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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
|X| QUARTERLY REPORT PERSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 For the quarterly period ended September 30, 2004
TRANSITION REPORT PERSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 For the transition period from ______to______
Commission file no. 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)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |_| No |X|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act) Yes |_| No |X|
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date: 19,697,966 shares of common
stock, par value of $0.01 per share, as of November 15, 2004.
1
INDEX
-----
PART I FINANCIAL INFORMATION PAGE
Item 1. Financial Statements (Unaudited)
Consolidated Balance Sheets
- September 30, 2004 and December 31, 2003 3
Consolidated Statements of Income and Comprehensive Net Income
- Three and nine months ended September 30, 2004 and 2003 4
Consolidated Statement of Changes in Shareholders' Equity
- Nine months ended September 30, 2004 5
Consolidated Statement of Cash Flows
- Three and nine months ended September 30, 2004 and 2003 6
Notes to Consolidated Financial Statements 7-16
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 17-33
Item 3. Quantitative and Qualitative Disclosures About Market Risk 34
Item 4. Controls and Procedures 34
PART II OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 34
Item 4. Submission of Matters to a Vote of Security Holders 35
Item 6. Exhibits 35
SIGNATURES 36
2
TOWER GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Unaudited)
September 30, 2004 December 31, 2003
------------------- -------------------
($ In thousands, except par value and share
amounts)
Assets
Fixed-maturity securities, available-for-sale, at fair value
(amortized cost: $116,464 in 2004; $53,265 in 2003) $ 117,737 $ 54,545
Equity securities, at fair value
(cost: $1,877 in 2004 and 2003) 2,059 2,184
Short-term Investments 9,426 9,407
------------------- -------------------
Total Investments 129,222 66,136
Cash and cash equivalents 16,129 20,932
Investment income receivable 1,030 552
Agents' balances receivable 21,125 21,952
Assumed premiums receivable 635 997
Receivable for cancelled reinsurance - 15,748
Ceding commission receivable 8,769 7,983
Notes and accrued interest receivable from related parties 1,459 1,421
Reinsurance recoverable 99,776 84,760
Receivable- claims paid by agency 2,707 1,812
Prepaid reinsurance premiums 52,857 55,645
Deferred acquisition costs net of deferred ceding
commission revenue 5,006 573
Deferred income taxes 1,722 2,033
Intangible assets 5,000 -
Fixed assets, net of accumulated depreciation 4,882 4,040
Other assets 3,371 1,388
------------------- -------------------
Total Assets $ 353,690 $ 285,972
=================== ===================
Liabilities and Stockholders' Equity
Liabilities
Loss and loss adjustment expenses $ 121,893 $ 99,475
Unearned premium 84,918 70,248
Reinsurance balances payable 19,687 20,788
Payable to issuing carriers 11,584 12,726
Funds held as agent 801 796
Funds held under reinsurance agreements 47,475 24,943
Accounts payable and accrued expenses 8,088 4,934
Checks outstanding 8,006 4,936
Payable for securities 5,565 3,004
Dividends payable to stockholders 175 160
Federal and state income taxes payable 277 1,019
Deferred compensation liability 330 1,294
Subordinated debentures 20,000 20,000
Long-term debt - CIT 4,950 5,588
Series A cumulative redeemable preferred stock 1,500 3,000
------------------- -------------------
Total Liabilities $ 335,249 $ 272,911
------------------- -------------------
Stockholders' Equity
Class A common stock ($0.01 par value per share; 4,000,000 shares
authorized; 2,147,561 shares issued in 2004 and 2,069,936 in 2003; 2,058,594
outstanding in 2004 and 1,977,369 in 2003) 21 21
Class B common stock ($0.01 par value per share; 4,000,000 shares
authorized; 2,561,953 shares issued in 2004 and 2,430,065 in 2003; 2,561,953
outstanding in 2004 and 2,430,065 in 2003) 26 24
Paid-in-capital 4,432 2,285
Accumulated other comprehensive net income 961 1,048
Retained earnings 15,486 10,197
Unearned compensation - restricted stock (1,991) -
Treasury stock- Class A common stock (88,967 shares in 2004 and 92,567 in
2003, at cost) (494) (514)
------------------- -------------------
Total Stockholders' Equity 18,441 13,061
------------------- -------------------
Total Liabilities, Redeemable Preferred Stock and
Stockholders' Equity $ 353,690 $ 285,972
=================== ===================
See accompanying notes to the consolidated financial statements.
3
TOWER GROUP, INC.
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE NET INCOME
(Unaudited)
($ In thousands, except share and per share amounts)
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------- ----------------------------
2004 2003 2004 2003
---- ---- ---- ----
Revenues
Net premiums earned $ 12,082 $ 7,489 $ 29,527 $ 17,794
Ceding commission revenue 9,375 8,883 30,426 26,738
Insurance services revenue 3,572 3,413 10,777 8,180
Net investment income 1,224 564 3,087 1,646
Net realized gains on
Investments 35 39 33 488
Policy billing fees 176 148 508 417
------------ ------------ ------------ ------------
Total revenues 26,464 20,536 74,358 55,263
------------ ------------ ------------ ------------
Expenses
Loss and loss adjustment
Expenses 7,420 4,915 18,329 11,697
Direct commission expense 7,751 6,556 23,405 18,986
Other operating expenses 6,912 5,770 21,416 16,661
Interest expense 752 401 2,127 847
------------ ------------ ------------ ------------
Total expenses 22,835 17,642 65,277 48,191
------------ ------------ ------------ ------------
Income before income taxes 3,629 2,894 9,081 7,072
Income tax expense 1,151 865 3,282 2,479
------------ ------------ ------------ ------------
Net Income $ 2,478 $ 2,029 $ 5,799 $ 4,593
============ ============ ============ ============
Comprehensive Net Income
Net income $ 2,478 $ 2,029 $ 5,799 $ 4,593
Other comprehensive income:
Gross unrealized gains/(losses) in
investment holding gains arising
during period 2,145 (494) (99) 536
Less: reclassification adjustment
for gains included in net income (35) (39) (33) (488)
------------ ------------ ------------ ------------
2,110 (533) (132) 48
Income tax (expense)/benefit
related to items of other
comprehensive income (717) 181 45 (16)
------------ ------------ ------------ ------------
Total other comprehensive net income 1,393 (352) (87) 32
/(loss) income
Comprehensive Net Income $ 3,871 $ 1,677 $ 5,712 $ 4,625
============ ============ ============ ============
Earnings Per Share
Basic earnings per common share
$ 0.55 $ 0.46 $ 1.31 $ 0.99
============ ============ ============ ============
Diluted earnings per common share $ 0.43 $ 0.36 $ 1.01 $ 0.79
============ ============ ============ ============
Weighted-Average Common Shares
Outstanding
Basic 4,502,831 4,407,433 4,439,233 4,469,144
Diluted 5,858,366 5,652,883 5,794,807 5,720,194
See accompanying notes to the consolidated financial statements.
4
TOWER GROUP, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(Unaudited)
($ In thousands)
Accumulated
Class A Class B Paid- Other Unearned Total
Common Common in- Comprehensive Retained Compensation Treasury Stockholders'
Stock Stock Capital Net Income Earnings Restricted Stock Stock Equity
--------- --------- --------- --------------- ---------- ---------------- ---------- --------------
Balance at January 1, 2004 $ 21 $ 24 $ 2,285 $ 1,048 $ 10,197 $ - $ (514) $ 13,061
Issuance of restricted stock 2 2,147 (2,149) -
Amortization of restricted
Stock 158 158
Stock options exercised 20 20
Dividends paid or declared (510) (510)
Net income 5,799 5,799
Net unrealized appreciation
on securities available
for sale, net of income tax (87) (87)
--------- --------- --------- --------------- ---------- ---------------- ---------- --------------
Balance at September 30, 2004 $ 21 $ 26 $ 4,432 $ 961 $ 15,486 $ (1,991) $ (494) $ 18,441
========= ========= ========= =============== ========== ================ ========== ==============
See accompanying notes to the consolidated financial statements.
5
TOWER GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------- ---------------------
2004 2003 2004 2003
--------- --------- --------- ---------
($ in thousands)
Cash flows from operating activities:
Net income $ 2,478 $ 2,029 $ 5,799 $ 4,593
Adjustments to reconcile net income to net cash provided by
(used in) operations:
Loss (gain) on sale of investments (35) (39) (33) (488)
Depreciation and amortization 501 268 1,399 782
Amortization of bond premium or discount 74 23 147 (25)
Amortization of debt issuance costs 13 - 39 -
Amortization of restricted stock 157 - 157 -
Deferred income taxes (209) 209 355 1,315
(Increase) decrease in assets:
Investment income receivable (48) (74) (478) (110)
Agents' balances receivable 6,115 1,069 827 283
Assumed premiums receivable 379 165 362 105
Receivable for cancelled reinsurance - - 15,748 -
Ceding commission receivable (350) - (786) -
Reinsurance recoverable (589) (1,498) (15,911) (26,726)
Prepaid reinsurance premium (453) (353) 2,788 (300)
Deferred acquisition costs, net (754) (1,425) (4,433) (6,699)
Intangible asset (5,000) - (5,000) -
Other assets (750) (493) (2,021) (912)
Increase (decrease) in liabilities:
Loss and loss adjustment expenses 6,386 3,080 22,418 25,382
Unearned premium 4,074 2,472 14,670 11,555
Checks outstanding 1,188 361 3,070 1,316
Reinsurance balances payable 2,005 2,994 (1,101) (2,278)
Payable to issuing carriers (5,916) 1,714 (1,142) 1,288
Accounts payable and accrued expenses 4,962 (94) 3,155 (3,856)
Federal and state income taxes payable (872) (594) (739) (1,803)
Funds held under reinsurance agreement 1,967 (14) 22,537 (115)
Deferred compensation liability - 21 (964) 63
--------- --------- --------- ---------
Net cash flows provided by operations 15,323 9,821 60,863 3,370
--------- --------- --------- ---------
Cash flows from investing activities:
Purchase of fixed assets (671) (671) (2,242) (1,575)
Purchase of investments:
Fixed-maturity securities (26,696) (5,853) (80,226) (12,928)
Short-term investments, net (209) (3,416) (19) (5,276)
Sale of investments:
Fixed-maturity securities 11,586 1,024 16,910 6,457
Equity securities - - - 25
Payable for securities (1,285) 731 2,561 2,024
--------- --------- --------- ---------
Net cash flows (used in) provided by investing activities (17,275) (8,185) (63,016) (11,273)
--------- --------- --------- ---------
Cash flows from financing activities:
Repayment of sinking fund-redeemable preferred stock - - (1,500) -
Proceeds from repurchase obligation - - - 29,650
Repayment of repurchase obligation - - - (32,650)
Proceeds from issuance of subordinated debenture - 301 - 10,000
Proceeds form long-term debt - CIT - 10,000 - 13,000
Repayment of long-term debt - CIT (225) (112) (638) (300)
Proceeds from surplus notes - - - 10,000
Increase in notes receivable from related parties (13) (14) (38) (37)
Stock repurchase - - - (514)
Exercise of stock options 20 - 20 -
Dividends paid (167) (550) (494) (1,551)
--------- --------- --------- ---------
Net cash flows provided by (used in) financing activities (385) 9,625 (2,650) 27,598
--------- --------- --------- ---------
Change in cash and cash equivalents (2,337) 11,261 (4,803) 19,695
Cash and cash equivalents, beginning of period 18,466 11,833 20,932 3,399
--------- --------- --------- ---------
Cash and cash equivalents, end of period $ 16,129 $ 23,094 $ 16,129 $ 23,094
========= ========= ========= =========
Supplemental disclosures of cash flow information:
Cash paid for income taxes $ 2,664 $ 1,898 $ 5,931 $ 5,017
Cash paid for interest $ 468 $ 394 $ 1,298 $ 672
See accompanying notes to the consolidated financial statements.
6
Tower Group, Inc.
Notes to Consolidated Financial Statements (Continued)
Basis of Presentation
The accompanying unaudited consolidated financial statements have been
prepared in accordance with instructions for Form 10-Q and, accordingly, do not
include the information and disclosures required by generally accepted
accounting principles (GAAP) in the Unites States of America. These statements
should be read in conjunction with the consolidated financial statements and
notes thereto included in the Company's Form S-1 filed on October 20, 2004. The
accompanying consolidated financial statements have not been audited by an
independent registered public accounting firm in accordance with standards of
the Public Company Accounting Oversight Board (United States), but in the
opinion of management such financial statements include all adjustments,
consisting only of normal recurring adjustments, necessary for a fair statement
of the Company's financial position and results of operations. The results of
operations for the nine months ended September 30, 2004 may not be indicative of
the results that may be expected for the year ending December 31, 2004. The
December 31, 2003 balance sheet was derived from audited financial statements,
but does not include all disclosure required by GAAP. The consolidated financial
statements include the accounts of the Company, its wholly owned subsidiaries
and other entities required by GAAP. All significant intercompany balances have
been eliminated. Business segment results are presented net of all material
intersegment transactions.
Segregated Assets
To reduce TICNY's (Tower Insurance Company of New York) credit exposure to
reinsurance, quota share reinsurance agreements effective October 2, 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, 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 $46.8 million as of
September 30, 2004 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 segregated trust accounts. The
amounts credited for the three months and nine months ended September 30, 2004
were $0.2 million and $0.7 million, respectively, and have been recorded as
interest expense.
A letter of credit in the amount of $19 million posted by Tokio Millennium
Re Ltd. as of December 31, 2003 was replaced by a Regulation 114 trust
established by Tokio Millennium Re Ltd. for the benefit of TICNY in the first
quarter of 2004. The amount of this Regulation 114 trust remains the same at $19
million as of September 30, 2004. As of September 30, 2004, additional letters
of credit collateralizing reinsurance recoverables, were secured from Endurance
Specialty Insurance, Ltd. ($0.8 million), Hannover Reinsurance (Ireland) Limited
($ 5.3 million) and E+S Reinsurance (Ireland) Limited ($1.3 million).
Dividends Declared
Dividends declared by the Company on Class A common stock for the three
months ended September 30, 2004 and for the same period of 2003 were $77,946 and
$71,646, respectively, or $0.0379 and $0.0362, respectively per share. For the
nine months ended September 30, 2004 and for the same period of 2003 dividends
declared for Class A common stock were $227,946 and $221,646 respectively, or $
0.1137 and $0.1103, respectively per share.
Dividends declared by the Company on Class B common stock for the three
months ended September 30, 2004 and for the same period of 2003 were $97,171 and
$88,285, respectively, or $0.0379 and $0.0363, respectively per share. For the
nine months ended September 30, 2004 and for the same period of 2003 dividends
declared for Class B common stock were $281,508 and $1,314,856 respectively, or
$ 0.1142 and $0.5410, respectively per share
7
Tower Group, Inc.
Notes to Consolidated Financial Statements (Continued)
Preferred stock dividends of $39,375 and $118,125 for the three and nine
months ending September 30, 2004, respectively, were included in interest
expense in accordance with SFAS 150, an accounting change that was adopted on
July 1, 2003.
Preferred stock dividends of $78,750 for the three ending months September
30, 2003 were included in interest expense in accordance with SFAS 150. The
preferred stock dividends for the first six months of 2003 were $157,500 and
were recorded as a reduction to stockholders' equity.
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). The shares and per share
amounts have been restated to reflect the 1. 8:1 stock split effective on the
Company's initial public offering date of October 20, 2004. The quarterly per
share amounts may not add to the year-to-date per share amounts due to rounding
Income Shares Per Share
(Numerator) (Denominator) Amount
----------- ------------- -----------
THREE MONTHS ENDED
September 30, 2004
Net income $ 2,478
Less: preferred stock dividends (1) -
-----------
Basic EPS 2,478 4,502,831 $ 0.55
----------- ------------- ===========
Effect of dilutive securities:
Stock options - 258,642
Restricted stock - 46,894
Warrants 21 1,049,999
----------- -------------
Diluted EPS $ 2,499 5,858,366 $ 0.43
=========== ============= ===========
Income Shares Per Share
(Numerator) (Denominator) Amount
----------- ------------- -----------
THREE MONTHS ENDED
September 30, 2003
Net income $ 2,029
Less: preferred stock dividends (1) -
-----------
Basic EPS 2,029 4,407,433 $ 0.46
----------- ------------- ===========
Effect of dilutive securities:
Stock options - 195,451
Restricted stock - -
Warrants 21 1,049,999
----------- -------------
Diluted EPS $ 2,050 5,652,883 $ 0.36
=========== ============= ===========
Income Shares Per Share
(Numerator) (Denominator) Amount
----------- ------------- -----------
NINE MONTHS ENDED
September 30, 2004
Net income $ 5,799
Less: preferred stock dividends (1) -
-----------
Basic EPS 5,799 4,439,233 $ 1.31
----------- ------------- ===========
Effect of dilutive securities:
Stock options - 258,681
Restricted stock - 46,894
Warrants 63 1,049,999
----------- -------------
Diluted EPS $ 5,862 5,794,807 $ 1.01
=========== ============= ===========
8
Tower Group, Inc.
Notes to Consolidated Financial Statements (Continued)
Income Shares Per Share
(Numerator) (Denominator) Amount
----------- ------------- -----------
NINE MONTHS ENDED
September 30, 2003
Net income $ 4,593
Less: preferred stock dividends (158)
-----------
Basic EPS 4,435 4,469,144 $ 0.99
----------- ------------- ===========
Effect of dilutive securities:
Stock options - 201,051
Restricted stock - -
Warrants 63 1,049,999
----------- -------------
Diluted EPS $ 4,498 5,720,194 $ 0.79
=========== ============= ===========
(1) Preferred stock dividends were included in interest expense beginning July
1, 2003 in accordance with SFAS 150: " Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity".
Employee Stock Option Plan
The Company has elected to follow APB 25, "Accounting for Stock Issued to
Employees," and related interpretations in accounting for its employee stock
option grants. The Company generally grants employee stock options at an
exercise price equal to the market price at the date of grant and, therefore,
under APB 25, no compensation expense is recorded. The Company follows the
disclosure provisions of SFAS 123, "Accounting for Stock-Based Compensation." In
2001, the Company made its first grant of stock options under its 2001 Stock
Award Plan and has disclosed the pro-forma impact to net income and earnings per
share if the Company had applied the fair value recognition provisions of SFAS
123, to stock--based employee compensation. As of December 31, 2002 all
2001options would have been expensed per the pro-forma provisions of SFAS 123.
On September 29, 2004 the Company awarded its second set of stock options
to certain key senior officers, issuing 161,077 options under its 2004 Long-Term
Equity Compensation. Please see "--- Employee Benefit Plans" for a further
discussion of this plan.
The fair value of the options granted on September 29, 2004 was estimated
using the Black-Scholes pricing model as of September 29, 2004. The Company used
the following weighted average assumptions to estimate fair value on the grant
date: 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 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 shares and per share
amounts). There was no impact to pro-forma compensation expense in the third
quarter and nine months ended September 30, 2004 due to the small amortization
on two days for the September 29, 2004 stock option awards.
9
Tower Group, Inc.
Notes to Consolidated Financial Statements (Continued)
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------- ----------------------------
2004 2003 2004 2003
---- ---- ---- ----
Net income $ 2,478 $ 2,029 $ 5,799 $ 4,593
Deduct preferred stock dividends - - - (158)
Deduct total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects - - - -
------------ ------------ ------------ ------------
Net income, pro-forma $ 2,478 $ 2,029 $ 5,799 $ 4,435
Earnings Per Share
Basic - as reported $ 0.55 $ 0.46 $ 1.31 $ 0.99
============ ============ ============ ============
Basic - pro-forma $ 0.55 $ 0.46 $ 1.31 $ 0.99
============ ============ ============ ============
Diluted - as reported $ 0.43 $ 0.36 $ 1.01 $ 0.79
============ ============ ============ ============
Diluted - pro-forma $ 0.43 $ 0.36 $ 1.01 $ 0.79
============ ============ ============ ============
Weighted-Average Common Shares Outstanding:
Basic 4,502,831 4,407,433 4,439,233 4,469,144
Diluted 5,858,366 5,652,883 5,794,807 5,720,194
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, (Tower Insurance Company of New York)
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
(Tower Risk Management) issuing companies or indirectly from reinsurers that
provide reinsurance coverage directly to these 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 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, are considered in total by management for
decision-making purposes.
10
Tower Group, Inc.
Notes to Consolidated Financial Statements (Continued)
Business segment results are as follows (in 000's):
Three Months Ended Nine Months Ended
Insurance Segment Information September 30, September 30,
2004 2003 2004 2003
--------- --------- --------- ---------
Revenues
Net premiums earned $ 11,758 $ 7,321 $ 28,703 $ 17,439
Ceding commission revenue 9,375 8,840 30,426 26,515
Policy billing fees 172 148 504 417
--------- --------- --------- ---------
Total revenues 21,305 16,309 59,633 44,371
--------- --------- --------- ---------
Expenses
Net loss and loss adjustment expenses 7,276 4,818 17,885 11,490
Underwriting expenses 11,231 9,578 34,759 28,354
--------- --------- --------- ---------
Total expenses 18,507 14,396 52,644 39,844
--------- --------- --------- ---------
Underwriting Profit $ 2,798 $ 1,913 $ 6,989 $ 4,527
========= ========= ========= =========
Three Months Ended Nine Months Ended
September 30, September 30,
Reinsurance Segment 2004 2003 2004 2003
--------- --------- --------- ---------
Revenues
Net premiums earned $ 324 $ 168 $ 824 $ 355
Ceding commission revenue - 42 - 223
--------- --------- --------- ---------
Total revenues 324 210 824 578
--------- --------- --------- ---------
Expenses
Net loss and loss adjustment expenses 144 98 444 207
Underwriting expenses 46 47 177 143
--------- --------- --------- ---------
Total expenses 190 145 621 350
--------- --------- --------- ---------
Underwriting Profit $ 134 $ 65 $ 203 $ 228
========= ========= ========= =========
11
Tower Group, Inc.
Notes to Consolidated Financial Statements (Continued)
Three Months Ended Nine Months Ended
September 30, September 30,
Insurance Services Segment 2004 2003 2004 2003
--------- --------- --------- ---------
Revenue
Direct commission revenue from managing
general agency $ 2,043 $ 2,080 $ 7,095 $ 4,586
Claims administration revenue 1,352 876 3,067 2,794
Reinsurance intermediary fees 178 458 615 800
Policy billing fees 3 - 4 -
--------- --------- --------- ---------
Total Revenues 3,576 3,414 10,781 8,180
--------- --------- --------- ---------
Expenses
Direct commissions expense paid to producers 1,438 1,341 4,875 3,107
Other insurance services expenses 576 487 1,937 1,256
Claims expense reimbursement to TICNY 1,345 863 2,987 2,753
--------- --------- --------- ---------
Total Expenses 3,359 2,691 9,799 7,116
--------- --------- --------- ---------
Insurance Services Pre-tax Income $ 217 $ 723 $ 982 $ 1,064
========= ========= ========= =========
Other insurance services underwriting expenses and claims expenses are
comprised entirely of expense reimbursements that are made by TRM to TICNY
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 claims administration expenses resulting from TRM's use of
TICNY's personnel, facilities and equipment in underwriting insurance and
administering claims on behalf of TRM's issuing companies. The reimbursement for
underwriting expenses is calculated based on the number of TRM policies in force
as a factor of total polices in force with a minimum of five percent of the
premiums produced by TRM. Expenses incurred by TRM on behalf of and for the
benefit of both companies, such as rent expense, are subtracted from this amount
in determining the amount of inter-company settlement. The amount of this
reimbursement on an incurred basis was $1.9 million for the nine months ended
September 30, 2004 compared to $1.3 million for the nine months ended September
30, 2003. For the three months ended September 30, 2004 and September 30, 2003
the amounts were $ 0.6 million and $0.5 million, respectively. TRM also
reimburses TICNY, at cost, for claims administration expenses pursuant to the
terms of this expense sharing agreement. Claims expenses reimbursed on an
incurred basis by TRM were $3.0 million for the nine months ended September 30,
2004 compared to $2.8 million for the nine months ended September 30, 2003. For
the three months ended September 30, 2004 the claims expenses reimbursed were
$1.3 million compared to $0.9 million for the three months ended September 30,
2003.
12
Tower Group, Inc.
Notes to Consolidated Financial Statements (Continued)
The following table reconciles revenues by segment to consolidated revenue (in 000's):
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------- ---------------------
Reconciliation 2004 2003 2004 2003
- --------------------------------------- --------- --------- --------- ---------
Revenue
Insurance segment $ 21,305 $ 16,309 $ 59,633 $ 44,371
Reinsurance segment 324 210 824 578
Insurance services segment 3,576 3,414 10,781 8,180
--------- --------- --------- ---------
Total segment revenues 25,205 19,933 71,238 53,129
Net investment income 1,224 564 3,087 1,646
Realized capital gains 35 39 33 488
--------- --------- --------- ---------
Consolidated revenues $ 26,464 $ 20,536 $ 74,358 $ 55,263
========= ========= ========= =========
The following table reconciles the results of our individual segments to consolidated income
before taxes (in 000's):
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------- ---------------------
2004 2003 2004 2003
--------- --------- --------- ---------
Insurance segment underwriting profit $ 2,798 $ 1,913 $ 6,989 $ 4,527
Reinsurance segment underwriting
profit 134 65 203 228
--------- --------- --------- ---------
Total underwriting profit 2,932 1,978 7,192 4,755
Insurance services segment pretax
income 217 723 982 1,064
Net investment income 1,224 564 3,087 1,646
Net realized investment gains 35 39 33 488
Corporate expenses (27) (9) (86) (34)
Interest expense (752) (401) (2,127) (847)
--------- --------- --------- ---------
Income before taxes $ 3,629 $ 2,894 $ 9,081 $ 7,072
========= ========= ========= =========
Employee Benefit Plans
On May 5, 2004 the Board of Directors of TRM approved the payment of
$1,000,000 to Michael H. Lee, Chairman of the Board, President and Chief
Executive Officer, which had been deferred under TRM's 2000 "Deferred
Compensation Plan for Michael Lee" and is the maximum award under this plan.
In May 2004, the Company's Board of Directors authorized the issuance of
131,888 shares of restricted Class B Common Stock to Michael H. Lee, Chairman of
the Board, President and Chief Executive Officer and 8,793 shares of restricted
Class A Common Stock to Francis M. Colalucci, 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, Messrs. Lee and Colalucci 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, which will be amortized as compensation
expense ratably over the vesting period. These shares were issued on August 1,
2004.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. For the three months and nine months ending
September 30, 2004 the Company amortized approximately $158,000 as a charge to
compensation expense and a credit to Unearned Compensation - Restricted Stock in
Stockholders' Equity on the balance sheet.
13
Tower Group, Inc.
Notes to Consolidated Financial Statements (Continued)
On August 26, 2004 the Company's Board of Directors adopted the "2004
Long-Term-Equity Compensation Plan" which was approved by written consent by all
of the outstanding Class A Common Stockholders and Class B Common Stockholders
of record as of August 26, 2004. The plan provided for the granting on
non-qualified stock options, incentive stock options, 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 SAR's.
On September 29, 2004 the Company's Board of Directors authorized the
issuance of 161,077 stock options, under the 2004 Long-Term Equity Compensation
Plan, to certain key senior officers with a grant price of $8.50 (the Company's
initial public offering price) that will vest ratably over five years and has a
term of ten years.
On September 29, 2004 the Company's Board of Directors authorized the
issuance of 68,832 restricted Class A Common Stock to various employees under
the 2004 Long Term -Equity Compensation Plan. The shares vest ratably over five
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 is $585,072. 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 five-year vesting
period as a charge to compensation expense and a credit to Unearned Compensation
- - Restricted Stock in Stockholders' Equity on the balance sheet.
Technology
As of December 31, 2003, TICNY held a warrant to acquire an additional 30%
of the outstanding shares of AgencyPort. On August 31, 2004, the Company entered
into an agreement with AgencyPort Insurance Services, Inc. to eliminate the
warrant in consideration for certain rights granted to TICNY including access to
certain software source code. The Company received the source code upon
execution of the agreement.
Capitalized Costs
The Company has capitalized $1.8 million in public offering costs as of
September 30, 2004. This amount and additional offering expenses of
approximately $0.9 million incurred after September 30, 2004 and the
underwriting discounts of $8.0 million, for both the public and concurrent
private placement, will be fully offset against the proceeds from the offering
and the concurrent private placement.
Commercial Renewal Rights Agreement
The Company has 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 that generated more than
$100 million in gross written premiums in 2003. Under the terms of the
agreement, the Company would not acquire any in-force business or historical
liabilities associated with the policies. In addition, the Company is not
obligated to renew any particular policies, but is free to seek to renew those
policies that meet its underwriting guidelines and on which a satisfactory
premium can be charged. Based upon the initial review of the subject policies
and the Company's current underwriting guidelines, the Company currently intends
to seek to renew policies generating at least $40 million in annual gross
written premiums, but there is no guarantee that the Company will be able to
write any particular level of renewals. The Company has agreed to pay OneBeacon
a commission on the policies the Company renews, 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, subject to the Company's obligation to pay minimum
commissions of $5 million in the aggregate over the three year period. The
Company has recorded this transaction as $5 million of intangible assets and
corresponding $5 million liability. The intangible assets acquired include
renewal rights and new agent contractual relationships. The fee paid to
OneBeacon will be allocated between these intangible assets based on the
relative fair value of the intangibles acquired. The renewal rights intangible
asset will be amortized over its estimated useful life in accordance with SFAS
142, "Goodwill and Other Intangible Assets." The new agent intangible asset has
been determined to have an indefinite useful life. Accordingly this intangible
asset will not be amortized but instead will be subject to annual impairment
testing. Shortly after signing this agreement the Company posted an irrevocable
a letter of credit in the amount of $2 million representing the estimated
commission for the first year of the agreement for the benefit of OneBeacon.
14
Tower Group, Inc.
Notes to Consolidated Financial Statements (Continued)
Subsequent Events
On October 27, 2004, following a downgrade of the A.M. Best rating of
Converium Reinsurance (North America) Inc. ("Converium") to "B-" (Fair) the
Company delivered notice to Converium under its quota share treaty of its intent
to terminate the quota share treaty on a cut-off basis effective December 31,
2004. The Company has reached an agreement with Converium, Tokio Millennium Re
Ltd. ("Tokio") and Hannover Reinsurance (Ireland) Limited and E+S Reinsurance
(Ireland) Limited (collectively "Hannover"), which effects a novation of
Converium's quota share treaty to those other reinsurers effective January 1,
2004, as a result of which Tokio and Hannover would agree 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. However, the Company will take back
the unearned premiums and risks as of December 31, 2004 that would have been
ceded to Converium absent the termination.
On October 20, 2004 Tower Group, Inc.'s registration statement was declared
effective by the Securities and Exchange Commission. The Company initial public
offering was for 13,000,000 shares and was priced at $8.50 per share. The
Company received net cash proceeds of $102,115,773 from this offering after the
underwriting discounts, commissions and certain offering expenses. The Company
and certain of its stockholders have granted the underwriters the option to
purchase up to 1,950,000 additional shares to cover the over-allotment. The
stock is trading on the NASDAQ National Market under the trading symbol "TWGP".
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 public offering, at
the public offering price of $8.50 per share. The Company received net cash
proceeds of $3,952,500 after deducting underwriting fees.
15
Tower Group, Inc.
Notes to Consolidated Financial Statements (Continued)
Immediately before the closing of the public offering on October 26, 2004,
the Company redeemed 30,000 shares, Series A Cumulative Redeemable Preferred
Shares for $1.5 million plus accrued interest. After the closing the Company
utilized some of the cash proceeds to pay off a $5.0 million loan and accrued
interest to CIT Group/Equipment Financing, Inc. The Company will recognize a
loss on early extinguishment of debt of approximately $133,000 in the fourth
quarter of 2004.
On October 26, 2004 the Company received notice from A.M. Best Company that
it has received a rating upgrade to "A-" (Excellent) from "B++" (Very Good).
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 will, among
other things, classify 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 public offering. 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 26, 2004 the Company contributed $98,000,000 in Paid in Capital
to its wholly owned affiliate Tower Insurance Company of New York.
On November 10, 2004 the Company's Board of Directors authorized the
issuance of 1,768 restricted Common Stock to all non-employee directors. The
fair value of the restricted shares is $17,503 which will be recorded 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
from grant date until the end of their vesting period on March 31, 2005.
On November 10, 2004 the underwriters exercised their 30-day over-allotment
option after the Company's public offering on October 20, 2004. Pursuant to the
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 public offering price of $8.50 per share, less the
underwriting discount, to cover the over-allotments. The Company will receive
net cash proceeds of $4,972,301 from this over-allotment option after the
underwriting discounts. The Company will not receive any proceeds from the sale
of common stock by any selling stockholder. The closing is expected to occur on
November 15, 2004.
16
Tower Group, Inc.
Management's Discussion and Analysis of Financial Condition and Results of
Operations
Note on Forward-Looking Statements
Some of the statements under "Management's Discussion and Analysis of
Financial Condition and Results of Operations," and elsewhere in this 10-Q may
include forward-looking statements which 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 which 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 the
following:
-- ineffectiveness or obsolescence of our business strategy due to
changes in current or future market conditions;
-- increased competition on the basis of pricing, capacity, coverage
terms or other factors;
-- greater frequency or severity of claims and loss activity, including
as a result of natural or man-made catastrophic events, than our
underwriting, reserving or investment practices anticipate based on
historical experience or industry data;
-- the effects of acts of terrorism or war;
-- developments in the world's financial and capital markets that
adversely affect the performance of our investments;
-- changes in regulation or tax laws applicable to us, our subsidiaries,
brokers or customers;
-- acceptance of our products and services, including new products and
services;
-- changes in the availability, cost or quality of reinsurance and
failure of our reinsurers to pay claims timely or at all;
-- decreased demand for our insurance or reinsurance products;
-- loss of the services of any of our executive officers or other key
personnel;
-- the effects of mergers, acquisitions and divestitures;
-- changes in rating agency policies or practices;
-- changes in legal theories of liability under our insurance policies;
-- changes in accounting policies or practices; and
-- changes in general economic conditions, including inflation and other
factors.
17
Tower Group, Inc.
Management's Discussion and Analysis of Financial Condition and Results of
Operations (Continued)
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 10-Q. We undertake no obligation to
publicly update or review any forward-looking statement, whether as a result of
new information, future developments or otherwise.
Consolidated Results of Operations
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- ------------------------
Revenues 2004 2003 2004 2003
---- ---- ---- ----
Earned premiums
Gross premiums earned $ 38,325 $ 31,899 $ 111,589 $ 92,698
Less: Ceded premiums
earned (26,243) (24,410) (82,062) (74,904)
--------- --------- ---------- ---------
Net premiums earned 12,082 7,489 29,527 17,794
--------- --------- ---------- ---------
Total commission and fee 13,123 12,444 41,711 35,335
income
Net investment income 1,224 564 3,087 1,646
Net realized investment gains 35 39 33 488
--------- --------- ---------- ---------
Total revenues 26,464 20,536 74,358 55,263
--------- --------- ---------- ---------
Expenses
Net loss and loss adjustment
expenses 7,420 4,915 18,329 11,697
Operating expenses 14,663 12,326 44,821 35,647
Interest Expense 752 401 2,127 847
--------- --------- ---------- ---------
Total Expenses 22,835 17,642 65,277 48,191
--------- --------- ---------- ---------
Income before taxes 3,629 2,894 9,081 7,072
Federal and State Income
Taxes 1,151 865 3,282 2,479
--------- --------- ---------- ---------
Net Income $ 2,478 $ 2,029 $ 5,799 $ 4,593
========= ========= ========== =========
Key Measures
Return on Average Equity 60.1% 75.7% 49.1% 59.6%
Consolidated Results of Operations Three Months Ended September 30, 2004 and
2003
Total revenues. Total revenues increased to $26.5 million or 28.9% for the
three months ended September 30, 2004 compared to $20.5 million in the same
period in 2003. The increases are primarily due to the increase in net earned
premiums, ceding commission and fee income as well as investment income. Net
earned premiums represented 45.7% of total revenues for the three months ended
September 30, 2004 compared to 36.5% in the same period in 2003. Ceding
commission and fee income represented 49.6% of total revenue in the three months
ended September 30, 2004 compared to 60.6% in the same period in 2003. Net
investment income, excluding realized capital gains, represented 4.6% and 2.7%
of total revenue for the three months ended September 30, 2004 and 2003,
respectively.
Premiums earned. Net premiums earned increased by 61.3% to $12.1 million
for the three months ended September 30, 2004 compared with $7.5 million in the
same period in 2003. The increase in net premiums earned was due the overall
increase in gross premiums written through September 30, 2004 and to our
decision to cede less business in 2004 than 2003.Please see "---Insurance
Segment Results of Operations" and "--- Reinsurance Segment Results of
Operations" for a discussion of premiums, total commissions and fee income.
18
Tower Group, Inc.
Management's Discussion and Analysis of Financial Condition and Results of
Operations (Continued)
Net investment income and realized gains. Net investment income increased
by 117.0% to $1.2 million, in the three months ended September 30, 2004 compared
to $0.6 million in the same period in 2003 as a result of growth in invested
assets, offset in part by a decrease in the yield on fixed-maturity investments.
Invested assets grew by $17.4 million from $111.8 million at June 30, 2004 to
$129.2 million at September 30, 2004 as compared to $7.7 million growth in
invested assets in the same period in 2003. Invested assets grew by $77.3
million from $51.9 million as of September 30, 2003 to $129.2 million as of
September 30, 2004. The growth in 2004 was due to greater operating cash flows
in the third quarter including an increase of $2.0 million in funds held as
collateral for reinsurance recoverables. The yield for our fixed income and
short-term investment assets held at September 30, 2004 was 4.5% compared to
5.1% for assets held at September 30, 2003. The decrease in yield in 2004
resulted primarily from lower available interest rates and an increased
allocation to tax exempt securities.
Net realized capital gains were $35,000 in the three months ended September
30, 2004 compared to net realized capital gains of $39,000 in the three months
ended September 30, 2003.
There was no impact on net realized gains attributable to adjustments for
other than temporary impairment of securities held during the three months
ending September 30, 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 for the three months ended September 30, 2004 were $21.3
million and 55.7%, respectively, compared to $18.0 million and 56.3%,
respectively, in the same period in 2003. The net loss ratio for the combined
segments was 61.4% in the three months ended September 30, 2004 and 65.6% in the
same period in 2003. The improvement in the net loss ratios in the third quarter
of 2004 compared to the same period in 2003 was due primarily to the improvement
in the gross and net loss ratios in the insurance and reinsurance assumed
segments due to increased rates on the 2004 treaties and an increase in net
premiums earned that reduced the effect of excess and catastrophe reinsurance
premiums on the net loss ratio as further explained in "-- Insurance Segment
Results of Operations" and "-- Reinsurance Segment Results of Operations."
Operating expenses. Total operating expenses increased by 19.0% to $14.7
million in the three months ended September 30, 2004 from $12.3 million in the
same period 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 as well as additional expenses incurred in anticipation of an
initial public offering. We capitalized $0.7 million of public offering costs in
the three months ended September 30, 2004, which will be fully offset against
the proceeds from the Company's public offering and a concurrent private
placement.
Interest expenses. Our interest expense increased in the three months ended
September 30, 2004 to $752,000 compared to $401,000 in the same period in 2003.
The increase resulted from interest on $10.0 million subordinated debentures
underlying trust-preferred securities issued in September 2003, and an increase
of $3.0 million of other borrowings in December 2003. In addition, $283,880 of
interest was incurred as a result of crediting reinsurers on funds withheld in
segregated trusts as collateral for reinsurance recoverables with an annual
effective yield of 2.5%.
Income tax expense. Our income tax expense was $1.2 million in the three
months ended September 30, 2004 compared to $865,000 in the same period in 2003.
The increased income tax expense was due primarily to the increase in income
before income taxes resulting in increased federal and state taxes that were
partially offset by a true up benefit of $175,000 for the 2003 federal tax
provision recorded in the three months ended September 30, 2004. The effective
income tax rate was 31.7% and 29.9% for the three months ending September 30,
2004 and September 30, 2003, respectively. The effective tax rate in 2003 was
lower due to a true up benefit for the 2002 state tax provision recorded in the
three months ended September 30, 2003.
19
Tower Group, Inc.
Management's Discussion and Analysis of Financial Condition and Results of
Operations (Continued)
Net income and return on average equity. Our net income and annualized
return on average equity was $2.5 million and 60.0%, respectively, in the three
months ended September 30, 2004 compared to $2.0 million and 75.7%,
respectively, in the same period of 2003, which represents a 22.1% increase in
net income. Our return on average equity declined to 60.1% from 75.7% as a
result of higher average stockholders' equity as of September 30, 2004 due to
increased accumulated retained earnings. In determining return on average equity
for a given period, net income is divided by the average of the beginning and
ending stockholders' equity for that period and the result is annualized for any
period less than a full year.
Consolidated Results of Operations Nine Months Ended September 30, 2004 and 2003
Total revenues. For the nine months ended September 30, 2004 total revenues
increased by 34.6% to $74.4 million compared to $55.3 million in the same period
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 39.7% of total revenues for the nine months ended
September 30, 2004 compared to 32.2% in the same period in 2003. Ceding
commission and fee income represented 56.1% of total revenue in the nine months
ended September 30, 2004 compared to 63.9% in the same period in 2003. Net
investment income, excluding realized capital gains, represented 4.2% and 3.0%
of total revenue for the nine months ended September 30, 2004 and 2003,
respectively.
Premiums earned. For the nine months ended September 30, 2004 net premiums
earned increased by 65.9% to $29.5 million for the nine months ended September
30, 2004 compared with $17.8 million in the same period in 2003. The increase in
net premiums earned was due to the overall increase of approximately 21.1% in
gross premiums written in the nine-month period and to our decision to cede less
business in 2004 than 2003. Please see "---Insurance Segment Results of
Operations" and "---Reinsurance Segment Results of Operations" for a discussion
of premiums and total commissions and fee income.
Net investment income and realized gains. For the nine months ended
September 30, 2004 net investment income increased by 87.5% to $3.1 million
compared to $1.6 million in the same period in 2003 as a result of the growth in
invested assets, offset in part by a decrease in the yield on fixed maturity
investments. Invested assets grew $63.1 million from $66.1 million at December
31, 2003 to $129.2 million at September 30, 2004 as compared to a $12.3 million
growth in invested assets in the same period in 2003. Invested assets grew by
$12.3 million from $39.6 million as of December 31, 2002 to $51.9 million as of
September 30, 2003. The growth in 2004 invested assets was due to greater
operating cash flows including an increase of $22.5 million in funds held as
collateral for reinsurance recoverables. The yield for our fixed income and
short-term investment assets held at September 30, 2004 was 4.5% compared to 5.1
% for assets held at September 30, 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 $33,000 in the nine month period ended
September 30, 2004 compared to net realized capital gains of $488,000 for the
nine months ended September 30, 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.
20
Tower Group, Inc.
Management's Discussion and Analysis of Financial Condition and Results of
Operations (Continued)
There was no impact on net realized capital gains attributable to
adjustments for other than temporary impairment of securities held during the
nine-month periods ending September 30, 2004 and 2003.
Losses and loss adjustment expenses. For the nine months ended September
30, 2004 gross loss and loss adjustment expenses and the gross loss ratio for
both the insurance and reinsurance segments combined were $63.7 million and
57.1%, respectively, compared to $52.9 million and 57.1%, respectively, in the
same period in 2003. The net loss ratio for the combined segments was 62.1% in
the nine months ended September 30, 2004 and 65.7% in the same period in 2003.
The improvement in the net loss ratio in the first nine months of 2004 compared
to the same period in 2003 was due to an increase in net premiums earned that
reduced the effect of excess and catastrophe reinsurance premiums on the net
loss ratio as further explained in "--- Insurance Segment Results of
Operations."
Operating expenses. For the nine months ended September 30, 2004 total
operating expenses increased by 25.7% to $44.8 million from $35.6 million in the
same period 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 as well as additional staffing and other expenditures in
anticipation of an initial public offering. We capitalized $1.8 million in
public offering costs as of September 30, 2004, which will be fully offset
against the proceeds from the public offering and a concurrent private
placement.
Interest expenses. Our interest expense increased in the nine months ended
September 30, 2004 to $2.1 million compared to $0.8 million in the same period
in 2003. The increase resulted primarily from interest on $20.0 million of
subordinated debentures underlying our trust-preferred securities issued in May
and September 2003, and an aggregate of $6.0 million of other borrowings in
February and December 2003, as well as dividends on $1.5 million of mandatorily
redeemable preferred stock required by an accounting change adopted on July 1,
2003 to be reported as an expense rather than as a reduction to stockholders'
equity. In addition, $0.7 million of interest was incurred as a result of
crediting reinsurers on funds withheld in segregated trusts as collateral for
reinsurance recoverables with an annual effective annual yield of 2.5%.
Income tax expense. For the nine months ended September 30, 2004, our
income tax expense was $3.3 million compared to $2.5 million in the same period
in 2003. The increased income tax expense was due primarily to the increase in
income taxes for federal and state taxes that was partially offset by a net true
up benefit of $139,000 for the 2003 federal tax provision recorded in the nine
months ended September 30, 2004.The effective income tax rate was 36.1% for the
first nine months of 2004 compared to 35.1% for the first nine months of 2003,
respectively. The effective tax rate in 2003 was lower due to a true up benefit
for the 2002 state income tax provision recorded in the nine months ended
September 30, 2003.
Net income and return on average equity. For the nine months ended
September 30, 2004 net income and annualized return on average equity was $5.8
million and 49.1%, respectively, compared to $4.6 million and 59.6%,
respectively, in the same period in 2003, which represents a 26.2% increase in
net income. The lower return on average equity is a result of the higher
stockholders' equity on September 30, 2004 due to increased accumulated retained
earnings.
21
Tower Group, Inc.
Management's Discussion and Analysis of Financial Condition and Results of
Operations (Continued)
Insurance Segment Results of Operations
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------- -------------------------
Revenues 2004 2003 2004 2003
---- ---- ---- ----
Earned premiums
Gross premiums earned $ 37,957 $ 31,539 $ 110,640 $ 91,573
Less: Ceded premiums earned (26,199) (24,218) (81,937) (74,134)
--------- --------- ---------- ----------
Net Premiums earned 11,758 7,321 28,703 17,439
--------- --------- ---------- ----------
Ceding commission revenue 9,375 8,840 30,426 26,515
Policy billing fees 172 148 504 417
--------- --------- ---------- ----------
Total 21,305 16,309 59,633 44,371
--------- --------- ---------- ----------
Expenses
Loss and Loss Adjustment Expenses
Gross loss and loss adjustment expenses 21,216 17,767 63,325 52,298
--------- --------- ---------- ----------
Less: Ceded loss and loss adjustment
expenses (13,940) (12,949) (45,440) (40,808)
--------- --------- ---------- ----------
Net Loss and loss adjustment expenses 7,276 4,818 17,885 11,490
Underwriting expenses
Direct commission expense 6,303 5,202 18,493 15,835
Other underwriting expenses 4,928 4,376 16,266 12,519
--------- --------- ---------- ----------
Total underwriting expenses 11,231 9,578 34,759 28,354
--------- --------- ---------- ----------
Underwriting Profit $ 2,798 $ 1,913 $ 6,989 $ 4,527
========= ========= ========== ==========
Key Measures
Premiums written
Gross premiums written $ 42,082 $ 34,100 $ 125,181 $ 103,436
Less: Ceded premiums written
(26,665) (24,698) (79,196) (75,041)
--------- --------- ---------- ----------
Net premiums written $ 15,417 $ 9,402 $ 45,985 $ 28,395
========= ========= ========== ==========
Loss Ratios
Gross 55.9% 56.3% 57.2% 57.1%
Net 61.9% 65.8% 62.3% 65.9%
Accident Year Loss Ratio
Gross 57.5% 56.3% 57.5% 57.1%
Net 61.7% 65.8% 62.2% 65.9%
Underwriting Expense Ratios
Gross 29.1% 29.9% 31.0% 30.5%
Net 14.3% 8.1% 13.3% 8.2%
Combined Ratios
Direct 85.0% 86.2% 88.2% 87.6%
Net 76.2% 73.9% 75.7% 74.0%
Insurance Segment Results of Operations Three Months Ended September 30, 2004
and 2003
Gross premiums. Gross premiums written increased by 23.4% to $42.1 million
in the three months ended September 30, 2004 from $34.1 million in the same
period in 2003. Gross premiums earned increased similarly by 20.3% to $38.0
million in the three months ended September 30, 2004 compared to $31.5 million
in the same period in 2003. These increases were due in part to a 10.0% growth
in policy count and to an increase in average premium size of 12.4% resulting
from rate increases and other pricing actions.
Ceded premiums. Ceded premiums written increased by 8.0% to $26.7 million
in the three months ended September 30, 2004 compared with $24.7 million in the
same period in 2003. The rate of increase in ceded premiums written was less
than for gross premiums written due to our decision to lower the percentage of
ceded premiums under our quota share reinsurance agreements to 60% in 2004
compared to 70% in the three months ended September 30, 2003 in order to
increase net written premiums in 2004 in relation to our statutory surplus.
Despite the reduction in the ceding percentage, ceded premiums written increased
as a result of the increase in gross premiums written.
22
Tower Group, Inc.
Management's Discussion and Analysis of Financial Condition and Results of
Operations (Continued)
Net premiums. Net premiums written increased by 64.0% to $15.4 million in
the three months ended September 30, 2004 compared to $9.4 million in the same
period in 2003. This increase was greater than the increase in gross premiums
written due to the decrease in the ceding percentage mentioned above from 70% in
the three months ended September 30, 2003 to 60% in the same period in 2004. Net
premiums earned increased by 60.6% to $11.8 million in the three months ended
September 30, 2004 compared to $7.3 million in the same period in 2003.
Ceding commission revenue. The ceding commission rate under our quota share
reinsurance agreements is directly related to the loss ratio on the ceded earned
premium. If the loss ratio for business ceded in a prior period changes in any
given year as a result of favorable or adverse development, we must reflect this
by changing the commission rate that we established during the prior accounting
period, and increasing or reducing ceding commission revenue in the current
period by the amount of the difference between commissions calculated at the old
commission rate and commissions calculated at the revised commission rate. We
monitor the ceded loss ratio on a quarterly basis to determine the effect on the
commission rate that we accrued during the prior accounting periods. Ceding
commission revenue increased by 6.1% to $9.4 million for the three months ended
September 30, 2004 compared to $8.8 million for the same period in 2003. Despite
the reduction in the quota share ceding percentage, ceding commission revenue
increased 6.1% as a result of overall growth as reflected in the increases in
gross and ceded premiums earned. Additionally, we experienced an increase in the
ceded loss ratio on prior years quota share treaties, which decreased ceding
commission revenue by $0.4 million in the three months ended September 30, 2004
Loss and loss adjustment expenses and loss ratio. Gross and net losses and
loss adjustment expenses were $21.2 million and $7.3 million, respectively for
the three months ended September 30, 2004 compared with $17.8 million and $4.8
million, respectively, for the same period in 2003. Our gross and net loss
ratios were 55.9% and 61.9%, respectively for the three months ended September
30, 2004 as compared with 56.3% and 65.8% for the same period in 2003. The
decrease in the net loss ratio in the third quarter of 2004 compared to the same
period in 2003 was due to a decrease in the gross loss ratio. In addition, the
increase in net premiums earned reduced the proportional effect of excess and
catastrophe reinsurance premiums on the net loss ratio. We ceded excess
catastrophe reinsurance premiums equal to 14.3% of net premiums earned during
the three months ended September 30, 2004 compared to 21.3% during the same
period of 2003. There was minimal adverse development from prior years'
reserves in the third quarter of 2004 compared to none in the same period of
2003. 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 "--- Insurance Services Segment Results of
Operations" for the amounts of claims reimbursements.
Underwriting expenses and underwriting expense ratio. Underwriting
expenses, which include direct commission expenses and other underwriting
expenses, were $11.2 million for the three months ended September 30, 2004 as
compared with $9.6 million in the same period in 2003. Our gross expense ratio
was 29.1% in the three months ended September 30, 2004 as compared with 29.9% in
the same period in 2003.
23
Tower Group, Inc.
Management's Discussion and Analysis of Financial Condition and Results of
Operations (Continued)
The commission portion of our expense ratio, which expresses direct
commission expense paid to our producers as a percentage of gross premiums
earned, was 16.6% in the three months ended September 30, 2004 as compared to
16.5% in the same period in 2003. Direct commission rates by line of business
were essentially the same in 2004 as in 2003.
The portion of the underwriting expense ratio represented by the other
underwriting expense ratio was 12.5% in the three months ended September 30,
2004 as compared with 13.4% in the same period in 2003. This decrease is mainly
due to a greater percentage increase in gross earned premiums than in other
underwriting expenses in the third quarter of 2004.
The net underwriting expense ratio was 14.3% in the three months ended
September 30, 2004 as compared to 8.1% in the same period in 2003. This increase
was mainly due to the reduced effects of ceding commission revenue on lowering
the gross expense ratio during the third quarter of 2004 compared with the same
period in 2003. While ceding commission revenue increased by 6.1% in the third
quarter of 2004 compared with the same period in 2003, gross expenses increased
by 17.3% in the third quarter of 2004 compared with the same period in 2003. As
a result of the higher growth rate in gross expenses relative to the growth in
ceding commission revenue, the impact of ceding commission revenue on lowering
the gross expense ratio was not as significant in the third quarter of 2004
compared to the same period in 2003. The limited growth in ceding commission
revenue in the third quarter of 2004 was due to a reduction in the quota share
ceding percentage to 60% in the third quarter of 2004 from 70% during the third
quarter of 2003.
Underwriting profits and combined ratio. The underwriting profit, which
reflects our underwriting results on a net basis after the effects of
reinsurance, was $2.8 million in the third quarter of 2004 and $1.9 million for
the same period in 2003. The net combined ratio was 76.2% for the three months
ended September 30, 2004 as compared with 73.9% for the same period in 2003. The
increase in the net combined ratio resulted from an increase in the net expense
ratio primarily due to the effects of reduced ceding commission revenue in
lowering gross expenses. Notwithstanding the increase in combined ratio for the
third quarter, underwriting profits did not decline due to the overall increase
in premiums earned.
The gross combined ratio was 85.0% in the three months ended September 30,
2004 as compared with 86.2% for the same period in 2003. The decrease in the
combined ratio in the third quarter of 2004 resulted from a decrease in the
gross loss ratio and in the gross underwriting expense ratio.
Insurance Segment Results of Operations Nine Months Ended September 30, 2004 and
2003
Gross premiums. For the nine months ended September 30, 2004 gross premiums
written increased by 21.0% to $125.2 million from $103.4 million in the same
period in 2003. Gross premiums earned increased similarly by 20.8% to $110.6
million in the nine months ended September 30, 2004 compared to $91.6 million in
the same period in 2003. These increases are attributable to a 10.0% growth in
policy count and to an increase in average premium size of 12.4% resulting
primarily from rate increases and other pricing actions.
Ceded premiums. For the nine months ended September 30, 2004, ceded
premiums written increased by 5.5% to $79.2 million compared with $75.0 million
in the same period in 2003. The rate of increase in ceded premiums written was
less than for gross premiums written due to our decision to lower the percentage
of ceded premiums under our quota share reinsurance agreements to 60% in the
first nine months of 2004 compared to 70% in the nine months ended September 30,
2003. Despite the reduction in the ceding percentage, ceded premiums written
increased as a result of the increase in gross premiums written. Ceded premiums
earned increased 10.5%. The rate of increase was greater than the 5.5% increase
in ceded premiums written since ceded premiums earned include ceded premiums
written in 2003 when the ceding percentages under our quota share reinsurance
agreements were higher.
24
Tower Group, Inc.
Management's Discussion and Analysis of Financial Condition and Results of
Operations (Continued)
Net premiums. For the nine months ended September 30, 2004, net premiums
written increased by 61.9% to $46.0 million compared to $28.4 million in the
same period in 2003. This increase was greater than the increase in gross
premiums written due to the decrease in the ceding percentage from 70% in the
nine months ended September 30, 2004 compared to 60% in the same period in 2003.
Net premiums earned increased by 64.6% to $28.7 million in the nine months ended
September 30, 2004 compared to $17.4 million in the same period in 2003. The
rate of increase in net premiums earned was greater than for net premiums
written due to the increase in ceded premiums earned mentioned above.
Ceding commission revenue. For the nine months ended September 30, 2004,
ceding commission revenue increased by 14.8% to $30.4 million compared to $26.5
million for the same period in 2003. Despite the reduction in the quota share
ceding percentage, ceding commission revenue increased 14.8% as a result of a
10.5% increase in ceded premiums earned. Additionally, we experienced an
improvement in ceded loss ratios on prior years' quota share treaties that
increased ceding commission revenue $0.5 million in the nine months ended
September 30, 2004.
Loss and loss adjustment expenses and loss ratio. For the nine months ended
September 30, 2004, gross and net losses and loss adjustment expenses were $63.3
million and $17.9 million, respectively compared with $52.3 million and $11.5
million, respectively, for the same period in 2003. Our gross and net loss
ratios were 57.2% and 62.3%, respectively for the nine months ended September
30, 2004 as compared with 57.1% and 65.9% for the same period in 2003. The
decrease in the net loss ratio in the nine months ending September 30, 2004 as
compared to the same period in 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 17.8% of net premiums earned during the nine months ended
September 30, 2004 compared to 25.2% during the same period in 2003. There was
minimal adverse development from prior years' reserves in the nine months ended
September 30, 2004 compared to none in the same period of 2003. 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 "--- Insurance Services Segment Results of Operations" for the amounts
of claims reimbursements.
Underwriting expenses and underwriting expense ratio. For the nine months
ended September 30, 2004 underwriting expenses, which include direct commission
expenses and other underwriting expenses, were $34.8 million compared with $28.4
million in the same period in 2003. Our gross underwriting expense ratio was
31.0% in the nine months ending September 30, 2004 as compared with 30.5% in the
same period in 2003.
For the nine months ended September 30, 2004 the commission portion of our
underwriting expense ratio, which expresses direct commission expense paid to
our producers as a percentage of gross premiums earned, was 16.7% compared to
17.3% in the same period in 2003. The commission ratio in the nine months ending
September 30, 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.
The portion of the underwriting expense ratio represented by the other
underwriting expense ratio was 14.2% in the nine months ended September 30, 2004
as compared with 13.2% in the same period in 2003. The increase in underwriting
expenses was due to the 17 % increase in the number of full time employees to
249 as of September 30, 2004 from 212 as of September 30, 2003. A significant
portion of the increase in salary expense in 2004 as compared to 2003 resulted
from an increase in staffing, especially at senior levels and other key areas,
in anticipation of an initial public offering.
25
Tower Group, Inc.
Management's Discussion and Analysis of Financial Condition and Results of
Operations (Continued)
For the nine months ended September 30, 2004 the net underwriting expense
ratio was 13.3% compared 8.2% in the same period in 2003. Net underwriting
expenses reflect the reduced effect of ceding commission revenue on lowering the
gross expense ratio during the nine months ended September 30, 2004 compared to
the same period in 2003.
Underwriting profits and combined ratio. The underwriting profit reflects
our underwriting results on a net basis after the effects of reinsurance. For
the nine months ended September 30, 2004 the underwriting profit increased by
54.4% to $7.0 million from $4.5 million in the same period in 2003. The net
combined ratio was 75.7% for the nine months ended September 30, 2004 as
compared with 74.0% for the same period in 2003. The increase in the net
combined ratio resulted from an increase in the net expense ratio due to the
reduced effects of lower ceding commission revenue on lowering gross expenses.
For the nine months ended September 30, 2004 the gross combined ratio was
88.2% compared with 87.6% for the same period in 2003. The slightly higher gross
combined ratio resulted from a higher gross underwriting expense ratio primarily
due to increased staffing in anticipation of an initial public offering.
26
Tower Group, Inc.
Management's Discussion and Analysis of Financial Condition and Results of
Operations (Continued)
Reinsurance Segment Results of Operations
Three Months Nine Months
Ended September Ended September
30, 30,
------------------- ---------------------
Revenues 2004 2003 2004 2003
---- ---- ---- ----
Earned premiums
Gross premiums earned $ 368 $ 360 $ 949 $ 1,125
Less: Ceded premiums earned (44) (192) (125) (770)
------- ------- -------- --------
Net Premiums earned 324 168 824 355
Ceded commission revenue - 42 - 223
------- ------- -------- --------
Total 324 210 824 578
------- ------- -------- --------
Expenses
Loss and Loss Adjustment Expenses
Gross loss and loss adjustment expenses 124 206 424 644
Less: Ceded loss and loss adjustment expenses 20 (108) 20 (437)
------- ------- -------- --------
Net Loss and loss adjustment expenses 144 98 444 207
Underwriting expenses
Ceding commissions expenses 10 12 37 44
Other underwriting expenses 36 35 140 99
------- ------- -------- --------
Total underwriting expenses 46 47 177 143
------- ------- -------- --------
Underwriting Profit $ 134 $ 65 $ 203 $ 228
======= ======= ======== ========
Key Measures
Premiums written
Gross premiums written $ 317 $ 272 $ 1,078 $ 817
Less: Ceded premiums written (31) (64) (78) (163)
------- ------- -------- --------
Net premiums written $ 286 $ 208 $ 1,000 $ 654
======= ======= ======== ========
Loss Ratios
Gross 33.7% 57.2% 44.7% 57.2%
Net 44.4% 58.3% 53.9% 58.3%
Accident Year Loss Ratio
Gross 45.1% 61.1% 49.2% 58.5%
Net 51.2% 123.8% 56.7% 89.3%
Underwriting Expense Ratios
Gross 12.6% 13.0% 18.7% 12.7%
Net 14.3% 2.9% 21.5% -22.6%
Combined Ratios
Gross 46.3% 70.2% 63.3% 69.9%
Net 58.7% 61.2% 75.4% 35.7%
Reinsurance Segment Results of Operations Three Months Ended September 30, 2004
and 2003
Gross premiums. Gross written premiums increased by 16.5% to $317,000 in
the three months ended September 30, 2004 as compared with $272,000 in the same
period 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 the reinsurance
assumed from these issuing companies.
Ceded premiums earned decreased by 77.1% to $44,000 in the three months
ended September 30, 2004 compared with $192,000 the same period in 2003, as we
no longer cede business in this segment to the quota share treaties.
Net premiums written increased 37.5% to $286,000 in the three months ended
September 30, 2004 as compared with $208,000 in the same period in 2003. Net
premiums earned increased by 92.9% to $324,000 in the three months ended
September 30, 2004 as compared with $168,000 in the same period in 2003 as a
result of the discontinuation of ceding premiums in this segment to our quota
share treaty reinsurers.
27
Tower Group, Inc.
Management's Discussion and Analysis of Financial Condition and Results of
Operations (Continued)
Loss and loss adjustment expenses and loss ratio. Gross loss and loss
adjustment expenses were $124,000 in the three months ended September 30, 2004
as compared with $206,000 in the same period in 2003. Net losses were $144,000
in the three months ended September 30, 2004 as compared to $98,000 in the same
period in 2003.The gross loss ratio decreased in the three months ended
September 30, 2004 to 33.7% as compared to 57.2% in the same period in 2003.
Similarly, the net loss ratio also decreased in the three months ended September
30, 2004 to 44.4% as compared to 58.3% in the same period in 2003. The
improvement in the loss ratios in 2004 resulted from increased pricing on 2004
policy year treaties, improving profitability of the underlying business
produced by TRM and favorable reserve development on prior years' reserves of
$43,000 which reduced the gross and net loss ratios by 11.7% and 13.3%,
respectively.
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 decreased slightly in the three months
ended September 30, 2004 to $46,000 as compared to $47,000 in the same period in
2003. Our net underwriting expense ratio increased to 14.3% in the three months
ended September 30, 2004 from a 2.9% in the same period in 2003. This was due to
the absence of ceding commission revenue in 2004 as we no longer cede to the
quota share treaties.
Underwriting profit and combined ratio. The underwriting profit from
assumed reinsurance, which reflects our results on a net basis after the effect
of ceded reinsurance, was $134,000 in the three months ended September 30, 2004
compared to $65,000 in the same period in 2003. The net combined ratio was 58.7%
in the third quarter of 2004 as compared to 61.2% in the same period of 2003.
The gross combined ratio decreased to 46.3% during the three months ended
September 30, 2004 compared to 70.2% in the same period of 2003. This resulted
from the decrease in the gross loss ratio for the three months ended September
30, 2004 to 33.7% compared to 57.2% for the same period in 2003 due to increased
pricing on 2004 policy year treaties and favorable reserve development on prior
years reserves and a decrease in the gross underwriting expense ratio to 12.6%
for the three months ended September 30, 2004 compared to 13.0% in the same
period last year.
Reinsurance Segment Results of Operations Nine Months Ended September 30, 2004
and 2003
Gross premiums. Gross written premiums written increased by 31.9% to $1.1
million for the nine months ended September 30, 2004 as compared with $0.8
million in the same period 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 83.8% to $125,000 in the nine months
ended September 30, 2004 as compared with $770,000 for the same period in 2003
as we no longer cede business in this segment to our quota share treaty
reinsurers.
28
Tower Group, Inc.
Management's Discussion and Analysis of Financial Condition and Results of
Operations (Continued)
Net premiums written increased 52.9% to $1.0 million compared with $0.7
million in the same period in 2003 due to the increased rates on 2004 treaties.
Net premiums earned increased by 132.1% to $824,000 in the nine months ended
September 30, 2003 as compared with $355,000 in the same period in 2003 because
we have discontinued ceding premiums in this segment to our quota share treaty
reinsurers.
Loss and loss adjustment expenses and loss ratio. For the nine months ended
September 30, 2004 gross loss and loss adjustment expenses were $424,000
compared with $644,000 in the same period in 2003. Net losses increased in the
nine months ended September 30, 2004 to $444,000 as compared to $207,000 in the
same period in 2003 due to the discontinuance of ceding business to the quota
share treaty. The gross loss ratio decreased in the nine months ended September
30, 2004 to 44.7% as compared to 57.2% in the same period in 2003. This
improvement resulted from increased pricing on 2004 policy year treaties and
favorable development on prior year's loss reserves of $43,000, which reduced
the gross loss ratio.
The net loss ratio decreased in the nine months ending September 30, 2004
to 53.9% as compared to 58.3% in the same period in 2003 due principally to the
improvement in the gross loss ratio.
Underwriting expenses and underwriting expense ratios. For the nine months
ended September 30, 2004 gross underwriting expenses increased to $177,000 as
compared to $143,000 in the same period 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 21.5% in the nine months ended September 30, 2004 compared to a negative
22.6% in the same period in 2003.The negative underwriting expense ratio in the
first nine months of 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. For the nine months ended September
30, 2004 the underwriting profit from assumed reinsurance was $203,000 compared
to $228,000 in the same period in 2003. The net combined ratio was 75.4% in the
nine months ending September 30, 2004 compared to 35.7% in the same period of
2003. The net combined ratio in the nine months ending September 30, 2004 was
affected by the absence of ceding commission revenue.
The gross combined ratio decreased to 63.3% for the first nine months of
2004 compared to 69.9% for the same period in 2003 due to a reduction in the
gross loss ratio to 44.7% in the first nine months of 2004 compared to 57.2% in
the same period in 2003. This was offset by an increase in the gross
underwriting expense ratio to 18.7% in the first nine months of 2004 compared to
12.7% in the same period for 2003 due to increased gross written premiums which
increases the allocation of underwriting expenses to this segment.
29
Tower Group, Inc.
Management's Discussion and Analysis of Financial Condition and Results of
Operations (Continued)
Insurance Services Segment Results of Operations
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ----------------------
Revenue 2004 2003 2004 2003
---- ---- ---- ----
Direct commission revenue from managing
general agency $ 2,043 $ 2,080 $ 7,095 $ 4,586
Claims administration revenue 1,352 876 3,067 2,794
Reinsurance intermediary fees 178 458 615 800
Policy billing fees 3 - 4 -
--------- -------- --------- --------
Total Revenues 3,576 3,414 10,781 8,180
--------- -------- --------- --------
Expenses
Direct commissions expense paid to producers 1,438 1,341 4,875 3,107
Other insurance services expenses 576 487 1,937 1,256
Claims expense reimbursement to TICNY 1,345 863 2,987 2,753
--------- -------- --------- --------
Total Expenses 3,359 2,691 9,799 7,116
--------- -------- --------- --------
Insurance Services Pre-Tax Income $ 217 $ 723 $ 982 $ 1,064
========= ======== ========= ========
Premium produced by TRM on behalf of issuing $ 10,285 $ 9,948 $ 35,289 $ 2,474
companies
Insurance Services Results of Operations Three Months Ended September 30, 2004
and 2003
Total revenues. Total revenue for the insurance services segment were $3.6
million in the three months ended September 30, 2004 as compared with $3.4
million in the same period in 2003. The principle components of total revenue
for our insurance services segment are direct commission revenue, claims
administration revenue and reinsurance intermediary fees. The increase in total
revenue was primarily due to claims administration revenue that increased by
54.3% to $1.4 million in the three months ended September 30, 2004 compared to
$0.9 million in the same period in 2003. The increase in claims administration
revenue was offset by a reduction in reinsurance intermediary fees in the third
quarter of 2004 to $0.2 million compared to $0.5 million in the same period in
2003 as a result of additional reinsurance intermediary fees recorded in the
third quarter of 2003 pertaining to reinsurance arrangements in 2002.
Direct commission revenue is dependent upon the premiums and losses on
business produced by TRM on behalf of its issuing companies. The decrease in
direct commission revenue is related to premiums produced by our managing
general agency on behalf of issuing companies. Although premiums produced
increased 3.4% to $10.3 million in the three months ended 2004 compared to $9.9
million in the same period of 2003 the composite direct commission revenue rate
decreased to 19.9% in the three months ended September 30, 2004 compared to
20.9% in the same period in 2003 due to a reduction in large lines premiums
produced and its related lower direct commission rate. The large lines premiums
produced were $3.6 million in the three months ended September 30, 2004 compared
to $6.9 million in the third quarter of 2003.
Direct commission expense. TRM's direct commission expense rate was 14.0%
in the three months ended September 30, 2004 as compared to 13.5% in the same
period in 2003. This was due to an increase in the small business overflow
program, which has a higher direct commission rate.
Other insurance services expenses. The amount of reimbursement for
underwriting expenses by TRM to TICNY was $ 0.6 million in the three months
ended September 30, 2004 as compared to $0.5 million in the same period in 2003.
The increase resulted from the increase in premiums produced.
30
Tower Group, Inc.
Management's Discussion and Analysis of Financial Condition and Results of
Operations (Continued)
Claims expense reimbursement. The amount of reimbursement by TRM for claims
administration pursuant to the terms of the expense sharing agreement with TICNY
was $1.3 million in the three months ended September 30, 2004 as compared with
$0.9 million in the same period in 2003 due to an increase in the number of
claims handled.
Pre-tax income. Our insurance services pre- tax income was $217,000 in the
three months ended September 30, 2004 as compared to $723,000 in the same period
in 2003. The lower pre-tax income was due principally to lower reinsurance
intermediary fees in the third quarter of 2004 compared to 2003 and an increase
in other insurance services expenses.
Insurance Services Results of Operations Nine Months Ended September 30, 2004
and 2003
Total Revenues. For the nine months ended September 30, 2004 total revenues
for the insurance services segment were $10.8 million compared with $8.2 million
in the same period in 2003. The increase in total revenue was primarily due to
direct commission revenue that increased by 54.7% to $7.1 million in 2004 as
compared to $4.6 million in the same period in 2003. The increase also resulted
from claims administration revenue that increased to $3.1 million in the nine
month ending September 30, 2004 from $2.8 million in the same period of 2003.
The increase in revenue from direct commission revenue and claims administration
revenue was offset by a reduction in reinsurance intermediary fees that
decreased by 23.1% to $0.6 million in the nine months ending September 30, 2004
as compared with $0.8 million in the same period in 2003 primarily as a result
of additional reinsurance intermediary fees recorded in the first nine months of
2003 pertaining to reinsurance arrangements in 2002.
Direct commission revenue is dependent upon the premiums and losses on
business produced by TRM on behalf of its issuing companies. For the nine-month
period 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 50.3% to $35.3 million for the nine months ended September 30, 2004 as
compared to $23.5 million in the same period in 2003 resulting primarily from
increases in premiums produced in the large lines and middle markets programs
and the implementation of TRM's small business overflow program. The composite
commission revenue rate increased to 20.1% in the nine months ending September
30, 2004 from 19.5% in the same period in 2003 due to an increase in large lines
premiums produced and its related higher direct commission rate.
Direct commission expense. For the nine months ended September 30, 2004
TRM's direct commission expense rate was 13.8% compared to 13.2% in the same
period in 2003. This was due to an increase in the small business overflow
program, which has a higher commission rate.
Other insurance services expense. For the nine months ended September 30,
2004 the amount of reimbursement for underwriting expenses by TRM to TICNY was
$1.9 million as compared to $1.3 million in the same period in 2003. The
increase resulted from the increase in premiums produced.
Claims expense reimbursement. For the nine months ended September 30, 2004
the amount of reimbursement by TRM for claims administration pursuant to the
terms of the expense sharing agreement was $3.0 million compared with $2.8
million in the same period in 2003 due to an increase in the number of claims
handled.
31
Tower Group, Inc.
Management's Discussion and Analysis of Financial Condition and Results of
Operations (Continued)
Pre-tax income. For the nine months ended September 30, 2004, pre-tax
income decreased 7.7% to $982,000 as compared to $1,064,000 for the same period
in 2003. The decrease was due to lower reinsurance intermediary fees in the
third quarter of 2004 compared to 2003.
Liquidity and Capital Resources
Cash Flows. For the nine months ended September 30, 2004 net cash provided
by operating activities was $60.9 million compared to operating cash flow of
$3.4 million in the same period of 2003. The increase in net cash provided by
operations in the nine months ending September 30, 2004 resulted from an
increase in collected premiums as a result of the growth in gross premiums and
the reduction in the quota share reinsurance ceding percentage from 70% in 2003
to 60% in 2004, an increase of $22.5 million in funds withheld as collateral for
reinsurance recoverable and a $15.7 million collection of a receivable for
cancelled reinsurance.
Cash flow needs at the Holding Company level are primarily for dividends to
its shareholders, interest payments on its $20 million of subordinated
debentures, interest payments on its approximately $5.0 million of long term
debt and dividend payments on its $1.5 million of mandatorily redeemable
preferred stock required by an accounting change adopted on July 1, 2003 to be
reported as interest expense rather than as a reduction to stockholders' equity.
The Company receives cash from long term borrowings, issuance of equity
securities and dividends from subsidiaries.
The operating subsidiaries primary sources of cash are from net premiums
received; commission and fee income; net investment income and proceeds from the
sale and redemption of both equity and fixed-maturity securities. Cash is used
to pay claims and operating expenses, to purchase investments and to pay
dividends to the parent. TICNY is subject to significant regulatory restrictions
limiting its ability to declare and pay dividends. As of September 30, 2004, the
maximum amount of distributions that TICNY could pay to its parent without
approval of the New York Insurance Department was $2.6 million.
32
On October 20, 2004 Tower Group, Inc.'s registration statement was declared
effective by the Securities and Exchange Commission. The Company initial public
offering was for 13,000,000 shares and was priced at $8.50 per share. The
Company received net cash proceeds of $102,115,773 from this offering after the
underwriting discounts, commissions and certain offering expenses. The Company
and certain of its stockholders have granted the underwriters the option to
purchase up to 1,950,000 additional shares to cover the over-allotment. The
stock is trading on the NASDAQ National Market under the trading symbol "TWGP".
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 public
offering, at the public offering price of $8.50 per share. The Company received
net cash proceeds of $3,952,500 after deducting underwriting fees.
Immediately before the closing of the public offering on October 26, 2004,
the Company redeemed 30,000 shares, Series A Cumulative Redeemable Preferred
Shares for $1.5 million plus accrued interest. After the closing the Company
utilized some of the cash proceeds to pay off a $5.0 million loan and accrued
interest to CIT Group/Equipment Financing, Inc. The Company will recognize a
loss on early extinguishment of debt of approximately $133,000 in the fourth
quarter of 2004.
On October 26, 2004 the Company contributed $98,000,000 in Paid in Capital
to its wholly owned affiliate Tower Insurance Company of New York.
On November 10, 2004 the underwriters exercised their 30-day over-allotment
option after the Company's public offering on October 20, 2004. Pursuant to the
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 public offering price of $8.50 per share, less the
underwriting discount, to cover the over-allotments. The Company will receive
net case proceeds of $4,972,301 from this over-allotment option after the
underwriting discounts. The Company will not receive any proceeds from the sale
of common stock by any selling stockholder. The closing is expected to occur on
November 15, 2004.
Investments
The investment portfolio provides a high degree of liquidity since it is
comprised of readily marketable equity, fixed income and short-term securities.
The Company classifies its investments in fixed maturity securities as available
for sale and reports these securities at their estimated fair values based on
quoted market prices. 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, net of
deferred taxes. Realized gains and losses are charged or credited to income in
the period in which they are realized.
The aggregate fair market value of our invested assets as of September 30,
2004 was $129.2 million. As of that date, our fixed maturity securities had a
fair market value of $117.7 million and amortized cost of $116.5 million. The
equity securities had a fair value of $2.1 million and a cost of $1.9 million.
33
PART 1 - FINANCIAL INFORMATION
Item 3. Quantitative and Qualitative Disclosures About Market Risk
There have been no material changes in the Company's market risk during the
quarter and nine months ended September 30, 2004. Market risk relates to changes
in the value of financial instruments that arise from adverse movements in
factors such as interest rates and equity prices. The Company is exposed mainly
to changes in interest rates that affect the fair value of its investment in
securities. Please refer to Form S-1 page 67 for a discussion of interest rate
risk and the Company's sensitivity analysis model that uses fair value to
measure its potential gain or loss due to a 100 basis point decline in interest
rates or a 100 basis point rise.
Item 4. Controls 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 quarterly 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.
PART II - OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
Unregistered Sales of Equity Securities
On September 29, 2004, the Company issued options to purchase 161,077
shares of its common stock under its 2004 Long-Term Equity Compensation Plan to
various executive officers. Also on September 29, 2004, 68,832 shares of
restricted stock were issued to various employees and officers. There were no
underwriters involved in these issuances, which were made in reliance on Rule
701 under the Securities Act.
On August 1, 2004, 131,888 shares of restricted stock were issued to
Michael H. Lee, the Company's Chief Executive Officer, and 8,793 shares of
restricted stock were issued to Francis M. Colalucci, the Company's Chief
Financial Officer. The shares of restricted stock issued to Mr. Lee will vest in
equal installments over a four year period. The shares of restricted stock
issued to Mr. Colalucci will vest in installments over a two and half year
period. There were no underwriters involved in these issuances, which were made
in reliance on Rule 701 under the Securities Act.
34
Use of Proceeds
Immediately before the closing of the public offering on October 26, 2004,
the Company redeemed 30,000 shares of its Series A Cumulative Redeemable
Preferred Shares for $1.5 million plus any accrued interest. After the closing
the Company utilized some of the cash proceeds to pay off a $5.0 million loan
and accrued interest to CIT Group/Equipment Financing, Inc. The Company will
recognize a loss on early extinguishment of debt of approximately $133,000 in
the fourth quarter of 2004.
On October 26, 2004 the Company contributed $98,000,000 in Paid in Capital
to its wholly owned affiliate Tower Insurance Company of New York.
Item 4. Submission of Matters to a Vote of Security Holders.
On August 26, 2004 the Company's Board of Directors adopted the "2004
Long-Term Equity Compensation Plan" which was approved by written consent by all
of the outstanding Class A Common Stockholders and Class B Common Stockholders
of record as of August 26, 2004.
Item 6. Exhibits
Exhibits
31.1 Chief Executive Officer-Sarbanes-Oxley Act of 2002 Section 302
31.2 Chief Financial Officer-Sarbanes-Oxley Act of 2002 Section 302
32.1 Chief Executive Officer-Sarbanes-Oxley Act of 2002 Section 906
32.2 Chief Executive Officer-Sarbanes-Oxley Act of 2002 Section 906
35
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registration has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Tower Group Inc.
------------------------
Registrant
Date: November 15, 2004 /s/ Michael H. Lee
----------------- ------------------------
Chairmen of the Board,
President and Chief
Executive Officer
Date: November 15, 2004 /s/ Francis M. Colalucci
------------------- ------------------------
Senior Vice President,
Chief Financial Officer and
Treasurer
36