments as of:
One year later 580 321 1,035 1,428 2,377 2,560 3,376 2,879 4,103 7,467
Two years later 775 831 1,849 2,827 3,890 4,767 5,439 4,906 6,707
Three years later 1,039 1,386 2,747 4,045 5,439 6,153 6,953 6,376
Four years later 1,516 1,928 3,397 5,191 6,340 6,896 7,896
Five years later 1,791 2,332 4,083 5,895 6,714 7,249
Six years later 2,018 2,723 4,454 6,220 6,935
Seven years later 2,281 2,970 4,691 6,413
Eight years later 2,455 3,132 4,847
Nine years later 2,515 3,266
Ten years later 2,618
Net liability re-estimated
as of:
One year later 1,783 2,020 4,154 5,954 6,842 7,493 9,702 11,521 15,551 24,162
Two years later 1,279 2,506 4,574 6,262 7,123 8,652 11,684 11,276 14,665
Three years later 1,811 2,839 4,457 6,428 7,871 9,516 11,458 10,494
Four years later 2,216 2,841 4,544 6,945 8,244 9,210 10,819
Five years later 2,225 2,926 4,992 7,169 7,963 8,955
Six years later 2,315 3,250 5,093 7,057 7,875
Seven years later 2,541 3,346 5,065 7,037
Eight years later 2,655 3,373 5,141
Nine years later 2,669 3,453
Ten years later 2,718
Cumulative Net
redundancy/(deficiency) (1,324) (1,214) (1,780) (2,032) (1,691) (2,145) (2,918) (1,874) 811 199
Net reserves $1,394 $2,239 $ 3,361 $ 5,005 $ 6,184 $ 6,810 $ 7,901 $ 8,620 $15,476 $24,361 $ 36,949
Ceded reserves 3,666 5,744 8,529 14,800 15,696 17,410 20,601 29,017 50,211 75,114 91,773
Gross reserves $5,060 $7,983 $11,890 $19,805 $21,880 $24,220 $28,502 $37,637 $65,687 $99,475 $128,722
Net re-estimated $2,718 $ 3,453 $ 5,141 $ 7,037 $ 7,875 $ 8,955 $10,819 $10,494 $14,665 $24,163
Ceded re-estimated 6,575 11,617 15,242 16,102 20,096 25,392 30,101 38,110 52,871 73,765
Gross re-estimated $9,293 $15,069 $20,383 $23,139 $27,972 $34,347 $40,921 $48,605 $67,536 $97,928
Cumulative Gross
redundancy/(deficiency) (4,233) (7,086) (8,493) (3,334) (6,092) (10,127) (12,419) (10,968) (1,849) 1,547
26
ANALYSIS OF RESERVES
The following table shows our net outstanding case loss reserves and IBNR
by line of business as of December 31, 2004.
OUTSTANDING CASE
LOSS RESERVES IBNR
------------------- -------------
($ in thousands)
Commercial Multiple Peril $10,520 $ 9,853
Other Liability 2,667 1,478
Workers Compensation 2,589 1,403
Commercial Automobile 760 1,443
Homeowners 4,149 1,228
Fire and Allied Lines 835 24
------- -------
ALL LINES $21,520 $15,429
======= =======
Prior to 2003 we had adverse loss development on our loss reserves. In
2001, the changes in reserves for prior accident years were $1.8 million and in
2002 the changes in reserves for prior accident years were $3.0 million. In 2003
there was minimal adverse loss development, amounting to $75,000. In 2004 we had
favorable redundancy that developed in our reserves of $199,000.
We carefully monitor our gross, ceded and net loss reserves by segment and
line of business to ensure that they are adequate, since a deficiency in
reserves will indicate inadequate pricing on our products and may impact our
financial condition.
Our actuaries utilize several methodologies to project losses and
corresponding reserves. These methodologies generally are classified into three
types:
o Loss development projections. Loss development projection methods are
characterized by determination of loss development factors utilizing
patterns of loss development from incurred and paid losses for prior
accident years. This is the main methodology utilized for each accident
year except for the most current accident year.
o Loss ratio projections. There also is significant weight given to the
loss ratio projections. Loss ratio projections determine the loss ratio
for the current year based upon applying inflation, or trend, and the
effect of rate changes to the loss ratios from the prior years. This
method is given weight for the current accident year when there is high
volatility in the reported development patterns at early ages.
o Frequency and severity projections. Frequency and severity projections
are characterized by development of numbers of claims reported and
average claims severity, and these methods are utilized as a check on
the other methods.
Based upon these methods our actuaries determine a best estimate of the
loss reserves. All of these methods are standard actuarial approaches and have
been utilized consistently, except that in 2002 the loss development factors
were significantly increased as explained below.
Almost one-half of the adverse reserves development in 2002 was attributed
to our reinsurance segment, and the amount of reserves development for
reinsurance was disproportionately large relative to the size of that business
as compared to our insurance segment. When we began our reinsurance segment in
1996, we did not have sufficient data for the reinsurance business to determine
its own loss development factors. As a result, we estimated that this business
would develop similarly to the way the insurance segment business developed.
This estimate ultimately proved to be incorrect. In 2001 we estimated the
reserves for this business still using loss development factors from the
insurance business but with some credibility given to the data that had emerged
by that time for the reinsurance business. In 2002 the loss development factors
were determined for the reinsurance business based upon its own experience. We
attribute the longer loss development patterns for our reinsurance segment to
the fact that the underlying policies have higher loss limits than those in our
insurance segment. This resulted in the large revised estimate of reserves for
the reinsurance segment.
For our insurance segment, the adverse loss development recognized in 2002
occurred primarily in the commercial multi-peril, other liability and
homeowner's lines. The homeowner's line was launched in 1998, and 1999 was the
first year with a significant amount of business. The case reserves initially
set in 1999 through 2001 for homeowners were inadequate as a result of our
limited experience in this line, and this was addressed in 2002. For other
liability and the liability claims stemming from commercial multi-peril policies
the cause of the adverse development was primarily due to strengthening of
individual case reserves by our claims department that began in 1999, which
became evident in the loss development patterns beginning in 2001. While there
were increases in average case reserves for our other lines of business, the
impact on loss reserves was most significant in these lines because of the
relative amount of reserves as compared to our other lines of business. During
this time the claims department gained significantly more knowledge about the
difficulties of adjusting claims in New York, particularly as the volume of
business in these lines expanded. For example, the actuarial studies at the end
of 2001 showed increases in average case reserves of 50% or more for other
liability and liability stemming from commercial multi-peril policies. In 2002
there were further significant increases in average case reserves. We retained a
different consulting actuary to analyze these reserves, and as a result of that
study significantly higher loss development factors were utilized to estimate
the IBNR reserves in 2002.
27
To reduce the potential for future adverse development, we took a number of
corrective actions in addition to the aforementioned reserve strengthening. We
thoroughly review individual case reserves adequacy on an ongoing basis. We have
increased our actuarial resources and the level of analysis of our loss reserves
to identify emerging trends as quickly as possible. Our cross functional teams,
including underwriting, claims and actuarial, closely monitor the underwriting
results in each line of business and implement corrective actions for any line
as soon as its loss ratio exceeds expectations. For our reinsurance segment, we
have restructured the business from quota share to excess of loss to reduce our
exposures in that segment. See "Item 1.-Reinsurance".
We are not aware of any claims trends that have emerged or that would cause
future adverse development that have not already been considered in existing
case reserves and in our current loss development factors. Examples of two
recent emerging issues that we monitor are sidewalk liability and mold
liability. Sidewalk liability refers to a law enacted in New York City effective
September 2003 that allows an injured party to sue the owner of a commercial
building located in New York City for any property damage or personal injury
that was caused by the failure of the owner to maintain the sidewalk abutting
the building in a reasonably safe condition. While we monitor this issue, we do
not believe it presents a significant risk of adverse loss development. Since
building owners have always been subject to these suits, our claims department
is experienced in handling claims related to sidewalk accidents in New York
City, having handled over 600 of such claims during our history, and these
claims have already been taken into consideration in our current loss
development factors. While the new law has expanded building owners' potential
liability, we have not to date received a significantly higher frequency of such
claims. Similarly, we carefully monitor mold claims due to national publicity
surrounding this issue, but we do not believe mold claims create a significant
adverse claim trend in our existing book of business; since inception TICNY has
received less than 20 mold related liability claims and these are included in
our case reserves and considered in our loss development factors.
Also, in New York State, lawsuits for negligence, subject to certain
limitations, must be commenced within three years from the date of the accident
or are otherwise barred. Accordingly, our exposure to IBNR for accident years
2002 and prior is limited although there remains the possibility of adverse
development on reported claims. Due to the reserve strengthening in 2002 and
close monitoring and analysis of reserves, we believe our loss reserves are
adequate. This is reflected by the loss development as of December 31, 2004
showing developed redundancies since 2003. However, there are no assurances that
future loss development and trends will be consistent with our past loss
development history, and so adverse loss reserves development remains a risk
factor to our business. See "Item 1.-Risks Related to Our Business-If our actual
loss and loss adjustment expenses exceed our loss reserves , our financial
condition and results of operations could be significantly adversely affected."
The net loss reserves for the most recent accident years on a consolidated
basis as of December 31, 2004 were $20.5 million for accident year 2004 and $8.7
million for accident year 2003. A 5% deficiency in net reserves for these years
would impact our income before income taxes by $1.0 million and $0.4 million for
accident years 2004 and 2003, respectively.
CLAIMS
Our claims division combines the services of our staff defense, coverage
and appellate attorneys with a traditional multi-line insurance claims adjusting
staff. See "Item 1.-Business Segments-Insurance Services Segment Products and
Services" for a description of TRM's claim service fee-based operations.
28
The claims division seeks to provide expedient, fair and consistent claims
handling, while controlling loss adjustment expenses. Handling the claims
adjustment and defense of insureds in-house enables us to accurately evaluate
coverage, promptly post accurate loss and loss adjustment expense reserves,
maintain the highest policyholders service standards and aggressively defend
against liability claims. In addition, through the use of a claims database that
captures detailed statistics and information on every claim, our underwriting
and loss control departments are able to access information to assist them in
the monitoring of the various lines of business and identification of adverse
loss trends, giving them the ability to make informed underwriting and pricing
decisions.
The claims division is divided into eight units: auto claims, workers'
compensation claims, property claims, liability claims, coverage, in-house
defense, administration and processing, and subrogation and recovery. Our
in-house legal staff consists of approximately 12 attorneys who are managed by
two co-managing attorneys reporting to the Senior Vice President Claims.
The continued development of in-house expertise in all areas remains a
primary goal of the claims division. We have continued to build an in-house
defense team in order to handle a substantial percentage of lawsuits in New York
State and vigorously defend against fraudulent and frivolous lawsuits. Given the
high cost of coverage counsel in those instances where coverage may be an issue,
we formed an in-house coverage law firm. Our claims staff and in-house attorneys
handle all of our claims and the majority of our lawsuits internally.
Approximately 75% of all lawsuits arising from our insurance company operation
are currently handled in-house. This approach enables us to maintain a high
level of service to our policyholders and vigorously defend non-meritorious and
frivolous claims while controlling loss adjustment expenses. We have also formed
a full time staff of in-house liability field investigators to replace a
traditionally outsourced claims function. We are also building an experienced
team of field property adjusters to push down costs and to ensure high quality
claims experience for our commercial and personal lines property policyholders.
Ultimately, the claims division endeavors to provide a prompt response to
the needs of policyholders in all first-party losses. Rapid review of the loss,
confirmation of coverage and speedy payment to the insured is the ongoing
commitment of our claims division. With respect to third-party claims, our
approach is the thorough investigation of all claims as soon as reported, in
order to separate those that should be resolved through settlement from those
that should be denied and/or defended. Suspicious or fraudulent first- and
third-party claims are always aggressively investigated and defended.
TECHNOLOGY
We seek to leverage technology and make use of business process redesign in
order to gain operating efficiencies and effectiveness. For example, we were
able to streamline redundant data entry of policy data into a single entry
process by upgrading our policy data entry system. This has enabled us to
control the growth of our clerical staff and improve our customer service. We
have implemented a number of technology improvements and redesign of business
processes, including an on-line imaging system, a data warehouse that houses
both claims and underwriting data to provide management reporting and a
web-based platform (WebPlus) for quoting and capturing policy submissions
directly from our producers.
We utilize Hewlett Packard/Compaq servers that run the Microsoft Windows
Server 2000 operating system. Backups of server data and programs are made to
tape daily and are taken to an off-site facility by an outside vendor. We have
begun migrating our production servers to an offsite location. This secure
facility will provide fully redundant power, air conditioning, communications
and 24-hour support. With this off site premise, we will have two operational
data centers, one primary and one secondary, to handle disaster recovery needs.
WEBPLUS
Since April 2003, we have been using WebPlus, our web-based software
platform for quoting and capturing policy submissions directly from our
producers. WebPlus allows our producers to submit, rate and, where permitted by
the program, bind small premium accounts. Through a rules based engine, we have
implemented our underwriting guidelines within WebPlus. Through an ongoing
monthly, quarterly and annual management review and analysis of the book of
business, we confirm the risk quality and loss ratio profile of policies
processed in WebPlus. We utilize WebPlus for all of our personal lines business
and landlord package policies. We started using WebPlus in April 2003 and in
April 2004 approximately 94% of our personal lines policies were processed
through WebPlus. We believe that this technology reduces underwriter involvement
in each policy application, as well as improves our ability to validate and
capture all relevant policy information early in the submission process and at a
single point. We believe that WebPlus has significantly reduced our expense
associated with processing business, improved customer service and made it
easier for our producers to do business with us. In February 2004, we added
workers' compensation to the suite of products that can be submitted to us
through WebPlus, and we are now developing commercial package and automobile
policies capability.
29
WebPlus was developed for us by AgencyPort Insurance Services, Inc.
("AgencyPort"), a technology company specializing in the property and casualty
insurance industry, in exchange for our commitment to invest $1 million in
AgencyPort. An application for trademark protection for the WebPlus name is
currently pending with the United States Patent and Trademark Office. In
addition, we licensed AgencyPort's KeyOnce software development kit (SDK), which
AgencyPort utilized to develop WebPlus. We also obtained a warrant to acquire
common shares in AgencyPort. On January 7, 2004 TICNY exercised this warrant in
full for 1,072,525 common shares of AgencyPort, for $1 million less $663,000
paid towards the development of WebPlus resulting in a payment of $337,000.
These payments have been capitalized as software and are being amortized over
three years. The 1,072,525 shares represented approximately 20% of the
outstanding shares of AgencyPort as of December 31, 2004. We do not exercise
significant influence over AgencyPort and we do not have any representation on
the Board of Directors of AgencyPort. The relationship is primarily one of
AgencyPort as a licensor and developer of software for our benefit. Accordingly,
we do not account for our investment in AgencyPort on the equity method. We have
assigned no value to the shares acquired as AgencyPort has only an immaterial
amount of net worth as of December 31, 2004. As of December 31, 2003, we held
another warrant to acquire an additional 30% of the outstanding shares of
AgencyPort. On August 31, 2004, we entered into an agreement with AgencyPort to
eliminate this warrant in consideration for certain rights granted to us
including access to certain software source code. We received the source code
upon execution of the agreement.
Our technology plan currently envisions that we will expand our use of
WebPlus to additional products and other business functions (such as claims
submission and reporting). We also intend to exploit technological improvements
and economies of scale realized through premium growth to continue to lower our
underwriting expense ratio while offering a strong value proposition to our
producer base.
COMPETITION
We compete with a large number of other companies in our selected lines of
business, including major U.S. and non-U.S. insurers and other regional
companies, as well as mutual companies, specialty insurance companies,
underwriting agencies and diversified financial services companies. We compete
for business on the basis of a number of factors, including price, coverages
offered, customer service, relationship with producers (including ease of doing
business, service provided and commission rates paid), financial strength and
size and rating by independent rating agencies.
As our territorial expansion has progressed within New York State, we have
developed an increased number of competitors. In our commercial lines business,
our competitors include The St. Paul Travelers Insurance Company, Hartford
Insurance Company, Safeco, Hannover Insurance Companies, Magna Carta Companies,
Greater New York Mutual Insurance Company, OneBeacon Insurance Company,
Selective, Utica First Insurance Company, Middlesex Mutual and Erie Insurance
Company. In our personal lines business, we compete against companies such as
Allstate Insurance Company, State Farm Companies, The St. Paul Travelers
Companies, Inc., Hartford Insurance Company, OneBeacon Insurance Group, New York
Central Insurance Company, Commercial Mutual Insurance Company, Preferred Mutual
Insurance Company and Otsego Mutual Fire Insurance Company.
The soft market that existed until sometime in 2001 was characterized by
pricing based competition, with a number of competitors attempting to gain or
retain market share by charging premium rates that ultimately proved to be
inadequate. The losses suffered by many of these companies have resulted in
their insolvencies or exit from our chosen markets. The pricing environment in
the hard market prevalent in 2004 was such that competition tends to focus more
on the non-pricing factors listed above. During the last quarter of 2004, a
moderation of the pricing environment within the commercial insurance
marketplace became evident as pricing increases on renewing policies lessened.
We seek to distinguish ourselves from our competitors by providing a broad
product line offering and targeting those market segments that we believe are
underserved and therefore provide us with the best opportunity to obtain
favorable policy terms, conditions and pricing. We believe that by offering
several different lines of business, we are able to compete effectively against
insurance companies that offer limited products. We also seek to limit the
extent to which we must directly compete with the companies listed above by
positioning our products in underserved market segments and adjusting our
premium volume in these market segments depending upon the level of competition.
We have historically targeted risks located in New York City and adjacent areas,
as we feel this is a market that historically has not been emphasized by
regional and national insurance companies. As our territorial expansion has
encompassed all of New York State and other northeastern states, we have
maintained our marketing approach. We will continue to compete with other
companies by quickly and opportunistically delivering products that respond to
our producers' needs, which may be determined by other companies' insolvencies
or voluntary withdrawals from particular market segments. Our ability to quickly
develop and replace various products that had previously been offered by Empire
Insurance Group when we purchased the renewal rights to the Empire business in
2001 is an example of this capability. In addition to being responsive to market
needs, we also focus on assisting our producers with placing business by
offering rating and submission capability through WebPlus and rating disks, as
well as by providing our producers with clear and concise underwriting
guidelines. We also compete by focusing on reducing our producers' costs of
doing business with us. For example, we directly bill our policyholders on most
of our policies with a per policy premium below $10,000 and provide customer
service support to policyholders on behalf of our producers. This increased
service allows us to deliver value to our producers other than through higher
commission rates. Finally, our success in reducing liability claims costs
through cost effective and aggressive claims handling has reduced the cost of
liability insurance premiums for our policyholders. This capability also helps
us compete with other insurance companies. Notwithstanding the positive
competitive factors discussed above, many of our competitors have greater
financial and marketing resources and higher ratings from rating agencies than
we do, which may have an adverse effect on our ability to compete with them.
30
RATINGS
Many insurance buyers, agents and brokers use the ratings assigned by A.M.
Best and other rating agencies to assist them in assessing the financial
strength and overall quality of the companies from which they are considering
purchasing insurance. TICNY was assigned a letter rating of "B+" (Very Good) by
A.M. Best in 1997 and was upgraded to "B++" (Very Good) in 2003. In October
2004, TICNY was upgraded to A- (Excellent) by A.M. Best, the 4th highest of 15
rating categories used by A.M. Best. In evaluating a company's financial
strength, A.M. Best reviews the company's profitability, leverage and liquidity,
as well as its book of business, the adequacy and soundness of its reinsurance,
the quality and estimated market value of its assets, the adequacy of its loss
and loss expense reserves, the adequacy of its surplus, its capital structure,
the experience and competence of its management and its market presence. This
rating is intended to provide an independent opinion of an insurer's financial
strength and is not an evaluation directed at investors. There is no guarantee
that TICNY will maintain the improved rating.
In April 2003, in connection with the issuance of subordinated debentures
underlying trust preferred securities, TICNY also received an insurer financial
strength rating from Standard & Poor's. This rating provides an assessment of
the financial strength of an insurance company and its capacity to meet
obligations to policyholders on a timely basis. TICNY's most recent rating from
Standard & Poor's is "BB+" with a stable outlook.
With the rating upgrade from A.M. Best, TICNY is positioned to enter into
new market segments that will provide additional premium growth opportunities.
Some segments of the insurance market are rating sensitive. This means that
customers in those segments require that their insurance company have a minimum
financial strength and/or a minimum rating. Additional rating sensitivity is
created by some insurance companies writing umbrella policies, who will not
issue a policy unless the underlying primary carrier has a minimum rating. We
believe that the A- rating will allow TICNY to participate in rating sensitive
markets such as the middle market segment described in "Item 1.-Business
Segments-Insurance Services Segment Products and Services", currently served by
TRM through the use of TRM's issuing companies. Likewise, with the higher
rating, we believe TICNY will be able to attract many large premium accounts in
the monoline liability and preferred property lines of business, where insureds
also tend to be rating sensitive.
EMPLOYEES
All of our employees are employed directly by TICNY. As of December 31,
2004, the total number of full-time equivalent employees of TICNY was 289 of
which 259 are in New York City, 11 are in the Long Island, New York branch and
19 are in the Buffalo, New York branch. None of these employees are covered by a
collective bargaining agreement. We have employment agreements with our senior
executive officers. The remainder of our employees are at-will employees.
31
REGULATION
U.S. INSURANCE HOLDING COMPANY REGULATION OF TOWER
Tower, as the parent of TICNY, is subject to the insurance holding company
laws of New York. These laws generally require TICNY to register with the New
York Insurance Department and to furnish annually financial and other
information about the operations of companies within the holding company system.
Generally under these laws, all material transactions among companies in the
holding company system to which TICNY is a party, including sales, loans,
reinsurance agreements and service agreements, must be fair and reasonable and,
if material or of a specified category, require prior notice and approval or
non-disapproval by the New York Insurance Department.
CHANGES OF CONTROL
Before a person can acquire control of a New York insurance company, prior
written approval must be obtained from the Superintendent of Insurance of the
State of New York. Prior to granting approval of an application to acquire
control of a New York insurer, the Superintendent of Insurance of the State of
New York will consider such factors as: the financial strength of the applicant,
the integrity and management of the applicant's Board of Directors and executive
officers, the acquirer's plans for the management of the applicant's Board of
Directors and executive officers, the acquirer's plans for the future operations
of the domestic insurer and any anti-competitive results that may arise from the
consummation of the acquisition of control. Pursuant to the New York insurance
holding company statute, "control" means the possession, direct or indirect, of
the power to direct or cause the direction of the management and policies of the
company, whether through the ownership of voting securities, by contract (except
a commercial contract for goods or non-management services) or otherwise.
Control is presumed to exist if any person directly or indirectly owns, controls
or holds with the power to vote 10% or more of the voting securities of the
company; however, the New York State Insurance Department, after notice and a
hearing, may determine that a person or entity which directly or indirectly
owns, controls or holds with the power to vote less than 10% of the voting
securities of the company, "controls" the company. Because a person acquiring
10% or more of our common stock would indirectly control the same percentage of
the stock of the TICNY, the insurance change of control laws of New York would
likely apply to such a transaction.
These laws may discourage potential acquisition proposals and may delay,
deter or prevent a change of control of Tower, including through transactions,
and in particular unsolicited transactions, that some or all of the stockholders
of Tower might consider to be desirable.
LEGISLATIVE CHANGES
From time to time, various regulatory and legislative changes have been
proposed in the insurance industry. Among the proposals that have in the past
been or are at present being considered are the possible introduction of Federal
regulation in addition to, or in lieu of, the current system of state regulation
of insurers and proposals in various state legislatures (some of which proposals
have been enacted) to conform portions of their insurance laws and regulations
to various model acts adopted by the National Association of Insurance
Commissioners ("NAIC"). We are unable to predict whether any of these laws and
regulations will be adopted, the form in which any such laws and regulations
would be adopted, or the effect, if any, these developments would have on our
operations and financial condition.
In 2002, in response to the tightening of supply in certain insurance and
reinsurance markets resulting from, among other things, the September 11, 2001
terrorist attacks, the Terrorism Act was enacted. The Terrorism Act is designed
to ensure the availability of insurance coverage for foreign terrorist acts in
the United States of America. This law established a Federal assistance program
through the end of 2005 to help the commercial property and casualty insurance
industry cover claims related to future terrorism-related losses and requires
such companies to offer coverage for certain acts of terrorism. As a result, we
are prohibited from adding certain terrorism exclusions to the policies written
by TICNY. Although TICNY is protected by Federally funded terrorism reinsurance
as provided for in the Terrorism Act, there is a substantial deductible that
must be met, the payment of which could have an adverse effect on our results of
operations. Potential future changes to the Terrorism Act could also adversely
affect us by causing our reinsurers to increase prices or withdraw from certain
markets where terrorism coverage is required.
32
In October 2003, New York State enacted a version of the NAIC Producer
Licensing Model Act (the "Act"), which provides uniform procedures and
guidelines for the licensing of insurance brokers and agents. The applicable
provisions of the Act took effect January 1, 2004. The Act is primarily directed
toward assisting New York insurance agents and brokers to transact business in
other states on a non-resident basis. The law includes provisions to increase
uniformity among states in regard to producer licensing. We do not anticipate
that this law will have a material impact on us.
STATE INSURANCE REGULATION
State insurance authorities have broad regulatory powers with respect to
various aspects of the business of U.S. insurance companies. The primary purpose
of such regulatory powers is to protect individual policyholders. The extent of
such regulation varies, but generally has its source in statutes that delegate
regulatory, supervisory and administrative power to state insurance departments.
Such powers relate to, among other things, licensing to transact business,
accreditation of reinsurers, admittance of assets to statutory surplus,
regulating unfair trade and claims practices, establishing reserve requirements
and solvency standards, regulating investments and dividends, approving policy
forms and related materials in certain instances and approving premium rates in
certain instances. State insurance laws and regulations require TICNY to file
financial statements with insurance departments everywhere it will be licensed
to conduct insurance business, and its operations are subject to examination by
those departments.
TICNY prepares statutory financial statements in accordance with statutory
accounting principles ("SAP") and procedures prescribed or permitted by the New
York Insurance Department. As part of their regulatory oversight process, state
insurance departments conduct periodic detailed examinations of the books and
records, financial reporting, policy filings and market conduct of insurance
companies domiciled in their states, generally once every three to five years.
Examinations are generally carried out in cooperation with the insurance
departments of other states under guidelines promulgated by the NAIC.
The terms and conditions of reinsurance agreements generally are not
subject to regulation by any U.S. state insurance department with respect to
rates or policy terms. As a practical matter, however, the rates charged by
primary insurers do have an effect on the rates that can be charged by
reinsurers.
INSURANCE REGULATORY INFORMATION SYSTEM RATIOS
The Insurance Regulatory Information System, or IRIS, was developed by the
NAIC and is intended primarily to assist state insurance departments in
executing their statutory mandates to oversee the financial condition of
insurance companies operating in their respective states. IRIS identifies twelve
industry ratios and specifies "usual values" for each ratio. Departure from the
usual values on four or more of the ratios can lead to inquiries from individual
state insurance commissioners as to certain aspects of an insurer's business.
For 2004 TICNY's results were outside the usual values for three IRIS ratios and
within the usual values for nine IRIS ratios. In 2004, the change in net
writings ratio was affected by the 239% increase in net premiums written due to
the reduction in our quota share ceding percentage effective October 1, 2004 as
well as growth in gross premiums written. The investment yield ratio and the
policyholder's surplus ratio were both affected by the $98.0 million capital
contribution in the fourth quarter of 2004 from the IPO net proceeds.
NEW YORK STATE DIVIDEND LIMITATIONS
TICNY's ability to pay dividends is subject to restrictions contained in
the insurance laws and related regulations of New York. Under New York law,
TICNY may pay dividends out of statutory earned surplus. In addition, the New
York Insurance Department must approve any dividend declared or paid by TICNY
that, together with all dividends declared or distributed by TICNY during the
preceding 12 months, exceeds the lesser of (1) 10% of TICNY's policyholder's
surplus as shown on its latest statutory financial statement filed with the New
York Insurance Department or (2) 100% of adjusted net investment income during
the preceding twelve months. TICNY paid approximately $850,000, $364,000 and
$1,555,000 in dividends to Tower in 2004, 2003, and 2002, respectively. As of
December 31, 2004, the maximum distribution that TICNY could pay without prior
regulatory approval was approximately $2.8 million.
RISK-BASED CAPITAL REGULATIONS
The New York Insurance Department requires domestic property and casualty
insurers to report their risk-based capital based on a formula developed and
adopted by the NAIC that attempts to measure statutory capital and surplus needs
based on the risks in the insurer's mix of products and investment portfolio.
The formula is designed to allow the New York Insurance Department to identify
potential weakly-capitalized companies. Under the formula, a company determines
its "risk-based capital" by taking into account certain risks related to the
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). At December 31, 2004,
TICNY's risk-based capital level exceeded the minimum level that would trigger
regulatory attention. In its 2004 statutory financial statements, TICNY has
complied with the NAIC's risk-based capital reporting requirements.
33
STATUTORY ACCOUNTING PRINCIPLES
SAP is a basis of accounting developed to assist insurance regulators in
monitoring and regulating the solvency of insurance companies. It is primarily
concerned with measuring an insurer's surplus to policyholders. Accordingly,
statutory accounting focuses on valuing assets and liabilities of insurers at
financial reporting dates in accordance with appropriate insurance law and
regulatory provisions applicable in each insurer's domiciliary state.
GAAP is concerned with a company's solvency, but it is also concerned with
other financial measurements, such as income and cash flows. Accordingly, GAAP
gives more consideration to appropriate matching of revenue and expenses and
accounting for management's stewardship of assets than does SAP. As a direct
result, different assets and liabilities and different amounts of assets and
liabilities will be reflected in financial statements prepared in accordance
with GAAP as opposed to SAP.
Statutory accounting practices established by the NAIC and adopted, in
part, by the New York regulators determine, among other things, the amount of
statutory surplus and statutory net income of TICNY and thus determine, in part,
the amount of funds it has available to pay dividends to us.
GUARANTY ASSOCIATIONS
In New York and in most of the jurisdictions where TICNY may in the future
be licensed to transact business there is a requirement that property and
casualty insurers doing business within the jurisdiction participate in guaranty
associations, which are organized to pay contractual benefits owed pursuant to
insurance policies issued by impaired, insolvent or failed insurers. These
associations levy assessments, up to prescribed limits, on all member insurers
in a particular state on the basis of the proportionate share of the premium
written by member insurers in the lines of business in which the impaired,
insolvent or failed insurer is engaged. Some states permit member insurers to
recover assessments paid through full or partial premium tax offsets.
In none of the past five years has the assessment in any year levied
against TICNY been material. Property and casualty insurance company
insolvencies or failures may result in additional security fund assessments to
TICNY at some future date. At this time we are unable to determine the impact,
if any, such assessments may have on the financial position or results of
operations of TICNY. We have established liabilities for guaranty fund
assessments with respect to insurers that are currently subject to insolvency
proceedings and assessments by the various workers' compensation funds. See
"Note 13. Commitments and Contingencies".
TRM
The activities of TRM are subject to licensing requirements and regulation
under the laws of New York and New Jersey. TRM's business depends on the
validity of, and continued good standing under, the licenses and approvals
pursuant to which it operates, as well as compliance with pertinent regulations.
TRM therefore devotes significant effort toward maintaining its licenses to
ensure compliance with a diverse and complex regulatory structure.
Licensing laws and regulations vary from jurisdiction to jurisdiction. In
all jurisdictions, the applicable licensing laws and regulations are subject to
amendment or interpretation by regulatory authorities. Generally such
authorities are vested with relatively broad and general discretion as to the
granting, renewing and revoking of licenses and approvals. Licenses may be
denied or revoked for various reasons, including the violation of such
regulations, conviction of crimes and the like. Possible sanctions which may be
imposed include the suspension of individual employees, limitations on engaging
in a particular business for specified periods of time, revocation of licenses,
censures, redress to clients and fines. In some instances, TRM follows practices
based on interpretations of laws and regulations generally followed by the
industry, which may prove to be different from the interpretations of regulatory
authorities.
34
INDUSTRY INVESTIGATIONS
The insurance industry recently has become the subject of increasing
scrutiny with respect to insurance broker and agent compensation arrangements
and sales practices. The New York State Attorney General and other state and
Federal regulators have commenced investigations and other proceedings relating
to compensation and bidding arrangements between producers and issuers of
insurance products and unsuitable sales practices by producers on behalf of
either the issuer or the purchaser. The practices currently under investigation
include, among other things, allegations that so-called contingent commission
arrangements may conflict with a broker's duties to its customers, that certain
brokers and insurers may have engaged in anti-competitive practices in
connection with insurance premium quotes. The New York State Attorney General
has recently entered into a settlement agreement with two large insurance
brokers. These investigations and proceedings are expected to continue, and new
investigative proceedings may be commenced, in the future. These investigations
and proceedings could result in legal precedents and new industry-wide practices
or legislation, rules or regulations that could significantly affect our
industry and may also cause stock price volatility for companies in the
insurance industry. Contingent commissions under our producers profit sharing
plan amounted to less than 1/4% of our overall commission expense in 2004.
Recently, regulators and other governmental authorities have been
investigating certain types of insurance and reinsurance arrangements that they
allege are intended only to smooth an insured company or ceding insurer's
earnings rather than to transfer insurance risk. We believe our quota share
reinsurance meets all requirements pertaining to risk transfer. However, these
investigations, the related legal actions and the accompanying increased
scrutiny of "non-traditional" reinsurance arrangements may lead to a change in
the applicable accounting standards or a reduction in the availability of some
types of reinsurance. In turn, these developments could produce higher prices
for reinsurance, an increase in the amount of risk we retain, reduced ceding
commission revenue, or other potentially adverse developments. In that event, we
may be required to restructure or reduce our use of quota share reinsurance or
reduce our premium writings.
RISK FACTORS
An investment in our common stock involves a number of risks. You should
carefully consider the following information about these risks, together with
the other information contained in this Form 10-K, in considering whether to
invest in or hold our common stock. Additional risks not presently known to us,
or that we currently deem immaterial may also impair our business or results of
operations. Any of the risks described below could result in a significant or
material adverse effect on our financial condition or results of operations, and
a corresponding decline in the market price of our common stock. You could lose
all or part of your investment.
This Form 10-K also contains forward-looking statements that involve risks
and uncertainties. Our actual results could differ materially from those
anticipated in the forward-looking statements as a result of certain factors,
including the risks described below and elsewhere in this Form 10-K. See "Item
1.-Note on Forward-Looking Statements".
RISKS RELATED TO OUR BUSINESS
IF OUR ACTUAL LOSS AND LOSS ADJUSTMENT EXPENSES EXCEED OUR LOSS RESERVES,
OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS COULD BE SIGNIFICANTLY
ADVERSELY AFFECTED.
Our results of operations and financial condition depend upon our ability
to assess accurately the potential losses associated with the risks that we
insure and reinsure. We establish loss reserves to cover our estimated liability
for the payment of all losses and loss adjustment expenses incurred under the
policies that we write. Loss reserves include case reserves, which are
established for specific claims that have been reported to us, and reserves for
claims that have been incurred but not reported (or "IBNR"). To the extent that
loss and loss adjustment expenses exceed our estimates, we will be required to
immediately recognize the less favorable experience and increase loss reserves,
with a corresponding reduction in our net income in the period in which the
deficiency is identified. For example, over the past ten years we have
experienced adverse development of reserves for losses and loss adjustment
expenses incurred in prior years. In 2002, following an annual review by an
outside actuarial consulting company of TICNY's net loss and loss adjustment
reserves, we increased such reserves by $2.9 million.
35
With respect to losses on the property coverage portion of our commercial
and personal lines policies, the primary component of our loss reserve is a case
reserve, which is posted by the assigned examiner shortly after the loss is
reported. The extent of the damage is evaluated through a primarily fact-based
loss assessment process. Property losses are typically reported within days of
occurrence and case reserves are posted promptly. While this case reserving
process is not free of errors in determining the scope of the loss or deviations
at the time the loss is paid, major deviations are infrequent. Consequently,
commercial and personal property lines of business generally do not require
significant IBNR nor are they difficult to predict with a relative amount of
certainty. Absent significant changes by underwriting personnel in risk
selection and coverage offered and assuming examiners are properly trained with
the requisite experience, loss reserves on property lines of business remain
relatively predictable from an actuarial standpoint.
With respect to losses on the liability coverage portions of our commercial
and personal lines policies, the reserving process possesses characteristics
that make case and IBNR reserving inherently less susceptible to accurate
actuarial estimation. Unlike property losses, liability losses are claims made
by third parties of which the policyholder may not be aware and therefore may be
reported a significant time after the occurrence, sometimes years. In addition,
as liability claims most often involve claims of bodily injury, assessment of
the proper case reserve is a far more subjective process than claims involving
property damages. In addition, the determination of a case reserve for a
liability claim is often without the benefit of information, which develops
slowly over the life of the claim and can subject the case reserve to
substantial modification well after the claim was first reported. Numerous
factors impact the liability case reserving process, such as venue, the amount
of monetary damage, the permanence of the injury, the age of the claimant and
many others.
Estimating an appropriate level of loss and loss adjustment expense
reserves is an inherently uncertain process. Accordingly, actual loss and loss
adjustment expenses paid will likely deviate, perhaps substantially, from the
reserve estimates reflected in our consolidated financial statements. It is
possible that claims could exceed our loss and loss adjustment expense reserves
and have a material adverse effect on our financial condition or results of
operations.
TICNY AND TRM CONDUCT BUSINESS IN A CONCENTRATED GEOGRAPHICAL AREA. ANY
SINGLE CATASTROPHE OR OTHER CONDITION AFFECTING LOSSES IN THIS AREA COULD
ADVERSELY AFFECT OUR RESULTS OF OPERATIONS.
TICNY currently writes business in a concentrated geographic area,
primarily in the southern portion of New York State, and reinsures business
produced by TRM in New York and to a lesser extent in New Jersey and
Pennsylvania. As a result, a single catastrophe occurrence, destructive weather
pattern, terrorist attack, regulatory development or other condition or general
economic trend affecting the region within which TICNY and TRM conduct their
business could adversely affect our financial condition or results of operations
more significantly than other insurance companies that conduct business across a
broader geographical area. During our history, we have not experienced any
single event that materially affected our results of operations. The most
significant single event was the terrorist attacks of September 11, 2001, as a
result of which we suffered $351,000 in net losses.
The incidence and severity of catastrophes are inherently unpredictable and
our losses from catastrophes could be substantial. The occurrence of claims from
catastrophic events is likely to result in substantial volatility in our
financial condition or results of operations for any fiscal quarter or year and
could have a material adverse effect on our financial condition or results of
operations and our ability to write new business. Increases in the values and
concentrations of insured property may increase the severity of such occurrences
in the future. Although we attempt to manage our exposure to such events,
including through the use of reinsurance, the frequency or severity of
catastrophic events could exceed our estimates. As a result, the occurrence of
one or more catastrophic events could have a material adverse effect on our
financial condition or results of operations.
IF WE CANNOT OBTAIN ADEQUATE REINSURANCE PROTECTION FOR THE RISKS WE HAVE
UNDERWRITTEN, WE MAY BE EXPOSED TO GREATER LOSSES FROM THESE RISKS OR WE MAY
REDUCE THE AMOUNT OF BUSINESS WE UNDERWRITE, WHICH WILL REDUCE OUR REVENUES.
Under state insurance law, insurance companies are required to maintain a
certain level of capital in support of the policies they issue. In addition,
rating agencies will reduce an insurance company's ratings if the company's
premiums exceed specified multiples of its capital. As a result, the level of
TICNY's statutory surplus and capital limits the amount of premiums that it can
write and retain risk on. Historically, we have utilized reinsurance to expand
our capacity to write more business than TICNY's surplus would have otherwise
supported. As a result of the increase in TICNY's surplus with proceeds
contributed from the IPO, the quota share ceding percentage was reduced from 60%
to 25% on October 1, 2004.
36
From time to time, market conditions have limited, and in some cases have
prevented, insurers from obtaining the types and amounts of reinsurance that
they consider adequate for their business needs. For example, beginning in 2001,
terms and conditions in the reinsurance market generally became less attractive
for insurers seeking reinsurance. In addition, recent investigations by the New
York State Attorney General, the SEC and other regulatory and government bodies
into the use of non-traditional reinsurance by certain reinsurers may lead to
the re-examination of applicable accounting standards or a reduction in the
availability of some types of reinsurance. In turn, these developments could
produce unfavorable changes in prices, reduced ceding commission revenue or
other potentially adverse changes in the terms of reinsurance. Accordingly, we
may not be able to obtain our desired amounts of reinsurance. In addition, even
if we are able to obtain such reinsurance, we may not be able to obtain such
reinsurance from entities with satisfactory creditworthiness or negotiate terms
that we deem appropriate or acceptable. Currently, three reinsurers provide
reinsurance to us on a quota share basis, six provide reinsurance on an excess
of loss basis and six provide catastrophe reinsurance. If we cannot obtain
adequate reinsurance protection for the risks we have underwritten, we may be
exposed to greater losses from these risks or we may be forced to reduce the
amount of business that we underwrite, which will reduce our revenues. As a
result, our inability to obtain adequate reinsurance protection could have a
material adverse effect on our financial condition or results of operation.
IF WE ARE ABLE TO OBTAIN REINSURANCE, OUR REINSURERS MAY NOT PAY LOSSES IN
A TIMELY FASHION, OR AT ALL, WHICH MAY CAUSE A SUBSTANTIAL LOSS AND INCREASE OUR
COSTS.
As of December 31, 2004, we had a net balance due in our favor from our
reinsurers of $129.6 million, consisting of $101.2 million in reinsurance
recoverables and $28.4 million in prepaid reinsurance premiums. This amount is
$3.5 million higher than our insurance subsidiary's statutory capital and
surplus at that date. Since October 1, 2003, we have sought to manage our
exposure to our reinsurers by placing our quota share reinsurance on a "funds
withheld" basis and requiring any non-admitted reinsurers to collateralize their
share of unearned premium and loss reserves. However, we have substantial
recoverables from our pre-October 1, 2003 reinsurance arrangements that are
uncollateralized, in that they are not supported by letters of credit, trust
accounts, "funds withheld" arrangements or similar mechanisms intended to
protect us against a reinsurer's inability or unwillingness to pay. Our net
exposure to our reinsurers totaled $66.2 million as of December 31, 2004
(representing 13.4% of our total assets on that date), including $46.8 million
due from PXRE Reinsurance Company, which is rated "A" (Excellent) by A.M. Best.
See "Item 1.--Reinsurance" for a detailed discussion of our reinsurance
exposures. Because we remain primarily liable to our policyholders for the
payment of their claims, in the event that one of our reinsurers under an
uncollateralized treaty became insolvent or refused to reimburse us for losses
paid, or delayed in reimbursing us for losses paid, our cash flow and financial
results overall could be materially and adversely affected.
OUR INSURANCE COMPANY SUBSIDIARY IS RATED "A-" (EXCELLENT) BY A.M. BEST,
AND A DECLINE IN THIS RATING OR THE RATINGS ASSIGNED BY OTHER RATING AGENCIES
COULD AFFECT OUR STANDING AMONG BROKERS, AGENTS AND INSUREDS AND CAUSE OUR SALES
AND EARNINGS TO DECREASE.
Ratings have become an increasingly important factor in establishing the
competitive position of insurance companies. A.M. Best maintains a letter scale
rating system ranging from "A++" (Superior) to "F" (In Liquidation). TICNY was
upgraded to "A-" (Excellent) by A.M. Best, which is the 4th highest of 15 rating
levels. There is no guarantee that TICNY will maintain this rating that is
subject to, among other things, A.M. Best's evaluation of our capitalization and
performance on an ongoing basis including our management of terrorism risks,
loss reserves and expenses. The expiration of the Terrorism Risk Insurance Act
of 2002 on December 31, 2005, if not renewed or extended, may impact any
evaluation of our terrorism risk and, therefore, our rating.
In April 2003, in connection with the issuance of subordinated debentures
underlying trust preferred securities, TICNY also received an insurer financial
strength rating from Standard & Poor's Rating Services, a division of The
McGraw-Hill Companies, Inc. ("Standard & Poor's"). The most recent rating from
Standard & Poor's is "BB+" with a stable outlook. A "BB+" rating is the 11th
highest of 21 rating levels used by Standard & Poor's.
Our ratings are subject to periodic review by, and may be revised downward
or revoked at the sole discretion of A.M. Best or Standard & Poor's. A decline
in a company's ratings indicating a reduced financial strength or other adverse
financial developments can cause concern about the viability of the downgraded
insurer among its agents, brokers and policyholders, resulting in a movement of
business away from the downgraded carrier to other stronger or more highly rated
carriers. Because many of our agents and brokers (whom we refer to as
"producers") and policyholders purchase our policies on the basis of our current
ratings, the loss or reduction of any of our ratings will adversely impact our
ability to retain or expand our policyholder base. The objective of the rating
agencies' rating systems is to provide an opinion of an insurer's financial
strength and ability to meet ongoing obligations to its policyholders. Our
ratings reflect the rating agencies' opinion of our financial strength and are
not evaluations directed to investors in our common stock nor recommendations to
buy, sell or hold our common stock.
37
THE FAILURE OF ANY OF THE LOSS LIMITATION METHODS WE EMPLOY COULD HAVE A
MATERIAL ADVERSE EFFECT ON OUR FINANCIAL CONDITION OR OUR RESULTS OF OPERATIONS.
Various provisions of our policies, such as limitations or exclusions from
coverage or choice of forum, which have been negotiated to limit our risks, may
not be enforceable in the manner we intend. At the present time we employ a
variety of endorsements to our policies that limit exposure to known risks,
including but not limited to exclusions relating to coverage for lead paint
poisoning, asbestos and most claims for bodily injury or property damage
resulting from the release of pollutants.
In addition, the policies we issue contain conditions requiring the prompt
reporting of claims to us and our right to decline coverage in the event of a
violation of that condition. Our policies also include limitations restricting
the period in which a policyholder may bring a breach of contract or other claim
against the company, which in many cases is shorter than the statutory
limitations for such claims in the states in which we write business. While
these exclusions and limitations reduce the loss exposure to us and help
eliminate known exposures to certain risks, it is possible that a court or
regulatory authority could nullify or void an exclusion or legislation could be
enacted modifying or barring the use of such endorsements and limitations in a
way that would adversely effect our loss experience, which could have a material
adverse effect on our financial condition or results of operations.
WE MAY FACE SUBSTANTIAL EXPOSURE TO LOSSES FROM TERRORISM, WE ARE CURRENTLY
REQUIRED BY LAW TO PROVIDE COVERAGE AGAINST SUCH LOSSES, AND THE TERRORISM RISK
INSURANCE ACT OF 2002 MAY EXPIRE ON DECEMBER 31, 2005.
Our location and concentration of business written in New York City and
adjacent areas expose us to losses from terrorism. We are required by state and
Federal law to provide coverage for terrorism in certain circumstances. We also
have limitations in our ceded reinsurance treaties pertaining to terrorism.
In response to the September 11, 2001 terrorist attacks, the United States
Congress enacted legislation designed to ensure, among other things, the
availability of insurance coverage for foreign terrorist acts, including the
requirement that insurers provide such coverage in certain circumstances. The
Terrorism Risk Insurance Act of 2002 (the "Terrorism Act") requires commercial
property and casualty insurance companies to offer coverage for certain acts of
terrorism and has established a Federal assistance program through the end of
2005 to help such insurers cover claims related to future terrorism-related
losses. Recently a bill has been introduced into Congress to extend the
Terrorism Act, but there is no assurance that Congress will pass such a bill or,
if passed, what provisions it may contain.
Pursuant to the Terrorism Act, TICNY must offer insureds the option to
purchase coverage for certified acts of terrorism for an additional premium or
decline such coverage. When the coverage is not purchased, we endorse the policy
to exclude coverage for certified acts of terrorism, but losses from an act of
terrorism that is not a certified event may be covered in any case. Also, even
for certified acts of terrorism, losses from fire following the act of terrorism
are covered.
The Terrorism Act reimburses up to 90% of the losses to commercial insurers
due to certified acts of terrorism in excess of a deductible. Our deductible in
2004 was 10% of our 2003 direct earned premium on commercial lines. Our
deductible in 2005 is 15% of our 2004 direct earned premiums on commercial
lines. Excess of loss reinsurance treaties for multiple-line and workers'
compensation contain various sublimits for terrorism coverage.
In the event that the Federal assistance under the Terrorism Act is not
extended or is altered (e.g., by increasing the deductible or reducing the
amount of loss that is reimbursed), our potential losses from a terrorist attack
could be substantially larger than previously expected. Potential future changes
to the Terrorism Act could also adversely affect us by causing our reinsurers to
increase prices or withdraw from certain markets where terrorism coverage is
required.
38
In addition, in the event that the Terrorism Act is not extended, while we
would no longer be required to offer the insured the ability to purchase
coverage for Certified Acts of Terrorism the New York State Insurance Department
has not approved a terrorism exclusion so it is possible that we would not be
permitted to exclude losses resulting from terrorist acts in New York State for
accounts under $100,000 premium size. An increased exposure to terrorism risk as
a result of the expiration of the Terrorism Act may impact our current
underwriting strategy in New York City, our ability to secure reinsurance, our
rating, as well as other elements of our operations.
A terrorist attack or series of attacks in New York City or the surrounding
areas could have a material adverse effect on our results of operations and
financial condition. In addition, terrorist attacks in these areas could depress
economic activity in our core market, which could hurt our business.
THE EFFECTS OF EMERGING CLAIM AND COVERAGE ISSUES ON OUR BUSINESS ARE
UNCERTAIN.
As industry practices and legal, judicial, social and other environmental
conditions change, unexpected and unintended issues related to claims and
coverage may emerge. These issues may adversely affect our business by either
extending coverage beyond our underwriting intent or by increasing the number or
size of claims. In some instances, these changes may not become apparent until
some time after we have issued insurance or reinsurance contracts that are
affected by the changes. As a result, the full extent of liability under our
insurance or reinsurance contracts may not be known for many years after a
contract is issued.
One recent example of an emerging claim and coverage issue is New York City
sidewalk liability. Effective as of September 14, 2003, a new law enacted by the
New York City Council allows an injured party to sue the owner of a commercial
building located in the five boroughs of New York City for any property damage
or personal injury that was caused by the failure of the owner to maintain the
sidewalk abutting the owner's building in a reasonably safe condition.
Previously, the City of New York, and not the building owner, was responsible
for the maintenance of city sidewalks. We have adjusted our underwriting
guidelines to attempt to screen out exposures that present a heightened risk
from this new law. However, the size and extent of the claims that may emerge
due to this change in law are as yet uncertain.
SINCE WE DEPEND ON A FEW PRODUCERS FOR A LARGE PORTION OF OUR REVENUES,
LOSS OF BUSINESS PROVIDED BY ANY ONE OF THEM COULD ADVERSELY AFFECT US.
Our products are marketed by independent producers. Other insurance
companies compete with us for the services and allegiance of these producers.
These producers may choose to direct business to our competitors, or may direct
less desirable risks to us. For the twelve months ended December 31, 2004,
approximately 49% of the total of TICNY's gross premiums written and premiums
produced by TRM on behalf of its issuing companies was derived from our top 10
producers. For the twelve months ended December 31, 2004, Morstan General
Agency, Davis Agency Inc., Simon Agency, Inc. and CRC Insurance Inc. produced
14%, 7%, 7% and 5%, respectively, of the total of TICNY's gross premiums written
and the premiums produced by TRM on behalf of its issuing companies. A
significant decrease in business from, or the entire loss of, our largest
producer or several of our other large producers would cause us to lose premium
and require us to seek alternative producers or to increase submissions from
existing producers. In the event we are unable to find replacement producers or
increase business produced by our existing producers, our premium revenues would
decrease and our business and results of operations would be materially and
adversely affected.
OUR RELIANCE ON PRODUCERS SUBJECTS US TO THEIR CREDIT RISK.
With respect to the premiums produced by TRM for its issuing companies and
a limited amount of premium volume written by TICNY, producers collect premium
from the policyholders and forward them to TRM and TICNY. In certain
jurisdictions, including New York, when the insured pays premiums for these
policies to producers for payment over to TRM and TICNY, the premiums might be
considered to have been paid under applicable insurance laws and regulations and
the insured will no longer be liable to us for those amounts, whether or not we
have actually received the premiums from the producer. Consequently, we assume a
degree of credit risk associated with producers. Although producers' failures to
remit premiums to us have not caused a material adverse impact on us to date,
there have been instances where producers collected premium but did not remit it
to us and we were nonetheless required under applicable law to provide the
coverage set forth in the policy despite the absence of premium. Because the
possibility of these events is dependent in large part upon the financial
condition and internal operations of our producers, which in most cases are not
public information, we are not able to quantify the exposure presented by this
risk. If we are unable to collect premiums from our producers in the future, our
financial condition and results of operations could be materially and adversely
affected.
39
WE OPERATE IN A HIGHLY COMPETITIVE ENVIRONMENT. IF WE ARE UNSUCCESSFUL IN
COMPETING AGAINST LARGER OR MORE WELL-ESTABLISHED RIVALS, OUR RESULTS OF
OPERATIONS AND FINANCIAL CONDITION COULD BE ADVERSELY AFFECTED.
The property and casualty insurance industry is highly competitive and has
historically been characterized by periods of significant pricing competition
alternating with periods of greater pricing discipline, during which competition
focuses upon other factors. In recent years the market environment was favorable
in that rates increased significantly. During the latter part of 2004, increased
competition in the marketplace became evident and, as a result, rate increases
have become moderate. A softening of the market could lead to reduced growth or
a reduction in premium volume, adverse effects on profitability and, ultimately,
dislocation in the insurance industry. A. M. Best estimates that industry wide
growth in net premiums written in the homeowner's line slowed in 2003 and 2004,
and is expected to slow further in 2005, while industry wide net premiums
written in commercial lines grew significantly less in 2004 than in 2003 and are
projected to decline slightly in 2005. Industry policyholders' surplus increased
to record levels in 2004 to approximately $387.5 billion as projected by A.M.
Best, a 9.5% increase over 2003. This additional underwriting capacity may
result in increased competition from other insurers seeking to expand the types
or amount of business they write or cause a shift in focus by some insurers to
maintaining market share at the expense of underwriting discipline. We attempt
to compete based primarily on products offered, service, experience, the
strength of our client relationships, reputation, speed of claims payment,
perceived financial strength, ratings, scope of business, commissions paid and
policy and contract terms and conditions. There are no assurances that in the
future we will be able to retain or attract customers at prices which we
consider to be adequate.
We compete with major U.S. insurers and certain underwriting syndicates,
including large national companies such as The St. Paul Travelers Companies,
Inc., Allstate Insurance Company and State Farm Fire and Casualty Company;
regional insurers such as OneBeacon Insurance Company; and smaller, more local
competitors such as Magna Carta Companies, Utica First Insurance Company,
Greater New York Mutual Insurance Company, Commercial Mutual Insurance Company
and Otsego Mutual Fire Insurance Company. Many of these companies have greater
financial, marketing and management resources than we do. Many of these
competitors also have more experience, better ratings and more market
recognition than we do. We seek to distinguish ourselves from our competitors by
providing a broad product line offering and targeting those market segments that
provide us with the best opportunity to earn an underwriting profit. We also
compete with other companies by quickly and opportunistically delivering
products that respond to our producers' needs.
In addition to competition in the operation of our business, we face
competition from a variety of sources in attracting and retaining qualified
employees. We also face competition because of entities that self-insure,
primarily in the commercial insurance market. From time to time, established and
potential customers may examine the benefits and risks of self-insurance and
other alternatives to traditional insurance. See "Item 1.--Competition".
In addition, a number of new, proposed or potential legislative or industry
developments could also increase competition in our industries. These
developments include:
o the enactment of the Gramm-Leach-Bliley Act of 1999, which, among other
things, repealed United States Federal laws that limited the ability of
banks to affiliate themselves with insurance companies and could result
in increased competition in the insurance market from new entrants with
large, preexisting customer bases and broad distribution networks,
including banks and other financial service companies;
o an increase in capital-raising by companies in our line of business,
which could result in stronger competitors, new entrants to our markets
and an excess of capital in the industry, all of which may make it
harder to generate sufficient business at profitable rates; and
o changing practices and other effects caused by the internet (e.g.,
increased availability of information regarding different insurance
companies and their policies and lower barriers to entry into new
geographic markets by insurance companies), which have led to greater
competition in the insurance business and, in some cases, greater
expectations for customer service.
New competition could cause the demand for insurance to fall or the expense
of customer acquisition and retention to increase, either of which could have a
material adverse effect on our financial condition or results of operations.
40
WE MAY EXPERIENCE DIFFICULTY IN EXPANDING OUR BUSINESS, WHICH COULD
ADVERSELY AFFECT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION.
We plan to expand our licensing or acquire other insurance companies with
multi-state property and casualty licensing in order to expand our product and
service offerings geographically. We also intend to continue to acquire books of
business that fit our underwriting competencies from competitors, managing
agents and other producers and to acquire other insurance companies. This
expansion strategy may present special risks:
o We have achieved our prior success by applying a disciplined approach
to underwriting and pricing in select markets that are not well served
by our competitors. We may not be able to successfully implement our
underwriting, pricing and product strategies in companies or books of
business we acquire or over a larger operating region;
o We may not be successful in obtaining the required regulatory approvals
to offer additional insurance products or expand into additional
states;
o We have limited acquisition experience and may not be able to
efficiently combine an acquired company or block of business with our
present financial, operational and management information systems; and
o An acquisition could dilute the book value and earnings per share of
our common stock.
We cannot assure you that we will be successful in expanding our business
or that any new business will be profitable. If we are unable to expand our
business or to manage our expansion effectively, our results of operations and
financial condition could be adversely affected.
WE COULD BE ADVERSELY AFFECTED BY THE LOSS OF ONE OR MORE PRINCIPAL
EMPLOYEES OR BY AN INABILITY TO ATTRACT AND RETAIN STAFF.
Our success will depend in substantial part upon our ability to attract and
retain qualified executive officers, experienced underwriting talent and other
skilled employees who are knowledgeable about our business. We rely
substantially upon the services of our executive management team. Although we
are not aware of any planned departures or retirements, if we were to lose the
services of members of our management team, our business could be adversely
affected. We believe we have been successful in attracting and retaining key
personnel throughout our history. We have employment agreements with Michael H.
Lee, our Chairman of the Board, President and Chief Executive Officer, and other
members of our senior management team. We do not currently maintain key man life
insurance policies with respect to our employees except for Michael H. Lee.
IF ISSUING COMPANIES OR REINSURERS ARE UNWILLING TO PARTICIPATE IN
INSURANCE ARRANGED BY TRM, OUR FINANCIAL CONDITION OR RESULTS OF OPERATIONS
COULD BE MATERIALLY ADVERSELY AFFECTED.
TRM produces insurance for other insurance companies, which we call TRM's
issuing companies that in turn cede 100% of the business to reinsurers,
including TICNY. TRM receives commissions and fees for producing the insurance
and arranging the reinsurance. TRM's ability to generate fee income therefore
depends upon the willingness of issuing companies to write the business produced
by TRM, which depends upon the willingness of reinsurers, including TICNY, to
assume the risk on the business produced by TRM. For example, in 2001 commission
revenue generated by TRM's managing general agency began to decline, as we were
unable to secure favorable reinsurance terms for the business produced for TRM's
issuing companies due to the unfavorable loss experience on that business during
the soft market. Currently, all of the premium produced by TRM is written
through two issuing insurance companies, Virginia Surety Company, Inc.
("Virginia Surety") and State National Insurance Company, Inc. ("State
National"). The contracts with these companies are terminable by either party
upon 90 days notice. If we are unable to successfully structure a reinsurance
transaction that would be satisfactory to these issuing companies or if the
issuing companies are otherwise unwilling to do business with us, and we are
unable to find additional or replacement issuing companies, we would have to
rely on our own insurance company to write the premium currently produced by TRM
for these issuing companies or else forego some or all of this business and the
associated fee revenues. Writing this business in our own insurance company
would require us to bear additional insurance risk. Depending on our insurance
company's statutory surplus and our premium growth, we may not be able to write
some or all of this business. Accordingly, the inability to retain or replace a
TRM issuing company or to obtain reinsurance acceptable to us or the issuing
companies could have a material adverse effect on our financial condition or
results of operations.
41
AN ISSUING COMPANY'S INSOLVENCY OR WEAKENED FINANCIAL CONDITION MAY HAVE AN
ADVERSE IMPACT ON TRM'S REVENUES.
In the event of the insolvency or liquidation of an issuing company or
other event having a negative impact on the financial strength of an issuing
company, TRM may be unable to collect commissions due on policies written
through that issuing company and may be unable to collect other fees due such as
claims administration fees. Commission revenue on policies written through TRM's
issuing companies represented 10.7% of consolidated revenues in 2004 and 2003,
7.5% in 2002 and 24.5% in 2001.
For example, one of TRM's previous issuing companies, Legion Insurance
Company ("Legion"), was placed into rehabilitation in March of 2002 and then
subsequently declared insolvent and placed into liquidation in July of 2003.
Although we were able to minimize the adverse financial impact in this case by
terminating our agreement with Legion prior to regulatory action being taken,
the insolvency, receivership, liquidation or weakened financial condition of one
of TRM's issuing companies would leave TRM with no guarantee of full or partial
payments of monies due. Accordingly, as a result of such an event, our financial
condition or results of operations could be materially adversely affected.
OUR INVESTMENT PERFORMANCE MAY SUFFER AS A RESULT OF ADVERSE CAPITAL MARKET
DEVELOPMENTS OR OTHER FACTORS, WHICH MAY AFFECT OUR FINANCIAL RESULTS AND
ABILITY TO CONDUCT BUSINESS.
We invest the premium we receive from policyholders until it is needed to
pay policyholder claims or other expenses. At December 31, 2004, our invested
assets consisted of $224.5 million in fixed maturity securities, $2.5 million in
equity securities $1.4 million in common trust securities - statutory business
trusts. Additionally, we held $55.2 million in cash and cash equivalents. In
2004, we earned $5.1 million of net investment income representing 4.7% of our
total revenues and 34.4% of our pre-tax income. Our funds are invested by a
professional investment advisory management firm under the direction of our
management team in accordance with detailed investment guidelines set by us. See
"Item 1.--Investments". Although our investment policies stress diversification
of risks, conservation of principal and liquidity, our investments are subject
to a variety of investment risks, including risks relating to general economic
conditions, market volatility, interest rate fluctuations, liquidity risk and
credit and default risk. (Interest rate risk is discussed below under the
heading, "--We may be adversely affected by interest rate changes"). In
particular, the volatility of our claims may force us to liquidate securities,
which may cause us to incur capital losses. If we do not structure our
investment portfolio so that it is appropriately matched with our insurance and
reinsurance liabilities, we may be forced to liquidate investments prior to
maturity at a significant loss to cover such liabilities. Investment losses
could significantly decrease our asset base and statutory surplus, thereby
affecting our ability to conduct business.
WE MAY BE ADVERSELY AFFECTED BY INTEREST RATE CHANGES.
Our operating results are affected, in part, by the performance of our
investment portfolio. Our investment portfolio contains interest rate sensitive
instruments, such as bonds, which may be adversely affected by changes in
interest rates. A significant increase in interest rates could have a material
adverse effect on our financial condition or results of operations. Generally,
bond prices decrease as interest rates rise. Changes in interest rates could
also have an adverse effect on our investment income and results of operations.
For example, if interest rates decline, investment of new premiums received and
funds reinvested will earn less than expected.
In addition, our investment portfolio includes mortgage-backed securities.
As of December 31, 2004, mortgage-backed securities constituted approximately
28.1% of our invested assets. As with other fixed income investments, the fair
market value of these securities fluctuates depending on market and other
general economic conditions and the interest rate environment. Changes in
interest rates can expose us to prepayment risks on these investments. When
interest rates fall, mortgage-backed securities are prepaid more quickly than
expected and the holder must reinvest the proceeds at lower interest rates. Our
mortgage-backed securities currently consist of securities with features that
reduce the risk of prepayment, but there is no guarantee that we will not invest
in other mortgage-backed securities that lack this protection. In periods of
increasing interest rates, mortgage-backed securities are prepaid more slowly,
which may require us to receive interest payments that are below the interest
rates then prevailing for longer than expected.
Interest rates are highly sensitive to many factors, including governmental
monetary policies, domestic and international economic and political conditions
and other factors beyond our control.
42
WE MAY REQUIRE ADDITIONAL CAPITAL IN THE FUTURE, WHICH MAY NOT BE AVAILABLE
OR ONLY AVAILABLE ON UNFAVORABLE TERMS.
Our future capital requirements depend on many factors, including our
ability to write new business successfully and to establish premium rates and
reserves at levels sufficient to cover losses. To the extent that our present
capital is insufficient to meet future operating requirements and/or cover
losses, we may need to raise additional funds through financings or curtail our
growth. Based on our current operating plan, we believe current capital together
with our anticipated retained earnings, will support our operations without the
need to raise additional capital. However, we cannot provide any assurance in
that regard, since many factors will affect our capital needs and their amount
and timing, including our growth and profitability, our claims experience, and
the availability of reinsurance, as well as possible acquisition opportunities,
market disruptions and other unforeseeable developments. If we had to raise
additional capital, equity or debt financing may not be available at all or may
be available only on terms that are not favorable to us. In the case of equity
financings, dilution to our stockholders could result, and in any case such
securities may have rights, preferences and privileges that are senior to those
of the shares offered hereby. If we cannot obtain adequate capital on favorable
terms or at all, our business, financial condition or results of operations
could be materially adversely affected.
THE REGULATORY SYSTEM UNDER WHICH WE OPERATE, AND POTENTIAL CHANGES
THERETO, COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS.
TICNY is subject to comprehensive regulation and supervision in New York,
which is the only state in which TICNY is presently licensed. The purpose of the
New York insurance laws and regulations is to protect insureds, not our
stockholders. These regulations are generally administered by the New York State
Insurance Department and relate to, among other things:
o standards of solvency, including risk based capital measurements;
o restrictions on the nature, quality and concentration of investments;
o required methods of accounting;
o rate and form regulation pertaining to certain of our insurance
businesses; and
o potential assessments for the provision of funds necessary for the
settlement of covered claims under certain policies provided by
impaired, insolvent or failed insurance companies.
Significant changes in these laws and regulations could make it more
expensive to conduct our business. The New York Insurance Department also
conducts periodic examinations of the affairs of insurance companies and
requires the filing of annual and other reports relating to financial condition,
holding company issues and other matters. These regulatory requirements may
adversely affect or inhibit our ability to achieve some or all of our business
objectives.
TICNY may not be able to obtain or maintain necessary licenses, permits,
authorizations or accreditations in New York or in new states we intend to
enter, or may be able to do so only at significant cost. In addition, we may not
be able to comply fully with or obtain appropriate exemptions from, the wide
variety of laws and regulations applicable to insurance companies or holding
companies. Failure to comply with or to obtain appropriate authorizations and/or
exemptions under any applicable laws could result in restrictions on our ability
to do business or engage in certain activities that are regulated in one or more
of the jurisdictions in which we operate and could subject us to fines and other
sanctions, which could have a material adverse effect on our business. In
addition, changes in the laws or regulations to which our operating subsidiaries
are subject could adversely affect our ability to operate and expand our
business or could have a material adverse effect on our financial condition or
results of operations.
In recent years, the U.S. insurance regulatory framework has come under
increased Federal scrutiny, and some state legislators have considered or
enacted laws that may alter or increase state regulation of insurance and
reinsurance companies and holding companies. Moreover, the National Association
of Insurance Commissioners ("NAIC"), which is an association of the insurance
commissioners of all 50 states and the District of Columbia, and state insurance
regulators regularly re-examine existing laws and regulations, often focusing on
modifications to holding company regulations, interpretations of existing laws
and the development of new laws. Changes in these laws and regulations or the
interpretation of these laws and regulations could have a material adverse
effect on our financial condition or results of operations. The recent highly
publicized investigations of the insurance industry by the New York State
Attorney General and other regulators and government officials have led to, and
may continue to lead to, additional legislative and regulatory requirements for
the insurance industry and may increase the costs of doing business.
43
The activities of TRM are subject to licensing requirements and regulation
under the laws of New York and New Jersey. TRM's business depends on the
validity of, and continued good standing under, the licenses and approvals
pursuant to which it operates, as well as compliance with pertinent regulations.
Licensing laws and regulations vary from jurisdiction to jurisdiction. In
all jurisdictions, the applicable licensing laws and regulations are subject to
amendment or interpretation by regulatory authorities. Generally such
authorities are vested with relatively broad and general discretion as to the
granting, renewing and revoking of licenses and approvals. Licenses may be
denied or revoked for various reasons, including the violation of such
regulations, conviction of crimes and the like. Possible sanctions which may be
imposed include the suspension of individual employees, limitations on engaging
in a particular business for specified periods of time, revocation of licenses,
censures, redress to clients and fines. In some instances, TRM follows practices
based on its or its counsels' interpretations of laws and regulations, or those
generally followed by the industry, which may prove to be different from those
of regulatory authorities.
IF NEW YORK DRASTICALLY INCREASES THE ASSESSMENTS TICNY IS REQUIRED TO PAY,
OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION WILL SUFFER.
TICNY is subject to assessments in New York for various purposes, including
the provision of funds necessary to fund the operations of the New York
Insurance Department and the New York Security Fund, which pays covered claims
under certain policies provided by impaired, insolvent or failed insurance
companies. In 2004, the assessment for the New York Insurance Department was
$556,000 and the New York Security Fund assessment was $435,000. These
assessments are generally set based on an insurer's percentage of the total
premiums written in New York State within a particular line of business. The
Company is permitted to assess premium surcharges on workers' compensation
policies that are based on statutorily enacted rates. However, assessments by
the various workers' compensation funds have recently exceeded the permitted
surcharges resulting in additional expenses of $1,143,000 in 2004. As of
December 31, 2004 the liability for the various workers' compensation funds,
which includes amounts assessed on workers' compensation policies was
$1,839,000. This amount is expected to be paid over an eighteen month period
ending June 30, 2006. As our company grows, our share of any assessments may
increase. However, we cannot predict with certainty the amount of future
assessments because they depend on factors outside our control, such as
insolvencies of other insurance companies. Significant assessments could have a
material adverse effect on our financial condition or results of operations.
OUR ABILITY TO MEET ONGOING CASH REQUIREMENTS AND PAY DIVIDENDS MAY BE
LIMITED BY OUR HOLDING COMPANY STRUCTURE AND REGULATORY CONSTRAINTS.
Tower is a holding company and, as such, has no direct operations of its
own. Tower does not expect to have any significant operations or assets other
than its ownership of the shares of its operating subsidiaries. Dividends and
other permitted payments from our operating subsidiaries are expected to be our
primary source of funds to meet ongoing cash requirements, including any future
debt service payments and other expenses, and to pay dividends, if any, to our
stockholders. TICNY is subject to significant regulatory restrictions limiting
its ability to declare and pay dividends. As of December 31, 2004, the maximum
amount of distributions that TICNY could pay to Tower without approval of the
New York Insurance Department was $2.8 million. The inability of TICNY to pay
dividends and other permitted payments in an amount sufficient to enable us to
meet our cash requirements at the holding company level would have a material
adverse effect on our operations and our ability to pay dividends to our
stockholders. While we currently intend to pay dividends, if you require
dividend income you should carefully consider these risks before relying on an
investment in our company. For more information regarding restrictions on the
payment of dividends. See "Item 5.-Dividend Policy" and "Item 1.-Regulation".
ALTHOUGH WE HAVE PAID CASH DIVIDENDS IN THE PAST, WE MAY NOT PAY CASH
DIVIDENDS IN THE FUTURE.
We have a history of paying dividends to our stockholders when sufficient
cash is available, and we currently intend to pay dividends in each quarter of
2005. However, future cash dividends will depend upon our results of operations,
financial condition, cash requirements and other factors, including the ability
of our subsidiaries to make distributions to us, which ability is restricted in
the manner previously discussed in this section. Also, there can be no assurance
that we will continue to pay dividends even if the necessary financial
conditions are met and if sufficient cash is available for distribution. See
"Item 5.-Dividend Policy".
44
RISKS RELATED TO OUR INDUSTRY
THE THREAT OF TERRORISM AND MILITARY AND OTHER ACTIONS MAY ADVERSELY AFFECT
OUR INVESTMENT PORTFOLIO AND MAY RESULT IN DECREASES IN OUR NET INCOME, REVENUE
AND ASSETS UNDER MANAGEMENT.
The threat of terrorism, both within the United States and abroad, and
military and other actions and heightened security measures in response to these
types of threats, may cause significant volatility and declines in the equity
markets in the United States, Europe and elsewhere, as well as loss of life,
property damage, additional disruptions to commerce and reduced economic
activity. Some of the assets in our investment portfolio may be adversely
affected by declines in the equity markets and economic activity caused by the
continued threat of terrorism, ongoing military and other actions and heightened
security measures.
We cannot predict at this time whether and the extent to which industry
sectors in which we maintain investments may suffer losses as a result of
potential decreased commercial and economic activity, or how any such decrease
might impact the ability of companies within the affected industry sectors to
pay interest or principal on their securities, or how the value of any
underlying collateral might be affected.
We can offer no assurances that terrorist attacks or the threat of future
terrorist events in the United States and abroad or military actions by the
United States will not have a material adverse effect on our business, financial
condition or results of operations.
OUR RESULTS OF OPERATIONS AND REVENUES MAY FLUCTUATE AS A RESULT OF MANY
FACTORS, INCLUDING CYCLICAL CHANGES IN THE INSURANCE INDUSTRY, WHICH MAY CAUSE
THE PRICE OF OUR SECURITIES TO BE VOLATILE.
The results of operations of companies in the property and casualty
insurance industry historically have been subject to significant fluctuations
and uncertainties. Our profitability can be affected significantly by:
o competition;
o rising levels of loss costs that we cannot anticipate at the time we
price our products;
o volatile and unpredictable developments, including man-made,
weather-related and other natural catastrophes or terrorist attacks;
o changes in the level of reinsurance capacity and capital capacity;
o changes in the amount of loss and loss adjustment expense reserves
resulting from new types of claims and new or changing judicial
interpretations relating to the scope of insurers' liabilities; and
o fluctuations in equity markets and interest rates, inflationary
pressures and other changes in the investment environment, which affect
returns on invested assets and may impact the ultimate payout of
losses.
The supply of insurance is related to prevailing prices, the level of
insured losses and the level of industry surplus which, in turn, may fluctuate
in response to changes in rates of return on investments being earned in the
insurance and reinsurance industry. As a result, the insurance business
historically has been a cyclical industry characterized by periods of intense
price competition due to excessive underwriting capacity as well as periods when
shortages of capacity permitted favorable premium levels. Premium levels for
many products have increased in recent years. However, beginning in the latter
part of 2004, rates for property and casualty insurance products began to
moderate, and for certain products, began to decrease due to increased levels of
competition. A. M. Best estimates that industry wide growth in net premiums
written in the homeowner's line slowed in 2003 and 2004, and is expected to slow
further in 2005, while industry wide net premiums written in commercial lines
grew significantly less in 2004 than in 2003 and are projected to decline
slightly in 2005. The supply of insurance and reinsurance as measured by the
amount of industry policyholders' surplus has increased and may continue to
increase, either by capital provided by new entrants or by the commitment of
additional capital by existing insurers or reinsurers, which may cause prices to
decrease further. Industry policyholders' surplus increased to record levels in
2004 to approximately $387.5 billion as projected by A.M. Best, a 9.5% increase
over 2003. This additional underwriting capacity may result in increased
competition from other insurers seeking to expand the types or amount of
business they write or cause a shift in focus by some insurers to maintaining
market share at the expense of underwriting discipline. These factors could lead
to a significant reduction in premium rates, less favorable policy terms and
fewer submissions for our underwriting services. In addition to these
considerations, changes in the frequency and severity of losses suffered by
insureds and insurers may affect the cycles of the insurance business
significantly, and we expect to experience the effects of such cyclicality. This
cyclicality could have a material adverse effect on our results of operations
and revenues, which may cause the price of our securities to be volatile. See
"Item 1.-Industry Background" for a more detailed discussion of the cyclicality
of the insurance industry.
45
NOTE ON FORWARD-LOOKING STATEMENTS
Some of the statements under "Risk Factors," "Management's Discussion and
Analysis of Financial Condition and Results of Operations," "Business" and
elsewhere in this Form 10-K may include forward-looking statements that reflect
our current views with respect to future events and financial performance. These
statements include forward-looking statements both with respect to us
specifically and the insurance sector in general. Statements that include the
words "expect," "intend," "plan," "believe," "project," "estimate," "may,"
"should," "anticipate," "will" and similar statements of a future or
forward-looking nature identify forward-looking statements for purposes of the
Federal securities laws or otherwise.
All forward-looking statements address matters that involve risks and
uncertainties. Accordingly, there are or will be important factors that could
cause our actual results to differ materially from those indicated in these
statements. We believe that these factors include, but are not limited to, those
described under "Item 1.-Risk Factors" and the following:
o ineffectiveness or obsolescence of our business strategy due to changes
in current or future market conditions;
o developments that may delay or limit our ability to enter new markets
as quickly as we anticipate;
o increased competition on the basis of pricing, capacity, coverage terms
or other factors;
o greater frequency or severity of claims and loss activity, including as
a result of natural or man-made catastrophic events, than our
underwriting, reserving or investment practices anticipate based on
historical experience or industry data;
o the effects of acts of terrorism or war;
o developments in the world's financial and capital markets that
adversely affect the performance of our investments;
o changes in regulations or laws applicable to us, our subsidiaries,
brokers or customers;
o acceptance of our products and services, including new products and
services;
o changes in the availability, cost or quality of reinsurance and failure
of our reinsurers to pay claims timely or at all;
o changes in the percentage of our premiums written that we ceded to
reinsurers;
o decreased demand for our insurance or reinsurance products;
o loss of the services of any of our executive officers or other key
personnel;
o the effects of mergers, acquisitions and divestitures;
o changes in rating agency policies or practices;
o changes in legal theories of liability under our insurance policies;
o changes in accounting policies or practices; and
o changes in general economic conditions, including inflation, interest
rates and other factors.
The foregoing review of important factors should not be construed as
exhaustive and should be read in conjunction with the other cautionary
statements that are included in this Form 10-K. We undertake no obligation to
publicly update or review any forward-looking statement, whether as a result of
new information, future developments or otherwise.
If one or more of these or other risks or uncertainties materialize, or if
our underlying assumptions prove to be incorrect, actual results may vary
materially from what we project. Any forward-looking statements you read in this
Form 10-K reflect our views as of the date of this Form 10-K with respect to
future events and are subject to these and other risks, uncertainties and
assumptions relating to our operations, results of operations, growth strategy
and liquidity. All subsequent written and oral forward-looking statements
attributable to us or individuals acting on our behalf are expressly qualified
in their entirety by this paragraph. Before making an investment decision, you
should specifically consider all of the factors identified in this Form 10-K
that could cause actual results to differ.
46
ITEM 2. PROPERTIES
We lease approximately 54,000 square feet of space at 120 Broadway, New
York, New York, on the entire 14th floor and a part of the 17th floor. We pay an
annual rent of $1,336,000, which will increase by the terms of the lease
agreement on September 16, 2005 to $1,354,000. The expiration date of the lease
is May 15, 2008, upon which date we have an option to extend the term of the
lease for a single renewal term of five years. If we exercise the option for
renewal, the rent will be adjusted to reflect the fair market rental value at
the time of renewal.
During the fourth quarter of 2004, we established two branch offices. The
first was set up in Melville, New York (Long Island Branch) for 17,127 square
feet of space at 225 Broadhollow Road, Melville, New York. We entered into a
sublease agreement for this property from April 15, 2005 until September 30,
2006 and entered into a lease agreement for the same property for the period
commencing October 1, 2006 that will expire in 10 years and 8 months. The second
branch was set up for 4,900 square feet of temporary space in Buffalo, New York
(Buffalo Branch).
ITEM 3. LEGAL PROCEEDINGS
From time to time, we are involved in various legal proceedings in the
ordinary course of business. For example, to the extent a claim asserted by a
third party in a law suit against one of our insureds is covered by a particular
policy, we may have a duty to defend the insured party against the claim. These
claims may relate to bodily injury, property damage or other compensable
injuries as set forth in the policy. Thus, when such a lawsuit is submitted to
us, in accordance with our contractual duty we appoint counsel to represent any
covered policyholders named as defendants in the lawsuit. In addition, from time
to time we may take a coverage position (e.g., denying coverage) on a submitted
property or liability claim with which the policyholder is in disagreement. In
such cases, we may be sued by the policyholder for a declaration of its rights
under the policy and/or for monetary damages, or we may institute a lawsuit
against the policyholder requesting a court to confirm the propriety of our
position. We do not believe that the resolution of any currently pending legal
proceedings, either individually or taken as a whole, will have a material
adverse effect on our business, results of operations or financial condition.
In addition to litigation arising from the policies we issue, as with any
company actively engaged in business, from time to time we may be involved in
litigation involving non-policyholders such as vendors or other third parties
with whom we have entered into contracts and out of which disputes have arisen,
or litigation arising from employment related matters, such as actions by
employees claiming unlawful treatment or improper termination. There are no
suits of a material nature and of the type described above presently pending
against us.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the
fourth quarter of 2004.
PART II.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
SHAREHOLDERS
The Company's common stock is traded on the Nasdaq National Market System
under the ticker symbol "TWGP". The Company has one class of authorized capital
stock for 40,000,000 shares at a par value of $0.01 per share.
47
On October 20, 2004, the Securities and Exchange Commission declared the
Company's registration statement effective. The Company's IPO was for 13,000,000
shares and was priced at $8.50 per share. On the same date, the Company also
offered a concurrent private placement of 500,000 shares of its common stock to
an affiliate of Friedman, Billings, Ramsey & Co., Inc., the lead underwriter for
the Company's IPO, at a price of $8.50 per share.
On November 10, 2004 the underwriters exercised their 30-day over-allotment
option after the Company's IPO. Pursuant to this exercise, the underwriters
purchased 629,007 additional shares of common stock from the Company and
1,320,993 shares of common stock from selling shareholders.
As of March 1, 2005, there were 19,737,168 common shares issued and
outstanding held by 139 shareholders of record.
PRICE RANGE OF COMMON STOCK
The high, low and close prices for shares as quoted on the Nasdaq from the
period of our IPO, October 20, 2004 to December 31, 2004 are $12.55, $8.50 and
$12.00 respectively.
DIVIDEND POLICY
Our Board of Directors currently intends to authorize the payment of
quarterly dividend of $0.025 per share of common stock to our stockholders of
record. Any determination to pay cash dividends will be at the discretion of our
Board of Directors and will be dependent upon our results of operations and cash
flows, our financial position and capital requirements, general business
conditions, legal, tax, regulatory and any contractual restrictions on the
payment of dividends and any other factors our Board of Directors deems
relevant.
We are a holding company and have no direct operations. Our ability to pay
dividends depends, in part, on the ability of TICNY to pay dividends to us.
TICNY is subject to significant regulatory restrictions limiting its ability to
declare and pay dividends.
The New York Insurance Department must approve any dividend declared or
paid by TICNY that, together with all dividends declared or distributed by TICNY
during the preceding twelve months, exceeds the lesser of (1) 10% of TICNY's
policyholders' surplus as shown on its latest statutory financial statements
filed with the New York State Insurance Department or (2) 100% of adjusted net
investment income during the preceding twelve months. TICNY paid approximately
$850,000, $364,000 and $1,555,000 in dividends to Tower in 2004, 2003, and 2002,
respectively. As of December 31, 2004, the maximum distribution that TICNY could
pay without prior regulatory approval was approximately $2.8 million.
Pursuant to the terms of the subordinated debentures underlying our trust
preferred securities, Tower and its subsidiaries cannot declare or pay any
dividends if we are in default of or if we have elected to defer payments of
interest on those debentures.
Effective upon the closing of the Company's IPO, on October 20, 2004, the
Company effected a 1.8:1 stock split while maintaining a par value of $0.01
after the split, and a restatement of the Company's Certificate of Incorporation
which, among other things, classified the Class A and Class B common stock into
one class of common stock and increased the authorized common stock to
40,000,000 shares.
The Company declared dividends on common and preferred stock as follows in
(000's):
2004 2003 2002
----- ------ ------
Common stock dividends declared $ 493 $ -- $ 473
Class A common stock dividends declared 228 293 --
Class B common stock dividends declared 281 1,403 --
------ ------ ------
Total common stock dividends declared 1,002 1,696 473
Preferred stock dividends declared -- 158 315
------ ------ ------
Total dividends declared $1,002 $1,854 $ 788
====== ====== ======
48
The Company declared dividends per share on common stock as follows:
2004 2003 2002
------- ------ -------
Common Stock $0.0250 -- $0.1048
Class A Stock $0.1137 $0.1465 --
Class B Stock $0.1142 $0.5773 --
Preferred stock dividends of $130,000 and $158,000 for the twelve months
ending December 31, 2004 and the last six months of 2003, respectively, were
included in interest expense in accordance with SFAS 150. The preferred stock
dividends for the first six months of 2003 were $158,000 and for the twelve
months ending December 31, 2002 were $315,000 and were recorded as a reduction
to stockholders' equity.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL INFORMATION
The selected consolidated income statement data for the years ended
December 31, 2004, 2003 and 2002 and the balance sheet data as of December 31,
2004 and 2003 are derived from our audited financial statements included
elsewhere in this document, which have been prepared in accordance with GAAP and
have been audited by Johnson Lambert & Co., our independent public accounting
firm. The selected consolidated income statement data for the years ended
December 31, 2001 and 2000 and the balance sheet data as of December 31, 2002,
2001 and 2000 are derived from our unaudited financial statements. These
historical results are not necessarily indicative of results to be expected from
any future period. You should read the following selected consolidated financial
information along with the information contained in this document, including
"Item 7.-Management's Discussion and Analysis of Financial Condition and Results
of Operations" and the consolidated financial statements and related notes
included elsewhere in this Form 10-K.
FOR THE YEAR ENDED DECEMBER 31,
2000
2004 2003 2002 2001 (UNAUDITED)
-------- -------- -------- -------- -----------
($ in thousands, except share and per share amounts)
INCOME STATEMENT DATA
Gross premiums written $177,766 $134,482 $106,740 $ 59,698 $ 26,084
Ceded premiums written 79,691 105,532 79,411 48,372 20,715
-------- -------- -------- -------- --------
Net premiums written $ 98,075 $ 28,950 $ 27,329 $ 11,326 $ 5,369
======== ======== ======== ======== ========
Net premiums earned $ 45,564 $ 22,941 $ 26,008 $ 6,974 $ 5,888
Ceding commission revenue 39,983 35,605 21,872 10,456 6,412
Insurance services revenue 16,381 12,830 12,428 14,419 19,035
Net investment income 5,070 2,268 1,933 828 644
Net realized gains (loss) on investments 13 493 95 69 25
Policy billing fees 679 545 376 144 --
-------- -------- -------- -------- --------
Total revenues 107,690 74,682 62,712 32,890 32,004
Losses and loss adjustment expenses 27,060 15,071 16,356 5,339 4,676
Operating expenses:
Direct and ceding commission expenses 32,825 26,158 19,187 12,540 13,389
Other operating expenses(1) 29,954 22,337 17,279 14,388 15,525
Interest expense 3,128 1,462 122 73 56
-------- -------- -------- -------- --------
Total expenses 92,967 65,028 52,944 32,340 33,646
Income (loss) before income taxes 14,723 9,654 9,768 550 (1,642)
Income tax expense (benefit) 5,694 3,374 4,135 189 (402)
-------- -------- -------- -------- --------
Net income (loss) $ 9,029 $ 6,280 $ 5,633 $ 361 $ (1,240)
======== ======== ======== ======== ========
Net income (loss) available to common
stockholders $ 9,029 $ 6,122 $ 5,318 $ 46 $ (1,555)
======== ======== ======== ======== ========
49
FOR THE YEAR ENDED DECEMBER 31,
2000
2004 2003 2002 2001 (UNAUDITED)
----------- ------------ ------------ ------------ --------------
($ in thousands, except share and per share amounts)
PER SHARE DATA
Basic earnings (loss) per share $ 1.23 $ 1.37 $ 1.18 $ 0.01 $ (0.35)
Diluted earnings (loss) per share $ 1.06 $ 1.09 $ 0.94 $ 0.01 $ (0.35)
Basic weighted average outstanding 7,335,286 4,453,717 4,500,000 4,500,000 4,500,000
Diluted weighted average per shares
outstanding 8,565,815 5,708,016 5,761,949 4,621,115 4,500,000
SELECTED INSURANCE RATIOS
Gross loss ratio(2) 55.2% 60.8% 63.8% 73.0% 66.1%
Gross underwriting expense ratio(3) 31.1% 30.0% 31.0% 33.8% 32.6%
----------- ------------ ------------ ------------- ------------
Gross combined ratio(4) 86.3% 90.8% 94.8% 106.8% 98.7%
=========== ============ ============ ============= ============
Net loss ratio(5) 59.4% 65.7% 62.9% 76.6% 79.4%
Net underwriting expense ratio(6) 16.2% 4.4% 18.5% 25.7% 32.6%
----------- ------------ ------------ ------------- ------------
Net combined ratio(7) 75.6% 70.1% 81.4% 102.3% 112.0%
=========== ============ ============ ============= ============
AS OF DECEMBER 31,
2000
2004 2003 2002 2001 (UNAUDITED)
----------- ---------- --------- -------- -------------
($ in thousands, except share and per share amounts)
SUMMARY BALANCE SHEET DATA
Cash and cash equivalents $ 55,201 $ 30,339 $ 3,399 $ 13,186 $ 4,845
Investments at fair market value 228,434 57,349 39,618 17,771 10,643
Reinsurance recoverable 101,173 84,760 55,110 33,085 23,035
Deferred acquisition costs, net 18,740 573 -- -- 569
Total assets 494,147 286,592 186,116 124,008 69,960
Reserve for losses and loss adjustment
expenses 128,722 99,475 65,688 37,637 28,507
Unearned premium 95,505 70,248 57,012 37,202 13,731
Long-term debt and redeemable preferred
stock 47,426 29,208 3,000 3,000 3,000
Deferred ceding commission revenue, net -- -- 3,494 5,984 --
Total stockholders' equity 129,447 13,061 9,067 3,336 3,473
PER SHARE DATA:
Book value per share(8) $ 6.56 $ 2.96 $ 2.01 $ 0.74 $ 0.77
Diluted book value per share(9) $ 6.45 $ 2.38 $ 1.62 $ 0.61 $ 0.64
Dividends declared per share
Common Stock $ 0.0250 $ -- $ 0.1048 $ 0.0486 $ 0.0464
Class A Stock $ 0.1137 $ 0.1465 $ -- $ -- $ --
Class B Stock $ 0.1142 $ 0.5773 $ -- $ -- $ --
(1) Includes acquisition expenses and other underwriting expenses (which are
general administrative expenses related to underwriting operations in our
insurance company) as well as other insurance services expenses (which are
general administrative expenses related to insurance services operations).
(2) The gross loss ratio is calculated by dividing gross losses (consisting of
losses and loss adjustment expenses) by gross premiums earned.
50
(3) The gross underwriting expense ratio is calculated by dividing gross
underwriting expenses (consisting of direct commission expenses and other
underwriting expenses net of policy billing fees) by gross premiums earned.
(4) The gross combined ratio is the sum of the gross loss ratio and the gross
underwriting expense ratio.
(5) The net loss ratio is calculated by dividing net losses by net premiums
earned.
(6) The net underwriting expense ratio is calculated by dividing net
underwriting expenses (consisting of direct commission expenses and other
underwriting expenses net of policy billing fees and ceding commission
revenue) by net premiums earned. Because the ceding commission revenue we
earn on our ceded premiums has historically been higher than our expenses
incurred to produce those premiums, our extensive use of quota share
reinsurance has caused our net underwriting expense ratio to be lower than
our gross underwriting expense ratio under GAAP.
(7) The net combined ratio is the sum of the net loss ratio and the net
underwriting expense ratio.
(8) Book value per share is based on total stockholders' equity divided by
common shares outstanding at year end.
(9) Diluted book value per share is calculated based on total stockholders'
equity divided by the sum of the number of shares of common stock
outstanding plus the appropriate common stock equivalents for stock options,
warrants and restricted stock using the treasury stock method.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis of our financial condition and
results of operations should be read in conjunction with our consolidated
financial statements and accompanying notes which appear elsewhere in this Form
10-K. It contains forward-looking statements that involve risks and
uncertainties. See "Item 1.-Note on Forward-Looking Statements" for more
information. Our actual results could differ materially from those anticipated
in these forward-looking statements as a result of various factors, including
those discussed below and elsewhere in this Form 10-K, particularly under the
headings "Item 1.-Risk Factors" and "Item 1.-Note on Forward-Looking
Statements."
OVERVIEW
We provide a broad range of property and casualty insurance products as
well as reinsurance through TICNY, our insurance company subsidiary. We also
provide managing general underwriting, claims administration and reinsurance
intermediary services through TRM, our insurance services subsidiary.
We manage these operations through three business segments: insurance
(commercial and personal lines underwriting), reinsurance, and insurance
services (managing general agency, claims administration and reinsurance
intermediary operations).
In our insurance segment, TICNY provides commercial and personal lines
insurance policies to businesses and individuals. TICNY's commercial lines
products include commercial multiple-peril (provides both property and liability
insurance), monoline general liability (insures bodily injury or property damage
liability), commercial umbrella, monoline property (insures buildings, contents
or business income), workers' compensation and commercial automobile policies.
Its personal lines products consist of homeowners, dwelling and other liability
policies. In our reinsurance segment, TICNY assumes reinsurance directly from
the insurance companies for which TRM produces insurance premiums (which we
refer to as TRM's "issuing companies") or indirectly from reinsurers that
provide reinsurance coverage directly to these issuing companies. In our
insurance services segment, TRM generates commission income from its managing
general agency by producing premiums on behalf of its issuing companies and
generates fees by providing claims administration and reinsurance intermediary
services.
INITIAL PUBLIC OFFERING
On June 22, 2004 the Company's Board of Directors approved a 1.8:1 stock
split, the maintaining of a par value of $0.01 after the split and the amendment
and restatement of the Company's Certificate of Incorporation which among other
things, combined the Class A and Class B common stock into one class of common
stock and increased the authorized common stock to 40,000,000 shares. These
actions became effective on October 20, 2004, which is the effective date of the
Company's IPO. All consolidated financial statements and per share amounts have
been retroactively adjusted for the above stock split and maintaining the par
value at $0.01 per share.
51
On October 20, 2004, the Company sold 13,000,000 shares in its IPO at $8.50
per share. On the same date, the Company also effected a concurrent private
placement of 500,000 shares of its common stock to an affiliate of Friedman,
Billings, Ramsey & Co., Inc., the lead underwriter for the Company's IPO, at a
price of $8.50 per share. On November 10, 2004 the underwriters exercised their
30-day over-allotment option after the Company's IPO. Pursuant to this exercise,
the underwriters purchased 629,007 additional shares of common stock from the
Company and 1,320,993 shares of common stock from selling shareholders. The
Company received net cash proceeds of $107,845,000 from the offering and
concurrent private placement after the underwriting discounts, commissions and
offering expenses. The total costs of the IPO and private placement were
$12,252,000 of which $8,407,000 was for the underwriters discount, and
$3,845,000 was for all other costs. Costs of the IPO have been reflected as a
reduction in Paid-in-Capital.
SHELL ACQUISITION
In January 2005, the Company announced that it entered into a stock
purchase agreement to acquire North American Lumber Insurance Company ("NALIC"),
a shell company with active licenses in the following nine states: New Jersey,
Connecticut, Massachusetts, Rhode Island, Vermont, Maryland, Delaware, South
Carolina and Wisconsin. Tower Group, Inc. will pay $1,050,000 in cash at
closing. An additional $75,000 per state will be paid within one year of the
closing date contingent upon license reactivation in each of Pennsylvania and
Maine.
NALIC will be initially capitalized with part of the $26,000,000 raised by
Tower Group, Inc. through two trust preferred securities offerings in December,
2004. According to the terms of the agreement, all liabilities and assets of
NALIC (which will be renamed) will be transferred to a liquidating trust prior
to closing with the exception of its charter and insurance licenses. The
transaction has obtained court approval in Massachusetts and is expected to
close in March or April of 2005.
MARKETPLACE CONDITIONS AND TRENDS
The property and casualty insurance industry is affected by naturally
occurring industry cycles known as "hard" and "soft" markets. Since we began
operations in 1990 and continuing into 2000, we operated in a soft market cycle,
generally considered an adverse industry cycle in the property and casualty
insurance industry. A soft market cycle is characterized by intense competition
that results in inadequate pricing, expanded coverage terms and increased
commissions paid to distribution sources in order to compete for business. We
believe that a hard market began sometime in late 2000. A hard market, generally
considered a beneficial industry trend, is characterized by reduced competition
that results in higher pricing, reduced coverage terms and lower commissions
paid to acquire business. While we sustained minimal losses from the September
11, 2001 terrorist attacks, the hard market conditions were significantly
intensified after this event.
Our perception of the shift in the property and casualty industry cycles
led to a revision of our business model. Until 2001, we relied upon reinsurance
and the capacity provided by TRM's issuing companies to support the expansion of
the premium volume we produced. A soft reinsurance market during that period
enabled us to secure favorable reinsurance terms and conditions for TICNY and
for the issuing companies utilized by TRM.
Beginning in 2001, commission revenue generated by TRM's managing general
agency began to decline, as we were unable to secure favorable reinsurance terms
for the business produced for TRM's issuing companies due to the unfavorable
loss experience on that business during the soft market. TICNY, however, was
able to maintain favorable reinsurance terms due to the profitability of its
business. As a result, we began to significantly increase TICNY's gross premiums
written and de-emphasized producing premiums through TRM. We also began to
reduce the percentage of premiums ceded by TICNY to our quota share reinsurers,
increasing our net premiums written. On March 1, 2001, we entered into an
agreement with one of our main regional insurance company competitors, Empire
Insurance Group ("Empire"), to acquire the renewal rights for a significant
portion of Empire's business. This transaction added gross premiums written of
$41.1 million in TICNY and $426,000 in TRM's issuing companies during the first
twelve months after we acquired the business.
TICNY's gross premiums written in 2004, 2003 and 2002 were $177.8 million,
$134.5 million and $106.7 million, respectively. After significant pricing
increases and reunderwriting that began in 2001, TRM's underlying business also
became profitable in 2003 and the premiums produced by TRM in 2004, 2003 and
2002 were $53.4 million, $39.5 million and $24.3 million, respectively.
52
Premium levels for many products have increased in recent years. However,
beginning in 2004, rates for property and casualty insurance products began to
moderate, and for certain products, began to decrease due to increased levels of
competition. A. M. Best estimates that industry wide growth in net premiums
written in the homeowner's line to be 7.9% in 2004, from 14.1% in 2003, and is
expected to slow further to a projected 5.0% in 2005. A.M. Best also estimated
that industry wide growth in net premiums written in commercial lines slowed
significantly in 2004 to an estimated 4.8% from 12.3% in 2003 and that
commercial lines net premium written in 2005 is projected to decline by 1.0%.
The supply of insurance and reinsurance as measured by the amount of industry
policyholders' surplus has increased and may continue to increase. Industry
policyholders' surplus increased to record levels in 2004 to approximately
$387.5 billion as projected by A.M. Best, a 9.5% increase over 2003. This
additional underwriting capacity may result in increased competition from other
insurers in order to generate an adequate return on capital or cause a shift in
focus by some insurers to maintaining market share at the expense of
underwriting discipline. These factors could lead to a significant reduction in
premium rates and less favorable policy terms. However, we believe that premium
levels remain relatively attractive in the sizeable underserved market segments
where we can continue to maintain underwriting discipline and selectivity in low
hazard classes of business, as well as adequate pricing and coverage terms.
Additionally, our broad product line platform allows us to achieve an optimal
business mix in response to varying market conditions.
PRINCIPAL REVENUE AND EXPENSE ITEMS
We derive our revenue from the net premiums earned, ceding commissions,
direct commission revenue and fees and net investment income and net realized
gains from investments. The limited surplus in our insurance company before our
October 2004 IPO constrained our ability to write net premiums because we are
required to maintain a minimum level of surplus to support premiums. As a
result, we ceded premiums to generate ceding commissions in our insurance
company, and we produced premiums for TRM's issuing companies to generate
non-risk bearing revenues in our insurance services operation. Consistent with
this strategy, during the five years ended December 31, 2004, we derived 34.6%
and 36.9% of our total revenues from net premiums earned and ceding commissions,
respectively from our insurance company and 24.8% of our total revenue from
direct commission and fees from our insurance services operation. Our investment
income and realized gains from investments comprised 3.7% of our total revenues
during this period. However, we contributed $98 million of the proceeds from the
IPO and the concurrent offering to TICNY, which increased its statutory surplus.
Additionally, TICNY received a rating upgrade from A.M Best to "A-" (Excellent).
With the increased surplus and higher rating we plan to increase net premiums
written. In order to more fully deploy the additional surplus capital, TICNY
decreased its quota share ceding percentage to 25% from 60% beginning October 1,
2004. See "Item 7.-Outlook" for additional discussion of changes in the
components of principal revenue items resulting from the IPO and concurrent
private placement.
Net premiums earned. Premiums written include all premiums received by an
insurance company during a specified accounting period, even if the policy
provides coverage beyond the end of the year. Premiums are earned over the term
of the related policies. At the end of each accounting period, the portion of
the premiums that are not yet earned are included in the unearned premium
reserve and are realized as income in subsequent periods over the remaining term
of the policy. Our policies typically have a term of 12 months. Thus, for
example, for a policy that is written on July 1, 2004, one-half of the premiums
would be earned in 2004 and the other half would be earned in 2005.
Net premiums earned are the earned portion of our net premiums written. Net
premiums written are equal to the difference between gross premiums written and
premiums ceded to reinsurers, or ceded premiums written. Our gross premiums
(written and earned) are the sum of both direct premiums from our insurance
segment and assumed premiums from our reinsurance segment. Throughout this Form
10-K, direct and assumed premiums (written or earned) separately or together are
also referred to as gross premiums.
Net investment income and realized gains and losses on investments. We
invest our statutory surplus and the funds supporting our insurance reserves
(including unearned premium reserve and the reserves established to pay for
losses and loss adjustment expenses) in cash, cash equivalents and securities.
Our investment income includes interest and dividends earned on our invested
assets. Realized gains and losses on invested assets are reported separately
from net investment income. We earn realized gains when invested assets are sold
for an amount greater than their amortized cost in the case of fixed maturity
securities and cost in the case of equities and recognize realized losses when
invested assets are written down or sold for an amount less than their amortized
cost or cost, as applicable.
53
Ceding commission revenues. We earn ceding commission revenues on the gross
premiums written that we cede to reinsurers.
Direct commission revenues and fees. Direct commission revenues and fees
consist of commissions earned by TRM on premiums produced by its managing
general agency and fees earned from its claims administration and reinsurance
intermediary services. It also includes policy billing fees that we earn in the
course of collecting premiums from our policyholders. This fee is charged
primarily on small policies written through our insurance segment.
Our expenses consist primarily of:
Losses and loss adjustment expenses. We establish loss and loss adjustment
expense reserves in an amount equal to our estimate of the ultimate liability
for claims under our insurance policies and the cost of adjusting and settling
those claims. Our provision for loss and loss adjustment expense reserves in any
period, which is the expense recorded, includes estimates for losses incurred
during the period and changes in estimates for prior periods.
Operating expenses. In our insurance and reinsurance segments, we refer to
the operating expenses that we incur to underwrite risks as underwriting
expenses. Underwriting expenses consist of direct and ceding commission expenses
and other underwriting expenses. In our insurance services segment, we refer to
our operating expenses as insurance services expenses, which consist of direct
commission expense and other insurance services expenses. On a consolidated
basis, operating expenses for all three business segments are divided into
direct and ceding commission expenses and other operating expenses as explained
below:
o Direct and ceding commission expenses. We pay direct commission expense
to our producers in our insurance segment for the premiums that they
generate for us. Our managing general agency also pays direct
commission expense to our producers in our insurance services segment.
In addition, TICNY also pays ceding commission expense to TRM's issuing
companies for the reinsurance premiums that we assume in our
reinsurance segment. Ceding commission is typically paid on quota share
reinsurance agreements, but not on excess of loss reinsurance
agreements.
o Other operating expenses. Other operating expenses consist of other
underwriting expenses related to TICNY's underwriting operations in our
insurance and reinsurance segments and other insurance services
expenses related to our managing general agency and reinsurance
intermediary operations conducted through TRM in our insurance services
segment. Other underwriting expenses consist of general administrative
expenses such as salaries, rent, office supplies, depreciation and all
other operating expenses not otherwise classified separately and
boards, bureaus and taxes, which are the assessments of statistical
agencies for items such as rating manuals, rating plans and experience
data, as well as state and local taxes based on premiums, licenses and
fees, assessments for fire patrol and contributions to workers'
compensation and state and local security funds. Other insurance
services expenses include general administrative expenses, principally
reimbursements to TICNY for underwriting services, and exclude expenses
that are incurred by TRM's issuing companies such as boards, bureau and
taxes. It also excludes general administrative expenses related to
claims administration services, which is billed on an hourly basis to
TRM's issuing companies.
o Interest expense. We pay interest on our loans, on subordinated
debentures and on segregated assets placed in trust accounts on a
"funds withheld" basis in order to collateralize reinsurance
recoverables.
o Income taxes. We pay Federal, state and local income taxes and other
taxes.
OUTLOOK
After the IPO and concurrent private placement in October 2004 we
contributed $98 million of the proceeds to increase the surplus of our insurance
company and received a rating upgrade to A- from A.M. Best. In January 2005, we
agreed to acquire a shell company that has 16 state insurance licenses (nine of
them active) for $1.1 million. Additionally, in December 2004 we raised
additional debt capital amounting to $26.0 million through the issuance of
subordinated debentures underlying trust preferred securities. We plan to use
the majority of the proceeds of the issuance of the trust preferred securities
to capitalize the shell company upon closing of the acquisition which is
expected in March or April 2005.
54
With the increased surplus in our insurance company, we plan to increase
our net premiums written up to a level that will maximize the use of our capital
while continuing to maintain a favorable rating from various rating agencies. In
the event that we generate premiums in excess of this level, we plan to utilize
quota share reinsurance and TRM's issuing companies to support this additional
premium volume and generate ceding commission and fee income. In the latter half
of 2004, increased competition began to become evident as premium rate increases
moderated. See "Item 7.-Marketplace Conditions and Trends". (Our outlook for
2005 discussed below takes into account generally softer market conditions that
we expect in 2005, but softening beyond our expectations could cause the actual
results to differ from what we currently expect). With the increased capital
from the IPO and the concurrent private placement, we anticipate the following
changes to our current financial and business structure and certain ratios
relative to periods prior to the IPO, including the nine months ended September
30, 2004 to the periods following the IPO:
o Change in leverage ratios. In 2003, our gross leverage ratio (the ratio
of gross premiums written to statutory surplus) was 3.79. For the first
nine months in 2004 the annualized gross leverage ratio was 4.10. Our
net leverage ratio (the ratio of net premiums written to statutory
surplus) was 0.82 in 2003 and an annualized 1.08 on an annualized basis
for the first nine months of 2004. The difference between the gross and
net leverage ratio, 2.97 in 2003 and 3.02 for the first nine months of
2004, represents ceded premiums in relation to our surplus and is
sometimes called the ceded leverage ratio. With the increased
capitalization of our insurance company, we plan to target a gross
leverage ratio of approximately 1.5 to 2.0, a net leverage ratio of
approximately 1.25 to 1.50 and a ceded leverage ratio of up to 0.50
during 2005. The actual gross, net and ceded leverage ratios may vary
from the target leverage ratios during that period, and even more
significantly thereafter depending upon many factors that affect our
rating with various organizations and capital adequacy requirements
imposed by insurance regulatory authorities. These factors include but
are not limited to the amount of statutory surplus, premium growth,
quality and terms of reinsurance (especially regarding
collateralization of reinsurance recoverables) and line of business
mix.
o Increased net premiums written. By increasing our net leverage ratio
from 0.82 in 2003 and 1.08 on an annualized basis for the first nine
months in 2004 to approximately 1.25 to 1.50 in 2005 with the increased
surplus in our insurance company, we would increase our underwriting
profit from net premiums written if our underwriting results continue
to be favorable. The underwriting profit from the increased net
premiums written, however, will not be recognized immediately, but over
time as net premiums written are earned.
o Reduced quota share reinsurance ceding. In 2003, our ceded leverage
ratio was 2.97 as we ceded 72.4% of our gross premiums written totaling
$97.4 million under our quota share treaties. For the first nine months
of 2004, the ceded leverage ratio was 3.02 as we ceded 73.6% of our
gross premium written. We reduced our ceded leverage ratio to 0.4 on an
annualized basis in the fourth quarter of 2004 by reducing the
percentage of our premiums ceded under our quota share treaty to 25%
effective October 1, 2004. During 2005, we expect to maintain this
quota share ceding percentage. In addition, we terminated Converium
Reinsurance (North America) Inc.'s participation in our quota share
treaty on a cut-off basis effective December 31, 2004. See "Item
1.--Reinsurance--2004 Reinsurance Program". In 2003 and for the first
nine months of 2004 our net underwriting expenses were, respectively,
$35.6 million and $30.3 million less than our gross underwriting
expenses due to ceding commission revenue. Our ceding commission
revenue from our quota share reinsurance treaties will be reduced as
the volume of reinsurance ceded decreases, but the reduced ceding
commission revenue will continue to lower our underwriting expenses and
augment our return on equity. In 2003 and for the first nine months of
2004, our ceding commission revenue reduced our gross expense ratio by
25.6 and 17.3 percentage points, respectively. With the increased
capitalization of our insurance company, we expect our ceding
commission revenue to reduce our gross expense ratio by up to 3
percentage points depending upon the extent of our use of quota share
reinsurance.
55
o Reduced reliance on TRM's issuing companies. In 2003 and for the first
nine months of 2004, premiums produced by TRM represented approximately
23.0% and 21.8%, respectively, of our gross premiums written by TICNY
and premiums produced by TRM. The increase in TICNY's statutory surplus
will enable us to reduce our reliance on TRM's issuing companies. TICNY
will be able to write directly more of the business that TRM has placed
with its issuing companies and therefore reduce the fees retained by
TRM's issuing companies for writing this business. As a result, we
expect that TRM's premiums produced as a percentage of our gross
premiums written by TICNY and premiums produced by TRM will be
approximately 10% to 15%. Additionally, TICNY will be able to lower its
expense ratio by writing the policies with larger premium per policy
than TRM currently produces, since these larger policies entail lower
direct commission expense (13.9% in 2004 and for TRM's business
compared with 16.6% for TICNY's business) as well as lower underwriting
cost relative to the size of the policy. However, we plan to continue
to utilize TRM's issuing companies to underwrite specific products in
certain market segments, especially in territories outside of New York,
and to increase our ability to produce premiums in excess of the
premiums that TICNY can generate utilizing its own statutory surplus.
By doing so, we plan to continue to generate commissions through our
managing general agency and other related fees in our insurance
services operation to improve our return on equity. In 2003 and 2004
our insurance services pre-tax income was 6.7% and 3.5% of our net
premiums earned. With the increased capitalization of our insurance
company, we expect our insurance services pre-tax income to decline to
approximately 1% to 2% of our net premiums earned.
o Increased investment income. TICNY's increase in statutory surplus and
in net premiums written will allow us to increase our invested assets.
We expect our investment income to increase as our invested assets
grow. Since loss and loss adjustment expense reserves are paid out over
a number of years, we expect to realize the benefit from increased
invested assets over several years.
o Investment portfolio leverage. When we have fully deployed our capital,
we plan to target an invested assets to equity ratio of between 2 to 1
and 3 to 1.
o Interest expense. With the increased capitalization of our insurance
company, we expect our interest expense as a percentage of average
stockholders' equity to decrease to approximately 2.0% to 2.5%.
o Improved ability to increase assumed reinsurance premiums. The increase
in TICNY's statutory surplus and the improvement in its rating will
enable TICNY to increase its assumed reinsurance from other insurance
companies, especially TRM's issuing companies. Due to its limited
statutory surplus and rating, TICNY often had relied on other
reinsurers to directly reinsure TRM's issuing companies and then cede a
modest amount of the assumed premiums to TICNY. As a result, while the
underwriting result of the business written through TRM and of the
assumed premiums improved significantly in 2003 and 2004, TICNY had not
been able to assume a meaningful participation on this business due to
statutory surplus constraints.
MEASUREMENT OF RESULTS
We use various measures to analyze the growth and profitability of our
three business segments. In the insurance and reinsurance segments, we measure
growth in terms of gross, ceded and net premiums written and we measure
underwriting profitability by examining our loss, expense and combined ratios.
We also measure our gross and net written premiums to surplus ratios to measure
the adequacy of capital in relation to premiums written. In the insurance
services segment, we measure growth in terms of premiums produced by TRM on
behalf of other insurance companies as well as fee and commission revenue
received and we analyze profitability by evaluating income before taxes and the
size of such income relative to TICNY's net premiums earned. On a consolidated
basis, we measure profitability in terms of net income and return on average
equity.
Premiums written. We use gross premiums written to measure our sales of
insurance products and, in turn, our ability to generate ceding commission
revenues from premiums that we cede to reinsurers. Gross premiums written also
correlates to our ability to generate net premiums earned.
Loss ratio. The loss ratio is the ratio of losses and loss adjustment
expenses incurred to premiums earned and measures the underwriting profitability
of a company's insurance business. We measure our loss ratio on a gross (before
reinsurance), and net basis (after reinsurance) as well as the loss ratio on the
ceded portion (the difference between gross and net premium) for our insurance
and reinsurance segments. We use the gross loss ratio as measures of the overall
underwriting profitability of the insurance business we write and to assess the
adequacy of our pricing. We use the ceded loss ratio to measure the experience
on the premiums that we cede to reinsurers, including the premiums ceded under
our quota share treaties. Beginning in 2001, the loss ratio on such ceded
business has determined the ceding commission rate that we earn on ceded
premiums. Our net loss ratio is meaningful in evaluating our financial results,
which are net of ceded reinsurance, as reflected in our consolidated financial
statements. In addition, we use accident year and calendar year loss ratios to
measure our underwriting profitability. An accident year loss ratio measures
losses and loss adjustment expenses for insured events occurring in a particular
year, regardless of when they are reported, as a percentage of premium earned
during that year. A calendar year loss ratio and measures losses and loss
adjustment expense for insured events occurring during a particular year and the
change in loss reserves from prior accident years as a percentage of premiums
earned during that year.
56
Underwriting expense ratios. The underwriting expense ratio is the ratio of
direct and ceding commission expenses and other underwriting expenses less
policy billing fees to premiums earned. The underwriting expense ratio measures
a company's operational efficiency in producing, underwriting and administering
its insurance business. Due to our historically high levels of reinsurance, we
calculate our underwriting expense ratios on a gross basis (before the effect of
ceded reinsurance) and net basis (after the effect of ceded reinsurance). Ceding
commission revenue is applied to reduce our underwriting expenses in our
insurance company operation. Because the ceding commission rate we earn on our
premiums ceded has historically been higher than our underwriting expense ratio
on those premiums, our extensive use of quota share reinsurance has caused our
net underwriting expense ratio to be lower than our gross expense ratio.
Combined ratio. We use the combined ratio to measure our underwriting
performance. The combined ratio is the sum of the loss ratio and the
underwriting expense ratio. We analyze the combined ratio on a gross (before the
effect of reinsurance) and net basis (after the effect of reinsurance). If the
combined ratio is at or above 100%, an insurance company is not underwriting
profitably and may not be profitable unless investment income is sufficient to
offset underwriting losses.
Premium produced by TRM. TRM operates a managing general agency that earns
commissions on written premiums produced on behalf of its issuing companies.
Although TRM is not an insurance company, we utilize TRM's access to its issuing
companies as a means to expand our ability to generate premiums beyond TICNY's
statutory surplus capacity. For this reason, we use written premiums produced by
TRM on behalf of its issuing companies as well as TRM's commission revenue to
evaluate our ability to achieve growth.
Net income and return on average equity. We use net income to measure our
profits and return on average equity and to measure our effectiveness in
utilizing our shareholders' equity to generate net income on a consolidated
basis. In determining return on average equity for a given year, net income is
divided by the average of shareholders' equity for that year. As the IPO was
completed in fourth quarter of 2004, the 2004 full year return on equity was
calculated by dividing net income by an average shareholders' equity for the
year.
CRITICAL ACCOUNTING POLICIES
In preparing our consolidated financial statements, management is required
to make estimates and assumptions that affect reported assets, liabilities,
revenues and expenses and the related disclosures as of the date of the
financial statements. Certain of these estimates result from judgments that can
be subjective and complex. Consequently, actual results may differ, perhaps
substantially, from the estimates.
Our most critical accounting policies involve the reporting of reserves for
losses (including losses that have occurred but had not been reported by the
financial statement date) and loss adjustment expenses, the reporting of ceding
commissions earned, the amount and recoverability of reinsurance recoverable
balances, deferred acquisition costs and investments.
Loss and loss adjustment expense reserves. Loss and loss adjustment expense
reserves represent our best estimate at a particular point in time of the
ultimate unpaid cost of all losses and loss adjustment expenses incurred,
including settlement and administration of losses, based on facts and
circumstances then known and including losses that have been incurred but not
yet been reported. The process of establishing the liability for unpaid losses
and loss adjustment expenses is complex, requiring the use of informed estimates
and judgments. Actuarial methodologies are employed to assist in establishing
these estimates and include judgments relative to estimates of future claims
severity and frequency, the length of time before losses will develop to their
ultimate level, possible changes in the law and other external factors that are
often beyond our control. The amount of loss and loss adjustment expense
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 loss adjustment expense reserves for unreported claims are determined using
historical information by line of insurance as adjusted to current conditions.
Due to the inherent uncertainty associated with the reserving process, the
ultimate liability may differ, perhaps substantially, from the original
estimate. Such estimates are regularly reviewed and updated and any resulting
adjustments are included in the current year's results. Reserves are closely
monitored and are recomputed periodically using the most recent information on
reported claims and a variety of statistical techniques. Specifically, on at
least a quarterly basis, we review, by line of business, existing reserves, new
claims, changes to existing case reserves and paid losses with respect to the
current and prior years. See "Item 1.-Loss and Loss Adjustment Expense
Reserves" and "Note 3. Property-Casualty Insurance" for additional information
regarding our loss reserves.
57
Prior to 2003 we had adverse loss development on our loss reserves. In
2001, the changes in reserves for prior accident years were $1.8 million and in
2002 the changes in reserves for prior accident years were $3.0 million. In 2003
there was minimal adverse loss development, amounting to $75,000. In 2004 we had
favorable redundancy that developed in our reserves of $199,000.
The net loss reserves for the most recent accident years on a consolidated
basis as of December 31, 2004 were $20.5 million for accident year 2004 and $8.7
million for accident year 2003. A 5% deficiency in net reserves for these years
would impact our income before income taxes by $1.0 million and $435,000 for
accident years 2004 and 2003, respectively.
Ceding commissions earned. We have historically relied on quota share,
excess of loss and catastrophe reinsurance to manage our regulatory capital
requirements and limit our exposure to loss. Generally, we have ceded a
significant portion of our insurance premiums to unaffiliated reinsurers in
order to maintain our net leverage ratio at our desired target level.
Ceding commission earned under a quota share reinsurance agreement is based
on the agreed upon commission rate applied to the amount of ceded premiums
written. Ceding commissions are realized as income as ceded premiums written are
earned. Since 2001, the ultimate commission rate earned on our quota share
reinsurance contracts has been determined by the loss ratio on the ceded
premiums earned. If the estimated loss ratio decreases from the level currently
in effect, the commission rate increases and additional ceding commissions are
earned in the period in which the decrease is recognized. If the estimated loss
ratio increases, the commission rate decreases, which reduces ceding commissions
earned. As a result, the same uncertainties associated with estimating loss and
loss adjustment expense reserves affect the estimates of ceding commissions
earned. We monitor the ceded ultimate loss ratio on a quarterly basis to
determine the effect on the commission rate of the ceded premiums earned that we
accrued during prior accounting periods. The increase in estimated ceding
commission income relating to prior years recorded in 2004, 2003 and 2002 was
$1.7 million, $1.3 million and $0, respectively.
Reinsurance recoverables. A reinsurance recoverable balance is established
for the portion of the loss reserves and unearned premiums that are ceded to
reinsurers. These are reported on our balance sheet separately as assets,
instead of being netted against the related liabilities, since reinsurance does
not relieve us of our legal liability to policyholders and ceding companies. We
are required to pay losses even if a reinsurer fails to meet its obligations
under the applicable reinsurance agreement. Consequently, we bear credit risk
with respect to our individual reinsurers and may be required to make judgments
as to the ultimate recoverability of our reinsurance recoverables. Additionally,
the same uncertainties associated with estimating loss and loss adjustment
expense reserves affect the estimates of the amount of ceded reinsurance
recoverables. We continually monitor the financial condition and rating agency
ratings of our reinsurers. Nonadmitted reinsurers are required to collateralize
their share of unearned premium and loss reserves either by placing funds in a
trust account meeting the requirements of New York's Regulation 114 or by
providing a letter of credit. In addition, since October 2003, we have placed
our new quota share treaties on a "funds withheld" basis, under which TICNY
retains the ceded premiums written and places that amount in segregated trust
accounts from which TICNY may withdraw amounts due to it from the reinsurers.
Tokio Millennium Re Ltd., a reinsurer under the October 1, 2003 quota share
treaty, posted a letter of credit at December 31, 2003 and replaced it with a
Regulation 114 trust during the first quarter of 2004. At December 31, 2004
approximately 52% of our reinsurance recoverables were collateralized.
Deferred acquisition costs/commission revenues. We defer certain expenses
and commission revenues related to producing and reinsuring insurance business,
including commission expense on gross premiums written, commission income on
ceded premiums written, premium taxes and certain other costs related to the
acquisition of insurance contracts. These costs and revenues are capitalized and
the resulting asset or liability, deferred acquisition costs/revenues, is
amortized and charged to expense or income in future periods as gross premiums
written are earned. The method followed in computing deferred acquisition
costs/income limits the amount of such deferred amounts to its estimated
realizable value. The ultimate recoverability of deferred acquisition costs is
dependent on the continued profitability of our insurance underwriting. If our
insurance underwriting ceases to be profitable, we may have to write-off a
portion of our deferred acquisition costs, resulting in a further charge to
income in the period in which the underwriting losses are recognized.
58
Investments. In accordance with our investment guidelines, our investments
consist largely of high-grade marketable fixed maturity securities. Investments
are carried at estimated fair value as determined by quoted market prices or
recognized pricing services at the reporting date for those or similar
investments. Changes in unrealized gains and losses on our investments, net of
any deferred tax effect, are included as an element of other comprehensive
income, and cumulative unrealized gains and losses are included as a separate
component of stockholders' equity. Realized gains and losses on sales of
investments are determined on a specific identification basis. In addition,
unrealized depreciation in the value of individual securities that management
considers to be other than temporary is charged to income in the period it is
determined. Investment income is recorded when earned and includes the
amortization of premium and discounts on investments.
Impairment of invested assets. Impairment of investment securities results
in a charge to income when a market decline below cost is deemed to be other
than temporary. We regularly review our fixed maturity and equity securities
portfolios to evaluate the necessity of recording impairment losses for other
than temporary declines in the fair value of investments. In general, we focus
our attention on those securities whose fair value was less than 80% of their
amortized cost or cost, as appropriate, for six or more consecutive months. In
evaluating potential impairment, we consider, among other criteria: the current
fair value compared to amortized cost or cost, as appropriate; the length of
time the security's fair value has been below amortized cost or cost; our intent
and ability to retain the investment for a period of time sufficient to allow
for any anticipated recovery in value; specific credit issues related to the
issuer; and current economic conditions. Other than temporary impairment losses
result in a permanent reduction of the cost basis of the underlying investment.
There were no other than temporary declines in the fair value of our fixed
maturity securities recorded during 2004, 2003 and 2002. Significant changes in
the factors we consider when evaluating investments for impairment losses could
result in a significant change in impairment losses reported in our consolidated
financial statements. See "Item 1.--Investments" and "Note 2. Investments" for
additional detail regarding our investment portfolio at December 31, 2004,
including disclosures regarding other than temporary declines in investment
value.
Intangible assets and potential impairment. The costs of a group of assets
acquired in a transaction is allocated to the individual assets including
identifiable intangible assets based on their relative fair values. Identifiable
intangible assets with a finite useful life are amortized over the period which
the asset is expected to contribute directly or indirectly to the future cash
flows of the Company. Identifiable intangible assets with finite useful lives
are tested for recoverability whenever events or changes in circumstances
indicate that a carrying amount may not be recoverable. An impairment loss is
recognized if the carrying value of an intangible asset is not recoverable and
its carrying amount exceeds its fair value. No impairment losses were recognized
in 2004, 2003 and 2002. Significant changes in the factors we consider when
evaluating our intangible assets for impairment losses could result in a
significant change in impairment losses reported in our consolidated financial
statements. See "Item 1.--OneBeacon Renewal Rights Transaction" and "Note 6.
Intangible Assets".
RESULTS OF OPERATIONS
We conduct our business in three distinct segments: insurance, reinsurance
and insurance services. Because we do not manage our assets by segments, our
investment income is not allocated among our segments. Operating expenses
incurred by each segment are recorded in each segment directly. General
corporate overhead not incurred by the individual segments is allocated based
upon a combination of employee head count, policy count or premiums written,
whichever method is most appropriate.
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 the two underwriting segments: insurance and reinsurance segments,
followed by the results of operations of our insurance services segment.
59
CONSOLIDATED RESULTS OF OPERATIONS
FOR THE YEAR ENDED DECEMBER 31,
2004 2003 2002
-------- --------- ---------
($ in thousands)
REVENUES
Earned premiums
Gross premiums earned $ 152,509 $ 122,023 $ 86,156
Less: Ceded premiums earned (106,945) (99,082) (60,148)
--------- --------- ---------
Net premiums earned 45,564 22,941 26,008
Total commission and fee income 57,043 48,980 34,676
Net investment income 5,070 2,268 1,933
Net realized investment gains 13 493 95
--------- --------- ---------
Total revenues 107,690 74,682 62,712
--------- --------- ---------
EXPENSES
Net loss and loss adjustment expenses 27,060 15,071 16,356
Operating expenses 62,779 48,495 36,466
Interest expense 3,128 1,462 122
--------- --------- ---------
Total expenses 92,967 65,028 52,944
--------- --------- ---------
Income before taxes 14,723 9,654 9,768
Federal and state income taxes 5,694 3,374 4,135
--------- --------- ---------
NET INCOME $ 9,029 $ 6,280 $ 5,633
========= ========= =========
KEY MEASURES
Return on average equity 23.7% 56.8% 90.8%
FOR THE YEAR ENDED DECEMBER 31,
2004 2003 2002
-------- --------- ---------
($ in thousands)
Insurance segment underwriting profit $ 9,524 $ 6,567 $ 5,769
Reinsurance segment underwriting profit
(loss) 1,582 287 (939)
--------- --------- ---------
Total underwriting profit 11,106 6,854 4,830
Insurance services segment income (loss)
before income taxes 1,951 1,541 3,060
Net investment income 5,070 2,268 1,933
Net realized investment gains 13 493 95
Corporate expenses 289 40 28
Interest expense 3,128 1,462 122
Federal and state income taxes 5,694 3,374 4,135
--------- --------- ---------
NET INCOME $ 9,029 $ 6,280 $ 5,633
========= ========= =========
Consolidated Results of Operations 2004 Compared to 2003
Total revenues. Total revenues increased by 44.2% in 2004 to $107.7 million
compared to $74.7 million in 2003. The increases were primarily due to the
increase in net earned premiums, ceding commission and fee income as well as
investment income. Net earned premium represented 42.3% of total revenues for
2004 compared to 30.7% in 2003. Ceding commission and fee income represented
53.0% of total revenue in 2004 compared to 65.6% in 2003. Net investment income,
excluding realized capital gains, represented 4.7% and 3.0% of total revenue for
2004 and 2003, respectively.
Premiums earned. Net premiums earned in 2004 increased by 98.6% to $45.6
million compared to $22.9 million in 2003. The increase in net premiums earned
was due to the overall increase of 32.2% in gross premiums written in 2004 and
to our decision to cede less business in 2004 than 2003. See "Item 7.-Insurance
Segment Results of Operations" and "Item 7.-Reinsurance Segment Results of
Operations" for a discussion of premiums and total commissions and fee income.
60
Net investment income and realized gains. Net investment income in 2004
increased by 123.6% to $5.1 million compared to $2.3 million in 2003. This
increase resulted from the growth in invested assets provided by operations, net
proceeds from subordinated debentures underlying trust preferred securities
issued in 2003 for $20.6 million, net proceeds of $107.8 million from the
October 2004 IPO and concurrent private placement and an increase of $29.2
million in funds withheld as collateral for reinsurance recoverables. This was
offset in part by a decrease in the yield on fixed maturity investments.
Invested assets grew $171.1 million from $57.3 million at December 31, 2003 to
$228.4 million at December 31, 2004. The yield for our fixed income investments
held at December 31, 2004 was 3.9% compared to 5.0% for assets held at December
31, 2003. On a tax equivalent basis, the yield was 4.4% for 2004 and 5.3% for
2003. The decrease in yield in 2004 resulted primarily from a lower available
interest rates and an increased allocation to tax exempt securities.
Net realized capital gains were $13,000 in 2004 compared to net realized
capital gains of $493,000 in 2003. The 2003 capital gains were a result of our
decision to reduce the weighted average duration of our fixed maturity
securities portfolio to protect the portfolio from rising interest rates by
selling certain securities.
There was no impact on net realized capital gains attributable to
adjustments for other than temporary impairment of securities held during 2004
and 2003.
Losses and loss adjustment expenses. Gross loss and loss adjustment
expenses and the gross loss ratio for both the insurance and reinsurance
segments combined in 2004 were $84.2 million and 55.2%, respectively, compared
to $74.2 million and 60.8%, respectively, in 2003. The net loss ratio for the
combined segments was 59.4% in 2004 and 65.7% in 2003. The improvement in the
net loss ratio in 2004 compared to 2003 was due primarily to an increase in net
premiums earned that reduced the effect of excess and catastrophe reinsurance
premiums on the net loss ratio and to favorable development from prior years'
reserves of $199,000. See "Item 7.-Insurance Segment Results of Operations" and
"Item 7.-Reinsurance Segment Results of Operations."
Operating expenses. Total operating expenses in 2004 increased by 29.5% to
$62.8 million from $48.5 million in 2003. The increase was due primarily to the
increase in underwriting expenses resulting from the growth in premiums earned
in TICNY and produced by TRM, costs related to the OneBeacon transaction
including establishing two new offices in Long Island and Western New York,
additional staffing and other expenses in preparation for a public company
environment, and an increase in regulatory assessments.
Interest expenses. Our interest expense increased in 2004 to $3.1 million
compared to $1.5 million in 2003. The increase resulted from an increase in
interest of $1.0 million on subordinated debentures underlying our trust
preferred securities issued in December, 2004 for $26.8 million and $20.6
million issued in 2003. In addition, $1.1 million of interest expense was
incurred as a result of crediting reinsurers on funds withheld in segregated
trusts as collateral for reinsurance recoverables effective January 1, 2004 with
an annual effective yield of 2.5%. Lastly, we had an aggregate of $6.0 million
of other borrowings issued in February and December 2003 that were repaid in
2004 and we recognized a loss on early extinguishment of debt of $133,000 in the
fourth quarter of 2004. These increases in interest expense were offset by a
$0.5 million reduction in interest on surplus notes repaid in 2003.
Income tax expense. Our income tax expense in 2004 was $5.7 million
compared to $3.4 million in 2003. The increased income tax in 2004 was due
primarily to an increase in income before income taxes. The effective income tax
rate was 38.7% in 2004 compared to 34.9% in 2003. The effective tax rates were
affected by TRM's pre-tax profits which are subject to state income taxes. See
"Note 11. Income Taxes".
Net income and return on average equity. Net income and return on average
equity in 2004 were $9.0 million and 23.7%, respectively, compared to $6.3
million and 56.8%, respectively, in 2003, which represents a 43.8% increase in
net income. Although net income was significantly higher in 2004 than in 2003,
the lower return on average equity resulted from the significant increase in
average shareholders' equity as the IPO was completed in the fourth quarter of
2004. For the year, the return was calculated by dividing net income of $9.0
million by an average shareholders' equity of $38.1 million.
Consolidated Results of Operations 2003 Compared to 2002
Total revenues. Total revenues increased by 19.1% to $74.7 million in 2003
from $62.7 million in 2002. The increase in 2003 was primarily due to increases
in ceding commission and fee income as well as investment income. Ceding
commission and fee income represented 65.6% of total revenues in 2003 compared
with 55.3% in 2002. Net premiums earned decreased to 30.7% of the total revenue
in 2003 from 41.5% in 2002. The decrease from 2002 to 2003 was the result of our
effort to maintain conservative leverage ratios. Net investment income and net
realized investment gains represented 3.7% of the total revenue in 2003 compared
to 3.2% in 2002.
61
Premiums earned. Net premiums written increased by 5.9% to $28.9 million in
2003 compared with $27.3 million in 2002. Net premiums earned, however,
decreased by 11.8% to $22.9 million in 2003 from $26.0 million in 2002. The
decrease in net premiums earned in 2003 was due to our effort to control the
amount of net premiums written in relation to our statutory surplus in 2003,
which caused us to increase the percentage of premiums ceded to 81.2% from 70.0%
in 2002. Net premiums earned from the insurance segment represented 97.5% of our
total net premiums earned in both 2002 and 2003.
See "Item 7.-Insurance Segment Results of Operations" and "Item
7.-Reinsurance Segment Results of Operations" for a discussion of premiums and
total commission and fee income.
Net investment income and realized gains. Net investment income increased
by 17.0% in 2003 to $2.3 million compared to $1.9 million in 2002. The increases
in each period were due to growth in our invested assets, offset in part by
declines in the average yield on our invested assets as a result of the
investment of new cash at lower rates.
We realized gains from the sale of securities of $493,000 in 2003 and
$95,000 in 2002. In the first half of 2003, we reduced the weighted average
duration of our fixed maturity securities portfolio to protect the portfolio
from rising interest rates by selling certain securities. These sales resulted
in a gross gain of $493,000. In 2002, we realized gross gains of $602,000 and
gross losses of $128,000 from the sale of fixed maturity securities and net
losses of $379,000 from the sale of equity securities.
Our invested assets were $57.3 million in 2003 compared to $39.6 million in
2002. The yield on our invested assets at the end of each year was 5.0% in 2003
and 5.8% in 2002. The increase in invested assets at December 31, 2003 from
December 31, 2002 resulted from operating cash flows and $16.0 million in net
proceeds from financing transactions after the repayment of a surplus note.
Additionally, in October 2003 we commuted a reinsurance contract with one of our
reinsurers, resulting in the return of $3.2 million representing ceded loss
reserves. The increases in invested assets in 2002 resulted from an increase in
operating cash flows and a decrease in cash and cash equivalents.
There was no impact on realized losses attributable to adjustments for
other than temporary impairment of securities still held during these periods.
As of December 31, 2003 and 2002, we had net unrealized gains of $1.3 million
and $1.6 million on our investments.
Losses and loss adjustment expenses and loss ratio. Gross loss and loss
adjustment expenses and the gross loss ratio for both the insurance and
reinsurance segments combined were $74.1 million and 60.8% in 2003, $55.0
million and 63.8% in 2002, respectively. The net loss ratio for the combined
segments was 65.7% in 2003 and 62.9% in 2002. The loss ratios for both years
were affected by the higher loss ratio in the reinsurance segment and, in 2002,
by adverse development of reserves for losses and loss adjustment expenses for
business written in prior years.
Operating expenses. Total operating expenses increased by 33.1% to $48.5
million in 2003 from $36.5 million in 2002. The increases were primarily due to
increases in underwriting expenses related to expansion of the volume of
premiums written by TICNY and premiums produced by TRM, offset in part by
expense efficiencies resulting from continued realization of economies of scale.
Interest expense. Our interest expense increased in 2003 to $1.4 million,
compared with $122,000 in 2002. The increase in 2003 resulted primarily from
interest payments on $20.0 million of subordinated debentures we issued in May
and September, 2003 in connection with issuances of trust preferred securities.
Additionally, we borrowed $3.0 million in February, 2003 and an additional $3.0
million in December, 2003 under five year amortizing loans to increase the
surplus of TICNY and retire $1.5 million of our Series A Preferred Stock (paid
in January 2004). The proceeds from the subordinated debentures were used in
part to retire a $10.0 million surplus note issued by TICNY in 2002 and to
increase TICNY's surplus. Due to an accounting change as required by the
implementation of FAS 150, which was effective for accounting periods after June
15, 2003 and which we implemented on July 1, 2003, the mandatorily redeemable
Series A Preferred Stock of $3.0 million was required to be reported in our
December 31, 2003 balance sheet as a liability, and dividends on the Series A
Preferred Stock paid after July 1, 2003 amounting to $157,500 are required to be
reported as interest expense in 2003 and charged to income rather than as a
direct reduction to stockholders' equity.
62
Income tax expense. Our income tax expense was $3.4 million in 2003
compared with $4.1 million in 2002. The decrease in income taxes in 2003 was
primarily due to a change in the New York State tax laws in that year that
shifted a portion of the state income tax to premium taxes. This change lowered
income taxes and increased expenses in our insurance segment in 2003 as premium
taxes are treated as an expense rather than as tax. The effective Federal tax
rate was approximately 30.4% in 2003 and 21.5% in 2002. The effective Federal
tax rate was lower than the statutory Federal rate of 34% in 2002 and 2003 due
to tax-exempt income and certain tax credits. See "Note 11. Income Taxes".
Net income and return on average equity. Our net income was $6.3 million in
2003, compared with $5.6 million in 2002. Despite slightly higher net income in
2003, our return on average equity declined to 56.8% in 2003 from 90.8% in 2002
as a result of the higher average stockholders' equity of $11.0 million in 2003
compared with $6.2 million in 2002. The average stockholders' equity for 2003
increased due to retained earnings accumulated in 2002 and 2003. In determining
return on average equity for a given year, net income is divided by the average
of stockholders' equity for that year.
INSURANCE SEGMENT RESULTS OF OPERATIONS
FOR THE YEAR ENDED DECEMBER 31,
2004 2003 2002
---------- ---------- -----------
($ in thousands)
REVENUES
Earned premiums
Gross premiums earned $ 151,210 $ 120,541 $ 84,518
Less: Ceded premiums earned (106,783) (98,176) (59,162)
--------- --------- ---------
Net premiums earned 44,427 22,365 25,356
--------- --------- ---------
Ceding commission revenue 39,983 35,311 21,399
Policy billing fees 671 545 376
--------- --------- ---------
TOTAL 85,081 58,221 47,131
--------- --------- ---------
EXPENSES
Loss and loss adjustment expenses
Gross loss and loss adjustment expenses 84,840 73,379 52,422
Less: Ceded loss and loss adjustment expenses (57,087) (58,680) (37,630)
--------- --------- ---------
Net loss and loss adjustment expenses 27,753 14,699 14,792
Underwriting expenses
Direct commissions expense 25,349 20,701 15,482
Other underwriting expenses 22,455 16,254 11,088
--------- --------- ---------
Total underwriting expenses 47,804 36,955 26,570
--------- --------- ---------
UNDERWRITING PROFIT $ 9,524 $ 6,567 $ 5,769
--------- --------- ---------
KEY MEASURES
PREMIUMS WRITTEN
Gross premiums written $ 176,166 $ 133,263 $ 105,266
Less: Ceded premiums written (79,571) (105,295) (78,418)
--------- --------- ---------
Net premiums written $ 96,595 $ 27,968 $ 26,848
========= ========= =========
LOSS RATIO
Gross 56.1% 60.9% 62.0%
Net 62.5% 65.7% 58.3%
ACCIDENT YEAR LOSS RATIO
Gross 56.6% 57.6% 55.1%
Net 61.2% 65.5% 52.3%
UNDERWRITING EXPENSE RATIO
Gross 31.2% 30.2% 31.0%
Net 16.1% 4.9% 18.9%
COMBINED RATIO
Gross 87.3% 91.1% 93.0%
Net 78.6% 70.6% 77.2%
63
Insurance Segment Results of Operations 2004 Compared to 2003
Gross premiums. Gross premiums written in 2004 increased by 32.2% to $176.2
million from $133.3 million in 2003. Gross premiums earned increased similarly
by 25.4% to $151.2 million in 2004 compared to $120.5 million in 2003. These
increases are attributable to a 12.3% growth in policy count and to a 16.8%
increase in average premium size resulting primarily from rate increases and
other pricing actions.
Ceded premiums. Ceded premiums written in 2004 decreased by 24.4% to $79.6
million compared with $105.3 million in 2003. Although gross written premiums
increased in 2004, ceded written premiums declined due to our decision to lower
the ceding percentage under our quota share reinsurance agreements. For the
first nine months of 2003, the ceding percentage under our quota share
reinsurance agreement was 70% and beginning October 1, 2003 was 80%. The
effective quota share ceding percentage was 77.2% for 2003. For the first nine
months of 2004, the ceding percentage under our quota share reinsurance
agreement was 60% and beginning October 1, 2004 was 25%. The effective quota
share ceding percentage was 41.6% in 2004 that also included a $13.1 million
reduction to ceded written premiums from the retention of the unearned premium
at December 31, 2004 that would have been ceded to Converium Re North America.
Following the downgrade of Converium Reinsurance (North America) Inc.'s rating
and decision by its parent to place that company into runoff in September 2004,
we terminated and novated Converium's participation under its 2004 quota share
treaty and decided to retain the ceded unearned premiums that would have been
ceded to Converium absent the termination. Excluding the $13.1 million that we
retained, the effective quota share ceding percentage would have been 49.1% in
2004. See "Note 5. Reinsurance-Converium" and "Item 1.-Reinsurance-2004
Reinsurance Program" for a further discussion. Despite the reduction in ceded
premiums written, ceded premiums earned increased by 8.8% in 2004 resulting from
the effect of earning ceded premiums that were written in 2003 and during the
first nine months of 2004 under higher quota share ceding percentages as
explained above.
Net premiums. Net premiums written in 2004 increased by 245.4% to $96.6
million compared to $28.0 million in 2003. This increase was greater than the
increase in gross premiums written due to the decrease in the effective ceding
quota share percentage from 77.2% in 2003 to 41.6% in 2004 which includes the
effect of retaining $13.1 million that was not ceded to Converium as discussed
above. Net premiums earned, which was not affected by the Converium novation,
increased by 98.6% to $44.4 million in 2004 compared to $22.4 million in 2003.
Only 46.0%, or $44.4 million of the net premiums written was earned in 2004,
compared to 80.0% or $22.4 million earned in 2003. This lower earned percentage
in 2004 reflects the lag in premiums written and earned resulting from the
growth in premiums written caused by the significant reduction in the quota
share ceding percentage.
Ceding commission revenue. Ceding commission revenue in 2004 increased by
13.2% to $40.0 million compared to $35.3 million in 2003. Despite the reduction
in the quota share ceding percentage, ceding commission revenue increased as a
result of an 8.8% increase in ceded premiums earned. Additionally, we
experienced an improvement in the ceded loss ratios on prior years' quota share
treaties, which increased ceding commission revenue by $1.7 million in 2004 and
$1.3 million 2003.
Loss and loss adjustment expenses and loss ratio. Gross and net losses and
loss adjustment expenses in 2004 were $84.8 million and $27.8 million,
respectively, compared with $73.4 million and $14.7 million, respectively, in
2003. Our gross and net loss ratios were 56.1% and 62.5%, respectively, in 2004
as compared to 60.9% and 65.7%, respectively, in 2003. The decrease in the net
loss ratio in 2004 as compared to 2003 was due primarily to an increase in net
premiums earned that reduced the effect of excess and catastrophe reinsurance
premiums on the net loss ratio. We ceded excess and catastrophe reinsurance
premiums equal to 15.8% of net premiums earned during 2004 compared to 25.0% in
2003. There was $568,000 adverse development from prior years' reserves on a net
basis in 2004 compared to $50,000 on a net basis in 2003 for the insurance
segment. Loss and loss adjustment expenses are net of reimbursements for loss
and loss adjustment expenses made by TRM pursuant to the expense sharing
agreement between TICNY and TRM. See "Item 7.-Insurance Services Segment Results
of Operations" for the amounts of claims reimbursements.
Underwriting expenses and underwriting expense ratio. Underwriting expenses
in 2004, which included direct commission expenses and other underwriting
expenses, were $47.8 million compared with $37.0 million in 2003. Our gross
underwriting expense ratio was 31.2% in 2004 as compared with 30.2% in 2003.
The commission portion of our underwriting expense ratio in 2004, which
expresses direct commission expense paid to our producers as a percentage of
gross premiums earned, was 16.8% compared to 17.2% in 2003. The commission ratio
in 2003 was affected by the higher commissions paid to producers in 2002 and
recognized as commission expense in 2003 as the related premium was earned.
64
The portion of the underwriting expense ratio represented by other
underwriting expenses was 14.4% in 2004 as compared with 13.0% in 2003. The
increase in underwriting expenses was due to the growth in premiums earned in
TICNY and premiums produced by TRM, costs related to the OneBeacon transaction
including establishing two new offices in Long Island and Western New York,
additional staffing of key positions in preparation for a public company
environment, and an increase in regulatory assessments.
The net underwriting expense ratio in 2004 was 16.1% compared to 4.9% in
2003 which reflects lower ceding commission revenue in 2004 due to the reduction
in the effective quota share ceding percentage from 77.2% in 2003 to 41.6% in
2004. In addition, other underwriting expenses increased by 38.2% to $22.5
million in 2004 compared to $16.3 million in 2003 due principally to the
increases mentioned above.
Underwriting profits and combined ratio. The underwriting profit reflects
our underwriting results on a net basis after the effects of reinsurance. The
underwriting profit in 2004 increased by 45.0% to $9.6 million from $6.6 million
in 2003. The net combined ratio was 78.6% in 2004 as compared with 70.6% in
2003. The increase in the net combined ratio resulted from an increase in the
net expense ratio, which was primarily due to the effects of reduced ceding
commission revenue in lowering gross expenses. Notwithstanding the increase in
the net combined ratio, underwriting profits increased due to the overall
increase in net premiums earned.
The gross combined ratio in 2004 was 87.3% compared with 91.1% in 2003. The
lower gross combined ratio resulted from a lower gross loss ratio due to
increased pricing in 2004.
Insurance Segment Results of Operations 2003 Compared to 2002
Gross premiums. Gross premiums written increased by 26.6% to $133.3 million
in 2003 from $105.3 million in 2002. Gross premiums earned increased by 42.6% to
$120.5 million in 2003 compared with $84.5 million in 2002. These increases were
due in part to the growth in policy count, which was 9.0% in 2003, and to an
increase in average premium size of 14.5% in 2003 resulting from rate increases
and other pricing actions.
Gross premiums written increased in 2003 in all lines of business, but
especially in commercial package (31%), workers' compensation (39%) and
commercial automobile (41%).
The growth rate for premiums earned was higher than for premiums written
because of significant premium growth in the second half of 2002 as a follow-on
effect of the Empire renewal rights transaction. See "Item 1.-Business
Segments-Insurance Segment Products-Other Liability". Much of the premiums
written in 2002 were earned in 2003 instead of 2002, causing premiums earned to
increase significantly in 2003 as premiums written in the later part of 2002
became earned in 2003.
Ceded premiums. As a result of the increase in gross premiums written in
2003, total ceded premiums written increased by 34.3% to $105.3 million from
$78.4 million in 2002. Total ceded earned premiums increased by 65.9% to $98.2
million in 2003 from $59.2 million in 2002. The ceded earned premiums under our
quota share treaty increased by 70.5% to $89.7 million from $52.6 million in
2002. The rate of increase for ceded premiums earned was higher than for ceded
premiums written for the same reason mentioned above for gross premiums earned.
Net premiums. In 2003, net premiums written increased by 4.2% to $28.0
million from $26.8 million in 2002. Net premiums earned decreased by 11.8% in
2003 to $22.4 million from $25.4 million in 2002. Net premiums earned declined
in 2003 despite the increase in the net premiums written as a result of an
increase in the percentage of premiums ceded in the last three months of 2003,
when we entered into a new reinsurance agreement to replace our reinsurance
agreement with PMA Reinsurance Company ("PMA"), which we commuted on September
30, 2003 after PMA's rating was downgraded by A.M. Best. As a result of the
commutation, direct losses and loss adjustment expenses that would have been
ceded and recorded as reinsurance recoverable from PMA during the nine months
ended September 30, 2003 were retained by us and settled in full by payment from
PMA. Accordingly, the effect of the commutation of such losses and loss
adjustment expense reserves increased our net reserves by $2.7 million. See
"Item 1.--Reinsurance--2003 Reinsurance Program". The percentage of premiums
ceded for 2003 increased to 81.5% from 70.0% in 2002. The increase in net
premiums earned in 2002 resulted from a 151.9% increase in gross premiums earned
and a decrease in the percentage of premiums ceded to 70.0% from 83.5% in 2001.
65
Ceding commission revenues. As a result of the increase in ceded premiums
earned, ceding commission revenues from our quota share reinsurance treaty
increased by 65.0% to $35.3 million in 2003 from $21.4 million in 2002. In 2003,
the ceding commission revenue included $1.5 million that was received in
connection with the commutation of TICNY's treaty with PXRE Barbados. This
treaty inured to the benefit of PXRE New Jersey only. As a non-admitted
reinsurer, PXRE Barbados was contractually required to provide collateral for
unearned premium and, if a loss penetrated the layer, loss reserves and IBNR.
During the course of the agreement, PXRE Barbados asked to be removed from the
transaction and PXRE New Jersey, an admitted reinsurer, agreed to the removal of
the inuring reinsurance and agreed to allow PXRE Barbados to pay us $1.5 million
in consideration of our increased credit risk exposure to PXRE New Jersey, which
does not provide collateral to us in the event of losses. The commutation did
not increase our loss reserves or the risk exposure but required us to depend
upon PXRE New Jersey as the sole reinsurer. See "Item 1.-Reinsurance" and "Note
5. Reinsurance". In 2003, we earned a commission rate of 36.3% on the 2003 quota
share treaties based upon a 57.1% loss ratio for those treaties. Due to an
improvement in the loss ratio on ceded premiums earned from 61.2% in 2002 to
57.9% in 2003 under the 2002 treaty, the commission rate on the 2002 quota share
treaty increased from 34.5% to 37.8% in 2003. As a result, the commission rate
applied in 2003 to premiums ceded under the 2002 treaty that were earned in 2003
increased to 40.8%, causing ceding commissions earned to increase by $1.3
million. The loss ratio for the 2001 quota share treaty remained at less than
70% in 2003, which resulted in no adjustment to the ceding commission rate for
this treaty. After the adjustments to the prior quota share treaties, the
commission rate that we earned in 2003 was 38.9% compared with 39.8% in 2002. No
changes in estimates were required for ceding commissions earned in 2002 under
the 2001 quota share treaty. The ceding commission rates are calculated under
GAAP, which requires these commissions to be recognized when ceded premiums
written are earned.
Loss and loss adjustment expenses and loss ratio. Gross and net losses and
loss adjustment expenses were $73.4 million and $14.7 million, respectively, in
2003, compared with $52.4 million and $14.8 million, respectively, in 2002. Our
gross and net loss ratios were 60.9% and 65.7%, respectively, in 2003, compared
with 62.0% and 58.3%, respectively, in 2002.
Results for 2002 were affected by additions to net loss reserves we made as
a result of adverse development from prior years. After we experienced adverse
reserve development in 2001, we retained a different independent actuarial firm
to analyze our reserves in 2002, resulting in further reserve strengthening. See
"Item 1.--Loss and Loss Adjustment Expense Reserves". On a net basis, reserve
strengthening of $1.9 million in 2002 added 7.4 points to our net loss ratio for
that year. In 2003, we had adverse reserve development on a net basis of $50,000
in our insurance segment, which, together with the reserve development of
$25,000 in assumed reinsurance, resulted in a consolidated adverse reserve
development of $75,000. See "Item 1.-Loss and Loss Adjustment Expense
Reserves". The net loss ratio in 2003 was also affected by catastrophe
reinsurance premium, which reduced earned premium by $2.7 million in 2003
compared with $1.7 million in 2002.
Our accident year gross and net loss ratios that exclude the effects of
adverse development from prior years were 57.6% and 65.5%, respectively, in
2003, compared with 55.1% and 52.3%, respectively, in 2002. In 2002, we retained
a higher proportion of our premiums in property lines, which represented 77.0%
of our total net premiums written. Due to the absence of severe weather related
losses that year, our greater retention in property lines resulted in a lower
accident year net loss ratio of 52.3%.
Underwriting expenses and underwriting expense ratio. Underwriting
expenses, which include direct commission expenses and other underwriting
expenses, were $37.0 million in 2003 compared with $26.6 million in 2002. Our
gross expense ratio in this segment was 30.2% in 2003 compared with 31.0% in
2002.
The commission portion of our underwriting expense ratio was 17.1% in 2003
as compared with 18.3% in 2002. Commissions in 2002 were affected by amounts
paid for the Empire renewal rights business, which amounted to $932,000 in 2002.
There was no such expense in 2003. Additionally, in 2003 we negotiated lower
commission rates with our producers and increased the volume of premiums in
lines with lower commissions such as workers' compensation.
The portion of the underwriting expense ratio represented by other
underwriting expenses was 13.4% in 2003 and 13.1% in 2002. Improvement in this
ratio in 2003 was due to operational efficiencies achieved through focused
expense management, technological integration and realization of greater
economies of scale. These benefits were partially offset in 2003 by increased
expenses incurred in anticipation of the IPO, including additions to senior
management, technology staff and consultants, and by the reclassification of New
York State taxes to premium taxes, which are treated as other underwriting
expenses.
66
The net underwriting expenses and underwriting expense ratio were $1.1
million and 4.9%, respectively, in 2003 compared with $4.8 million and 18.9%,
respectively, in 2002. These net underwriting expenses reflect the reduction of
our gross expenses by the ceding commission revenues of $35.3 million in 2003
and $21.4 million in 2002. In addition, these net underwriting expenses are net
of underwriting expense reimbursements that were made by TRM pursuant to an
expense sharing agreement between TRM and TICNY. See "Item 1.-Insurance
Services Segment Results of Operations" for the amounts of underwriting expense
reimbursements.
Underwriting profits and combined ratio. The underwriting profit increased
by 13.8% to $6.6 million in 2003 from $5.8 million in 2002. The net combined
ratio was 70.6% in 2003 compared with 77.2% in 2002. The improvement in 2003 was
primarily due to the increase in ceding commission revenue from increased ceded
premiums and a lower ceded loss ratio, and from lower direct commission expense.
These improvements were offset by an increase in losses incurred resulting from
more severe winter weather in the Northeast region and slightly higher expenses
incurred in anticipation of the IPO.
The gross combined ratio was 91.1% in 2003 compared with 93.0% in 2002. The
improvement in the gross combined ratio in 2003 from 2002 reflects reductions in
both the gross loss ratio and the gross underwriting expense ratio.
REINSURANCE SEGMENT RESULTS OF OPERATIONS
FOR THE YEAR ENDED DECEMBER 31,
2004 2003 2002
------- ------- --------
($ in thousands)
REVENUES
Earned premiums
Gross premiums earned $ 1,299 $ 1,482 $ 1,638
Less: Ceded premiums earned (162) (906) (986)
------- ------- -------
Net premiums earned 1,137 576 652
Ceding commission revenue -- 294 473
------- ------- -------
TOTAL 1,137 870 1,125
------- ------- -------
EXPENSES
Loss and loss adjustment expenses
Gross loss and loss adjustment expenses (676) 782 2,543
Less: Ceded loss and loss adjustment expenses (17) (410) (979)
------- ------- -------
Net loss and loss adjustment expenses (693) 372 1,564
Underwriting expenses
Ceding commissions expense 44 63 345
Other underwriting expenses 204 148 155
------- ------- -------
Total underwriting expenses 248 211 500
------- ------- -------
UNDERWRITING PROFIT $ 1,582 $ 287 $ (939)
======= ======= =======
KEY MEASURES
PREMIUMS WRITTEN
Gross premiums written $ 1,600 $ 1,219 $ 1,474
Less: Ceded premiums written (120) (237) (993)
------- ------- -------
NET PREMIUMS WRITTEN $ 1,480 $ 982 $ 481
======= ======= =======
LOSS RATIO
Gross -52.0% 52.8% 155.2%
Net -60.9% 64.7% 239.9%
ACCIDENT YEAR LOSS RATIO
Gross 5.7% 58.6% 52.3%
Net 6.5% 60.2% 70.1%
UNDERWRITING EXPENSE RATIO
Gross 19.1% 14.3% 30.5%
Net 21.8% -14.4% 4.1%
COMBINED RATIO
Gross -33.0% 67.1% 185.7%
Net -39.1% 50.3% 244.0%
67
Reinsurance Segment Results of Operations 2004 Compared to 2003
Gross premiums. Gross written premiums written increased by 31.3% to $1.6
million in 2004 as compared to $1.2 million in 2003. The increase was due to an
increase in the premiums produced by TRM's issuing companies as well as higher
rates charged on reinsurance assumed from these issuing companies. In 2003 our
reinsurance assumed was converted from a pro rata reinsurance basis to an excess
of loss basis, which significantly reduced the amount of premiums assumed
although treaties written in 2002 still contributed somewhat to gross earned
premiums in 2003.
Ceded premiums earned decreased by 82.1% to $162,000 in 2004 compared to
$906,000 in 2003 because we no longer cede premiums in this segment to our quota
share treaty reinsurers.
Net premiums written increased 50.7% to $1.5 million compared with $1.0
million in 2003 due to the increase in gross premiums written. Net premiums
earned increased by 97.4% to $1.1 million in 2004 as compared with $0.6 million
in 2003 as a result of the increase in net written premiums and the
discontinuation of ceding premiums to our quota share treaty reinsurers.
Loss and loss adjustment expenses and loss ratio. The gross and net loss
and loss adjustment expenses in 2004 were a benefit of $0.7 million compared to
a $0.8 million and $0.4 million expense, respectively, in 2003. Our gross and
net loss ratios were negative 52.0% and negative 60.9%, respectively in 2004
compared to 52.8% and 64.7% in 2003. The improvement in the loss ratios in 2004
resulted from the full conversion of the current treaties to an aggregate excess
of loss basis with improved pricing on the current treaties, improvement in the
loss experience of the underlying business and favorable development of prior
years' reserves of $0.7 million.
Underwriting expenses and underwriting expense ratios. Underwriting
expenses for the reinsurance segment are comprised of ceding commission expense
paid to TRM's issuing companies and other third-party reinsurers to acquire the
ceded premium and this segment's allocated share of our other underwriting
expenses. Gross underwriting expenses in 2004 increased to $248,000 as compared
to $211,000 in 2003 primarily as a result of the increase in gross premiums
written which is the basis of the other underwriting expense allocation to this
segment. Our net underwriting expense ratio increased to 21.8% in 2004 compared
to a negative 14.4% in 2003. The negative underwriting expense ratio in 2003
resulted from ceding commission revenue earned in 2003 on premiums ceded under
our 2002 quota share treaty, which exceeded the underwriting expenses incurred.
Underwriting profit and combined ratio. The underwriting profit from
assumed reinsurance in 2004 was $1.6 million compared to $0.3 million in 2003.
The net combined ratio was a negative 39.1% in 2004 compared to 50.3% in 2003.
The net combined ratio in 2004 was the result of the negative net loss ratio as
explained above.
The gross combined ratio decreased to a negative 33.0% in 2004 compared to
67.1% in 2003 due to a reduction in the gross loss ratio to negative 52.0% in
2004 compared to 52.8% in 2003. This was offset by an increase in the gross
underwriting expense ratio to 19.1% in 2004 compared to 14.3% in 2003 due to
increased gross written premiums which is the basis for the allocation of
underwriting expenses to this segment.
Reinsurance Segment Results of Operations 2003 Compared to 2002
Premiums. Gross premiums written decreased by 17.3% to $1.2 million from
$1.5 million in 2002. Gross premiums earned decreased by 9.5% in 2003 to $1.5
million as compared with $1.6 million in 2002. We ceded 19.4% and 67.4% of the
gross reinsurance premiums written in 2003 and 2002 to our quota share
reinsurance treaty, which also reinsured our insurance segment. After the
effects of reinsurance, net premiums written increased by 104.2% to $1.0 million
in 2003 from $481,000 in 2002. Net premiums earned decreased by 11.7% to
$576,000 in 2003 from $652,000 in 2002.
Loss and loss adjustment expenses and loss ratio. Gross and net losses and
loss adjustment expenses were $782,000 and $372,000, respectively, in 2003,
compared with $2.5 million and $1.6 million, respectively, in 2002. Our gross
and net loss ratios were 52.8% and 64.7%, respectively, in 2003, compared with
155.2% and 239.9%, respectively, in 2002.
The gross and net loss ratios improved significantly in 2003 as a result of
minimal adverse development ($25,000) and improvements in the underlying assumed
business produced by TRM due to significant rate increases and re-underwriting
that began in 2001. The gross and net loss ratios in 2002 were primarily
affected by adverse loss development from accident years prior to 2001. The
adverse loss reserve development was $1.1 million in 2002. Prior to 2001, 100%
of the gross premiums were retained, whereas in 2002, 32.6% of the gross
premiums were retained. For this reason, 100% of the adverse development from
accident years prior to 2001 adversely affected our gross and net results. Due
to the reduced net earned premium base resulting from ceding assumed premiums
from 2002, however, our net results were affected more significantly due to this
adverse loss development as indicated by the higher net loss ratios. The
accident year gross and net loss ratios that exclude the effects of adverse
development from prior years were 58.6% and 60.2%, respectively, for 2003 and
52.3% and 70.1%, respectively, for 2002.
68
Underwriting expenses and underwriting expense ratios. The ceding
commission revenue earned on the assumed business reduced gross underwriting
expenses. As a result, TICNY incurred gross and net underwriting expense ratios
of 14.3% and negative 14.4%, respectively, in 2003 and 30.5% and 4.1%
respectively in 2002. The negative underwriting expense ratios in 2003 resulted
from ceding commission revenue earned in 2003 on premiums ceded under our 2002
quota share treaty, which exceeded the underwriting expenses incurred.
Underwriting profit/losses and combined ratio. The underwriting profit from
assumed reinsurance, which reflects our underwriting results on a net basis
after the effect of ceded reinsurance, was $287,000 in 2003 compared with an
underwriting loss of $939,000 in 2002. The net combined ratio was 50.3% in 2003
compared with 244.0% in 2002. The underwriting profit in 2003 resulted from the
absence of adverse loss development, favorable net accident year loss ratio and
a negative net underwriting expense ratio due to the minimal expenses, which
were further reduced by the effect of ceding commission revenue.
The gross combined ratio improved significantly to 67.1% in 2003 compared
with 185.7% in 2002. The improvement in the gross combined ratio in 2003 was due
to minimal adverse loss development, a favorable accident year loss ratio and
minimal ceding commission expense. The gross combined ratio in 2002 was high
primarily due to the effects of continued adverse development from prior
accident years.
INSURANCE SERVICES SEGMENT RESULTS OF OPERATIONS
FOR THE YEAR ENDED DECEMBER 31,
2004 2003 2002
-------- -------- --------
($ in thousands)
REVENUE
Direct commission revenue from managing general
agency $11,546 $ 7,984 $ 4,693
Claims administration revenue 4,105 3,746 4,495
Reinsurance intermediary fees(1) 730 1,100 3,240
Policy Billing Fees 8 -- --
------- ------- -------
TOTAL REVENUES 16,389 12,830 12,428
------- ------- -------
EXPENSES
Direct commissions expense paid to producers 7,432 5,394 3,361
Other insurance services expenses (2) 2,987 2,247 1,608
Claims expense reimbursement to TICNY 4,019 3,648 4,399
------- ------- -------
TOTAL EXPENSES 14,438 11,289 9,368
------- ------- -------
INSURANCE SERVICES PRE-TAX INCOME (LOSS) $ 1,951 $ 1,541 $ 3,060
======= ======= =======
Premiums produced by TRM on behalf of issuing
companies $53,445 $39,494 $24,330
======= ======= =======
(1) The reinsurance intermediary fees include commissions earned for placement
of reinsurance on behalf of TICNY.
(2) Consists of underwriting expenses reimbursed to TICNY pursuant to an expense
sharing agreement.
Insurance Services Segment Results of Operations 2004 Compared to 2003
Total Revenues. Total revenues in 2004 increased by 27.7% for the insurance
services segment to $16.4 million compared to $12.8 million in 2003. The
increase in total revenue was primarily due to direct commission revenue that
increased by 44.6% to $11.5 million in 2004 as compared to $8.0 million in 2003
and claims administration revenue that increased by 9.6% to $4.1 million in 2004
from $3.7 million in 2003. The increase in revenue from direct commission
revenue and claims administration revenue was offset by a reduction in
reinsurance intermediary fees, which decreased by 33.6% to $0.7 million in 2004
as compared with $1.1 million in 2003. The reduction in reinsurance intermediary
fees was primarily a result of lower ceded premiums in the insurance segment in
2004 and additional reinsurance intermediary fees recorded in 2003 pertaining to
reinsurance arrangements in 2002.
69
Direct commission revenue is dependent upon the premiums and losses on
business produced by TRM on behalf of its issuing companies. In 2004, direct
commission revenues increased as a result of increases in premiums produced by
TRM and in the commission rate. Premiums produced by TRM increased by 35.3% to
$53.4 million in 2004 as compared to $39.5 million in 2003 resulting primarily
from increases in premiums produced in the middle market and small business
overflow programs. The composite commission revenue rate increased to 21.6% in
2004 from 20.2% in 2003 due to growth in the middle market program, which
carries a higher commission rate, to $18.8 million of premiums produced in 2004
compared to $7.7 million in 2003. Additionally, due to a lower loss ratio on the
business placed by TRM, additional commissions of $0.2 million were earned in
2004.
Direct commission expense. TRM's direct commission expense rate in 2004 was
13.9% compared to 13.7% in 2003. This was due to an increase in the small
business overflow program to $9.9 million of premiums produced in 2004 from $6.7
million of premiums produced in 2003. The small business overflow program has a
higher commission rate.
Other insurance services expense. The amount of reimbursement for
underwriting expenses by TRM to TICNY in 2004 was $3.0 million as compared to
$2.2 million in 2003. The increase resulted from the increase in premiums
produced.
Claims expense reimbursement. The amount of reimbursement by TRM for claims
administration pursuant to the terms of the expense sharing agreement in 2004
was $4.0 million compared with $3.6 million in 2003 due to an increase in the
number of claims handled.
Pre-tax income. Pre-tax income in 2004 increased by 26.6% to $2.0 million
as compared to $1.5 million in 2003. The increase was due to the 44.6% increase
in direct commission revenue that was partially offset by a 27.9% increase in
expenses for 2004 compared to 2003.
Insurance Services Segment Results of Operations 2003 Compared to 2002
Total revenues for the insurance services segment were $12.8 million in
2003, compared with $12.4 million in 2002, as an increase in reinsurance
commission revenue was offset by decreases in claims administration revenue and
reinsurance intermediary fees.
Direct commission revenue from TRM's operation in 2003 was $8.0 million,
compared with $4.7 million in 2002. The composite commission revenue rate was
20.2% in 2003 compared to 19.3% in 2002 on premiums produced by TRM on behalf of
its issuing companies of $39.5 million in 2003 and $24.3 million in 2002. The
increase in direct commission revenue in 2003 reflects improved operating
results due to increased profitability of the underlying business, improved
reinsurance market conditions and the introduction of TRM's small business
overflow program. See "Item 1.--Insurance Services Segment Products and
Services".
TRM generated $1.1 million and $3.7 million in reinsurance intermediary and
claims administration revenues, respectively, in 2003, compared with $3.2
million and $4.5 million, respectively, in 2002. TRM's reinsurance intermediary
fees in 2002 were higher than 2003 due to an additional one-time intermediary
fee in 2002. Claims administration revenue was mostly offset by an approximately
equal amount of claims expense allocated to TRM in 2002 and 2003 under an
expense sharing agreement with TICNY, with the exception of $259,000 that was
earned in the aggregate in those years for arranging claims administration
services for self-insureds and other work unrelated to the premiums underwritten
for TRM's issuing companies.
TRM's average commission rate paid to its producers was 13.8% in 2002 and
13.7% in 2003. Commissions paid to producers were $5.4 million in 2003, compared
with $3.4 million in 2002.
The amount of this reimbursement for underwriting expenses was $2.2 million
in 2003 compared with $1.6 million in 2002. Claims expenses reimbursed by TRM
were $3.6 million in 2003 compared with $4.4 million in 2002.
Our insurance services pre-tax income for TRM was $1.5 million in 2003,
compared with $3.1 million in 2002.
INVESTMENTS
We classify our investments in fixed maturity securities as available for
sale and report these securities at their estimated fair values based on quoted
market prices or a recognized pricing service. Changes in unrealized gains and
losses on these securities are reported as a separate component of comprehensive
net income, and accumulated unrealized gains and losses are reported as a
component of accumulated other comprehensive net income in stockholders' equity.
Realized gains and losses are charged or credited to income in the period in
which they are realized.
70
The aggregate fair market value of our invested assets as of December 31,
2004 was $228.4 million. As of that date, our fixed maturity securities had a
fair market value of $224.5 million and amortized cost of $223.6 million. The
equity securities had a fair value of $2.5 million and a cost of $1.8 million.
The Company's common trust securities - statutory business trusts had a fair
value and equity value of $1.4 million.
The following table provides a breakdown of the amortized cost, aggregate
fair value and unrealized gains and losses by investment type as of December 31,
2004 and December 31, 2003.
AS OF DECEMBER 31,
2004 2003
------------------------------------- -------------------------------------
COST OR AGGREGATE UNREALIZED COST OR UNREALIZED
AMORTIZED FAIR GAINS/ AMORTIZED AGGREGATE GAINS
COST VALUE (LOSSES) COST FAIR VALUE (LOSSES)
---------- ---------- ---------- --------- --------- ----------
CATEGORY ($ in thousands)
- --------
U.S. Treasury securities $ 1,818 $ 1,784 $ (34) $ 1,840 $ 1,783 $ (57)
U.S. Agency securities 19,640 19,636 (4) 5,512 5,738 226
Corporate fixed maturity securities 48,898 49,381 483 13,978 14,415 437
Mortgage-backed securities 64,116 64,159 43 19,429 19,756 327
Asset-backed securities 12,443 12,473 30 2,234 2,242 8
Other taxable fixed maturity
securities 250 243 (7) 250 236 (14)
Municipal securities 76,397 76,847 450 10,022 10,375 353
Preferred stocks 113 117 4 163 167 4
Common stocks 1,714 2,368 654 1,714 2,017 303
Common trust securities -
statutory business trusts 1,426 1,426 -- 620 620 --
---------- ---------- ---------- --------- --------- ----------
TOTAL $ 226,815 $ 228,434 $ 1,619 $ 55,762 $ 57,349 $ 1,587
========== ========== ========== ========= ========= ==========
The following table presents information regarding our invested assets that
were in an unrealized loss position at December 31, 2004 by amount of time in a
continuous unrealized loss position.
LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL
------------------------ ------------------------ -----------------------
FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED
VALUE LOSS VALUE LOSS VALUE LOSS
---------- ----------- ---------- ----------- ---------- ----------
CATEGORY ($ in thousands)
- --------
U.S. Treasury securities $ -- $ -- $ 1,252 $ (40) $ 1,252 $ (40)
U.S. Agency securities 15,425 (79) -- -- 15,425 (79)
Corporate fixed maturity securities 22,777 (166) 1,495 (95) 24,272 (261)
Mortgage-backed securities 42,172 (363) 5,312 (57) 47,484 (420)
Asset-backed securities 3,216 (33) 247 (3) 3,463 (36)
Municipal securities 24,150 (118) 2,077 (36) 26,227 (154)
---------- ----------- ---------- ----------- ---------- ----------
TOTAL TEMPORARILY IMPAIRED SECURITIES $ 107,740 $ (759) $ 10,383 $ (231) $ 118,123 $ (990)
========== =========== ========== =========== ========== ==========
LIQUIDITY AND CAPITAL RESOURCES
SOURCES AND USES OF FUNDS
We are organized as a holding company with two operating company
subsidiaries, TICNY and TRM. The holding company's principal liquidity needs
include interest on debt, income taxes and stockholder dividends. The holding
company's principal sources of liquidity include dividends from TICNY and TRM
and other permitted payments from our subsidiaries, as well as financing through
borrowings and sales of securities.
Under New York law, TICNY is limited in the amount of dividends it can pay
to Tower. Under New York law, TICNY may pay dividends to Tower only out of
statutory earned surplus. In addition, the New York Insurance Department must
approve any dividend declared or paid by TICNY that, together with all dividends
declared or distributed by TICNY during the preceding twelve months, exceeds the
lesser of (1) 10% of TICNY's policyholders' surplus as shown on its latest
statutory financial statement filed with the New York State Insurance Department
or (2) 100% of adjusted net investment income during the preceding twelve
months. TICNY paid approximately $850,000, $364,000 and $1,555,000 in dividends
to Tower in 2004, 2003, and 2002, respectively. As of December 31, 2004, the
maximum distribution that TICNY could pay without prior regulatory approval was
approximately $2.8 million.
71
TRM is not subject to any limitations on its dividends to Tower, other than
the basic requirement that dividends may be declared or paid if the net assets
of TRM remaining after such declaration or payment will at least equal the
amount of TRM's stated capital. TRM paid a dividend of $860,000 to Tower in 2002
but did not pay any dividends to us in 2004 or 2003.
Pursuant to a Tax Allocation Agreement, dated as of January 1, 2001, by and
among Tower, TICNY and TRM, we compute and pay Federal income taxes on a
consolidated basis. At the end of each consolidated return year, TICNY and TRM
each must compute and pay to Tower its share of the Federal income tax liability
primarily based on separate return calculations. The tax allocation agreement
with TICNY and TRM allows Tower to make certain Code elections in the
consolidated Federal tax return. In the event such Code elections are made, any
benefit or liability is accrued or paid by TICNY and TRM. If a unitary or
combined state income tax return is filed, each entity's share of the liability
is based on the methodology required or established by state income tax law or,
if none, the percentage of each entity's separate income or tax divided by the
total separate income or tax reported on the return. During 2004, TICNY paid
$4.1 million and TRM paid $0.8 million to Tower under this agreement.
CASH FLOWS FROM IPO AND PRIVATE PLACEMENT
On October 20, 2004, the Company sold 13,000,000 shares in its IPO at $8.50
per share. On the same date, the Company also effected a concurrent private
placement of 500,000 shares of its common stock to an affiliate of Friedman,
Billings, Ramsey & Co., Inc., the lead underwriter for the Company's IPO, at a
price of $8.50 per share. On November 10, 2004 the underwriters exercised their
30-day over-allotment option after the Company's IPO. Pursuant to this exercise,
the underwriters purchased 629,007 additional shares of common stock from the
Company and 1,320,993 shares of common stock from selling shareholders. The
Company received net cash proceeds of $107,845,000 from the offering and
concurrent private placement after the underwriting discounts, commissions and
offering expenses. The total costs of the IPO and private placement were
$12,252,000 of which $8,407,000 was for the underwriting discount, and
$3,845,000 was for all other costs.
Immediately before the closing of the IPO on October 26, 2004, we redeemed
30,000 shares of our Series A Cumulative Redeemable Preferred Shares for $1.5
million plus accrued interest. After the closing we utilized some of the cash
proceeds to pay off a $5.0 million loan and accrued interest to CIT
Group/Equipment Financing, Inc. We recognized a loss on early extinguishment of
debt of $133,000 in the fourth quarter of 2004.
On October 26, 2004 we contributed $98,000,000 in Paid in Capital to our
wholly owned affiliate TICNY, which in turn invested this cash in its
fixed-income portfolio.
SURPLUS LEVELS
TICNY is 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 New York Insurance Department to identify
potential weakly capitalized companies. Under the formula, a company determines
its "risk-based capital" by taking into account certain risks related to the
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, 2004, TICNY's risk-based capital exceeded the
minimum level that would trigger regulatory attention. In addition to monitoring
RBC to ensure regulatory compliance, we monitor various financial ratios,
including gross and net premiums written to surplus ratios. Capital
contributions to TICNY were $98.0 million and $17.1 in 2004 and 2003,
respectively, and none in 2002.
72
The statutory surplus that we are required to maintain varies depending on
the type and amount of revenue that is derived. The statutory surplus
requirements are based upon various capital adequacy tests and ratios
established by rating agencies and insurance regulators. Statutory surplus
requirements are greater for net premiums earned than for premiums that we cede
or transfer to reinsurers. Non-risk bearing revenues that are generated
primarily from TRM do not require us to maintain any surplus, except capital
necessary to meet TRM's operating expenses. For these reasons, throughout our
history before the October 2004 IPO we attempted to reduce our statutory surplus
requirement by limiting our net retention of premiums while emphasizing ceding
commissions and non-risk bearing revenues from TRM.
CASH FLOWS
The primary sources of cash flow in TICNY are gross premiums written,
reinsurance commissions from our quota share reinsurers, loss payments by our
reinsurers, investment income and proceeds from the sale or maturity of
investments. Funds are used by TICNY for ceded premium payments, which are paid
on a net basis after subtracting losses paid on reinsured claims and reinsurance
commissions. TICNY also uses funds for loss payments and loss adjustment
expenses on our net business, commissions to producers, salaries and other
underwriting expenses as well as to purchase investments and to pay dividends to
Tower. TRM's primary sources of cash are premiums produced on behalf of issuing
companies and commission and fee income. TRM's primary uses of cash are premium
payments and fees to issuing companies, net of paid losses and commission
income, commissions to producers and expenses reimbursed to TICNY under an
expense sharing agreement.
Our 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 and issuing company settlements and the timing of our
loss payments.
Comparison of Years Ended December 31, 2004 and 2003
For the year ended December 31, 2004 net cash provided by operating
activities was $76.1 million compared to operating cash flow of $22.7 million in
2003. The increase in net cash provided by operations in 2004 resulted from an
increase in collected premiums as a result of the growth in gross premiums and
the reduction in the effective quota share reinsurance ceding percentage from
77.2% in 2003 to 41.6% in 2004, an increase of $29.2 million in funds withheld
as collateral for reinsurance recoverable and a $15.7 million collection of a
receivable for cancelled reinsurance.
Net cash used by investing activities was $177.0 million for the year ended
December 31, 2004, compared to $19.0 million in 2003 due principally to the
investment of $98.0 million of IPO proceeds contributed to and invested by TICNY
and cash provided by operations.
Cash flows from financing activities for 2004 of $125.7 million included
$107.8 million of net proceeds from the IPO and concurrent private placement in
the fourth quarter of 2004 and $26.0 million in net proceeds from the issuance
of subordinated debentures in connection with offerings of trust preferred
securities in December, 2004. In 2004, we repaid $5.6 million of notes payable
and redeemed all of our Series A cumulative redeemable preferred shares for $3.0
million. Additionally, the Company collected its employee notes receivable
balance of $1.4 million before December 31, 2004. The Company paid stockholder
dividends of $1.2 million and $1.8 million in 2004 and 2003, respectively.
Comparison of Years Ended December 31, 2003 and 2002
Net cash provided by operating activities was $22.7 million for the year
ended December 31, 2003, a 120.6% increase from $10.3 million for 2002, which
was a 38.5% decrease from $16.8 million for 2001. The increase in net cash
provided by operations in 2003 resulted from an increase in premiums produced by
TRM, improved underwriting profitability in our insurance segment and the
retention, as funds withheld, of amounts due to reinsurers to provide collateral
for reinsurance recoverables. Additionally, operating cash flow increased due to
the commutation of the reinsurance contract with PMA Reinsurance Company and
increased investment income from a larger investment portfolio.
Net cash used by investing activities was $19.0 million for the year ended
December 31, 2003, compared to $19.0 million for 2002.
Cash flows from financing activities in 2003 included $6.0 million from the
issuance of notes payable under a credit agreement in February and December and
$20.0 million net proceeds from the issuance of subordinated debentures in
connection with offerings of trust preferred securities in May and September. In
2003, we repaid $413,000 of notes payable and contributed $17.1 million to TICNY
(of which $10.0 million was used to repay a $10.0 million surplus note). The
Company paid stockholder dividends of $1.8 million in 2003 and repurchased
92,567 shares of our common stock for an aggregate purchase price of $514,260.
73
LIQUIDITY
We maintain sufficient liquidity to pay claims, operating expenses and meet
our other obligations. We held $55.2 million and $30.3 million of cash and cash
equivalents at December 31, 2004 and 2003, respectively, which included $34.9
and $9.4 million, respectively, which were of short-term duration of less than
ninety days and were recorded as cash equivalents on the balance sheet. We
monitor our expected claims payment needs and maintain a sufficient portion of
our invested assets in cash and cash equivalents to enable us to fund our claims
payments without having to sell longer-duration investments. As of December 31,
2004, cash and cash equivalents greatly exceeded the estimated $13.4 million of
loss reserves as of that date that we expected to pay within the next year. As
necessary, we adjust our holdings of short-term investments and cash and cash
equivalents to provide sufficient liquidity to respond to changes in the
anticipated pattern of claims payments. See "Item 1.--Investments".
COMMITMENTS
The following table summarizes information about contractual obligations
and commercial commitments. The minimum payments under these agreements as of
December 31, 2004 were as follows:
PAYMENTS DUE BY PERIOD
LESS THAN 1-3 4-5 AFTER 5
TOTAL 1 YEAR YEARS YEARS YEARS
---------- ---------- --------- --------- ----------
($ in thousands)
Subordinated debentures $ 47,426 $ -- $ -- $ -- $ 47,426
Operating lease obligations 4,682 1,412 2,750 520 --
Net loss reserves 36,949 13,403 13,012 6,439 4,095
---------- ---------- --------- --------- ----------
TOTAL CONTRACTUAL OBLIGATIONS $ 89,057 $ 14,815 $ 15,762 $ 6,959 $ 51,521
========== ========== ========= ========= ==========
The net loss reserves payments due by period in the table above are based
upon the loss and loss expense reserves estimates as of December 31, 2004 and
actuarial estimates of expected payout patterns by line of business. As a
result, our calculation of loss reserve payments due by period is subject to the
same uncertainties associated with determining the level of reserves and to the
additional uncertainties arising from the difficulty of predicting when claims
(including claims that have not yet been reported to us) will be paid. For a
discussion of our reserving process. See "Item 1.-Loss and Loss Adjustment
Expense Reserves". Actual payments of loss and loss adjustment expenses by
period will vary, perhaps materially, from the above table to the extent that
current estimates of loss reserves vary from actual ultimate claims amounts and
as a result of variations between expected and actual payout patterns. See "Item
1.-Risks Related to Our Business-If our actual loss and loss adjustment expenses
exceed our loss reserves, our financial condition and results of operations
could be significantly affected", for a discussion of the uncertainties
associated with estimating loss and loss adjustment expense reserves. This
payment pattern also assumes timely reimbursement from our reinsurers. If our
reinsurers do not meet their contractual obligations or a timely basis, the
payment assumptions presented above could vary materially.
CAPITAL RESOURCES
In 2003, we formed two statutory business trusts and we own all of the
common trust securities of each trust. The trusts issued $20.0 million of trust
preferred securities in private placements and invested the proceeds thereof and
the proceeds from the sale of common trust securities in exchange for $20.6
million of junior subordinated debentures issued by our holding company. In
December 2004, we formed two additional statutory business trusts and we own all
of the common securities of each of those trusts. The trusts issued $26 million
of trust preferred securities in a private placement and invested the proceeds
thereof and the proceeds from the sale of common trust securities in exchange
for $26.8 million of junior subordinated debentures issued by our holding
company. All of the debentures have stated maturities of thirty years. We have
the option to call any or all of the securities at par beginning five years from
the date of issuance. The interest rate on $10.3 million of the subordinated
debentures issued in May 2003 will float quarterly for changes in the three
month London Interbank Offered Rate ("LIBOR") plus 4.1% and may not exceed 12.5%
prior to the first call date of May 15, 2008. The interest rate on $10.3 million
of subordinated debentures issued in September 2003 is a combination fixed and
floating rate with a fixed rate of 7.5% during the no call period of five years
after which the interest rate will float quarterly for changes in the three
month LIBOR interest rate plus 4%. The interest rate on $13.4 million of
subordinated debentures issued on December 17, 2004 is fixed at 7.4% for the
first five years after which the interest rate will float quarterly for changes
in the three month LIBOR interest rate plus 3.4%. The interest rate on $13.4
million of subordinated debentures issued on December 21, 2004 will float based
on the three month LIBOR interest rate plus 3.4%. Under the terms for all of the
trust preferred securities, an event of default may occur upon:
74
o non-payment of interest on the trust preferred securities, unless such
non-payment is due to a valid extension of an interest payment period;
o non-payment of all or any part of the principal of the trust preferred
securities;
o our failure to comply with the covenants or other provisions of the
indentures or the trust preferred securities; or
o bankruptcy or liquidation of us or of either of the financing trusts
through which the trust preferred securities were issued.
If an event of default occurs and is continuing, the entire principal and
the interest accrued thereon may be declared to be due and payable immediately.
Pursuant to the terms of our subordinated debentures, Tower and its
subsidiaries cannot declare or pay any dividends if we are in default or have
elected to defer payments of interest on the subordinated debentures.
OFF BALANCE SHEET ARRANGEMENTS
We have posted an irrevocable letter of credit for $2.0 million for the
benefit of OneBeacon Insurance Group LLC ("OneBeacon") representing the
estimated commissions due to OneBeacon for the first year of the Commercial
Renewal Rights Agreement dated September 13, 2004.
INFLATION
Property and casualty insurance premiums are established before we know the
amount of losses and loss adjustment expenses or the extent to which inflation
may affect such amounts. We attempt to anticipate the potential impact of
inflation in establishing our reserves. Inflation in excess of the levels we
have assumed could cause loss and loss adjustment expenses to be higher than we
anticipated.
Substantial future increases in inflation could also result in future
increases in interest rates, which in turn are likely to result in a decline in
the market value of the investment portfolio and cause unrealized losses or
reductions in stockholders' equity.
ITEM 7A. 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 interest rates, changes in credit quality of issuers
of investment securities and reinsurers, and changes in equity prices.
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.
75
We also bear credit risk on our reinsurance recoverables and premiums ceded
to reinsurers. As of December 31, 2004, we had unsecured reinsurance
recoverables and premiums ceded of $46.8 million owed by PXRE Reinsurance
Company, $15.6 million owed by American Re-Insurance Company and $3.8 million
owed by other 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
materially impaired. To mitigate the credit risk associated with reinsurance
recoverables, we secure certain of our reinsurance recoverables by withholding
ceded premium and requiring funds be placed in trust as well as monitoring our
reinsurers' financial condition and rating agency ratings and outlook. See "Item
1.--Reinsurance". In 2003, we commuted our reinsurance agreement with PMA
Reinsurance Company when its rating was reduced below our minimum financial
strength rating threshold of "A-" (Excellent) by A.M. Best. In September 2004,
A.M. Best downgraded the rating of Converium to "B-" (Fair) and Converium was
placed into run-off by its parent company. As a result, in September 2004, we
delivered notice to Converium under our quota share treaty of our intent to
terminate their participation under the quota share treaty on a cut-off basis
effective November 1, 2004. Subsequently we reached an agreement with Converium,
Tokio Millenium Re Ltd. ("Tokio Millenium") and Hannover Reinsurance (Ireland)
Ltd. and E+S Reinsurance (Ireland) Ltd. (collectively "Hannover") to effect a
novation of Converium's quota share treaty to those other reinsurers effective
January 1, 2004, as a result of which Tokio and Hannover agreed to each take 50%
of Converium's share under the quota share treaty. In connection with the
agreement, Tokio, Hannover and TICNY agreed to fully release Converium for any
liabilities under the quota share treaty. As a result of the novation, we did
not retain, and Tokio and Hannover assumed, the earned premiums and risks for
the period from November 1, 2004 through December 31, 2004 that we would have
retained if the Converium treaty had been terminated effective November 1, 2004.
However, we decided to retain the unearned premiums and risks as of December 31,
2004 that would have been ceded to Converium absent the termination. See "Item
1.-Reinsurance-2004 Reinsurance Program".
We also bear credit risk for premiums produced by TRM and a limited
portion, generally a deposit amount, of the direct premiums written by TICNY.
Producers collect such premiums and remit them to the company within prescribed
periods. After receiving a deposit, the TICNY premiums are directly billed 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.
EQUITY RISK
Equity risk is the risk that we may incur economic losses due to adverse
changes in equity prices. Our exposure to changes in equity prices primarily
results from our holdings of common stocks, mutual funds and other equities. Our
portfolio of equity securities is carried on the balance sheet at fair value.
Since only a small percentage of our assets are invested in equity securities,
we do not believe that our exposure to equity price risk is significant.
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. 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 December 31, 2004 was $224.5 million.
For fixed maturity securities, short-term liquidity needs and the potential
liquidity needs for the 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 of December 31, 2004, we had a total of $23.7 million of outstanding
floating rate debt all of which is outstanding subordinated debentures
underlying our trust securities issued by our wholly owned statutory business
trusts carrying an interest rate that is determined by reference to market
interest rates. If interest rates increase, the amount of interest payable by us
would also increase.
76
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 time going forward 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 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 December 31, 2004.
The following table summarizes the estimated change in fair value on our
fixed maturity portfolio including short-term investments based on specific
changes in interest rates as of December 31, 2004:
ESTIMATED INCREASE ESTIMATED PERCENTAGE
(DECREASE) IN FAIR VALUE INCREASE (DECREASE)
CHANGE IN INTEREST RATE ($ IN THOUSANDS) IN FAIR VALUE
- ----------------------- ---------------- -------------
300 basis point rise (32,068) (14.3%)
200 basis rise (21,853) (9.7%)
100 basis rise (11,072) (4.9%)
As of December 31, 2004 -- 0.0%
50 basis point decline 5,399 2.4%
100 basis point decline 10,604 4.7%
The sensitivity analysis model used by us produces a predicted pre-tax loss
in fair value of market-sensitive instruments of $11.1 million or 4.9% based on
a 100 basis point increase in interest rates as of December 31, 2004. This loss
amount only reflects the impact of an interest rate increase on the fair value
of our fixed maturities and short-term investments, which constituted
approximately 99.0% of our total invested assets as of December 31, 2004.
Interest expense would also be affected by a hypothetical change in
interest rates. As of December 31, 2004 we had $23.7 million of floating rate
debt obligations. Assuming this amount remains constant, a hypothetical 100
basis point increase in interest rates would increase annual interest expense by
$237,000, a 200 basis point increase would increase interest expense by $474,000
and a 300 basis point increase would increase interest expense by $711,000.
With respect to investment income, the most significant assessment of the
effects of hypothetical changes in interest rates on investment income would be
based on Statement of Financial Accounting Standards No. 91, Accounting for
Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and
Initial Direct Costs of Leases ("FAS 91"), issued by the Financial Accounting
Standards Board ("FASB"), which requires amortization adjustments 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 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 December 31, 2004, the par value of our mortgage backed securities
holdings was $64.6 million and the book value of our mortgage backed securities
holdings was $64.1 million. This equates to an average price of 99.3% of par.
Since few of our mortgage backed securities were purchased at more than two
points (below 98% and above 102%) from par, a FAS 91 adjustment would not have a
significant effect on investment income.
77
Furthermore, significant hypothetical changes in interest rates in either
direction would not have a significant effect on principal redemptions, and
therefore investment income, because of the prepayment protected mortgage
securities in the portfolio. The mortgage backed securities portion of the
portfolio totaled 24.5% as of December 31, 2004. Of this total, only 0.9% 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 collaterialized 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.
RECENT CHANGES IN ACCOUNTING PRINCIPLES
In December 2004, the Financial Accounting Standards Board issued the
revised statement SFAS No. 123-R, an amendment to SFAS No. 123, "Accounting for
Stock-Based Compensation" which suspends APB 25, requires that the cost of
share-based payment transactions be recognized in the financial statements after
the first fiscal quarter beginning after June 15, 2005. For calendar year
companies, this means that pro-forma footnote disclosures, developed under the
current SFAS 123 can continue to be provided in the first two quarters of 2005,
with mandatory expensing of equity-based compensation beginning in the third
quarter of 2005. The intended adoption by the Company of SFAS 123-R in June 2005
is not expected to have a material impact on the Company's financial position or
results of operations.
In March 2004, the FASB issued EITF Issue No. 03-1, The Meaning of
Other-Than Temporary Impairment and Its Application to Certain Investments,
which provides new guidance for assessing impairment losses on debt and equity
investments. Additionally, EITF Issue No. 03-1 includes new disclosure
requirements for investments that are deemed to be temporarily impaired. The
FASB has delayed the application of the accounting provisions until 2005 but
requires new disclosures for annual periods ending after June 15, 2004.
Management does not expect the adoption of this new accounting pronouncement to
have a material impact on the Company's financial statements upon adoption.
78
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE
----
Report of Independent Registered Public Accounting Firm 80
Consolidated Balance Sheets at December 31, 2004 and 2003 81
Consolidated Statements of Income and Comprehensive Net Income for the
years ended December 31, 2004, 2003 and 2002 83
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 2004, 2003 and 2002 84
Consolidated Statements of Cash Flows for the years ended
December 31, 2004, 2003 and 2002 85
Notes to Consolidated Financial Statements 87
79
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
Tower Group, Inc.
We have audited the accompanying consolidated balance sheets of Tower Group,
Inc. and subsidiaries (the "Company") as of December 31, 2004 and 2003 and the
related consolidated statements of income and comprehensive net income, changes
in stockholders' equity and cash flows for each of the three years in the period
ended December 31, 2004. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes consideration of
internal control over financial reporting as a basis for designing audit
procedures that are appropriate in the circumstances, but not for the purpose of
expressing an opinion on the effectiveness of the Company's internal control
over financial reporting. Accordingly, we express no such opinion. An audit also
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the Company's financial statements present fairly, in all
material respects, the financial position of the Company as of December 31, 2004
and 2003, and the results of its operations and its cash flows for each of the
three years in the period ended December 31, 2004 in conformity with accounting
principles generally accepted in the United States.
As discussed in Note 1, during 2003, the Company changed its method of
accounting for its redeemable preferred stock to conform to Statement of
Financial Accounting Standards No. 150.
/s/ JOHNSON LAMBERT & CO.
Reston, Virginia
February 22, 2005
80
TOWER GROUP, INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 31,
2004 2003
-------- --------
($ in thousands)
ASSETS
Fixed-maturity securities, available-for-sale, at fair value
(amortized cost $223,562 in 2004 and $53,265 in 2003) $224,523 $ 54,545
Equity securities, at fair value (cost $1,827 in 2004 and $1,877 in 2003) 2,485 2,184
Common trust securities - statutory business trusts, equity method 1,426 620
-------- --------
TOTAL INVESTMENTS 228,434 57,349
Cash and cash equivalents 55,201 30,339
Investment income receivable 1,975 552
Agents' balances receivable 33,473 21,952
Assumed premiums receivable 1,197 997
Receivable for cancelled reinsurance -- 15,748
Ceding commission receivable 8,329 7,983
Notes and accrued interest receivable from related parties -- 1,421
Reinsurance recoverable 101,173 84,760
Receivable -- claims paid by agency 1,622 1,812
Prepaid reinsurance premiums 28,391 55,645
Deferred acquisition costs net of deferred ceding commission revenue 18,740 573
Federal income taxes and state taxes recoverable 1,975 --
Deferred income taxes -- 2,033
Intangible assets 4,978 --
Fixed assets, net of accumulated depreciation 5,420 4,040
Other assets 3,239 1,388
-------- --------
TOTAL ASSETS $494,147 $286,592
======== ========
- Continued-
81
TOWER GROUP, INC.
CONSOLIDATED BALANCE SHEETS (CONTINUED)
DECEMBER 31,
2004 2003
--------- ---------
($ in thousands, except par value and
share amounts)
LIABILITIES
Loss and loss adjustment expenses $ 128,722 $ 99,475
Unearned premium 95,505 70,248
Reinsurance balances payable 2,735 20,788
Payable to issuing carriers 18,652 12,726
Funds held as agent 785 796
Funds held under reinsurance agreements 54,152 24,943
Accounts payable and accrued expenses 12,410 4,934
Checks outstanding 2,726 4,936
Payable for securities -- 3,004
Dividends payable to stockholders -- 160
Federal and state income taxes payable -- 1,019
Deferred income taxes 1,587 --
Deferred compensation liability -- 1,294
Subordinated debentures 47,426 20,620
Long-term debt -- CIT -- 5,588
Series A cumulative redeemable preferred stock -- 3,000
--------- ---------
TOTAL LIABILITIES 364,700 273,531
--------- ---------
STOCKHOLDERS' EQUITY
Common stock (2004: $0.01 par value per share; 40,000,000
shares authorized, 19,826,135 shares issued and 19,737,168
outstanding shares) 198 --
Class A common stock (2003: $0.01 par value per share;
4,000,000 shares authorized, 2,069,936 shares issued and
1,977,369 outstanding shares) -- 21
Class B common stock (2003: $0.01 par value per share;
4,000,000 shares authorized, 2,430,065 shares issued and
outstanding shares) -- 24
Paid-in-capital 112,375 2,285
Accumulated other comprehensive net income 1,052 1,048
Retained earnings 18,224 10,197
Unearned compensation - restricted stock (1,908) --
Treasury stock (88,967 shares in 2004 and 92,567 in 2003) (494) (514)
--------- ---------
TOTAL STOCKHOLDERS' EQUITY 129,447 13,061
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 494,147 $ 286,592
========= =========
See accompanying notes to the consolidated financial statements.
82
TOWER GROUP, INC.
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE NET INCOME
YEAR ENDED DECEMBER 31,
2004 2003 2002
----------- ----------- -----------
($ in thousands, except per share and share amounts)
REVENUES
Net premiums earned $ 45,564 $ 22,941 $ 26,008
Ceding commission revenue 39,983 35,605 21,872
Insurance services revenue 16,381 12,830 12,428
Net investment income 5,070 2,268 1,933
Net realized gains on investments 13 493 95
Policy billing fees 679 545 376
----------- ----------- -----------
Total revenues 107,690 74,682 62,712
----------- ----------- -----------
EXPENSES
Loss and loss adjustment expenses 27,060 15,071 16,356
Direct commission expense 32,825 26,158 19,187
Other operating expenses 29,954 22,337 17,279
Interest expense 3,128 1,462 122
----------- ----------- -----------
Total expenses 92,967 65,028 52,944
----------- ----------- -----------
Income before income taxes 14,723 9,654 9,768
Income tax expense 5,694 3,374 4,135
----------- ----------- -----------
NET INCOME $ 9,029 $ 6,280 $ 5,633
=========== =========== ===========
COMPREHENSIVE NET INCOME
Net income $ 9,029 $ 6,280 $ 5,633
Other comprehensive income:
Gross unrealized investment holding gains
arising during period 44 617 1,437
Less: reclassification adjustment for gains
included in net income (13) (493) (95)
----------- ----------- -----------
31 124 1,342
Income tax expense related to items of other
comprehensive income (27) (42) (456)
Total other comprehensive net income 4 82 886
----------- ----------- -----------
COMPREHENSIVE NET INCOME $ 9,033 $ 6,362 $ 6,519
=========== =========== ===========
EARNINGS PER SHARE
Basic earnings per common share $ 1.23 $ 1.37 $ 1.18
=========== =========== ===========
Diluted earnings per common share $ 1.06 $ 1.09 $ 0.94
=========== =========== ===========
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
Basic 7,335,286 4,453,717 4,500,000
Diluted 8,565,815 5,708,016 5,761,949
See accompanying notes to the consolidated financial statements.
83
TOWER GROUP, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
($ in thousands)
ACCUMULATED UNEARNED
CLASS A CLASS B OTHER COMPENSATION
COMMON COMMON COMMON PAID-IN COMPREHENSIVE RETAINED RESTRICTED
STOCK STOCK STOCK CAPITAL NET INCOME EARNINGS STOCK
--------- --------- --------- --------- --------- --------- ---------
BALANCE AT DECEMBER 31, 2001 $ 45 $ -- $ -- $ 2,285 $ 80 $ 926 $ --
--------- --------- --------- --------- --------- --------- ---------
Dividends paid or declared -- -- -- -- -- (788) --
Net income -- -- -- -- -- 5,633 --
Net unrealized appreciation on
securities available for
sale, net
of income tax -- -- -- -- 886 -- --
--------- --------- --------- --------- --------- --------- ---------
BALANCE AT DECEMBER 31, 2002 45 -- -- 2,285 966 5,771 --
--------- --------- --------- --------- --------- --------- ---------
Stock repurchase -- -- -- -- -- -- --
Capital restructuring (45) 21 24 -- -- -- --
Dividends paid or declared -- -- -- -- -- (1,854) --
Net income -- -- -- -- -- 6,280 --
Net unrealized appreciation on
securities available for
sale, net
of income tax -- -- -- -- 82 -- --
--------- --------- --------- --------- --------- --------- ---------
BALANCE AT DECEMBER 31, 2003 -- 21 24 2,285 1,048 10,197 --
--------- --------- --------- --------- --------- --------- ---------
Capital restructuring 45 (21) (24) -- -- -- --
Dividends paid or declared -- -- -- -- -- (1,002) --
IPO and private
placement, net proceeds 141 -- -- 107,704 -- -- --
Stock based compensation 3 -- -- 2,395 -- -- (1,908)
Am Re warrant exercise 9 -- -- (9) -- -- --
Net income -- -- -- -- -- 9,029 --
Net unrealized appreciation on
securities available for
sale, net
of income tax -- -- -- -- 4 -- --
--------- --------- --------- --------- --------- --------- ---------
BALANCE AT DECEMBER 31, 2004 $ 198 $ -- $ -- $ 112,375 $ 1,052 $ 18,224 $ (1,908)
========= ========= ========= ========= ========= ========= =========
TOTAL
TREASURY STOCKHOLDERS'
STOCK EQUITY
--------- ---------
BALANCE AT DECEMBER 31, 2001 $ -- $ 3,336
--------- ---------
Dividends paid or declared -- (788)
Net income -- 5,633
Net unrealized appreciation on
securities available for
sale, net
of income tax -- 886
--------- ---------
BALANCE AT DECEMBER 31, 2002 -- 9,067
--------- ---------
Stock repurchase (514) (514)
Capital restructuring -- --
Dividends paid or declared -- (1,854)
Net income -- 6,280
Net unrealized appreciation on
securities available for
sale, net
of income tax -- 82
--------- ---------
BALANCE AT DECEMBER 31, 2003 (514) 13,061
--------- ---------
Capital restructuring -- --
Dividends paid or declared -- (1,002)
IPO and private
placement, net proceeds -- 107,845
Stock based compensation 20 510
Am Re warrant exercise -- --
Net income -- 9,029
Net unrealized appreciation on
securities available for
sale, net
of income tax -- 4
--------- ---------
BALANCE AT DECEMBER 31, 2004 $ (494) $ 129,447
========= =========
See accompanying notes to the consolidated financial statements.
84
TOWER GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31,
2004 2003 2002
--------- --------- ---------
($ in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 9,029 $ 6,280 $ 5,633
Adjustments to reconcile net income to net cash
provided by
(used in) operations:
Gain on sale of investments (13) (493) (95)
Depreciation 1,984 1,142 972
Amortization of intangible assets 22 -- --
Amortization of bond premium or discount 365 24 66
Amortization of debt issuance costs 178 28 --
Amortization of restricted stock 310 -- --
Deferred income taxes 3,595 629 426
(Increase) decrease in assets:
Investment income receivable (1,423) (159) (112)
Agents' balances receivable (11,521) (2,002) (4,803)
Assumed premiums receivable (200) 56 218
Receivable for cancelled reinsurance 15,748 (15,748) --
Ceding commissions receivable (346) 1,321 (4,832)
Reinsurance recoverable (16,223) (29,944) (22,002)
Prepaid reinsurance premiums 27,254 (7,226) (18,489)
Deferred acquisition costs, net (18,168) (4,067) (2,490)
Federal and state income taxes recoverable (2,102) -- --
Intangible assets (5,000) -- --
Other assets (2,029) (819) 64
Increase (decrease) in liabilities:
Loss and loss adjustment expenses 29,247 33,787 28,052
Unearned premium 25,257 13,235 19,810
Checks outstanding (2,209) 1,316 2,609
Reinsurance balances payable (18,053) (349) 5,401
Payable to issuing carriers 5,926 4,369 (3,274)
Accounts payable and accrued expenses 7,475 (1,944) 3,911
Federal and state income taxes payable (892) (1,595) (213)
Funds held under reinsurance agreements 29,198 24,818 (623)
Deferred compensation liability (1,294) 85 79
--------- --------- ---------
Net cash flows provided by operations 76,115 22,744 10,308
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of fixed assets (3,364) (2,502) (1,495)
Purchases of investments:
Fixed-maturity securities (197,129) (25,560) (36,199)
Equity securities -- -- (1,793)
Sale of investments:
Fixed-maturity securities 23,474 8,992 19,717
Equity securities 50 25 791
--------- --------- ---------
Net cash flows used in investing activities (176,969) (19,045) (18,979)
--------- --------- ---------
-Continued-
85
TOWER GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS -- (CONTINUED)
YEAR ENDED DECEMBER 31,
2004 2003 2002
--------- --------- ---------
($ in thousands)
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of redeemable preferred stock $ (3,000) $ -- $ --
Proceeds from repurchase obligation -- 29,650 31,080
Repayment of repurchase obligation -- (32,650) (28,080)
Proceeds from issuance of subordinated debentures 26,806 20,620 --
Purchase of common trust securities - statutory business trusts (806) (620) --
Proceeds from long-term debt -- CIT -- 6,000 --
Repayment of long-term debt -- CIT (5,588) (413) --
Proceeds from surplus notes -- 10,000 --
Repayment of surplus notes -- (10,000) --
Decrease (increase) in notes receivable from related parties 1,421 (50) (454)
Stock repurchase -- (514) --
Exercise of stock options 200 -- --
IPO and private placement, net proceeds 107,845 -- --
Dividends paid (1,162) (1,811) (670)
--------- --------- ---------
Net cash flows provided by financing activities 125,716 20,212 1,876
--------- --------- ---------
Increase (decrease) in cash and cash equivalents 24,862 23,911 (6,795)
Cash and cash equivalents, beginning of year 30,339 6,428 13,223
--------- --------- ---------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 55,201 $ 30,339 $ 6,428
========= ========= =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for income taxes $ 5,114 $ 2,263 $ 3,775
Cash paid for interest $ 2,261 $ 1,286 $ 423
See accompanying notes to the consolidated financial statements.
86
TOWER GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Background
The consolidated financial statements include the accounts of Tower Group,
Inc. ("Tower") and its wholly-owned subsidiaries, Tower Insurance Company of New
York ("TICNY"), and Tower Risk Management Corporation ("TRM") (collectively "the
Company"). The Company's stock is traded on the NASDAQ National Market under the
symbol "TWGP".
Initial Public Offering ("IPO")
On June 22, 2004 the Company's Board of Directors approved a 1.8:1 stock
split, the maintaining of a par value of $0.01 after the split and the amendment
and restatement of the Company's Certificate of Incorporation which among other
things, combined the Class A and Class B common stock into one class of common
stock and increased the authorized common stock to 40,000,000 shares. These
actions became effective on October 20, 2004, which is the effective date of the
Company's IPO. All consolidated financial statements and per share amounts have
been retroactively adjusted for the above stock split and maintaining the par
value at $0.01 per share.
On October 20, 2004, the Securities and Exchange Commission declared Tower
Group, Inc.'s registration statement effective. The Company's IPO was for
13,000,000 shares and was priced at $8.50 per share. Also on October 20, 2004
Tower Group, Inc. offered a concurrent private placement of 500,000 shares of
its common stock to an affiliate of Friedman, Billings, Ramsey & Co., Inc. the
lead underwriter for the Company's IPO, at the price of $8.50 per share. On
November 10, 2004 the underwriters exercised their 30-day over-allotment option.
Pursuant to this exercise, the underwriters purchased 629,007 additional shares
of common stock from the Company and 1,320,993 shares of common stock from the
selling stockholders at the IPO price of $8.50 per share, less the underwriting
discount. The Company did not receive any proceeds from the sale of common stock
by any selling stockholder. The Company received net cash proceeds of
$107,845,000 from the offering and concurrent private placement after the
underwriting discounts, commissions and offering expenses. The total costs of
the IPO and private placement were $12,252,000 of which $8,407,000 was for the
underwriters discount, and $3,845,000 was for all other costs. Costs of the IPO
have been reflected as a reduction in Paid-in-Capital.
Description of Business
TICNY is a property-casualty insurance company incorporated in the State of
New York in June 1989. TICNY obtained its license to operate in the State of New
York in December 1990, at which time it commenced underwriting operations. TICNY
provides coverage for many different market segments, including nonstandard
risks that do not fit the underwriting criteria of standard carriers due to
factors such as type of business, location and the relatively small amount of
premium per policy. TICNY offers commercial multiple-peril, monoline general
liability, commercial umbrella, monoline property, workers' compensation and
commercial automobile policies as well as personal lines products such as
homeowners, dwelling and other liability policies. Generally, TICNY targets
customers that have a reduced potential for loss severity and are not normally
exposed to long-tailed, complex or contingent risks, such as products liability,
asbestos or environmental claims. TICNY's commercial lines products provide
insurance coverages to businesses such as retail and wholesale stores, grocery
stores, restaurants, artisan contractors and residential and commercial
buildings. Personal lines products focus on modestly valued homes and dwellings.
TICNY's products are marketed through independent agents. All direct premiums
are written in the State of New York.
87
TRM is a non-risk-bearing insurance services company that produces, through
its managing general agency, business on behalf of other insurance companies
(which are referred to as TRM's issuing companies) and primarily focuses on
commercial risks with higher per policy premium, including risks that TICNY has
not been able to target due to historical surplus, rating and geographical
license constraints. TICNY also reinsures a portion of the premiums written by
TRM's issuing companies. The Company utilizes these non-risk-bearing insurance
services operations to generate commission income on premiums produced for other
insurance companies. In addition, the insurance services operation earns fee
revenues by providing claims administration and reinsurance intermediary
services to TRM's issuing companies and to other insurance companies. In 2004
and 2003, two companies accounted for 100% of the managing general agency
commissions of TRM. TRM generated 94% of its reinsurance intermediary commission
income in 2002 from the placement of one reinsurance agreement. See "Note 5.
Reinsurance" for further description.
Certain activities of the Company are provided by TICNY, DBA the Law Office
of Steven Fauth. These activities primarily consist of claims management
activities of TICNY and claims management services provided by TRM to other
issuing carriers. Mr. Fauth is an officer and director of the Company.
During 2003 and 2002, the Company engaged in significant transactions with
PXRE Reinsurance Company ("PXRE"), which had a significant impact on the
operations and financial statements of the Company. Transactions between PXRE
and the Company include reinsurance arrangements, debt financing and equity
transactions. To reduce the credit risk associated with having a significant
amount of reinsurance recoverable from PXRE the Company cancelled PXRE's
participation in the 2003 quota share agreement as of September 30, 2003. See
"Note 5. Reinsurance" and "Note 8. Debt".
Additionally, during 2003 and 2002 the Company engaged in significant
reinsurance arrangements with American Re-Insurance Company ("Am Re"), which
owned all of the Company's outstanding shares of Series A Cumulative Redeemable
Preferred Stock as of December 31, 2003. The Series A Cumulative Redeemable
Preferred Stock was redeemed during 2004. Am Re also held warrants for the
purchase of common stock that were exercised during 2004. See "Note 5.
Reinsurance", "Note 8. Debt", and "Note 9. Capital Stock".
Basis of Presentation
The accompanying consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of
America ("GAAP"). All significant intercompany transactions have been eliminated
in consolidation. Certain 2003 amounts have been reclassified to conform to the
2004 presentation.
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 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.
Premiums Earned
Insurance policies issued or reinsured by the Company are short-duration
contracts. Accordingly, premium revenue, including direct writings and
reinsurance assumed, net of premiums ceded to reinsurers, is recognized as
earned in proportion to the amount of insurance protection provided, on a
pro-rata basis over the terms of the underlying policies. Unearned premiums
represent premium applicable to the unexpired portions of in-force insurance
contracts at the end of each year. Prepaid reinsurance premiums represent the
unexpired portion of reinsurance premiums ceded.
88
Liability for Loss and Loss Adjustment Expense
The liability for loss and loss adjustment expenses represents management's
best estimate of the ultimate cost of all reported and unreported losses that
are unpaid as of the balance sheet date. The liability for loss and loss
adjustment expenses is estimated on an undiscounted basis, using individual
case-basis valuations, statistical analyses, and various actuarial procedures.
The projection of future claim payment and reporting is based upon an analysis
of the Company's historical experience, supplemented by analyses of industry
loss data. Management believes that the reserves for loss and loss adjustment
expenses are adequate to cover the ultimate cost of losses and claims to date;
however, because of the uncertainty from various sources, including changes in
reporting patterns, claims settlement patterns, judicial decisions, legislation,
and economic conditions, actual loss experience may not conform to the
assumptions used in determining the estimated amounts for such liability at the
balance sheet date. As adjustments to these estimates become necessary, such
adjustments are reflected in current operations. Because of the nature of the
business historically written, the Company's management believes that the
Company has limited exposure to environmental claim liabilities.
Reinsurance
The Company accounts for reinsurance in accordance with Statement of
Financial Accounting Standards No. 113, "Accounting and Reporting for
Reinsurance of Short-Duration and Long-Duration Contracts" ("SFAS 113").
Management believes the Company's reinsurance arrangements qualify for
reinsurance accounting in accordance with SFAS 113. Management has evaluated its
reinsurance arrangements and determined that insurance risk is transferred to
the reinsurers. Reinsurance agreements have been determined to be short-duration
prospective contracts and, accordingly, the costs of the reinsurance are
recognized over the life of the contract in a manner consistent with the earning
of premiums on the underlying policies subject to the reinsurance contract.
Reinsurance recoverable represents management's best estimate of unpaid
loss and loss adjustment expenses recoverable from reinsurers. Ceded losses
recoverable are estimated using techniques and assumptions consistent with those
used in estimating the liability for loss and loss adjustment expenses.
Management believes that reinsurance recoverables as recorded represent its best
estimate of such amounts; however, as changes in the estimated ultimate
liability for loss and loss adjustment expenses are determined, the estimated
ultimate amount recoverable from the reinsurer will also change. Accordingly,
the ultimate recoverable could be significantly in excess of or less than the
amount indicated in the consolidated financial statements. As adjustments to
these estimates become necessary, such adjustments are reflected in current
operations. Loss and loss adjustment expenses incurred as presented in the
consolidated statement of income and comprehensive net income are net of
reinsurance recoveries.
In preparing financial statements, management makes estimates of amounts
receivable from reinsurers estimated to be uncollectible based on an assessment
of factors including an assessment of the creditworthiness of the reinsurers and
the adequacy of collateral obtained, where applicable. The Company recorded no
allowance for uncollectible reinsurance at December 31, 2004 and 2003 and did
not expense any uncollectible reinsurance during 2004, 2003 and 2002.
Significant uncertainties are inherent in the assessment of the creditworthiness
of reinsurers and estimates of any uncollectible amounts due from reinsurers.
Any change in the ability of the Company's reinsurers to meet their contractual
obligations could have a detrimental impact on the consolidated financial
statements and TICNY's ability to meet its regulatory capital and surplus
requirements.
Ceding Commission Revenue
Commissions on reinsurance premiums ceded are earned in a manner consistent
with the recognition of the costs of the reinsurance, generally on a pro-rata
basis over the terms of the policies reinsured. Certain reinsurance agreements
contain provisions whereby the ceding commission rates vary based on the loss
experience under the agreements. The Company records ceding commission revenue
based on its current estimate of losses. The Company records adjustments to the
ceding commission revenue in the period that changes in the estimated losses are
determined. Ceding commissions receivable of $8,329,000 and $7,983,000 as of
December 31, 2004 and 2003, respectively represent ceding commissions receivable
from PXRE which are not due until final settlement of losses subject to the
contracts or commutation of the agreements.
89
Insurance Services Revenue
Direct commission revenue from the Company's managing general underwriting
services, which is the largest component of insurance services revenue, is
generally recognized and earned as insurance policies are placed with TRM's
issuing companies. Fees from reinsurance intermediary services are earned when
TICNY or TRM's issuing companies cede premiums to reinsurers. Claims
administration fees are earned as services are performed. See "Note 17. Segment
Information" for a further description of the components of insurance services
revenue.
Cash and Cash Equivalents
Cash and cash equivalents are presented at cost, which approximates fair
value. The Company considers all highly liquid investments with original
maturities of three months or less to be cash equivalents. For the purpose of
presentation in the Company's statements of cash flows, cash equivalents are
short-term, highly liquid investments that are both (a) readily convertible to
known amounts of cash, and (b) so near to maturity that they present
insignificant risk of changes in value due to changing interest rates.
The Company maintains its cash balances at several financial institutions.
The Federal Deposit Insurance Corporation secures accounts up to $100,000 at
these institutions. Management monitors balances in excess of insured limits and
believes they do not represent a significant credit risk to the Company.
Investments
The Company accounts for its investments in accordance with Statement of
Financial Accounting Standards No. 115, "Accounting for Certain Investments in
Debt and Equity Securities" ("SFAS 115"), which requires that fixed-maturity and
equity securities that have readily determined fair values be segregated into
categories based upon the Company's intention for those securities. In
accordance with SFAS 115, the Company has classified its fixed-maturity and
equity securities as available-for-sale. The Company may sell its
available-for-sale securities in response to changes in interest rates,
risk/reward characteristics, liquidity needs or other factors.
Fixed-maturity securities and equity securities are reported at their
estimated fair values based on quoted market prices or a recognized pricing
service, with unrealized gains and losses, net of tax effects, reported as a
separate component of comprehensive income in stockholders' equity. Short-term
investments are carried at cost, which approximates fair value. Realized gains
and losses are determined on the specific identification method.
Impairment of investment securities results in a charge to operations when
a market decline below cost is deemed to be other-than-temporary. The Company
regularly reviews its fixed-maturity and equity securities portfolios to
evaluate the necessity of recording impairment losses for other-than-temporary
declines in the fair value of investments. In general, attention is focused on
those securities whose fair value was less than 80% of their amortized cost or
cost, as appropriate, for six or more consecutive months. In evaluating
potential impairment, management considers, among other criteria: the current
fair value compared to amortized cost or cost, as appropriate; the length of
time the security's fair value has been below amortized cost or cost;
management's intent and ability to retain the investment for a period of time
sufficient to allow for any anticipated recovery in value; specific credit
issues related to the issuer; and current economic conditions.
Other-than-temporary impairment losses result in a permanent reduction of the
cost basis of the underlying investment. During 2004, 2003 and 2002, the Company
did not record any other-than-temporary impairments.
90
At December 31, 2004 and 2003, U.S. Treasury Notes with fair values of
approximately $651,000 and $546,000, respectively, were held by the
Superintendent of Insurance of the State of New York in order to comply with New
York Insurance Law.
Agents' Balances
Agents' balances receivable are presented net of an allowance for doubtful
accounts of $123,000 at December 31, 2004 and 2003. The allowance for
uncollectible amounts is based on an analysis of amounts receivable giving
consideration to historical loss experience and current economic conditions and
reflects an amount that, in management's judgment, is adequate. Uncollectible
agent's balances in 2004 were $27,000 and none in 2003 and 2002. One agent
accounted for approximately 12% and 16%, respectively, of TICNY's and TRM's
agents' balances at December 31, 2004 and 2003 and 14% and 17% of TICNY's direct
premiums written and TRM's premiums produced in 2004 and 2003, respectively.
Receivable - Claims Paid by Agency
Receivable - claims paid by agency represent claim payments due from
issuing carriers to reimburse claims paid by TRM on their behalf in conjunction
with claims administration services. The receivables are partially secured by
funds held totaling $785,000 and $796,000 as of December 31, 2004 and 2003,
respectively. As of December 31, 2004 and 2003, no reserve for uncollectible
recoverables was recorded. During 2004, 2003 and 2002, no amounts relating to
these receivables were written-off.
With respect to the business produced by TRM for other issuing carriers,
agents collect premiums from the policyholders and forward them to TRM. In
certain jurisdictions, when the insured pays premium for these policies to
agents for payment to TRM, the premium might be considered to have been paid and
the insured will no longer be liable to TRM for those amounts, whether or not
TRM has actually received the premiums from the agent. Consequently, TRM assumes
a degree of credit risk associated with agents and brokers. The Company recorded
no losses in 2004, 2003 and 2002 for this activity.
Notes Receivable from Related Parties
The Company received promissory notes from certain officers, directors, and
employees in exchange for cash. The notes bear interest at 4% per year and
maturity terms varied from 5 years to no stated maturity. Notes receivables as
of December 31, 2003 from the Company's Chairman of the Board, President and
Chief Executive Officer, totaled $1,338,000 and were repaid in 2004.
Deferred Acquisition Costs and Deferred Ceding Commission Revenue
Acquisition costs represent the costs of writing business that vary with,
and are primarily related to, the production of insurance business. Policy
acquisition costs are deferred and recognized as expense as related premiums are
earned. Deferred acquisitions costs as presented in the balance sheet are net of
deferred ceding commission revenue. The Company considers anticipated investment
income in determining the recoverability of these costs and believes they are
fully recoverable.
Intangible Assets
The Company has recorded as an asset acquired identifiable intangible
assets with finite useful lives. In accounting for such assets, the Company
follows "Statement of Financial Accounting Standard No. 142, "Goodwill and Other
Intangible Assets" ("SFAS 142").
The costs of a group of assets acquired in a transaction is allocated to
the individual assets including identifiable intangible assets based on their
relative fair values. Identifiable intangible assets with a finite useful life
are amortized over the period which the asset is expected to contribute directly
or indirectly to the future cash flows of the Company. Identifiable intangible
assets with finite useful lives are tested for recoverability whenever events or
changes in circumstances indicate that a carrying amount may not be recoverable.
An impairment loss is recognized if the carrying value of an intangible asset is
not recoverable and its carrying amount exceeds its fair value. No impairment
losses were recognized in 2004, 2003 and 2002.
91
Fixed Assets
Furniture, computer equipment, leasehold improvements and software are
reported at cost less accumulated depreciation and amortization. Depreciation
and amortization is provided using the straight-line method over the estimated
useful lives of the assets.
Statutory Business Trusts
In December 2003, the Financial Accounting Standards Board ("FASB") issued
FASB Interpretation No. 46(R), "Consolidation of Variable Interest Entities"
("FIN 46(R)"), which establishes accounting guidance for consolidation of
variable interest entities ("VIE") that function to support the activities of
the primary beneficiary. The primary beneficiary of a VIE is the entity that
absorbs a majority of the VIE's expected losses, receives a majority of the
VIE's expected residual returns, or both, as a result of ownership, controlling
interest, contractual relationship or other business relationship with a VIE.
Prior to the implementation of FIN 46(R), VIE's were generally consolidated by
an enterprise when the enterprise had a controlling financial interest through
ownership of a majority of voting interest in the entity. As of December 31,
2003, the Company does not consolidate interest in its statutory business trusts
for which the Company holds 100% of the common trust securities because Tower is
not the primary beneficiary of the trusts. See "Note 8. Debt". The Company's
investment in common trust securities of the statutory business trust are
reported in investments at equity. The Company reports as a liability the
outstanding subordinated debentures owed to the statutory business trusts.
Cumulative Redeemable Preferred Stock
In May 2003, the FASB issued Statement of Financial Accounting Standards
No. 150, "Accounting for Certain Financial Instruments with Characteristics of
both Liabilities and Equity" ("SFAS 150"). SFAS 150 establishes standards for
how an issuer classifies and measures certain financial instruments with
characteristics of both liabilities and equity. Due to the adoption by the
Company of SFAS 150, Series A Cumulative Redeemable Preferred Stock was
reclassified as debt as of July 1, 2003. Effective with adoption, dividends paid
are reported as interest expense. See "Note 8. Debt" and "Note 9. Capital
Stock".
Income Taxes
Pursuant to a Tax Allocation Agreement, dated as of January 1, 2001, Tower,
TICNY and TRM compute and pay Federal income taxes on a consolidated basis.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
basis and for operating loss and tax credit carry forwards. Deferred tax assets
and liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which those temporary differences are expected to
be recovered or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date.
Treasury Stock
The Company accounts for the treasury stock at the repurchase price as a
reduction to stockholders' equity as it does not intend to retire the treasury
stock held at December 31, 2004.
Equity Compensation Plans
The Company accounts for employee stock options using the intrinsic value
method in accordance with Accounting Principles Board Opinion No. 25,
"Accounting for Stock-Based Compensation" ("APB 25"). Under APB 25, because the
exercise price of the Company's employee stock options is equal to the estimated
market price of the underlying stock at the date of the grant, no compensation
expense is recognized. The effect of applying Statement of Financial Accounting
Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), as
amended by Statement of Financial Accounting Standards No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure" ("SFAS 148") requires
pro-forma disclosure of EPS for the impact on the financial statements as if the
stock options were expensed. See "Note 1. Summary of Significant Accounting
Policies-Recent Accounting Developments".
92
The Company accounts for restricted stock shares awarded at fair value at
the dated awarded as a charge to Unearned Compensation - Restricted Stock,
included as a separate component of Stockholders' Equity, and a credit to Common
Stock and Paid-in-Capital. The fair value of the shares will amortize ratably
over their one to five year vesting period as a charge to compensation expense
and a reduction to Unearned Compensation - Restricted Stock in Stockholders'
Equity.
Segment Reporting
The Company manages its operations through three reportable segments:
insurance (commercial and personal lines underwriting), reinsurance, and
insurance services (managing general agency, claims administration and
reinsurance intermediary operations). See "Note 17. Segment Information".
Earnings Per Share
In accordance with Statement of Financial Accounting Standards No. 128,
"Earnings Per Share", the Company measures earnings per share at two levels:
basic earnings per share and diluted earnings per share. Basic per share data is
calculated by dividing income (loss) allocable to common stockholders by the
weighted average number of shares outstanding during the year excluding issued
but unvested restricted stock shares. Diluted per share data is calculated by
dividing income (loss) allocable to common stockholders by the weighted average
number of shares outstanding during the year, as adjusted for the potentially
dilutive effects of stock options, warrants, unvested restricted stock and/or
convertible preferred stock, unless common equivalent shares are antidilutive.
Recent Accounting Developments
In December 2004, the Financial Accounting Standards Board issued the
revised statement SFAS No. 123-R, an amendment to SFAS No. 123, "Accounting for
Stock-Based Compensation" which suspends APB 25, requires that the cost of
share-based payment transactions be recognized in the financial statements after
the first fiscal quarter beginning after June 15, 2005. For calendar year
companies, this means that pro-forma footnote disclosures, developed under the
current SFAS 123 can continue to be provided in the first two quarters of 2005,
with mandatory expensing of equity-based compensation beginning in the third
quarter of 2005. The intended adoption by the Company of SFAS 123-R in June 2005
is not expected to have a material impact on the Company's financial position or
results of operations.
In March 2004, the FASB issued EITF Issue No. 03-1, The Meaning of
Other-Than Temporary Impairment and Its Application to Certain Investments,
which provides new guidance for assessing impairment losses on debt and equity
investments. Additionally, EITF Issue No. 03-1 includes new disclosure
requirements for investments that are deemed to be temporarily impaired. The
FASB has delayed the application of the accounting provisions until 2005 but
requires new disclosures for annual periods ending after June 15, 2004.
Management does not expect the adoption of this new accounting pronouncement to
have a material impact on the Company's financial statement upon adoption.
93
NOTE 2 -- INVESTMENTS
The amortized cost and fair value of investments in fixed-maturity
securities are summarized as follows:
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
---------- -------- ------- ----------
DECEMBER 31, 2004:
U.S. Government bonds $ 21,458 $ 80 $ (117) $ 21,421
Municipal bonds 76,647 597 (154) 77,090
Corporate and other bonds 61,341 810 (298) 61,853
Mortgage-backed securities 64,116 464 (421) 64,159
---------- -------- ------- ----------
TOTAL $ 223,562 $ 1,951 $ (990) $ 224,523
========== ======== ======= ==========
DECEMBER 31, 2003:
U.S. Government bonds $ 1,840 $ 6 $ (63) $ 1,783
Municipal bonds 10,022 386 (33) 10,375
Corporate and other bonds 19,739 866 (216) 20,389
Mortgage-backed securities 21,664 428 (94) 21,998
---------- -------- ------- ----------
TOTAL $ 53,265 $ 1,686 $ (406) $ 54,545
========== ======== ======= ==========
A summary of the amortized cost and fair value of the Company's investments
in fixed-maturity securities at December 31, 2004 by contractual maturity is
shown below (in 000's):
AMORTIZED FAIR
COST VALUE
----------- -----------
YEARS TO MATURITY:
One or less $ 8,224 $ 8,243
After one through five 54,705 54,924
After five through ten 91,361 92,094
After ten 5,156 5,103
Mortgage-backed securities 64,116 64,159
----------- -----------
TOTAL $ 223,562 $ 224,523
=========== ===========
The actual maturities may differ from contractual maturities because
certain borrowers have the right to call or prepay obligations with or without
penalties.
The cost and estimated fair value of investments in equity securities are
as follows (in 000's):
GROSS GROSS
UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
-------- ---------- ---------- --------
DECEMBER 31, 2004:
Preferred stocks $ 113 $ 4 $ -- $ 117
Common stocks 1,714 654 -- 2,368
-------- ------ ----- --------
TOTAL $ 1,827 $ 658 $ -- $ 2,485
======== ====== ===== ========
DECEMBER 31, 2003:
Preferred stocks $ 163 $ 4 $ -- $ 167
Common stocks 1,714 303 -- 2,017
-------- ------ ----- --------
TOTAL $ 1,877 $ 307 $ -- $ 2,184
======== ====== ===== ========
94
Major categories of the Company's net investment income are summarized as
follows (in 000's):
2004 2003 2002
------ ------ ------
Income:
Fixed-maturity securities $4,868 $2,190 $1,762
Equity securities 48 39 41
Short-term investments and cash 294 121 190
Interest on notes receivable from related
parties 46 54 47
Dividends on common trust securities 52 -- --
------ ------ ------
TOTAL 5,308 2,404 2,040
Expenses:
Investment expenses 238 136 107
------ ------ ------
NET INVESTMENT INCOME $5,070 $2,268 $1,933
====== ====== ======
Proceeds from the sale and maturity of fixed-maturity securities were
$23,474,000, $8,992,000 and $19,717,000 in 2004, 2003 and 2002, respectively.
Proceeds from the sale of equity securities were $50,000, $25,000 and $791,000
in 2004, 2003, and 2002, respectively. The Company's gross realized gains and
losses on investments are summarized as follows (in 000's):
2004 2003 2002
----- ----- -----
Fixed maturity securities:
Gross realized gains $ 137 $ 493 $ 602
Gross realized losses (124) -- (128)
----- ----- -----
13 493 474
Equity securities:
Gross realized gains -- -- 50
Gross realized losses -- -- (429)
----- ----- -----
-- -- (379)
----- ----- -----
NET REALIZED GAINS $ 13 $ 493 $ 95
===== ===== =====
The following table presents information regarding the Company's invested
assets that were in an unrealized loss position at December 31, 2004 by amount
of time in a continuous unrealized loss position (in 000's)
LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL
-------------------------- ------------------------- -------------------------
FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED
VALUE LOSS VALUE LOSS VALUE LOSS
--------- ----------- --------- ---------- --------- ----------
U.S. Gov't bonds $ 15,425 $ (79) $ 1,252 $ (40) $ 16,677 $ (119)
Municipal bonds 24,150 (118) 2,077 (36) 26,227 (154)
Corp. and other bonds 25,993 (199) 1,742 (98) 27,736 (297)
Mortgage-backed
securities 42,172 (363) 5,312 (57) 47,485 (420)
--------- ------- --------- ------- --------- -------
TOTAL $ 107,740 $ (759) $ 10,383 $ (231) $ 118,123 $ (990)
========= ======= ========= ======= ========= =======
As of December 31, 2004, 81 securities accounted for the gross unrealized
losses, all of which are deemed to be temporary. Significant factors influencing
Management's determination that unrealized losses were temporary included the
mild severity of the unrealized losses in relation to each securities cost and
the nature of the investments and management's intent and ability to retain the
investment for a period of time sufficient to allow for anticipated recovery in
value.
95
NOTE 3 -- PROPERTY - CASUALTY INSURANCE ACTIVITY
Premiums written, ceded and earned are as follows (in 000's):
DIRECT ASSUMED CEDED NET
--------- --------- --------- ---------
2004:
Premiums written $ 176,166 $ 1,600 $ (79,691) $ 98,075
Change in unearned premiums (24,956) (301) (27,254) (52,511)
--------- --------- --------- ---------
PREMIUMS EARNED $ 151,210 $ 1,299 $(106,945) $ 45,564
========= ========= ========= =========
2003:
Premiums written $ 133,263 $ 1,219 $(105,532) $ 28,950
Change in unearned premiums (12,722) 263 6,450 (6,009)
--------- --------- --------- ---------
PREMIUMS EARNED $ 120,541 $ 1,482 $ (99,082) $ 22,941
========= ========= ========= =========
2002:
Premiums written $ 105,266 $ 1,474 $ (79,411) $ 27,329
Change in unearned premiums (20,748) 164 19,263 (1,321)
--------- --------- --------- ---------
PREMIUMS EARNED $ 84,518 $ 1,638 $ (60,148) $ 26,008
========= ========= ========= =========
The components of the liability for loss and loss adjustment expenses and
related reinsurance recoverables are as follows (in 000's):
GROSS LIABILITY REINSURANCE RECOVERABLES
--------------- ------------------------
DECEMBER 31, 2004:
Case-basis reserves $ 76,793 $ 55,273
IBNR reserves 51,929 36,500
Recoverable on paid losses -- 9,400
-------- --------
TOTAL $128,722 $101,173
======== ========
DECEMBER 31, 2003:
Case-basis reserves $ 61,622 $ 45,544
IBNR reserves 37,853 29,570
Recoverable on paid losses -- 9,646
-------- --------
TOTAL $ 99,475 $ 84,760
======== ========
Activity in the liability for loss and loss adjustment expenses is
summarized as follows (in 000's):
2004 2003 2002
--------- --------- ---------
Balance at January 1, $ 99,475 $ 65,688 $ 37,637
Less reinsurance recoverables (75,114) (50,212) (29,017)
--------- --------- ---------
24,361 15,476 8,620
Incurred related to:
Current year 27,259 14,996 13,416
Prior years (199) 75 2,940
--------- --------- ---------
TOTAL INCURRED 27,060 15,071 16,356
--------- --------- ---------
Paid related to:
Current year 6,991 2,084 6,585
Prior years 7,481 4,102 2,915
--------- --------- ---------
TOTAL PAID 14,472 6,186 9,500
--------- --------- ---------
Net balance at December 31, 36,949 24,361 15,476
Add reinsurance recoverables 91,773 75,114 50,212
--------- --------- ---------
BALANCE AT DECEMBER 31, $ 128,722 $ 99,475 $ 65,688
========= ========= =========
96
Incurred losses and loss adjustment expenses are net of reinsurance
recoveries under reinsurance contracts of $57,104,000, $59,090,000 and
$38,609,000 in 2004, 2003 and 2002, respectively.
For 2004, 2003 and 2002 the incurred loss and loss adjustment expenses
attributable to insured events of prior years decreased by $199,000 and
increased by $75,000 and $2,940,000, respectively, as a result of re-estimation
of loss and loss adjustment expenses. No additional premiums or return premiums
have been accrued as a result of these prior year effects.
The increase in 2002 is the result of recent loss development trends in the
reinsurance segment. The Company's management continually monitors claims
activity to assess the appropriateness of carried case and IBNR reserves, giving
consideration to Company and industry trends.
NOTE 4 - DEFERRED ACQUISITION COSTS AND DEFERRED CEDING
COMMISSION REVENUE
Acquisition costs incurred and policy-related ceding commission revenue are
deferred and amortized to income on property and casualty business as follows
(in 000's):
2004 2003 2002
-------- -------- --------
Net deferred acquisition costs (ceding
commission revenue), January 1, $ 573 $ (3,494) $ (5,984)
Costs incurred and deferred during years:
Commissions and brokerage 29,732 22,218 18,771
Other underwriting and acquisition costs 24,482 17,779 12,697
Ceding commission revenue (10,379) (35,415) (24,429)
-------- -------- --------
Net acquisition costs (ceding commission
revenue) deferred during year 43,835 4,582 7,039
Amortization (25,668) (515) (4,549)
-------- -------- --------
Net deferred acquisition costs (ceding
commission revenue), December 31, $ 18,740 $ 573 $ (3,494)
======== ======== ========
NOTE 5 - REINSURANCE
The Company offers insurance coverage for limits up to $10,000,000 for
property risks, $2,000,000 for liability coverages and $10,000,000 for workers'
compensation. Through various quota share, excess of loss and catastrophe
reinsurance agreements, as described further below, the Company limits its
exposure to a maximum loss on any one risk of $400,000 during the period January
1, through September 30, 2004, $750,000 during the period October 1, through
December 31, 2004, $450,000 during the period January 1, through September 30,
2003 (after commutation - see discussion below), $312,500 during the period
October 1 through December 31, 2003 and $250,000 in 2002.
In an effort to manage the cost of quota share reinsurance in the time of
rising cost and limited availability, the Company implemented provisions for
loss ratio caps to its quota share reinsurance agreements. These provisions have
been structured to provide the reinsurers with some limit on the amount of
potential loss being assumed, while maintaining the transfer of significant
insurance risk with the possibility of a significant loss to the reinsurer, and
thereby to reduce the cost of reinsurance. Loss ratio caps cut off the
reinsurers' liability for losses above a specified loss ratio. The loss ratio
caps in the 2004, 2003 and 2002 quota share agreements were 95.0%, 92.0% and
97.5%, respectively.
97
The structure of the Company's reinsurance program enables the Company to
reflect significant reductions in premiums written and earned and also provides
income as a result of ceding commissions earned pursuant to reinsurance
contracts. This structure has enabled the Company to significantly grow its
premium volume while maintaining regulatory capital and other financial ratios
generally within expected ranges used for regulatory oversight purposes. The
Company's participation in reinsurance arrangements does not relieve the Company
from its obligations to policyholders.
Approximate reinsurance recoverables by reinsurer are as follows (in
000's):
UNPAID PAID
LOSSES LOSSES TOTAL
-------- -------- --------
DECEMBER 31, 2004:
PXRE Reinsurance Company $ 33,852 $ 3,804 $ 37,656
American Re-Insurance Company 13,298 1,175 14,473
Tokio Millennium Re Ltd. 31,278 3,317 34,595
Hannover Reinsurance (Ireland) Ltd. 7,750 850 8,600
E+S Reinsurance (Ireland) Ltd. 1,937 212 2,149
SCOR Reinsurance Company 1,323 9 1,332
Others 2,335 33 2,368
-------- -------- --------
TOTAL $ 91,773 $ 9,400 $101,173
======== ======== ========
DECEMBER 31, 2003:
PXRE Reinsurance Company $ 51,697 $ 7,354 $ 59,051
American Re-Insurance Company 12,565 1,474 14,039
Tokio Millennium Re Ltd. 9,972 777 10,749
Others 880 41 921
-------- -------- --------
TOTAL $ 75,114 $ 9,646 $ 84,760
======== ======== ========
The Company recorded prepaid reinsurance premiums as follows (in 000's):
DECEMBER 31,
2004 2003
------- -------
PXRE Reinsurance Company $ -- $ 109
American Re-Insurance Company 1,376 1,760
Tokio Millennium Re Ltd. 13,093 52,389
Hannover Reinsurance (Ireland Ltd.) 10,474 --
E+S Reinsurance (Ireland) Ltd. 2,619 --
Others 829 1,387
------- -------
TOTAL $28,391 $55,645
======= =======
The following collateral is available to the Company for amounts receivable
from reinsurers (in 000's) as of December 31, 2004 and 2003:
REGULATION LETTERS OF
114 TRUST CREDIT FUNDS HELD TOTAL
----------- ---------- ---------- -------
DECEMBER 31, 2004
Tokio Millennium Re Ltd. $19,345 $ -- $38,296 $57,641
Hannover Reinsurance (Ireland) Ltd. -- 5,355 12,685 18,040
E+S Reinsurance (Ireland) Ltd. -- 1,338 3,171 4,509
Others -- 796 -- 796
------- ------- ------- -------
Total $19,345 $ 7,489 $54,152 $80,986
======= ======= ======= =======
DECEMBER 31, 2003
Tokio Millennium Re Ltd. $ -- $20,000 $24,943 $44,943
Others -- 735 -- 735
------- ------- ------- -------
Total $ -- $20,735 $24,943 $45,678
======= ======= ======= =======
98
To reduce TICNY's credit exposure to reinsurance, quota share reinsurance
agreements effective October 1, 2003 and January 1, 2004 were placed on a "funds
withheld" basis. Under these agreements TICNY places the collected ceded
premiums written, net of commissions and the reinsurers margin, in segregated
trusts for the benefit of TICNY and the reinsurers. TICNY may withdraw funds for
loss and loss adjustment expense payments and commission adjustments. Segregated
assets in trust accounts amounted to $53,888,000 and $24,943,000 at December 31,
2004 and 2003 and are included in invested assets. The Company is obliged under
the reinsurance agreements to credit reinsurers with a 2.5% annual effective
yield on the monthly balance in the funds held under reinsurance agreements
liability accounts. The amounts credited for 2004 and 2003 were $1,069,000 and
$523,000, respectively, and have been recorded as interest expense.
The Company earns ceding commissions under quota share reinsurance
agreements for 2004, 2003 and 2002 based on a sliding scale of commission rates
and ultimate treaty year loss ratios on the policies reinsured under each of
these agreements. The sliding scale includes minimum and maximum commission
rates in relation to specified ultimate loss ratios. The commission rate and
ceding commissions earned increase when the estimated ultimate loss ratio
decreases and, conversely, the commission rate and ceding commissions earned
decrease when the estimated ultimate loss ratio increases.
As of December 31, 2004, the Company's estimated ultimate loss ratios are
lower than the contractual ultimate loss ratios at which the minimum amount of
ceding commissions can be earned. Accordingly, the Company has recorded ceding
commissions earned that are greater than the minimum commissions. The relevant
estimated ultimate loss ratios and commissions as of December 31, 2004 are set
forth below (dollars in 000's):
CONTRACTUAL LOSS
RATIO AT WHICH MAXIMUM POTENTIAL
MINIMUM CEDING ESTIMATED CEDING REDUCTION OF
COMMISSION RATE ULTIMATE LOSS COMMISSIONS MINIMUM CEDING
TREATY YEAR APPLIES RATIO EARNED COMMISSION COMMISSIONS EARNED
----------- ---------------- ------------- ----------- ---------- ------------------
2002 63.0% 56.0% $29.7 $23.6 $6.1
2003 65.6% 57.1% $31.1 $24.0 $7.1
2004 68.0% 54.0% $19.0 $13.3 $5.7
Based on the amount of ceded premiums earned, the maximum potential
reduction to ceding commissions earned related to an increase in the Company's
estimated ultimate loss ratios is $18.9 million for all treaties for all three
years. The maximum potential reduction for the 2004 treaty year may increase as
additional ceded premiums are earned in 2005 (assuming the estimated ultimate
loss ratio remains the same). The ceded premiums for the 2002 and 2003 treaty
years have been fully earned as of December 31, 2004.
The estimated ultimate loss ratios are the Company's best estimate based on
facts and circumstances known at the end of each period that losses are
estimated. The estimation process is complex and involves the use of informed
estimates, judgments and actuarial methodologies relative to future claims
severity and frequency, the length of time for losses to develop to their
ultimate level, possible changes in law and other external factors. The same
uncertainties associated with estimating loss and loss adjustment expense
reserves affect the estimates of ceding commissions earned. The Company monitors
and adjusts the ultimate loss ratio on a quarterly basis to determine the effect
on the commission rate and ceding commissions earned. The increase in estimated
ceding commission income relating to prior years recorded in 2004, 2003 and 2002
was $1,663,000, $1,326,000 and $0, respectively.
PMA
Effective October 1, 2003, the Company commuted PMA's participation under
the 2003 quota share reinsurance treaty. Prior to the commutation, PMA assumed
17.5% of the layer of coverage representing the first $500,000 of each loss on
policies written or renewed on or after January 1, 2003. The effect of this
commutation was to conclude PMA's participation in the quota share treaty and to
discharge PMA from future related liabilities effective October 1, 2003. Loss
related amounts recoverable from PMA at the commutation date including loss and
loss adjustment expense reserve liabilities ceded of $2,700,000 and ceded paid
losses of $4,000,000 that had not yet been recovered from PMA were settled with
a payment received from PMA of $3,100,000. The Company also received $2,500,000
for ceded unearned premium at the commutation date resulting in a total cash
settlement of $5,600,000. The Company incurred a cost of $800,000 representing
consideration retained by PMA for reinsuring the Company from January 1, 2003 to
September 30, 2003.
99
PXRE
PXRE participated in various reinsurance agreements with the Company from
2001 through September 30, 2003, including a quota share participation in the
layer of coverage representing the first $500,000 of each loss. Ceded written
premiums include $20,261,000 and $72,434,000 ceded to PXRE in 2003 and 2002,
respectively. Effective September 30, 2003, the 2003 quota share agreement with
PXRE was cancelled. The quota share agreements with PXRE are in run-off. As a
result of the cancellation of the 2003 quota share agreement with PXRE as of
September 30, 2003, the Company was owed $15,748,000 in return premium net of
ceding commissions as of December 31, 2003. This amount was collected in
January, 2004.
In addition to the ceding commission provisions described above, the 2002
PXRE quota share agreement contained a provision that provided the Company with
a non-refundable special commission of $5,000,000, which the Company received in
December 2001. The Company deferred this special commission as of December 31,
2001 to be earned over the period during which the underlying premiums are
earned.
In January 2003, the Company entered into an excess of loss reinsurance
agreement with PXRE Barbados Ltd. ("PXRE Barbados"), an affiliate of PXRE, and
remitted $10,000,000 as deposit premium to PXRE Barbados as called for by the
contract. This excess of loss agreement inured solely to the benefit of PXRE in
connection with its participation in the 2003 quota share agreement with the
Company. Effective September 30, 2003, the Company and PXRE Barbados commuted
the excess of loss agreement. As a result of the commutation of the agreement,
the Company recorded $1,537,000 in ceding commission revenue.
The Company entered into a borrowing arrangement during 2002 with PXRE
Barbados, for $10,000,000. See "Note 8. Debt". The terms and conditions of the
note were structured to comply with the New York Insurance Law, which permitted
TICNY to reflect this note as surplus as regards policyholders for statutory
accounting purposes as of December 31, 2002.
In 2001, the Company entered into quota share reinsurance and option
agreements with PXRE. Under the option agreement, which was effective on June
30, 2001, PXRE was granted the right to purchase 599,400 shares of common stock
of the Company for $16.67 per share. PXRE paid the Company $5,000,000 for this
option, which becomes exercisable on June 30, 2006 and expires on July 31, 2006.
The agreement provides that PXRE's right to exercise the option terminates if
the Company meets certain conditions. Those conditions included the Company
granting to PXRE a right of first refusal with respect to all quota share
reinsurance cessions made by the Company through December 31, 2005 and
presenting reinsurance submissions to PXRE involving gross written premiums of
at least $25,000,000 per year from 2001 through 2005. The terms and conditions
of the 2001 quota share reinsurance treaty between PXRE and TICNY, including the
commission rate, were amended to reflect the payment of the $5,000,000 under the
option agreement. The Company classified the $5,000,000 proceeds for the stock
options as commission income in 2001 and attributed no value to the options
issued to PXRE due to the $16.67 per share exercise price.
At the end of 2001, the Company, through TRM, provided reinsurance
intermediary services to PXRE and TICNY for the placement of quota-share
reinsurance covering the 2002 calendar year. As part of the placement of this
reinsurance treaty, TRM entered into a reinsurance intermediary commission
agreement with PXRE. During 2002, TRM earned commissions of $3,000,000 related
to this intermediary commission agreement that is reflected in the Company's
consolidated statement of income.
100
AM RE
The Company has participated in various reinsurance agreements with Am Re.
Ceded written premiums include $2,753,000, $3,811,000 and $3,154,000 ceded to Am
Re in 2004, 2003 and 2002, respectively. Am Re had owned all outstanding shares
of the Company's Series A Cumulative Redeemable Preferred Stock and held
warrants for the purchase of common stock. See "Note 8. Debt" and "Note 9.
Capital Stock". During 2004, all of the preferred stock was redeemed and the
warrants were exercised.
CONVERIUM
In September 2004, A.M. Best downgraded the rating of Converium Reinsurance
(North America) Inc. ("Converium") to "B-" (Fair) and Converium was placed into
run-off by its parent company. As a result, on September 2, 2004, the Company
delivered notice to Converium under our quota share treaty of our intent to
terminate Converium's participation on a cut-off basis effective November 1,
2004. Subsequently the Company reached an agreement with Converium, Tokio
Millenium Re Ltd. ("Tokio") and Hannover Reinsurance (Ireland) Ltd. and E+S
Reinsurance (Ireland) Ltd. (collectively "Hannover") to effect a novation of
Converium's participation under the quota share treaty to those other reinsurers
effective January 1, 2004, as a result of which Tokio and Hannover agreed to
each take 50% of Converium's share. In connection with the agreement, Tokio,
Hannover and the Company agreed to fully release Converium for any liabilities
under the quota share treaty. As a result of the novation, Tokio and Hannover
assumed the earned premiums and related risks for the period from January 1,
2004 through December 31, 2004. In addition, the Company has retained the
unearned premiums and related risks of $13,090,000 as of December 31, 2004 that
would have been ceded to Converium absent the novation.
NOTE 6 - INTANGIBLE ASSETS
The Company entered into a Commercial Renewal Rights Agreement with
OneBeacon Insurance Group LLC on September 13, 2004 under which it has acquired
OneBeacon's rights to seek to renew a block of commercial lines insurance
policies in New York State consisting of commercial multiple-peril, workers
compensation, commercial umbrella, commercial inland marine, commercial auto,
fire and allied lines and general liability coverages. Under the terms of the
agreement, the Company did not acquire any in-force business or historical
liabilities associated with the policies. Pursuant to the agreement, the Company
also obtained the rights to establish contractual relationships with certain
OneBeacon agents. The Company has agreed to pay OneBeacon an amount equal to 5%
of the direct premiums written resulting from the Company's renewal of any
subject policies in the first year, 4% in the second year and 1% in the third
year, with no payments due after the third year, subject to the Company's
obligation to pay a minimum of $5,000,000 in the aggregate over the three year
period. The Company has recorded this transaction as $5,000,000 of intangible
assets and a corresponding $5,000,000 liability. Shortly after signing this
agreement the Company provided an irrevocable letter of credit for the benefit
of OneBeacon in the amount of $2,000,000 representing the estimated payments for
the first year of the agreement.
The Company has determined that two intangible assets were acquired in this
transaction: renewal rights and new agent contractual relationships, both of
which were determined to be intangible assets with a finite useful life. The
renewal rights were recorded at $1,250,000 and will be amortized over ten years
in proportion to anticipated renewal premiums to be written during this time
period. The new agent contractual relationships have been recorded at $3,750,000
and will be amortized over twenty years on a straight-line basis. During 2004,
the Company recorded amortization expense of $22,000 on the intangible assets.
101
The weighted average amortization period of identified intangible assets of
finite useful life is 17.5 years. The estimated aggregate amortization expense
for each of the next five years is:
2005 $445,000
2006 $412,000
2007 $367,000
2008 $331,000
2009 $302,000
The components of intangible assets are summarized as follows (in 000's):
ACCUMULATED
INITIAL BALANCE AMORTIZATION NET
--------------- ------------ -------
DECEMBER 31, 2004:
Renewal rights $ 1,250 $ (6) $ 1,244
Agency force 3,750 (16) 3,734
------- ----- -------
$ 5,000 $ (22) $ 4,978
======= ===== =======
NOTE 7 - FIXED ASSETS
The components of fixed assets are summarized as follows (in 000's):
ACCUMULATED
COST DEPRECIATION NET
------- ------- -------
DECEMBER 31, 2004:
Furniture $ 626 $ (298) $ 328
Leasehold improvements 1,123 (649) 474
Computer equipment 4,954 (3,716) 1,238
Software 5,705 (2,325) 3,380
------- ------- -------
Net fixed assets $12,408 $(6,988) $ 5,420
======= ======= =======
DECEMBER 31, 2003:
Furniture $ 614 $ (223) $ 391
Leasehold improvements 1,114 (498) 616
Computer equipment 4,008 (3,063) 945
Software 3,308 (1,220) 2,088
------- ------- -------
Net fixed assets $ 9,044 $(5,004) $ 4,040
======= ======= =======
NOTE 8 - DEBT
SUBORDINATED DEBENTURES
During the second and third quarters of 2003, Tower formed two statutory
business trusts ("Trust I" and "Trust II"), of which the Company owns all of the
common trust securities. On May 15, 2003 and September 30, 2003, Trust I and
Trust II, respectively, each issued $10,000,000 floating rate trust preferred
securities totaling $20,000,000 to investment pools. The trusts invested the
proceeds thereof and the proceeds received from the issuance of the common trust
securities to Tower in exchange for $20,620,000 of floating rate junior
subordinated debentures ("subordinated debentures") issued by Tower. The
subordinated debentures are unsecured obligations of Tower and are subordinated
and junior in right of payment to all present and future senior indebtedness of
Tower. Tower has entered into guarantee agreements, which provide for full and
unconditional guarantee of the trust securities. The subordinated debentures and
the floating rate preferred securities issued by Trust I accrue and pay interest
quarterly at 3 month LIBOR, plus 4.10%, which cannot exceed 12.50% prior to May
15, 2008. At December 31, 2004 this interest rate was 6.38%. The Trust II
floating rate preferred securities bear interest at a fixed rate of 7.5% until
September 30, 2008 and at a variable rate, reset quarterly, equal to the 3-month
LIBOR, plus 4.00%, thereafter. The final maturity on the subordinated debentures
is May 15, 2033 and September 30, 2033 for Trust I and Trust II, respectively,
with prepayment at the option of the company available beginning in 2008.
Issuance costs, primarily legal fees, of $301,000 and $338,000 for the Trust I
and Trust II offerings, respectively, were deferred and are being amortized over
the term of the subordinated debentures using the effective interest method.
102
In December, 2004, Tower formed two statutory business trusts ("Trust III"
and "Trust IV"), of which the Company owns all of the common trust securities.
On December 7, 2004 and December 17, 2004, Trust III and Trust IV, respectively,
each issued $13,000,000 floating rate trust preferred securities totaling
$26,000,000 to investment pools. The trusts invested the proceeds thereof and
the proceeds received from the issuance of the common trust securities to Tower
in exchange for $26,806,000 of floating rate junior subordinated debentures
("subordinated debentures") issued by Tower. The subordinated debentures are
unsecured obligations of Tower and are subordinated and junior in right of
payment to all present and future senior indebtedness of Tower. Tower has
entered into guarantee agreements, which provide for full and unconditional
guarantee of the trust securities. The Trust III preferred securities bear
interest that is fixed at 7.4% until December 7, 2009 and the coupon will float
quarterly thereafter at the three months LIBOR rate plus 3.4%. The Trust IV
preferred securities bear interest that will float based on the three month
LIBOR interest rate plus 3.4% and their rate as of December 31, 2004 was 5.92%.
The final maturity on the subordinated debentures is December 15, 2034 and March
15, 2035 for Trust III and Trust IV, respectively, with prepayment at the option
of the company available beginning in 2009. Issuance costs, primarily legal
fees, of $262,000 and $252,000 for the Trust III and Trust IV offerings,
respectively, were deferred and are being amortized over the term of the
subordinated debentures using the effective interest method.
Total interest expense incurred for all subordinated debentures, including
amortization of deferred origination costs, was $1,461,000 and $559,000,
respectively for the years ended December 31, 2004 and 2003.
CIT FINANCING AGREEMENT
On February 21, 2003, Tower entered into a Credit Agreement with The CIT
Group/Equipment Financing, Inc. ("CIT") for borrowings up to $6,000,000.
Pursuant this agreement TOWER borrowed $3,000,000 ("First Advance") on February
25, 2003 and an additional $3,000,000 on December 31, 2003 ("Second Advance").
The Credit Agreement required that $1,800,000 of the First Advance be
contributed to TICNY. The Credit Agreement included certain compliance
requirements including certain financial requirements. Tower had pledged all of
the outstanding common stock of TICNY and TRM as collateral for the borrowings
pursuant to the Credit Agreement. TRM guaranteed Tower's obligations pursuant to
the credit agreement and also granted CIT a security interest in all of TRM's
assets. Interest is variable, adjusting each quarter, and is determined as LIBOR
as of the first day of each quarter plus 4.50%. During 2003 interest rates
pursuant to the credit agreement ranged from 5.62% to 5.88%. As of December 31,
2003, the interest rate was 5.66%. During 2004, interest rates pursuant to the
credit agreement ranged from 5.61% to 6.11%. Origination fees, primarily legal
fees, incurred with respect to the First and Second Advances totaling $175,000
were deferred amortized using the effective interest method and reported as an
adjustment to interest expense. Interest expense incurred for the years ended
December 31, 2004 and 2003, including amortization of origination costs, was
$283,000 and $158,000, respectively. In October 2004, the remaining $5.0 million
loan was repaid, the credit agreement was terminated and a loss of $133,000 was
recorded reflecting unamortized origination fees.
103
SURPLUS NOTE
On December 19, 2002, TICNY entered into a borrowing arrangement with PXRE
Barbados for $10,000,000 ("Surplus Note"). The borrowings under this arrangement
were not reflected in the December 31, 2002 consolidated GAAP basis financial
statements as the Company received the proceeds from the Surplus Note on January
10, 2003. The Surplus Note accrued interest at the rate of 5.0% per annum,
payable quarterly commencing April 1, 2003 upon prior approval of the State of
New York Insurance Department's Superintendent ("the Superintendent"). TICNY
issued the Surplus Note in conjunction with a financing agreement structured in
accordance with the standards of Section 1307 of the New York Insurance Law in
order to reflect the proceeds as surplus for statutory accounting purposes. The
New York Insurance Law provides that notes of this nature have no due date and
the Company cannot repay principal or interest to PXRE without the prior written
approval of the Superintendent. On December 19, 2003, the Company repaid the
balance owed under this agreement and terminated the borrowing agreement, having
received approval for such repayment from the Superintendent. Interest expense
incurred for 2003 pursuant to the Surplus Note was $500,000.
SECURITIES REPURCHASE AGREEMENT
In 2002, the Company, through its investment manager, executed a securities
repurchase agreement with J.P. Morgan Securities, Inc. At December 31, 2002, the
Company owed approximately $3,000,000 under this repurchase agreement, which was
collateralized by certain mortgage-backed securities owned by the Company.
During 2003 and 2002, the Company incurred interest totaling $23,000 and
$43,000, respectively, relating to its repurchase obligations. This facility is
still open as of December 31, 2004.
SERIES A CUMULATIVE REDEEMABLE PREFERRED STOCK
The 60,000 shares of the Company's Series A Cumulative Redeemable Preferred
Stock ("the preferred stock"), $0.01 par value were held by Am Re. The preferred
stock carried a rate of 10.5% per annum with dividends payable quarterly and in
arrears, and was redeemable in advance of the mandatory redemption dates at the
option of the Company. The preferred stock did not have rights to vote with the
holders of common stock. In January 2004, the Company redeemed 30,000 of the
outstanding shares of the preferred stock for $1,500,000 and the remaining
30,000 shares were redeemed by the Company in October 2004 for $1,500,000 plus
accrued interest.
Due to the adoption by the Company of SFAS 150, the mandatorily redeemable
Series A Cumulative Redeemable Preferred Stock of $3,000,000 was reclassified as
a liability as of July 1, 2003. Preferred stock dividends of $130,000 for 2004
and $158,000 for the period from July 1, 2003 through December 31, 2003, are
reported as interest expense. The dividends paid prior to the adoption of SFAS
150 were accounted for as a direct reduction to stockholders' equity.
Aggregate scheduled maturities of the subordinated debentures at December
31, 2004 are (in 000's):
2033 $20,620
2034 13,403
2035 13,403
-------
TOTAL $47,426
=======
104
NOTE 9 - CAPITAL STOCK
The roll forward of shares of common stock (adjusted to reflect 1.8:1 stock
split) is as follows (in 000's):
SHARES ISSUED
-------------------------------------------
TREASURY STOCK
COMMON CLASS A CLASS B COMMON (CLASS A WHEN
Increase (decrease) STOCKS COMMON STOCK COMMON STOCK APPLICABLE)
------- ------------ -------------- --------------
BALANCE AT JANUARY 1, 2002 4,500 -- -- --
No activity -- -- -- --
------- ------- ------- -------
BALANCE AT DECEMBER 31, 2002 4,500 -- -- --
Purchased into treasury -- -- -- (93)
Issuance of Class A and Class B
common stock (4,500) 2,070 2,430 --
------- ------- ------- -------
BALANCE AT DECEMBER 31, 2003 -- 2,070 2,430 (93)
Restricted stock issued to employees -- 209 -- --
Stock options exercised 34 -- -- 4
Combined Class A and Class B 4,709 (2,279) (2,430) --
IPO 13,000 -- -- --
Private placement 500 -- -- --
Am Re warrant exercise 947 -- -- --
Over-allotment 629 -- -- --
Restricted stock issued to Directors 7 -- -- --
------- ------- ------- -------
BALANCE AT DECEMBER 31, 2004 19,826 -- -- (89)
======= ======= ======= =======
As part of the IPO in October, 2004, the Company agreed to issue Friedman
Billings Ramsey (FBR), the lead underwriter, warrants to purchase 189,000 shares
of the Company's commons stock at the same price as the common stock sold in the
offering, $8.50 per share. The warrants are exercisable for a term of four years
beginning on the first anniversary of the date of the offering and expiring on
the fifth anniversary of the date of the offering, and are restricted from sale,
transfer, assignment or hypothecation for a period of 180-days from the
effective date of the offering except to officers or partners of FBR and members
of the selling group and their officers or partners. The Company granted FBR
registration rights with respect to the shares issuable upon exercise of the
warrants. Warrants to purchase 189,000 shares of the Company's common stock held
by FBR are included in the calculation of diluted EPS.
The Company declared dividends on common and preferred stock as follows in
(000's):
2004 2003 2002
------ ------ ------
Common stock dividends declared $ 493 $ -- $ 473
Class A common stock dividends declared 228 293 --
Class B common stock dividends declared 281 1,403 --
------ ------ ------
Total common stock dividends declared 1,002 1,696 473
Preferred stock dividends declared -- 158 315
------ ------ ------
Total dividends declared $1,002 $1,854 $ 788
====== ====== ======
The Company declared dividends per share on common stock as follows:
2004 2003 2002
-------- -------- --------
Common Stock $ 0.0250 -- $ 0.1048
Class A Stock $ 0.1137 $ 0.1465 --
Class B Stock $ 0.1142 $ 0.5773 --
105
The Company's Series A Cumulative Preferred Stock was reclassified as debt
as of July 1, 2003.
See "Note 1. Summary of Significant Accounting Policies" and "Note 8.
Debt". The preferred stock dividends for the first six months of 2003 (prior to
the adoption of FAS 150) were $157,500 and for the twelve months ending December
31, 2002 were $315,000. The preferred stock dividends were recorded as a
reduction to stockholders' equity.
The Company issued 946,642 additional shares of common stock immediately
prior to its IPO as a result of the exercise in full of Am Re's warrant to
purchase 1,049,999 shares of common stock at an exercise price of $0.76 per
share, pursuant to a cashless exercise provision, and based upon the IPO price
of $8.50 per share.
NOTE 10 - EQUITY COMPENSATION PLANS
2004 LONG-TERM EQUITY COMPENSATION PLAN
In 2004, the Company's Board of Directors adopted and its shareholders
approved a long-term incentive plan (the "2004 Long-Term Equity Compensation
Plan"). With the adoption of the 2004 Long-Term Equity Compensation Plan, no
further grants will be made under the 2001 Stock Award Plan.
The plan provides for the granting of non-qualified stock options,
incentive stock options (within the meaning of Section 422 of the Code), stock
appreciation rights ("SARs"), restricted stock and restricted stock unit awards,
performance shares and other cash or share-based awards. The maximum number of
shares of common stock that may be issued in connection with awards under the
plan is 1,162,723, of which 872,042 may be issued under awards other than stock
options or SARs. As of December 31, 2004, awards in respect of 236,981 shares
have been made under the plan.
2001 STOCK AWARD PLAN
In December 2000, the Board of Directors adopted a long-term incentive plan
(the "2001 Stock Award Plan"). The plan provided for a variety of awards,
including incentive or non-qualified stock options, performance shares, SARs or
any combination of the foregoing.
Under the 2001 Stock Award Plan, 450,000 shares may be made the subject of
awards granted under the plan. At December 31, 2004, 358,200 shares of common
stock have been issued or are subject to issuance upon the exercise or payment
of outstanding awards under the plan. The remaining 91,800 shares eligible for
grants under the plan that have not been the subject of awards are now eligible
under our 2004 Long-Term Incentive Compensation Plan, such that no further
awards may be granted under the 2001 Stock Award Plan.
RESTRICTED STOCK
In May 2004, the Company's Board of Directors authorized the issuance of
131,888 shares of restricted Common Stock to the President and Chief Executive
Officer and 8,793 shares of restricted Common Stock to the Senior Vice
President, Chief Financial Officer and Treasurer. The shares vest in
installments over a varying period from one to four years from the date of grant
contingent upon continuous employment with the Company from the date of grant
through the vesting date. During the vesting period, the recipients have voting
rights and will receive dividends but the shares may not be sold, assigned,
transferred, exchanged, pledged or otherwise encumbered. The fair value of the
restricted shares was $1,563,000 on the grant date. These restricted shares were
authorized and issued prior to the adoption and approval of the 2004 Long-Term
Equity Compensation Plan.
106
On September 29, 2004 the Company's Board of Directors authorized the
issuance of 68,832 restricted Common Stock to various employees under the 2004
Long Term-Equity Compensation Plan. The fair value of the restricted shares was
$585,000. The restricted shares vest ratably over five years from the date of
grant. During the vesting period, the recipients have voting rights and will
receive dividends but the shares may not be sold, assigned, transferred,
exchanged, pledged or otherwise encumbered.
On November 10, 2004 the Company's Board of Directors authorized the
issuance of 7,072 restricted Common Stock to all non-employee directors. The
fair value of the restricted shares was $70,000 at the grant date. These shares
vest March 31, 2005.
The restricted stock shares were recorded at fair value as a charge to
Unearned Compensation - Restricted Stock in Stockholders' Equity and a credit to
Common Stock and Paid-in-Capital. These shares will amortize ratably over their
vesting period as a charge to compensation expense and a credit to Unearned
Compensation - Restricted Stock in Stockholders' Equity on the balance sheet. In
2004, the Company amortized approximately $310,000 as a charge to compensation
expense and a credit to Unearned Compensation - Restricted Stock.
STOCK OPTIONS
The following table provides an analysis of stock option activity during
the three years ended December 31, 2004.
2004 2003 2002
----------------------- --------------------- ----------------------
AVERAGE AVERAGE AVERAGE
NUMBER OF EXERCISE NUMBER OF EXERCISE NUMBER OF EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
--------- -------- --------- -------- ----------- --------
Outstanding, beginning of
year 358,200 $ 2.78 408,600 $ 2.78 423,900 $ 2.78
Granted at market value 161,077 8.50 -- -- -- --
Forfeitures and
expirations (9,000) 2.78 (50,400) 2.78 (15,300) 2.78
Exercised (37,500) 2.78 -- -- -- --
-------- -------- -------- -------- -------- --------
OUTSTANDING, END OF YEAR 472,777 $ 4.73 358,200 $ 2.78 408,600 $ 2.78
======== ======== ======== ======== ======== ========
EXERCISABLE, END OF YEAR 295,320 $ 2.78 316,260 $ 2.78 344,700 $ 2.78
======== ======== ======== ======== ======== ========
Options outstanding and exercisable as of December 31, 2004 are shown on
the following schedule:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
--------------------------------------- ----------------------
AVERAGE
REMAINING AVERAGE AVERAGE
NUMBER OF CONTRACTUAL EXERCISE NUMBER OF EXERCISE
Range of Exercise Prices SHARES LIFE PRICE SHARES PRICE
------- --------- -------- ------- --------
Under $4.00 311,700 7.0 years $ 2.78 295,320 $ 2.78
$5.00 - $10.00 161,077 9.8 years 8.50 -- --
------- --------- -------- ------- --------
TOTAL OPTIONS 472,777 8.0 years $ 4.73 295,320 $ 2.78
======= ========= ======== ======= ========
The Company has elected to follow Accounting Principles Board Opinion No.
25, "Accounting for Stock Based Compensation" and related interpretations in
accounting for its employee stock options. Under APB 25, no compensation expense
is recognized upon the granting of stock options because the exercise price is
equal to the estimated market price at the date of the grant. In June 2005, the
Company intends to adopt SFAS 123-R which calls for mandatory expensing of
equity-based compensation beginning in the third quarter of 2005.
The fair value of the 2001 options granted was estimated using the
Black-Scholes pricing model as of January 1, 2001, the date of the initial
grant, with the following weighted average assumptions: risk free interest rate
of 4.97%, dividend yield of 1.75%, volatility factors of the expected market
price of the Company's common stock of 35%, and a weighted-average expected life
of the options of 7 years.
107
The fair value of the 2004 options granted was estimated using the
Black-Scholes pricing model as of September 29, 2004, the date of the initial
grant, with the following weighted average assumptions: risk free interest rate
of 3.8%, dividend yield of 1.2%, volatility factors of the expected market price
of the Company's common stock of 30.6% and a weighted-average expected life of
the options of 7 years.
The following table illustrates the effect on net income and earnings per
share if the Company had applied the fair value recognition provisions of SFAS
123, to stock-based employee compensation (in 000's, except per share amounts).
2004 2003 2002
--------- --------- ---------
Net income as reported $ 9,029 $ 6,280 $ 5,633
Deduct preferred stock dividends -- (158) (315)
Deduct total stock-based employee compensation
expense determined under fair value based
method for all awards, net of related tax
effects (16) -- (14)
--------- --------- ---------
Net income, pro forma $ 9,013 $ 6,122 $ 5,304
========= ========= =========
Earnings per share
Basic -- as reported $ 1.23 $ 1.37 $ 1.18
Basic -- pro forma $ 1.23 $ 1.37 $ 1.18
Fully diluted -- as reported $ 1.06 $ 1.09 $ 0.94
Fully diluted -- pro forma $ 1.06 $ 1.09 $ 0.94
NOTE 11 - INCOME TAXES
The Company files a consolidated Federal income tax return. The provision
for Federal, state and local income taxes consists of the following components
(in 000's):
2004 2003 2002
------ ------ ------
Current Federal income tax expense $1,462 $2,304 $1,676
Current state income tax expense 638 441 2,032
Deferred Federal and State income tax expense 3,594 629 427
------ ------ ------
Provision for income taxes $5,694 $3,374 $4,135
====== ====== ======
Deferred tax assets and liabilities are determined utilizing the enacted
tax rates applicable to the period the temporary differences are expected to be
recovered. Accordingly, the current period income tax provision can be affected
by the enactment of new tax rates. The net deferred income taxes on the balance
sheet reflect temporary differences between the carrying amounts of the assets
and liabilities for financial reporting purposes and income tax purposes, tax
effected at a 34% rate for 2003 and 2002 and 35% for 2004.
108
Significant components of the Company's deferred tax assets and liabilities
are as follows (in 000's):
2004 2003
------- -------
Deferred tax asset:
Claims reserve discount $ 1,601 $ 1,126
Unearned premium 4,698 993
Deferred compensation -- 607
Allowance for doubtful accounts 43 42
Employee benefit plans 108 --
Other 157 --
------- -------
Total deferred tax asset 6,607 2,768
Deferred tax liability:
Deferred acquisition costs net of deferred ceding
commission revenue 6,559 195
Depreciation and Amortization 952 --
Unrealized appreciation of securities 664 540
Other 19 --
------- -------
Total deferred tax liabilities 8,194 735
------- -------
Net deferred income tax (liability)/asset $(1,587) $ 2,033
======= =======
In assessing the valuation of deferred tax assets, the Company considers
whether it is more likely than not that some portion or all of the deferred tax
assets will not be realized. The ultimate realization of deferred tax assets is
dependent upon the generation of future taxable income during the periods in
which those temporary differences become deductible. No valuation allowance
against deferred tax assets has been established, as the Company believes it is
more likely than not the deferred tax assets will be realized.
The provision for Federal income taxes incurred is different from that
which would be obtained by applying the Federal income tax rate to net income
before income taxes. The items causing this difference are as follows (in
000's):
2004 2003 2002
------- ------- -------
Theoretical Federal income tax expense at
U.S. statutory rate (34%) $ 5,006 $ 3,282 $ 3,321
Tax advantaged investments (210) (101) (40)
State income taxes net of Federal 385 291 1,340
benefit
Other 513 (98) (23)
Tax credits -- -- (463)
------- ------- -------
Provision for income taxes $ 5,694 $ 3,374 $ 4,135
======= ======= =======
NOTE 12 - EMPLOYEE BENEFIT PLANS
The Company maintains a defined contribution Employee Pretax Savings Plan
(401(k) Plan) for its employees. The Company contributes 50% of each
participant's contribution up to 8% of the participant's compensation. The
Company incurred approximately $461,000, $332,000 and $319,000 of expense in
2004, 2003 and 2002, respectively, related to this plan.
The Company sponsored a nonqualified deferred compensation plan ("the
Plan") for the Chairman of the Board, President and Chief Executive Officer of
the Company. As of December 31, 2002, the Company has granted the maximum amount
allowed under the Plan, $1,000,000. Amounts contributed to the Plan earn
interest at the rate of 7% per year. During 2004, 2003 and 2002, the Company
recognized deferred compensation expense of $44,000, $85,000 and $79,000,
respectively. On May 5, 2004 the Board of TRM approved the payment of the entire
deferred compensation balance and terminated the plan.
109
NOTE 13 - COMMITMENTS AND CONTINGENCIES
From time to time, the Company is involved in various legal proceedings in
the ordinary course of business. For example, to the extent a claim asserted by
a third party in a law suit against one of the Company's insureds covered by a
particular policy, the Company may have a duty to defend the insured party
against the claim. These claims may relate to bodily injury, property damage or
other compensable injuries as set forth in the policy. Such proceedings are
considered in estimating the liability for loss and loss adjustment expenses.
The Company is not subject to any other pending legal proceedings that
management believes are likely to have a material adverse effect in the
financial statements.
The Company entered lease agreements for office space and equipment. The
Company's future minimum lease payments are as follows ($'s in 000's):
2005 $ 1,412
2006 1,375
2007 1,375
2008 520
---------
Total $ 4,682
=========
Total rental expense charged to operations was approximately $1,536,000,
$1,336,000 and $1,206,000 in 2004, 2003 and 2002, respectively.
TICNY is subject to assessments in New York for various purposes, including
the provision of funds necessary to fund the operations of the New York
Insurance Department, the New York Property/Casualty Insurance Security Fund,
which pays covered claims under certain policies provided by impaired, insolvent
or failed insurance companies and various funds administered by the New York
Workers' Compensation Board which pays covered claims under certain policies
provided by impaired, insolvent or failed insurance companies The Company was
assessed approximately $435,000, $340,000 and $280,000 in 2004, 2003 and 2002,
respectively, for its proportional share of the total assessment for the
Property/Casualty Security Fund and approximately $556,000, $312,000 and
$129,000 in 2004, 2003 and 2002, respectively, for its proportional share of the
operating expenses of the New York Insurance Department. Property casualty
insurance company insolvencies or failures may result in additional security
fund assessments to the Company at some future date. At this time the Company is
unable to estimate the possible amounts, if any, of such assessments.
Accordingly, the Company is unable to determine the impact, if any, such
assessments may have on financial position or results of operations of the
Company. The Company is permitted to assess premium surcharges on workers'
compensation policies that are based on statutorily enacted rates. However,
assessments by the various workers' compensation funds have recently exceeded
the permitted surcharges resulting in additional expenses of $1,143,000, $0 and
$0 in 2004, 2003 and 2002, respectively. As of December 31, 2004 the liability
for the various workers' compensation funds, which includes amounts assessed on
workers' compensation policies was $1,839,000. This amount is expected to be
paid over an eighteen month period ending June 30, 2006.
NOTE 14 - STATUTORY FINANCIAL INFORMATION AND ACCOUNTING POLICIES
For regulatory purposes, TICNY, domiciled in the State of New York,
prepares its statutory basis financial statements in accordance with practices
prescribed or permitted by the State of New York Insurance Department
("statutory basis" or "SAP"). The more significant SAP variances from GAAP are
as follows:
o Policy acquisition costs are charged to operations in the year such
costs are incurred, rather than being deferred and amortized as
premiums are earned over the terms of the policies.
110
o Ceding commission revenues are earned when ceded premiums are written
rather than being deferred and amortized as the underlying ceded
premiums are earned over the term of the reinsurance agreements.
o Certain assets including certain receivables, a portion of the net
deferred tax asset, prepaid expenses and furniture and equipment are
not admitted.
o Investments in fixed-maturity securities are valued at NAIC value for
statutory financial purposes, which is primarily amortized cost. GAAP
requires certain investments in fixed-maturity securities to be
reported at fair value.
o Certain amounts related to ceded reinsurance are reported on a net
basis within the statutory basis financial statements. GAAP requires
these amounts to be shown gross.
o For SAP purposes, changes in deferred income taxes relating to
temporary differences between net income for financial reporting
purposes and taxable income are recognized as a separate component of
gains and losses in surplus rather than included in income tax expense
or benefit as required under GAAP.
For the years ended December 31, 2004, 2003 and 2002, TICNY reported
statutory basis net (loss)/income of ($5,705,000), $2,782,000, and $2,612,000,
respectively. At December 31, 2004 and 2003 TICNY reported statutory basis
surplus as regards policyholders of $126,082,000 and $36,645,000, respectively.
As of December 31, 2004 TICNY is required to maintain $4,900,000 of minimum
capital and surplus in accordance with New York Insurance Law.
Under New York law, TICNY is limited in the amount of dividends it can pay
to Tower. Under New York law, TICNY may pay dividends to Tower only out of
statutory earned surplus. In addition, the New York Insurance Department must
approve any dividend declared or paid by TICNY that, together with all dividends
declared or distributed by TICNY during the preceding twelve months, exceeds the
lesser of (1) 10% of TICNY's policyholders' surplus as shown on its latest
statutory financial statement filed with the New York State Insurance Department
or (2) 100% of adjusted net investment income during the preceding twelve months
immediately preceding the declaration or distribution of the current dividend
increased by the excess, if any, of net investment income over dividends
declared or distributed during the period commencing thirty-six months prior to
the declaration or distribution of the current dividend and ending twelve months
prior thereto. TICNY paid approximately $850,000, $363,000 and $1,555,000 in
dividends to Tower in 2004, 2003, and 2002, respectively. As of December 31,
2004, the maximum distribution that TICNY could pay without prior regulatory
approval was approximately $2.8 million.
NOTE 15 - FAIR VALUE OF FINANCIAL INSTRUMENTS
Statement of Financial Accounting Standards No. 107, "Disclosures about
Fair Value of Financial Instruments" ("SFAS 107") requires all entities to
disclose the fair value of financial instruments, both assets and liabilities
recognized and not recognized in the balance sheet, for which it is practicable
to estimate fair value. The Company uses the following methods and assumptions
in estimating its fair value disclosures for financial instruments:
EQUITY AND FIXED INCOME INVESTMENTS: Fair value disclosures for investments
are included in "Note 2. Investments".
COMMON TRUST SECURITIES - STATUTORY BUSINESS TRUSTS: Common trust
securities are investments in related parties; as such it is not practical to
estimate the fair value of these instruments. Accordingly, these amounts are
reported using the equity method.
SHORT-TERM INVESTMENTS: The carrying values reported in the accompanying
balance sheets for the financial instruments approximate their fair values.
111
AGENTS' BALANCES RECEIVABLE, ASSUMED PREMIUMS RECEIVABLE, RECEIVABLE-CLAIMS
PAID BY AGENCY: The carrying values reported in the accompanying balance sheets
for these financial instruments approximate their fair values.
NOTES RECEIVABLE FROM RELATED PARTIES: Notes receivable are from related
parties; as such it is not practicable to estimate the fair value of these
instruments. Accordingly, these notes receivable are reported at their
outstanding principal and accrued interest balances.
REINSURANCE BALANCES PAYABLE, PAYABLE TO ISSUING CARRIER AND FUNDS HELD:
The carrying value reported in the balance sheet for these financial instruments
approximates fair value.
SUBORDINATED DEBENTURES: The carrying values reported in the accompanying
balance sheets for these financial instruments approximate fair value. Fair
value was estimated using projected cash flows, discounted at rates currently
being offered for similar notes.
LONG-TERM DEBT - CIT: The carrying values reported in the accompanying
balance sheets for these financial instruments approximate fair value. Fair
value was estimated using projected cash flows, discounted at rates currently
being offered for similar notes.
SERIES A CUMULATIVE REDEEMABLE PREFERRED STOCK: The carrying values
reported in the accompanying balance sheets for these financial instruments
approximate fair value. Fair value was estimated using projected cash flows,
discounted at rates currently being offered for similar securities.
NOTE 16 - EARNINGS PER SHARE
The following table shows the computation of the Company's earnings per
share (in 000's, except shares and per share amounts):
INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNT
----------- ------------ ----------
2004:
Net income $ 9,029
Less: preferred stock dividends --
--------- ---------
Basic EPS 9,029 7,335,286 $ 1.23
--------- --------- ========
Effect of dilutive securities:
Stock options -- 266,712
Unvested restricted stock 112,379
Warrants 68 851,438
--------- ---------
Diluted EPS $ 9,097 8,565,815 $ 1.06
========= ========= ========
2003:
Net income $ 6,280
Less: preferred stock dividends (158)
---------
Basic EPS 6,122 4,453,717 $ 1.37
--------- --------- ========
Effect of dilutive securities:
Stock options -- 204,300
Warrants 84 1,049,999
--------- ---------
Diluted EPS $ 6,206 5,708,016 $ 1.09
========= ========= ========
2002:
Net income $ 5,633
Less: preferred stock dividends (315)
---------
Basic EPS 5,318 4,500,000 $ 1.18
========= ========= ========
Effect of dilutive securities:
Stock options -- 211,950
Warrants 84 1,049,999
--------- ---------
Diluted EPS $ 5,402 5,761,949 $ 0.94
========= ========= ========
112
Am Re had the right to surrender shares of Series A Cumulative Preferred
Stock for the exercise of warrants for the liquidation preference price of $50
per share of preferred stock surrendered. In applying the treasury stock method
to the warrants, it was assumed that 16,000 preferred shares were liquidated at
the beginning of each year presented and corresponding dividends were reduced.
Am Re exercised these warrants in October 2004. These warrants are included in
the computation of diluted EPS prior to their exercise.
PXRE holds an option agreement to purchase 599,400 common shares of the
Company for $16.67 per share. See "Note 5. Reinsurance". These options are not
included in the computation of diluted EPS because their effect would be
antidilutive.
NOTE 17 - SEGMENT INFORMATION
The Company manages its operations through three business segments:
insurance (commercial and personal lines underwriting), reinsurance, and
insurance services (managing general agency, claims administration and
reinsurance intermediary operations). The Company considers many factors in
determining reportable segments including economic characteristics, production
sources, products or services offered and regulatory environment.
In the insurance segment, TICNY provides commercial and personal lines
insurance policies to businesses and individuals. TICNY's commercial lines
products include commercial multiple-peril, monoline general liability,
commercial umbrella, monoline property, workers' compensation and commercial
automobile policies. Its personal lines products consist of homeowners, dwelling
and other liability policies.
In the reinsurance segment, TICNY assumes reinsurance directly from TRM's
issuing companies or indirectly from reinsurers that provide reinsurance
coverage directly to the issuing companies. TICNY assumes, as a reinsurer, a
modest amount of the risk on the premiums that TRM's managing general agency
produces.
In the insurance services segment, TRM generates commission revenue from
its managing general agency by producing premiums on behalf of its issuing
companies and generates fees by providing claims administration and reinsurance
intermediary services. Placing risks through TRM's issuing companies allows the
Company to underwrite larger policies and gain exposure to market segments that
are unavailable to TICNY due to its rating, financial size and geographical
licensing limitations. TRM does not assume any risk on business produced by it.
All of the risk is ceded by the issuing companies to a variety of reinsurers
pursuant to reinsurance programs arranged by TRM's reinsurance intermediary
working with outside reinsurance intermediaries. Through its issuing companies,
TRM's managing general agency offers commercial package, monoline general
liability, monoline property, commercial automobile and commercial umbrella
products.
The insurance services segments direct commission revenue is from two
issuing carriers. Each issuing carrier provides less than 10% of the Company's
consolidated total revenues. Although this segment is dependent upon two issuing
carriers, it is management's opinion that the loss of one or both can be
remedied by replacement issuing carriers. There is no intercompany commission
revenue in the insurance services segment.
The accounting policies of the segments are the same as those described in
the summary of significant accounting policies. The Company evaluates segment
performance based on segment profit, which excludes investment income, realized
gains and losses, interest expenses, income taxes and incidental corporate
expenses. The Company does not allocate assets to segments because assets, which
consist primarily of investments and fixed assets, are considered in total by
management for decision making purposes.
113
Business segment results are as follows (in 000's):
2004 2003 2002
-------- -------- --------
INSURANCE SEGMENT
Revenues
Net premiums earned $ 44,427 $ 22,365 $ 25,356
Ceding commission revenue 39,983 35,311 21,399
Policy billing fees 671 545 376
-------- -------- --------
TOTAL REVENUES 85,081 58,221 47,131
-------- -------- --------
Expenses
Net loss and loss adjustment expenses 27,753 14,699 14,792
Underwriting expenses 47,804 36,955 26,570
-------- -------- --------
TOTAL EXPENSES 75,557 51,654 41,362
-------- -------- --------
Underwriting Profit $ 9,524 $ 6,567 $ 5,769
======== ======== ========
REINSURANCE SEGMENT
Revenues
Net premiums earned $ 1,137 $ 576 $ 652
Ceding commission revenue -- 294 473
-------- -------- --------
TOTAL REVENUES 1,137 870 1,125
-------- -------- --------
Expenses
Net loss and loss adjustment expenses (693) 372 1,564
Underwriting expenses 248 211 500
-------- -------- --------
Total Expenses (445) 583 2,064
-------- -------- --------
Underwriting Profit (Loss) $ 1,582 $ 287 $ (939)
======== ======== ========
INSURANCE SERVICES SEGMENT
Revenues
Direct commission revenue from managing $ 11,546 $ 7,984 $ 4,693
general agency
Claims administration revenue 4,105 3,746 4,495
Reinsurance intermediary fees 730 1,100 3,240
Policy billing fees 8 -- --
-------- -------- --------
TOTAL REVENUES 16,389 12,830 12,428
-------- -------- --------
Expenses
Direct commissions expense paid to producers 7,432 5,394 3,361
Other insurance services expenses
(Underwriting expenses reimbursed to TICNY) 2,987 2,247 1,608
Claims expense reimbursement to TICNY 4,019 3,648 4,399
-------- -------- --------
TOTAL EXPENSES 14,438 11,289 9,368
-------- -------- --------
Insurance Services Pretax Income (Loss) $ 1,951 $ 1,541 $ 3,060
======== ======== ========
Underwriting expenses in the insurance segment are net of expense
reimbursements that are made by the insurance services segment pursuant to an
expense sharing agreement between TRM and TICNY. In accordance with terms of
this agreement, TRM reimburses TICNY for a portion of TICNY's underwriting and
other expenses resulting from TRM's use of TICNY's personnel, facilities and
equipment in underwriting insurance on behalf of TRM's issuing companies. The
reimbursement for underwriting and other expenses is calculated as a minimum
reimbursement of 5% of the premiums produced by TRM, and is adjustable according
to the terms of the agreement based on the number of policies in force and
additional expenses that may be incurred by TRM. The amount of this
reimbursement was $2,876,000 in 2004, $2,247,000 in 2003 and $1,608,000 in 2002.
TRM also reimburses TICNY, at cost, for claims administration expenses pursuant
to the terms of this expense sharing agreement. Claims expenses reimbursed by
TRM were $4,019,000 in 2004, $3,648,000 in 2003 and $4,399,000 in 2002.
114
The following table reconciles revenues by segment to consolidated revenue
(in 000's):
2004 2003 2002
-------- -------- --------
Revenue
Insurance segment $ 85,081 $ 58,221 $ 47,131
Reinsurance segment 1,137 870 1,125
Insurance services segment 16,389 12,830 12,428
-------- -------- --------
Total segment revenues 102,607 71,921 60,684
Investment income 5,070 2,268 1,933
Realized capital gains 13 493 95
-------- -------- --------
Consolidated revenues $107,690 $ 74,682 $ 62,712
======== ======== ========
The following table reconciles the results of our individual segments to
consolidated income before taxes (in 000's):
2004 2003 2002
-------- -------- --------
Insurance segment underwriting profit $ 9,524 $ 6,567 $ 5,769
Reinsurance segment underwriting
profit (loss) 1,582 287 (939)
-------- -------- --------
Total underwriting profit (loss) 11,106 6,854 4,830
Insurance services segment pretax
income (loss) 1,951 1,541 3,060
Net investment income 5,070 2,268 1,933
Net realized investment gains 13 493 95
Corporate expenses (289) (40) (28)
Interest expense (3,128) (1,462) (122)
-------- -------- --------
Income before taxes $ 14,723 $ 9,654 $ 9,768
======== ======== ========
NOTE 18 - SUBSEQUENT EVENTS
On January 18, 2005 Tower Group, Inc. announced that it entered into a
stock purchase agreement to acquire North American Lumber Insurance Company
(NALIC), a shell company with active licenses in the following nine states: New
Jersey, Connecticut, Massachusetts, Rhode Island, Vermont, Maryland, Delaware,
South Carolina and Wisconsin. Tower Group, Inc. will pay $1,050,000 in cash at
closing. An additional $75,000 per state will be paid within one year of the
closing date contingent upon license reactivation in each of Pennsylvania and
Maine.
NALIC will be initially capitalized with part of the $26,000,000 raised by
Tower Group, Inc. through two trust preferred offerings in December, 2004. See
"Note 8. Debt". According to the terms of the agreement, all liabilities and
assets of NALIC (which will be renamed) will be transferred to a liquidating
trust prior to closing with the exception of its charter and insurance licenses.
The transaction is subject to court approval in Massachusetts and is expected to
close in March or April of 2005.
115
NOTE 19 - UNAUDITED QUARTERLY FINANCIAL INFORMATION
2004
(in thousands, except per -------------------------------------------------------------------
share amounts) FIRST SECOND THIRD FOURTH TOTAL
----------- ---------- ---------- ---------- -----------
Revenues $ 21,704 $ 26,190 $ 26,464 $ 33,332 $ 107,690
Net Income 1,322 1,999 2,478 3,230 9,029
Net income per share:
Basic 0.30 0.45 0.55 0.20 1.23
Diluted 0.23 0.35 0.43 0.19 1.06
2003
-------------------------------------------------------------------
(in thousands, except per FIRST SECOND THIRD FOURTH TOTAL
share amounts) ----------- ---------- ---------- ---------- -----------
Revenues $ 16,778 $ 17,949 $ 20,536 $ 19,419 $ 74,682
Net Income 1,078 1,486 2,029 1,687 6,280
Net income per share:
Basic 0.22 0.31 0.46 0.38 1.37
Diluted 0.18 0.25 0.36 0.30 1.09
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS OR ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROL AND PROCEDURES
Our management, with the participation of our Chief Executive Officer and
Chief Financial Officer, has evaluated the effectiveness of the design and
operation of our disclosure controls and procedures (as defined in Exchange Act
Rule 13a-15 (e)) as of the end of the period covered by this report. Based on
that evaluation, the Chief Executive Officer and Chief Financial Officer have
concluded that our disclosure controls and procedures are effective to ensure
that material information relating to us and our consolidated subsidiaries is
made known to such officers by others within these entities, particularly during
the period this annual report was prepared, in order to allow timely decisions
regarding required disclosure.
There have not been any changes in our internal control over financial
reporting during the period covered by this report that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.
ITEM 9B. OTHER INFORMATION
The Company has filed all required Form 8-K information during the fourth
quarter.
116
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information called for by this Item and not provided herein will be
contained in the Company's Proxy Statement, which the Company intends to file
within 120 days after the end of the Company's fiscal year ended December 31,
2004, and such information is incorporated herein by reference.
The Company has adopted a Code of Business Conduct and Ethics and posted it
on its website http://www.twrgrp.com/ under Investor Information and then under
Corporate Governance.
ITEM 11. EXECUTIVE COMPENSATION
The information called for by this item will be contained in the Company's
Proxy Statement, which the company intends to file within 120 days after the end
of the Company's fiscal year ended December 31, 2004, and such information is
incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The information called for by the Item and not provided herein will be
contained in the Company's Proxy Statement, with the Company intends to file
within 120 days after the end of the Company's fiscal year ended December 31,
2004, and such information is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information called for by the Item and not provided herein will be
contained in the Company's Proxy Statement, with the Company intends to file
within 120 days after the end of the Company's fiscal year ended December 31,
2004, and such information is incorporated herein by reference.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information called for by the Item and not provided herein will be
contained in the Company's Proxy Statement, with the Company intends to file
within 120 days after the end of the Company's fiscal year ended December 31,
2004, and such information is incorporated herein by reference.
117
PART IV.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
A. (1) The financial statements and notes to financial statements are
filed as part of this report in "Item 8. Financial Statements and
Supplementary Data".
(2) The financial statement schedules are listed in the Index to
Consolidated Financial Statement Schedules.
(3) The exhibits are listed in the Index to Exhibits.
The following entire exhibits are included:
Exhibit 21.1 Subsidiaries of Tower Group, Inc.
Exhibit 23.1 Consent of Johnson Lambert & Co.
Exhibit 31.1 Certification of CEO to Section 302(a)
Exhibit 31.2 Certification of CFO to Section 302(a)
Exhibit 32 Certification of CEO & CFO to Section 906
118
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
DATED: MARCH 21, 2005
TOWER GROUP, INC.
BY: /S/ MICHAEL H. LEE
-------------------------------------
NAME: MICHAEL H. LEE
TITLE: CHAIRMAN OF THE BOARD, PRESIDENT AND
CHIEF EXECUTIVE OFFICER
Pursuant to the requirements of the Securities Act of 1934, this report has
been signed by the following persons, dated March 21, 2005, on behalf of the
registrant and in the capacities indicated.
SIGNATURE TITLE
--------- -----
/s/ Michael H. Lee Chairman of the Board, President and
- --------------------------- Chief Executive Officer
Michael H. Lee (Principal Executive Officer)
/s/ Francis M. Colalucci Senior Vice President, Chief Financial
- --------------------------- Officer and Treasurer, Director
Francis M. Colalucci (Principal Financial Officer,
Principal Accounting Officer)
/s/ Steven G. Fauth Senior Vice President, General Counsel
- --------------------------- and Secretary, Director
Steven G. Fauth
/s/ Steven W. Schuster Director
- ---------------------------
Steven W. Schuster
/s/ Charles A. Bryan Director
- ---------------------------
Charles A. Bryan
/s/ Gregory T. Doyle Director
- ---------------------------
Gregory T. Doyle
/s/ Austin Young Director
- ---------------------------
Austin Young
119
TOWER GROUP, INC.
INDEX TO FINANCIAL STATEMENT SCHEDULES
SCHEDULES PAGES
- --------- -----
Report of Independent Registered Public Accounting Firm on
Financial Statement Schedules 121
I Summary of Investments - other than investments in related parties 122
II Condensed Financial Information of the Registrant as of and for the
years ended December 31, 2004, 2003 and 2002 123
III Supplementary Insurance Information for the years ended
December 31, 2004, 2003 and 2002 127
IV Reinsurance for the years ended December 31, 2004, 2003 and 2002 128
V Valuation and Qualifying Accounts for the years ended
December 31, 2004, 2003 and 2002 129
VI Supplemental Information Concerning Insurance Operations
for the years ended December 31, 2004, 2003 and 2002 130
120
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON
FINANCIAL STATEMENT SCHEDULES
To the Board of Directors
Tower Group, Inc.
The audits referred to in our report dated February 22, 2005 included the
related financial statement schedules as of December 31, 2004, and for each of
the years in the three-year period ended December 31, 2004, included in the
annual report on Form 10-K. These financial statement schedules are the
responsibility of Tower Group, Inc.'s management. Our responsibility is to
express an opinion on these financial statement schedules based on our audits.
In our opinion, such financial statement schedules, when considered in relation
to the basic consolidated financial statements taken as a whole, present fairly,
in all material respects, the information set forth therein.
/s/ JOHNSON LAMBERT & CO.
Reston, Virginia
February 22, 2005
121
TOWER GROUP, INC.
SCHEDULE I - SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES
($ in thousands)
DECEMBER 31, 2004
------------------------------------------
AMOUNT
FAIR REFLECTED ON
COST VALUE BALANCE SHEET
-------- -------- -------------
Fixed maturities:
Available for sale:
U.S. Treasury securities and obligations
of U.S. Government agencies $ 21,458 $ 21,420 $ 21,420
Corporate securities 48,898 49,381 49,381
Mortgage-backed securities 64,116 64,159 64,159
Asset-backed securities 12,443 12,473 12,473
Other taxable fixed maturity securities 250 243 243
Municipal securities 76,397 76,847 76,847
-------- -------- --------
TOTAL FIXED MATURITIES 223,562 224,523 224,523
Equity securities - available for sale 1,827 2,485 2,485
Common trust securities - statutory business trusts,
equity method 1,426 1,426 1,426
-------- -------- --------
TOTAL INVESTMENTS $226,815 $228,434 $228,434
======== ======== ========
122
TOWER GROUP, INC.
SCHEDULE II - CONDENSED FINANCIAL INFORMATON OF THE REGISTRANT
CONDENSED BALANCE SHEETS
($ in thousands)
DECEMBER 31,
--------------------
2004 2003
-------- --------
ASSETS
Cash and cash equivalents $ 26,910 $ 4,567
Investment in subsidiaries 147,775 39,980
Common trust securities - statutory business trusts, equity method 1,426 620
Intangible assets 4,888 --
Notes receivable from related parties -- 44
Federal income tax recoverable -- 879
Other assets 1,587 802
-------- --------
TOTAL ASSETS $182,586 $ 46,892
======== ========
LIABILITIES
Subordinated debentures $ 47,426 $ 20,620
Long-term debt - CIT -- 5,588
Payable to subsidiaries -- 4,400
Accounts payable and accrued expenses 5,586 63
Federal income taxes payable 127 --
Dividends payable -- 160
Series A cumulative redeemable preferred stock -- 3,000
-------- --------
TOTAL LIABILITIES 53,139 33,831
-------- --------
STOCKHOLDERS' EQUITY 129,447 13,061
-------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $182,586 $ 46,892
======== ========
123
TOWER GROUP, INC.
SCHEDULE II - CONDENSED FINANCIAL INFORMATON OF THE REGISTRANT
CONDENSED STATEMENTS OF CASH FLOWS
($ in thousands)
2004 2003 2002
--------- --------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 9,029 $ 6,280 $ 5,633
Adjustments to reconcile net income to net cash
(used in) provided by operations:
Dividends received from consolidated subsidiaries 850 363 2,415
Equity in undistributed net income of subsidiaries (10,544) (6,888) (5,657)
Amortization of debt issuance costs 178 -- --
Amortization of restricted stock 310 -- --
(Increase) decrease in assets:
Federal income tax recoverable 1,006 (879) --
Intangible asset (4,888) -- --
Other assets (804) 7 11
(Increase) decrease in liabilities:
Accounts payable and accrued expenses 5,523 63 (32)
Payable to subsidiaries (4,400) 234 1,310
Dividends payable (160) -- --
--------- --------- ---------
Net cash flows (used) provided by operations (3,900) (820) 3,680
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Investment in subsidiary (98,096) (17,105) --
--------- --------- ---------
Net cash flows used in investing activities (98,096) (17,105) --
--------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of redeemable preferred stock (3,000) -- --
Repayment of long-term debt - CIT (5,588) -- --
Decrease in notes receivable from related parties 44 -- --
Proceeds from issuance of subordinated debentures 26,806 25,588 --
Deferred cost, long-term debt -- (786) --
Purchase of common trust securities - statutory
business trusts (806) -- --
Stock repurchase -- (514) --
Exercise of stock options 200 -- --
IPO and private placement, net proceeds 107,845 -- --
Dividends paid (1,162) (1,811) (670)
--------- --------- ---------
Net cash flows provided by (used in) financing activities 124,339 22,477 (670)
--------- --------- ---------
INCREASE IN CASH AND CASH EQUIVALENTS 22,343 4,552 3,010
Cash and cash equivalents, beginning of year 4,567 15 (2,995)
--------- --------- ---------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 26,910 $ 4,567 $ 15
========= ========= =========
124
TOWER GROUP, INC.
SCHEDULE II - CONDENSED FINANCIAL INFORMATON
OF THE REGISTRANT
CONDENSED STATEMENTS OF INCOME AND
COMPREHENSIVE INCOME
($ in thousands)
YEAR ENDED DECEMBER 31,
2004 2003 2002
---------------- --------------- -----------------
REVENUES
Net investment income $ 75 $ 42 $ --
---------------- --------------- -----------------
Total Revenue 75 42 --
---------------- --------------- -----------------
EQUITY IN NET EARNINGS OF SUBSIDIARIES 10,544 6,888 5,657
EXPENSES
Other operating expenses 289 40 28
Interest expense 2,015 854 --
---------------- --------------- -----------------
INCOME BEFORE INCOME TAXES 8,315 6,036 5,629
---------------- --------------- -----------------
Benefit for income taxes (714) (244) (4)
---------------- --------------- -----------------
NET INCOME $ 9,029 $ 6,280 $ 5,633
================ =============== =================
COMPREHENSIVE NET INCOME
Net income $ 9,029 $ 6,280 $ 5,633
Other comprehensive income:
Gross unrealized investment
holding gains arising during
period 44 617 1,437
Less: reclassification adjustment
for gains included in net income (13) (493) (95)
---------------- --------------- -----------------
31 124 1,342
Income tax expense related to
items of other comprehensive
income (27) (42) (456)
---------------- --------------- -----------------
Total other comprehensive net
income 4 82 886
---------------- --------------- -----------------
COMPREHENSIVE NET INCOME $ 9,033 $ 6,362 $ 6,519
================ =============== =================
125
TOWER GROUP, INC.
SCHEDULE II - CONDENSED FINANCIAL INFORMATON OF THE REGISTRANT
CONDENSED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
($ in thousands)
ACCUMULATED
CLASS A CLASS B OTHER
COMMON COMMON COMMON PAID-IN COMPREHENSIVE
STOCK STOCK STOCK CAPITAL NET INCOME
----------- ------------ ----------- ------------- -------------
BALANCE AT DECEMBER 31, 2001 $ 45 $ -- $ -- $ 2,285 $ 80
----------- ------------ ----------- ------------- -------------
Dividends declared -- -- -- -- --
Net income -- -- -- -- --
Net unrealized appreciation on
securities available for
sale, net
of income tax -- -- -- -- 886
----------- ------------ ----------- ------------- -------------
BALANCE AT DECEMBER 31, 2002 45 -- -- 2,285 966
----------- ------------ ----------- ------------- -------------
Stock repurchase -- -- -- -- --
Capital restructuring (45) 21 24 -- --
Dividends declared -- -- -- -- --
Net income -- -- -- -- --
Net unrealized appreciation on
securities available for
sale, net
of income tax -- -- -- -- 82
----------- ------------ ----------- ------------- -------------
BALANCE AT DECEMBER 31, 2003 -- 21 24 2,285 1,048
----------- ------------ ----------- ------------- -------------
Capital restructuring 45 (21) (24) -- --
Dividends declared -- -- -- -- --
IPO and privat
placement, net proceeds 141 -- -- 107,704 --
Stock based compensation 3 -- -- 2,395 --
Warrant exercise 9 -- -- (9) --
Net income -- -- -- -- --
Net unrealized appreciation on
securities available for
sale, net
of income tax -- -- -- -- 4
----------- ------------ ----------- ------------- -------------
BALANCE AT DECEMBER 31, 2004 $ 198 $ -- $ -- $ 112,375 $ 1,052
=========== ============ =========== ============= =============
UNEARNED
COMPENSATION - TOTAL
RETAINED RESTRICTED TREASURY STOCKHOLDERS'
EARNINGS STOCK STOCK EQUITY
-------------- ------------- ---------- -------------
BALANCE AT DECEMBER 31, 2001 $ 926 $ -- $ -- $ 3,336
-------------- ------------- ---------- -------------
Dividends declared (788) -- -- (788)
Net income 5,633 -- -- 5,633
Net unrealized appreciation on
securities available for
sale, net
of income tax -- -- -- 886
-------------- ------------- ---------- -------------
BALANCE AT DECEMBER 31, 2002 5,771 -- -- 9,067
-------------- ------------- ---------- -------------
Stock repurchase -- -- (514) (514)
Capital restructuring -- -- -- --
Dividends declared (1,854) -- -- (1,854)
Net income 6,280 -- -- 6,280
Net unrealized appreciation on
securities available for
sale, net
of income tax -- -- -- 82
-------------- ------------- ---------- -------------
BALANCE AT DECEMBER 31, 2003 10,197 -- (514) 13,061
-------------- ------------- ---------- -------------
Capital restructuring -- -- -- --
Dividends declared (1,002) -- -- (1,002)
IPO and privat
placement, net proceeds -- -- -- 107,845
Stock based compensation -- (1,908) 20 510
Warrant exercise -- -- -- --
Net income 9,029 -- -- 9,029
Net unrealized appreciation on
securities available for
sale, net
of income tax -- -- -- 4
-------------- ------------- ---------- -------------
BALANCE AT DECEMBER 31, 2004 $ 18,224 $ (1,908) $ (494) $ 129,447
============== ============= ========== =============
126
TOWER GROUP, INC.
SCHEDULE III - SUPPLEMENTARY INSURANCE INFORMATION
($ in thousands)
DEFERRED
ACQUISITION
COST, NET OF
DEFERRED FUTURE POLICY
CEDING BENEFITS, BENEFITS,
COMMISSION LOSSES AND NET UNEARNED NET EARNED LOSSES AND
REVENUE LOSS EXPENSES PREMIUMS PREMIUMS LOSS EXPENSES
------------- ------------- ------------ ------------ --------------
2004
Segments:
Insurance $ 18,718 $ 34,275 $ 66,226 $ 44,427 $ 27,753
Reinsurance 22 2,674 888 1,137 (693)
------------- ------------- ----------- ------------ ------------
TOTAL $ 18,740 $ 36,949 $ 67,114 $ 45,564 $ 27,060
============= ============= =========== ============ ============
2003
Segments:
Insurance $ 544 $ 20,036 $ 14,058 $ 22,365 $ 14,699
Reinsurance 29 4,325 545 576 372
------------- ------------- ----------- ------------ ------------
TOTAL $ 573 $ 24,361 $ 14,603 $ 22,941 $ 15,071
============= ============= =========== ============ ============
2002
Segments:
Insurance $ (3,237) $ 11,047 $ 8,454 $ 25,356 $ 14,792
Reinsurance (257) 4,429 139 652 1,564
------------- ------------- ----------- ------------ ------------
TOTAL $ (3,494) $ 15,476 $ 8,593 $ 26,008 $ 16,356
============= ============= =========== ============ ============
AMORTIZATION OPERATING PREMIUMS
OF DAC EXPENSES WRITTEN
--------------- ------------- -------------
2004
Segments: $ (25,028) $ 22,455 $ 96,595
Insurance (640) 204 1,480
------------ ------------ --------------
Reinsurance $ (25,668) $ 22,659 $ 98,075
============ ============ ==============
TOTAL
2003
Segments: $ (502) $ 16,254 $ 27,968
Insurance (13) 148 982
------------ ------------ --------------
Reinsurance $ (515) $ 16,402 $ 28,950
============ ============ ==============
TOTAL
2002
Segments: $ (4,435) $ 11,088 $ 26,848
Insurance (114) 155 481
------------ ------------ --------------
Reinsurance $ (4,549) $ 11,243 $ 27,329
============ ============ ==============
TOTAL
127
TOWER GROUP, INC.
SCHEDULE IV - REINSURANCE
($ in thousands)
PERCENTAGE OF
CEDED TO OTHER ASSUMED FROM AMOUNT ASSUMED
DIRECT AMOUNT COMPANIES OTHER COMPANIES NET AMOUNT TO NET
------------- --------- --------------- ---------- ---------------
YEAR ENDED DECEMBER 31, 2004
Premiums
Property and Casualty $ 151,210 $ 106,945 $ 1,299 $ 45,564 2.9%
Insurance
Accident and Health Insurance -- -- -- -- 0.0%
-------------- ----------- -------------- ----------- ----------
TOTAL PREMIUMS $ 151,210 $ 106,945 $ 1,299 $ 45,564 2.9%
============== =========== ============== =========== ==========
YEAR ENDED DECEMBER 31, 2003
Premiums
Property and Casualty $ 120,541 $ 99,082 $ 1,482 $ 22,941 6.5%
Insurance
Accident and Health Insurance -- -- -- -- 0.0%
-------------- ----------- -------------- ----------- ----------
TOTAL PREMIUMS $ 120,541 $ 99,082 $ 1,482 $ 22,941 6.5%
============== =========== ============== =========== ==========
YEAR ENDED DECEMBER 31, 2002
Premiums
Property and Casualty $ 84,518 $ 60,148 $ 1,638 $ 26,008 6.3%
Insurance
Accident and Health Insurance -- -- -- -- 0.0%
-------------- ----------- -------------- ----------- ----------
TOTAL PREMIUMS $ 84,518 $ 60,148 $ 1,638 $ 26,008 6.3%
============== =========== ============== =========== ==========
128
TOWER GROUP, INC.
SCHEDULE V - VALUATION AND QUALIFYING ACCOUNTS
DECEMBER 31, 2004, 2003 AND 2002
($ in thousands)
DECEMBER 31,
2004 2003 2002
---------- ----------- ----------
Balance, January 1 $ 123 $ 123 $ 123
Additions 27 -- --
Deletions (27) -- --
---------- ---------- ---------
BALANCE, DECEMBER 31 $ 123 $ 123 $ 123
========== ========== =========
129
TOWER GROUP, INC.
SCHEDULE VI - SUPPLEMENTAL INFORMATION CONCERNING INSURANCE OPERATIONS
($ in thousands)
RESERVE FOR CLAIMS AND CLAIMS
UNPAID ADJUSTMENT EXPENSES
CLAIMS AND INCURRED AND RELATED
DEFERRED CLAIM NET NET -------------------------
ACQUISITION ADJUSTMENT DISCOUNT UNEARNED NET EARNED INVESTMENT CURRENT PRIOR
COST EXPENSES RESERVES PREMIUM PREMIUM INCOME YEAR YEAR
------------ ------------ ---------- --------- ----------- ----------- ------------ -----------
2004 $ 18,740 $ 36,949 $ -- $ 67,114 $ 45,564 $ 5,070 $ 27,259 $ (199)
2003 $ 573 $ 24,361 $ -- $ 14,603 $ 22,941 $ 2,268 $ 14,996 $ 75
2002 $ (3,494) $ 15,476 $ -- $ 8,593 $ 26,008 $ 1,933 $ 13,416 $ 2,940
PAID CLAIMS
AND CLAIM
AMORTIZATION ADJUSTMENT PREMIUM
OF DAC EXPENSES WRITTEN
-------------- ------------ -----------
2004 $ (25,668) $ 14,472 $ 98,075
2003 $ (515) $ 6,186 $ 28,950
2002 $ (4,549) $ 9,500 $ 27,329
130
The exhibits listed below and designated with an asterisk are filed with
this report. The exhibits listed below and not so designated are incorporated by
reference to the documents following the descriptions of the exhibits.
EXHIBIT
NUMBER DESCRIPTION OF EXHIBITS
- ------ -----------------------
3.1 Amended and Restated Certificate of Incorporation of Tower Group,
Inc., incorporated by reference to Exhibit 3.1 to the Company's
Registration Statement on Form S-1 (Amendment No. 2) (No.
333-115310) filed on July 23, 2004
3.2 Amended and Restated By-laws of Tower Group, Inc., incorporated by
reference to Exhibit 3.2 to the Company's Registration Statement
on Form S-1 (Amendment No. 2) (No. 333-115310) filed on July 23,
2004
4.1 Specimen Common Stock Certificate, incorporated by reference to
Exhibit 4.1 to the Company's Registration Statement on Form S-1
(Amendment No. 6) (No. 333-115310) filed on September 30, 2004
4.2 Purchase Agreement, dated as of June 30, 2001, by and between
Tower Group, Inc. and PXRE Reinsurance Ltd., incorporated by
reference to Exhibit 4.2 to the Company's Registration Statement
on Form S-1 (Amendment No. 2) (No. 333-115310) filed on July 23,
2004
4.3 Warrant issued to Friedman, Billings, Ramsey & Co., incorporated
by reference to Exhibit 4.3 to the Company's Registration
Statement on Form S-1 (Amendment No. 3) (No. 333-115310) filed on
August 25, 2004
10.1 Employment Agreement, dated as of August 1, 2004, by and between
Tower Group, Inc. and Michael H. Lee, incorporated by reference to
Exhibit 10.1 to the Company's Registration Statement on Form S-1
(Amendment No. 3) (No. 333-115310) filed on August 25, 2004
10.2 Employment Agreement, dated as of August 1, 2004, by and between
Tower Group, Inc. and Steven G. Fauth, incorporated by reference
to Exhibit 10.2 to the Company's Registration Statement on Form
S-1 (Amendment No. 3) (No. 333-115310) filed on August 25, 2004
10.3 Employment Agreement, dated as of August 1, 2004, by and between
Tower Group, Inc. and Francis M. Colalucci, incorporated by
reference to Exhibit 10.3 to the Company's Registration Statement
on Form S-1 (Amendment No. 3) (No. 333-115310) filed on August 25,
2004
10.4 Employment Agreement, dated as of August 1, 2004, by and between
Tower Group, Inc. and Ian Drachman, incorporated by reference to
Exhibit 10.4 to the Company's Registration Statement on Form S-1
(Amendment No. 3) (No. 333-115310) filed on August 25, 2004
10.5 Employment Agreement, dated as of August 1, 2004, by and between
Tower Group, Inc. and Christian K. Pechmann, incorporated by
reference to Exhibit 10.5 to the Company's Registration Statement
on Form S-1 (Amendment No. 3) (No. 333-115310) filed on August 25,
2004
10.6 Employment Agreement, dated as of August 1, 2004, by and between
Tower Group, Inc. and Joel Weiner, incorporated by reference to
Exhibit 10.6 to the Company's Registration Statement on Form S-1
(Amendment No. 3) (No. 333-115310) filed on August 25, 2004
10.7 2004 Long-Term Equity Compensation Plan, incorporated by reference
to Exhibit 10.7 to the Company's Registration Statement on Form
S-1 (Amendment No. 6) (No. 333-115310) filed on September 30, 2004
10.8 2001 Stock Award Plan, incorporated by reference to Exhibit
10.8 to the Company's Registration Statement on Form S-1 (No.
333-115310) filed on May 7, 2004
10.9 2000 Deferred Compensation Plan, incorporated by reference to
Exhibit 10.9 to the Company's Registration Statement on Form S-1
(Amendment No. 6) (No. 333-115310) filed on September 30, 2004
131
EXHIBIT
NUMBER DESCRIPTION OF EXHIBITS
- ------ -----------------------
10.10 Amended & Restated Declaration of Trust, dated as of May 15, 2003,
by and between Tower Group, Inc., Tower Statutory Trust I and U.S.
Bank National Association, incorporated by reference to Exhibit
10.10 to the Company's Registration Statement on Form S-1 (No.
333-115310) filed on May 7, 2004
10.11 Indenture, dated as of May 15, 2003, by and between Tower Group,
Inc. and U.S. Bank National Association, incorporated by reference
to Exhibit 10.11 to the Company's Registration Statement on Form
S-1 (No. 333-115310) filed on May 7, 2004
10.12 Guarantee Agreement, dated as of May 15, 2003, by and between
Tower Group, Inc. and U.S. Bank National Association, incorporated
by reference to Exhibit 10.12 to the Company's Registration
Statement on Form S-1 (No. 333-115310) filed on May 7, 2004
10.13 Amended and Restated Trust Agreement, dated as of September 30,
2003, by and between Tower Group, Inc., JPMorgan Chase Bank, Chase
Manhattan Bank USA, National Association and Michael H. Lee,
Steven G. Fauth and Francis M. Colalucci as Administrative
Trustees of Tower Group Statutory Trust II, incorporated by
reference to Exhibit 10.13 to the Company's Registration Statement
on Form S-1 (No. 333-115310) filed on May 7, 2004
10.14 Junior Subordinated Indenture, dated as of September 30, 2003, by
and between Tower Group, Inc. and JPMorgan Chase Bank,
incorporated by reference to Exhibit 10.14 to the Company's
Registration Statement on Form S-1 (No. 333-115310) filed on May
7, 2004
10.15 Guarantee Agreement, dated as of September 30, 2003, by and
between Tower Group, Inc. and JPMorgan Chase Bank, incorporated by
reference to Exhibit 10.15 to the Company's Registration Statement
on Form S-1 (No. 333-115310) filed on May 7, 2004
10.16 Service and Expense Sharing Agreement, dated as of December 28,
1995, by and between Tower Insurance Company of New York and Tower
Risk Management Corp., incorporated by reference to Exhibit 10.16
to the Company's Registration Statement on Form S-1 (No.
333-115310) filed on May 7, 2004
10.17 Real Estate Lease and amendments thereto, by and between Broadpine
Realty Holding Company, Inc. and Tower Insurance Company of New
York, incorporated by reference to Exhibit 10.17 to the Company's
Registration Statement on Form S-1 (Amendment No. 1) (No.
333-115310) filed on June 24, 2004
10.18 License and Services Agreement, dated as of June 11, 2002, by and
between AgencyPort Insurance Services, Inc. and Tower Insurance
Company of New York, incorporated by reference to Exhibit 10.18 to
the Company's Registration Statement on Form S-1 (Amendment No. 3)
(No. 333-115310) filed on August 25, 2004
10.19 Agreement, dated as of April 17, 1996, between Morstan General
Agency, Inc. and Tower Risk Management Corp., incorporated by
reference to Exhibit 10.19 to the Company's Registration Statement
on Form S-1 (No. 333-115310) filed on May 7, 2004
10.20 Managing General Agency Agreement, dated January 1, 2002, by and
between Virginia Surety Company and Tower Risk Management Corp.,
incorporated by reference to Exhibit 10.20 to the Company's
Registration Statement on Form S-1 (Amendment No. 1) (No.
333-115310) filed on June 24, 2004
10.21 General Agency Agreement by and among State National Insurance
Company, Inc., Tower Insurance Company of New York and Tower Risk
Management Corp., incorporated by reference to Exhibit 10.21 to
the Company's Registration Statement on Form S-1 (Amendment No. 1)
(No. 333-115310) filed on June 24, 2004
10.22 Quota Share Reinsurance Agreement, dated as of January 1, 2004, by
and between Tower Insurance Company of New York and Converium
Reinsurance (North America) Inc., incorporated by reference to
Exhibit 10.22 to the Company's Registration Statement on Form S-1
(Amendment No. 3) (No. 333-115310) filed on August 25, 2004
10.23 Quota Share Reinsurance Agreement, dated as of January 1, 2004, by
and between Tower Insurance Company of New York, Tokio Millennium
Re Ltd. and Hannover Reinsurance (Ireland) Ltd. and E+S
Reinsurance (Ireland) Ltd., incorporated by reference to Exhibit
10.23 to the Company's Registration Statement on Form S-1
(Amendment No. 3) (No. 333-115310) filed on August 25, 2004
132
EXHIBIT
NUMBER DESCRIPTION OF EXHIBITS
- ------ -----------------------
10.24 Amended and Restated Promissory Note, dated August 2, 2004, by
Michael H. Lee in favor of Tower Risk Management, Inc.,
incorporated by reference to Exhibit 10.24 to the Company's
Registration Statement on Form S-1 (Amendment No. 6) (No.
333-115310) filed on September 30, 2004
10.25 Quota Share Reinsurance Agreement, dated as of October 1, 2003, by
and between Tower Insurance Company of New York and Tokio
Millennium Re Ltd., incorporated by reference to Exhibit 10.25 to
the Company's Registration Statement on Form S-1 (No. 333-115310)
filed on May 7, 2004
10.26 Quota Share Reinsurance Agreement, dated as of January 1, 2003, by
and between Tower Insurance Company of New York and PXRE
Reinsurance Company and PMA Capital Insurance Company,
incorporated by reference to Exhibit 10.26 to the Company's
Registration Statement on Form S-1 (Amendment No. 1) (No.
333-115310) filed on June 24, 2004
10.27 Aggregate Excess of Loss Retrocession Agreement, dated as of
January 1, 2004, by and between Converium Reinsurance (North
America) Inc. and Tower Insurance Company of New York,
incorporated by reference to Exhibit 10.27 to the Company's
Registration Statement on Form S-1 (No. 333-115310) filed on May
7, 2004
10.28 Aggregate Excess of Loss Retrocession Agreement, dated as of
January 1, 2004, by and between Hannover Reinsurance (Ireland)
Ltd. and E+S Reinsurance (Ireland) Ltd. and Tower Insurance
Company of New York, incorporated by reference to Exhibit 10.28 to
the Company's Registration Statement on Form S-1 (No. 333-115310)
filed on May 7, 2004
10.29 Excess of Liability Reinsurance Agreement dated as of January 1,
2004, by and between State National Insurance Company, Tower
Insurance Company of New York and Tower Risk Management
Corporation, incorporated by reference to Exhibit 10.29 to the
Company's Registration Statement on Form S-1 (No. 333-115310)
filed on May 7, 2004
10.30 Commercial Renewal Rights Agreement, dated as of September 13,
2004, by and among OneBeacon Insurance Group LLC, each of the
insurance company subsidiaries of OneBeacon Insurance Group LLC
listed therein and Tower Group, Inc., incorporated by reference to
Exhibit 10.30 to the Company's Registration Statement on Form S-1
(Amendment No. 5) (No. 333-115310) filed on September 15, 2004
10.31 Addendum No. 1 to the Quota Share Reinsurance Agreement, effective
January 1, 2004 by and between Tower Insurance Company of New York
and Converium Reinsurance (North America) Inc., incorporated by
reference to Exhibit 10.31 to the Company's Registration Statement
on Form S-1 (Amendment No. 6) (No. 333-115310) filed on September
30, 2004
10.32 Addendum No. 1 to the Quota Share Reinsurance Agreement, effective
January 1, 2004, by and between Tower Insurance Company of New
York, Tokio Millenium Re Ltd. and Hannover Reinsurance (Ireland)
Ltd. and E+S Reinsurance (Ireland) Ltd., incorporated by reference
to Exhibit 10.32 to the Company's Registration Statement on Form
S-1 (Amendment No. 6) (No. 333-115310) filed on September 30, 2004
10.33 General Agency Agreement, effective October 1, 2004, by and among
State National Insurance Company Inc., Tower Insurance Company of
New York and Tower Risk Management Corp. (Equipment breakdown
business)*
10.34 General Agency Agreement, effective October 1, 2004, by and among
State National Insurance Company Inc., Tower Insurance Company of
New York and Tower Risk Management Corp. (Umbrella business)*
10.35 Excess of Liabilities Reinsurance Agreement, effective October 1,
2004, by and among State National Insurance Company Inc., Tower
Insurance Company of New York and Tower Risk Management Corp.
(Umbrella business)*
10.36 Wrap-Around Multiline Quota Share Agreement, effective December 1,
2004, by and between Virginia Surety Company, Inc. and Tower
Insurance Company of New York*
133
EXHIBIT
NUMBER DESCRIPTION OF EXHIBITS
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10.37 Managing General Agency Agreement, effective December 1, 2004, by
and between Virginia Surety Company Inc. and Tower Risk Management
Corp.*
10.38 Quota Share Reinsurance Agreement, effective January 1, 2005, by
and among Tower Insurance Company of New York, Hannover
Reinsurance (Ireland) Ltd., E+S Reinsurance (Ireland) Ltd. and
Tokio Millennium Re Ltd.*
10.39 General Agency Agreement, effective January 1, 2005, by and among
State National Insurance Company Inc., Tower Insurance Company of
New York and Tower Risk Management Corp.*
10.40 Amended and Restated Declaration of Trust, dated December 15,
2004, by and among Wilmington Trust Company, as Institutional
Trustee; Wilmington Trust Company, as Delaware Trustee; Tower
Group, Inc., as Sponsor; and the Trust Administrators Michael H.
Lee, Francis M. Colalucci and Steve G. Fauth, incorporated by
reference to Exhibit 10.04 to the Company's Current Report on Form
8-K on December 20, 2004
10.41 Indenture between Tower Group, Inc. and Wilmington Trust Company,
as Trustee, dated December 15, 2004, incorporated by reference to
Exhibit 10.03 to the Company's Current Report on Form 8-K on
December 20, 2004
10.42 Guarantee Agreement dated December 15, 2004, by and between Tower
Group, Inc. and Wilmington Trust Company, incorporated by
reference to Exhibit 10.02 to the Company's Current Report on Form
8-K on December 20, 2004
10.43 Amended and Restated Declaration of Trust, dated December 21,
2004, by and among JPMorgan Chase Bank, National Association, as
Institutional Trustee, Chase Manhattan Bank USA, National
Association, as Delaware Trustee; Tower Group, Inc., as Sponsor;
and the Trust Administrators Michael H. Lee, Francis M. Colalucci
and Steve G. Fauth, incorporated by reference to Exhibit 10.04 to
the Company's Current Report on Form 8-K on December 23, 2004
10.44 Indenture between Tower Group, Inc. and JPMorgan Chase Bank,
National Association, as Trustee, dated December 21, 2004,
incorporated by reference to Exhibit 10.03 to the Company's
Current Report on Form 8-K on December 23, 2004
10.45 Guarantee Agreement dated December 21, 2004, by and between Tower
Group, Inc. and JPMorgan Change Bank, National Association,
incorporated by reference to Exhibit 10.02 to the Company's
Current Report on Form 8-K on December 23, 2004
21.1 Subsidiaries of the registrant*
23.1 Consent of Johnson Lambert & Co.*
31.1 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 by Michael H. Lee*
31.2 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 by Francis M. Colalucci*
32 Certification of Chief Executive Officer and Chief Financial
Officer, Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002*
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134