-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, NqKGbegWuobiJWHKHVcqVFHYyyxSvuaf14oVDKOX+4WG0+Mo2RvACpa3SSN7tXJL kaFL6QB1oIYpkM+B5qm2nA== 0001157523-06-010843.txt : 20061103 0001157523-06-010843.hdr.sgml : 20061103 20061103152449 ACCESSION NUMBER: 0001157523-06-010843 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20060930 FILED AS OF DATE: 20061103 DATE AS OF CHANGE: 20061103 FILER: COMPANY DATA: COMPANY CONFORMED NAME: Tower Group, Inc. CENTRAL INDEX KEY: 0001289592 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 133894120 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-50990 FILM NUMBER: 061186629 BUSINESS ADDRESS: STREET 1: 120 BROADWAY STREET 2: 14TH FLOOR CITY: NEW YORK STATE: NY ZIP: 10271 BUSINESS PHONE: (212) 655-2000 MAIL ADDRESS: STREET 1: 120 BROADWAY STREET 2: 14TH FLOOR CITY: NEW YORK STATE: NY ZIP: 10271 10-Q 1 a5265591.txt TOWER GROUP, INC. 10-Q - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2006 [ ] 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 (I.R.S. Employer Identification No.) incorporation or organization) 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. 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] The aggregate market value of the registrant's common stock held by non-affiliates on June 30, 2006 (based on the closing price on the Nasdaq National Market) on such date was approximately $515,117,298. Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 19,982,038 shares of common stock, par value $0.01 per share, as of November 1, 2006.
INDEX PAGE PART I FINANCIAL INFORMATION Item 1. Financial statements Consolidated Balance Sheets - September 30, 2006 (unaudited) and December 31, 2005 1 Consolidated Statements of Income and Comprehensive Net Income -- Three Months ended September 30, 2006 and 2005 (unaudited) 2 -- Nine Months ended September 30, 2006 and 2005 (unaudited) 2 Consolidated Statements of Cash Flows -- Three Months ended September 30, 2006 and 2005 (unaudited) 3 -- Nine Months ended September 30, 2006 and 2005 (unaudited) 3 Notes to Consolidated Financial Statements (unaudited) 4 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 13 Item 3. Quantitative and Qualitative Disclosures About Market Risk 27 Item 4. Controls and Procedures 28 PART II OTHER INFORMATION Item 6. Exhibits 29 SIGNATURES 29
1. Part I - FINANCIAL INFORMATION Item 1. Financial Statements
Tower Group, Inc. Consolidated Balance Sheets (Unaudited) September 30, December 31, 2006 2005 -------------- --------------- ($ in thousands, except par value and share amounts) Assets Fixed-maturity securities, available-for-sale, at fair value (amortized cost $402,668 in 2006 and $331,123 in 2005) $401,032 $326,681 Equity securities, available-for-sale, at fair value (cost $42,676 in 2006 and $6,681 in 2005) 42,646 5,934 Equity securities, at cost - 24,558 Common trust securities - statutory business trusts, equity method 2,045 1,426 -------------- --------------- Total investments 445,723 358,599 Cash and cash equivalents 40,533 38,760 Investment income receivable 4,123 3,337 Agents' balances receivable 55,245 46,004 Assumed premiums receivable 4,910 1,076 Ceding commission receivable - 8,727 Reinsurance recoverable 108,515 104,811 Receivable - claims paid by agency 3,633 2,309 Prepaid reinsurance premiums 79,102 43,319 Deferred acquisition costs net of deferred ceding commission revenue 34,783 29,192 Federal and state income taxes recoverable 3,134 365 Deferred income taxes 242 3,204 Intangible assets 5,830 5,835 Fixed assets, net of accumulated depreciation 23,912 7,920 Investment in unconsolidated affiliate 27,436 - Other assets 4,342 3,999 -------------- --------------- Total Assets $841,463 $657,457 ============== =============== Liabilities Loss and loss adjustment expenses $279,600 $198,724 Unearned premium 204,666 157,779 Reinsurance balances payable 24,851 19,200 Payable to issuing carriers 1,818 5,252 Funds held as agent 8,195 8,191 Funds held under reinsurance agreements 57,024 59,042 Accounts payable and accrued expenses 12,179 13,694 Deferred rent liability 6,040 - Payable for securities 939 - Other liabilities 3,580 2,867 Federal income taxes payable - 460 Subordinated debentures 68,045 47,426 -------------- --------------- Total Liabilities 666,937 512,635 -------------- --------------- Stockholders' Equity Common stock ($0.01 par value per share; 40,000,000 shares authorized; and 20,005,758 shares issued in 2006 and 19,872,672 in 2005) 200 199 Paid-in-capital 112,824 111,066 Accumulated other comprehensive net income (1,108) (3,352) Retained earnings 62,789 37,019 Treasury stock (23,720 shares in 2006 and 17,881 in 2005) (179) (110) -------------- --------------- Total Stockholders' Equity 174,526 144,822 -------------- --------------- Total Liabilities and Stockholders' Equity $841,463 $657,457 ============== =============== See accompanying notes to the consolidated financial statements
1
Tower Group, Inc. Consolidated Statements of Income and Comprehensive Net Income (Unaudited) Three Months Ended Nine Months Ended September 30, September 30, --------------------------------- --------------------------------- 2006 2005 2006 2005 ---------------- ---------------- --------------- ----------------- ($ in thousands, except share and per share amounts) Revenues Net premiums earned $ 52,366 $ 45,324 $ 168,908 $ 112,933 Ceding commission revenue 13,171 6,845 30,550 18,021 Insurance services revenue 1,243 3,418 5,274 10,541 Net investment income 5,923 4,131 15,875 10,479 Net realized gains (losses) on investments 32 (15) (84) 214 Policy billing fees 286 234 830 671 ---------------- ---------------- --------------- ----------------- Total revenues 73,021 59,937 221,353 152,859 ---------------- ---------------- --------------- ----------------- Expenses Loss and loss adjustment expenses 30,392 26,512 105,026 66,587 Direct commission expense 15,309 11,277 43,654 30,738 Other operating expenses 13,127 12,068 38,718 30,265 Interest expense 1,863 1,296 5,066 3,567 ---------------- ---------------- --------------- ----------------- Total expenses 60,691 51,153 192,464 131,157 ---------------- ---------------- --------------- ----------------- Other Income Equity income in unconsolidated affiliate 418 - 364 - Gain from issuance of common stock by unconsolidated affiliate - - 7,883 - Warrant received from unconsolidated affiliate - - 4,605 - ---------------- ---------------- --------------- ----------------- Income before income taxes 12,748 8,784 41,741 21,702 Income tax expense 4,292 3,076 14,490 7,512 ---------------- ---------------- --------------- ----------------- Net income $ 8,456 $ 5,708 $ 27,251 $ 14,190 ================ ================ =============== ================= Comprehensive Net Income Net income $ 8,456 $ 5,708 $ 27,251 $ 14,190 Other comprehensive income: Gross unrealized investment holding gains (losses) arising during period 9,150 (4,765) 3,273 (4,424) Equity in net unrealized gains in investment in unconsolidated affiliate's investment portfolio 296 - 184 - Less: reclassification adjustment for (gains) losses included in net income (32) 15 84 (214) ---------------- ---------------- --------------- ----------------- 9,414 (4,750) 3,541 (4,638) Income tax (expense) benefit related to items of other comprehensive income (3,295) 1,669 (1,297) 1,630 ---------------- ---------------- --------------- ----------------- Total other comprehensive net income (loss) 6,119 (3,081) 2,244 (3,008) ---------------- ---------------- --------------- ----------------- Comprehensive Net Income $ 14,575 $ 2,627 $ 29,495 $ 11,182 ================ ================ =============== ================= Earnings Per Share Basic earnings per common share $ 0.43 $ 0.29 $ 1.38 $ 0.73 ================ ================ =============== ================= Diluted earnings per common share $ 0.42 $ 0.28 $ 1.36 $ 0.71 ================ ================ =============== ================= Weighted Average Common Shares Outstanding: Basic 19,776,188 19,575,728 19,734,365 19,550,722 Diluted 20,074,058 20,161,873 20,032,256 20,119,280 See accompanying notes to the consolidated financial statements
2
Tower Group, Inc. Consolidated Statements of Cash Flows (Unaudited) Three Months Ended Nine Months Ended September 30, September 30, ----------------------------- ----------------------------- 2006 2005 2006 2005 -------------- -------------- -------------- -------------- ($ in thousands) Cash flows from operating activities: Net income $ 8,456 $ 5,708 $ 27,251 $ 14,190 Adjustments to reconcile net income to net cash provided by (used in) operations: Gain on issuance of common shares by unconsolidated affiliate - - (7,883) - Warrant received from unconsolidated affiliate - - (4,605) - Gain on sale of investments (32) 15 84 (214) Depreciation 1,273 642 3,236 1,814 Amortization of intangible assets 110 112 316 334 Amortization of bond premium or discount 176 311 644 784 Amortization of debt issuance costs 14 9 38 29 Amortization of restricted stock 262 147 604 469 Deferred income taxes 2001 193 1,666 (1,352) (Increase) decrease in assets: Investment income receivable (66) (491) (786) (1,259) Agents' balances receivable (938) 3,818 (9,241) (3,731) Assumed premiums receivable 2,073 (23) (3,834) 120 Ceding commissions receivable - - 8,727 (398) Reinsurance recoverable (12,994) (978) (5,028) (1,550) Prepaid reinsurance premiums (5,653) (1,895) (35,783) (12,704) Deferred acquisition costs, net (1,928) (2,306) (5,591) (8,980) Federal and state taxes recoverable (3,229) - (3,229) - Intangible assets (281) (78) (311) (1,224) Equity in unconsolidated affiliate (418) - (364) - Excess tax benefits from share-based payment arrangements (202) - (852) - Other assets 2,150 249 (381) 26 Increase (decrease) in liabilities: Loss and loss adjustment expenses 25,188 19,659 80,876 46,795 Unearned premium 4,948 7,962 46,887 55,708 Reinsurance balances payable (8,270) 594 5,651 15,628 Payable to issuing carriers (1,767) 224 (3,434) (6,163) Accounts payable and accrued expenses 391 2,344 (802) (1,608) Deferred rent liability 6,040 - 6,040 - Federal and state income taxes payable (3,236) (2,999) - 156 Funds held under reinsurance agreements (2,768) 2,760 (2,014) 618 -------------- -------------- -------------- -------------- Net cash flows provided by operations 11,300 35,977 97,882 97,488 -------------- -------------- -------------- -------------- Cash flows used in investing activities: Purchase of fixed assets (14,158) (1,110) (19,228) (3,530) Investment in unconsolidated affiliate 128 - (14,400) - Purchases of investments: Fixed-maturity securities (52,711) (50,678) (124,685) (125,538) Equity securities - at fair value (35,362) (617) (35,995) (30,588) Short-term investments - net 16 - 16 - Sale of investments: Fixed-maturity securities 24,956 2,669 53,168 36,825 Equity securities - at cost 24,558 - 24,558 1,972 -------------- -------------- -------------- -------------- Net cash flows used in investing activities (52,573) (49,736) (116,566) (120,859) -------------- -------------- -------------- -------------- Cash flows from financing activities: Proceeds from subordinated debentures - - 20,619 - Purchase of common trust securities - statutory business trusts - - (619) - Dividends paid (493) (490) (1,481) (1,467) Share based compensation 270 165 1,155 245 Excess tax benefits from share-based payment arrangements 202 - 852 - Stock repurchase (2) - (69) - -------------- -------------- -------------- -------------- Net cash flows provided by (used in) financing activities (23) (325) 20,457 (1,222) -------------- -------------- -------------- -------------- Increase (decrease) in cash and cash equivalents (41,296) (14,084) 1,773 (24,593) Cash and cash equivalents, beginning of period 81,829 44,692 38,760 55,201 -------------- -------------- -------------- -------------- Cash and cash equivalents, end of period $ 40,533 $ 30,608 $ 40,533 $ 30,608 ============== ============== ============== ============== Supplemental disclosures of cash flow information: Cash paid for income taxes $ 7,982 $ 5,778 $ 15,306 $ 8,488 Cash paid for interest $ 1,479 $ 883 $ 3,384 $ 2,535 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 United 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 and nine months ended September 30, 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 the Company, its wholly owned subsidiaries Tower Insurance Company of New York ("TICNY"), Tower National Insurance Company ("TNIC"), Tower Risk Management Corporation ("TRM"), Tower Indemnity Company of America ("TICA") 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. Investment in Unconsolidated Affiliate The Company has invested in an unconsolidated Bermuda holding company, CastlePoint Holdings, Ltd. ("CastlePoint"), which the Company organized and sponsored with an initial investment of $15.0 million on February 6, 2006. The Company consolidated the activities of CastlePoint as a wholly owned subsidiary during the first quarter of 2006 and recognized approximately $0.5 million of non-recurring start-up costs. On April 4, 2006, CastlePoint raised $249.9 million, net of expenses, in a private placement offering of unissued shares, which reduced the Company's investment ownership from 100% to 8.6%. The book value per share of the Company's 2,555,000 shares of CastlePoint common stock increased from $5.87 per share to $8.96 per share as a result of this offering. The carrying value of the Company's investment in CastlePoint increased from $15.0 million to $22.9 million. The Company has recorded this gain of $7.9 million in income before taxes in accordance with the Securities and Exchange Commission's Staff Accounting Bulletin ("SAB") No. 51 - Accounting for Sales of Stock by a Subsidiary in the nine months ended September 30, 2006. On April 6, 2006, the Company received a warrant from CastlePoint to purchase an additional 3.7% or 1,127,000 shares of common stock with a fair value of approximately $4.6 million using a Black-Scholes option pricing model. The warrant is exercisable in whole or in part at any time up to April 6, 2016, and the exercise price is $10 per share. Shares acquired through the exercise of the warrant may not be sold prior to April 9, 2009. The warrant was received in exchange for sponsorship services, which included management, operational and industry expertise to establish the CastlePoint organization and prepare for a private placement offering. Accordingly, the Company recognized $4.6 million in income before taxes in the nine months ending September 30, 2006 relating to non-recurring sponsorship services. The warrant has been recorded as an equity instrument at cost, which was determined to be the fair value of the warrant on the date it was received and will be subject to impairment testing. The Company has determined that its ownership in CastlePoint qualifies as a variable interest entity ("VIE") under the provisions of FIN 46-(R). The Company has determined that its investment in CastlePoint does not meet the requirements for consolidation because the Company is not the primary beneficiary of the VIE as defined in FIN 46-(R). However, the Company has recorded its 8.6% investment in CastlePoint using the equity method of accounting as the Company exercises significant influence over CastlePoint. The Company and CastlePoint have the same CEO. Through its two insurance subsidiaries, TICNY and TNIC, the Company entered into three, multi-year quota share reinsurance agreements with 4 CastlePoint Reinsurance Company, Ltd. ("CastlePoint Reinsurance"), which were effective April 4, 2006 and a service and expense sharing agreement whereby the Company's staff provides CastlePoint administrative and underwriting services at cost. At September 30, 2006, the Company's maximum exposure to a loss from its investment in CastlePoint was approximately $27.4 million, which consists of its equity ownership interest of approximately $22.8 million (after deducting dividends received in the third quarter of 2006) and the fair value of the warrant the Company received from CastlePoint of $4.6 million. The carrying value of the Company's equity investment in CastlePoint as of September 30, 2006 is as follows in millions: Initial investment in CastlePoint $ 15.0 Consolidated net loss for the three months ended (0.5) March 31, 2006 Equity in net income of CastlePoint for the six months ended September 30, 2006 0.3 Gain from issuance of common stock by CastlePoint 7.9 Equity in net unrealized gains of the CastlePoint investment portfolio 0.2 Dividends received from CastlePoint (0.1) Value of warrant received 4.6 ---------------- Carrying value of equity investment in CastlePoint $ 27.4 ================ A general dividend and a special dividend of $0.025 per share each were declared and paid by CastlePoint in September 2006. The Company recorded its $128,000 of CastlePoint dividends as a reduction to its investment in CastlePoint. CastlePoint Reinsurance entered into three multi-year quota share reinsurance agreements with the Company's insurance subsidiaries that will cede to CastlePoint Reinsurance between 25% and 45%, subject to a periodic adjustment by the Company, of premiums and losses on their brokerage insurance business that the Company has historically written through its retail and wholesale agents. The ceding commission for the brokerage business is fixed at 34% of ceded written premiums. During the second quarter of 2006, the Company ceded 30% of its brokerage insurance business to CastlePoint Reinsurance and ceded 40% of its new and renewal brokerage insurance business written in the third quarter of 2006 to CastlePoint. The Company ceded 50% of its traditional program business and 85% of its specialty program business written during the third quarter of 2006 to CastlePoint. Traditional program business written through program underwriting agencies is comprised of classes of business that the Company has historically written. The ceding commission rate for the traditional program business is 30% and may be adjusted upward based upon the loss ratio. The ceding commission for the specialty program business is 30%. During the nine months ended September 30, 2006, the Company ceded $40.9 million of unearned premiums as of April 1, 2006, which consisted of $19.2 million and $21.7 million of unearned premiums retained by the Company on policies written in 2006 and 2005, respectively, and $68.8 million on premiums written during the nine months ended September 30, 2006. In addition, CastlePoint Reinsurance participates as a reinsurer on the Company's catastrophe reinsurance program, effective July 1, 2006, and excess of loss reinsurance program effective, May 1, 2006. The Company ceded excess of loss reinsurance and catastrophe premiums to CastlePoint Reinsurance of $1.0 million and $1.4 million, respectively for the three months and nine months ended September 30, 2006. Recoverables totaling $86.9 million from CastlePoint Reinsurance, which is an unauthorized reinsurer, are collateralized in a New York State Regulation 114 Compliant Trust account for the benefit of the Company with a balance of $62.6 million as of September 30, 2006 with the remaining amount offset by ceded balances payable of $28.0 million. The Company's insurance companies entered into a service and expense sharing agreement with CastlePoint, pursuant to which they will provide insurance company services now offered by the Company, such as claims adjustment, policy administration, technology solutions, underwriting, and risk management services, to the U.S. domiciled insurance subsidiaries of CastlePoint, as well as to companies appointed as managing general underwriters by those companies. The Company charged CastlePoint $0.3 million for such 5 services in the third quarter of 2006 and $0.6 million for the nine months ended September 30, 2006, which have been recorded as reductions to the Company's operating expenses. Effective April 4, 2006, the Company novated business assumed from the Accident Insurance Company ("AIC") by TICNY to CastlePoint Reinsurance. TICNY recorded $0.1 million as ceded premiums written and earned and eliminated liabilities of $0.1 million, which was recorded as a reduction to losses incurred during the three months ending June 30, 2006. Purchase of Shell Company and Intangible Assets On June 28, 2006, the Company closed on its purchase of 100% of the outstanding common stock of a shell insurance company, MIIX Insurance Company of New York, which was renamed Tower Indemnity Company of America. The total cost to acquire TICA was $8.6 million and included the purchase price, legal fees and a broker fee. TICA has active state insurance licenses in New York and New Jersey. The Company capitalized $0.3 million of the $8.6 million as an intangible asset related to state licenses with an indefinite life subject to annual impairment testing. See "Subsequent Events" for further discussion. Commutation and Novation with PXRE Reinsurance Company On June 29, 2006, to eliminate its exposure to uncollateralized reinsurance recoverables from PXRE Reinsurance Company ("PXRE"), which had requested the withdrawal of its financial strength and issuer rating from A.M.Best, the Company concluded, through commutation agreements, PXRE's participation under various reinsurance agreements with TICNY covering the 2001, 2002 and a portion of the 2003 policy periods. Ceded loss and loss adjustment expense recoverables of $20.5 million, ceded paid losses of $2.4 million and ceding commissions receivable of $8.7 million, totaling $31.6 million of unsecured recoverables were settled with a payment from PXRE of $26.7 million, which represents an estimate of the present value of these recoverables. This resulted in a $4.8 million pre-tax charge, of which $1.6 million was recognized in loss and loss adjustment expenses and $3.2 million was recognized as a reduction to ceding commission income in the second quarter of 2006. In addition, on the same date, novation agreements were executed with PXRE relating to other reinsurance agreements covering business written in 2001, 2002 and 2003 by other insurance companies and managed on their behalf by TRM, the Company's risk management subsidiary. As a result of the novation, TICNY assumed loss reserves of $12.2 million for which it received as consideration $11.4 million in cash and other assets and TRM recorded a reduction in commission liabilities for $0.2 million, the total of which resulted in a $0.6 million pre-tax charge. As a result of the commutation and novation agreements, which are effective as of June 29, 2006, PXRE is discharged from future obligations under the reinsurance agreements. There are no other agreements outstanding with PXRE. Investments The Company accounts for its investments in accordance with Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"), which requires that fixed-maturity securities 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 certain 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. During the third quarter of 2006, the Company reclassified its entire balance of equity securities at cost to equity securities at fair value in compliance with GAAP for insurance companies. 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 6 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 September 30, 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 $20.0 million 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. Interest 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") plus 330 basis points. The Trust simultaneously issued 619 of the Trust's common securities to the Company for a purchase price of $0.6 million, 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 and common securities to purchase for $20.6 million a Junior Subordinated Debt Security due 2036 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 were used to pay the purchase price of TICA and for working capital purposes. Fixed Assets During the third quarter of 2006, the Company relocated its New York City Corporate Headquarters within the same building. The Company capitalized $14.2 million for the purchase of fixed assets that included $8.0 million for leasehold improvements, $3.9 million for furniture & equipment and $2.2 million for computer hardware and software. The landlord provided a $4.5 million build-out allowance which partially financed the $8.0 million of leasehold improvements. For the nine months of 2006, the Company capitalized $19.2 million for the purchase of fixed assets. This included $9.5 million for leasehold improvements, $5.1 million for furniture & equipment and $4.6 million for computer hardware and software. The Company will amortize the leasehold improvements over the remaining life of the lease which is approximately fifteen years. Dividends Declared Dividends declared by the Company on common stock for the three months ended September 30, 2006 were $495,000 or $0.025 per share and were $489,000 for the three months ended September 30, 2005 or $0.025 per share. For the nine months ended September 30, 2006 dividends declared on common stock by the Company were $1,481,000 or $0.075 per share and were $1,467,000 or $0.075 per share for the nine months ended September 30, 2005. Accounting Pronouncements In June 2006, FASB Interpretation ("FIN") No. 48, "Accounting for Uncertainty in Income Taxes," was issued. This guidance clarifies what criteria must be met prior to recognition of the financial statement benefit of a position taken in a tax return. Additionally, it applies to the recognition and measurement of income tax uncertainties resulting from a purchase business combination. This guidance is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact FIN 48 will have on its consolidated results of operations and financial position. 7 In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements." This new standard provides guidance for using fair value to measure assets and liabilities. Under SFAS 157, fair value refers to the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts. In this standard, the FASB clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, SFAS 157 establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data such as the reporting entity's own data. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy. The provisions of SFAS 157 are effective for financial statements issued beginning November 15, 2007. The Company is currently reviewing this statement to determine what if any effect it may have on its consolidated results of operations and financial position. In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and other Postretirement Plans." The Company has no defined benefit pension plan and therefore, SFAS 158 will have no effect on the Company's results of operations or financial position. In September 2006, the SEC issued Staff Accounting Bulletin (SAB) 108 that expresses the SEC staff's view that it is improper to allow immaterial, incorrect assets or liabilities from prior years' errors to remain unadjusted on the balance sheet as these balance sheet corrections could result in material charges to the current year income statement. The Company has determined that there is no effect on its results of operations or financial position for this SAB. 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 September 30, 2006 Net income $ 8,456 --------------- Basic earnings per share 8,456 19,776,188 $ 0.43 --------------- -------------- ================= Effect of dilutive securities: Stock options - 195,798 Unvested restricted stock - 69,286 Warrants - 32,786 --------------- -------------- Diluted earnings per share $ 8,456 20,074,058 $ 0.42 =============== ============== ================= Three Months Ended September 30, 2005 Net income $ 5,708 --------------- Basic earnings per share 5,708 19,575,728 $ 0.29 --------------- -------------- ================= Effect of dilutive securities: Stock options - 317,178 Unvested restricted stock - 184,353 Warrants - 84,614 --------------- -------------- Diluted earnings per share $ 5,708 20,161,873 $ 0.28 =============== ============== ================= Nine Months Ended September 30, 2006 Net income $27,251 --------------- -------------- Basic earnings per share 27,251 19,734,365 $ 1.38 --------------- -------------- ================= Effect of dilutive securities Stock options - 204,087 Unvested restricted stock - 62,799 Warrants - 31,005 --------------- -------------- Diluted earnings per share $27,251 20,032,256 $ 1.36 =============== ============== ================= Nine Months Ended September 30, 2005 Net income $14,190 --------------- -------------- Basic earnings per share 14,190 19,550,722 $ 0.73 --------------- -------------- ================= Effect of dilutive securities: Stock options - 300,225 Unvested restricted stock - 199,760 Warrants - 68,573 --------------- -------------- Diluted earnings per share $14,190 20,119,280 $ 0.71 =============== ============== ================= 8 As of September 30, 2006 the Company adjusted the calculation of weighted average diluted shares relating to stock options and unvested shares that increased the assumed proceeds used in applying the treasury stock method as a result of adopting FASB 123R "Share Based Payment". This adjustment resulted in an immaterial reduction in the effect of dilutive securities and an immaterial increase in the diluted earnings per share for the first two quarters of 2006. The effect of the adjustment is $0.01 and has been reflected in diluted earnings per share for the nine months ended September 30, 2006. Equity Compensation Plans The Company adopted the provision of SFAS 123-R effective January 1, 2006 and 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 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 R. Compensation expense net of tax recorded related to stock options was $14,000 for the three months ended September 30, 2006 and $48,718 for the nine months ended September 30, 2006. These amounts have been included in reported net income for the third quarter and nine months ended September 30, 2006. The remaining total compensation cost related to non vested stock option and restricted stock awards not yet recognized in the income statement was $3,113,000 of which $260,000 was for stock options and $2,853,000 was for restricted stock as of September 30, 2006. The weighted average period over which this compensation cost is expected to be recognized is 3.6 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 December 31, 2005. During the third quarter of 2006, the Company issued 10,599 new common shares as the result of employee stock option exercises and issued 38,553 new common shares as the result of restricted stock grants. During the third quarter of 2005, the Company issued 19,250 new common shares as the result of employee stock option exercises and issued no new common shares as the result of restricted stock grants. For the nine months ended September 30, 2006, the Company issued 58,067 new common shares as the result of employee stock option exercises and issued 75,019 new common shares as the result of restricted stock grants. During the nine months ended September 30, 2005, the Company issued 29,170 new common shares as the result of employee stock option exercises and issued 11,248 new common shares as the result of restricted stock grants. The Company incurred restricted stock expense of $170,000 net of tax for the three months ended September 30, 2006 which has been included in reported net income for the third quarter of 2006. For the three months ended September 30, 2005, the Company incurred restricted stock expense of $95,000 net of tax that was included in reported net income for the third quarter of 2005. For the nine months ended September 30, 2006 and 2005, the Company incurred restricted stock expense of $393,000 and $305,000, respectively, net of tax that was included in reported net income. Prior to the adoption of SFAS 123-R, the Company followed the intrinsic value method in accordance with APB 25 to account for employee stock options and accordingly recognized no compensation expense for the stock option grants. In accordance with SFAS 123-R, the Company adopted the provisions of the statement on January 1, 2006 using the modified prospective application method. Under this method, prior periods are not restated. Had compensation cost for share-based plans been determined consistent with SFAS 123-R, the Company's net earnings and earnings per share for the three months and nine months ended September 30, 2005 would have been the following pro-forma amounts: 9 Three Months Ended Nine Months Ended September 30, September 30, ------------------ ----------------- 2005 2005 ------------------ ----------------- ($ in thousands, except shares and per share amounts) Net income $5,708 $14,190 Deduct total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (15) (46) ------------------ ----------------- Net income, pro-forma $5,693 $14,144 Earnings Per Share Basic - as reported $0.29 $0.73 ================== ================= Basic - pro-forma $0.29 $0.72 ================== ================= Diluted - as reported $0.28 $0.71 ================== ================= Diluted - pro-forma $0.28 $0.70 ================== ================= Weighted-Average Common Shares Outstanding Basic 19,575,728 19,550,722 Diluted 20,161,873 20,119,280 Changes in Estimates TICNY and TNIC recorded favorable development in net losses from prior accident years of $616,000 and $1,298,000 in the third quarter of 2006 and in the nine months ended September 30, 2006, respectively, compared to favorable development in the third quarter of 2005 and nine months ended September 30, 2005 of $222,000 and $315,000, respectively. TICNY's changes in estimated sliding scale commission resulted in an increase in ceding commission revenue of $245,000 and $1,046,000 in the third quarter of 2006 and for the nine months ended September 30, 2006, respectively as compared to an increase in commission revenue of $7,000 in the third quarter of 2005 and a reduction in ceding commission revenue for prior years of $712,000 for the nine months ended September 30, 2005. TRM's changes in estimated sliding scale commission was an increase in direct commission revenue of $393,000 and $180,000 in the third quarter of 2006 and in the nine months ended September 30, 2006, respectively, compared to an increase in direct commission revenue of $110,000 and $487,000 in the third quarter of 2005 and in the nine months ended September 30, 2005, respectively. Segment Information The Company manages its operations through three business segments: insurance (commercial and personal lines underwriting), reinsurance and insurance services (managing general agency, claims administration and reinsurance intermediary operations). The accounting policies of the segments are the same as those described in the summary of significant accounting policies as described in the Company's most recently filed Form 10-K. The Company evaluates segment performance based on segment profit, which excludes investment income, realized gains and losses, interest expense, income taxes and incidental corporate expenses. The Company does not allocate assets to segments because assets, which consist primarily of investments, are considered in total by management for decision-making purposes. Business Segment results are as follows:
Three Months Ended Nine Months Ended September 30, September 30, -------------------------------- -------------------------------- 2006 2005 2006 2005 ---------------- --------------- --------------- ---------------- Insurance Segment Information ($ in thousands) Revenues Net premiums earned $49,796 $44,940 $152,356 $111,767 Ceding commission revenue 13,171 6,845 30,550 18,021 Policy billing fees 286 227 825 653 ---------------- --------------- --------------- ---------------- Total revenues 63,253 52,012 183,731 130,441 ---------------- --------------- --------------- ----------------
10
Three Months Ended Nine Months Ended September 30, September 30, -------------------------------- -------------------------------- 2006 2005 2006 2005 ---------------- --------------- --------------- ---------------- Expenses Net loss and loss adjustment expenses 28,853 26,293 89,895 65,870 Underwriting expenses 25,688 20,309 73,263 51,671 ---------------- --------------- --------------- ---------------- Total expenses 54,541 46,602 163,158 117,541 ---------------- --------------- --------------- ---------------- Underwriting profit $ 8,712 $ 5,410 $ 20,573 $ 12,900 ================ =============== =============== ================ Reinsurance Segment Revenues Net premiums earned $ 2,569 $ 384 $ 16,552 $ 1,166 ---------------- --------------- --------------- ---------------- Total revenues 2,569 384 16,552 1,166 ---------------- --------------- --------------- ---------------- Expenses Net loss and loss adjustment expenses 1,538 219 15,131 717 Underwriting expenses 1,235 52 2,354 136 ---------------- --------------- --------------- ---------------- Total expenses 2,773 271 17,485 853 ---------------- --------------- --------------- ---------------- Underwriting (loss) profit $ (204) $ 113 $ (933) $ 313 ================ =============== =============== ================ Insurance Services Segment Revenues Direct commission revenue from managing general agency $ 380 $ 2,022 $ 2,291 $ 6,713 Claims administration revenue 688 1,137 2,572 3,287 Reinsurance intermediary fees 176 259 411 541 Policy billing fees - 7 5 18 ---------------- --------------- --------------- ---------------- Total revenues 1,244 3,425 5,279 10,559 ---------------- --------------- --------------- ---------------- Expenses Direct commissions expense paid to producers 211 1,143 1,545 3,528 Other insurance services expenses 193 472 735 1,412 Claims expense reimbursement to TICNY 687 1,135 2,556 3,276 ---------------- --------------- --------------- ---------------- Total expenses 1,091 2,750 4,836 8,216 ---------------- --------------- --------------- ---------------- Insurance services pre-tax income $ 153 $ 675 $ 443 $ 2,343 ================ =============== =============== ================
Underwriting expenses in the insurance segment are net of expense reimbursements by the insurance services segment pursuant to an expense sharing agreement between TRM and TICNY. In accordance with the 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 $0.2 million and $0.5 million for the three months ended September 30, 2006 and September 30, 2005, respectively, and $0.7 million and $1.4 million for the nine months ended September 30, 2006 and September 30, 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 $0.7 million and $1.1 million for the three months ended September 30, 2006 and September 30, 2005, respectively, and $2.6 million and $3.3 million for the nine months ended September 30, 2006 and September 30, 2005, respectively. In addition, underwriting expenses in the insurance segment are net of expense reimbursements by CastlePoint pursuant to a service and expense sharing agreement entered into in April 2006 between CastlePoint, the Company and its subsidiaries. In accordance with the terms of this agreement, CastlePoint reimburses the Company for services rendered on a cost basis. During the three 11 months and nine months ended September 30, 2006, the amount of CastlePoint's reimbursement was $0.3 million and $0.6 million, respectively and have been reflected as reductions to the Company's operating expenses. The following table reconciles revenue by segment to consolidated revenue:
Three Months Ended Nine Months Ended, September 30, September 30, -------------------------------- --------------------------------- 2006 2005 2006 2005 --------------- ---------------- --------------- ----------------- ($ in thousands) Insurance segment $63,253 $52,012 $183,731 $130,441 Reinsurance segment 2,569 384 16,552 1,166 Insurance services segment 1,244 3,425 5,279 10,559 --------------- ---------------- --------------- ----------------- Total segment revenue 67,066 55,821 205,562 142,166 Investment income 5,923 4,131 15,875 10,479 Realized capital gains/(losses) 32 (15) (84) 214 --------------- ---------------- --------------- ----------------- Consolidated revenues $73,021 $59,937 $221,353 $152,859 =============== ================ =============== =================
The following table reconciles the results of the Company's individual segments to consolidated income before taxes:
Three Months Ended Nine Months Ended, September 30, September 30, ----------------------------------- --------------------------------- 2006 2005 2006 2005 ---------------- ------------------ ---------------- ---------------- ($ in thousands) Insurance segment underwriting profit $ 8,712 $ 5,410 $20,573 $12,900 Reinsurance segment underwriting (loss) profit (204) 113 (933) 313 ---------------- ------------------ --------------------------------- Total underwriting profit 8,508 5,523 19,640 13,213 Insurance services segment pre-tax income 153 675 443 2,343 Net investment income 5,923 4,131 15,875 10,479 Net realized investment gains/(losses) 32 (15) (84) 214 Corporate expenses (423) (234) (1,919) (980) Other income 418 - 12,852 - Interest expense (1,863) (1,296) (5,066) (3,567) ---------------- ------------------ ---------------- ---------------- Income before taxes $12,748 $ 8,784 $41,741 $21,702 ================ ================== ================ ================
Subsequent Events On October 26, 2006 the Company's Board of Directors approved a quarterly dividend of $0.025 per share payable December 27, 2006 to stockholders of record as of December 15, 2006. On October 30, 2006 the Company executed an agreement to sell all of the issued and outstanding common shares of Tower Indemnity Company of America ("TICA"), a New York property and casualty insurance company, to CastlePoint Management Corp., a subsidiary of CastlePoint Holdings, Ltd. The purchase price is an amount equal to TICA's aggregate statutory surplus as of the closing date plus $350,000 for additional legal and other costs. As of September 30, 2006 TICA's statutory surplus was $8.4 million. The Company entered into this sale to facilitate its pooling arrangement with CastlePoint. The Company does not expect to recognize any gain or loss on this sale. TICA is a shell insurance company and has no net liabilities for insurance losses. 12 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," "annualized" 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. We undertake no obligation to publicly update or review any forward-looking statement, whether as a result of new information, future developments or otherwise. Consolidated Results of Operations
Three Months Ended Nine Months Ended September 30, September 30, ------------------------------- ------------------------------- 2006 2005 2006 2005 --------------- --------------- --------------- --------------- ($ in thousands) Revenues Earned premiums Gross premiums earned $ 92,528 $ 64,859 $264,711 $165,787 Less: ceded premiums earned (40,162) (19,535) (95,803) (52,854) --------------- --------------- --------------- --------------- Net premiums earned 52,366 45,324 168,908 112,933 --------------- --------------- --------------- --------------- Total commission and fee income 14,700 10,497 36,654 29,233 Net investment income 5,923 4,131 15,875 10,479 Net realized investment gains 32 (15) (84) 214 --------------- --------------- --------------- --------------- Total revenues 73,021 59,937 221,353 152,859 --------------- --------------- --------------- --------------- Expenses Net loss and loss adjustment expenses 30,392 26,512 105,026 66,587 Operating expenses 28,436 23,345 82,372 61,003 Interest expenses 1,863 1,296 5,066 3,567 --------------- --------------- --------------- --------------- Total expenses 60,691 51,153 192,464 131,157 --------------- --------------- --------------- --------------- Other Income Equity income in unconsolidated affiliate 418 - 364 - Gain from issuance common stock by unconsolidated affiliate - - 7,883 - Warrant received from unconsolidated affiliate - - 4,605 - --------------- --------------- --------------- --------------- Income before taxes 12,748 8,784 41,741 21,702 Federal and state income taxes 4,292 3,076 14,490 7,512 --------------- --------------- --------------- --------------- Net Income $ 8,456 $ 5,708 $ 27,251 $ 14,190 =============== =============== =============== =============== Key Measures Return on Average Equity 20.2% 16.5% 22.8% 14.1% =============== =============== =============== ===============
13 Consolidated Results of Operations Three Months Ended September 30, 2006 and 2005 Total revenues. Total revenues increased by 21.8% to $73.0 million for the three months ended September 30, 2006 compared to $59.9 million for the same period in 2005. The increase is primarily due to the increase in net premiums earned, total commission and fee income and net investment income. Net premiums earned represented 71.7% of total revenues for the three months ended September 30, 2006 compared to 75.6% for the same period in 2005. Net investment income, excluding realized capital gains, represented 8.1% and 6.9% of total revenues for the three months ended September 30, 2006 and 2005, respectively. In addition, total commission and fee income increased for the three months ended September 30, 2006 to $14.7 million, or 20.1% of total revenue, compared to $10.5 million, or 17.5% of total revenue, for the same period in 2005. Premiums earned. Net premiums earned increased by 15.5% to $52.4 million for the three months ended September 30, 2006 compared to $45.3 million for the same period in 2005. The increase in net premiums earned was due to the overall increase in gross premiums written through September 30, 2006 which resulted from increases in our homeowners and commercial multi-peril and other liability lines, partially offset by increased quota share and catastrophe reinsurance during the third quarter of 2006. During the third quarter of 2006 under quota share reinsurance agreements we ceded to CastlePoint Reinsurance approximately 40% of our brokerage business, 50% of our traditional program business and 85% of our specialty program business. This is compared to a 25% quota share ceding percentage in the three months ended September 30, 2005. In addition, ceded premiums earned increased in the third quarter of 2006 as a result of ceding unearned premiums to CastlePoint as of April 1, 2006 which related to business written in 2005 and that we had previously retained. Catastrophe premiums increased approximately $3.0 million in the third quarter of 2006 as compared to the same period last year. Commission and fee income. Total commission and fee income increased by 40.0% to $14.7 million in the third quarter of 2006 compared to $10.5 million in the third quarter of 2005. This was due to the increase in the ceding commission revenue earned as a result of the increase in ceded premiums earned as discussed above. This increase was offset in part by a reduction in fee income in our Insurance Services Segment as more policies previously produced in that segment were written in our Insurance Segment. For the three months ended September 30, 2006 the change in estimated sliding scale commission rate for commissions earned in prior periods in both the Insurance Segment and the Insurance Services Segment resulted in a net increase of $0.6 million of commission and fee income compared to a $0.1 million increase in the same period of 2005. 14 Net investment income and realized gains. Net investment income increased by 43.4% to $5.9 million for the three months ended September 30, 2006 compared to $4.1 million in the same period in 2005. This growth resulted from an increase in invested assets to $443.7 million as of September 30, 2006 compared to $357.2 million as of September 30, 2005, excluding our investments in statutory business trusts underlying our trust preferred securities. The increase in invested assets in the third quarter of 2006 resulted from net cash flow provided by operations of $11.3 million. On a tax equivalent basis, the yield was 5.6% as of September 30, 2006 and 5.1% as of September 30, 2005. Net realized capital gains were $32,000 for the three months ended September 30, 2006 compared to net realized capital loss of $15,000 for the same period in 2005. There was no impact on net realized gains attributable to adjustments for other than temporary impairment of securities held during the three months ending September 30, 2006 or during the same period in 2005. Loss and loss adjustment expenses. Gross loss and loss adjustment expenses and the gross loss ratio for the Insurance and Reinsurance Segments combined for the three months ended September 30, 2006 were $49.1 million and 53.1%, respectively, compared to $36.3 million and 56.0%, respectively, for the same period in 2005. The net loss ratio decreased to 58.0% in the third quarter of 2006 compared to 58.5% in the same period last year. The decrease in the gross and net loss ratios in the third quarter of 2006 compared to the same period in 2005 was primarily due to lower than expected loss emergence for the property lines for the current accident year that resulted in lower loss ratios for the third quarter of 2006 compared to the same period in 2005. However, the decrease in the net loss ratio was offset in part by the increase in the catastrophe reinsurance premiums ceded. See "Insurance Segment Results of Operations" and "Reinsurance Segment Results of Operations" for further discussion. Operating expenses. Operating expenses increased by 21.8% to $28.4 million for the three months ended September 30, 2006 from $23.3 million for the same period in 2005. The increase was due primarily to the increase in underwriting expenses resulting from the growth in premiums earned. Interest expense. Our interest expense increased for the three months ended September 30, 2006 to $1.9 million compared to $1.3 million for the same period in 2005. The increase resulted from $0.5 million of interest expense from the $20.6 million of subordinated debentures issued on March 31, 2006 and $0.1 million resulting from an increase in interest rates on the floating rate portions of our subordinated debentures. Other income. We recorded $0.4 million of income representing our 8.6% equity in CastlePoint's net income for the three months ended September 30, 2006. See -- "Notes to Consolidated Financial Statements --Investments in Unconsolidated Affiliate" elsewhere in this report for further details. Income tax expense. Our income tax expense was $4.3 million for the three months ended September 30, 2006 compared to $3.1 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 33.7% for the three months ending September 30, 2006 compared to 35.0% for the same period in 2005 due to a prior year federal tax benefit recorded in the third quarter of 2006. Net income and return on average equity. Our net income and annualized return on average equity was $8.5 million and 20.2%, respectively, for the three months ended September 30, 2006 compared to $5.7 million and 16.5%, respectively, for the same period in 2005. For the third quarter of 2006, the return was calculated by dividing annualized net income of $33.8 million by an average stockholders' equity of $167.2 million. For the third quarter of 2005, the return was calculated by dividing annualized net income of $22.8 million by an average stockholders' equity of $138.7 million. Consolidated Results of Operations Nine Months Ended September 30, 2006 and 2005 During the nine months ended September 30, 2006 a number of significant events affected the consolidated results of operations. We executed commutation and novation agreements between us and PXRE in order to eliminate our exposure to uncollateralized reinsurance recoverables from PXRE. We recorded a net charge as a result of these agreements of $5.5 million. In addition, we realized gains on our investment in CastlePoint as result of the sale of unissued CastlePoint shares in a private offering, which resulted in a $7.9 million gain. We also received a warrant to purchase additional CastlePoint shares which was valued at $4.6 million resulting in additional income for that amount in exchange for sponsorship services, which included management, organizational and industry 15 expertise. Lastly, we entered into three multi-year quota share reinsurance agreements and a service and expense agreement with CastlePoint and completed our acquisition of MIIX Insurance Company of New York which we renamed Tower Indemnity Company of America. Since we did not place quota share reinsurance in the first quarter of 2006, pending the formation of CastlePoint Reinsurance, we ceded $40.9 million of unearned premiums to CastlePoint Reinsurance as of April 1, 2006. Total revenues. Total revenues increased by 44.8% to $221.4 million for the nine months ended September 30, 2006 compared to $152.9 million for the same period in 2005. The increase is primarily due to the increase in net premiums earned, total commission and fee income, net investment income and net realized investment gains. Net premiums earned represented 76.3% of total revenues for the nine months ended September 30, 2006 compared to 73.9% for the same period in 2005. Net investment income, excluding realized capital losses, represented 7.2% and 6.9% of total revenues for the nine months ended September 30, 2006 and 2005, respectively. In addition, total commission and fee income increased to $36.7 million, or 16.6% of total revenue, for the nine months ended September 30, 2006 compared to $29.2 million, or 19.1% of total revenue for the same period in 2005. Premiums earned. Net premiums earned increased by 49.6% to $168.9 million for the nine months ended September 30, 2006 compared to $112.9 million for the same period in 2005. The increase in net premiums earned was due to the overall increase in gross premiums written through September 30, 2006 especially in our homeowner and commercial multi peril and other liability lines, as well as the novation agreements with PXRE. The novation agreements added $11.4 million to gross and net premiums earned in the nine months ended September 30, 2006. Since we did not place quota share reinsurance in the first quarter of 2006, pending the formation of CastlePoint Reinsurance, we ceded $40.9 million of unearned premiums as of April 1, 2006 and $68.8 million of premiums written on policies that began on April 1, 2006 through the period ending September 30, 2006. The second and third quarter cessions to CastlePoint reflected a 30% and 40% quota share ceding percentage for the brokerage business, respectively. We also ceded smaller amounts through the traditional program business and specialty program business of 50% and 85%, respectively. This is compared to a 25% quota share ceding percentage in the nine months ended September 30, 2005. Also, ceded premiums earned increased in the nine months ended September 30, 2006 as a result of ceding unearned premiums to CastlePoint as of April 1, 2006 which related to business written in 2005 and that we had previously retained. Commission and fee income. Total commission and fee income increased by 25.4% to $36.7 million in the nine months ended September 30, 2006 compared to $29.2 million in the same period of 2005.This was due to the increase in the ceding commission revenue earned as a result of the increase in ceded premiums earned as discussed above. This increase was offset in part by a reduction in fee income in our Insurance Services Segment as more policies previously produced in that segment were written in our Insurance Segment. Additionally, as a result of the commutation agreements with PXRE, we recorded a charge of $3.2 million to ceding commissions representing the difference between the carried amount of commissions due from PXRE and the amount received at an estimated present value. For the nine months ended September 30, 2006 the change in estimated sliding scale commission rate for commissions earned in prior periods in both the Insurance Segment and the Insurance Services Segment resulted in a net increase of $1.2 million of commission and fee income compared to a reduction of $0.2 million for the same period of 2005. Net investment income and realized gains. Net investment income increased by 51.5% to $15.9 million for the nine months ended September 30, 2006 compared to $10.5 million for the same period in 2005. This resulted from an increase in invested assets to $443.7 million as of September 30, 2006 compared to $357.2 million as of September 30, 2005, excluding our investments in statutory business trusts underlying our trust preferred securities. Net cash flow provided by operations, including $37.0 million of cash received from PXRE resulting from the commutation and novation transactions, contributed to the $86.6 million increase in invested assets during the nine months ended September 30, 2006. On a tax equivalent basis, the yield was 5.6% as of September 30, 2006 and 5.1% as of September 30, 2005. Net realized capital losses were $0.1 million in the nine months ended September 30, 2006 compared to net realized capital gains of $0.2 million for the same period in 2005. There was no impact on net realized losses attributable to adjustments for other-than-temporary impairment of securities held during the nine months ended September 30, 2006 or during the same period in 2005. 16 Loss and loss adjustment expenses. Gross loss and loss adjustment expenses and the gross loss ratio for the insurance and reinsurance segments combined for the nine months ended September 30, 2006 were $151.0 million and 57.0%, respectively, compared to $93.8 million and 56.6%, respectively, for the same period in 2005. The net loss ratio for the combined segments was 62.2% for the nine months ended September 30, 2006 as compared to 59.0% in the same period of 2005. The net loss ratio for the nine months ended September 30, 2006 reflected a $1.6 million charge resulting from the commutation agreements with PXRE. In addition to the commutation agreements with PXRE, we executed novation agreements with PXRE relating to other reinsurance agreements covering business written in 2001, 2002 and 2003. These agreements were written by other insurance companies and managed on their behalf by TRM. The Company assumed loss liabilities of $12.2 million and received consideration of $11.4 million as a result of the novation agreements with PXRE. Since novation transactions are recorded by including the consideration received as premiums written and earned and the liabilities assumed as losses incurred, the gross and net loss ratios were also affected. Both of the PXRE transactions added 2.2 and 4.3 percentage points to the gross and net loss ratios, respectively. Operating expenses. Operating expenses increased by 35.0% to $82.4 million for the nine months ended September 30, 2006 from $61.0 million for the same period in 2005. The increase was due primarily to the increase in underwriting expenses resulting from the growth in premiums earned. Operating expenses for the nine months ending September 30, 2006 also include organizational and start up costs of approximately $0.5 million related to our sponsorship of CastlePoint which was a wholly owned subsidiary during the first quarter of 2006. Interest expense. Our interest expense increased for the nine months ended September 30, 2006 to $5.1 million compared to $3.6 million for the same period in 2005. The increase resulted from $0.9 million of interest expense from the $20.6 million of subordinated debentures issued on March 31, 2006, $0.4 million resulting from an increase in interest rates on the floating rate portions of our subordinated debentures and $0.2 million as a result of crediting reinsurers on funds withheld in segregated trusts as collateral for reinsurance recoverables. Other Income. We recorded a gain of $7.9 million resulting from the sale of CastlePoint's unissued shares and other income of $4.6 million from a warrant that we received from CastlePoint for our sponsorship and formation activities. We also recorded $0.4 million income representing our 8.6% equity in CastlePoint's net income for the nine months ended September 30, 2006. See -- "Notes to Consolidated Financial Statements --Investments in Unconsolidated Affiliate" elsewhere in this report for further details regarding gains and losses recorded on these transactions. Income tax expense. Our income tax expense was $14.5 million for the nine months ended September 30, 2006 compared to $7.5 million for the same period in 2005. The increased income tax expense was due primarily to the increase in income before income taxes. The effective income tax rate was 34.7% for the nine months ending September 30, 2006 compared to 34.6% for the same period in 2005. Net income and return on average equity. Our net income and annualized return on average equity was $27.3 million and 22.8%, respectively, for the nine months ended September 30, 2006 compared to $14.2 million and 14.1%, respectively, for the same period in 2005. For the nine months ended September 30, 2006, the return was calculated by dividing annualized net income of $36.3 million by an average stockholders' equity of $159.6 million. The net effects of the commutation and novation transactions, as well as the gains recorded on the CastlePoint investment and warrant added $4.1 million to our net income and 3.2 percentage points to our annualized return on average equity for the nine months ended September 30, 2006. For the nine months ended September 30, 2005, the return was calculated by dividing annualized net income of $18.9 million by an average stockholders' equity of $134.7 million. 17
Insurance Segment Results of Operations Three Months Ended Nine Months Ended September 30, September 30, ---------------------------- ------------------------------ 2006 2005 2006 2005 ------------- -------------- -------------- --------------- ($ in thousands) Revenues Earned premiums Gross premiums earned $ 89,910 $ 64,441 $ 248,066 $164,520 Less: ceded premiums earned (40,114) (19,501) (95,710) (52,753) ------------- -------------- -------------- --------------- Net premiums earned 49,796 44,940 152,356 111,767 Ceding commission revenue 13,171 6,845 30,550 18,021 Policy billing fees 286 227 825 653 ------------- -------------- -------------- --------------- Total 63,253 52,012 183,731 130,441 Expenses Loss and loss adjustment expenses Gross loss and loss adjustment expenses 47,551 36,166 136,044 93,675 Less: ceded loss and loss adjustment expenses (18,698) (9,873) (46,149) (27,805) ------------- -------------- -------------- --------------- Net loss and loss adjustment expenses 28,853 26,293 89,895 65,870 Underwriting expenses Direct commission expense 14,204 10,131 40,444 27,194 Other underwriting expenses 11,484 10,178 32,819 24,477 ------------- -------------- -------------- --------------- Total underwriting expenses 25,688 20,309 73,263 51,671 ------------- -------------- -------------- --------------- Underwriting Profit $ 8,712 $ 5,410 $ 20,573 $ 12,900 ============= ============== ============== =============== Key Measures Premiums written Gross premiums written $ 98,523 $ 72,483 $ 289,779 $220,419 Less: ceded premiums written (48,071) (21,397) (131,507) (65,453) ------------- -------------- -------------- --------------- Net premiums written $ 50,452 $ 51,086 $ 158,272 $154,966 ============= ============== ============== =============== Loss Ratios Gross 52.9% 56.1% 54.8% 56.9% Net 57.9% 58.5% 59.0% 58.9% Accident Year Loss Ratio Gross 53.5% 56.5% 55.2% 57.2% Net 59.1% 59.0% 58.8% 59.2% Underwriting Expense Ratios Gross 28.3% 31.2% 29.2% 31.0% Net 24.6% 29.5% 27.5% 29.5% Combined Ratios Gross 81.2% 87.3% 84.0% 87.9% Net 82.5% 88.0% 86.5% 88.4%
Insurance Segment Results of Operations Three Months Ended September 30, 2006 and 2005 Gross premiums. Gross premiums written increased by 35.9% to $98.5 million for the three months ended September 30, 2006 compared to $72.5 million for the same period in 2005 due principally to increases in our homeowners and commercial multi peril, as well as other liability lines. Gross premiums earned increased by 39.5% to $89.9 million for the three months ended September 30, 2006 compared to $64.4 million for the same period in 2005. The number of policies in force increased by 19.1% as of September 30, 2006 compared to September 30, 2005. Additionally, during the third quarter of 2006, premium increases on renewed business averaged 9.4% in personal lines and 4.5% in commercial lines. The retention rate during the third quarter of 2006 was 91% for personal lines and 85% for commercial lines. New business written during the third quarter of 2006 through former OneBeacon producers that we appointed in connection with the 2004 renewal rights transaction amounted to $3.3 million compared to $3.8 million in the same period of 2005. Ceded premiums. Ceded premiums written increased by 124.7% to $48.1 million for the three months ended September 30, 2006 compared to $21.4 million for the same period in 2005. This increase was greater than the increase in gross premiums written for the following reasons. Consistent with our business plan as previously discussed in prior periods, in April 2006, we entered into three multi-year quota share reinsurance agreements with CastlePoint Reinsurance. For the three months ended September 30, 2006, we ceded $38.8 million of premiums written to CastlePoint Reinsurance. During this period our principal quota share reinsurance transaction with CastlePoint Reinsurance was on our brokerage business for which we ceded approximately 40% as compared to a 25% quota share ceding percentage in the three months ended September 30, 2005. Ceded premiums earned increased during the third quarter of 2006 as a result of the aforementioned increase in the ceded quota share percentage and an additional $5.6 million as a result of the second quarter portfolio of unearned premiums that was ceded to CastlePoint Reinsurance which related to business written in 2005 and that we had previously retained. Ceded premiums earned during the third quarter also increased as a result of the increased catastrophe reinsurance premiums of $3.9 million as compared to $1.0 million for the same period last year. 18 Net premiums. Net premiums written decreased by 1.2% to $50.5 million for the three months ended September 30, 2006 compared to $51.1 million for the same period in 2005. This decrease was due to our decision to increase the brokerage business quota share ceding percentage to 40% as compared to 25% in the same period in 2005. Notwithstanding the slight decrease in net premiums written, net premiums earned increased by 10.8% to $49.8 million in the three months ended September 30, 2006 compared to $44.9 million in the same period in 2005 driven primarily by the increase in gross premiums earned and lower quota share ceding percentages in effect during the previous quarters in which the third quarter earned premiums were written. The increase in net premiums earned was partially offset by $3.0 million related to the increase in catastrophe reinsurance premiums referred to above under ceded premiums. Ceding commission revenue. Ceding commission revenue increased by 92.4% to $13.2 million for the three months ended September 30, 2006 compared to $6.8 million for the same period in 2005 largely due to the 105.7% increase in ceded premiums earned described above. This increase was reduced, in part, by a lower quota share ceding commission rate of 34% as compared to a ceding commission rate of 38% in the three months ended September 30, 2005. In addition, ceding commission income was increased by $0.2 million resulting from a decrease in the ceded loss ratio on a prior year quota share treaty recognized in the third quarter of 2006 compared to a small increase in the same period last year. Loss and loss adjustment expenses and loss ratio. Gross and net loss and loss adjustment expenses were $47.6 million and $28.9 million, respectively, for the three months ended September 30, 2006 compared with $36.2 million and $26.3 million, respectively, for the same period in 2005. Our gross loss ratio was 52.9% for the three months ended September 30, 2006 as compared with 56.1% for the same period in 2005. The net loss ratio was 57.9% for the three months ended September 30, 2006 compared to 58.5% for the same period last year. The decrease in the gross and net loss ratios in the third quarter of 2006 compared to the same period in 2005 was primarily due to lower than expected loss emergence for the property lines for the current accident year that resulted in lower loss ratios for property lines for the third quarter of 2006 compared to the same period in 2005. However the decrease in the net loss ratio was offset, in part, by the increase in the catastrophe reinsurance premiums ceded. We ceded catastrophe reinsurance premiums equal to 7.2% of net earned premiums during the three months ended September 30, 2006 as compared to 2.2% in the same period in 2005. There was favorable development of $0.6 million on a net basis in the third quarter of 2006 compared to favorable development of $0.2 million 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 arrangement between TICNY and TRM. See -"Insurance Services Segment Results of Operations" for the amounts of loss and loss adjustment expense reimbursements. Underwriting expenses and underwriting expense ratio. Underwriting expenses, which include direct commission expenses and other underwriting expenses, were $25.7 million for the three months ended September 30, 2006 as compared with $20.3 million for the same period in 2005. Our gross expense ratio was 28.3% for the three months ended September 30, 2006 as compared with 31.2% 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 15.8% for the three months ended September 30, 2006, compared to 15.7% for the same period in 2005. The underwriting expense portion of the gross expense ratio was 12.5% for the three months ended September 30, 2006 as compared to 15.4% for the same period in 2005. Although underwriting expenses increased due to the growth in premium volume, the gross underwriting expense ratio declined as gross premiums earned increased more rapidly than underwriting expenses. The net underwriting expense ratio, which reflects the benefit of ceding commission revenue which lowers the gross expense ratio, was 24.6% for the three months ended September 30, 2006 as compared to 29.5% for the same period in 2005. This was due to the lower gross expense ratio and the increased effects of ceding commission 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 $8.7 million in the third quarter of 2006 and $5.4 million in the same period in 2005. The gross combined ratio was 81.2% for the three months ended September 30, 2006 as compared with 87.3% for the same period in 2005. The 19 decrease in the gross combined ratio in the third quarter of 2006 resulted primarily from a decrease in both the gross loss ratio and the gross underwriting expense ratio. The net combined ratio was 82.5% for the three months ended September 30, 2006 as compared to 88.0% for the same period in 2005. The decrease in the net combined ratio resulted from a decrease in both the net loss ratio and net underwriting expense ratio, as explained above. Insurance Segment Results of Operations Nine Months Ended September 30, 2006 and 2005 Gross premiums. Gross premiums written increased by 31.5% to $289.8 million for the nine months ended September 30, 2006 compared to $220.4 million for the same period in 2005. Gross premiums earned increased by 50.8% to $248.1 million for the nine months ended September 30, 2006 compared to $164.5 million for the same period in 2005. Gross premiums earned was affected by the increase in gross premiums written in 2005. The increase in gross premiums earned was due to the overall increase in gross premiums written through September 30, 2006 especially in our homeowners and commercial multi peril and other liability lines. The number of policies in force increased by 19.1% as of September 30, 2006 compared to September 30, 2005. Additionally, during the first nine months of 2006, premium increases on renewed business averaged 8.3% in personal lines and 4.2% in commercial lines. The retention rate was 88% for personal lines and 81% for commercial lines during the nine months ended September 30, 2006. New business written during the first nine months of 2006 through former OneBeacon producers that we appointed in connection with the 2004 renewal rights transaction amounted to $15.4 million compared to $12.4 million in the same period of 2005. Ceded premiums. Ceded premiums written increased by 100.9% to $131.5 million for the nine months ended September 30, 2006 compared to $65.5 million for the same period in 2005. This increase was greater than the increase in gross premiums written for the following reasons. In April 2006, we entered into three multi-year quota share reinsurance agreements with CastlePoint Reinsurance. Since we did not place quota share reinsurance in the first quarter of 2006, we ceded to CastlePoint Reinsurance $40.9 million of unearned premiums as of April 1, 2006. In addition, we ceded $68.8 million of premiums written on policies that began on April 1, 2006 through the period ending September 30, 2006. Consistent with our business plans and targeted net premiums written levels, the second and third quarter cessions to CastlePoint Reinsurance reflected a 30% and 40% quota share ceding percentage for the brokerage business, respectively, as compared to a 25% quota share ceding percentage in the nine months ended September 30, 2005. Ceded premiums earned increased 81.4% during the first nine months of 2006 as compared to the same period in 2005 as a result of the increase in gross premiums earned and these changes in quota share ceding percentages, as well as an additional $15.4 million of ceded premiums earned as a result of the April 1, 2006 portfolio of unearned premiums that was ceded to CastlePoint Reinsurance which related to business written in 2005 that we had previously retained. Net premiums. Net premiums written increased by 2.1% to $158.3 million for the nine months ended September 30, 2006 compared to $155.0 million for the same period in 2005 notwithstanding the 31.5% increase in gross premiums written. This was due to the increased ceded premiums written as described above. Net premiums earned increased by 36.3% to $152.4 million in the nine months ended September 30, 2006 compared to $111.8 million in the same period in 2005 as a result of the 50.8% increase in gross premiums earned offset by the 81.4% increase in ceded premiums earned discussed above Ceding commission revenue. Ceding commission revenue increased by 69.5% to $30.6 million for the nine months ended September 30, 2006 compared to $18.0 million for the same period in 2005 due to the 81.4% increase in ceded premiums earned offset, in part, by a lower quota share ceding commission rate of 34% as compared to a ceding commission rate of 41% in the nine months ended September 30, 2005. Also,, as a result of the commutation agreements with PXRE, we recorded a charge of $3.2 million to ceding commission revenue. Ceding commission revenue increased $1.0 million in the nine months ended September 30, 2006 as a result of an improvement in the ceded loss ratios on prior years' quota share treaties compared to a decrease of $0.7 million in the same period in 2005. Loss and loss adjustment expenses and loss ratio. Gross and net losses and loss adjustment expenses were $136.0 million and $89.9 million, respectively, for the nine months ended September 30, 2006 compared with $93.7 million and 20 $65.9 million, respectively, for the same period in 2005. Our gross loss ratio was 54.8% for the nine months ended September 30, 2006 as compared with 56.9% for the same period in 2005. The net loss ratio was 59% for the nine months ended September 30, 2006 and reflected the $1.6 million charge resulting from the commutation agreement with PXRE referred to previously. The effect of the commutation added 1.0 percentage point to the net loss ratio in the nine months ended September 30, 2006 as compared to 58.9% in the same period of 2005. The decrease in the gross and net loss ratios, excluding the impact of PXRE, for the nine months ended September 30, 2006 compared to the same period in 2005 was primarily due to lower than expected loss emergence for the property lines for the current accident year that resulted in lower loss ratios for property lines for the nine months of 2006 compared to the same period in 2005. However the decrease in the net loss ratio, excluding the impact of PXRE, was offset, in part, by the increase in the catastrophe reinsurance premiums ceded. We ceded catastrophe reinsurance premiums equal to 4.0% of net premiums earned during the nine months ended September 30, 2006 as compared to 2.8% in the same period in 2005. During the first nine months of 2006, prior accident years loss reserves developed favorably to the extent of $1.2 million which excludes the $1.6 million loss related to the commutation with PXRE. There was favorable development from prior years' loss reserves on a net basis of approximately $331,000 in the first nine months of 2005. Loss and loss adjustment expenses are net of reimbursements for loss and loss adjustment expensed made by TRM pursuant to the expense sharing arrangement between TICNY and TRM. See "Insurance Service Segment Results of Operations" for the amounts of loss and loss adjustment expense reimbursements. Underwriting expenses and underwriting expense ratio. Underwriting expenses, which include direct commission expenses and other underwriting expenses, were $73.3 million for the nine months ended September 30, 2006 as compared with $51.7 million for the same period in 2005. Our gross expense ratio was 29.2% for the nine months ended September 30, 2006 as compared with 31.0% 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 16.3% for the nine months ended September 30, 2006, compared to 16.5% for the same period in 2005. The lower ratio was attributable primarily 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 12.9% for the nine months ended September 30, 2006 as compared to 14.5% for the same period in 2005. Although underwriting expenses increased due to the growth in premium volume, the gross ratio declined as gross premiums earned increased more rapidly than underwriting expenses. The net underwriting expense ratio was 27.5% for the nine months ended September 30, 2006 as compared to 29.5% for the same period in 2005. The net expense ratio, which reflects ceding commission revenue, was affected by the reduction in ceding commissions of $3.2 million resulting from the commutations with PXRE which added 2.1 percentage points to the net expense ratio. The net expense ratio for the nine months ended September 30, 2006 also included the benefit of additional ceding commission revenue recognized during the nine months due to the additional ceded premiums earned to CastlePoint Reinsurance as of April 1, 2006. Underwriting profit and combined ratio. The underwriting profit, which reflects our underwriting results on a net basis after the effects of reinsurance, was $20.6 million in the first nine months of 2005 and $12.9 million in the same period in 2005. The gross combined ratio was 84.0% for the nine months ended September 30, 2006 as compared with 87.9% for the same period in 2005. The decrease in the gross combined ratio in the first nine months of 2006 resulted primarily from a decrease in both the gross loss ratio and gross underwriting expense ratio. The net combined ratio was 86.5% for the nine months ended September 30, 2006 as compared to 88.4% for the same period in 2005. The decrease in the net combined ratio resulted from a decrease in the net underwriting expense ratio described above. The effects of the commutations reduced underwriting profits by $4.8 million and added 3.1 percentage points to the net combined ratio. 21
Reinsurance Segment Results of Operations Three Months Ended Nine Months Ended September 30, September 30, --------------------------- --------------------------- 2006 2005 2006 2005 ------------- ------------- ------------ -------------- ($ in thousands) Revenues Premiums earned Gross premiums earned $2,617 $ 418 $16,645 $1,267 Less: ceded premiums earned (48) (34) (93) (101) ------------- ------------- ------------ -------------- Net premiums earned 2,569 384 16,552 1,166 ------------- ------------- ------------ -------------- Expenses Loss and loss adjustment expenses Gross loss and loss adjustment expenses 1,549 167 14,930 153 Ceded loss and loss adjustment expenses (11) 52 201 564 ------------- ------------- ------------ -------------- Net loss and loss adjustment expenses 1,538 219 15,131 717 Underwriting expenses Ceding commission expense 895 4 1,665 17 Other underwriting expenses 340 48 689 119 ------------- ------------- ------------ -------------- Total underwriting expenses 1,235 52 2,354 136 ------------- ------------- ------------ -------------- Underwriting (Loss) Profit $ (204) $ 113 $ (933) $ 313 ============= ============= ============ ============== Key Measures Premiums written Gross premiums written $1,287 $ 338 $21,818 $1,076 Less: ceded premiums written (79) (33) (79) (105) ------------- ------------- ------------ -------------- Net premiums written $1,208 $ 305 $21,739 $ 971 ============= ============= ============ ============== Loss Ratios Gross 59.2% 40.0% 89.7% 12.1% Net 59.9% 57.0% 91.4% 61.5% Accident Year Loss Ratios Gross 59.3% 55.0% 91.3% 55.2% Net 60.4% 59.9% 91.8% 60.0% Underwriting Expense Ratios Gross 47.2% 12.6% 14.1% 10.8% Net 48.1% 13.7% 14.2% 11.7% Combined Ratios Gross 106.4% 52.5% 103.8% 22.8% Net 107.9% 70.7% 105.6% 73.2%
Reinsurance Segment Results of Operations Three Months Ended September 30, 2006 and 2005 Gross premiums. Gross premiums written, which were premiums assumed on business produced by TRM on behalf of its issuing companies in the Insurance Services Segment, increased to $1.3 million for the three months ended September 30, 2006 as compared to $0.3 million for the same period in 2005. In 2006 we decided to assume substantially all of the premiums placed through the Insurance Services Segment compared to 2005 when we assumed premiums only on an excess of loss basis. Gross premiums earned increased to $2.6 million from $0.4 million in the third quarter of 2005 as a result of an increase in gross premiums written in prior periods. Net premiums. Net premiums written increased to $1.2 million for the three months ended September 30, 2006 as compared to $0.3 million for the same period in 2005. The increase in net premiums written was due to our decision to assume as gross premiums written substantially all of the premiums placed through the Insurance Services Segment. Net premiums earned increased to $2.6 million for the three months ended September 30, 2006 as compared to $0.4 million for the same period of 2005 as a result of the increase in gross premiums earned. Loss and loss adjustment expenses and loss ratio. Gross loss and loss adjustment expenses were $1.5 million for the three months ended September 30, 2006 as compared to $0.2 million for the same period in 2005. Net losses were $1.5 million for the three months ended September 30, 2006 as compared to $0.2 million for the same period in 2005. The gross and net loss ratios were 59.2% and 59.9%, respectively for the three months ended September 30, 2006 as compared to 40.0% and 57.0%, respectively, in the same period in 2005. The gross loss ratio was 40.0% for the three months ended September 30, 2005 was reduced by 15.0 percentage points due to favorable prior year loss reserve development. 22 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 premiums and this segment's allocated share of other underwriting expenses. Gross underwriting expenses increased for the three months ended September 30, 2006 to $1.2 million compared to $52,000 in the same period in 2005. These increases resulted from a 34% ceding commission paid to an issuing carrier. 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. The gross and net underwriting expense ratios were 47.2% and 48.1% for the three months ended September 30, 2006 compared to 12.6% and 13.7%, respectively, for the same period in 2005. Underwriting profit (loss) and combined ratio. The underwriting loss from assumed reinsurance for the third quarter of 2006 was $0.2 million compared to an underwriting profit of $0.1 million for the third quarter of 2005. The net combined ratio was 107.9% for the third quarter of 2006 compared to 70.7% for the third quarter of 2005. The higher net combined ratio for the third quarter of 2006 was a result of the increased net underwriting expense ratio as explained above. The gross combined ratio increased to 106.4% for the third quarter of 2006 compared to 52.5% for the third quarter of 2005 due to an increase in the gross loss ratio and gross underwriting expense ratios in the third quarter of 2006 compared to the same period last year. Reinsurance Segment Results of Operations Nine Months Ended September 30, 2006 and 2005 Gross premiums. Gross premiums written increased to $21.8 million for the nine months ended September 30, 2006 as compared to $1.1 million for the same period in 2005. This increase was due to our having entered into novation agreements with PXRE in June 2006 which increased assumed premiums written by $11.4 million and our decision to assume substantially all of the premiums placed through the Insurance Services Segment. Gross premiums earned increased to $16.6 million for the nine months ended September 30, 2006 from $1.3 million in the nine months ended September 30, 2005 due to the significant increase in gross premiums written and the novation agreements with PXRE. Net premiums. Net premiums written increased to $21.7 million for the nine months ended September 30, 2006 as compared to $1.0 million for the same period in 2005. The increase in net premiums written was due to an increase in gross premiums as discussed above. Net premiums earned increased to $16.6 million for the nine months ended September 30, 2006 as compared to $1.2 million for the same period of 2005 as a result of the increase in gross premiums earned, which included the premiums arising from the novation agreements with PXRE. Loss and loss adjustment expenses and loss ratio. Gross loss and loss adjustment expenses were $14.9 million for the nine months ended September 30, 2006 as compared to $0.2 million for the same period in 2005. Net losses were $15.1 million for the nine months ended September 30, 2006 as compared to $0.7 million for the same period in 2005. Both gross and net losses for the nine months ended September 30, 2006 were increased by $12.2 million as a result of the novation agreements with PXRE. The gross and net loss ratios were 89.7% and 91.4%, respectively, for the nine months ended September 30, 2006 as compared to 12.1% and 61.5%, respectively, in the same period in 2005. The gross loss ratio was 12.1 % in the first nine months of 2005 due to a favorable prior year loss reserve development of $0.5 million which fully offset gross accident year losses. The effect of the novation agreements added 37.5 percentage points and 34.4 percentage points to the gross and net loss ratio, respectively, for the nine months ending September 30, 2006. Underwriting expenses and underwriting expense ratio. Gross underwriting expenses increased for the nine months ended September 30, 2006 to $2.4 million as compared to $0.1 million for the same period in 2005. Our net underwriting expense ratio increased to 14.2% for the nine months ended September 30, 2006 from 11.7% for the same period in 2005. These increases resulted from a 34% commissions paid to an issuing carrier. 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. The gross and net underwriting expense ratios were 14.1% and 14.2%, respectively, for the nine months ended September 30, 2006 compared to 10.8% and 11.7%, respectively, for the same period last year. The PXRE novation added $11.4 million of 23 additional gross and net premiums earned. The effects of the PXRE novation reduced the gross and net underwriting expense ratios by 31.1 percentage points and 31.8 percentage points, respectively, for the nine months ended September 30, 2006. Underwriting (loss) profit and combined ratio. The underwriting loss from assumed reinsurance for the nine months ended September 30, 2006 was $0.9 million compared to underwriting profit of $0.3 million for the same period of 2005 and includes the charge of $0.8 million resulting from the novation agreements with PXRE. The net combined ratio was 105.6% for the nine months ended September 30, 2006 compared to 73.2% for the same period of 2005. The higher net combined ratio for the first nine months of 2006 was the result of the increased net loss ratio as explained above. The gross combined ratio increased to 103.8% for the nine months ended September 30, 2006 compared to 22.8% for the same period of 2005 due to the increase in the gross loss ratio and the other underwriting expense ratio. The effects of the novation agreements added 6.5 percentage points and 2.5 percentage points to the gross and net combined ratios for the nine months ended September 30, 2006.
Insurance Services Segment Results of Operations Three Months Ended Nine Months Ended September 30, September 30, --------------------------- --------------------------- 2006 2005 2006 2005 ------------- ------------- ------------- ------------- ($ in thousands) Revenues Direct commission revenue from managing general agency $ 380 $2,022 $ 2,291 $ 6,713 Claims administration revenue 688 1,137 2,572 3,287 Reinsurance intermediary fees(1) 176 259 411 541 Policy billing fees - 7 5 18 ------------- ------------- ------------- ------------- Total Revenues 1,244 3,425 5,279 10,559 ------------- ------------- ------------- ------------- Expenses Direct commissions expense paid to producers 211 1,143 1,545 3,528 Other insurance services expenses(2) 193 472 735 1,412 Claims expense reimbursement to TICNY 687 1,135 2,556 3,276 ------------- ------------- ------------- ------------- Total Expenses 1,091 2,750 4,836 8,216 ------------- ------------- ------------- ------------- Insurance Services Pre-tax Income $ 153 $ 675 $ 443 $ 2,343 ============= ============= ============= ============= Premium produced by TRM on behalf of issuing companies $1,408 $8,013 $10,270 $24,888 ============= ============= ============= ============= (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 September 30, 2006 and 2005 Total revenues. Total revenues for the insurance services segment were $1.2 million for the three months ended September 30, 2006 as compared with $3.4 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 81.2% to $0.4 million for the third quarter of 2006 compared to $2.0 million for the third quarter of 2005. Claims administration revenues decreased by 39.5% to $0.7 million in the third quarter of 2006 compared to $1.1 million in the same period of last year as a result of fewer hours associated with claims handled for issuing carriers. Reinsurance intermediary fees revenue decreased by 32.0% to $0.2 million for the third quarter of 2006 as compared to $0.3 million for the third quarter of 2005 in which reinsurance intermediary fees were increased as a result of an adjustment to a prior year reinsurance contract. Direct commission revenue is dependent upon the premiums and losses on business produced by TRM on behalf of its issuing companies. For the third quarter of 2006, direct commission revenues decreased by 81.2% to $0.4 million compared to $2.0 million for the third quarter of 2005 as a result of the decrease in premiums produced by TRM as more policies were renewed in the Insurance Segment. Premiums produced by TRM decreased by 82.4% to $1.4 million in the third quarter of 2006 as compared to $8.0 million in the same period of 2005. There was an increase in commission revenue of $0.4 million the third 24 quarter of 2006 as a result of favorable loss development on the premiums produced in prior years compared to an increase of $0.1 million in the same period of last year. Direct commission expense. TRM's direct commission expense rate was 15.0% for the third quarter of 2006 compared to 14.3% for the third quarter of 2005 as the majority of premiums in 2006 are on smaller policies that typically carry a higher commission rate as compared to the third quarter of 2005 in which there were larger proportions of policies with larger premiums and lower commission rates. Other insurance services expenses. The amount of reimbursement for underwriting expenses by TRM to TICNY in the third quarter of 2006 was $0.2 million as compared to $0.5 million in the third 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 third quarter of 2006 was $0.7 million as compared to $1.1 million in the third quarter of 2005 due to a decrease in the number of claims handled. Pre-tax income. Pre-tax income in the third quarter of 2006 decreased by 77.3% to $0.2 million as compared to $0.7 million in the third quarter of 2005. The decrease was due to the decrease in premiums produced offset partially by a favorable adjustment in direct commission revenue of $0.4 million in the three months ended September 30, 2006 as compared to a favorable adjustment in direct commission income of $0.1 million resulting from favorable loss development on premiums produced in prior periods for the three months ended September 30, 2005. Insurance Services Segment Results of Operations Nine Months Ended September 30, 2006 and 2005 Total revenues. Total revenues for the insurance services segment were $5.3 million for the nine months ended September 30, 2006 as compared with $10.6 million for the same period in 2005. The decrease in total revenues was due to direct commission revenue that decreased by 65.9% to $2.3 million for the first nine months of 2006 compared to $6.7 million for the same period of 2005 and reinsurance intermediary fees that decreased by 24.0% to $0.4 million in the nine months ended September 30, 2006 compared to $0.5 million in the same period of last year in which reinsurance intermediary fees were increased as a result of an adjustment to a prior year reinsurance contract. Claims administration revenue decreased by 21.8% to $2.6 million for the nine months ended September 30, 2006 as compared to $3.3 million for the same period last year as a result of fewer hours associated with claims handled for issuing carriers. As a result of the PXRE novation, TRM increased its direct commission revenue by $0.2 million. For the first nine months of 2006, direct commission revenues decreased as compared to last year as a result of the 58.7% decrease in premiums produced by TRM to $10.3 million from $24.9 million as more policies were renewed in the Insurance Segment. In addition there was an increase in commission revenue of $0.2 million the nine months ended September 30, 2006 as a result of favorable loss development on the premiums produced in prior years compared to additional commission income of $0.5 million resulting from favorable loss development on premiums produced in prior periods for the nine months ended September 30, 2005. As a result of the PXRE novation, TRM recognized $0.2 million of direct commission revenue. Direct commission expense. TRM's direct commission expense rate was 15.0% for the first nine months of 2006 compared to 14.2% for the same period last year as the majority of premiums in 2006 are on smaller policies that typically carry a higher commission rate as compared to 2005 in which there were larger proportions of policies with larger premiums and lower commission rates. Other insurance services expenses. The amount of reimbursement for underwriting expenses by TRM to TICNY in the first nine months of 2006 was $0.7 million as compared to $1.4 million in the same period last year, as a result of 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 nine months of 2006 was $2.6 million as compared to $3.3 million in the same period last year due to a decrease in the number of claims handled. 25 Pre-tax income. Pre-tax income in the first nine months of 2006 decreased by 81.1% to $0.4 million as compared to $2.3 million in the same period last year. The decrease was due to the decrease in premiums produced offset partially by a favorable adjustment in direct commission revenue of $0.2 million in the nine months ended September 30, 2006 as compared to a favorable adjustment in direct commission income of $0.5 million resulting from favorable loss development on premiums produced in prior periods for the three and nine months ended September 30, 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 our $68.0 million of subordinated debentures underlying our trust preferred securities. For the three months ended September 30, 2006, net cash provided by operating activities was $11.3 million. Net cash provided by operations was $36.0 million for the same period in 2005. The lower net cash provided by operating activities was due to an increase in collected premiums as a result of the growth in gross premiums written, offset by the payment of $21.5 million to CastlePoint Reinsurance for the remaining April 1, 2006 ceded unearned premiums and the third quarter quota share reinsurance as well as an increase in premiums paid for catastrophe coverage. For the nine months ended September 30, 2006, net cash provided by operating activities was $97.9 million compared to $97.5 million for the same period last year. The increase in net cash provided by operations for the nine months ended September 30, 2006 resulted primarily from an increase in collected premiums as a result of the growth in gross premiums written and the commutation and novation agreements executed during the second quarter of 2006, offset by the partial payment of $41.8 million for the April 1, 2006 ceded unearned premiums and the quota share reinsurance ceded to CastlePoint Reinsurance in the nine months ended September 30, 2006 as well as an increase in premiums paid for catastrophe coverage. For the three months and nine months ended September 30, 2006, we had $52.6 million and $116.6 million, respectively, of net cash flows used in investing activities that were funded from operating cash flow. During the third quarter of 2006, the Company capitalized $14.2 million for the purchase of fixed assets. The Company relocated its New York City Corporate Headquarters within the same building. The Company capitalized $8.0 million for leasehold improvements, $3.9 million for furniture & equipment and $2.2 million for computer hardware and software in the third quarter of 2006. The landlord provided a $4.5 million build-out allowance which partly financed the $8.0 million of leasehold improvements as of September 30, 2006. During the nine months of 2006, the Company capitalized $19.2 million for the purchase of fixed assets. This included $9.5 million for leasehold improvements, $5.1 million for furniture & equipment and $4.6 million for computer hardware and software. In addition, there were an increases in the mortgage-backed, corporate bond sectors and equity investments in the three months ended September 30, 2006. The net cash flows provided by financing activities for the nine months ended September 30, 2006 was $20.5 million and included the net proceeds from the issuance of $20.0 million in subordinated debentures on March 31, 2006, compared to $0.3 million and $1.2 million of net cash flows used in financing activity for the three and nine months ended September 30, 2005, respectively. 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 fixed assets 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 September 30, 2006, the maximum amount of distributions that TICNY could pay to its parent without approval of the New York State Insurance Department was $11.3 million. TNIC may not pay more than 10% of its capital stock in dividends per year in accordance with the Massachusetts Insurance Code. As of September 30, 2006, the maximum amount of distributions that TNIC could pay to its parent without approval of the Massachusetts Commissioner of Insurance was $0.3 million. 26 Subordinated Debentures On March 31, 2006, we participated in a private placement of $20.0 million 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. Interest 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 us for a purchase price of $0.6 million, 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 and common securities to purchase for $20.6 million a Junior Subordinated Debt Security due 2036 issued by us. Investments The aggregate fair value of our invested assets as of September 30, 2006 was $ 443.7 million; excluding our investment in common trust securities-statutory business trusts. Our fixed maturity securities as of this date had a fair value of $401.0 million and an amortized cost of $402.7 million. The equity securities carried at fair value were $42.6 million with a cost of $42.7 million as of September 30, 2006. Equity securities carried at cost were reclassified to equity securities at fair value as of September 30, 2006 in accordance with GAAP for insurance companies. 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 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 September 30, 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 investment 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. 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 27 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, 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 September 30, 2006: Estimated Increase (Decrease) in Fair Estimated Percentage Value Increase (Decrease) Change in Interest Rate ($ in thousands) in Fair Value - --------------------------------- --------------------- --------------------- 300 basis point rise ($ 50,029) (12.5%) 200 basis rise (33,815) (8.4%) 100 basis rise (17,055) (4.3%) As of September 30, 2006 0 0.0% 50 basis point decline 8,290 2.1% 100 basis point decline 16,243 4.1% The sensitivity analysis model used by us produces a predicted pre-tax loss in fair value of market-sensitive instruments of $17.1 million or 4.3% based on a 100 basis point increase in interest rates as of September 30, 2006. This loss amount only reflects the impact of an interest rate increase on the fair value of our fixed maturities, which constituted approximately 90.0% of our total invested assets as of September 30, 2006. As of September 30, 2006 we had a total of $23.7 million of outstanding floating rate debt all of which were 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 September 30, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 28 2. 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 Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the registration has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Tower Group, Inc. --------------------------------------- Registrant Date: November 3, 2006 /s/ Michael H. Lee --------------------------- --------------------------------------- Michael H. Lee Chairman of the Board, President and Chief Executive Officer Date: November 3, 2006 /s/ Francis M. Colalucci --------------------------- --------------------------------------- Francis M. Colalucci Senior Vice President, Chief Financial Officer and Treasurer 29 EX-31.1 2 a5265591-ex311.txt EXHIBIT 31.1 Exhibit 31.1 CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Michael H. Lee, certify that: 1. I have reviewed the Quarterly Report of Tower Group, Inc. (the "Company") on Form 10-Q for the period ending September 30, 2006 as filed with the Securities and Exchange Commission on the date hereof (the "Report"); 2. Based on my knowledge, the Report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by the Report; 3. Based on my knowledge, the financial statements, and other financial information included in the Report, fairly present in all material respects the financial condition, results of operations and cash flows of the Company as of, and for, the periods presented in the Report; 4. The Company's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a - 15(e) and 15d - 15(e) and internal control over financial reporting (as defined in Exchange Act Rules 13a - 15(f) and 15d - 15(f)) for the Company and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which the Report is being prepared; b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) evaluated the effectiveness of the Company's disclosure controls and procedures and presented in the Report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by the Report based on such evaluation; and d) disclosed in the Report any changes in the Company's internal control over financial reporting that occurred during the Company's third quarter of 2006 that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting; and 5. The Company's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Company's auditors and to the audit committee of the Company's Board of Directors: a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Company's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Company's internal control over financial reporting. /s/ Michael H. Lee - ------------------ Michael H. Lee Chief Executive Officer November 3, 2006 30 EX-31.2 3 a5265591-ex312.txt EXHIBIT 31.2 Exhibit 31.2 CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Francis M. Colalucci, certify that: 1. I have reviewed the Quarterly Report of Tower Group, Inc. (the "Company") on Form 10-Q for the period ending September 30, 2006 as filed with the Securities and Exchange Commission on the date hereof (the "Report"); 2. Based on my knowledge, the Report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by the Report; 3. Based on my knowledge, the financial statements, and other financial information included in the Report, fairly present in all material respects the financial condition, results of operations and cash flows of the Company as of, and for, the periods presented in the Report; 4. The Company's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a - 15(e) and 15d - 15(e) and internal control over financial reporting (as defined in Exchange Act Rules 13a - 15(f) and 15d - 15(f)) for the Company and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which the Report is being prepared; b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) evaluated the effectiveness of the Company's disclosure controls and procedures and presented in the Report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by the Report based on such evaluation; and d) disclosed in the Report any changes in the Company's internal control over financial reporting that occurred during the Company's third quarter of 2006 that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting; and 5. The Company's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Company's auditors and to the audit committee of the Company's Board of Directors: a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Company's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Company's internal control over financial reporting. /s/ Francis M. Colalucci - ------------------------ Francis M. Colalucci Chief Financial Officer November 3, 2006 31 EX-32 4 a5265591-ex32.txt EXHIBIT 32 Exhibit 32 CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Tower Group, Inc. (the "Company") on Form 10-Q for the period ending September 30, 2006, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), we, Michael H. Lee, President and Chief Executive Officer of the Company, and Francis M. Colalucci, Senior Vice President, Chief Financial Officer and Treasurer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) and 15(d) of the Securities and Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ Michael H. Lee - ------------------------------------- Michael H. Lee President and Chief Executive Officer November 3, 2006 /s/ Francis M. Colalucci - ------------------------------------- Francis M. Colalucci Senior Vice President, Chief Financial Officer and Treasurer November 3, 2006 32 -----END PRIVACY-ENHANCED MESSAGE-----