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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PERSUANT TO SECTION 13 or 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2006
[ ] TRANSITION REPORT PERSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _________________ to ______________
Commission file no. 000-50990
Tower Group, Inc.
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Delaware 13-3894120
- ---------------------------------------- -----------------------------------
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
120 Broadway, 14th 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. Yes [X] No [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
Large accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as defined in
rule 12b-2 of the Exchange Act). Yes [ ] No [X]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date: 19,892,855 shares of common
stock, par value $0.01 per share, as of May 1, 2006.
INDEX
PAGE
PART I FINANCIAL INFORMATION
Item 1. Financial statements
Consolidated Balance Sheets - March 31, 2006 (unaudited) and
December 31, 2005 1
Consolidated Statements of Income and Comprehensive Net Income
- Three months ended March 31, 2006 and 2005 (unaudited) 2
Consolidated Statements of Cash Flows
- Three months ended March 31, 2006 and 2005 (unaudited) 3
Notes to Consolidated Financial Statements (unaudited) 4
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 10
Item 3. Quantitative and Qualitative Disclosures About Market Risk 19
Item 4. Controls and Procedures 20
PART II OTHER INFORMATION
Item 6. Exhibits 20
SIGNATURES 21
Part I - FINANCIAL INFORMATION
Item 1. Financial Statements
Tower Group, Inc.
Consolidated Balance Sheets
(Unaudited)
March 31, December 31,
2006 2005
-------------- --------------
($ in thousands, except par
value and share amounts)
Assets
Fixed-maturity securities, available-for-sale, at
fair value (amortized cost $356,440 in 2006 and
$331,123 in 2005) $ 348,536 $ 326,681
Equity securities, available-for-sale, at fair
value (cost $6,681 in 2006 and $6,681 in 2005) 6,284 5,934
Equity securities, at cost 24,802 24,558
Common trust securities - statutory business
trusts, equity method 2,045 1,426
-------------- --------------
Total investments 381,667 358,599
Cash and cash equivalents 71,720 38,760
Investment income receivable 3,564 3,337
Agents' balances receivable 41,659 46,004
Assumed premiums receivable 3,486 1,076
Ceding commission receivable 8,727 8,727
Reinsurance recoverable 106,325 104,811
Receivable - claims paid by agency 2,252 2,309
Prepaid reinsurance premiums 28,375 43,319
Deferred acquisition costs net of deferred ceding
commission revenue 38,790 29,192
State income taxes recoverable 297 365
Deferred income taxes 2,480 3,204
Intangible assets 5,732 5,835
Fixed assets, net of accumulated depreciation 8,398 7,920
Other assets 6,076 3,999
-------------- --------------
Total Assets $ 709,548 $ 657,457
============== ==============
Liabilities
Loss and loss adjustment expenses $ 219,927 $ 198,724
Unearned premium 168,456 157,779
Reinsurance balances payable 9,452 19,200
Payable to issuing carriers 6,029 5,252
Funds held as agent 8,195 8,191
Funds held under reinsurance agreements 62,157 59,042
Accounts payable and accrued expenses 12,243 13,694
Payable for securities 1,939 -
Other liabilities 2,867 2,867
Federal income taxes payable 1,312 460
Subordinated debentures 68,045 47,426
-------------- --------------
Total Liabilities 560,622 512,635
-------------- --------------
Stockholders' Equity
Common stock ($0.01 par value per share;
40,000,000 shares authorized; 19,907,498 and
19,872,672 shares issued in 2006 and 2005) 199 199
Paid-in-capital 111,326 111,066
Accumulated other comprehensive net income (5,525) (3,352)
Retained earnings 43,036 37,019
Treasury stock (17,881 shares in 2006 and in 2005) (110) (110)
-------------- --------------
Total Stockholders' Equity 148,926 144,822
-------------- --------------
Total Liabilities and Stockholders' Equity $ 709,548 $ 657,457
============== ==============
See accompanying notes to the consolidated financial statements
1
Tower Group, Inc.
Consolidated Statements of Income and
Comprehensive Net Income
(Unaudited)
Three Months Ended
March 31,
2006 2005
-------------- --------------
($ in thousands, except par
value and share amounts)
Revenues
Net premiums earned $ 57,256 $ 30,018
Ceding commission revenue 7,302 5,846
Insurance services revenue 1,829 3,781
Net investment income 4,660 2,615
Net realized (losses) gains on investments (145) 209
Policy billing fees 270 201
-------------- --------------
Total revenues 71,172 42,670
-------------- --------------
Expenses
Loss and loss adjustment expenses 33,210 18,062
Direct commission expense 13,080 8,792
Other operating expenses 13,384 8,917
Interest expense 1,350 1,165
-------------- --------------
Total expenses 61,024 36,936
-------------- --------------
Income before income taxes 10,148 5,734
Income tax expense 3,638 2,017
-------------- --------------
Net income $ 6,510 $ 3,717
============== ==============
Comprehensive Net Income
Net income $ 6,510 $ 3,717
Other comprehensive income (loss):
Gross unrealized investment holding losses
arising during period (3,399) (4,486)
Less: reclassification adjustment for losses
(gains) included in net income 145 (209)
-------------- --------------
(3,254) (4,695)
Income tax benefit related to items
of other comprehensive income 1,081 1,644
-------------- --------------
Total other comprehensive net loss (2,173) (3,051)
-------------- --------------
Comprehensive Net Income $ 4,337 $ 666
============== ==============
Earnings Per Share
Basic earnings per common share $ 0.33 $ 0.19
============== ==============
Diluted earnings per common share $ 0.32 $ 0.19
============== ==============
Weighted Average Common Shares Outstanding:
Basic 19,684,902 19,521,111
Diluted 20,212,344 20,076,884
See accompanying notes to the consolidated financial statements
2
Tower Group, Inc.
Consolidated Statements of Cash Flows
(Unaudited)
Three Months Ended
March 31,
2006 2005
-------------- --------------
($ in thousands)
Cash flows from operating activities:
Net income $ 6,510 $ 3,717
Adjustments to reconcile net income to net
cash provided by (used in) operations:
Losses (gains) on sale of investments 145 (209)
Depreciation 925 563
Amortization of intangible assets 103 111
Amortization of bond premium or discount 281 288
Amortization of debt issuance costs 10 9
Amortization of restricted stock 152 172
Deferred income taxes 1,805 (424)
(Increase) decrease in assets:
Investment income receivable (227) (474)
Agents' balances receivable 4,345 (653)
Assumed premiums receivable (2,410) 53
Ceding commissions receivable - (398)
Reinsurance recoverable (1,456) 90
Prepaid reinsurance premiums 14,944 (3,456)
Deferred acquisition costs, net (9,598) (3,483)
Intangible assets - (1,172)
Other assets (2,204) (629)
Increase (decrease) in liabilities:
Loss and loss adjustment expenses 21,202 11,796
Unearned premium 10,676 18,801
Checks outstanding - (32)
Reinsurance balances payable (9,748) 6,132
Payable to issuing carriers 778 (3,182)
Accounts payable and accrued expenses (1,451) (1,169)
Federal and state income taxes payable 851 2,434
Funds held under reinsurance agreements 3,118 (593)
-------------- --------------
Net cash flows provided by operations 38,751 28,292
-------------- --------------
Cash flows from investing activities:
Purchase of fixed assets (1,404) (763)
Purchases of investments:
Fixed-maturity securities (46,879) (42,627)
Equity securities - at fair value - (6,568)
Equity securities - at cost (244) (23,000)
Sale of investments:
Fixed-maturity securities 23,121 12,089
Equity securities - at fair value - 1,972
-------------- --------------
Net cash flows used in investing activities (25,406) (58,897)
-------------- --------------
Cash flows from financing activities:
Proceeds from issuance of subordinated debenture 20,619 -
Purchase of common trust securities - statutory
business trusts (619) -
Dividends paid (492) (488)
Exercise of stock options 107 22
-------------- --------------
Net cash flows provided by / (used in) financing
activities 19,615 (466)
-------------- --------------
Increase (decrease) in cash and cash equivalents 32,960 (31,071)
Cash and cash equivalents, beginning of period 38,760 55,201
-------------- --------------
Cash and cash equivalents, end of period $ 71,720 $ 24,130
============== ==============
Supplemental disclosures of cash flow information:
Cash paid for income taxes $ 986 $ 201
Cash paid for interest $ 938 $ 804
See accompanying notes to the consolidated financial statements
3
Tower Group, Inc.
Notes to Consolidated Financial Statements (Unaudited)
Basis of Presentation
The accompanying unaudited consolidated financial statements have been
prepared in accordance with instructions for Form 10-Q and, accordingly, do not
include the information and disclosures required by generally accepted
accounting principles ("GAAP") in the Unites States of America. These statements
should be read in conjunction with the consolidated financial statements as of
and for the year ended December 31, 2005 and notes thereto included in the
Company's Annual Report on Form 10-K filed on March 15, 2006. The accompanying
consolidated financial statements have not been audited by an independent
registered public accounting firm in accordance with standards of the Public
Company Accounting Oversight Board (United States), but in the opinion of
management such financial statements include all adjustments, consisting only of
normal recurring adjustments, necessary for a fair statement of the Company's
financial position and results of operations. The results of operations for the
three months ended March 31, 2006 may not be indicative of the results that may
be expected for the year ending December 31, 2006. The consolidated financial
statements include the accounts of Tower Group, Inc. (the "Company"), its wholly
owned subsidiaries (Tower Insurance Company of New York ("TICNY"), Tower
National Insurance Company ("TNIC"), Tower Risk Management ("TRM") and other
entities required by GAAP. All significant inter-company balances have been
eliminated. Business segment results are presented net of all material
inter-segment transactions.
Sponsoring a Bermuda Holding Company
The Company's financial statements as of March 31, 2006 include the
consolidation of CastlePoint Holdings, Ltd., ("CastlePoint"), a Bermuda based
holding company that the Company sponsored with an initial investment of $15
million on February 6, 2006. On April 4, 2006 CastlePoint was capitalized with
$265 million in a private offering. Following the capitalization of CastlePoint,
Tower's ownership stands at 8.6%. In addition, Tower has been issued warrants to
purchase CastlePoint's common shares that would have resulted in an additional
3.7% of ownership if they had been exercised on April 4, 2006. The warrants are
exercisable at any time up to the tenth anniversary of the warrant issuance. The
effective date of the warrants was April 6, 2006. Shares that may be acquired
through the exercise of the warrants may not be sold prior to April 6, 2009 (see
also Subsequent Events Note for further details regarding this investment).
Tower consolidated approximately $500,000 of non-recurring start up costs
related to our sponsorship of CastlePoint which was a wholly owned subsidiary
during the first quarter of 2006.
Investments
The Company accounts for its investments in marketable securities in
accordance with Statement of Financial Accounting Standards No. 115, "Accounting
for Certain Investments in Debt and Equity Securities" ("SFAS 115"), which
requires that fixed-maturity and equity securities that have readily determined
fair values be segregated into categories based upon the Company's intention for
those securities. In accordance with SFAS 115, the Company has classified its
fixed-maturity and equity securities as available-for-sale. The Company may sell
its available-for-sale securities in response to changes in interest rates,
risk/reward characteristics, liquidity needs or other factors.
Fixed-maturity securities and equity securities are reported at their
estimated fair values based on quoted market prices or a recognized pricing
service, with unrealized gains and losses, net of tax effects, reported as a
separate component of comprehensive income in stockholders' equity. Realized
gains and losses are determined on the specific identification method.
Included in equity securities at cost as of March 31, 2006 are common
shares of a closed-end management investment company investing predominately in
asset-backed securities and mortgage-backed securities with a cost of
$19,802,000. This investment is carried at cost on the balance sheet because
there is no publicly traded price quote available. Also included in equity
securities at cost is an investment in a Real Estate Investment Trust ("REIT")
with a cost of $5,000,000 and an estimated fair value of $5,000,000. The
estimated fair value for this security is determined based on recent trades and
an expected second quarter 2006 IPO price for this security. This single REIT
investment has not been registered under the Securities Act of 1933 and no
active market exists for this investment.
4
On November 3, 2005, the FASB issued FSP FAS 115-1 and FAS 124-1,
"Other-Than-Temporary Impairment and Its Application to Certain Investments."
The guidance in this FSP addresses the determination of when an investment is
considered impaired, whether that impairment is other than temporary, and the
measurement of an impairment loss. The FSP also includes accounting
considerations subsequent to the recognition of an other-than temporary
impairment and requires certain disclosures about unrealized losses that have
not been recognized as other-than-temporary impairments. The guidance in this
FSP applies to reporting periods beginning after December 15, 2005.
Impairment of investment securities results in a charge to operations when
a market decline below cost is deemed to be other-than-temporary. As of March
31, 2006, the Company reviewed its fixed-maturity and equity securities
portfolios to evaluate the necessity of recording impairment losses for
other-than-temporary declines in the fair value of investments in accordance
with the provisions of this FSP. The Company determined that it did not hold any
investments that would have been considered other than temporarily impaired.
Subordinated Debentures
On March 31, 2006, the Company participated in a private placement of
$20,000,000 of fixed/floating rate capital securities (the "Trust Preferred
Securities") issued by Tower Group Statutory Trust V (the "Trust"), an
affiliated Delaware trust formed on March 29, 2006. The Trust Preferred
Securities mature in April 2036, are redeemable at the Company's option at par
beginning April 7, 2011, and require quarterly distributions of interest by the
Trust to the holder of the Trust Preferred Securities. Distributions are
initially at a fixed rate of 8.5625% for the first five years and will then
reset quarterly for changes in the three-month London Interbank Offered Rate
("LIBOR") rate plus 330 basis points. The Trust simultaneously issued 619 of the
Trust's common securities to the Company for a purchase price of $619,000, which
constitutes all of the issued and outstanding common securities of the Trust.
The Trust used the proceeds from the sale of the Trust Preferred Securities to
purchase for $20,000,000 a Junior Subordinated Debt Security due 2036 in the
principal amount of $20,000,000 issued by the Company. The Company does not
consolidate interest in its statutory business trusts for which the Company
holds 100% of the common trust securities because the Company is not the primary
beneficiary of the trusts. The Company's investment in common trust securities
of the statutory business trust are reported in investments as equity
securities. The Company reports as a liability the outstanding subordinated
debentures owed to the statutory business trusts. The net proceeds to the
Company from the sale of the debenture to the Trust will be used by the Company
to acquire and capitalize a shell insurance company with multi-state licensing
and for working capital purposes.
Dividends Declared
Dividends declared by the Company on common stock for the three months
ended March 31, 2006 were $492,000 or $0.025 per share. Dividends declared by
the Company on common stock for the three months ended March 31, 2005 were
$488,000 or $0.025 per share.
5
Earnings Per Share
The following table shows the computation of the Company's earnings per
share:
Income Shares Per Share
(Numerator) (Denominator) Amount
------------- ----------------- -------------
($ in thousands, except shares and per share amounts)
Three Months Ended
March 31, 2006
Net Income $ 6,510
------------- -----------------
Basic earnings per share 6,510 19,684,902 $ 0.33
------------- ----------------- =============
Effect of dilutive securities:
Stock options - 328,911
Unvested restricted stock - 171,573
Warrants - 26,958
------------- -----------------
Diluted earnings per share $ 6,510 20,212,344 $ 0.32
============= ================= =============
Three Months Ended
March 31, 2005
Net Income $ 3,717
------------- -----------------
Basic earnings per share 3,717 19,521,111 $ 0.19
------------- ----------------- =============
Effect of dilutive securities:
Stock options - 284,873
Unvested restricted stock 216,673
Warrants - 54,227
------------- -----------------
Diluted earnings per share $ 3,717 20,076,884 $ 0.19
============= ================= =============
Employee Stock Option Plan
In December 2004, the Financial Accounting Standards Board issued the
revised statement SFAS No. 123-R, an amendment to SFAS No. 123, which suspends
APB 25 and requires that the cost of share-based payment transactions be
recognized in the financial statements after the fiscal quarter beginning after
June 15, 2005. The intended adoption by the Company of SFAS 123-R was postponed
to January 2006 per the Securities and Exchange Commission's rule amendment
promulgated April 14, 2005, that allows calendar year-end companies to elect
implementing SFAS No. 123-R at the beginning of their next fiscal year after
June 15, 2005. The Company has elected the modified prospective application
method and is expensing all unvested stock options outstanding as of January 1,
2006. The compensation expense is recognized over the requisite service period
that still has not been rendered and is based upon the original grant date fair
value of the award as calculated for recognition of the pro forma disclosure
under SFAS 123. For the three months ended March 31, 2006 the compensation
expense recorded related to stock options was $21,000 net of tax and has been
included in reported net income for the first quarter of 2006.
The remaining total compensation cost related to non vested stock option
and restricted stock awards not yet recognized in the income statement was
$2,273,000 of which $303,000 was for stock options and $1,970,000 was for
restricted stock as of March 31, 2006. The weighted average period over which
this compensation cost is expected to be recognized is 3.05 years.
Per the requirements of SFAS 123 R the balance of unearned compensation -
restricted stock in stockholders' equity has been reclassified to
paid-in-capital as of March 31, 2006 and as of December 31, 2005.
During the first quarter of 2006, the Company issued 6,318 new common
shares as the result of employee stock option exercises and issued 28,508 new
common shares as the result of restricted stock grants to executive officers and
its independent directors.
The Company incurred restricted stock amortization expense of $99,000 net
of tax for the three months ended March 31, 2006 which has been included in
reported net income for the first quarter of 2006.
6
Changes In Estimates
TICNY has recorded favorable development in its net losses from prior
accident years of $525,000 in the first quarter of 2006 compared to $20,000 of
adverse development in the first quarter of 2005. TICNY's changes in estimated
sliding scale commission revenue resulted in $393,000 of commission revenue in
the first quarter of 2006 compared to $50,000 of commission revenue in the first
quarter of 2005. TRM's changes in estimated sliding scale commission was a
reduction in ceding commission revenue for prior years of $348,000 in the first
quarter of 2006 compared to an increase of $491,000 in commission revenue in the
first quarter of 2005.
Segment Information
The Company manages its operations through three business segments:
insurance (commercial and personal lines underwriting), reinsurance and
insurance services (managing general agency, claims administration and
reinsurance intermediary operations).
The accounting policies of the segments are the same as those described in
the summary of significant accounting policies as described in the Company's
most recently filed Form 10-K. The Company evaluates segment performance based
on segment profit, which excludes investment income, realized gains and losses,
interest expense, income taxes and incidental corporate expenses. The Company
does not allocate assets to segments because assets, which consist primarily of
investments, are considered in total by management for decision-making purposes.
7
Business Segments results are as follows:
Three Months Ended
March 31,
2006 2005
-------------- --------------
($ in thousands)
Insurance Segment Information
Revenues
Net premiums earned $ 56,589 $ 29,633
Ceding commission revenue 7,302 5,846
Policy billing fees 267 196
-------------- --------------
Total revenues 64,158 35,675
-------------- --------------
Expenses
Net loss and loss adjustment expenses 32,833 17,780
Underwriting expenses 23,399 14,494
-------------- --------------
Total expenses 56,232 32,274
-------------- --------------
Underwriting profit $ 7,926 $ 3,401
============== ==============
Reinsurance Segment
Revenues
Net premiums earned $ 667 $ 385
-------------- --------------
Total revenues 667 385
-------------- --------------
Expenses
Net loss and loss adjustment expenses 377 282
Underwriting expenses 253 47
-------------- --------------
Total expenses 630 329
-------------- --------------
Underwriting Profit $ 37 $ 56
============== ==============
Insurance Services Segment
Revenues
Direct commission revenue from managing
general agency $ 806 $ 2,525
Claims administration revenue 962 1,053
Reinsurance intermediary fees 61 203
Policy billing fees 3 5
-------------- --------------
Total revenues 1,832 3,786
-------------- --------------
Expenses
Direct commission expense paid to producers 603 1,211
Other insurance services expenses 237 485
Claims expense reimbursement to TICNY 958 1,050
-------------- --------------
Total expenses 1,798 2,746
-------------- --------------
Insurance Services Pre-tax Income $ 34 $ 1,040
============== ==============
The Company entered into a multi-year quota share reinsurance agreement
with CastlePoint Reinsurance, a wholly owned subsidiary of CastlePoint Holdings,
Ltd. on April 6, 2006. See Subsequent Events Note for further details regarding
the multi-year reinsurance agreement with CastlePoint Reinsurance. The Company
retained all of the risk for the first three months of 2006 that would have been
ceded to quota share reinsurers. In 2005, the Company ceded 25% of its net
premiums written to reinsurers in accordance with its quota share treaty.
Underwriting expenses in the insurance segment are net of expense
reimbursements that are made by the insurance services segment pursuant to an
expense sharing agreement between TRM, TNIC and TICNY. In accordance with terms
of this agreement, TRM reimburses TICNY for a portion of TICNY's underwriting
and other expenses resulting from TRM's use of TICNY's personnel, facilities and
equipment in underwriting insurance on behalf of TRM's issuing companies. The
reimbursement for underwriting and other expenses is calculated as a minimum
reimbursement of 5% of the premiums produced by TRM and is adjustable according
to the terms of the agreement based on the number of policies in force and
additional expenses that may be incurred by TRM. The amount of this
reimbursement was $237,000 and $485,000 for the three months ended March 31,
2006 and March 31, 2005, respectively. TRM also reimburses TICNY, at cost, for
claims administration expenses pursuant to the terms of this expense sharing
agreement. Claims expenses reimbursed by TRM were $958,000 and $1,050,000 for
the three months ended March 31, 2006 and March 31, 2005, respectively.
8
The following table reconciles revenue by segment to consolidated revenue:
Three Months Ended
March 31,
2006 2005
-------------- --------------
($ in thousands)
Reconciliation
Revenues
Insurance segment $ 64,158 $ 35,675
Reinsurance segment 667 385
Insurance services segment 1,832 3,786
-------------- --------------
Total segment revenue 66,657 39,846
Investment income 4,660 2,615
Realized capital (losses) gains (145) 209
-------------- --------------
Consolidated revenues $ 71,172 $ 42,670
============== ==============
The following table reconciles the results of the Company's individual
segments to consolidated income before taxes:
Three Months Ended
March 31,
2006 2005
-------------- --------------
($ in thousands)
Insurance segment underwriting profit $ 7,926 $ 3,401
Reinsurance segment underwriting profit 37 56
-------------- --------------
Total underwriting profit 7,963 3,457
Insurance services segment pre-tax 34 1,040
income
Net investment income 4,660 2,615
Net realized investment (losses) gains (145) 209
Corporate expenses (1,014) (422)
Interest expense (1,350) (1,165)
-------------- --------------
Income before income taxes $ 10,148 $ 5,734
============== ==============
Subsequent Events
During the three months ended March 31, 2006, the Company was organizing
and preparing to sponsor a Bermuda based holding company and its reinsurance
subsidiary, CastlePoint Holdings, Ltd. and CastlePoint Reinsurance,
respectively. TICNY was also in discussion with CastlePoint Reinsurance (in
formation) with respect to a multi-year quota share reinsurance agreement.
Accordingly, Tower did not place quota share reinsurance for policies that began
in 2006 during the first quarter in expectation that CastlePoint Reinsurance,
post formation, would agree to enter into the multi-year quota share reinsurance
agreement. Therefore, the consolidated results of operations and the insurance
segment underwriting results for the first quarter of 2006 reflect net
underwriting results without quota share reinsurance with respect to policies
that began in 2006. TICNY and TNIC entered into a multi-year quota share
reinsurance agreement with CastlePoint Reinsurance on April 6, 2006.
In April 2006, the Company received approval from the New York State
Insurance Department of the Company's proposed acquisition of MIIX Insurance
Company of New York ("MIIX"), an insurance company with licenses in New York and
New Jersey. The closing of the transaction is expected to occur during the
second quarter of 2006. The Company will pay $225,000 in cash at closing as well
as an amount equal to MIIX's adjusted statutory surplus as of the second
business day immediately preceding the closing date. MIIX's assets consist of
U.S. Treasuries and cash.
9
On April 11, 2006, PXRE Reinsurance Company requested the withdrawal of its
financial strength and issuer credit rating by A.M. Best. As of March 31, 2006
the Company had unsecured reinsurance recoverables and ceding commissions
receivable totaling $32,100,000 owed by PXRE Reinsurance Company. The Company
believes that the unsecured reinsurance recoverables and ceding commissions
receivable from PXRE, none of which are past due, are fully collectible. The
Company is exploring options to novate the reinsurance recoverables to another
reinsurer or to commute the reinsurance recoverables. No assurances can be made
as to the outcome of either option.
On April 27, 2006, the Company's Board of Directors approved a quarterly
dividend of $0.025 per share payable June 27, 2006 to stockholders of record as
of June 15, 2006.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Note on Forward-Looking Statements
Some of the statements under "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and elsewhere in this Form 10-Q
may include forward-looking statements that reflect our current views with
respect to future events and financial performance. These statements include
forward-looking statements both with respect to us specifically and the
insurance sector in general. Statements that include the words "expect,"
"intend," "plan," "believe," "project," "estimate," "may," "should,"
"anticipate," "will" and similar statements of a future or forward-looking
nature identify forward-looking statements for purposes of the Federal
securities laws or otherwise.
All forward-looking statements address matters that involve risks and
uncertainties. Accordingly, there are or will be important factors that could
cause our actual results to differ materially from those indicated in these
statements. We believe that these factors include, but are not limited to, the
following:
o ineffectiveness or obsolescence of our business strategy due to
changes in current or future market conditions;
o developments that may delay or limit our ability to enter new
markets as quickly as we anticipate;
o increased competition on the basis of pricing, capacity, coverage
terms or other factors;
o greater frequency or severity of claims and loss activity,
including as a result of natural or man-made catastrophic events,
than our underwriting, reserving or investment practices
anticipate based on historical experience or industry data;
o the effects of acts of terrorism or war;
o developments in the world's financial and capital markets that
adversely affect the performance of our investments;
o changes in regulations or laws applicable to us, our
subsidiaries, brokers or customers;
o acceptance of our products and services, including new products
and services;
o changes in the availability, cost or quality of reinsurance and
failure of our reinsurers to pay claims timely or at all;
o changes in the percentage of our premiums written that we cede to
reinsurers;
o decreased demand for our insurance or reinsurance products;
o loss of the services of any of our executive officers or other
key personnel;
o the effects of mergers, acquisitions and divestitures;
o changes in rating agency policies or practices;
o changes in legal theories of liability under our insurance
policies;
o changes in accounting policies or practices; and
o changes in general economic conditions, including inflation,
interest rates and other factors.
The foregoing review of important factors should not be construed as exhaustive
and should be read in conjunction with the other cautionary statements that are
included in this Form 10-Q.
10
We undertake no obligation to publicly update or review any forward-looking
statement, whether as a result of new information, future developments or
otherwise.
Consolidated Results of Operations
Three Months Ended
March 31,
2006 2005
-------------- --------------
($ in thousands)
Revenues
Earned premiums
Gross premiums earned $ 76,616 $ 45,868
Less: ceded premiums earned (19,360) (15,850)
-------------- --------------
Net premiums earned 57,256 30,018
-------------- --------------
Total commission and fee income 9,401 9,828
Net investment income 4,660 2,615
Net realized investment gains (145) 209
-------------- --------------
Total revenues 71,172 42,670
-------------- --------------
Expenses
Net loss and loss adjustment expenses 33,210 18,062
Operating expenses 26,464 17,709
Interest expenses 1,350 1,165
-------------- --------------
Total expenses 61,024 36,936
-------------- --------------
Income before taxes 10,148 5,734
Federal and state income taxes 3,638 2,017
-------------- --------------
Net Income $ 6,510 $ 3,717
============== ==============
Key Measures
Return on average equity 17.7% 11.5%
Consolidated Results of Operations Three Months Ended March 31, 2006 and 2005
During the three months ended March 31, 2006, the Company was organizing
and preparing to sponsor a Bermuda based holding company and its reinsurance
subsidiary, CastlePoint Holdings, Ltd. and CastlePoint Reinsurance,
respectively. TICNY was also in discussion with CastlePoint Reinsurance (in
formation) with respect to a multi-year quota share reinsurance agreement.
Accordingly, Tower did not place quota share reinsurance for policies that began
in 2006 during the first quarter in expectation that CastlePoint Reinsurance,
post formation, would agree to enter into the multi-year quota share reinsurance
agreement. Therefore, the consolidated results of operations and the insurance
segment underwriting results for the first quarter of 2006 reflect net
underwriting results without quota share reinsurance with respect to policies
that began in 2006. TICNY and TNIC entered into a multi-year quota share
reinsurance agreement with CastlePoint Reinsurance on April 6, 2006.
Total revenues. Total revenues increased by 66.8 % to $71.2 million for the
three months ended March 31, 2006 compared to $42.7 million for the same period
in 2005. The increase is primarily due to the increase in net premiums earned
and net investment income. Net premiums earned represented 80.4% of total
revenues for the three months ended March 31, 2006 compared to 70.3% for the
same period in 2005. Net investment income, excluding realized capital losses or
gains, represented 6.5% and 6.1% of total revenues for the three months ended
March 31, 2006 and March 31, 2005, respectively. These increases were partially
offset by lower total commission and fee income for the three months ended March
31, 2006 of $9.4 million, or 13.2% of total revenue, compared to $9.8 million,
or 23.0% of total revenue, for the same period in 2005. During the three months
ended March 2006 there were net realized capital losses of $145,000 from the
sale of automotive credit bonds and other securities as compared to net realized
capital gains of $209,000 for the same period of 2005.
11
Premiums earned. Net premiums earned increased by 90.7% to $57.3 million
for the three months ended March 31, 2006 compared to $30.0 million for the same
period in 2005. The increase in net premiums earned was due to the overall
increase in gross premiums written through March 31, 2006 and our decision not
to enter into a quota share reinsurance agreement for the three months ended
March 31, 2006 compared to a 25% quota share agreement for the same period of
2005. During the first quarter of 2006, we were in discussion with CastlePoint
Reinsurance while it was in formation to enter into a multi-year quota share
reinsurance agreement. CastlePoint Reinsurance was capitalized and formed on
April 4, 2006 and the quota share reinsurance agreement was executed post
formation on April 6, 2006. During the three months ended March 31, 2006, we
retained all of the risk for policies written in 2006 that would have been ceded
to quota share reinsurers.
Commission and fee income. Total commission and fee income decreased by
4.3% to $9.4 million in the first quarter of 2006 compared to $9.8 million in
the first quarter of 2005. This was due to lower direct commission revenue in
the insurance services segment resulting primarily from a reduction in premiums
produced which was offset by an increase in ceding commission revenue earned in
the insurance segment.
Net investment income and realized losses or gains. Net investment income
increased by 78.2% to $4.7 million for the three months ended March 31, 2006
compared to $2.6 million for the same period in 2005. This resulted from an
increase in invested assets to $379.6 million as of March 31, 2006 compared to
$281.6 million as of March 31, 2005, excluding our investments in statutory
business trusts underlying our trust preferred securities. Net cash flows
provided by operations of $38.8 million contributed to the increase in invested
assets during the three months ended March 31, 2006. On a tax equivalent basis,
the yield was 5.4% as of March 31, 2006 compared to 5.1% as of March 31, 2005.
Net realized capital losses were $145,000 in the three months ended March
31, 2006 from the sale of automotive credit bonds and other securities compared
to net realized capital gains of $209,000 for the same period in 2005
There was no impact on net realized losses or gains attributable to
adjustments for other than temporary impairment of securities held during the
three months ending March 31, 2006 and during the same period in 2005.
Losses and loss adjustment expenses. Gross loss and loss adjustment
expenses and the gross loss ratio for both the insurance and reinsurance
segments combined for the three months ended March 31, 2006 were $43.3 million
and 56.5%, respectively, compared to $26.1 million and 56.9%, respectively, in
the same period in 2005. The net loss ratio for the combined segments was 58.0%
in the three months ended March 31, 2006 and 60.2% in the same period in 2005.
The improvement in the net loss ratio in the first quarter of 2006 compared to
the same period in 2005 was due primarily to an increase in net premiums earned
that reduced the effect of catastrophe reinsurance premiums on the net loss
ratio and favorable development on prior accident years reserves.
Operating expenses. Operating expenses increased by 49.4% to $26.5 million
for the three months ended March 31, 2006 from $17.7 million for the same period
in 2005. The increase was due primarily to an increase in underwriting expenses
resulting from the growth in premiums earned in addition non-recurring
organizational and start up costs of approximately $500,000 related to our
sponsorship of CastlePoint which was a wholly owned subsidiary during the first
quarter of 2006.
Interest expense. Interest expense increased for the three months ended
March 31, 2006 to $1.4 million compared to $1.2 million for the same period in
2005 resulting from an increase in interest expense of $113,000 on subordinated
debentures underlying our trust preferred securities and $72,000 from crediting
reinsurers on funds withheld in segregated trusts as collateral for reinsurance
recoverables.
Income tax expense. Income tax expense was $3.6 million for the three
months ended March 31, 2006 compared to $2.0 million for the same period in
2005. The increase was due primarily to the increase in income before income
taxes. The effective income tax rate was 35.8% for the three months ending March
31, 2006 compared to 35.2% for the same period in 2005. The effective tax rate
in 2006 was higher due to non-recurring organizational and start up costs
relating to our sponsoring CastlePoint that are not deductible for tax purposes.
The effective tax rate of the first three months of 2006 would have been 34.3%
excluding the effects of the non-recurring expenses.
12
Net income and return on average equity. Net income and annualized return
on average equity was $6.5 million and 17.7%, respectively, for the three months
ended March 31, 2006 compared to $3.7 million and 11.5%, respectively, for the
same period in 2005. For the first quarter of 2006, the return was calculated by
dividing annualized net income of $26.0 million by an average stockholders'
equity of $146.9 million. For the first quarter of 2005, the return was
calculated by dividing annualized net income of $14.9 million by an average
stockholders' equity of $129.6 million. Excluding the effect of the above
mentioned organizational and start up expenses our net income and return on
average equity would have been $ 7.0 million and 19.0%, respectively, in the
first quarter of 2006.
Insurance Segment Results of Operations
Three Months Ended
March 31,
2006 2005
-------------- --------------
($ in thousands)
Revenues
Premiums Earned
Gross premiums earned $ 75,922 $ 45,449
Less: ceded premiums earned (19,333) (15,816)
-------------- --------------
Net premiums earned 56,589 29,633
Ceding commission revenue 7,302 5,846
Policy billing fees 267 196
-------------- --------------
Total 64,158 35,675
Expenses
Loss and loss adjustment expenses
Gross loss and loss adjustment
expenses 42,916 26,291
Less: ceded loss and loss adjustment
expenses (10,083) (8,511)
-------------- --------------
Net loss and loss adjustment expenses 32,833 17,780
Underwriting expenses
Direct commission expense 12,325 7,573
Other underwriting expenses 11,074 6,921
-------------- --------------
Total underwriting expenses 23,399 14,494
-------------- --------------
Underwriting Profit $ 7,926 $ 3,401
============== ==============
Key Measures
Premiums written
Gross premiums written $ 83,431 $ 64,302
Less: ceded premiums written (4,495) (19,274)
-------------- --------------
Net premiums written $ 78,936 $ 45,028
============== ==============
Loss Ratios
Gross 56.5% 57.8%
Net 58.0% 60.0%
Accident Year Loss Ratios
Gross 57.6% 57.9%
Net 58.9% 60.0%
Underwriting Expense Ratios
Gross 30.5% 31.5%
Net 28.0% 28.5%
Combined Ratios
Direct 87.0% 89.3%
Net 86.0% 88.5%
Insurance Segment Results of Operations Three Months Ended March 31, 2006 and
2005
Gross premiums. Gross premiums written increased by 29.7% to $83.4 million
for the three months ended March 31, 2006 compared to $64.3 million for the same
period in 2005. Gross premiums earned increased by 67.0% to $75.9 million for
the three months ended March 31, 2006 compared to $45.4 million for the same
period in 2005. Policies in force increased 25.2% for the three months ended
March 31, 2006 compared to the same period in 2005. Additionally, during the
first quarter of 2006, premium increases on renewed business averaged 7.5% in
personal lines and 5.3% in commercial lines. The retention rate was 91% for
personal lines and 86% for commercial lines. New business written during the
first quarter of 2006 through former OneBeacon producers that we appointed in
connection with the renewal rights transaction amounted to $5.4 million compared
to $4.9 million in the same period of 2005.
13
Ceded premiums. Ceded premiums written decreased by 76.7% to $4.5 million
for the three months ended March 31, 2006 compared to $19.3 million for the same
period in 2005. The lower ceded premiums written was the result of our decision
to not enter into a quota share reinsurance agreement for the three months ended
March 31, 2006 whereas a 25% quota share agreement was in effect for the same
period of 2005. During the first quarter of 2006, we were in discussions with
CastlePoint Reinsurance while it was in formation to enter into a multi-year
quota share reinsurance agreement that was executed post formation on April 6,
2006. During the three months ended March 31, 2006 we retained all of the risk
for 2006 that would have been ceded to quota share reinsurers. In the first
quarter of 2005 our quota share ceding percentage was 25%.
Net premiums. Net premiums written increased by 75.3% to $78.9 million for
the three months ended March 31, 2006 compared to $45.0 million for the same
period in 2005. This increase was greater than the increase in gross premiums
written due to our decision to not enter into a quota share reinsurance
agreement until CastlePoint Reinsurance was capitalized and formed on April 4,
2006. Net premiums earned increased by 91.0% to $56.6 million in the three
months ended March 31, 2006 compared to $29.6 million in the same period in
2005. This increase resulted primarily from the increase in gross premiums
written in 2005 that were earned in the first quarter of 2006 and the absence of
ceded premiums under quota share agreements for policies that began in 2006.
Ceding commission revenue . Ceding commission revenue increased by 24.9% to
$7.3 million for the three months ended March 31, 2006 compared to $5.8 million
for the same period in 2005 due to the increase in ceded written premiums in
2005 that were earned in 2006. Ceded premiums earned increased 22% in the first
quarter of 2006 as compared to the first quarter of 2005. Additionally, ceding
commission revenue included $393,000 in the first quarter of 2006 as a result of
an improvement in the ceded loss ratios on prior years' quota share treaties.
Loss and loss adjustment expenses and loss ratio. Gross and net losses and
loss adjustment expenses were $42.9 million and $32.8 million, respectively for
the three months ended March 31, 2006 compared with $26.3 million and $17.8
million, respectively, for the same period in 2005. Our gross and net loss
ratios were 56.5% and 58.0%, respectively for the three months ended March 31,
2006 as compared with 57.8% and 60.0% for the same period in 2005. The decrease
in the net loss ratio in the first quarter of 2006 compared to the same period
in 2005 was due to a decrease in the gross loss ratio. In addition, the increase
in net premiums earned reduced the proportional effect of catastrophe
reinsurance premiums on the net loss ratio. We ceded catastrophe reinsurance
premiums equal to 2.0% of net premiums earned during the three months ended
March 31, 2006 compared to 3.1% during the same period of 2005. There was
favorable development of $502,000 from prior years' reserves in the first
quarter of 2006 compared to $20,000 of adverse development in the same period of
2005. Loss and loss adjustment expenses are net of reimbursements for loss and
loss adjustment expenses made by TRM pursuant to the expense sharing agreement
between TICNY, TNIC and TRM. See "--- Insurance Services Segment Results of
Operations" for the amounts of claims reimbursements.
Underwriting expenses and underwriting expense ratio. Underwriting
expenses, which include direct commission expenses and other underwriting
expenses, were $23.4 million for the three months ended March 31, 2006 as
compared with $14.5 million for the same period in 2005. Our gross expense ratio
was 30.5% for the three months ended March 31, 2006 as compared with 31.5% for
the same period in 2005.
The commission portion of the gross expense ratio, which expresses direct
commission expense paid to our producers as a percentage of gross premiums
earned, was 16.2% for the three months ended March 31, 2006, as compared with
16.7% for the same period in 2005. The lower ratio was attributable to an
increase in the number of larger policies that carry a lower commission rate.
The underwriting expense portion of the gross expense ratio was 14.2% for
the three months ended March 31, 2006 as compared to 14.8% for the same period
in 2005. Although underwriting expenses increased due to the growth in premium
volume, the gross expense ratio declined as gross premiums earned increased at a
higher percentage than underwriting expenses.
The net underwriting expense ratio was 28.0% for the three months ended
March 31, 2006 as compared to 28.5% for the same period in 2005. This was due to
the lower gross expense ratio and the increased effects of ceding commission
revenue on lowering the gross expense ratio.
Underwriting profit and combined ratio. The underwriting profit, which
reflects our underwriting results on a net basis after the effects of
reinsurance, was $7.9 million in the first quarter of 2006 and $3.4 million in
the same period in 2005. The gross combined ratio was 87.0% for the three months
ended March 31, 2006 as compared with 89.3% for the same period in 2005. The
decrease in the gross combined ratio in the first quarter of 2006 resulted from
a decrease in both the gross loss ratio and the gross underwriting expense
ratio. The net combined ratio was 86.0% for the three months ended March 31,
2006 as compared to 88.5% for the same period in 2005. The decrease in the net
combined ratio resulted from a decrease in both the net loss ratio and the net
underwriting expense ratio.
14
Reinsurance Segment Results of Operations
Three Months Ended
March 31,
2006 2005
-------------- --------------
($ in thousands)
Revenues
Premiums earned
Gross premiums earned $ 694 $ 419
Less: ceded premiums earned (27) (34)
-------------- --------------
Net premiums earned 667 385
-------------- --------------
Total 667 385
Expenses
Loss and loss adjustment expenses
Gross loss and loss adjustment
expenses 396 (214)
Less: ceded loss and loss adjustment
expenses (19) 496
-------------- --------------
Net loss and loss adjustment expenses 377 282
Underwriting expenses
Direct commission expense 152 8
Other underwriting expenses 101 39
-------------- --------------
Total underwriting expenses 253 47
-------------- --------------
Underwriting Profit $ 37 $ 56
============== ==============
Key Measures
Premiums written
Gross premiums written $ 3,942 $ 366
Less: ceded premiums written - (33)
-------------- --------------
Net premiums written $ 3,942 $ 333
============== ==============
Loss Ratios
Gross 57.1% -51.1%
Net 56.5% 73.2%
Accident Year Loss Ratios
Gross 59.9% 59.9%
Net 60.0% 65.2%
Underwriting Expense Ratios
Gross 36.5% 11.3%
Net 38.0% 12.3%
Combined Ratios
Direct 93.5% -39.8%
Net 94.5% 85.6%
Reinsurance Segment Results of Operations Three Months Ended March 31, 2006 and
2005
Gross premiums. Gross premiums written increased to $3.9 million for the
three months ended March 31, 2006 as compared to $366,000 for the same period in
2005. This increase resulted from our decision to assume substantially all of
the premiums placed through the Insurance Services Segment. Gross premiums
earned increased to 65.6% to $694,000 from $419,000 in the first quarter of 2005
due to the significant increase in gross premiums written.
Net premiums. Since we decided to retain substantially all of the gross
premiums written, net premiums written increased to $3.9 million for the three
months ended March 31, 2006 as compared to $333,000 for the same period in 2005.
Net premiums earned increased by 73.2% to $667,000 for the three months ended
March 31, 2006 as compared to $385,000 for the same period in 2005 as a result
of the 65.6% increase in gross premiums earned.
Loss and loss adjustment expenses and loss ratio. Gross losses and loss
adjustment expenses were $396,000 for the three months ended March 31, 2006
compared to a benefit of $214,000 for the same period in 2005. Net losses and
loss adjustment expenses were $377,000 for the three months ended March 31, 2006
compared to $282,000 for the same period in 2005. Our gross and net loss ratios
were 57.1% and 56.6%, respectively for the three months ended March 31, 2006 as
compared with negative 51.1% and 73.2% for the same period in 2005. The gross
loss ratio was a negative 51.1% in the first quarter of 2005 due to favorable
development on prior years' reserves.
15
Underwriting expenses and underwriting expense ratio. Underwriting expenses
for the reinsurance segment are comprised of ceding commission expense paid to
TRM's issuing companies and other third-party reinsurers to acquire gross
premiums and this segment's allocated share of our other underwriting expenses.
Gross underwriting expenses and the gross underwriting expense ratio increased
for the three months ended March 31, 2006 to $253,000 and 36.5%, respectively,
as compared to $47,000 and 11.3%, respectively, for the same period in 2005
These increases resulted from commissions paid to one of TRM's issuing carriers
of approximately 30%. In 2005 this segment assumed premiums on an excess of loss
basis which did not incur a commission payment. Additionally, the increase in
gross premiums written resulted in an increase in the allocated share of other
underwriting expenses to this segment.
Underwriting profit and combined ratio. The underwriting profit from
assumed reinsurance for the first quarter of 2006 was $37,000 compared to
$56,000 for the first quarter of 2005. The net combined ratio was 94.5% for the
first quarter of 2006 compared to 85.6% for the first quarter of 2005. The
higher net combined ratio for the first quarter of 2006 was the result of the
increased net underwriting expense ratio as explained above.
The gross combined ratio increased to 93.5% for the first quarter of 2006
compared to a negative 39.8% for the first quarter of 2005 due to an increase in
the gross loss ratio to 57.1% for the first quarter of 2006 compared to a
negative 51.1% for the first quarter of 2005 and to an increase in the gross
underwriting expense ratio to 36.5% for the first quarter of 2006 compared to
11.3% for the first quarter of 2005.
Insurance Services Segment Results of Operations
Three Months Ended
March 31,
2006 2005
-------------- --------------
($ in thousands)
Revenues
Direct commission revenue from managing
general agency $ 806 $ 2,525
Claims administration revenue 962 1,053
Reinsurance intermediary fees(1) 61 203
Policy billing fees 3 5
-------------- --------------
Total Revenues 1,832 3,786
-------------- --------------
Expenses
Direct commissions expense paid to
producers 603 1,211
Other insurance services expenses(2) 237 485
Claims expense reimbursement to TICNY 958 1,050
-------------- --------------
Total Expenses 1,798 2,746
-------------- --------------
Insurance Services Pre-tax Income $ 34 $ 1,040
============== ==============
Premiums produced by TRM on behalf of
issuing companies $ 4,028 $ 8,444
============== ==============
(1) The reinsurance intermediary fees include commissions earned for
placement of reinsurance on behalf of TICNY.
(2) Consists of underwriting expenses reimbursed to TICNY pursuant to an
expense sharing agreement.
Insurance Services Segment Results of Operations Three Months Ended March 31,
2006 and 2005
Total revenues. Total revenues for the insurance services segment were $1.8
million for the three months ended March 31, 2006 as compared with $3.8 million
for the same period in 2005. The principal components of total revenues for our
insurance services segment are direct commission revenue, claims administration
revenue and reinsurance intermediary fees. The decrease in total revenues was
primarily due to direct commission revenue that decreased by 68.1% to $0.8
million for the first quarter of 2006 compared to $2.5 million for the first
quarter of 2005. Claims administration revenue decreased by 8.6% to $1.0 million
for the first quarter of 2006 as compared to $1.1 million for the first quarter
of 2005.
16
Direct commission revenue is dependent upon the premiums and losses on
business produced by TRM on behalf of its issuing companies. For the first
quarter of 2006 direct commission revenues decreased by 68.1% to $0.8 million
compared to $2.5 million for the first quarter of 2005 as a result in the
decrease in premiums produced by TRM as more policies were renewed in the
Insurance Segment. Premiums produced by TRM decreased by 52.3% to $4.0 million
in the first quarter of 2006 as compared to $8.4 million in the first quarter of
2005. In addition there was a reduction in commission revenue of $348,000 in the
first quarter of 2006 as a result of unfavorable loss development on the
premiums produced in prior years compared to an increase in direct commission
revenue which increased by $491,000 in the same period of 2005 from favorable
loss development on premiums produced in prior years.
Direct commission expense. TRM's direct commission expense ratio was 15.0 %
for the first quarter of 2006 compared to 14.3% for the first quarter of 2005.
Other insurance services expenses. The amount of reimbursement for
underwriting expenses by TRM to TICNY in the first quarter of 2006 was $0.2
million as compared to $0.5 million in the first quarter of 2005. The decrease
resulted from the decrease in premiums produced.
Claims expense reimbursement. The amount of reimbursement by TRM for claims
administration pursuant to the terms of the expense sharing agreement with TICNY
in the first quarter of 2006 was $1.0 million as compared to $1.1 million in the
first quarter of 2005 due to a slight decrease in the number of claims handled.
Pre-tax income. Pre-tax income in the first quarter of 2006 decreased by
96.7% to $34,000 as compared to $1.0. million in the first quarter of 2005. The
decrease was due to the decrease in premiums produced and the unfavorable
adjustment in direct commission revenue of $348,000 in the first quarter of 2006
as compared to a favorable adjustment in direct commission revenue of $491,000
in 2005.
Liquidity and Capital Resources
Cash flows. Cash flow needs at the holding company level are primarily for
dividends to our stockholders and interest payments on $68.0 million of
subordinated debentures.
For the three months ended March 31, 2006 net cash provided by operating
activities in our insurance operations was $38.6 million compared to $28.3
million for the same period in 2005. The increase in net cash provided by
operations for the three months ended March 31, 2006 resulted from an increase
in collected premiums as a result of the growth in gross premiums written and
because no premiums were ceded under quota share reinsurance for the 2006 policy
period.
During the three months ended March 31, 2006, we had $25.4 million of net
cash flows used in investing activities that were funded from operating cash
flow. The most significant impact from this activity was an increase in the
mortgage-backed and corporate bond sectors. The net cash flows provided from
financing activity was $19.7 million as of March 31, 2006 and included the net
proceeds from the issuance of $20.0 million in subordinated debentures on March
31, 2006.
The operating subsidiaries' primary sources of cash are net premiums
received, commission and fee income, net investment income and proceeds from the
sale and redemption of both equity and fixed-maturity investments. Cash is used
to pay claims, commissions and operating expenses, to purchase investments and
to pay dividends to the holding company. TICNY and TNIC are subject to
significant regulatory restrictions limiting their ability to declare and pay
dividends. As of March 31, 2006, the maximum amount of distributions that TICNY
could pay to its parent without approval of the New York State Insurance
Department was $5.1 million. As of March 31, 2006, TNIC may not pay any
dividends to its parent without the approval of the Massachusetts Commissioner
of Insurance because it does not have any positive unassigned surplus.
Subordinated Debentures
On March 31, 2006, we participated in a private placement of $20,000,000 of
fixed/floating rate capital securities (the "Trust Preferred Securities") issued
by Tower Group Statutory Trust V (the "Trust"), an affiliated Delaware trust
formed on March 29, 2006. The Trust Preferred Securities mature in April 2036,
are redeemable at our option at par beginning April 7, 2011, and require
quarterly distributions of interest by the Trust to the holder of the Trust
Preferred Securities. Distributions are initially at a fixed rate of 8.5625% for
the first five years and will then reset quarterly for changes in the
three-month London Interbank Offered Rate ("LIBOR") rate plus 330 basis points.
17
The Trust simultaneously issued 619 of the Trust's common securities to us for a
purchase price of $619,000, which constitutes all of the issued and outstanding
common securities of the Trust. The Trust used the proceeds from the sale of the
Trust Preferred Securities to purchase for $20,000,000 a Junior Subordinated
Debt Security due 2036 in the principal amount of $20,000,000 issued by us. The
net proceeds from the sale of the debenture to the Trust are expected to be used
to acquire and capitalize a shell insurance company with multi-state licensing
and for working capital purposes.
Investments
The aggregate fair market value of our invested assets as of March 31, 2006
was $379.6 million, excluding our investment in common trust
securities-statutory business trusts. Our fixed maturity securities as of this
date had a fair market value of $348.5 million and an amortized cost of $356.4
million. The equity securities carried at fair value were $6.3 million with a
cost of $6.7 million as of March 31, 2006. Equity securities carried at cost
were $24.8 million as of March 31, 2006.
Included in equity securities at cost as of March 31, 2006 are common
shares of a closed-end management investment company investing predominately in
asset-backed securities and mortgage-backed securities with a cost of
$19,802,000. This investment is carried at cost on the balance sheet because
there is no publicly traded price quote available. However, management estimated
the fair value for this fund by taking the market prices for all the securities
in the fund provided by a third party pricing service and then dividing by the
number of shares outstanding to determine its price per share. Also included in
equity securities at cost is an investment in a Real Estate Investment Trust
("REIT") with a cost of $5,000,000 and an estimated fair value of $5,000,000.
The estimated fair value for this security is determined based on recent trades
and an expected second quarter 2006 IPO price for this security. This single
REIT investment has not been registered under the Securities Act of 1933 and no
active market exists for this investment.
On November 3, 2005, the FASB issued FSP FAS 115-1 and FAS 124-1,
"Other-Than-Temporary Impairment and Its Application to Certain Investments."
The guidance in this FSP addresses the determination of when an investment is
considered impaired, whether that impairment is other than temporary, and the
measurement of an impairment loss. The FSP also includes accounting
considerations subsequent to the recognition of an other-than temporary
impairment and requires certain disclosures about unrealized losses that have
not been recognized as other-than-temporary impairments. The guidance in this
FSP applies to reporting periods beginning after December 15, 2005
Impairment of investment securities results in a charge to operations when
a market decline below cost is deemed to be other-than-temporary. As of March
31, 2006, we reviewed our fixed-maturity and equity securities portfolios to
evaluate the necessity of recording impairment losses for other-than-temporary
declines in the fair value of investments in accordance with the provisions of
this FSP. We determined that we did not hold any investments that would have
been considered other than temporarily impaired.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market risk relates to changes in the value of financial instruments that
arise from adverse movements in factors such as interest rates and equity
prices. We are exposed mainly to changes in interest rates that affect the fair
value of our investments in securities.
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.
18
In this sensitivity analysis model, we use fair values to measure our
potential loss. The sensitivity analysis model includes fixed maturities and
short-term investments.
For invested assets, we use modified duration modeling to calculate changes
in fair values. Durations on invested assets are adjusted for call, put and
interest rate reset features. Durations on tax-exempt securities are adjusted
for the fact that the yield on such securities is less sensitive to changes in
interest rates compared to Treasury securities. Invested asset portfolio
durations are calculated on a market value weighted basis, including accrued
investment income, using holdings as of March 31, 2006.
The following table summarizes the estimated change in fair value on our
fixed maturity portfolio including short-term investments based on specific
changes in interest rates as of March 31, 2006:
Estimated Increase Estimated Percentage
(Decrease) in Fair Value Increase (Decrease)
Change in Interest Rate ($ in thousands) in Fair Value
- ------------------------------ ------------------------- ---------------------
300 basis point rise (35,126) (10.1%)
200 basis rise (23,763) (6.8%)
100 basis rise (12,015) (3.4%)
As of March 31, 2006 -- 0.0%
50 basis point decline 6,015 1.7%
100 basis point decline 11,957 3.4%
19
The sensitivity analysis model used by us produces a predicted pre-tax loss
in fair value of market-sensitive instruments of $12.0 million or 3.4% based on
a 100 basis point increase in interest rates as of March 31, 2006. This loss
amount only reflects the impact of an interest rate increase on the fair value
of our fixed maturities, which constituted approximately 91.3% of our total
invested assets as of March 31, 2006.
As of March 31, 2006 we had a total of $23.7 million of outstanding
floating rate debt all of which are outstanding subordinated debentures
underlying our trust securities issued by our wholly owned statutory business
trusts carrying an interest rate that is determined by reference to market
interest rates. If interest rates increase, the amount of interest payable by us
would also increase.
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.
There have not been any changes in our internal control over financial
reporting during the three months ended March 31, 2006 that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.
Part II - OTHER INFORMATION
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
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Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registration has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Tower Group, Inc.
----------------------------
Registrant
Date: May 5, 2006 /s/ Michael H. Lee
---------------------- -------------------------------------
Michael H. Lee
Chairman of the Board,
President and Chief Executive Officer
Date: May 5, 2006 /s/ Francis M. Colalucci
---------------------- -------------------------------------
Francis M. Colalucci
Senior Vice President,
Chief Financial Officer and Treasurer
21