Tower Group International (TWGP) 10-Q 2010 Q3 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

þ Quarterly Report Pursuant To Section 13 or 15(d) of the Securities Exchange Act Of 1934

For the quarterly period ended September 30, 2010

o Transition Report Pursuant 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 incorporation or organization)	(I.R.S. Employer Identification No.)
120 Broadway, 31st Floor New York, NY	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.þ Yeso No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T ( § 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).þ Yeso No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filerþ Accelerated filero Non-accelerated filero(Do not check if a smaller reporting company) Smaller reporting companyo

Indicate by check mark whether the registrant is a shell company (as defined in rule 12b-2 of the Exchange Act).o Yesþ No

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 41,525,941 shares of common stock, par value $0.01 per share, as of November 5, 2010.

Tower Group, Inc.
Quarterly Report on Form 10-Q
For the Period Ended September 30, 2010

INDEX	Page
PART I FINANCIAL INFORMATION
Item 1. Financial Statements of Tower Group, Inc.
Consolidated Balance Sheets (Unaudited) — September 30, 2010 and December 31, 2009	1
Consolidated Statements of Income and Comprehensive Income (Unaudited) — Three and Nine Months Ended September 30, 2010 and 2009	2
Consolidated Statements of Changes in Stockholders’ Equity (Unaudited) — Nine Months Ended September 30, 2010 and 2009	3
Consolidated Statements of Cash Flows (Unaudited) — Nine Months Ended September 30, 2010 and 2009	4
Notes to Consolidated Financial Statements (Unaudited)	6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	30
Item 3. Quantitative and Qualitative Disclosures About Market Risk	48
Item 4. Controls and Procedures	49
PART II OTHER INFORMATION
Item 1. Legal Proceedings	50
Item 1A. Risk Factors	50
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	50
Item 6. Exhibits	51
SIGNATURES	52

Part I — FINANCIAL INFORMATION

Item 1. Financial Statements

Tower Group, Inc.

Consolidated Balance Sheets

(Unaudited)

	September 30,			December 31,
($ in thousands, except par value and share amounts)	2010			2009
Assets
Investments — Tower
Available-for-sale investments, at fair value:
Fixed-maturity securities (amortized cost of $2,058,448 and $1,729,117)	$	2,189,524		$	1,783,596
Equity securities (cost of $37,105 and $78,051)		40,480			76,733
Short-term investments (cost of $26,656 and $36,500)		26,902			36,500
Investments — Reciprocal Exchanges
Available-for-sale investments, at fair value:
Fixed-maturity securities (amortized cost of $306,832)		316,602			—
Total available-for-sale investments, at fair value		2,573,508			1,896,829
Cash and cash equivalents (includes $11,675 relating to Reciprocal Exchanges in 2010)		118,436			164,882
Investment income receivable (includes $833 relating to Reciprocal Exchanges in 2010)		26,264			20,240
Premiums receivable (includes $35,948 relating to Reciprocal Exchanges in 2010)		361,030			308,075
Reinsurance recoverable on paid losses (includes $7,245 relating to Reciprocal Exchanges in 2010)		27,084			14,819
Reinsurance recoverable on unpaid losses (includes $17,460 relating to Reciprocal Exchanges in 2010)		299,970			199,687
Prepaid reinsurance premiums (includes $17,284 relating to Reciprocal Exchanges in 2010)		90,510			94,818
Deferred acquisition costs, net (includes $19,185 relating to Reciprocal Exchanges in 2010)		230,775			170,652
Deferred income taxes		—			41,757
Intangible assets (includes $5,702 relating to Reciprocal Exchanges in 2010)		114,808			53,350
Goodwill		249,404			244,690
Other assets (includes $8,206 relating to Reciprocal Exchanges in 2010)		197,569			103,153
Total assets	$	4,289,358		$	3,312,952
Liabilities
Loss and loss adjustment expenses (includes $181,439 relating to Reciprocal Exchanges in 2010)	$	1,632,361		$	1,131,989
Unearned premium (includes $111,413 relating to Reciprocal Exchanges in 2010)		873,122			658,940
Reinsurance balances payable (includes $9,719 relating to Reciprocal Exchanges in 2010)		57,176			89,080
Funds held under reinsurance agreements		78,358			13,737
Other liabilities (includes $22,916 relating to Reciprocal Exchanges in 2010)		143,954			133,647
Deferred income taxes (includes $4,634 relating to Reciprocal Exchanges in 2010)		3,795			—
Debt		373,637			235,058
Total liabilities		3,162,403			2,262,451
Contingencies (Note 16)
Stockholders’ equity
Common stock ($0.01 par value; 100,000,000 shares authorized, 45,592,109 and
45,092,321 shares issued, and 41,525,941 and 44,984,953 shares outstanding)		456			451
Treasury stock (4,066,168 and 107,368 shares)		(87,303	)		(1,995	)
Paid-in-capital		759,598			751,878
Accumulated other comprehensive income		87,560			34,554
Retained earnings		333,628			265,613
Tower Group, Inc. stockholders’ equity		1,093,939			1,050,501
Noncontrolling interests — Reciprocal Exchanges		33,016			-
Total stockholders’ equity		1,126,955			1,050,501
Total liabilities and stockholders’ equity	$	4,289,358		$	3,312,952

See accompanying notes to the consolidated financial statements.

1

Tower Group, Inc.

Consolidated Statements of Income and Comprehensive Income

(Unaudited)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(in thousands, except per share amounts)	2010			2009			2010			2009
Revenues
Net premiums earned	$	378,779		$	223,978		$	919,792		$	621,519
Ceding commission revenue		10,916			6,933			29,557			27,674
Insurance services revenue		1,116			270			1,922			4,253
Policy billing fees		1,896			871			3,677			2,191
Net investment income		29,294			21,733			76,400			53,683
Net realized investment gains (losses)
Other-than-temporary impairments		(4,953	)		(19,451	)		(13,935	)		(34,322	)
Portion of loss recognized in other comprehensive income		4,400			7,761			10,120			15,278
Other net realized investment gains		2,270			14,245			11,438			21,369
Total net realized investment gains		1,717			2,555			7,623			2,325
Total revenues		423,718			256,340			1,038,971			711,645
Expenses
Loss and loss adjustment expenses		231,463			120,839			560,668			330,922
Direct and ceding commission expense		81,173			50,289			197,837			150,238
Other operating expenses		52,199			31,631			142,126			89,794
Acquisition-related transaction costs		148			1,987			1,398			13,335
Interest expense		6,192			5,055			16,287			13,497
Total expenses		371,175			209,801			918,316			597,786
Other income (expense)
Equity in loss of unconsolidated affiliate		—			—			—			(777	)
Gain on investment in acquired unconsolidated affiliate		—			—			—			7,388
Other expense		—			—			(466	)		—
Income before income taxes		52,543			46,539			120,189			120,470
Income tax expense		18,022			16,561			39,939			41,888
Net income	$	34,521		$	29,978		$	80,250		$	78,582
Less: Net income attributable to Reciprocal Exchanges		814			—			814			—
Net income attributable to Tower Group, Inc.	$	33,707		$	29,978		$	79,436		$	78,582
Net income	$	34,521		$	29,978		$	80,250		$	78,582
Gross unrealized investment holding gains arising during periods		55,667			67,113			98,941			115,672
Cumulative effect of adjustment resulting from adoption of new accounting guidance		—			—			—			(2,497	)
Equity in net unrealized gains on investment in unconsolidated affiliate’s investment portfolio		—			—			—			3,124
Less: Reclassification adjustment for gains included in net income		(1,717	)		(2,555	)		(7,623	)		(2,325	)
Income tax (expense) related to items of other comprehensive income		(18,882	)		(20,934	)		(31,961	)		(37,507	)
Comprehensive income	$	69,589		$	73,602		$	139,607		$	155,049
Less: Comprehensive income attributable to Reciprocal Exchanges		6,351			—			6,351			-
Comprehensive income attributable to Tower Group, Inc.		63,238			73,602			133,256			155,049
Earnings per share attributable to Tower stockholders:
Basic	$	0.79		$	0.74		$	1.81		$	2.05
Diluted	$	0.78		$	0.74		$	1.79		$	2.04
Weighted average common shares outstanding:
Basic		42,924			40,482			44,106			38,248
Diluted		43,098			40,701			44,294			38,462
Dividends declared and paid per common share	$	0.13		$	0.07		$	0.27		$	0.19

See accompanying notes to the consolidated financial statements.

2

Tower Group, Inc.

Consolidated Statements of Changes in Stockholders’ Equity

(Unaudited)

											Accumulated						Noncontrolling
											Other						Interests -		Total
	Common Stock				Treasury			Paid-in			Comprehensive			Retained			Reciprocal		Stockholders’
(in thousands)	Shares		Amount		Stock			Capital			Income			Earnings			Exchanges		Equity
Balance at December 31, 2009		45,092	$	451	$	(1,995	)	$	751,878		$	34,554		$	265,613		$	—	$	1,050,501
Dividends declared		—		—		—			—			—			(11,421	)		—		(11,421	)
Stock based compensation		500		5		(1,441	)		6,810			—			—			—		5,374
Repurchase of common stock		—		—		(83,867	)		—			—			—			—		(83,867	)
Reciprocal Exchanges equity on July 1, 2010, date of consolidation		—		—		—			—			—			—			25,851		25,851
Equity component of convertible senior notes issuance, net of tax and issue costs		—		—		—			7,055			—			—			—		7,055
Convertible senior notes hedge transaction, net of tax		—		—		—			(9,945	)		—			—			—		(9,945	)
Warrants issued related to convertible senior notes		—		—		—			3,800			—			—			—		3,800
Net income		—		—		—			—			—			79,436			814		80,250
Net unrealized appreciation on securities available for sale, net of income tax		—		—		—			—			53,006			—			6,351		59,357
Balance at September 30, 2010		45,592		456		(87,303	)		759,598			87,560			333,628			33,016		1,126,955
Balance at December 31, 2008		23,408		234		(1,026	)		208,094			(37,498	)		165,400			—		335,204
Cumulative effect of adjustment resulting from adoption of new accounting guidance		—		—		—			—			(1,623	)		1,623			—		—
Dividends declared		—		—		—			—			—			(7,591	)		—		(7,591	)
Stock based compensation		283		2		(429	)		5,056			—			—			—		4,629
Issuance of common stock		16,870		169		—			421,454			—			—			—		421,623
Fair value of outstanding CastlePoint stock options		—		—		—			9,138			—			—			—		9,138
Warrant exercise		—		—		90			(90	)		—			—			—		—
Net income		—		—		—			—			—			78,582			—		78,582
Net unrealized appreciation on securities available for sale, net of income tax		—		—		—			—			78,090			—			—		78,090
Balance at September 30, 2009		40,561	$	405	$	(1,365	)	$	643,652		$	38,969		$	238,014		$	—	$	919,675

See accompanying notes to the consolidated financial statements.

3

Tower Group, Inc.

Consolidated Statements of Cash Flows
(Unaudited)

	Nine Months Ended
	September 30,
($ in thousands)	2010			2009
Cash flows provided by (used in) operating activities:
Net income	$	80,250		$	78,582
Adjustments to reconcile net income to net cash provided by (used in) operations:
Gain on investment in acquired unconsolidated affiliate		—			(7,388	)
Net realized investment (gains) losses		(7,623	)		(2,325	)
Depreciation and amortization		16,472			13,629
Amortization of bond premium or discount		(4,974	)		(633	)
Amortization of restricted stock		6,394			4,504
Deferred income taxes		22,355			2,429
Excess tax benefits from share-based payment arrangements		563			(82	)
(Increase) decrease in assets:
Investment income receivable		(5,992	)		(5,448	)
Premiums receivable		33,993			178,907
Reinsurance recoverable		(56,781	)		164,279
Prepaid reinsurance premiums		32,141			143,728
Deferred acquisition costs, net		(19,330	)		(20,013	)
Other assets		(31,376	)		20,545
Increase (decrease) in liabilities:
Loss and loss adjustment expenses		98,103			(145,396	)
Unearned premium		(22,174	)		(82,677	)
Reinsurance balances payable		(37,874	)		(158,423	)
Funds held under reinsurance agreements		64,621			(19,977	)
Other liabilities		(37,187	)		(30,646	)
Net cash flows provided by operations		131,581			133,595
Cash flows provided by (used in) investing activities:
Net cash acquired from acquisition of CastlePoint		—			242,338
Acquisition of Hermitage, net of cash acquired		—			(42,218	)
Acquisition of OBPL, net of cash acquired		(151,884	)		—
Purchase of fixed assets		(28,803	)		(17,572	)
Purchase — fixed-maturity securities		(2,124,199	)		(834,375	)
Purchase — equity securities		(29,968	)		(82,260	)
Short-term investments, net		536,478			(17,188	)
Sale or maturity — fixed-maturity securities		1,513,946			593,192
Sale — equity securities		69,141			46,243
Net cash flows provided by (used in) investing activities		(215,289	)		(111,840	)
Cash flows provided by (used in) financing activities:
Proceeds from credit facility borrowings		56,000			—
Repayment of credit facility borrowings		(56,000	)		—
Proceeds from convertible senior notes		145,634			—
Payments for convertible senior notes hedge		(15,300	)		—
Proceeds from issuance of warrants		3,800			—
Exercise of stock options and warrants		420			556
Excess tax benefits from share-based payment arrangements		(563	)		82
Treasury stock acquired-net employee share-based compensation		(1,441	)		(429	)
Repurchase of Common Stock		(83,867	)		—
Dividends paid		(11,421	)		(7,592	)
Net cash flows (used in) financing activities		37,262			(7,383	)
Increase (decrease) in cash and cash equivalents		(46,446	)		14,372
Cash and cash equivalents, beginning of period		164,882			136,253
Cash and cash equivalents, end of period	$	118,436		$	150,625

See accompanying notes to the consolidated financial statements. (Continued)

4

Tower Group, Inc.
Consolidated Statements of Cash Flows — (Continued)
(Unaudited)

	Nine Months Ended
	September 30,
	2010		2009
Supplemental disclosures of cash flow information:
Cash paid for income taxes	$	16,000	$	40,879
Cash paid for interest		13,444		13,766
Schedule of non-cash investing and financing activities:
Issuance of common stock in acquisition of CastlePoint	$	—	$	421,623
Value of CastlePoint stock options at date of acquisition		—		9,138

See accompanying notes to the consolidated financial statements.

5

Tower Group, Inc.

Notes to Consolidated Financial Statements(Unaudited)

Note 1—Nature of Business

Tower Group, Inc. (the “Company” or “Tower”), through its subsidiaries, offers a broad range of commercial, personal and specialty property and casualty insurance products and services to businesses in various industries and to individuals. The Company’s common stock is publicly traded on the NASDAQ Global Select Market under the symbol “TWGP”.

On July 1, 2010, the Company completed its acquisition of the Personal Lines Division of OneBeacon Insurance Group, Ltd. (“OBPL”). Subsequent to this acquisition, the Company changed the presentation of its business results, beginning July 1, 2010, by allocating the personal insurance business previously reported in the Brokerage Insurance segment along with the newly acquired OBPL business to a new Personal Insurance segment and merged the commercial business previously reported in either the Brokerage Insurance or Specialty Business segments in a new Commercial Insurance segment. The Company has retained its Insurance Services segment which includes fees earned by management companies, acquired as a part of the OBPL transaction. This change in presentation reflects the way management organizes the Company for making operating decisions and assessing profitability subsequent to the OBPL acquisition. This will result in the reporting of three operating segments. The prior period segment disclosures have been restated to conform to the current presentation.

Following the change in presentation described above, the Company now operates three business segments: Commercial Insurance, Personal Insurance and Insurance Services:

• Commercial Insurance (“Commercial”) Segment offers a broad range of commercial lines property and casualty insurance products to small to mid-sized businesses distributed through a network of retail and wholesale agents on both an admitted and non-admitted basis. This segment also includes reinsurance solutions provided primarily to small insurance companies. The reinsurance business has been de-emphasized effective January 1, 2010;

• Personal Insurance (“Personal”) Segment offers a broad range of personal lines property and casualty insurance products to individuals distributed through a network of retail and wholesale agents; and

• Insurance Services (“Services”) Segment provides underwriting, claims and reinsurance brokerage services to insurance companies.

Note 2—Accounting Policies and Basis of Presentation

Basis of Presentation

The accompanying unaudited consolidated financial statements included in this report have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Securities and Exchange Commission (“SEC”) Form 10-Q and Article 10 of SEC Regulation S-X. The principles for condensed interim financial information do not require the inclusion of all the information and footnotes required by GAAP for complete financial statements. Therefore, these financial statements should be read in conjunction with the consolidated financial statements as of and for the year ended December 31, 2009 and notes thereto included in the Annual Report on Form 10-K filed on March 1, 2010. The accompanying consolidated financial statements have not been audited by an independent registered public accounting firm in accordance with standards of the Public Company Accounting Oversight Board (United States) but, in the opinion of management, such financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the Company’s financial position, results of operations and cash flows.

The results of operations for the nine months ended September 30, 2010 may not be indicative of the results that may be expected for the year ending December 31, 2010. All significant inter-company transactions have been eliminated in consolidation.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Reclassifications

Certain amounts in the 2009 consolidated financial statements have been reclassified to conform to the 2010 presentation. None of these reclassifications had an effect on consolidated net earnings, total stockholders’ equity or cash flows. As disclosed in “Note 1 — Nature of Business”, the Company has restated its segments for 2009 to be consistent with the presentation in 2010.

6

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

Accounting Pronouncements

Accounting guidance adopted in 2010

In June 2009, the Financial Accounting Standards Board (“FASB”) issued new guidance which requires more information about transfers of financial assets, including securitization transactions, and where entities have continuing exposure to the risks related to transferred financial assets. This guidance eliminates the concept of a “qualifying special-purpose entity,” changes the requirements for derecognizing financial assets, and requires additional disclosures. The new guidance enhances information reported to users of financial statements by providing greater transparency about transfers of financial assets and an entity’s continuing involvement in transferred financial assets. The Company adopted this new guidance on January 1, 2010, with no material effects on its financial statements as of September 30, 2010.

In June 2009, the FASB issued new guidance which concerns the consolidation of variable interest entities and changes how a reporting entity determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a reporting entity is required to consolidate another entity is based on, among other things, the other entity’s purpose and design and the reporting entity’s ability to direct the activities of the other entity that most significantly affect the other entity’s economic performance. The new guidance requires a reporting entity to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement. A reporting entity is required to disclose how its involvement with a variable interest entity affects the reporting entity’s financial statements. The Company adopted this new guidance on January 1, 2010, with no material effects as of the date of adoption. As disclosed in “Note 4 — Variable Interest Entities (“VIEs”)”, the Company has determined that the Reciprocal Exchanges managed by the management companies acquired in the OBPL transaction qualify as VIEs and that the Company is their primary beneficiary. Accordingly, the Company has consolidated these VIEs in its financial statements as of and for the nine months ended September 30, 2010.

In January 2010, the FASB issued new guidance that requires additional disclosure of the fair value of assets and liabilities. This guidance requires additional disclosures to be made about significant transfers in and out of Levels 1 and 2 of the fair value hierarchy within GAAP. The Company adopted this guidance on January 1, 2010, with the required disclosure included in “Note 5 — Fair Value Measurements”.

Accounting guidance not yet effective

The guidance issued by the FASB in January 2010 also requires additional disclosure about the gross activity within Level 3 of the fair value hierarchy within GAAP as opposed to the net disclosure currently required. This disclosure will be effective for annual and interim periods beginning after December 15, 2010. As this guidance relates to disclosure rather than measurement of assets and liabilities, there will be no effect on the financial results or position of the Company. The Company will comply with this disclosure requirement when it becomes effective.

In October 2010, the FASB issued new guidance concerning the accounting for costs associated with acquiring or renewing insurance contracts. This guidance generally follows the model of that for loan origination costs. Under the new guidance, only direct incremental costs associated with successful insurance contract acquisitions or renewals would be deferrable. The guidance also states that advertising costs and indirect costs should be expensed as incurred. Although this guidance states that certain advertising costs that meet current accounting guidance could be deferred and treated as deferred acquisition costs (“DAC”), the Company does not currently record any advertising costs in DAC. This guidance will be effective for fiscal years beginning after December 15, 2011 with earlier adoption permitted as of the first day of a company’s fiscal year. The Company expects to early adopt this guidance as of January 1, 2011 and is currently assessing the impact on its financial statements. The following categories of acquisition costs are included within the September 30, 2010 caption “Deferred acquisition costs, net of deferred ceding commission revenue”:

7

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

($ in millions)
Commissions	$	154.8
Taxes and assessments		26.5
Other deferred acquisition expenses		69.9
Deferred ceding commission revenue		(20.4	)
Net deferred acquisition costs	$	230.8

The amount included in the category “other deferred acquisition expenses” will be significantly reduced as a result of the adoption of this guidance.

Note 3—Acquisitions

Acquisition of the OneBeacon Personal Lines Division

On July 1, 2010, Tower completed the OBPL acquisition pursuant to a definitive agreement (the “Agreement”) dated February 2, 2010 by and among the Company and OneBeacon Insurance Group (“OneBeacon”). This acquisition expanded Tower’s suite of personal lines insurance products to include private passenger automobile, homeowners, umbrella, and the signature package product, OneChoice CustomPac, which provides customers with one policy for all of their homeowners, auto and umbrella needs.

Under the terms of the Agreement, the Company acquired Massachusetts Homeland Insurance Company (“Homeland”), York Insurance Company of Maine (“York”) and two management companies (collectively the “Stock Companies”). The management companies are the attorneys-in-fact for Adirondack Insurance Exchange, a New York reciprocal insurer, and New Jersey Skylands Insurance Association, a New Jersey reciprocal insurer (together, the “Reciprocal Exchanges”). Tower purchased $102 million principal of surplus notes issued by the Reciprocal Exchanges (the “surplus notes”). In addition, Tower also reinsured the personal lines business written by other subsidiaries of OneBeacon not acquired by Tower. The total consideration paid for OBPL was $167 million.

Effective July 1, 2010, Tower entered into transition service agreements with OneBeacon whereby OneBeacon will provide certain information technology and operational support to Tower until such time that these processes are migrated to Tower. Expenses incurred under such transition service agreements were $7.0 million for the three months ended September 30, 2010.

Tower has consolidated OBPL as of July 1, 2010 and the purchase consideration has been allocated to the assets acquired and liabilities assumed, including separately identified intangible assets, based on their fair values as of the close of the acquisition, with the amounts exceeding the fair value recorded as goodwill. The goodwill consists largely of the synergies and economies of scale expected from combining the operations of the Company and OBPL.

Direct costs of the acquisition are accounted for separately from the business combination and are expensed as incurred. As the values of certain assets and liabilities are preliminary in nature, they are subject to adjustment as additional information is obtained, including, but not limited to, valuation of separately identifiable intangibles, fixed assets, deferred taxes and loss reserves. The valuations will be finalized within 12 months of the close of the acquisition. When the valuations are finalized, any changes to the preliminary valuation of assets acquired or liabilities assumed may result in adjustments to separately identifiable intangible assets and goodwill.

The following unaudited condensed balance sheet presents assets acquired and liabilities assumed with the OBPL acquisition, including the assets and liabilities of the Reciprocal Exchanges, based on their fair values and the fair value hierarchy level under GAAP as of July 1, 2010. See Note 4 for a description of accounting for the Reciprocal Exchanges.

8

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

														Stock
														Companies
											Reciprocal			and Surplus
($ in thousands)	Level 1		Level 2		Level 3			Total			Exchanges			Notes
Assets
Investments	$	—	$	531,619	$	—		$	531,619		$	292,773		$	238,846
Surplus notes		—		—		77,200			77,200			—			77,200
Cash and cash equivalents		9,030		—		—			9,030			9,023			7
Receivables		—		—		92,024			92,024			44,758			47,266
Prepaid reinsurance premiums		—		—		27,833			27,833			14,503			13,330
Reinsurance recoverable on paid losses		—		—		5,634			5,634			5,634			—
Reinsurance recoverable on unpaid losses		—		—		50,135			50,135			12,843			37,292
Deferred acquisition costs / VOBA		—		—		40,793			40,793			17,301			23,492
Deferred income taxes		—		—		10,781			10,781			6			10,775
Intangibles		—		—		65,800			65,800			5,900			59,900
Other assets		—		—		16,351			16,351			3,597			12,754
Liabilities
Loss and loss adjustment expenses		—		—		(402,270	)		(402,270	)		(171,495	)		(230,775	)
Unearned premium		—		—		(236,355	)		(236,355	)		(111,150	)		(125,205	)
Surplus notes		—		—		(77,200	)		(77,200	)		(77,200	)		—
Other liabilities		—		—		(24,612	)		(24,612	)		(20,642	)		(3,970	)
Net assets acquired								$	186,763		$	25,851			160,912
Purchase consideration															166,568
Goodwill														$	5,656

The Company incurred approximately $1.0 million of transaction costs, including legal, accounting, investment advisory and other costs directly related to the acquisition, which were expensed in the nine months ended September 30, 2010.

The Company is required to allocate goodwill to its reportable segments. All goodwill associated with the acquisition of OBPL has been allocated to the Personal Insurance segment.

For the three and nine months ended September 30, 2010, OBPL contributed revenue and earnings to the Company from its acquisition date as follows:

	Three and Nine
	Months Ended
($ in thousands)	September 30, 2010
Total revenue	$	64,060
Net income		4,659

Acquisition of Specialty Underwriters’ Alliance, Inc. (“SUA”)

On November 13, 2009, the acquisition of 100% of the issued and outstanding common stock of SUA, a specialty property and casualty insurance company for $106.7 million was completed. The purchase consideration consisted primarily of 4.4 million shares of Tower stock. The acquisition strengthened Tower’s regional presence in the Midwest.

Acquisition of the Renewal Rights of AequiCap Program Administrators Inc. (“AequiCap”)

On October 14, 2009, the acquisition of the renewal rights to the workers’ compensation business of AequiCap was completed. These renewal rights were purchased for $5.5 million in cash. The acquired business primarily consists of small, low to moderate hazard workers’ compensation policies in Florida. Most of the employees of AequiCap involved in the servicing of the workers’ compensation business became employees of the Company. The acquisition of this business strengthened the regional presence in the Southeast.

9

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

Acquisition of HIG, Inc. (“Hermitage”)

On February 27, 2009, the acquisition of Hermitage, a property and casualty insurance holding company, for $130.1 million in cash was completed. This transaction further expanded the wholesale distribution system nationally and established a network of retail agents in the Southeast.

Acquisition of CastlePoint Holding, Ltd. (“CastlePoint”)

On February 5, 2009 the acquisition of 100% of the issued and outstanding common stock of CastlePoint, a Bermuda exempted corporation, was completed. The consideration for this transaction was $491.4 million consisting of 16.9 million shares of Tower common stock with an aggregate value of $421.7 million, $4.4 million related to the fair value of unexercised warrants, and $65.3 million of cash. The Company issued 1.1 million employee stock options to replace the CastlePoint employee and director stock options as of the acquisition date. The value of the Company’s stock options attributed to the services rendered by the CastlePoint employees as of the acquisition date totaled $9.1 million and was included in the purchase consideration. This transaction has expanded and diversified revenues by accessing CastlePoint’s programs and risk sharing businesses.

In connection with recording the acquisition, the previous investment in CastlePoint was revalued resulting in a gain of $7.4 million, before income taxes. This gain was included in the Consolidated Statements of Income in the first quarter of 2009. There were $11.4 million of transaction costs, including legal, accounting, investment advisory and other costs directly related to the acquisition incurred, which were expensed in the first quarter of 2009.

Pro Forma Results of Operations

Selected unaudited pro forma results of operations, assuming the OBPL, SUA, AequiCap, Hermitage and CastlePoint acquisitions had occurred as of January 1, 2010 and 2009, respectively, are set forth below:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
($ in thousands)	2010		2009		2010		2009
Total revenue	$	423,718	$	366,405	$	1,133,404	$	1,014,083
Net income		34,441		34,996		89,969		95,139

Note 4—Variable Interest Entities (“VIEs”)

The Reciprocal Exchanges are policyholder-owned insurance carriers organized as unincorporated associations. Each policyholder insured by the Reciprocal Exchanges shares risk with the other policyholders. In the event of dissolution, policyholders would share any residual unassigned surplus in the same proportion as the amount of insurance purchased but are not subject to assessment for any deficit in unassigned surplus of the Reciprocal Exchanges. Through its management companies, Tower is the attorney-in-fact for the Reciprocal Exchanges and has the ability to direct their activities. Tower receives management fee income for the services provided to the Reciprocal Exchanges. The assets of the Reciprocal Exchanges can be used only to settle the obligations of the Reciprocal Exchanges and general creditors to their liabilities have no recourse with Tower as the primary beneficiary.

The Reciprocal Exchanges were originally capitalized by issuing surplus notes. The obligation to repay principal on the surplus notes is subordinated to all other liabilities including obligations to policyholders and claimants for benefits under insurance policies. Principal and interest on the surplus notes are repayable only with regulatory approval. New Jersey Skylands Insurance Association was capitalized with a $31.3 million surplus note issued in 2002. Adirondack Insurance Exchange was capitalized with a $70.7 million surplus note issued in 2006. As discussed in “Note 3 – Acquisitions” above, on July 1, 2010, the Company completed the acquisition of OBPL and acquired the surplus notes of the Reciprocal Exchanges. The Company has no ownership interest in the Reciprocal Exchanges.

The Company determined that each of the Reciprocal Exchanges qualifies as a VIE and that the Company is the primary beneficiary as it has both the power to direct the activities of the Reciprocal Exchanges that most significantly impact their economic performance and the obligation to absorb losses or receive benefits from the management services provided to the Reciprocal Exchanges. Accordingly, the Company consolidates these Reciprocal Exchanges and eliminates all intercompany balances and transactions with Tower.

10

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

For the three months ended September 30, the Reciprocal Exchanges recognized total revenues and total expenses of $50.3 million and $49.5 million, respectively, and had net income of $0.8 million.

Note 5—Investments

The cost or amortized cost and fair value of the Company’s invested assets, gross unrealized gains and losses, and other-than-temporary impairment losses as of September 30, 2010 and December 31, 2009 are summarized as follows:

	Cost or		Gross		Gross					Unrealized
	Amortized		Unrealized		Unrealized			Fair		OTTI
($ in thousands)	Cost		Gains		Losses			Value		Losses (1)
September 30, 2010
U.S. Treasury securities	$	44,332	$	1,801	$	—		$	46,133	$	—
U.S. Agency securities		90,871		1,585		(178	)		92,278		—
Municipal bonds		574,128		38,680		(225	)		612,583		—
Corporate and other bonds
Finance		301,347		20,872		(252	)		321,967		—
Industrial		589,394		36,468		(340	)		625,522		—
Utilities		52,215		4,445		(42	)		56,618		—
Commercial mortgage-backed securities		219,050		28,718		(2,337	)		245,431		(2,294	)
Residential mortgage-backed securities
Agency backed securities		423,335		10,632		(746	)		433,221		(422	)
Non-agency backed securities		29,554		3,403		(1,731	)		31,226		(1,603	)
Asset-backed securities		41,054		626		(533	)		41,147		(491	)
Total fixed-maturity securities		2,365,280		147,230		(6,384	)		2,506,126		(4,810	)
Preferred stocks, principally financial sector		36,795		3,554		(179	)		40,170		—
Common stocks		310		—		—			310		—
Short-term investments		26,656		246		—			26,902		—
Total, September 30, 2010	$	2,429,041	$	151,030	$	(6,563	)	$	2,573,508	$	(4,810	)
Tower	$	2,122,209	$	141,255	$	(6,558	)	$	2,256,906	$	(4,810	)
Reciprocal Exchanges		306,832		9,775		(5	)		316,602		—
Total, September 30, 2010	$	2,429,041	$	151,030	$	(6,563	)	$	2,573,508	$	(4,810	)
December 31, 2009
U.S. Treasury securities	$	73,281	$	235	$	(225	)	$	73,291	$	—
U.S. Agency securities		40,063		134		(214	)		39,983		—
Municipal bonds		508,204		18,241		(730	)		525,715		—
Corporate and other bonds
Finance		174,971		11,150		(1,390	)		184,731		—
Industrial		371,848		13,225		(1,334	)		383,739		—
Utilities		43,154		3,559		(62	)		46,651		—
Commercial mortgage-backed securities		195,580		16,603		(8,736	)		203,447		(7,713	)
Residential mortgage-backed securities
Agency backed securities		283,403		6,245		(963	)		288,685		—
Non-agency backed securities		27,597		2,772		(2,924	)		27,445		(1,948	)
Asset-backed securities		11,016		214		(1,321	)		9,909		(1,301	)
Total fixed-maturity securities		1,729,117		72,378		(17,899	)		1,783,596		(10,962	)
Preferred stocks, principally financial sector		77,536		919		(2,165	)		76,290		—
Common stocks		515		78		(150	)		443		—
Short-term investments		36,500		—		—			36,500		—
Total, December 31, 2009	$	1,843,668	$	73,375	$	(20,214	)	$	1,896,829	$	(10,962	)

(1) Represents the gross unrealized loss on other-than-temporarily impaired securities recognized in accumulated other comprehensive income (loss).

11

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

Major categories of net investment income are summarized as follows:

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
($ in thousands)	2010			2009			2010			2009
Income
Fixed-maturity securities	$	23,200		$	20,362		$	69,661		$	51,910
Equity securities		1,232			1,684			3,769			2,233
Cash and cash equivalents		6,280			95			6,461			919
Other		132			139			406			412
Total		30,844			22,280			80,297			55,474
Expenses
Investment expenses		(1,550	)		(547	)		(3,897	)		(1,791	)
Net investment income	$	29,294		$	21,733		$	76,400		$	53,683
Tower	$	26,628		$	21,733		$	73,734		$	53,683
Reciprocal Exchanges		2,665			—			2,665			—
Net investment income	$	29,294		$	21,733		$	76,400		$	53,683

Proceeds from the sale and maturity of fixed-maturity securities were $1.5 billion and $593.2 million for the nine months ended September 30, 2010 and 2009, respectively. Proceeds from the sale of equity securities were $69.1 million and $46.2 million for the nine months ended September 30, 2010 and 2009, respectively.

Gross realized gains, losses and impairment write-downs on investments are summarized as follows:

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
($ in thousands)	2010			2009			2010			2009
Fixed-maturity securities
Gross realized gains	$	2,968		$	14,163		$	18,023		$	21,279
Gross realized losses		(698	)		(11	)		(4,813	)		(335	)
		2,270			14,152			13,210			20,944
Equity securities
Gross realized gains		—			123			270			516
Gross realized losses		—			(30	)		(2,042	)		(91	)
		—			93			(1,772	)		425
Net realized gains on investments		2,270			14,245			11,438			21,369
Other-than-temporary impairment losses:
Fixed-maturity securities		(553	)		(11,690	)		(3,815	)		(19,044	)
Total net realized investment gains (losses)	$	1,717		$	2,555		$	7,623		$	2,325
Tower	$	1,292		$	2,555		$	7,198		$	2,325
Reciprocal Exchanges		425			—			425			—
Total net realized investment gains (losses)	$	1,717		$	2,555		$	7,623		$	2,325

Management may dispose of a particular security due to changes in facts and circumstances related to the invested asset that have arisen since the last analysis supporting management’s determination whether or not it intended to sell the security, and if not, whether it is more likely than not that the Company would be required to sell the security before recovery of its amortized cost basis.

Impairment Review

Management regularly reviews the Company’s fixed-maturity and equity security portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. In evaluating potential impairment, management considers, among other criteria: (i) the overall financial condition of the issuer, (ii) the current fair value compared to amortized cost or cost, as appropriate; (iii) the length of time the security’s fair value has been below amortized cost or cost;

12

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

(iv) specific credit issues related to the issuer such as changes in credit rating, reduction or elimination of dividends or non-payment of scheduled interest payments; (v) whether management intends to sell the security and, if not, whether it is not more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis; (vi) specific cash flow estimations for certain mortgage-backed and asset-backed securities and (vii) current economic conditions. If an other-than-temporary impairment loss (“OTTI”) is determined for a fixed-maturity security and management does not intend to sell and it is more likely than not that it will not be required to sell the security before recovery of cost or amortized cost, the credit portion is included in the statement of income in net realized investment gains (losses) and the non-credit portion is included in comprehensive net income. The credit portion results in a permanent reduction of the cost basis of the underlying investment and the security is amortized up to the expected recovery amount. The determination of OTTI is a subjective process and different judgments and assumptions could affect the timing of loss realization.

Corporate bonds, commercial mortgage-backed securities (“CMBS”), and non-agency residential mortgage-backed securities (“RMBS”) represent the largest unrealized loss positions as of September 30, 2010.

For certain non-highly rated structured fixed-maturity securities, management determines the credit loss component by utilizing discounted cash flow modeling to determine the present value of the security and comparing the present value with the amortized cost of the security. If the amortized cost is greater than the present value of the expected cash flows, the difference is considered a credit loss and included in net realized investment gains (losses). During the nine months ended September 30, 2010, $3.8 million of credit related OTTI, primarily related to commercial and non-agency residential mortgage-backed securities, was recorded.

Management analyzes certain of its non-agency RMBS on a quarterly basis using default loss models based on the performance of the underlying loans. Performance metrics include delinquencies, defaults, foreclosures, prepayment speeds and cumulative losses incurred. The expected losses for a mortgage pool are compared to the break-even loss, which represents the point at which the Company’s tranche begins to experience losses. For certain of the non-agency RMBS holdings, the estimated cash flows have continued to decline. This is primarily attributable to the decline in home prices.

The CMBS holdings are also evaluated on a quarterly basis using analytical techniques and various metrics including the level of subordination, debt-service-coverage ratios, loan-to-value ratios, delinquencies, defaults and foreclosures. For certain of the CMBS holdings, the estimated cash flows have continued to decline during the quarter. The primary reason for this decline has been an increase of delinquencies, higher vacancies and a decline in real estate values.

For certain non-structured fixed-maturity securities (U.S. Treasury securities, obligations of U.S. Government and government agencies and authorities, obligations of states, municipalities and political subdivisions, and certain corporate debt) the unrealized loss is reviewed to determine whether full recovery of principal and interest will be received. The estimate of expected cash flows is determined by projecting a recovery value and a recovery time frame and assessing whether further principal and interest will be received. The determination of recovery value incorporates an issuer valuation assumption utilizing one or a combination of valuation methods as deemed appropriate by management. The present value of the cash flows is determined by applying the effective yield of the security at the date of acquisition (or the most recent implied rate used to accrete the security if the implied rate has changed as a result of a previous impairment) and an estimated recovery time frame. For securities for which the issuer is financially troubled but not in bankruptcy, that time frame is generally longer. Included in the present value calculation are expected principal and interest payments; however, for securities for which the issuer is classified as bankrupt or in default, the present value calculation assumes no interest payments and a single recovery amount. In situations for which a present value of cash flows cannot be estimated, a write down to fair value is recorded.

In estimating the recovery value, significant judgment is involved in the development of assumptions relating to a number of factors related to the issuer including, but not limited to, revenue, margin and earnings projections, the likely market or liquidation values of assets, potential additional debt to be incurred pre- or post- bankruptcy/restructuring, the ability to shift existing or new debt to different priority layers, the amount of restructuring/bankruptcy expenses, the size and priority of unfunded pension obligations, litigation or other contingent claims, the treatment of intercompany claims and the likely outcome with respect to inter-creditor conflicts.

The following table shows the number and amount of fixed-maturity and equity securities that were OTTI for the three and nine months ended September 30, 2010 and 2009. This resulted in recording impairment write-downs included in net realized investment gains (losses), and reduced the unrealized loss in other comprehensive net income:

13

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

	Three Months Ended September 30,										Nine Months Ended September 30,
	2010					2009					2010					2009
($ in thousands)	No.		Amount			No.		Amount			No.		Amount			No.		Amount
Corporate and other bonds		—	$	—			6	$	(485	)		—	$	—			14	$	(1,851	)
Commercial mortgage-backed securities		9		(1,760	)		27		(13,566	)		35		(6,562	)		42		(21,593	)
Residential mortgage-backed securities		21		(2,123	)		31		(3,785	)		62		(5,594	)		55		(7,884	)
Asset-backed securities		14		(1,070	)		8		(1,615	)		19		(1,779	)		21		(2,994	)
		44		(4,953	)		72		(19,451	)		116		(13,935	)		132		(34,322	)
Portion of loss recognized in accumulated other comprehensive income (loss)				4,400					7,761					10,120					15,278
Impairment losses recognized in earnings			$	(553	)			$	(11,690	)			$	(3,815	)			$	(19,044	)
Tower			$	(553	)			$	(11,690	)			$	(3,815	)			$	(19,044	)
Reciprocal Exchanges				—					—					—					—
Impairment losses recognized in earnings			$	(553	)			$	(11,690	)			$	(3,815	)			$	(19,044	)

The following table provides a rollforward of the cumulative amount of OTTI for Tower securities still held showing the amounts that have been included in earnings on a pretax basis for the nine months ended September 30, 2010 and 2009 (none of such OTTI was included within the Reciprocal Exchanges):

	Nine Months Ended
	September 30,
($ in thousands)	2010			2009
Balance, January 1,	$	40,734		$	24,638
Cumulative effect of adjustment upon adoption of 2009 GAAP guidance on OTTI		—			(2,497	)
Additional credit losses recognized during the period, related to securities for which:
No OTTI has been previously recognized		407			14,041
OTTI has been previously recognized		2,552			5,003
Reductions due to:
Securities sold during the period (realized)		(22,987	)		(320	)
Balance, September 30,	$	20,706		$	40,865

The following table provides a rollforward of the cumulative amount of OTTI for Tower securities still held showing the amounts that have been included in earnings on a pretax basis for the three months ended September 30, 2010 and 2009 (none of such OTTI has been included within the Reciprocal Exchanges):

	Three Months Ended
	September 30,
($ in thousands)	2010			2009
Balance, July 1,	$	31,937		$	29,495
Additional credit losses recognized during the period, related to securities for which:
No OTTI has been previously recognized		246			8,919
OTTI has been previously recognized		190			2,771
Reductions due to:
Securities sold during the period (realized)		(11,667	)		(320	)
Balance, September 30,	$	20,706		$	40,865

Unrealized Losses

There are 301 securities at September 30, 2010 that account for the gross unrealized loss, none of which is deemed by management to be OTTI. Temporary losses on corporate and other bonds resulted from purchases made in a lower interest rate environment or lower yield spread environment. In addition, there have been some ratings downgrades on certain of these securities. After analyzing the credit quality, balance sheet strength and company outlook, management believes these securities will recover in value as liquidity and the economy continue to improve. The structured securities that had significant unrealized losses resulted primarily from declines in both residential and commercial real estate prices. To the extent projected cash flows on structured securities change adversely, they would be considered OTTI and an impairment loss would be recognized.

14

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

Management considered all relevant factors, including expected recoverability of cash flows, in assessing whether the loss was other-than-temporary. The Company does not intend to sell these fixed maturity securities, and it is not more likely than not that these securities will be sold before recovering their cost basis.

For all securities in an unrealized loss position at September 30, 2010, the Company has received all contractual interest payments (and principal if applicable). Based on the continuing receipt of cash flow and the foregoing analyses, management expects continued timely payments of principal and interest and considers the losses to be temporary.

The following table presents information regarding invested assets that were in an unrealized loss position at September 30, 2010 and December 31, 2009 by amount of time in a continuous unrealized loss position:

	Less than 12 Months							12 Months or Longer							Total
			Fair		Unrealized					Fair		Unrealized					Aggregate		Unrealized
($ in thousands)	No.		Value		Losses			No.		Value		Losses			No.		Fair Value		Losses
September 30, 2010
U.S. Agency securities		20	$	65,996	$	(178	)		—	$	—	$	—			20	$	65,996	$	(178	)
Municipal bonds		12		14,571		(165	)		1		980		(60	)		13		15,551		(225	)
Corporate and other bonds
Finance		18		6,329		(234	)		2		641		(18	)		20		6,970		(252	)
Industrial		95		28,831		(296	)		3		842		(44	)		98		29,673		(340	)
Utilities		8		1,704		(42	)		—		—		—			8		1,704		(42	)
Commercial mortgage- backed securities		24		17,866		(2,337	)		—		—		—			24		17,866		(2,337	)
Residential mortgage- backed securities
Agency backed		77		101,624		(746	)		—		—		—			77		101,624		(746	)
Non-agency backed		16		7,291		(1,603	)		5		1,771		(128	)		21		9,062		(1,731	)
Asset-backed securities		12		16,928		(531	)		1		177		(2	)		13		17,105		(533	)
Total fixed-maturity securities		282		261,140		(6,132	)		12		4,411		(252	)		294		265,551		(6,384	)
Preferred stocks		2		2,226		(32	)		5		3,404		(147	)		7		5,630		(179	)
Total, September 30, 2010		284	$	263,366	$	(6,164	)		17	$	7,815	$	(399	)		301	$	271,181	$	(6,563	)
Tower		281	$	258,250	$	(6,159	)		17	$	7,815	$	(399	)		298	$	266,065	$	(6,558	)
Reciprocal Exchanges		3		5,116		(5	)		—		—		—			3		5,116		(5	)
Total, September 30, 2010		284	$	263,366	$	(6,164	)		17	$	7,815	$	(399	)		301	$	271,181	$	(6,563	)
December 31, 2009
U.S. Treasury securities		24	$	43,421	$	(225	)		—	$	—	$	—			24	$	43,421	$	(225	)
U.S. Agency securities		21		27,652		(214	)		—		—		—			21		27,652		(214	)
Municipal bonds		42		50,526		(587	)		5		2,569		(143	)		47		53,095		(730	)
Corporate and other bonds
Finance		32		28,342		(291	)		20		14,906		(1,099	)		52		43,248		(1,390	)
Industrial		104		69,475		(726	)		25		14,563		(608	)		129		84,038		(1,334	)
Utilities		6		3,575		(37	)		2		625		(25	)		8		4,200		(62	)
Commercial mortgage- backed securities		20		25,810		(598	)		27		22,904		(8,138	)		47		48,714		(8,736	)
Residential mortgage- backed securities
Agency backed		43		79,005		(963	)		—		—		—			43		79,005		(963	)
Non-agency backed		4		1,081		(14	)		37		19,672		(2,910	)		41		20,753		(2,924	)
Asset-backed securities		5		334		(116	)		11		2,962		(1,205	)		16		3,296		(1,321	)
Total fixed-maturity securities		301		329,221		(3,771	)		127		78,201		(14,128	)		428		407,422		(17,899	)
Preferred stocks		87		59,243		(1,441	)		6		4,827		(724	)		93		64,070		(2,165	)
Common stocks		4		31		(150	)		—		—		—			4		31		(150	)
Total, December 31, 2009		392	$	388,495	$	(5,362	)		133	$	83,028	$	(14,852	)		525	$	471,523	$	(20,214	)

The unrealized loss position associated with the fixed-maturity portfolio was $6.4 million as of September 30, 2010, consisting primarily of mortgage-backed and asset-backed securities representing 83.8% of the gross unrealized loss related to fixed-maturity securities. The total fixed-maturity portfolio of gross unrealized losses included 294 securities which were, in aggregate, approximately 2.3% below amortized cost. Of the 294 fixed maturity investments identified, 12 have been in an unrealized loss position for more than 12 months. The total unrealized loss on these investments at September 30, 2010 was $0.3 million. Management does not consider these investments to be other-than-temporarily impaired.

15

Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited)

The unrealized loss on the investment in preferred securities was primarily due to the market disruptions. All of the preferred securities that were in an unrealized loss position as of September 30, 2010 were evaluated. The evaluation consisted of a detailed review, including but not limited to some or all of the following factors for each security: the current S&P rating, analysts’ reports, past earning trends and analysts’ earnings expectations for the next 12 months, liquidity, near-term financing risk, and whether the company was currently paying dividends on its equity securities. Management does not consider these investments to be other-than-temporarily impaired.

The unrealized loss for the corporate and other bonds was $0.6 million with 5 securities in an unrealized loss position over 12 months. These investments are not considered to be other-than-temporarily impaired.

The following tables stratify the gross unrealized losses in the portfolio at September 30, 2010, by duration in a loss position and magnitude of the loss as a percentage of the cost or amortized cost of the security:

			Total Gross			Decline of Investment Value
	Fair		Unrealized			>15%					>25%					>50%
($ in thousands)	Value		Losses			No.		Amount			No.		Amount			No.		Amount
Unrealized loss for less than 6 months	$	259,032	$	(6,104	)		3	$	(196	)		17	$	(1,699	)		8	$	(2,111	)
Unrealized loss for over 6 months		4,335		(60	)		—		—			—		—			—		—
Unrealized loss for over 12 months		227		(9	)		—		—			—		—			—		—
Unrealized loss for over 18 months		—		—			—		—			—		—			—		—
Unrealized loss for over 2 years		7,587		(390	)		1		(124	)		—		—			—		—
Total unrealized loss	$	271,181	$	(6,563	)		4	$	(320	)		17	$	(1,699	)		8	$	(2,111	)
Tower	$	266,065	$	(6,558	)		4	$	(320	)		17	$	(1,699	)		8	$	(2,111	)
Reciprocal Exchanges -
Unrealized loss for less than 6 months		5,116		(5	)		—		—			—		—			—		—
Total unrealized loss	$	271,181	$	(6,563	)		4	$	(320	)		17	$	(1,699	)		8	$	(2,111	)

Management evaluated the severity of the impairment in relation to the carrying values for the securities referred to above and considered all relevant factors in assessing whether the loss was other-than-temporary. Management does not intend to sell its fixed-maturity securities, and it is not more likely than not that these securities will be sold until there is a recovery of fair value to the original cost basis, which may be at maturity.

Fixed-Maturity Investment—Time to Maturity

The following table shows the composition of the fixed-maturity portfolio by remaining time to maturity at September 30, 2010 and December 31, 2009. For securities that are redeemable at the option of the issuer and have a market price that is greater than par value, the maturity used for the table below is the earliest redemption date. For securities that are redeemable at the option of the issuer and have a market price that is less than par value, the maturity used for the table below is the final maturity date.

	September 30, 2010
	Tower				Reciprocal Exchanges				Total				December 31, 2009
	Amortized		Fair		Amortized		Fair		Amortized		Fair		Amortized		Fair
($ in thousands)	Cost		Value		Cost		Value		Cost		Value		Cost		Value
Remaining Time to Maturity
Less than one year	$	5,216	$	5,267	$	—	$	—	$	5,216	$	5,267	$	30,282	$	30,465
One to five years		514,169		538,070		22,641		23,411		536,810		561,481		346,309		355,402
Five to ten years		573,195		615,377		116,466		120,802		689,661		736,179		477,843		492,517
More than 10 years		385,767		416,017		34,833		36,157		420,600		452,174		357,087		375,726
Mortgage and asset-backed securities		580,101		614,793		132,892		136,232		712,993		751,025		517,596		529,486
Total	$	2,058,448	$	2,189,524	$	306,832	$	316,602	$	2,365,280	$	2,506,126	$	1,729,117	$	1,783,596

Note 6—Fair Value Measurements

GAAP establishes a three-level hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the assets or liabilities fall within different levels of the hierarchy, the classification is based on the lowest level input that is significant to the fair value measurement of the asset or liability. Classification of assets and liabilities within the hierarchy considers the markets in which the assets and liabilities are traded, including during periods of market disruption, and the reliability and transparency of the assumptions used to determine fair value. The hierarchy requires the use of observable market data when available. The levels of the hierarchy are as follows:

16

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

Level 1— Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities traded in active markets. Included are those investments traded on an active exchange, such as the NASDAQ Global Select Market.

Level 2— Inputs to the valuation methodology include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability and market-corroborated inputs. Included are investments in U.S. Treasury securities and obligations of U.S. government agencies, together with municipal bonds, corporate debt securities, commercial mortgage and asset-backed securities, certain residential mortgage-backed securities that are generally investment grade and certain equity securities. Additionally, interest-rate swap contracts utilize Level 2 inputs in deriving fair values.

Level 3— Inputs to the valuation methodology are unobservable for the asset or liability and are significant to the fair value measurement. Material assumptions and factors considered in pricing investment securities may include projected cash flows, collateral performance including delinquencies, defaults and recoveries, and any market clearing activity or liquidity circumstances in the security or similar securities that may have occurred since the prior pricing period. Generally included in this valuation methodology are investments in certain mortgage-backed and asset-backed securities.

The availability of observable inputs varies and is affected by a wide variety of factors. When the valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires significantly more judgment. The degree of judgment exercised by management in determining fair value is greatest for investments categorized as Level 3. For investments in this category, management considers prices and inputs that are current as of the measurement date. In periods of market dislocation, as characterized by current market conditions, the ability to observe stable prices and inputs may be reduced for many instruments. This condition could cause a security to be reclassified between levels.

As at September 30, 2010 and December 31, 2009, the Company’s fixed-maturities, equity investments and short-term investments are allocated among levels as follows:

17

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

($ in thousands)	Level 1		Level 2		Level 3		Total
September 30, 2010 Fixed-maturity securities
U.S. Treasury securities	$	—	$	46,133	$	—	$	46,133
U.S. Agency securities		—		92,278		—		92,278
Municipal bonds		—		612,583		—		612,583
Corporate and other bonds		—		1,004,107		—		1,004,107
Commercial mortgage-backed securities		—		245,431		—		245,431
Residential mortgage-backed securities
Agency		—		432,441		780		433,221
Non-agency		—		29,546		1,680		31,226
Asset-backed securities		—		40,502		645		41,147
Total fixed-maturities		—		2,503,021		3,105		2,506,126
Equity investments		40,170		310		—		40,480
Short-term investments		2,685		24,217		—		26,902
Total, September 30, 2010	$	42,855	$	2,527,548	$	3,105	$	2,573,508
Tower	$	42,855	$	2,210,946	$	3,105	$	2,256,906
Reciprocal Exchanges		—		316,602		—		316,602
Total, September 30, 2010	$	42,855	$	2,527,548	$	3,105	$	2,573,508
December 31, 2009
Fixed-maturity securities
U.S. Treasury securities	$	—	$	73,291	$	—	$	73,291
U.S. Agency securities		—		39,983		—		39,983
Municipal bonds		—		525,715		—		525,715
Corporate and other bonds		—		615,121		—		615,121
Commercial mortgage-backed securities		—		203,447		—		203,447
Residential mortgage-backed securities
Agency		—		288,685		—		288,685
Non-agency		—		16,937		10,508		27,445
Asset-backed securities		—		6,822		3,087		9,909
Total fixed-maturities		—		1,770,001		13,595		1,783,596
Equity investments		54,044		22,689		—		76,733
Short-term investments		36,500		—		—		36,500
Total, December 31, 2009	$	90,544	$	1,792,690	$	13,595	$	1,896,829

The fair values of the fixed-maturity, equity investments and short-term investments are determined by management after taking into consideration available sources of data. Various factors are considered that may indicate an inactive market, including levels of activity, source and timeliness of quotes, abnormal liquidity risk premiums, unusually wide bid-ask spreads, and lack of correlation between fair value of assets and relevant indices. If management believes that the price provided from the pricing source is distressed, management will use a valuation method that reflects an orderly transaction between market participants, generally a discounted cash flow method that incorporates relevant interest rate, risk and liquidity factors.

Substantially all of the portfolio valuations at September 30, 2010 classified as Level 1 or Level 2 in the above table is priced by utilizing the services of several independent pricing services that provide the Company with a price quote for each security. The remainder of the Level 1 and Level 2 portfolio valuations represents non-binding broker quotes. There were no adjustments made to the prices obtained from the independent pricing sources and dealers on securities classified as Level 1 or Level 2.

In 2010, there were no transfers of investments between Level 1 and Level 2. Approximately $5.5 million of Agency backed RMBS securities were transferred from Level 3 to Level 2 when quoted market prices for similar securities that were considered reliable and could be validated against an alternative source became available in 2010.

The Level 3 classified securities in the investment portfolio consist of primarily non-agency mortgage-backed and asset-backed securities that were either not traded or very thinly traded. Management, in conjunction with its outside portfolio manager, has considered the various factors that may indicate an inactive market and has concluded that prices provided by the pricing sources represent an inactive or distressed market. As a result, prices from independent third party pricing services, broker quotes or other

18

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

observable inputs were not always available or were deemed unrealistic, or, in the case of certain broker quotes, were non- binding. Therefore, the fair values of these securities were determined using a model to develop a security price using future cash flow expectations that were developed based on collateral composition and performance and discounted at an estimated market rate (including estimated risk and liquidity premiums) taking into account estimates of the rate of future prepayments, current credit spreads, credit subordination protection, mortgage origination year, default rates, benchmark yields and time to maturity. For certain securities, non-binding broker quotes were available and these were also considered in determining the appropriateness of the security price.

Use of Level 3 (the unobservable inputs) included 13 securities and accounted for less than 0.1% of total investments at September 30, 2010.

Management has reviewed the pricing techniques and methodologies of the independent pricing sources and believes that their policies adequately consider market activity, either based on specific transactions for the issue valued or based on modeling of securities with similar credit quality, duration, yield and structure that were recently traded. Management monitors security-specific valuation trends and discusses material changes or the absence of expected changes with the pricing sources to understand the underlying factors and inputs and to validate the reasonableness of pricing.

The following table summarizes changes in Level 3 assets measured at fair value for the nine months ended September 30, 2010 and 2009 for Tower (the Reciprocal Exchanges have no Level 3 assets):

	Nine Months Ended
	September 30,
($ in thousands)	2010			2009
Beginning balance, January 1	$	13,595		$	18,084
Total gains (losses)-realized / unrealized
Included in net income		(11	)		(17,193	)
Included in other comprehensive income (loss)		(4,968	)		9,701
Purchases, issuances and settlements		—			34,266
Net transfers into (out of) Level 3		(5,511	)		14,059
Ending balance, September 30	$	3,105		$	58,917

The following table summarizes the changes in Level 3 assets measured at fair value for the three months ended September 30, 2010 and 2009:

	Three Months Ended
	September 30,
($ in thousands)	2010			2009
Beginning balance, July 1	$	9,000		$	22,912
Total gains (losses)-realized / unrealized
Included in net income		119			(11,191	)
Included in other comprehensive income (loss)		(2,930	)		9,902
Purchases, issuances and settlements		—			33,519
Net transfers into (out of) Level 3		(3,084	)		3,775
Ending balance, September 30	$	3,105		$	58,917

Note 7—Goodwill and Intangible Assets

Goodwill

Goodwill is calculated as the excess of purchase price over the net fair value of assets acquired. See Note 3 — “Acquisitions” for information regarding the calculation of goodwill related to the acquisition of OBPL in 2010 and the acquisitions of CastlePoint, Hermitage and AequiCap in 2009. The acquisition of SUA resulted in negative goodwill which was recorded as a gain on bargain purchase in 2009. Under GAAP, the Company is required to allocate goodwill to its reportable segments. The following is a summary of goodwill by reporting units:

19

Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited)

	Commercial			Personal
($ in thousands)	Insurance			Insurance		Total
Balance, January 1, 2010	$	191,742		$	52,948	$	244,690
Adjustment to SUA acquisition valuations		(942	)		—		(942	)
Acquisition of OBPL		—			5,656		5,656
Total, September 30, 2010	$	190,800		$	58,604	$	249,404

The Company does not expect any of the goodwill related to the acquisition of OBPL to be deductible for tax purposes.

The Company performs an analysis annually to identify potential goodwill impairment and measures the amount of any goodwill impairment loss that may need to be recognized. This test is performed during the fourth quarter of each year or more frequently if events or circumstances change in a way that requires the Company to perform the impairment analysis on an interim basis. Goodwill impairment testing requires an evaluation of the estimated fair value of each reporting unit to its carrying value, including the goodwill. An impairment charge is recorded if the estimated fair value is less than the carrying amount of the reporting unit. No impairments have been identified to date.

Intangible Assets

Intangible assets consist of finite and indefinite life assets. Finite life intangible assets include customer relationships and trademarks. Insurance company licenses and management contracts are considered indefinite life intangible assets subject to annual impairment testing. The weighted average amortization period of identified intangible assets with a finite life is 7.3 years as of September 30, 2010.

The components of intangible assets and their useful lives, accumulated amortization, and net carrying value as of September 30, 2010 and December 31, 2009 are as follows:

			September 30, 2010							December 31, 2009
	Useful		Gross					Net		Gross					Net
	Life		Carrying		Accumulated			Carrying		Carrying		Accumulated			Carrying
($ in thousands)	(in-yrs)		Amount		Amortization			Amount		Amount		Amortization			Amount
Insurance licenses		—	$	19,003	$	—		$	19,003	$	17,703	$	—		$	17,703
Management contracts		—		54,600		—			54,600							—
Customer relationships		10-25		46,590		(9,442	)		37,148		39,290		(5,858	)		33,432
Trademarks		5		5,290		(1,233	)		4,057		2,690		(475	)		2,215
Total			$	125,483	$	(10,675	)	$	114,808	$	59,683	$	(6,333	)	$	53,350
Tower			$	119,583	$	(10,477	)	$	109,106	$	59,683	$	(6,333	)	$	53,350
Reciprocal Exchanges				5,900		(198	)		5,702		—		—			—
Total			$	125,483	$	(10,675	)	$	114,808	$	59,683	$	(6,333	)	$	53,350

20

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

The activity in the components of intangible assets for the nine months ended September 30, 2010 consisted of intangible assets acquired from business combinations and amortization expense as shown in the table below:

	Insurance		Management		Customer
($ in thousands)	Licenses		Contracts		Relationships			Trademarks			Total
Balance, January 1, 2010	$	17,703	$	—	$	33,432		$	2,215		$	53,350
Additions (a)		1,300		54,600		7,300			2,600			65,800
Deductions (b)		—		—		(3,584	)		(758	)		(4,342	)
Balance, September 30, 2010	$	19,003	$	54,600	$	37,148		$	4,057		$	114,808
Tower	$	18,603	$	54,600	$	33,766		$	2,137		$	109,106
Reciprocal Exchanges		400		—		3,382			1,920			5,702
Balance, September 30, 2010	$	19,003	$	54,600	$	37,148		$	4,057		$	114,808

(a)	Relates to the acquisition of OBPL
(b)	Amortization

The Company recorded amortization expense related to intangibles of $1.7 million and $4.3 million in the three and nine months ended September 30, 2010, respectively and $0.9 million and $2.3 million for the same periods in the prior year. The estimated amortization expense for each of the next five years is:

			Reciprocal
($ in thousands)	Tower		Exchanges		Total
2011	$	4,672	$	665	$	5,337
2012		4,003		585		4,588
2013		3,228		517		3,745
2014		2,804		466		3,270
2015		2,253		405		2,658

Note 8—Loss and Loss Adjustment Expense

In the nine months ended September 30, 2010, favorable development of $4.5 million was recorded as a result of lower than anticipated claims emergence in the personal lines segment. The favorable development in 2009 was comprised primarily of savings in loss adjustment expense (“LAE”) as a result of changing to a fixed fee billing for the Company’s in-house attorneys for claims handled and legal fee auditing of attorneys’ bills.

The following table provides a reconciliation of the beginning and ending balances for unpaid losses and LAE for the nine months ended September 30, 2010 and 2009:

21

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

	Nine Months Ended
	September 30, 2010
				Reciprocal					September 30,
($ in thousands)	Tower			Exchanges		Total			2009
Balance at January 1,	$	1,131,989		$	—	$	1,131,989		$	534,991
Less reinsurance recoverables on unpaid losses		(199,687	)		—		(199,687	)		(222,229	)
		932,302			—		932,302			312,762
Net reserves, at fair value, of acquired entities		193,484			158,652		352,136			370,001
Incurred related to:
Current year		530,592			34,649		565,241			337,556
Prior years		(4,573	)		—		(4,573	)		(6,634	)
Total incurred		526,019			34,649		560,668			330,922
Paid related to:
Current year		187,950			20,300		208,250			105,009
Prior years		295,443			9,022		304,465			185,783
Total paid		483,393			29,322		512,715			290,792
Net balance at end of period		1,168,412			163,979		1,332,391			722,893
Add reinsurance recoverables on unpaid losses		282,510			17,460		299,970			105,053
Balance at September 30,	$	1,450,922		$	181,439	$	1,632,361		$	827,946

Note 9—Stockholders’ Equity

Authorized Shares of Common Stock

On January 28, 2009, an amendment to increase the number of authorized shares of common stock, par value $0.01 per share, from 40,000,000 shares to 100,000,000 shares was approved at a special meeting of stockholders.

Shares of Common Stock Issued

In connection with the acquisition of SUA in 2009, 4.4 million shares were issued to the shareholders of SUA increasing Common Stock by $44,600 and Paid-in Capital by $105.8 million.

In connection with the acquisition of CastlePoint in 2009, 16.9 million shares were issued to the shareholders of CastlePoint increasing Common Stock by $169,000 and Paid-in Capital by $421.5 million.

For the nine months ended September 30, 2010 and 2009, 114,807 and 40,076 new common shares, respectively, were issued as the result of employee stock option exercises and 355,539 and 317,545 new common shares, for the same periods, respectively, were issued as the result of restricted stock grants.

For the nine months ended September 30, 2010 and 2009, 65,377 and 17,844 shares, respectively, of common stock were purchased from employees in connection with the vesting of restricted stock issued under the 2004 Long Term Equity Compensation Plan (the “Plan”). The shares were withheld at the direction of employees as permitted under the Plan in order to pay the expected amount of tax liability owed by the employees from the vesting of those shares. In addition, for the nine months ended September 30, 2010 and 2009, 11,852 and 11,011 shares, respectively, of common stock were surrendered as a result of restricted stock forfeitures.

Share Repurchase Program

The Board of Directors of Tower approved a $100 million share repurchase program on February 26, 2010. Purchases can be made from time to time in the open market or in privately negotiated transactions in accordance with applicable laws and regulations. The share repurchase program has no expiration date. In the three and nine months ended September 30, 2010, 1.7 million and 3.9 million shares of common stock, respectively, were purchased under this program at an aggregate consideration of $36.7 million and $83.9 million, respectively.

22

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

Dividends Declared

Dividends on common stock of $5.3 million and $2.8 million for the three months ended September 30, 2010 and 2009, respectively, were declared. Dividends on common stock of $11.4 million and $7.6 million for the nine months ended September 30, 2010 and 2009, respectively, were declared.

On October 22, 2010, the Board of Directors approved a quarterly dividend of $0.125 per share payable on December 24, 2010 to stockholders of record as of December 13, 2010.

Note 10—Debt

Total interest expense incurred was $16.3 million and $13.5 million for the nine months ended September 30, 2010 and 2009, respectively.

On May 14, 2010, the Company entered into a $125 million credit facility agreement. The credit facility will be used for general corporate purposes and expires on May 14, 2013.

The Company may request that the facility be increased by an amount not to exceed $50 million. The credit facility contains customary covenants for facilities of this type, including restrictions on indebtedness and liens, limitations on mergers, dividends and the sale of assets, and requirements to maintain certain consolidated net worth, debt to capitalization ratios, minimum risk-based capital and minimum statutory surplus. The credit facility also provides for customary events of default, including failure to pay principal when due, failure to pay interest or fees within three days after becoming due, failure to comply with covenants, any representation or warranty made by the Company being false in any material respect, default under certain other indebtedness, certain insolvency or receivership events affecting the Company and its material subsidiaries, the occurrence of certain material judgments, or a change in control of the Company, and upon an event of default the administrative agent (subject to the consent of the requisite percentage of the lenders) may immediately terminate the obligations to make loans and to issue letters of credit, declare the Company’s obligations under the credit facility to become immediately due and payable, and require the Company to deposit in a collateral account cash collateral with a value equal to the then outstanding amount of the aggregate face amount of any outstanding letters of credit. The Company was in compliance with all covenants under the credit facility at September 30, 2010.

Fees payable by the Company under the credit facility include a fee on the daily unused portion of each letter of credit, a letter of credit fronting fee with respect to each fronted letter of credit and a commitment fee.

The Company has no balance outstanding as of September 30, 2010.

Convertible Senior Notes

In September 2010, the Company issued $150.0 million principal amount of 5.0% convertible senior notes (“the Notes”), which mature on September 15, 2014. Interest on the Notes is payable semi-annually in arrears on March 15 and September 15 of each year, commencing March 15, 2011. Holders may convert their Notes into cash or common shares, at the Company’s option, at any time on or after March 15, 2014 or earlier under certain circumstances determined by: (i) the market price of the Company’s stock, (ii) the trading price of the Notes, or (iii) the occurrence of specified corporate transactions. Upon conversion, the Company intends to settle its obligation either entirely or partially in cash. The initial conversion rate is 36.3782 shares of common stock per $1,000 principal amount of the Notes (equivalent to an initial conversion price of $27.49 per share), subject to adjustment upon the occurrence of certain events. Additionally, in the event of a fundamental change, the holders may require the Company to repurchase the Notes for a cash price equal to 100% of the principal plus any accrued and unpaid interest.

The proceeds from the issuance of the Notes were allocated to the liability component and the embedded conversion option, or equity component. The equity component was reported as an adjustment to paid-in-capital, net of tax, and is reflected as an original issue discount (“OID”). The OID of $11.5 million and deferred origination costs relating to the liability component of $5.0 million will be amortized into interest expense over the term of the Notes. After considering the contractual interest payments and amortization of the original issue discount, the Notes’ effective interest rate is approximately 7.2%. Transaction costs of $0.4 million associated with the equity component were netted with the equity component in paid-in-capital. Interest expense, including amortization of deferred origination costs, recognized on the Notes was $0.3 million for the three months ended September 30, 2010.

23

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

The following table shows the amounts recorded for the Notes as of September 30, 2010:

($ in thousands)
Liability component
Outstanding principal	$	150,000
Unamortized OID		(11,421	)
Liability component		138,579
Equity component, net of tax	$	7,469

To the extent the market value per share of the Company’s common stock exceeds the conversion price, the Company will use the “treasury stock” method in calculating the dilutive effect on earnings per share.

Convertible Senior Notes Hedge and Warrant Transactions

In connection with the offering of the Notes, the Company also entered into convertible senior notes hedge transactions (the “Note Hedges” or “purchased call options”) and warrant transactions (the “Warrants”) with respect to its common stock with financial institutions. The Note Hedges and Warrants are intended generally to reduce the potential dilution of the Company’s common stock and to offset potential cash payments in excess of the principal of the Notes upon conversion. The Note Hedges and Warrants are separate transactions, entered into by the Company with the financial institutions, and are not part of the terms of the Notes.

The Company paid $15.3 million for the Note Hedges which cover approximately 5.5 million shares of common stock at a strike price of $27.49 per share, subject to anti-dilution provisions, and are exercisable upon conversion of the Notes. The Note Hedges have been accounted for as an adjustment to the Company’s paid-in-capital, net of deferred taxes.

The Company received $3.8 million for Warrants sold to the financial institutions. The Warrants provide for the acquisition of approximately 5.5 million shares of common stock at a strike price of $33.42 per share, subject to anti-dilution adjustments. If the market value per share of the Company’s common stock exceeds the strike price of the warrants, the warrants will have a dilutive effect on the Company’s net income per share. The Warrants have been accounted for as an adjustment to the Company’s paid-in-capital.

Note 11—Stock Based Compensation

Restricted Stock

During the nine months ended September 30, 2010 and 2009, restricted stock shares were granted to senior officers, key employees and directors as shown in the table below. Restricted stock expense recognized for the nine months ended September 30, 2010 and 2009 was $3.2 million and $1.9 million net of tax, respectively. The total intrinsic value of restricted stock vesting was $4.4 million and $1.7 million for the nine months ended September 30, 2010 and 2009, respectively. The intrinsic value of the unvested restricted stock outstanding as of September 30, 2010 and 2009 was $14.4 million and $12.0 million, respectively.

The following table provides an analysis of restricted stock activity for the nine months ended September 30, 2010 and 2009:

	Nine Months Ended September 30,
	2010					2009
				Weighted					Weighted
				Average					Average
	Number of			Grant Date		Number of			Grant Date
	Shares			Fair Value		Shares			Fair Value
Outstanding, January 1		474,023		$	24.64		258,645		$	26.05
Granted		355,539			21.84		317,545			22.89
Vested		(200,368	)		24.51		(73,945	)		26.24
Forfeitures		(11,852	)		23.33		(11,011	)		26.05
Outstanding, September 30		617,342		$	23.09		491,234		$	23.98

24

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

Stock Options

The following table provides an analysis of stock option activity for the nine months ended September 30, 2010 and 2009:

	Nine Months Ended September 30,
	2010					2009
				Average					Average
	Number of			Exercise		Number of			Exercise
	Shares			Price		Shares			Price
Outstanding, January 1		1,387,019		$	19.62		258,530		$	5.47
Granted at fair value		—			—		1,148,308			20.61
Exercised		(114,807	)		3.83		(40,076	)		13.84
Forfeitures and expirations		(38,140	)		23.94		(134,617	)		22.37
Outstanding, September 30		1,234,072		$	20.96		1,232,145		$	17.46
Exercisable, September 30		1,178,858		$	21.06		1,043,985		$	16.76

The options granted in 2009 were originally issued to employees or directors of CastlePoint on four grant dates and were converted into options to acquire shares of the Company’s common stock upon the acquisition of CastlePoint.

The fair value of the options granted to replace the CastlePoint options was estimated using the Black-Scholes pricing model as of February 5, 2009, the date of conversion from CastlePoint stock options to the Company’s stock options, with the following weighted average assumptions: risk free interest rate of 1.46% to 1.83%, dividend yield of 0.8%, volatility factors of the expected market price of the Company’s common stock of 43.8% to 45.3%, and a weighted-average expected life of the options of 3.3 to 5.3 years.

The fair value measurement objective of the relevant GAAP guidance is achieved using the Black-Scholes model as the model (a) is applied in a manner consistent with the fair value measurement objective and other requirements of GAAP, (b) is based on established principles of financial economic theory and generally applied in that field and (c) reflects all substantive characteristics of the instrument.

Compensation expense (net of tax) related to stock options was $0.3 million and $0.9 million for the nine months ended September 30, 2010 and 2009, respectively. The intrinsic value of stock options outstanding as of September 30, 2010 was $5.6 million, of which $5.3 million was related to vested options.

The total remaining compensation cost related to non-vested stock options and restricted stock awards not yet recognized in the income statement was $14.4 million of which $0.2 million was for stock options and $14.2 million was for restricted stock as of September 30, 2010. The weighted average period over which this compensation cost is expected to be recognized is 3.6 years.

Note 12—Income Taxes

The Company files a consolidated Federal income tax return. The Reciprocal Exchanges are not included in the Company’s consolidated tax return as the Company does not have an ownership interest in the Reciprocal Exchanges and they are not a part of the consolidated tax sharing agreement.

Deferred tax assets and liabilities are determined using the enacted tax rates applicable to the period the temporary differences are expected to be recovered. Accordingly, the current period income tax provision can be affected by the enactment of new tax rates. The net deferred income taxes on the balance sheet reflect temporary differences between the carrying amounts of the assets and liabilities for financial reporting purposes and income tax purposes. Significant components of the Company’s deferred tax assets and liabilities are as follows:

25

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

	September 30, 2010
			Reciprocal						December 31,
($ in thousands)	Tower		Exchanges			Total			2009
Deferred tax asset:
Claims reserve discount	$	51,539	$	3,931		$	55,470		$	32,477
Unearned premium		51,700		7,211			58,911			40,113
Equity compensation plans		5,810		—			5,810			7,077
Investment impairments		15,424		—			15,424			16,103
Net operating loss carryforwards		16,553		2,963			19,516			18,839
Convertible senior note and note hedge OID		1,325		—			1,325			—
Accrued expenses		—		1,355			1,355			—
Other		—		—			—			2,360
Total gross deferred tax assets		142,351		15,460			157,811			116,969
Less: valuation allowance		—		5,634			5,634			—
Total deferred tax assets		142,351		9,826			152,177			116,969
Deferred tax liability:
Deferred acquisition costs net of deferred ceding commission revenue		58,288		3,208			61,496			40,673
Depreciation and amortization		30,117		—			30,117			14,439
Net unrealized appreciation (depreciation) of securities		40,989		3,335			44,324			18,730
Accrual of bond discount		3,385		—			3,385			986
Other		8,733		7,917			16,650			384
Total deferred tax liabilities		141,512		14,460			155,972			75,212
Net deferred income tax asset (liability)	$	839	$	(4,634	)	$	(3,795	)	$	41,757

In assessing the valuation of deferred tax assets, the Company considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible.

The provision for Federal income taxes incurred is different from that which would be obtained by applying the Federal income tax rate to net income before taxes. The items causing this difference are as follows:

	Nine Months Ended September 30, 2010
				Reciprocal
($ in thousands)	Tower			Exchanges			Total			2009
Federal income tax expense at
U.S. statutory rate	$	41,677		$	378		$	42,055		$	42,165
Tax exempt interest		(3,029	)		(79	)		(3,108	)		(2,804	)
State income taxes net of Federal benefit		896			—			896			866
Other		95			1			96			1,661
Provision for income taxes	$	39,639		$	300		$	39,939		$	41,888

Note 13—Earnings per Share

In accordance with the two-class method, undistributed net earnings (net income less dividends declared during the period) are allocated to both common stock and unvested share-based payment awards (“unvested restricted stock”). Because the common shareholders and share-based payment award holders share in dividends on a 1:1 basis, the earnings per share on undistributed earnings is equivalent. Undistributed earnings are allocated to all outstanding share-based payment awards, including those for which the requisite service period is not expected to be rendered.

The following table shows the computation of the earnings per share pursuant to the two-class method:

26

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(in thousands, except per share amounts)	2010		2009		2010		2009
Numerator
Net income attributable to Tower Group, Inc.	$	33,707	$	29,978	$	79,436	$	78,582
Denominator
Weighted average common shares outstanding		42,924		40,482		44,106		38,248
Effect of dilutive securities:
Stock options		161		210		175		202
Other		13		10		13		13
Weighted average common and potential dilutive shares outstanding		43,098		40,702		44,294		38,463
Earnings per share attributable to Tower stockholders — basic
Common stock:
Distributed earnings	$	0.13	$	0.07	$	0.27	$	0.19
Undistributed earnings		0.66		0.67		1.54		1.86
Total		0.79		0.74		1.81		2.05
Earnings per share attributable to Tower stockholders — diluted	$	0.78	$	0.74	$	1.79	$	2.04

The computation of diluted earnings per share excludes outstanding options and other common stock equivalents in periods where inclusion of such potential common stock instruments would be anti-dilutive. For both the three and nine months ended September 30, 2010, 383,900 options and other common stock equivalents to purchase Tower shares were excluded from the computation of diluted earnings per share because the exercise price of the options was greater than the average market price while for both the three and nine months ended September 30, 2009, 228,700 options and other common stock equivalents were excluded.

Note 14—Segment Information

The accounting policies of the segments are the same as those described in the summary of significant accounting policies in the Annual Report on Form 10-K for the year ended December 31, 2009.

As disclosed in “Note 1 — Nature of Business”, the Company revised its business segments to present Commercial Insurance, Personal Insurance and Insurance Services segments. The Company has restated prior period segments to be consistent with the current presentation.

The Personal Insurance segment includes revenues and expenses associated with the Reciprocal Exchanges, including fees paid to Tower for underwriting, claims, investment management and other services provided pursuant to a management services agreement with the Reciprocal Exchanges. The Insurance Services segment reports revenues earned by Tower from the Reciprocal Exchanges as management fee income, which is calculated as a percentage of the Reciprocal Exchanges’ gross written premiums. The effects of this management services agreement between Tower and the Reciprocal Exchanges are eliminated in consolidation to derive consolidated net income. However, the management fee income is reported in net income attributable to Tower Group, Inc. and included in basic and diluted earnings per share.

Segment performance is evaluated based on segment profit, which excludes investment income, realized gains and losses, interest expense, income taxes and incidental corporate expenses. Assets are not allocated to segments because assets, which consist primarily of investments and fixed assets, other than intangibles and goodwill, are considered in total by management for decision-making purposes.

27

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

Business segments results are as follows:

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
($ in thousands)	2010			2009			2010			2009
Commercial Insurance Segment
Revenues
Premiums earned	$	233,769		$	195,367		$	692,871		$	535,413
Ceding commission revenue		9,239			5,920			27,809			23,820
Policy billing fees		721			747			2,011			1,635
Total revenues		243,729			202,034			722,691			560,868
Expenses
Loss and loss adjustment expenses		148,367			101,837			429,895			286,134
Underwriting expenses		91,007			70,783			263,299			200,676
Total expenses		239,374			172,620			693,194			486,810
Underwriting profit	$	4,355		$	29,414		$	29,497		$	74,058
Personal Insurance Segment
Revenues
Premiums earned	$	145,010		$	28,611		$	226,921		$	86,106
Ceding commission revenue		1,677			1,012			1,748			3,854
Policy billing fees		1,175			183			1,666			536
Total revenues		147,862			29,806			230,335			90,496
Expenses
Loss and loss adjustment expenses		83,097			19,001			130,773			44,787
Underwriting expenses		45,599			10,413			77,750			32,462
Total expenses		128,696			29,414			208,523			77,249
Underwriting profit (loss)	$	19,166		$	392		$	21,812		$	13,247
Tower	$	19,465		$	392		$	22,111		$	13,247
Reciprocal Exchanges		(299	)		—			(299	)		—
Total underwriting profit (loss)	$	19,166		$	392		$	21,812		$	13,247
Insurance Services Segment
Revenues
Direct commission revenue from managing general agency	$	(114	)	$	(270	)	$	(553	)	$	2,013
Management fee income		7,871			—			7,871			—
Reinsurance intermediary fees		599			417			1,380			718
Other revenue		631			65			1,095			1,542
Total revenues		8,987			212			9,793			4,273
Expenses
Direct commission expense paid to producers		51			56			311			1,672
Other insurance services expenses		3,794			57			4,326			2,078
Total expenses		3,845			113			4,637			3,750
Insurance services pretax income (loss)	$	5,142		$	99		$	5,156		$	523

28

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

The following table reconciles revenue by segment to consolidated revenues:

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
($ in thousands)	2010			2009		2010			2009
Commercial insurance segment	$	243,729		$	202,034	$	722,691		$	560,868
Personal insurance segment		147,862			29,806		230,335			90,496
Insurance services segment		8,987			212		9,793			4,273
Total segment revenues		400,578			232,052		962,819			655,637
Elimination of management fee income		(7,871	)		—		(7,871	)		—
Net investment income		29,294			21,733		76,400			53,683
Net realized gains (losses) on investments, including other-than-temporary impairments		1,717			2,555		7,623			2,325
Consolidated revenues	$	423,718		$	256,340	$	1,038,971		$	711,645

The following table reconciles the results of the Company’s individual segments to consolidated income before income taxes:

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
($ in thousands)	2010			2009			2010			2009
Commercial insurance segment underwriting profit	$	4,355		$	29,414		$	29,497		$	74,058
Personal insurance segment underwriting profit (loss)		19,166			392			21,812			13,247
Insurance services segment pretax income (loss)		5,142			99			5,156			523
Net investment income		29,294			21,733			76,400			53,683
Net realized gains (losses) on investments, including other-than-temporary impairments		1,717			2,555			7,623			2,325
Corporate expenses		(791	)		(612	)		(2,148	)		(3,145	)
Acquisition-related transaction costs		(148	)		(1,987	)		(1,398	)		(13,335	)
Interest expense		(6,192	)		(5,055	)		(16,287	)		(13,497	)
Other income (expense)		—			—			(466	)		6,611
Income before income taxes	$	52,543		$	46,539		$	120,189		$	120,470

Note 15—Contingencies

Legal Proceedings

On May 28, 2009, Munich Reinsurance America, Inc. (“Munich”) commenced an action against Tower Insurance Company of New York (“TICNY”), a wholly-owned subsidiary of Tower Group, Inc., in the United States District Court for the District of New Jersey seeking, inter alia, to recover approximately $6.1 million under various retrocessional contracts pursuant to which TICNY reinsures Munich. On June 22, 2009, TICNY filed its answer, in which it, inter alia, asserted two separate counterclaims seeking to recover approximately $2.8 million under various reinsurance contracts pursuant to which Munich reinsures TICNY. A separate action commenced by Munich against TICNY on June 17, 2009 in the United States District Court for the District of New Jersey seeking a declaratory judgment that Munich is entitled to access to TICNY’s books and records pertaining to various quota share agreements, to which TICNY filed its answer on July 7, 2009, was subsequently dismissed pursuant to the stipulation of the parties on March 17, 2010. The parties are currently engaged in discovery and the Company is therefore unable to assess the likelihood of any particular outcome.

On May 12, 2010, Mirabilis Ventures, Inc. (“Mirabilis”) commenced an action against Specialty Underwriters’ Alliance Insurance Co. (“SUA”, now known as CastlePoint National Insurance Company (“CNIC”), a subsidiary of Tower Group, Inc.) and Universal Reinsurance Co., Ltd., an unrelated entity, in the United States District Court for the Middle District of Florida. The Complaint is based upon a Worker’s Compensation/Employer’s Liability policy issued by SUA to AEM, Inc. (“AEM”), to whose legal rights Mirabilis is alleged to have succeeded as a result of the Chapter 11 bankruptcy of AEM. The Complaint, which includes claims against SUA for breach of contract and breach of the duty of good faith, alleges that SUA failed to properly audit AEM’s operations to determine AEM’s worker’s compensation exposure for two policy years, in order to compute the premium owed by AEM, such that SUA owes Mirabilis the principal sum of $3.4 million for one policy year and $0.6 million for the other policy year, plus interest and costs. On July 30, 2010, CNIC filed its answer in which it asserted nine separate

29

Tower Group, Inc.
Notes to Consolidated Financial Statements(Unaudited)

counterclaims, to which Mirabilis responded on September 3, 2010. The litigation is only in its preliminary stage and the Company is therefore unable to assess the likelihood of any particular outcome.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Note on Forward-Looking Statements

The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements. Some of the statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere in this Form 10-Q may include forward-looking statements that reflect our current views with respect to future events and financial performance. Forward-looking statements can generally be identified by the use of forward-looking terminology such as “may,” “will,” “plan,” “expect,” “project,” “intend,” “estimate,” “anticipate,” “believe” and “continue” or their negative or variations and similar terminology. These statements include forward-looking statements both with respect to us specifically and to the insurance sector in general.

All forward-looking statements address matters that involve risks and uncertainties. Accordingly, there are or will be important factors that could cause our actual results to differ materially from those indicated in these statements. We believe that these factors include, but are not limited to, the following:

• ineffectiveness or obsolescence of our business strategy due to changes in current or future market conditions;

• developments that may delay or limit our ability to enter new markets as quickly as we anticipate;

• increased competition on the basis of pricing, capacity, coverage terms or other factors;

• greater frequency or severity of claims and loss activity, including as a result of natural or man-made catastrophic events, than our underwriting, reserving or investment practices anticipate based on historical experience or industry data;

• the effects of acts of terrorism or war;

• developments in the world’s financial and capital markets that adversely affect the performance of our investments;

• changes in domestic or foreign regulations or laws applicable to us, our subsidiaries, brokers or customers;

• changes in acceptance of our products and services, including new products and services;

• changes in the availability, cost or quality of reinsurance and failure of our reinsurers to pay claims timely or at all;

• changes in the percentage of our premiums written that we cede to reinsurers;

• decreased demand for our insurance or reinsurance products;

• loss of the services of any of our executive officers or other key personnel;

• the effects of mergers, acquisitions and divestitures;

• changes in rating agency policies or practices;

• changes in legal theories of liability under our insurance policies;

• changes in accounting policies or practices;

• changes in general economic conditions, including inflation, interest rates, recession and other factors;

• disruptions in Tower’s business arising from the integration of Tower with acquired businesses and the anticipation of potential and pending acquisitions or mergers;

• unanticipated difficulties in combining acquired companies; and

• currently pending or future litigation or governmental proceedings.

The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included in this Form 10-Q. We undertake no obligation to publicly update or review any forward-looking statement, whether as a result of new information, future developments or otherwise.

Operating Income

Operating income excludes realized gains and losses and acquisition-related transaction costs, net of tax. This is a common measurement for property and casualty insurance companies. We believe this presentation enhances the understanding of our

30

results of operations by highlighting the underlying profitability of our insurance business. Additionally, these measures are a key internal management performance standard.

The following table provides a reconciliation of operating income to net income on a GAAP basis. Operating income is used to calculate operating earnings per share and operating return on average equity:

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
($ in thousands)	2010			2009			2010			2009
Operating income	$	33,004		$	30,170		$	76,053		$	87,980
Net realized gains (losses) on investments, net of tax		840			1,661			4,679			1,511
Acquisition-related transaction costs, net of tax		(137	)		(1,853	)		(1,296	)		(10,909	)
Net income attributable to Tower Group, Inc.	$	33,707		$	29,978		$	79,436		$	78,582

Critical Accounting Estimates

As of September 30, 2010, there were no material changes to our critical accounting estimates; refer to the Company’s 2009 Annual Report on Form 10-K for a complete discussion of critical accounting estimates.

Critical Accounting Policies

See Note 2—“Accounting Policies and Basis of Presentation” for information related to updated accounting policies.

Consolidated Results of Operations

Our reported results in the quarter and nine month periods ended September 30, 2010 reflect the impact of acquisitions that we made during 2010 and 2009. On July 1, 2010, we closed on the acquisition of OBPL. In the first quarter of 2009, we closed on the acquisitions of CastlePoint and Hermitage on February 5, 2009 and February 27, 2009, respectively. In the fourth quarter of 2009, we closed on the acquisitions of AequiCap and SUA on October 14, 2009 and November 13, 2009, respectively. Our consolidated revenues and expenses for the nine months ended September 30, 2010 and 2009 reflect the results of these acquired companies from their respective acquisition dates. This affects the comparability of our results between years.

Subsequent to the acquisition of OBPL, the Company has changed the presentation of its business results, beginning July 1, 2010, by allocating the personal insurance business previously reported in Brokerage Insurance segment along with the newly acquired OBPL business to a new Personal Insurance segment and merged the commercial business previously reported in either the Brokerage Insurance or Specialty Business segments in a new Commercial Insurance segment. The Company has retained its Insurance Services segment which will include fees earned by management companies, acquired as a part of the OBPL transaction. This change in presentation reflects the way management organizes the Company for making operating decisions and assessing profitability subsequent to the OBPL acquisition. In developing cost allocations between the commercial and personal lines segments, management has made significant assumptions regarding costs of reinsurance and internal services provided on behalf of such segments. As management receives additional facts which enhance its ability to apportion such costs, it may modify such allocation. If modifications are made, such adjustments will be made to all reporting periods disclosed. The results for all prior periods presented in this Management Discussion and Analysis have been restated to reflect the re-segmentation.

Because we do not manage our invested assets by segments, our investment income is not allocated among our segments. Operating expenses incurred by each segment are recorded in such segment directly. General corporate overhead not incurred by an individual segment is allocated based upon the methodology deemed to be most appropriate which may include employee head count, policy count and premiums earned in each segment.

Our results of operations are discussed below in two parts. The first part discusses the consolidated results of operations. The second part discusses the results of each of our three segments. The comparison between quarters is affected by the acquisitions described above.

31

Consolidated Results of Operations

	Three Months Ended												Nine Months Ended
	September 30,												September 30,
($ in millions)	2010			2009			Change			%			2010			2009			Change			%
Commercial insurance segment underwriting profit	$	4.3		$	29.3		$	(25.0	)		-85.3	%	$	29.5		$	74.0		$	(44.5	)		-60.0	%
Personal insurance segment underwriting profit (1)		19.3			0.4			18.9		NM				21.9			13.2			8.7			65.9	%
Insurance services segment pretax income (2)		5.1			—			5.1			0.0	%		5.2			0.4			4.8		NM
Net investment income		29.3			21.7			7.6			35.0	%		76.4			53.7			22.7			41.3	%
Net realized gains on investments, including other- than-temporary impairments		1.7			2.6			(0.9	)		-34.6	%		7.6			2.3			5.3		NM
Corporate expenses		(0.9	)		(0.6	)		(0.3	)		50.0	%		(2.2	)		(3.0	)		0.8			-23.3	%
Acquisition-related transaction costs		(0.1	)		(1.9	)		1.8			-94.7	%		(1.4	)		(13.3	)		11.9			-89.5	%
Interest expense		(6.2	)		(5.0	)		(1.2	)		24.0	%		(16.3	)		(13.4	)		(2.9	)		21.6	%
Other income (expense)		—			—			—			0.0	%		(0.5	)		6.6			(7.1	)		0.0	%
Income before income taxes		52.5			46.5			6.0			12.9	%		120.2			120.5			(0.3	)		-0.2	%
Income tax expense		18.0			16.6			1.4			8.8	%		39.9			41.9			(2.0	)		-4.9	%
Net income	$	34.5		$	29.9		$	4.6			15.2	%	$	80.3		$	78.6		$	1.7			2.2	%
Less net income attributable to Reciprocal Exchanges		0.8			—			0.8		NM				0.8			—			0.8		NM
Net income attributable to Tower Group, Inc.	$	33.7			29.9			3.8			12.5	%	$	79.5			78.6			0.9			1.2	%
NM is shown where percentage change exceeds 500%
Key Measures
Gross premiums written and produced:
Written by Commercial
Insurance and Personal
Insurance segments	$	447.6		$	282.8		$	164.8			58.3	%	$	1,062.5		$	743.5		$	319.0			42.9	%
Produced by Insurance Services segment		—			0.3			(0.3	)		-100.0	%		—			11.5			(11.5	)		-100.0	%
Total	$	447.6		$	283.1		$	164.5			58.1	%	$	1,062.5		$	755.0		$	307.5			40.7	%
Percent of total revenues:
Net premiums earned		89.4	%		87.4	%								88.5	%		87.4	%
Commission and fee income (3)		3.3	%		3.1	%								3.4	%		4.8	%
Net investment income		6.9	%		8.5	%								7.4	%		7.5	%
Net realized investment gains (losses)		0.4	%		1.0	%								0.7	%		0.3	%

(Continued)

32

	Three Months Ended								Nine Months Ended
	September 30,								September 30,
	2010			2009			Change	%	2010			2009			Change	%
	Underwriting Ratios for Commercial and Personal Insurance Segments Combined
Calendar Year Loss Ratios
Gross		60.1	%		48.0	%				60.2	%		52.3	%
Net		61.1	%		54.0	%				61.0	%		53.2	%
Accident Year Loss Ratio
Net		62.9	%		54.1	%				61.5	%		54.3	%
Underwriting Expense Ratios
Gross (5)		30.5	%		30.4	%				31.1	%		30.9	%
Net (5)		32.7	%		32.7	%				33.5	%		32.8	%
Combined Ratios
Gross		90.6	%		78.4	%				91.3	%		83.2	%
Net		93.8	%		86.7	%				94.5	%		86.0	%
Return on average equity (4)		12.9	%		13.6	%				10.2	%		16.3	%

(1)	Personal Insurance segment underwriting profit includes underwriting results of the Reciprocal Exchanges for the three and nine months ended September 30, 2010.
(2)	Insurance Services segment pretax income for the three and nine months ended September 30, 2010 includes results related to Tower’s management services agreement with the Reciprocal Exchanges.
(3)	Commission and fee income for the three and nine months ended September 30, 2010 excludes management fee income earned by Tower from the Reciprocal Exchanges. These amounts are eliminated in reporting consolidated net income.
(4)	For the three months ended September 30, 2010, the after-tax impact of acquisition-related transaction costs, offset by net realized investment gains, lowered return on average equity by 0.2% and increased return on equity by 0.1% for the nine months ended September 30, 2010. For the three and nine months ended September 30, 2009, the after-tax impact of acquisition-related transaction costs and net realized investment losses increased return on equity by 0.1% and 2.0%, respectively.
(5)	The gross and net underwriting expense ratios include fees paid by the Reciprocal Exchanges to Tower in excess of Tower’s direct costs to service the management services agreement. These fees increased the gross and net expense ratios by 0.9% and 1.0%, respectively, for the three month period ended September 30, 2010, and gross and net expense ratios by 0.3% and 0.4%, respective, for the nine month period ended September 30, 2010.

Consolidated Results of Operations for the Three and Nine Months Ended September 30, 2010 and 2009

Total revenues.Total revenues increased by 65.3% and 46.0%, respectively, for the three and nine months ended September 30, 2010 as compared to the same periods of 2009, primarily due to increased net premiums earned and net investment income resulting from the acquisitions of OBPL in the third quarter of 2010 and of SUA and AequiCap in the fourth quarter of 2009.

Premiums earned.Gross premiums earned in the three and nine months ended September 30, 2010 increased 58.3% and 42.9%, respectively, compared to the same periods in 2009, primarily as a result of the aforementioned acquisitions. Ceded premiums earned increased by a lower percentage than the gross growth percentage as we retained a larger percentage of our gross premiums because of our increased capital base. Accordingly, net premiums earned in the three and nine months ended September 30, 2010 increased by $154.8 million and $298.3 million, respectively, as compared to the same periods in 2009.

Commission and fee income.Commission and fee income increased by $5.9 million in the three month period ended September 30, 2010. This increase is partially attributed to our decision to cede commercial liability premiums on an in-force and renewal basis, effective October 1, 2009. Additionally, the Company recognized additional policy billing fees in connection with the OBPL business. Commission and fee income increased by $1.0 million in the nine month period ended September 30, 2010 due to the increase in ceded premium revenue and policy billing fees. This was offset by a reduction caused by Tower Risk Management Corp. ceasing to produce business on behalf of CPIC subsequent to the CastlePoint acquisition in the first quarter of 2009.

Net investment income and net realized gains (losses).Net investment income increased 34.8% and 42.3%, respectively in the three and nine months ended September 30, 2010 compared to the same periods in 2009. The increase in net investment income

33

resulted from an increase in average cash and invested assets for the three and nine months ended September 30, 2010 as compared to the same periods of 2009. The increase in cash and invested assets resulted primarily from invested assets acquired from the aforementioned acquisitions (reduced by cash used to finance such acquisitions) and to operating cash flows of $214.7 million generated during 2009 and $131.6 million generated during the first nine months of 2010. The positive cash flow from operations was the result of the aforementioned acquisitions and an increase in premiums collected from a growing book of business. The tax equivalent investment yield at amortized cost was 5.1% at September 30, 2010 compared to 5.6% at September 30, 2009. Operating cash invested in 2009 and in 2010 has been affected by a low yield environment, as asset classes other than US Treasuries have experienced tightening spreads, the result of investors reaching for yield in a low interest rate environment. We have increased our investment in high yield securities to reduce the impact of this low rate environment.

Net realized investment gains were $7.6 million for the nine months ended September 30, 2010 compared to gains of $2.3 million in the same period last year. Credit related OTTI losses in the three and nine months ended September 30, 2010 of $0.6 million and $3.5 million respectively were considerably lower than the $11.7 million and $19.0 million, respectively, which were recorded for the comparable periods of 2009.

Loss and loss adjustment expenses.For the nine months ended September 30, 2010 the loss ratio increased 7.8 points due to the impact of losses from the Northeast U.S. Storm occurring during March 13 to March 15, 2010 as well as changing business mix and price competition which was partially offset during the second quarter by lower property losses. The amortization of the reserves risk premium, which was established in connection with the acquisitions completed in 2010 and 2009, reduced consolidated losses by $4.8 million or approximately 0.5 loss ratio points for the nine months ended September 30, 2010.

Operating expenses.Operating expenses were $340.0 million for the nine months ended September 30, 2010, an increase of 41.6% from the same period in 2009, primarily as a result of the aforementioned acquisitions.

Acquisition-related transaction costs.Acquisition-related transaction costs for the three and nine months ended September 30, 2010 were $0.1 million and $1.4 million, respectively, and relate to the acquisition of OBPL. In the comparable periods of the prior year, we recorded acquisition related transaction costs of $2.0 million and $13.3 million, respectively, primarily related to the CastlePoint acquisition.

Interest expense.Interest expense increased by $1.1 million and $2.8 million, respectively, for the three and nine months ended September 30, 2010 compared to the same periods in 2009. Interest expense increased mainly due to interest expense on subordinated debentures which were assumed as a result of the merger with CastlePoint, the issuance of the convertible senior notes in September 2010 and, to a much lesser extent, interest of $0.1 million on the $56 million draw-down under our credit facility on May 24, 2010. The credit facility draw-down was repaid in September 2010.

Other income (expense).Other expense for the nine months ended 2009 included a gain of $7.4 million on the revaluation of the shares owned in CastlePoint at the time of the acquisition. As a result of the acquisition of CastlePoint, we recorded equity in CastlePoint’s net loss of $0.8 million for the period of January 1, 2009 through February 5, 2009. We did not record any other income (expense) items in 2010.

Income tax expense.Income tax expense decreased in 2010 compared to 2009. The effective income tax rate (including state and local taxes) was 33.3% for the nine months ended September 30, 2010, compared to 34.8% for the same period in 2009.The decrease in the effective tax rate for the nine months ended September 30, 2010 was primarily related to an increase in our tax exempt municipal investments.

Net income and return on average equity.Net income and annualized return on average equity were $33.7 million and 12.9% for the three months ended September 30, 2010 compared to $30.0 million and 13.6% for the same period in 2009. The decline in the net income and annualized return on equity in 2010 is primarily due to the increase in incurred loss and LAE described above.

Net income and annualized return on average equity were $79.4 million and 10.2% for the nine months ended September 30, 2010 compared to $78.6 million and 16.3% for the same period in 2009. The decline in the annualized return on equity in 2010 is primarily due to the reduced earnings resulting from higher incurred loss and LAE, including the $17.5 million pre-tax charge for the Northeast U.S. Storm occurring during March 13 to March 15, 2010.

34

Commercial Insurance Segment Results of Operations

	Three Months Ended September 30,												Nine Months Ended September 30,
($ in millions)	2010			2009			Change			Percent			2010			2009			Change			Percent
Revenues
Premiums earned
Gross premiums earned	$	272.4		$	226.7		$	45.7			20.2	%	$	825.1		$	637.5		$	187.6			29.4	%
Less: ceded premiums earned		(38.6	)		(31.3	)		(7.3	)		23.3	%		(132.2	)		(102.0	)		(30.2	)		29.6	%
Net premiums earned		233.8			195.4			38.4			19.7	%		692.9			535.5			157.4			29.4	%
Ceding commission revenue		9.2			5.9			3.3			56.0	%		27.8			23.8			4.0			16.7	%
Policy billing fees		0.7			0.7			—			-3.6	%		2.0			1.6			0.4			22.9	%
Total revenue		243.7			202.0			41.7			20.6	%		722.7			560.9			161.8			28.9	%
Expenses
Loss and loss adjustment expenses
Gross loss and loss adjustment expenses		172.9			103.3			69.6			67.4	%		510.4			338.3			172.1			50.9	%
Less: ceded loss and loss adjustment expenses		(24.5	)		(1.4	)		(23.1	)	NM				(80.5	)		(52.1	)		(28.4	)		54.4	%
Net loss and loss adjustment expenses		148.4			101.9			46.5			45.7	%		429.9			286.2			143.7			50.2	%
Underwriting expenses
Direct commission expenses		52.6			43.9			8.7			19.8	%		153.3			128.3			25.0			19.5	%
Other underwriting expenses		38.4			26.9			11.5			43.0	%		110.0			72.4			37.6			51.9	%
Total underwriting expenses		91.0			70.8			20.2			28.6	%		263.3			200.7			62.6			31.2	%
Underwriting profit	$	4.3		$	29.3		$	(25.0	)		-85.2	%	$	29.5		$	74.0		$	(44.5	)		-60.2	%
Key Measures
Premiums written
Gross premiums written	$	279.1		$	232.8		$	46.3			19.9	%	$	806.4		$	615.0		$	191.4			31.1	%
Less: ceded premiums written		(29.8	)		(17.6	)		(12.2	)	NM				(97.2	)		(49.1	)		(48.1	)		97.8	%
Net premiums written	$	249.3		$	215.2		$	34.1			15.9	%	$	709.2		$	565.9		$	143.3			25.3	%
NM shown where percentage change exceeds 500%
Ceded premiums as a percent of gross premiums
Written		10.7	%		7.6	%								12.1	%		8.0	%
Earned		14.2	%		13.8	%								16.0	%		16.0	%
Calendar Year Loss Ratios
Gross		63.5	%		45.6	%								61.9	%		53.1	%
Net		63.5	%		52.1	%								62.0	%		53.4	%
Accident Year Loss Ratio
Net		64.1	%		54.0	%								61.7	%		55.5	%
Underwriting Expense Ratios
Gross		33.1	%		30.9	%								31.7	%		31.2	%
Net		34.7	%		32.8	%								33.7	%		32.7	%
Combined Ratios
Gross		96.6	%		76.5	%								93.6	%		84.3	%
Net		98.2	%		84.9	%								95.7	%		86.1	%

Commercial Insurance Segment Results of Operations for the Three and Nine Months Ended September 30, 2010 and 2009

Gross premiums.Commercial Insurance gross premium written increased by $46.3 million and $191.4 million for the three months and nine months ended September 30, 2010, respectively, compared to the same periods last year. The increase in both the three and nine months ended September 30, 2010 was primarily due to the acquisition of SUA in November 2009 and, to a lesser extent, the acquisition of CastlePoint and Hermitage in February 2009. These increases were slightly offset by the reduction of third-party reinsurance written by CPRe.

35

Renewal retention, particularly for small policies, continued to offset a challenging market environment for new business. We restricted underwriting in some of our programs and for middle to larger policies, which resulted in a decline in premiums from these customer types. Written premiums decreased $10.5 million on program business for the three months ended September 30, 2010. Excluding programs, renewal retention rate was 80% and 78%, respectively, for the three and nine months ended September 30, 2010. Premiums on renewed Commercial business, other than programs, increased 0.2%. Excluding programs, policies in-force for our Commercial business increased by 10.0% as of September 30, 2010 compared to September 30, 2009.

Ceded premiums.Ceded premiums written and earned were $29.8 million and $38.6 million, respectively, for the three months ended September 30, 2010 and were $97.2 million and $132.2 million, respectively, for the nine months ended September 30, 2010. The increase in ceded premiums written and earned for the three and nine months ended September 30, 2010 compared to the same periods of 2009 was a result of our decision to cede Commercial liability premiums on an in-force new and renewal basis, effective October 1, 2009. In the first nine months of 2009, we did not cede any premiums written to our quota share reinsurers, which included CPRe prior to the acquisition on February 5, 2009.

Catastrophe reinsurance ceded premiums were $15.7 million for the nine months ended September 30, 2010 compared to $13.7 million for the same period in 2009. The increase in catastrophe costs in 2010 primarily resulted from property exposure and modestly higher cost of catastrophe coverage.

Net premiums.The change in net premiums written and earned increased in line with increases in gross premiums that were driven primarily by the acquisition of SUA and the aforementioned increase in ceded premiums.

Ceding commission revenue.Ceding commission revenue increased for the three and nine months ended September 30, 2010 by $3.3 million and $4.0 million compared to the same periods in 2009. The increase was a result of our decision to cede Commercial liability premiums on an in-force and new and renewal basis, effective October 1, 2009. Ceding commission revenue was reduced by $.07 million and $2.1 million for the three and nine months ended September 30, 2010 as a result of increases in ceded loss ratios on prior year’s quota share treaties.

Loss and loss adjustment expenses and loss ratio.The net loss ratio increased by 8.6 percentage points for the nine months ended September 30, 2010 as compared to the same period in 2009. The increase in the net loss ratio for the nine months is largely due to more competitive market conditions. Also impacting the current period loss ratio are winter storms in March 2010 that added $6.0 million in incurred losses.

Underwriting expenses and underwriting expense ratio. Underwriting expenses include direct commissions and other underwriting expenses. The increase in underwriting expenses was due to the increase in gross premiums earned, which was primarily due to the SUA, CastlePoint and Hermitage acquisitions. The gross underwriting expense ratio was 33.1% and 31.7% for the three and nine months ended September 30, 2010 as compared to 30.9% and 31.2% for the same periods last year. The net expense ratio was 34.7% and 33.7% for the three and nine months ended September 30, 2010 as compared to 32.8% and 32.7% for the same periods last year.

The other underwriting expense (“OUE”) ratio, which includes boards, bureaus and taxes (“BB&T”), was 13.8% and 13.1% for the three and nine months ended September 30, 2010 compared to 11.5% and 11.1% for the same periods in 2009. Our investment in technology and overall integration efforts have increased given the previously mentioned acquisitions over the past eighteen months which were mainly Commercial Lines focused. With the recent acquisition of the OBPL business, some of the resources and associated costs are expected to be redeployed to the Personal Lines segment in the near future. Compensation-related costs of $2.1 million were incurred in connection with staff reductions related to ongoing restructuring and closing of acquired offices.

The commission portion of the gross underwriting expense ratio, which is expressed as a percentage of gross premiums earned, was 19.3% and 18.6% for the three and nine months ended September 30, 2010 compared to 19.4% and 20.1% for the same periods last year. The decrease in commission rate for the year to date 2010 period resulted from significantly higher amortization costs in 2009 for the value of business acquired (“VOBA”) of CastlePoint.

Underwriting profit and combined ratio. The net combined ratios were 98.2% and 95.7% for the three and nine months ended September 30, 2010, respectively, and 84.9% and 86.1% for the three and nine months ended September 30, 2009, respectively. The increase in the combined ratio for the nine months resulted from an increase in the net loss ratio due to catastrophe losses, softer market conditions and increases in the net expense ratios as describe above.

36

Personal Insurance Segment Results of Operations

	Three Months Ended September 30,
	2010
				Reciprocal
($ in millions)	Tower			Exchanges			Total			2009			Change			Percent
Revenues
Premiums earned
Gross premiums earned	$	113.6			56.0		$	169.6		$	37.1		$	132.5			357.4	%
Less: ceded premiums earned		(14.6	)		(9.9	)		(24.5	)		(8.5	)		(16.0	)		190.2	%
Net premiums earned		99.0			46.1			145.1			28.6			116.5			406.8	%
Ceding commission revenue		0.7			1.0			1.7			1.0			0.7			65.7	%
Policy billing fees		1.0			0.2			1.2			0.2			1.0		NM
Total		100.7			47.3			148.0			29.8			118.2			396.1	%
Expenses
Loss and loss adjustment expenses
Gross loss and loss adjustment expenses		51.9			41.0			92.9			23.2			69.7			300.5	%
Less: ceded loss and loss adjustment expenses		(3.5	)		(6.3	)		(9.8	)		(4.2	)		(5.6	)		133.3	%
Net loss and loss adjustment expenses		48.4			34.7			83.1			19.0			64.1			337.3	%
Underwriting expenses
Direct commission expense		20.2			8.3			28.5			6.3			22.2			349.8	%
Other underwriting expenses		12.6			4.5			17.1			4.1			13.0			319.5	%
Total underwriting expenses		32.8			12.8			45.6			10.4			35.2			337.9	%
Underwriting profit (loss)		19.5			(0.2	)		19.3			0.4			18.9		NM
Key Measures
Premiums written
Gross premiums written	$	112.2		$	56.2		$	168.4		$	50.0		$	118.4			236.6	%
Less: ceded premiums written		(15.4	)		(12.7	)		(28.1	)		(6.6	)		(21.5	)		328.2	%
Net premiums written	$	96.8		$	43.5		$	140.3		$	43.4		$	96.9			222.7	%
NM is shown where percentage change exceeds 500%
Ceded premiums as a percent of gross premiums
Written		13.7	%		22.6	%		16.7	%		13.2	%
Earned		12.9	%		17.7	%		14.4	%		22.9	%
Calendar Year Loss Ratios
Gross		45.7	%		73.2	%		54.8	%		62.5	%
Net		48.9	%		75.3	%		57.3	%		66.4	%
Accident Year Loss Ratio
Net		54.2	%		75.3	%		60.9	%		55.2	%
Underwriting Expense Ratios
Gross		27.9	%		22.7	%		26.2	%		27.6	%
Net		31.4	%		25.3	%		29.5	%		32.2	%
Combined Ratios
Gross		73.6	%		95.9	%		81.0	%		90.1	%
Net		80.3	%		100.6	%		86.8	%		98.6	%

37

Personal Insurance Segment Results of Operations (Continued)

	Nine Months Ended September 30,
	2010
				Reciprocal
($ in millions)	Tower			Exchanges			Total			2009			Change			Percent
Revenues
Premiums earned
Gross premiums earned	$	203.6			56.0		$	259.6		$	110.0		$	149.6			136.0	%
Less: ceded premiums earned		(22.7	)		(9.9	)		(32.6	)		(23.9	)		(8.7	)		36.7	%
Net premiums earned		180.9			46.1			227.0			86.1			140.9			172.7	%
Ceding commission revenue		0.7			1.0			1.7			3.9			(2.2	)		-54.6	%
Policy billing fees		1.5			0.2			1.7			0.5			1.2			210.8	%
Total		183.1			47.3			230.4			90.5			139.9			328.9	%
Expenses
Loss and loss adjustment expenses
Gross loss and loss adjustment expenses		101.6			41.0			142.6			52.7			89.9			170.7	%
Less: ceded loss and loss adjustment expenses		(5.5	)		(6.3	)		(11.8	)		(7.9	)		(3.9	)		49.7	%
Net loss and loss adjustment expenses		96.1			34.7			130.8			44.8			86.0			220.4	%
Underwriting expenses
Direct commission expense		35.9			8.3			44.2			20.3			23.9			117.9	%
Other underwriting expenses		29.0			4.5			33.5			12.2			21.3			175.6	%
Total underwriting expenses		64.9			12.8			77.7			32.5			45.2			139.5	%
Underwriting profit (loss)		22.1			(0.2	)		21.9		$	13.2		$	8.7			-31.0	%
Key Measures
Premiums written
Gross premiums written	$	199.9		$	56.2		$	256.1		$	128.5		$	127.6			99.2	%
Less: ceded premiums written		(23.2	)		(12.7	)		(35.9	)		(13.6	)		(22.3	)		164.0	%
Net premiums written	$	176.7		$	43.5		$	220.2		$	114.9		$	105.3			91.6	%
NM is shown where percentage change exceeds 500%
Ceded premiums as a percent of gross premiums
Written		11.6	%		22.6	%		14.0	%		10.6	%
Earned		11.1	%		17.7	%		12.6	%		21.7	%
Calendar Year Loss Ratios
Gross		49.9	%		73.2	%		54.9	%		47.9	%
Net		53.1	%		75.3	%		57.6	%		52.0	%
Accident Year Loss Ratio
Net		57.0	%		75.3	%		60.7	%		47.3	%
Underwriting Expense Ratios
Gross		31.1	%		22.7	%		29.3	%		29.0	%
Net		34.6	%		25.3	%		32.8	%		32.6	%
Combined Ratios
Gross		81.0	%		95.9	%		84.2	%		76.9	%
Net		87.7	%		100.6	%		90.4	%		84.6	%

Personal Insurance Segment Results of Operations for the Three and Nine Months Ended September 30, 2010 and 2009

Gross premiums.Gross written premiums increased for the three and nine months ended September 30, 2010 by $118.4 million and $127.6 million compared to the same periods in 2009. The acquisition of OBPL accounted for $116.2 million of this increase

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for the three and nine months ended September 30, 2010 and the remaining increase was attributable to general growth in our personal lines business.

The increase in gross premiums earned for the three and nine months ended September 30, 2010 mirrors the growth in written premiums. The OBPL acquisition added $117.8 million of gross premiums earned for both the three and nine months ended September 30, 2010.

Ceded premiums.Ceded premiums written and earned were $28.1 million and $24.5 million, respectively, for the three months ended September 30, 2010 and were $35.9 million and $32.6 million, respectively, for the nine months ended September 30, 2010. The increase in ceded premiums written and ceded premiums earned for the three and nine months ended September 30, 2010 as compared to the same periods of the prior year is primarily attributed to OBPL ceded premiums written and earned of $22.5 million and $18.6 million, respectively, for the three months ended September 30, 2010.

Catastrophe ceded premiums written were $11.6 million for the nine month periods ended September 30, 2010 compared to $10.4 for the same periods, respectively, in the prior periods. The increase in catastrophe ceded premiums is primarily attributed to $2.6 million for OBPL.

Net premiums.Net premiums written increased by $105.3 million to $220.2 million for the nine months ended September 30, 2010, as compared to the same period of the prior year. The acquisition of OBPL accounted for $93.7 million of this increase for the nine months ended September 30, 2010, and the remaining increase is attributable to general growth in our personal lines business.

Ceding commission revenue.Ceding commission revenue, as a percentage of ceded premiums written and earned declined from the three month and nine month periods ended September 30, 2009 to 2010. This decline is primarily attributed to the acquisition of OBPL. In recording the fair value adjustments on acquisition, the Company’s VOBA was established as the value of business acquired, offset by embedded ceding commissions, as of July 1, 2010. Accordingly, the fair value of deferred ceding commissions was recorded at zero. VOBA is being amortized into commission expense in proportion to the earnings of the business acquired. Ceding commission revenue as a percentage of ceded premiums written and earned is expected to increase in the fourth quarter 2010 as we earn the ceded commission revenue for business written in the third quarter 2010.

Loss and loss adjustment expenses. The net loss ratio decreased by 9.1 percentage points for the three months ended September 30, 2010 compared to the same period in 2009 and increased by 5.6 points for the nine months ended September 30, 2010 as compared to the same period in 2009. The increase in loss ratio for the nine month period reflects winter storms in March 2010 that added approximately $12.0 million in incurred losses and increased the loss ratio by 13.9 points.

For the three and nine month periods, the loss ratio includes better than expected prior year development on the personal lines business including the personal automobile business acquired from OneBeacon. Aggregate favorable development recorded in the quarter for the segment was $5.0 million.

Underwriting expenses and underwriting expense ratio.The increase in underwriting expenses results from the increase in gross premiums earned, primarily related to the OBPL acquisition. The gross underwriting expense ratios of 26.2% and 29.3% for the three and nine months ended September 30, 2010 and net underwriting expense ratios of 29.5% and 32.8% declined from the respective ratios in the third quarter of 21010 compared to 2009, and was relatively flat for the nine month periods in 2010 compared to 2009.

The commission portion of the gross underwriting expense ratio was 16.8% and 17.0% for the three and nine months ended September 30, 2010 compared to 17.1% and 18.5% for the same periods last year. The other underwriting expense (“OUE”) ratio, which includes boards, bureaus and taxes (“BB&T”), was 9.4% and 12.3% for the three and nine months ended September 30, 2010 compared to 10.5% and 10.6% for the same periods last year. The decrease in the OUE expense ratio resulted from the Company deferring third quarter acquisition costs relating to OBPL with no offsetting expense as VOBA associated with the acquired business was amortized in commission expense. The increase in the OUE expense ratio for the nine month period is due to the integration efforts associated with the OBPL acquisition.

If the commission expense and OUE were adjusted for their implied amounts in the VOBA amortization, gross underwriting expense ratios would have been 28.3% and 29.2% for the three and nine month periods ended September 30, 2010, modestly higher than the corresponding ratio in 2009.

The net underwriting expense ratios were 29.5% and 32.8% for the three and nine months ended September 30, 2010 as compared to 32.2% and 32.6% for the comparable periods in 2009.

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Underwriting profit and combined ratio.The increase in underwriting profit for the three months and nine months ended September 30, 2010 primarily resulted from the OBPL business and the decline in loss ratios. Changes in combined ratio reflect the changes in the loss ratio and the expense ratio for reasons described above.

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Insurance Services Segment Results of Operations

	Three Months Ended September 30,												Nine Months Ended September 30,
($ in millions)	2010			2009			Change			Percent			2010			2009		Change			Percent
Revenue
Direct commission revenue from managing general agency	$	(0.1	)	$	(0.3	)	$	0.2			-57.8	%	$	(0.6	)	$	2.0	$	(2.6	)		-127.5	%
Management fee income		7.9			—			7.9			0.0	%		7.9			—		7.9			0.0	%
Reinsurance intermediary fees		0.6			0.4			0.2			43.6	%		1.4			0.7		0.7			92.3	%
Other revenue		0.6			0.1			0.5		NM				1.1			1.5		(0.4	)		-29.0	%
Total revenue		9.0			0.2			8.8		NM				9.8			4.2		5.6			129.2	%
Expenses
Direct commission expenses paid to producers		0.1			0.1			—			-8.9	%		0.3			1.7		(1.4	)		-81.4	%
Other insurance services expenses		3.8			—			3.8		NM				4.3			1.0		3.3			320.4	%
Claims expense reimbursement to TICNY		—			0.1			(0.1	)		-87.3	%		—			1.1		(1.1	)		-98.4	%
Total expenses		3.9			0.2			3.7		NM				4.6			3.8		0.8			23.7	%
Insurance services pre-tax income	$	5.1		$	—		$	5.1			-100.0	%	$	5.2		$	0.4	$	4.8			0.0	%

NM is shown where percentage change exceeds 500%

Insurance Services Segment Results of Operations for the Three and Nine Months Ended September 30, 2010 and 2009

Total revenue. The increase in total revenue for the three and nine months ended September 30, 2010 compared to the same periods in the prior year was primarily due to the management fee income earned by Tower for underwriting, claims, investment management and other services provided to the Reciprocal Exchanges pursuant to a management services agreement with the Reciprocal Exchanges. The management fee income is calculated as a percentage of the Reciprocal Exchanges’ gross written premiums.

Total expenses. The increase in total expenses for the three and nine months ended September 30, 2010 compared to the same periods in the prior year was primarily due to the costs incurred under the management services agreement between Tower and the Reciprocal Exchanges.

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Investments

Portfolio Summary

The following table presents a breakdown of the amortized cost, aggregate fair value and unrealized gains and losses by investment type as of September 30, 2010 and December 31, 2009:

	Cost or		Gross		Gross Unrealized Losses								% of
	Amortized		Unrealized		Less than 12			More than 12			Fair		Fair
($ in thousands)	Cost		Gains		Months			Months			Value		Value
September 30, 2010
U.S. Treasury securities	$	44,332	$	1,801	$	—		$	—		$	46,133		1.8	%
U.S. Agency securities		90,871		1,585		(178	)		—			92,278		3.6	%
Municipal bonds		574,128		38,680		(165	)		(60	)		612,583		23.8	%
Corporate and other bonds		942,956		61,785		(572	)		(62	)		1,004,107		39.0	%
Commercial, residential and asset-backed securities		712,993		43,379		(5,217	)		(130	)		751,025		29.2	%
Total fixed-maturity securities		2,365,280		147,230		(6,132	)		(252	)		2,506,126		97.4	%
Equity securities		37,105		3,554		(32	)		(147	)		40,480		1.6	%
Short-term investments		26,656		246		—			—			26,902		1.0	%
Total, September 30, 2010	$	2,429,041	$	151,030	$	(6,164	)	$	(399	)	$	2,573,508		100.0	%
Tower	$	2,122,209	$	141,255	$	(6,159	)	$	(399	)	$	2,256,906		87.7	%
Reciprocal Exchanges		306,832		9,775		(5	)		—			316,602		12.3	%
Total, September 30, 2010	$	2,429,041	$	151,030	$	(6,164	)	$	(399	)	$	2,573,508		100.0	%
December 31, 2009
U.S. Treasury securities	$	73,281	$	235	$	(225	)	$	—		$	73,291		3.9	%
U.S. Agency securities		40,063		134		(214	)		—			39,983		2.1	%
Municipal bonds		508,204		18,241		(587	)		(143	)		525,715		27.7	%
Corporate and other bonds		589,973		27,934		(1,054	)		(1,732	)		615,121		32.4	%
Commercial, residential and asset-backed securities		517,596		25,834		(1,691	)		(12,253	)		529,486		27.9	%
Total fixed-maturity securities		1,729,117		72,378		(3,771	)		(14,128	)		1,783,596		94.0	%
Equity securities		78,051		997		(1,591	)		(724	)		76,733		4.1	%
Short-term investments		36,500		—		—			—			36,500		1.9	%
Total	$	1,843,668	$	73,375	$	(5,362	)	$	(14,852	)	$	1,896,829		100.0	%

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Credit Rating of Fixed-Maturity Securities

The average credit rating of our fixed-maturity securities, using ratings assigned to securities by Standard & Poor’s, was AA- at September 30, 2010 and December 31, 2009. The following table shows the ratings distribution of our fixed-maturity portfolio:

	September 30, 2010					December 31, 2009
			Percentage					Percentage
			of Fair					of Fair
($ in thousands)	Fair Value		Value			Fair Value		Value
Rating
U.S. Treasury securities	$	46,133		1.8	%	$	73,291		4.1	%
AAA		923,673		36.9	%		597,932		33.5	%
AA		417,530		16.7	%		377,283		21.2	%
A		619,419		24.7	%		400,639		22.5	%
BBB		221,032		8.8	%		165,173		9.2	%
Below BBB		278,339		11.1	%		169,278		9.5	%
Total	$	2,506,126		100.0	%	$	1,783,596		100.0	%
Tower	$	2,189,524		87.4	%	$	1,783,596		100.0	%
Reciprocal Exchanges		316,602		12.6	%		—		0.0	%
Total	$	2,506,126		100.0	%	$	1,783,596		100.0	%

Fixed-Maturity Investments with Third Party Guarantees

At September 30, 2010, $239.7 million of our municipal bonds, at fair value, were guaranteed by third parties from a total of $2.5 billion, at fair value, of all fixed-maturity securities held by us. The amount of securities guaranteed by third parties along with the credit rating with and without the guarantee is as follows:

	With		Without
($ in thousands)	Guarantee		Guarantee
AAA	$	11,986	$	11,986
AA		175,718		155,342
A		44,349		63,287
BBB		6,233		—
BB		959		3,596
No underlying rating		480		5,514
Total	$	239,725	$	239,725
Tower	$	237,692	$	237,692
Reciprocal Exchanges		2,033		2,033
Total	$	239,725	$	239,725

The securities guaranteed, by guarantor, are as follows:

	Guaranteed		Percent
($ in thousands)	Amount		of Total
National Public Finance Guarantee Corp.	$	96,428		40.2	%
Assured Guaranty Municipal Corp.		85,950		35.9	%
Ambac Financial Corp.		41,935		17.5	%
FGIC Corp.		6,097		2.5	%
Berkshire Hathaway Assurance Corp.		6,030		2.5	%
Others		3,285		1.4	%
Total	$	239,725		100.0	%
Tower	$	237,692		99.2	%
Reciprocal Exchanges		2,033		0.8	%
Total	$	239,725		100.0	%

Fair Value Consideration

Under GAAP, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an “exit price”). GAAP establishes a fair value hierarchy that distinguishes between inputs based on market data from independent sources (“observable inputs”) and a reporting entity’s internal assumptions based

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upon the best information available when external market data is limited or unavailable (“unobservable inputs”). The fair value hierarchy in GAAP prioritizes fair value measurements into three levels based on the nature of the inputs. Quoted prices in active markets for identical assets have the highest priority (“Level 1”), followed by observable inputs other than quoted prices including prices for similar but not identical assets or liabilities (“Level 2”), and unobservable inputs, including the reporting entity’s estimates of the assumption that market participants would use, having the lowest priority (“Level 3”).

As of September 30, 2010, substantially all of the investment portfolio recorded at fair value was priced based upon quoted market prices or other observable inputs. For investments in active markets, we used the quoted market prices provided by the outside pricing services to determine fair value. In circumstances where quoted market prices were unavailable, we used fair value estimates based upon other observable inputs including matrix pricing, benchmark interest rates, market comparables and other relevant inputs. When observable inputs were adjusted to reflect management’s best estimate of fair value, such fair value measurements are considered a lower level measurement in the GAAP fair value hierarchy.

Our process to validate the market prices obtained from the outside pricing sources includes, but is not limited to, periodic evaluation of model pricing methodologies and analytical reviews of certain prices. We also periodically perform testing of the market to determine trading activity, or lack of trading activity, as well as market prices. Several securities sold during the quarter were “back-tested” (i.e., the sales price is compared to the previous month end reported market price to determine reasonableness of the reported market price).

In certain instances, we deemed it necessary to utilize Level 3 pricing over prices available through pricing services used throughout 2009 and 2010. In the periods of market dislocation, the ability to observe stable prices and inputs may be reduced for some instruments as currently is the case for certain non-agency residential, commercial mortgage-backed securities and asset-backed securities.

A number of our Level 3 investments have also been written down as a result of our impairment analysis. At September 30, 2010, there were 13 securities that were priced in Level 3 with a fair value of $3.1 million and an unrealized gain of $0.8 million.

As more fully described in Note 5 to our Consolidated Financial Statements, “Investments—Impairment Review,” we completed a detailed review of all our securities in a continuous loss position, including but not limited to residential and commercial mortgage-backed securities, and concluded that the unrealized losses in these asset classes are the result of a decrease in value due to technical spread widening and broader market sentiment, rather than fundamental collateral deterioration, and are temporary in nature.

Refer to Note 6 to the Consolidated Financial Statements for a description of the valuation methodology utilized to value Level 3 assets, how the valuation methodology is validated and an analysis of the change in fair value of Level 3 assets. As of September 30, 2010, the fair value of Level 3 assets as a percentage of our total assets carried at fair value was as follows:

					Level 3 Assets
	Assets Carried at				as a Percentage of
	Fair Value at		Fair Value of		Total Assets Carried
($ in thousands)	September 30, 2010		Level 3 Assets		at Fair Value
Fixed-maturity investments	$	2,506,126	$	3,105		0.1	%
Equity investments		40,480		—
Short-term investments		26,902		—
Total investments available for sale		2,573,508		3,105		0.1	%
Cash and cash equivalents		118,436		—
Total	$	2,691,944	$	3,105		0.1	%

Unrealized Losses

In the third quarter of 2010, the rally in the markets continued. Over the last nine months, there has been a notable return of investor risk appetite. As a result, spread sectors have continued to benefit from further improvement in economic data as investors seek out higher yielding investments. CMBS was the strongest performing sector in the nine months ended September 30, 2010.

Changes in interest rates directly impact the fair value of our fixed maturity portfolio. We regularly review both our fixed-maturity and equity portfolios to evaluate the necessity of recording impairment losses for other-than temporary declines in the fair value of investments.

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The following table presents information regarding our invested assets that were in an unrealized loss position at September 30, 2010 and December 31, 2009 by amount of time in a continuous unrealized loss position:

	Less than 12 Months							12 Months or Longer							Total
			Fair		Unrealized					Fair		Unrealized					Aggregate		Unrealized
($ in thousands)	No.		Value		Losses			No.		Value		Losses			No.		Fair Value		Losses
September 30, 2010
U.S. Agency securities		20	$	65,996	$	(178	)		—	$	—	$	—			20	$	65,996	$	(178	)
Municipal bonds		12		14,571		(165	)		1		980		(60	)		13		15,551		(225	)
Corporate and other bonds
Finance		18		6,329		(234	)		2		641		(18	)		20		6,970		(252	)
Industrial		95		28,831		(296	)		3		842		(44	)		98		29,673		(340	)
Utilities		8		1,704		(42	)		—		—		—			8		1,704		(42	)
Commercial mortgage- backed securities		24		17,866		(2,337	)		—		—		—			24		17,866		(2,337	)
Residential mortgage- backed securities
Agency backed		77		101,624		(746	)		—		—		—			77		101,624		(746	)
Non-agency backed		16		7,291		(1,603	)		5		1,771		(128	)		21		9,062		(1,731	)
Asset-backed securities		12		16,928		(531	)		1		177		(2	)		13		17,105		(533	)
Total fixed-maturity securities		282		261,140		(6,132	)		12		4,411		(252	)		294		265,551		(6,384	)
Preferred stocks		2		2,226		(32	)		5		3,404		(147	)		7		5,630		(179	)
Total, September 30, 2010		284	$	263,366	$	(6,164	)		17	$	7,815	$	(399	)		301	$	271,181	$	(6,563	)
Tower		281	$	258,250	$	(6,159	)		17	$	7,815	$	(399	)		298	$	266,065	$	(6,558	)
Reciprocal Exchanges		3		5,116		(5	)		—		—		—			3		5,116		(5	)
Total, September 30, 2010		284	$	263,366	$	(6,164	)		17	$	7,815	$	(399	)		301	$	271,181	$	(6,563	)
December 31, 2009
U.S. Treasury securities		24	$	43,421	$	(225	)		—	$	—	$	—			24	$	43,421	$	(225	)
U.S. Agency securities		21		27,652		(214	)		—		—		—			21		27,652		(214	)
Municipal bonds		42		50,526		(587	)		5		2,569		(143	)		47		53,095		(730	)
Corporate and other bonds
Finance		32		28,342		(291	)		20		14,906		(1,099	)		52		43,248		(1,390	)
Industrial		104		69,475		(726	)		25		14,563		(608	)		129		84,038		(1,334	)
Utilities		6		3,575		(37	)		2		625		(25	)		8		4,200		(62	)
Commercial mortgage- backed securities		20		25,810		(598	)		27		22,904		(8,138	)		47		48,714		(8,736	)
Residential mortgage- backed securities
Agency backed		43		79,005		(963	)		—		—		—			43		79,005		(963	)
Non-agency backed		4		1,081		(14	)		37		19,672		(2,910	)		41		20,753		(2,924	)
Asset-backed securities		5		334		(116	)		11		2,962		(1,205	)		16		3,296		(1,321	)
Total fixed-maturity securities		301		329,221		(3,771	)		127		78,201		(14,128	)		428		407,422		(17,899	)
Preferred stocks		87		59,243		(1,441	)		6		4,827		(724	)		93		64,070		(2,165	)
Common stocks		4		31		(150	)		—		—		—			4		31		(150	)
Total, December 31, 2009		392	$	388,495	$	(5,362	)		133	$	83,028	$	(14,852	)		525	$	471,523	$	(20,214	)

At September 30, 2010, the unrealized losses for fixed-maturity securities were primarily in our investments in commercial mortgage-backed securities, and residential non-agency mortgage-backed securities.

The following table shows the number of securities, fair value, unrealized loss amount and percentage below amortized cost and the ratio of fair value by security rating as of September 30, 2010:

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					Unrealized Loss
								Percent of			Fair Value by Security Rating
			Fair					Amortized															BB or
($ in thousands)	Count		Value		Amount			Cost			AAA			AA			A			BBB			Lower
U.S. Agency securities		20	$	65,996	$	(178	)		0	%		100	%		0	%		0	%		0	%		0	%
Municipal bonds		13		15,551		(225	)		-1	%		14	%		62	%		15	%		3	%		6	%
Corporate and other bonds		126		38,347		(634	)		-2	%		2	%		1	%		35	%		6	%		56	%
Commercial mortgage- backed securities		24		17,866		(2,337	)		-12	%		63	%		0	%		0	%		7	%		30	%
Residential mortgage-backed securities		98		110,686		(2,477	)		-2	%		93	%		2	%		0	%		1	%		4	%
Asset-backed securities		13		17,105		(533	)		-3	%		91	%		3	%		2	%		0	%		4	%
Equities		7		5,630		(179	)		-3	%		0	%		0	%		0	%		31	%		69	%

See Note 5—“Investments” in our unaudited financial statements for further information about impairment testing and other-than-temporary impairments.

Liquidity and Capital Resources

Cash Flows

The primary sources of cash flow in our Insurance Subsidiaries are gross premiums collected, ceding commissions from our quota share reinsurers, loss payments by our reinsurers, investment income and proceeds from the sale or maturity of investments. Funds are used by the Insurance Subsidiaries for loss payments and loss adjustment expenses. The Insurance Subsidiaries also use funds for ceded premium payments to reinsurers, which are paid on a net basis after subtracting losses paid on reinsured claims and reinsurance commissions on our net business, commissions to producers, salaries and other underwriting expenses as well as to purchase investments, fixed assets and to pay dividends to Tower. TRM’s primary sources of cash are commissions and fees collected.

Our reconciliation of net income to cash provided from operations is generally influenced by the collection of premiums in advance of paid losses, the timing of reinsurance, issuing company settlements and loss payments.

Cash flow and liquidity are categorized into three sources: (1) operating activities; (2) investing activities; and (3) financing activities, which are shown in the following table:

	Nine Months Ended
	September 30,
($ in thousands)	2010			2009
Cash provided by (used in):
Operating activities	$	131,581		$	133,595
Investing activities		(215,289	)		(111,840	)
Financing activities		37,262			(7,383	)
Net increase in cash and cash equivalents		(46,446	)		14,372
Cash and cash equivalents, beginning of year		164,882			136,253
Cash and cash equivalents, end of period	$	118,436		$	150,625

For the nine months ended September 30, 2010, net cash provided by operating activities was $131.6 million as compared to $133.6 million for the same period in 2009. The decrease in cash flow for the nine months ended September 30, 2010 primarily resulted from increased claims payments offset by reductions in cash paid for income taxes attributed to 2009 tax overpayments and increased tax deductions in 2010 relating to capital losses for the sale of certain fixed income securities.

Net cash flows used in investing activities were $215.3 million for the nine months ended September 30, 2010 compared to $111.8 million used for the nine months ended September 30, 2009. The nine months ended September 30, 2009 included net cash acquired of $200.1 million with the acquisitions of CastlePoint and Hermitage whereas for the nine months ended September 30, 2010 we used $151.9 million net cash to acquire OBPL. The remaining cash flows in both years primarily related to purchases and sales of fixed-maturity securities and preferred stock.

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The net cash flows provided by financing activities for the nine months ended September 30, 2010 are primarily the result of new borrowings of $145.6 million from the issuance of our convertible senior notes, reduced by the repurchase of common stock for $83.9 million and dividends of $11.4 million

Our insurance companies are subject to significant regulatory restrictions limiting their ability to declare and pay dividends. As of September 30, 2010, the maximum amount of distributions that our insurance companies could pay to us without approval of their domiciliary Insurance Departments was approximately $25.9 million. In addition, we can return capital of approximately $39.3 million from CPRe without permission from the Bermuda Monetary Authority.

Cash flow needs at the holding company level are primarily for dividends to our stockholders and interest payments on our outstanding debt.

On May 14, 2010, the Company entered into a $125.0 million credit facility agreement. The facility was organized by J.P. Morgan Securities Inc. and Banc of America Securities LLC as Joint Lead Book Runners and Joint Book Managers, and with Bank of America, N.A., as Administrative Agent, Fronting Bank and L/C Administrator and a syndicate of lenders. The credit facility is a revolving credit facility with a letter of credit sublimit of $25.0 million. The credit facility will be used for general corporate purposes.

The Company may request that the facility be increased by an amount not to exceed $50.0 million. The credit facility contains customary covenants for facilities of this type, including restrictions on indebtedness and liens, limitations on mergers, dividends and the sale of assets, and requirements to maintain certain consolidated net worth, debt to capitalization ratios, minimum risk-based capital and minimum statutory surplus. The credit facility also provides for customary events of default, including failure to pay principal when due, failure to pay interest or fees within three days after becoming due, failure to comply with covenants, any representation or warranty made by the Company being false in any material respect, default under certain other indebtedness, certain insolvency or receivership events affecting the Company and its material subsidiaries, the occurrence of certain material judgments, or a change in control of the Company, and upon an event of default the administrative agent (subject to the consent of the requisite percentage of the lenders) may immediately terminate the obligations to make loans and to issue letters of credit, declare the Company’s obligations under the credit facility to become immediately due and payable, and require the Company to deposit in a collateral account cash collateral with a value equal to the then outstanding amount of the aggregate face amount of any outstanding letters of credit. The credit facility expires on May 14, 2013.

Fees payable by the Company under the credit facility include a fee on the daily unused portion of each letter of credit, a letter of credit fronting fee with respect to each fronted letter of credit and a commitment fee

As of September 30, 2010, the Company had no outstanding balance under this credit facility

We believe that the cash flow generated by the operating activities of our subsidiaries, combined with other available capital sources, will provide sufficient funds for us to meet our liquidity needs over the next twelve months. Beyond the next twelve months, cash flow available to us may be influenced by a variety of factors, including general economic conditions and conditions in the insurance and reinsurance markets, as well as fluctuations from year to year in claims experience.

Our capital resources consist of funds deployed or available to be deployed to support our business operations. At September 30, 2010 and December 31, 2009, our capital resources were as follows:

	September 30,			December 31,
($ in thousands)	2010			2009
Outstanding under credit facility	$	—		$	—
Subordinated debentures		235,058			235,058
Convertible Senior Notes		138,579			—
Tower Group, Inc. stockholders’ equity		1,093,939			1,050,501
Total capitalization	$	1,467,576		$	1,285,559
Ratio of debt to total capitalization		25.5	%		18.3	%

We monitor our capital adequacy to support our business on a regular basis. The future capital requirements of our business will depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. Our ability to underwrite is largely dependent upon the quality of our claims paying and financial strength ratings as evaluated by independent rating agencies. In particular, we require (1) sufficient capital to maintain our financial strength ratings, as issued by A.M. Best, at a level considered necessary by management to enable our Insurance

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Subsidiaries to compete, and (2) sufficient capital to enable our Insurance Subsidiaries to meet the capital adequacy tests performed by statutory agencies in the United States and Bermuda.

As part of Tower’s capital management strategy, the Board of Directors approved a $100.0 million share repurchase program on February 26, 2010. Purchases are permitted from time to time at prevailing prices in open market or privately negotiated transactions. The share repurchase program has no expiration date. The timing and amount of purchases under the program depend on a variety of factors, including the trading price of the stock, market conditions and corporate and regulatory considerations. During the three and nine months ended September 30, 2010, 1.7 million and 3.9 million shares of common stock were purchased under this program at an aggregate consideration of $36.7 million and $83.9 million, respectively

We may seek to raise additional capital or may seek to return additional capital to our stockholders through share repurchases, cash dividends or other methods (or a combination of such methods). Any such determination will be at the discretion of our Board of Directors and will be dependent upon our profits, financial requirements and other factors, including legal restrictions, rating agency requirements, credit facility limitations and such other factors as our board of directors deems relevant.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Market risk is the risk that we will incur losses in our investments due to adverse changes in market rates and prices. Market risk is directly influenced by the volatility and liquidity in the market in which the related underlying assets are invested. We believe that we are principally exposed to three types of market risk: changes in credit quality of issuers of investment securities, changes in equity prices, and changes in interest rates.

Interest Rate Risk

Interest rate risk is the risk that we may incur economic losses due to adverse changes in interest rates. The primary market risk to the investment portfolio is interest rate risk associated with investments in fixed-maturity securities, although conditions affecting particular asset classes (such as conditions in the commercial and housing markets that affect commercial and residential mortgage-backed securities) can also be significant sources of market risk. Fluctuations in interest rates have a direct impact on the market valuation of these securities. The fair value of our fixed-maturity securities as of September 30, 2010 was $2.5 billion.

For fixed-maturity securities, short-term liquidity needs and potential liquidity needs for our business are key factors in managing our portfolio. We use modified duration analysis to measure the sensitivity of the fixed income portfolio to changes in interest rates as discussed more fully below under sensitivity analysis.

As of September 30, 2010, we had a total of $59.8 million of outstanding floating rate subordinated debentures underlying our trust preferred securities issued by our wholly owned statutory business trusts and carrying an interest rate that is determined by reference to market interest rates. If interest rates increase, the amount of interest payable by us would also increase, as more fully discussed below under sensitivity analysis.

Sensitivity Analysis

Sensitivity analysis is a measurement of potential loss in future earnings, fair values or cash flows of market sensitive instruments resulting from one or more selected hypothetical changes in interest rates and other market rates or prices over a selected time. In our sensitivity analysis model, we select a hypothetical change in market rates that reflects what we believe are reasonably possible near-term changes in those rates. The term “near-term” means a period of time going forward up to one year from the date of the consolidated financial statements. Actual results may differ from the hypothetical change in market rates assumed in this disclosure, especially since this sensitivity analysis does not reflect the results of any action that we may take to mitigate such hypothetical losses in fair value.

In this sensitivity analysis model, we use fair values to measure our potential loss. The sensitivity analysis model includes fixed-maturities, preferred stocks and short-term investments.

For invested assets, we use modified duration modeling to calculate changes in fair values. Durations on invested assets are adjusted for call, put and interest rate reset features. Durations on tax-exempt securities are adjusted for the fact that the yield on such securities is less sensitive to changes in interest rates compared to Treasury securities. Invested asset portfolio durations are calculated on a market value weighted basis, including accrued investment income, using holdings as of September 30, 2010.

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The following table summarizes the estimated change in fair value on our fixed-maturity portfolio including preferred stocks and short-term investments based on specific changes in interest rates as of September 30, 2010:

	Estimated			Estimated
	Increase			Percentage
	(Decrease)			Increase
	in Fair Value			(Decrease)
Change in interest rate	(in thousands)			in Fair Value
300 basis point rise	$	(313,622	)		-11.9	%
200 basis point rise		(200,083	)		-7.6	%
100 basis point rise		(128,096	)		-4.8	%
As of September 30, 2010		—			0.0	%
100 basis point decline		128,890			4.9	%

The sensitivity analysis model used by us produces a predicted pre-tax loss in fair value of market-sensitive instruments of $128.1 million or (4.8%) based on a 100 basis point increase in interest rates as of September 30, 2010. This loss amount only reflects the impact of an interest rate increase on the fair value of our fixed-maturity investments.

Interest expense would also be affected by a hypothetical change in interest rates. As of September 30, 2010 we had $59.8 million of floating rate debt obligations. Assuming this amount remains constant, a hypothetical 100 basis point increase in interest rates would increase annual interest expense by $0.6 million, pre-tax, a 200 basis point increase would increase interest expense by $1.2 million, pre-tax, and a 300 basis point increase would increase interest expense by $1.8 million, pre-tax.

With respect to investment income, the most significant assessment of the effects of hypothetical changes in interest rates on investment income would be an adjustment to amortization for mortgage-backed securities. The rates at which the mortgages underlying mortgage-backed securities are prepaid, and therefore the average life of mortgage-backed securities, can vary depending on changes in interest rates (for example, mortgages are prepaid faster and the average life of mortgage-backed securities falls when interest rates decline). The adjustments for changes in amortization, which are based on revised average life assumptions, would have an impact on investment income if a significant portion of our mortgage-backed securities holdings had been purchased at significant discounts or premiums to par value. As of September 30, 2010, the par value of our residential mortgage-backed securities holdings was $457.2 million and the amortized cost of our residential mortgage-backed securities holdings was $452.9 million. This equates to an average price of 99.1% of par. Historically, few of our mortgage-backed securities were purchased at more than three points (below 97% and above 103%) from par, thus an adjustment in accordance with this GAAP guidance would not have a significant effect on investment income. However, since many of our non-investment grade mortgage-backed securities have been impaired as a result of adverse cash flows, the required adjustment to book yield can have a significant effect on our future investment income.

Furthermore, significant hypothetical changes in interest rates in either direction can affect principal redemptions, and therefore investment income, because of the residual mortgage securities in the portfolio. The residential mortgage-backed securities portion of the fixed-maturity securities portfolio totaled 18.5% as of September 30, 2010. Of this total, 93.3% was in agency pass through securities, which have the highest amount of prepayment risk from declining rates. The remainder of our mortgage-backed securities portfolio is invested in agency planned amortization class collateralized mortgage obligations, non-agency residential non-accelerating securities, and commercial mortgage-backed securities.

The planned amortization class collateralized mortgage obligation securities maintain their average life over a wide range of prepayment assumptions, while the non-agency residential non-accelerating securities have five years of principal lock-out protection and the commercial mortgage-backed securities have very onerous prepayment and yield maintenance provisions that greatly reduce the exposure of these securities to prepayments.

Item 4. Controls and Procedures

Our management, with the participation of the 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 Securities 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 provide reasonable assurance that material information relating to us and our consolidated subsidiaries required to be disclosed in our reports filed with or submitted to the Securities and Exchange Commission under the Securities Exchange Act 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.

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Changes in internal control over financial reporting

On November 13, 2009, we completed our acquisition of SUA. SUA has been fully integrated into our Sarbanes Oxley program for internal controls over financial reporting and Section 404 compliance. On July 1, 2010, we completed the acquisition of OBPL. We are in the process of integrating OBPL’s operations, including internal controls over financial reporting, and extending our Section 404 compliance program to this business. OBPL accounted for 20.2% of assets and 5.8% of net income of the Company as of and for the three months ended September 30, 2010.

Part II — OTHER INFORMATION

Item 1. Legal Proceedings

On May 28, 2009, Munich Reinsurance America, Inc. (“Munich”) commenced an action against Tower Insurance Company of New York (“TICNY”), a wholly-owned subsidiary of Tower Group, Inc., in the United States District Court for the District of New Jersey seeking, inter alia, to recover approximately $6.1 million under various retrocessional contracts pursuant to which TICNY reinsures Munich. On June 22, 2009, TICNY filed its answer, in which it, inter alia, asserted two separate counterclaims seeking to recover approximately $2.8 million under various reinsurance contracts pursuant to which Munich reinsures TICNY. A separate action commenced by Munich against TICNY on June 17, 2009 in the United States District Court for the District of New Jersey seeking a declaratory judgment that Munich is entitled to access to TICNY’s books and records pertaining to various quota share agreements, to which TICNY filed its answer on July 7, 2009, was subsequently dismissed pursuant to the stipulation of the parties on March 17, 2010. The parties are currently engaged in discovery and the Company is therefore unable to assess the likelihood of any particular outcome.

On May 12, 2010, Mirabilis Ventures, Inc. (“Mirabilis”) commenced an action against Specialty Underwriters’ Alliance Insurance Co. (“SUA”, now known as CastlePoint National Insurance Company (“CNIC”), a subsidiary of Tower Group, Inc.) and Universal Reinsurance Co., Ltd., an unrelated entity, in the United States District Court for the Middle District of Florida. The Complaint is based upon a Worker’s Compensation/Employer’s Liability policy issued by SUA to AEM, Inc. (“AEM”), to whose legal rights Mirabilis is alleged to have succeeded as a result of the Chapter 11 bankruptcy of AEM. The Complaint, which includes claims against SUA for breach of contract and breach of the duty of good faith, alleges that SUA failed to properly audit AEM’s operations to determine AEM’s worker’s compensation exposure for two policy years, in order to compute the premium owed by AEM, such that SUA owes Mirabilis the principal sum of $3.4 million for one policy year and $0.6 million for the other policy year, plus interest and costs. On July 30, 2010, CNIC filed its answer in which it asserted nine separate counterclaims, to which Mirabilis responded on September 3, 2010. The litigation is only in its preliminary stage and the Company is therefore unable to assess the likelihood of any particular outcome.

Item 1A. Risk Factors

In connection with the Company’s private offering of senior notes completed on September 15, 2010, the Company filed a Current Report on Form 8-K on September 14, 2010 with the SEC (the “September 8-K”) that contained updated risk factors. These updated risk factors are incorporated by reference into this Quarterly Report from Item 8.01 to the September 8-K and supplement the risk factors described in Part 1, Item 1A, “Risk Factors” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

During the three months ended September 30, 2010, the Company purchased 761 shares of its common stock from employees in connection with the vesting of restricted stock issued in connection with its 2004 Long Term Equity Compensation Plan (the “Plan”). The shares were withheld at the direction of the employees as permitted under the Plan in order to pay the minimum amount of tax liability owed by the employee from the vesting of those shares.

The Board of Directors of Tower approved a $100 million share repurchase program on February 26, 2010. Purchases can be made from time to time in the open market or in privately negotiated transactions in accordance with applicable laws and regulations. The share repurchase program has no expiration date. In the three months ended September 30, 2010, the Company purchased 1,696,198 shares of its common stock under this program.

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The following table summarizes the Company’s stock repurchases for the three-month period ended September 30, 2010, and represents employees’ withholding tax obligations on the vesting of restricted stock and the share repurchase program:

	Total				Total Number of Shares		Approximate Dollar
	Number		Average		Purchased as Part of		Value of Shares that
	of Shares		Price Paid		Publically Announced		May Yet be Purchased
Period	Purchased (1)		per Share (2)		Plan or Program		Under Plan or Program
July 1 - 31, 2010		761	$	21.53		—	$	52,816,712
August 1 - 31, 2010		—		—		—		52,816,712
September 1 - 30, 2010		1,696,198		21.63		1,696,198		16,132,871
Total		1,696,959	$	21.63		1,696,198

(1)	Includes 761 shares that were withheld to satisfy tax withholding amount due from employees upon the receipt of previously restricted shares.
(2)	Including commissions.

Item 6. Exhibits

31.1	Chief Executive Officer — Certification pursuant to Sarbanes-Oxley Act of 2002 Section 302
31.2	Chief Financial Officer — Certification pursuant to Sarbanes-Oxley Act of 2002 Section 302
32	Chief Executive Officer and Chief Financial Officer — Certification pursuant to Sarbanes-Oxley Act of 2002 Section 906
EX-101	INSTANCE DOCUMENT
EX-101	SCHEMA DOCUMENT
EX-101	CALCULATION LINKBASE DOCUMENT
EX-101	LABELS LINKBASE DOCUMENT
EX-101	PRESENTATION LINKBASE DOCUMENT
EX-101	DEFINITION LINKBASE DOCUMENT

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Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	Tower Group, Inc.
	Registrant
Date: November 9, 2010	/s/ Michael H. Lee
	Michael H. Lee
	Chairman of the Board, President and Chief Executive Officer
Date: November 9, 2010	/s/ William E. Hitselberger
	William E. Hitselberger
	Senior Vice President, Chief Financial Officer

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