-----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, Ix3PB17baXPyjL93J+5wxB11ae2MRADvytI5I18/0bI6RlvYWbxNTHCp18g59Gpf Xw33fHOz6GQeZoUPqfs6RA== 0001157523-07-007789.txt : 20070803 0001157523-07-007789.hdr.sgml : 20070803 20070803070505 ACCESSION NUMBER: 0001157523-07-007789 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20070630 FILED AS OF DATE: 20070803 DATE AS OF CHANGE: 20070803 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: 071022214 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 a5462691.txt TOWER GROUP 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 June 30, 2007 |_| 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 29, 2007 (based on the closing price on the Nasdaq on such date was approximately $646,552,454. Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 23,192,002 shares of common stock, par value $0.01 per share, as of August 1, 2007.
PAGE PART I FINANCIAL INFORMATION Item 1. Financial statements Consolidated Balance Sheets - June 30, 2007 (unaudited) and December 31, 2006 1 Consolidated Statements of Income and Comprehensive Net Income - Three months ended June 30, 2007 and 2006 (unaudited) 2 - Six months ended June 30, 2007 and 2006 (unaudited) 2 Consolidated Statements of Cash Flows - Three months ended June 30, 2007 and 2006 (unaudited) 3 - Six months ended June 30, 2007 and 2006 (unaudited) 3 Notes to Consolidated Financial Statements (unaudited) 4 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 17 Item 3. Quantitative and Qualitative Disclosures About Market Risk 33 Item 4. Controls and Procedures 34 PART II OTHER INFORMATION Item 4. Submission of Matters to a Vote of Security Holders 34 Item 6. Exhibits 34 SIGNATURES 35
Part I - FINANCIAL INFORMATION Item 1. Financial Statements Tower Group, Inc. Consolidated Balance Sheets
(Unaudited) June 30, 2007 December 31, 2006 ----------------------------------- ($ in thousands, except par value and share amounts) Assets Fixed-maturity securities, available-for-sale, at fair value (amortized cost $578,003 at June 30, 2007 and $416,642 at December 31, 2006) $ 566,837 $ 414,567 Equity securities, available-for-sale, at fair value (cost $59,312 at June 30, 2007 and $47,971 at December 31, 2006) 58,756 49,453 ----------------------------------- Total investments 625,593 464,020 Cash and cash equivalents 64,969 100,598 Investment income receivable 6,453 4,767 Agents' balances receivable 97,701 65,578 Assumed premiums receivable 1,763 77 Ceding commission receivable 4,355 3,237 Reinsurance recoverable 186,859 118,003 Receivable - claims paid by agency 7,779 5,186 Prepaid reinsurance premiums 136,105 94,063 Deferred acquisition costs net of deferred ceding commission revenue 40,118 35,811 Federal and state taxes recoverable 1,910 - Deferred Income taxes 19,015 - Intangible assets 22,314 5,423 Goodwill 9,608 - Fixed assets, net of accumulated depreciation 29,015 20,563 Investment in unconsolidated affiliate 31,459 27,944 Investment in statutory business trusts, equity method 3,036 2,045 Other assets 8,505 6,767 ----------------------------------- Total Assets $ 1,296,557 $ 954,082 =================================== Liabilities Loss and loss adjustment expenses $ 468,910 $ 302,541 Unearned premium 290,012 227,017 Reinsurance balances payable 61,051 38,560 Payable to issuing carriers 5,919 662 Funds held as agent 6,073 8,181 Funds held under reinsurance agreements 44,641 51,527 Accounts payable and accrued expenses 15,638 18,267 Deferred rent liability 7,371 6,295 Payable for securities 1,836 2,922 Other liabilities 3,645 3,515 Federal and state income taxes payable - 1,163 Deferred income taxes - 1,255 Dividends payable - 212 Subordinated debentures 101,036 68,045 ----------------------------------- Total Liabilities 1,006,132 730,162 ----------------------------------- Stockholders' Equity Series A perpetual preferred stock ($0.01 par value per share; 2,000,000 shares authorized; no shares issued and outstanding at June 30, 2007; 40,000 shares issued and outstanding at December 31, 2006; liquidation preference of $1,000 per share, net of $0.4 million of issuance costs) - 39,600 Common stock ($0.01 par value per share; 40,000,000 shares authorized, 23,212,686 and 20,005,758 shares issued at June 30, 2007 and December 31, 2006, respectively, and 23,191,070 and 19,980,306 shares outstanding at June 30, 2007 and December 31, 2006, respectively) 232 200 Paid-in-capital 204,661 113,168 Accumulated other comprehensive net loss (7,927) (437) Retained earnings 93,759 71,596 Treasury stock (21,616 shares at June 30, 2007 and 25,452 at December 31, 2006) (300) (207) ----------------------------------- Total Stockholders' Equity 290,425 223,920 ----------------------------------- Total Liabilities and Stockholders' Equity $ 1,296,557 $ 954,082 ===================================
See accompanying notes to the consolidated financial statements. 1 Tower Group, Inc. Consolidated Statements of Income and Comprehensive Net Income (Unaudited)
Three Months Ended Six Months Ended June 30, June 30, -------------------------------------------------------------------- 2007 2006 2007 2006 -------------------------------------------------------------------- ($ in thousands, except share and per share amounts) Revenues Net premiums earned $ 74,035 $ 59,286 $ 134,418 $ 116,542 Ceding commission revenue 17,032 10,077 31,266 17,379 Insurance services revenue 1,639 2,202 3,099 4,031 Net investment income 9,446 5,292 17,401 9,952 Net realized gains (losses) on investments 89 29 72 (116) Policy billing fees 543 274 845 544 -------------------------------------------------------------------- Total revenues 102,784 77,160 187,101 148,332 -------------------------------------------------------------------- Expenses Loss and loss adjustment expenses 40,611 41,424 74,521 74,634 Direct commission expense 21,808 15,265 40,443 28,345 Other operating expenses 19,432 12,207 34,521 25,591 Interest expense 2,446 1,853 4,530 3,203 -------------------------------------------------------------------- Total expenses 84,297 70,749 154,015 131,773 -------------------------------------------------------------------- Other Income Equity income in unconsolidated affiliate 734 (54) 1,423 (54) Gain from issuance of common stock of unconsolidated affiliate - 7,883 2,705 7,883 Warrant received from unconsolidated affiliate - 4,605 - 4,605 -------------------------------------------------------------------- Income before income taxes 19,221 18,845 37,214 28,993 Income tax expense 6,842 6,560 13,207 10,198 -------------------------------------------------------------------- Net income $ 12,379 $ 12,285 $ 24,007 $ 18,795 ==================================================================== Comprehensive Net Income Net income $ 12,379 $ 12,285 $ 24,007 $ 18,795 Other comprehensive income: Gross unrealized investment holding losses arising during period (11,575) (2,478) (11,029) (5,877) Equity in net unrealized gains in investment in unconsolidated affiliate's investment portfolio (477) (112) (422) (112) Less: reclassification adjustment for net realized losses (gains) included in net income (89) (29) (72) 116 -------------------------------------------------------------------- (12,141) (2,619) (11,523) (5,873) Income tax benefit related to items of other comprehensive income 4,249 917 4,033 1,998 -------------------------------------------------------------------- Total other comprehensive net loss (7,892) (1,702) (7,490) (3,875) -------------------------------------------------------------------- Comprehensive Net Income $ 4,487 $ 10,583 $ 16,517 $ 14,920 ==================================================================== Earnings Per Share Basic earnings per common share $ 0.54 $ 0.62 $ 1.04 $ 0.95 ==================================================================== Diluted earnings per common share $ 0.53 $ 0.61 $ 1.03 $ 0.93 ==================================================================== Weighted Average Common Shares Outstanding: Basic 22,895,783 19,742,004 22,442,345 19,713,453 Diluted 23,169,573 20,265,054 22,729,005 20,241,611 Dividends declared and paid per common share: Common stock $ 0.025 $ 0.025 $ 0.050 $ 0.050
See accompanying notes to the consolidated financial statements. 2 Tower Group, Inc. Consolidated Statements of Cash Flows (Unaudited)
Three Months Ended Six Months Ended June 30, June 30, -------------------------------------------------------------------- 2007 2006 2007 2006 -------------------------------------------------------------------- ($ in thousands) Cash flows from operating activities: Net income $ 12,379 $ 12,285 $ 24,007 $ 18,795 Adjustments to reconcile net income to net cash provided by operations: Gain from IPO of common shares of unconsolidated affiliate - - (2,705) - Gain on sale of investments (89) (29) (72) 116 Depreciation 2,101 1,038 3,562 1,963 Amortization of intangible assets 308 103 399 206 Amortization of bond premium or discount 151 187 354 468 Amortization of debt issuance costs 16 14 32 24 Amortization of restricted stock 712 190 1,001 342 Deferred income taxes (56) (2,140) (651) (335) (Increase) decrease in assets: Investment income receivable (421) (493) (441) (720) Agents' balances receivable (10,713) (12,648) (3,333) (8,303) Assumed premiums receivable 1,478 (3,497) (1,686) (5,907) Ceding commissions receivable (920) 8,727 (1,118) 8,727 Reinsurance recoverable (13,826) 9,422 (31,539) 7,966 Prepaid reinsurance premiums (21,881) (45,074) (38,079) (30,130) Deferred acquisition costs, net 4,862 5,935 9,647 (3,663) Intangible assets - (30) - (30) Equity in unconsolidated affiliate (734) 54 (1,423) 54 Gain on issuance of common shares by unconsolidated affiliate - (7,883) - (7,883) Warrant received from unconsolidated affiliate - (4,605) - (4,605) Excess tax benefits from share-based payment arrangements (894) (650) (959) (650) Other assets 468 (327) (516) (2,531) Increase (decrease) in liabilities: Loss and loss adjustment expenses 20,793 34,486 52,021 55,688 Unearned premium 18,018 31,263 20,271 41,939 Reinsurance balances payable 6,203 23,669 17,689 13,921 Payable to issuing carriers 5,919 (2,445) 5,257 (1,667) Accounts payable and accrued expenses (959) 258 (10,848) (1,193) Deferred rent (88) - 1,076 - Federal and state income taxes payable (7,863) 2,385 (3,073) 3,236 Funds held under reinsurance agreements (5,335) (2,364) (8,994) 754 -------------------------------------------------------------------- Net cash flows provided by operations 9,629 47,831 29,879 86,582 -------------------------------------------------------------------- Cash flows used in investing activities: Acquisition of Preserver Group Inc. (66,233) - (66,233) - Preserver transaction costs (4,729) - (4,729) - Purchase of fixed assets (3,210) (3,666) (6,552) (5,070) Investment in unconsolidated affiliate 487 (14,528) 613 (14,528) Purchases of investments: Fixed-maturity securities (60,109) (25,095) (135,312) (71,974) Equity securities (11,317) (389) (13,887) (633) Sale of investments: Fixed-maturity securities 34,527 5,091 70,518 28,212 Equity securities 775 - 3,776 - -------------------------------------------------------------------- Net cash flows used in investing activities (109,809) (38,587) (151,806) (63,993) -------------------------------------------------------------------- Cash flows provided by financing activities: Redemption of preferred stock - - (40,000) - Proceeds from subordinated debentures - - 20,619 20,619 Purchase of common trust securities - statutory business trusts - - (619) (619) Dividends paid (573) (496) (1,655) (988) Exercise of stock options 917 778 1,010 885 Excess tax benefits from share-based payment arrangements 894 650 959 650 Equity offering and overallotment, net of issuance costs (21) - 89,366 - Stock repurchase 55 (67) 55 (67) -------------------------------------------------------------------- Net cash flows provided by financing activities 1,272 865 69,735 20,480 -------------------------------------------------------------------- (Decrease) increase in cash and cash equivalents (98,908) 10,109 (52,192) 43,069 Cash and cash equivalents, beginning of period 163,877 71,720 117,161 38,760 -------------------------------------------------------------------- Cash and cash equivalents, end of period $ 64,969 $ 81,829 $ 64,969 $ 81,829 ==================================================================== Supplemental disclosures of cash flow information: Cash paid for income taxes $ 14,095 $ 6,338 $ 15,172 $ 7,324 Cash paid for interest $ 2,366 $ 967 $ 3,792 $ 1,905
See accompanying notes to the consolidated financial statements. 3 Tower Group, Inc. Notes to Consolidated Financial Statements (Unaudited) Basis of Presentation The accompanying unaudited consolidated financial statements have been prepared in accordance with instructions for Form 10-Q and, accordingly, do not include the information and disclosures required by generally accepted accounting principles ("GAAP") in the Unites States of America. These statements should be read in conjunction with the consolidated financial statements as of and for the year ended December 31, 2006 and notes thereto included in the Company's Annual Report on Form 10-K filed on March 8, 2007. 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 six months ended June 30, 2007 may not be indicative of the results that may be expected for the year ending December 31, 2007. The consolidated financial statements as of June 30, 2007 include the accounts of Tower Group, Inc. (the "Company"), its wholly owned subsidiaries Tower Insurance Company of New York ("TICNY"), Tower National Insurance Company ("TNIC"), Tower Risk Management Corp. ("TRM"), Preserver Group, Inc. ("Preserver") and its subsidiaries, Preserver Insurance Company ("PIC"), Mountain Valley Indemnity Company ("MV") and North East Insurance Company ("NE"), 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. Acquisition of Preserver Group Inc. On April 10, 2007, the Company completed the acquisition of 100% of the issued and outstanding common stock of Preserver, a New Jersey corporation, pursuant to the stock purchase agreement ("the Agreement"), dated as of November 13, 2006, by and among the Company, Preserver and the Sellers named therein. The acquisition was accounted for using the purchase method in accordance with the Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 141, Business Combinations. Under the terms of the Agreement, the Company acquired Preserver for approximately $64.9 million comprised of $34.1 million in cash paid to the Sellers and a contribution of $30.8 million to the capital of Preserver to enable Preserver to repay the principal and accrued interest on indebtedness held by certain of the Sellers. In accordance with SFAS No. 141, the cost of the acquisition was preliminarily allocated to the assets acquired and liabilities assumed based on their fair values as of the close of the acquisition, with the amounts exceeding the fair value recorded as goodwill. As the values of certain assets and liabilities are preliminary in nature, they are subject to adjustment as additional information is obtained, including, but not limited to, valuation of separately identifiable intangibles, fixed assets, and deferred taxes. The valuations will be finalized within 12 months of the close of the acquisition. When the valuations are finalized, any changes to the preliminary valuation of assets acquired or liabilities assumed may result in adjustments to separately identifiable intangibles and goodwill. The results of operations of Preserver have been included in the Company's consolidated financial statements since the acquisition date of April 10, 2007. Selected unaudited pro forma results of operations assuming the acquisition had occurred as of January 1, 2006, are set forth below:
Three Months Ended June 30, Six months ended June 30, --------------------------------------------------------------------- 2007 2006 2007 2006 --------------------------------------------------------------------- ($ in thousands , except per share amounts) Total revenue $ 105,013 $ 98,334 $ 209,654 $ 190,842 Net income 11,133 12,851 22,688 20,000 Net income per common share-basic $ 0.49 $ 0.56 $ 0.98 $ 0.88 Net income per common share-diluted $ 0.48 $ 0.56 $ 0.98 $ 0.87
4 The above pro forma results are presented for information purposes only and may not be indicative of the operating results that would have occurred had this acquisition been consummated as of the beginning of 2006. The following unaudited condensed balance sheet presents assets acquired and liabilities assumed with the acquisition of Preserver on April 10, 2007, based on their fair values ($ in thousands): Assets Investments $ 98,079 Cash & cash equivalents 16,563 Accounts receivable 30,035 Reinsurance recoverable 39,910 Deferred acquisition costs, net 13,954 Fixed assets 5,462 Goodwill 9,608 Intangibles 17,290 Deferred income taxes 15,724 Other assets 5,846 ---------- Total Assets $ 252,471 ========== Loss and loss adjustment expenses $ 114,348 Unearned premiums 42,723 Accounts payable and accrued expenses 16,795 Subordinated debentures 12,372 ---------- Total liabilities 186,238 ---------- Total Stockholders' equity 66,233 ---------- Total Liabilities & Stockholders' equity $ 252,471 ========== Preserver's stockholders' equity on April 10, 2007 was $66.2 million, which includes the purchase price of $64.9 million plus an additional $1.3 million for Tower's direct transaction costs. The base purchase price was reduced by the amount (net of taxes) of certain expenses paid by Preserver in connection with the transaction including amounts that were paid or payable to officers, directors and employees of Preserver in connection with legal and financial advisor fees and the sale of Preserver. The amount of this reduction was approximately $3.3 million. An additional purchase price may be payable approximately three years following the closing if Preserver has favorable development on its June 30, 2006 reserves for losses and loss adjustment expenses. The amount of this additional purchase price will be 65% of any such favorable development but will not exceed $13 million. Prior to closing the acquisition of Preserver on April 10, 2007, the Company formulated a plan to terminate a number of employees of Preserver primarily working in the underwriting, operations, and information technology areas. The Company accrued a liability as of the closing date, in accordance with Emerging Issues Task Force, ("EITF"), number 95-3 in the amount of $500,000 representing severance costs, including employee benefits of the terminated employees. The Company expects that all planned terminations will be completed by the end of 2007. Equity Offering On January 22, 2007, the Company signed an underwriting agreement providing for the issuance and sale of 2,704,000 shares of common stock at a price of $31.25 per share, less underwriting discounts, and granted to the underwriters an option to purchase of up to 405,600 additional shares of common stock at the same price to cover over-allotments. On January 26, 2007, the Company closed on its sale of 2,704,000 shares of common stock. On February 5, 2007 the underwriters exercised their over-allotment option with respect to 340,600 shares of common stock. The Company received aggregate net proceeds from the offering and over-allotment option, after underwriting discounts and expenses of approximately $89.4 million. Subordinated Debentures On January 25, 2007, 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 VI (the "Trust"), an affiliated Delaware trust formed on January 11, 2007. 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 5 are initially at a fixed rate of 8.155% for the first five years and will then reset quarterly for changes in the three-month London Interbank Offered Rate ("LIBOR") plus 300 basis points. 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 2037 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 reports the outstanding subordinated debentures owed to the statutory business trusts as a liability. The net proceeds to the Company from the sale of the debenture to the Trust were used by the Company to redeem a portion of the Company's perpetual preferred stock as described below. The Company incurred $0.4 million of fees related to the issuance of these subordinated debentures which have been capitalized and will be amortized over the term of the subordinated debentures. As part of the Preserver acquisition, the Company assumed $12.0 million in Junior Subordinated Notes ("Junior Notes") issued by the Preserver Capital Trust I ("Preserver Capital Trust"), an affiliated Delaware Trust. The Company does not consolidate Preserver Capital Trust as the Company is not considered the primary beneficiary. The Junior Notes are redeemable in whole or in part on any interest payment date subsequent to May 24, 2009. They bear interest at a three-month LIBOR rate plus 425 basis points, with a cap of 12.50% through May 24, 2009. Preserver incurred loan origination costs of $368,000 which are being amortized over the term of the Junior Notes. The Junior Notes had a weighted average interest rate of 9% and 8% and interest paid was $1.2 million during 2006. Preserver incurred $0.4 million of fees related to the issuance of these subordinated debentures which were capitalized and are currently being amortized over the term of the subordinated debentures. The Trust simultaneously issued 372 of the Trust's common securities to the Company for a purchase price of $0.4 million, which constitutes all of the issued and outstanding common securities of the Trust. Aggregate scheduled maturities of the Company's outstanding subordinated debentures at June 30, 2007 are ($ in thousands): 2009.............................................. $ 12,372 2033.............................................. 20,620 2034.............................................. 13,403 2035.............................................. 13,403 2036.............................................. 41,238 --------------- Total............................................. $ 101,036 =============== Redemption of Perpetual Preferred Stock On January 10, 2007, the Company exchanged its outstanding Series A perpetual preferred stock for 40,000 shares of perpetual preferred Series A-1 stock. On January 26, 2007, the Company fully redeemed all 40,000 shares of perpetual preferred Series A-1 stock for $40.0 million using $20.0 million of the net proceeds from its Trust Preferred Securities issued on January 25, 2007 and $20.0 million of the net proceeds from its common stock offering. Investment in Unconsolidated Affiliate-CastlePoint At June 30, 2007, the Company's maximum exposure to a loss from its investment in CastlePoint Holdings Ltd. ("CastlePoint") was approximately $31.5 million, which consists of its equity ownership interest with a carrying value of approximately $26.9 million as of June 30, 2007 and the warrant the Company received from CastlePoint in 2006, with a carrying value of $4.6 million as of June 30, 2007. The carrying value of the Company's equity investment in CastlePoint with a carrying value as of June 30, 2007 is as follows in millions:
Carrying value of equity investment in CastlePoint at December 31, 2006 $ 27.9 Equity in net income of CastlePoint 1.4 Gain from IPO of common stock of CastlePoint 2.7 Equity in net unrealized loss of the CastlePoint investment portfolio (0.3) Dividends received from CastlePoint (0.2) ---------------- Carrying value of equity investment in CastlePoint at June 30, 2007 $ 31.5 ================
6 The Company has determined that CastlePoint qualifies as a variable interest entity ("VIE") under the provisions of Financial Accounting Standards Board Interpretation ("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 investment in CastlePoint using the equity method of accounting as the Company exercises significant influence over CastlePoint. The Company and CastlePoint have the same Chief Executive Officer, Michael H. Lee. On March 23, 2007, CastlePoint raised $114.8 million net of expenses in an initial public offering which reduced the Company's investment ownership from 8.6% to 6.7%. As a result of the initial public offering, the book value of CastlePoint increased from $279.7 million as of December 31, 2006 to $401.3 million as of March 31, 2007. Accordingly, In the three months ended March 31, 2007, the Company recorded a gain of $2.7 million in income before taxes on its common stock investment in CastlePoint in accordance with the Securities and Exchange Commission's staff accounting bulletin ("SAB") No. 51-"Accounting for Sales of Stock by a Subsidiary." The carrying value of the Company's investment in CastlePoint increased from $27.9 million as of December 31, 2006 to $31.5 million as of June 30, 2007, including the warrant the Company received from CastlePoint in 2006. Dividends of $0.025 per share were declared and paid by CastlePoint in December 2006, March 2007 and June 2007. The Company has recorded $192,000 of CastlePoint dividends received or accrued since inception as a reduction to its investment in CastlePoint. As of June 30, 2007, the aggregate fair value of the Company's investment in its 2,555,000 shares of CastlePoint common stock listed on the Nasdaq Global Market under the symbol "CPHL" was $37,532,950. Reinsurance Agreements with CastlePoint The Company's insurance subsidiaries are parties to three multi-year quota share reinsurance agreements with CastlePoint Reinsurance Company, Ltd. ("CastlePoint Reinsurance") covering brokerage business, traditional program business and specialty program business. Under the brokerage business quota share reinsurance agreement, which covers business that the Company has historically written through its retail and wholesale agents, the Company's insurance subsidiaries cede between 25% and 50% of premiums and losses, such ceding percentage being subject to periodic adjustment by the Company. The Company's insurance subsidiaries ceded $69.6 million and $120.7 million of premiums written during the three months and six months ended June 30, 2007, under this agreement. As of April 1, 2007, CastlePoint Insurance Company ("CPIC") was added as a reinsurer under the brokerage business quota share reinsurance agreement. Effective April 1, 2007, under the brokerage business quota share reinsurance agreement, CastlePoint agreed to pay 30% of the Company's property catastrophe reinsurance premiums and 30% of the Company's net retained property catastrophe losses. The premium payment was $1.6 million for the second quarter of 2007. CastlePoint Reinsurance also participated as a reinsurer on the Company's overall property catastrophe reinsurance program from July 1, 2006 to June 30, 2007, and the Company's excess of loss reinsurance program, effective May 1, 2006. Under these programs, the Company's insurance subsidiaries ceded premiums to CastlePoint Reinsurance of $1.7 million and $2.9 million for the three months and six months ended June 30, 2007, respectively. Brokerage business risk sharing (pooling) between the Company and CPIC under which the Company's CPIC will share approximately 85% and 15%, respectively, of the Company's and CPIC's combined brokerage business is expected to begin on July 1, 2007. Under this risk sharing arrangement, the Company and CPIC plan on entering into aggregate excess of loss agreements, effective July 1, 2007, under which the Company will reinsure 85% of CPIC's brokerage business in excess of a 52.5% net loss ratio and CPIC will reinsure 15% of the Company's brokerage business in excess of a 52.5% net loss ratio. These agreements are subject to regulatory approval. 7 Other Agreements with CastlePoint During the second quarter of 2007, TRM entered into a management agreement with CastlePoint Management Corp. ("CPM") whereby TRM will produce and manage, on behalf of CPM, CPIC's 15% share of the brokerage business. TRM will receive a 34% provisional management fee which is subject to adjustment based on the ultimate loss ratio of the business managed. During the three months ended June 30, 2007, the Company produced $480,000 of premium via TRM and earned $158,000 in fees from CPM, pursuant to this agreement. Effective May 1, 2007, TRM entered into a service agreement with CPM, a subsidiary of CastlePoint, pursuant to which TRM may provide to CPM and CPM may provide to TRM insurance company services such as claims adjustment, policy administration, technology solutions, underwriting and risk management services. The Company has not charged nor provided any services to CPM as of June 30, 2007. Investments 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 June 30, 2007, 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. The Company determined that it did not hold any investments that would have been considered other than temporarily impaired. Intangible Assets Intangible assets consist of finite and indefinite life assets. Finite life intangible assets include both renewal rights and the agency force book of business. Insurance company licenses are considered indefinite life intangible assets subject to annual impairment testing. The weighted average amortization period of identified intangible assets of finite useful life is 17.9 years. Upon the acquisition of Preserver on April 10, 2007, the Company recognized $17.3 million of identifiable intangible assets including Preserver's renewal rights of $1.9 million, its agency force book of business of $10.2 million and insurance company licenses of $5.2 million. The renewal rights and agency force book of business acquired are finite lived assets that will be amortized over ten and twenty years, respectively and are subject to annual impairment testing. The insurance company licenses are included as indefinite lived intangibles subject to annual impairment testing. The components of intangible assets are summarized as follows ($ in thousands):
Beginning Accumulated Net Intangible June 30, 2007 Balance Amortization Assets - ------------------------------------------------------------------------------------- Renewal rights $ 3,164 $ (697) $ 2,467 Agency force 13,926 (582) 13,344 Insurance licenses 6,503 - 6,503 ------------------------------------------------------- Total Intangible assets $ 23,593 $ (1,279) $ 22,314 ======================================================= Beginning Accumulated Net Intangible December 31, 2006 Balance Amortization Assets - ------------------------------------------------------------------------------------- Renewal rights $ 1,250 $ (505) $ 745 Agency force 3,750 (375) 3,375 Insurance licenses 1,303 - 1,303 ------------------------------------------------------- Total Intangible assets $ 6,303 $ ( 880) $ 5,423 =======================================================
Goodwill Goodwill is calculated as the excess of purchase price over the net fair value of assets acquired. In acquiring Preserver, the Company entered into an agreement which provided for a base purchase price of approximately $68.3 million, subject to certain purchase price adjustments. The Agreement provided for using a portion of the proceeds to pay off certain debt owed to Preserver shareholders and to settle Preserver's direct transaction costs. The purchase price, net of Preserver's direct transaction costs was approximately $64.9 million plus approximately $1.3 million of transaction costs incurred by Tower. Approximately $30.8 million of the purchase price was used to pay off certain debt owed to Preserver stockholders. 8 The determination of goodwill as it relates to the Preserver acquisition is based upon the following ($ in thousands): Purchase Price Base purchase price paid $ 68,250 Preserver direct transaction costs, net of tax benefit (3,322) ----------- Total purchase price paid to Preserver 64,928 Direct transaction costs 1,305 ----------- Total purchase price 66,233 Allocation of Purchase Price Book value of Preserver at 4/10/2007 11,064 Preserver shareholder debt repayment 30,754 Estimated fair value adjustments 14,807 ----------- Estimated fair value of assets acquired 56,625 ----------- Goodwill as of June 30, 2007 $ 9,608 =========== The purchase price was allocated to balance sheet assets acquired (including identifiable intangible assets arising from the acquisition) and liabilities assumed based on their estimated fair value. Goodwill at June 30, 2007 and December 31, 2006 was $9.6 million and $0, respectively. The Company performs an annual impairment analysis to identify potential goodwill impairment and measures the amount of a goodwill impairment loss to be recognized (if any). This annual test is performed at December 31 of each year or more frequently if events or circumstances change in a way that requires the Company to perform the impairment analysis on an interim basis. Goodwill impairment testing requires an evaluation of the estimated fair value of each reporting unit to its carrying value, including the goodwill. An impairment charge is recorded if the carrying amount of the reporting unit is less than its estimated fair value. Fixed Assets The components of fixed assets are summarized as follows ($ in thousands): Accumulated Cost Depreciation Net Fixed Assets ------------------------------------------------------ June 30, 2007: - ------------------------- Software $ 21,868 $ (9,061) $ 12,807 Leasehold improvements 12,858 (699) 12,159 Computer equipment 8,928 (6,410) 2,518 Furniture 1,759 (341) 1,418 Automobiles 20 (4) 16 Artwork 97 - 97 ------------------------------------------------------ Total fixed assets $ 45,530 $ (16,515) $ 29,015 ====================================================== December 31, 2006: - ------------------------- Software $ 13,367 $ (6,947) $ 6,420 Leasehold improvements 10,781 (272) 10,509 Computer Equipment 7,954 (5,700) 2,254 Furniture 1,511 (191) 1,320 Artwork 60 - 60 ------------------------------------------------------ Total fixed assets $ 33,673 $ (13,110) $ 20,563 ====================================================== The Company's net fixed assets increased by $5.5 million from the purchase of Preserver. Commitments The Company has various lease agreements for office space and equipment. The terms of the office space lease agreements provide for annual rental increase and certain lease incentives including initial free rent periods and cash allowances for leasehold improvements. The Company amortizes scheduled annual rental increases and lease incentives ratably over the term of the lease. The difference between rent cash payments and recognized rent expense is recorded as deferred rent. 9 The Company's future minimum lease payments are as follows ($ in thousands): Year Amount ------------------------------------------- ---------------- July 1, 2007-December 31, 2007............. $ 3,221 2008....................................... 6,506 2009....................................... 6,352 2010....................................... 6,294 2011....................................... 5,784 Thereafter................................. 36,133 ---------------- Total...................................... $ 64,290 ================ Dividends Declared Dividends declared by the Company on common stock for the three and six months ended June 30, 2007 were $572,831 and $1,144,071, or $0.025 and $0.05 per share, respectively. Dividends declared by the Company on common stock for the three months and six months ended June 30, 2006 were $494,401 and $986,649 or $0.025 and $0.05 per share, respectively. Dividends paid by the Company on its perpetual preferred Series A-1 stock for the three months and six months ended June 30, 2007 were $0 and $298,289 and none in the three months and six months ended June 30, 2006. Equity Compensation Plans Restricted Stock Awards During the three and six months ended June 30, 2007, 12,654 and 89,128 restricted stock shares were granted to senior officers, directors and key employees. The fair value of the awards was $0.4 million and $2.9 million, respectively, on the grant date. For the three and six months ended June 30, 2007, 38,950 and 49,256 restricted stock shares respectively vested, and 3,593 and 6,064 shares, respectively, were forfeited. Compensation expense related to restricted stock awards recognized for the three months ended June 30, 2007 and 2006 was $304,000 and $124,000 net of tax, respectively. Compensation expense recognized for the six months ended June 30, 2007 and 2006 was $492,000 and $223,000 net of tax, respectively. Total unrecognized compensation expense before tax for grants of restricted stock was $4.6 million and $2.6 million at June 30, 2007 and December 31, 2006, respectively. The intrinsic value of the unvested restricted stock outstanding as of June 30, 2007 is $6.8 million. Changes in restricted stock for the six months ended June 30, 2007 were as follows: Weighted Average Number Grant Date Fair of Shares Value ----------------------------------- Outstanding at December 31, 2006 180,766 $ 17.35 Granted 89,128 32.42 Vested (49,256) 15.12 Forfeited (6,064) 24.41 --------------- Outstanding at June 30, 2007 214,574 23.93 =============== 10 Stock Options Compensation expense net of tax related to stock options was $29,000 and $43,000 for the three and six months ended, respectively, June 30, 2007 compared to $14,000 and $35,000, respectively, in the same periods last year. Total unrecognized expense, before tax, for grants of stock options was $173,000 and $238,000 as of June 30, 2007 and December 31, 2006, respectively. The intrinsic value of stock options outstanding as of June 30, 2007 is $7.8 million, of which $5.9 million is related to vested options. Changes in stock options for the six months ended June 30, 2007 were as follows: Average Number of Exercise Shares Price ----------------------------- Outstanding at December 31, 2006 362,996 $ 4.94 Exercised (73,200) 2.78 -------------- Outstanding at June 30, 2007 289,796 5.49 ============== Exercisable at June 30, 2007 216,895 4.48 ============== Options outstanding and exercisable as of June 30, 2007 were as follows: Options outstanding Options exercisable --------------------------------- -------------------- Average remaining Average Average Number of contractual exercise Number of exercise Range of exercise prices shares life price shares price - ---------------------------------------------------------- -------------------- Under $4.00 152,480 3.5 $ 2.78 152,480 $ 2.78 $5.00 - $10.00 137,316 7.3 8.50 64,415 8.50 ---------- ---------- Total Options 289,796 5.3 5.49 216,895 4.48 ========== ========== Deferred tax assets and liabilities are determined using the enacted tax rates applicable to the period over which the temporary differences are expected to be recovered. Accordingly, the current period income tax provision can be affected by the enactment of new tax rates. The net deferred income taxes on the balance sheet reflect temporary differences between the carrying amounts of the assets and liabilities for financial reporting purposes and income tax purposes, tax effected at a 35% rate. Significant components of the Company's deferred tax assets and liabilities are as follows ($ in thousands):
June 30, 2007 December 31, 2006 ------------------------------------ Deferred tax asset: Claims reserve discount $ 11,501 $ 6,839 Unearned premium 11,362 9,488 Allowance for doubtful accounts 60 87 Deferred rent 354 351 Equity compensation plans 177 232 Net unrealized depreciation of securities 4,200 157 Net operating losses carryforwards 14,113 - Other 231 33 ------------------------------------ Total deferred tax asset 41,998 17,187 Deferred tax liability: Deferred acquisition costs net of deferred ceding commission revenue 14,885 12,482 Depreciation and amortization 1,118 597 Warrant received from unconsolidated affiliate 1,612 1,612 Gain from issuance of common stock by unconsolidated affiliate 2,759 2,759 Gain from IPO of common stock of unconsolidated affiliate 947 - Equity income in unconsolidated affiliate 706 320 Accrual of bond discount 953 672 Other 3 - ------------------------------------ Total deferred tax liabilities 22,983 18,442 ------------------------------------ Net deferred income tax asset (liability) $ 19,015 $ (1,255) ====================================
11 In assessing the valuation of deferred tax assets, the Company considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. No valuation allowance against deferred tax assets has been established as the Company believes it is more likely than not the deferred tax assets will be realized. Preserver, which was acquired by the Company on April 10, 2007, has tax loss carryforwards and other tax assets that the Company believes will be used in the future, subject to change of ownership limitations pursuant to Section 382 of the Internal Revenue Code and to the ability of the combined post-merger company to generate sufficient taxable income to utilize the benefits before the expiration of the applicable carryforward periods. Section 382 imposes limitations on a corporation's ability to utilize its net operating loss carry forwards (NOL) if it experiences an "ownership change." In general terms, an ownership change results from transactions increasing the ownership of certain stockholders in the stock of a corporation by more than 50 percentage points over a three-year period. As a result of the acquisition, Preserver underwent an ownership change. Utilization of Preserver's NOL of $39.6 million is subject to an annual limitation under Section 382 determined by multiplying the value of Preserver's stock at the time of purchase by the applicable long-term rate resulting in an annual limitation amount of approximately $2,769,000. Any unused annual limitation may be carried over to later years. The Company adopted the provisions of FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109" ("FIN 48"), on January 1, 2007. As of June 30, 2007, the Company had no material unrecognized tax benefit and no adjustments to liabilities or operations were required. The Company recognizes interest and penalties related to uncertain tax positions in income tax expense which were zero for the three and six months ended June 30, 2007. Tax years 2003 through 2006 are subject to examination by the federal authorities. There is currently a New York State Department of Taxation and Finance audit under way for the tax years of 2003 through 2004, but the Company does not anticipate any material adjustments. Accounting Pronouncements In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments" ("SFAS No. 155"). Under the current GAAP, an entity that holds a financial instrument with an embedded derivative must bifurcate the financial instrument, resulting in the host and the embedded derivative being accounted for separately. SFAS No. 155 permits, but does not require, entities to account for financial instruments with an embedded derivative at fair value, thus negating the need to bifurcate the instrument between its host and the embedded derivative. The Company adopted SFAS No. 155 on January 1, 2007. The adoption of SFAS No. 155 did not have any effect on our consolidated financial condition or results of operations. In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of SFAS No. 115". This standard permits an entity to choose to measure many financial instruments and certain other items at fair value. Most of the provisions in SFAS No. 159 are elective; however, the amendment to SFAS No. 115 applies to all entities with available-for-sale and trading securities. The FASB's stated objective in issuing this standard is as follows: "to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions." The fair value option established by SFAS No. 159 permits all entities to choose to measure eligible items at fair value at specified election dates. A business entity will report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option: (a) may be applied instrument by instrument, with a few exceptions, such as investments otherwise accounted for by the equity method; (b) is irrevocable (unless a new election date occurs); and (c) is applied only to entire instruments and not to portions of instruments. SFAS No. 159 is effective as of the beginning of the entity's first fiscal year that begins after November 15, 2007. The Company is currently evaluating the impact that the adoption of SFAS No. 159 will have on its consolidated financial position and results of operations. 12 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 June 30, 2007 Net Income $ 12,379 ================ Basic earnings per share $ 12,379 22,895,783 $ 0.54 ==================== Effect of dilutive securities: Stock options - 188,731 Unvested restricted stock - 54,975 Warrants - 30,084 ------------------------------ Diluted earnings per share $ 12,379 23,169,573 $ 0.53 ================================================== Three Months Ended June 30, 2006 Net Income $ 12,285 ================ Basic earnings per share $ 12,285 19,742,004 $ 0.62 ==================== Effect of dilutive securities: Stock options - 323,455 Unvested restricted stock - 167,502 Warrants - 32,093 ------------------------------ Diluted earnings per share $ 12,285 20,265,054 $ 0.61 ================================================== Six Months Ended June 30, 2007 Net Income $ 24,007 Less: Preferred stock dividends (298) Preferred stock excess consideration (400) ---------------- Basic earnings per share $ 23,309 22,442,345 $ 1.04 ==================== Effect of dilutive securities: Stock options - 193,029 Unvested restricted stock - 61,528 Warrants - 32,103 ------------------------------ Diluted earnings per share $ 23,309 22,729,005 $ 1.03 ================================================== Six Months Ended June 30, 2006 Net Income $ 18,795 ================ Basic earnings per share $ 18,795 19,713,453 $ 0.95 ==================== Effect of dilutive securities: Stock options - 328,747 Unvested restricted stock - 169,488 Warrants - 29,923 ------------------------------ Diluted earnings per share $ 18,795 20,241,611 $ 0.93 ==================================================
As of June 30, 2007 the Company reviewed its calculation of basic and diluted earnings per share for the first quarter of 2007. During the first quarter the Company redeemed all of its perpetual preferred Series A-1 stock for $40 million which had a carrying value, net of issuance costs, of $39.6 million. In accordance with Emerging Issues Task Force ("EITF") D-42, "The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock", the excess of the consideration transferred to the holders of the preferred stock over the carrying amount of the preferred stock should be subtracted from net earnings available to common shareholders in the calculation of earnings per share. In our first quarter calculation of earnings per share we deducted the $400,000 from paid-in-capital rather than earnings available to common shareholders. The correction of this calculation results in a reduction in the basic and diluted earnings per share for the first quarter of 2007 by $0.02 and $0.02, respectively. 13 Changes In Estimates TICNY and TNIC recorded favorable development in their net loss reserves from prior accident years of $27,000 and $28,000 in the second quarter of 2007 and in the six months ended June 30, 2007, respectively, compared to $157,000 of favorable development in the second quarter of 2006 and $682,000 for the six months ended June 30, 2006. Preserver's insurance companies recorded favorable development in their net loss reserves from the prior accident years of $4,000 in the second quarter of 2007. TICNY's changes in estimated sliding scale commission resulted in a decrease in ceding commission revenue of $58,000 and an increase in ceding commission revenue of $3,000 in the second quarter and six months ended June 30, 2007, respectively, as compared to an increase in ceding commission revenue of $407,000 and $801,000 in the second quarter and six months ended June 30, 2006, respectively. TRM's changes in estimated sliding scale commission was an increase in direct commission revenue of $520,000 in the second quarter of 2007 and an increase in direct commission revenue of $1,021,000 in the six months ended June 30, 2007, compared to an increase in direct commission revenue of $136,000 in the second quarter of 2006 and a decrease in direct commission revenue of $212,000 in the six months ended June 30, 2006. Segment Information The Company manages its operations through three business segments: insurance (commercial and personal lines underwriting), reinsurance and insurance services (managing general agency, claims administration and reinsurance intermediary operations). The Company considers many factors in determining reportable segments including economic characteristics, production sources, products or services offered and regulatory environment. The accounting policies of the segments are the same as those described in the summary of significant accounting policies in the Company's Annual Report on Form 10-K for the year ended December 31, 2006. The Company evaluates segment performance based on segment profit, which excludes investment income, realized gains and losses, interest expense, income taxes and incidental corporate expenses. The Company does not allocate assets to segments because assets, which consist primarily of investments and fixed assets, are considered in total by management for decision-making purposes. The Company included Preserver's insurance operations in its insurance segment for the three and six months ended June 30, 2007. Business segments results are as follows:
Three Months Ended Six Months Ended June 30, June 30, ------------------------- -------------------------- 2007 2006 2007 2006 ------------ ------------ ------------ ------------- ($ in thousands) Insurance Segment Revenues Net premiums earned $ 72,385 $ 45,971 $ 130,135 $ 102,560 Ceding commission revenue 17,034 10,077 31,268 17,379 Policy billing fees 543 272 845 539 ------------ ------------ ------------ ------------- Total revenues 89,962 56,320 162,248 120,478 ------------ ------------ ------------ ------------- Expenses Net loss and loss adjustment expenses 40,215 28,209 72,685 61,042 Underwriting expenses 39,160 24,176 70,411 47,575 ------------ ------------ ------------ ------------- Total expenses 79,375 52,385 143,096 108,617 ------------ ------------ ------------ ------------- Underwriting profit $ 10,587 $ 3,935 $ 19,152 $ 11,861 ============ ============ ============ ============= Reinsurance Segment Revenues Net premiums earned $ 1,650 $ 13,316 $ 4,283 $ 13,983 Ceding commission revenue (2) - (2) - ------------ ------------ ------------ ------------- Total revenues $ 1,648 $ 13,316 $ 4,281 $ 13,983 ------------ ------------ ------------ ------------- Expenses Net loss and loss adjustment expenses 396 13,216 1,836 13,593 Underwriting expenses 812 866 2,098 1,119 ------------ ------------ ------------ ------------- Total expenses 1,208 14,082 3,934 14,712 ------------ ------------ ------------ ------------- Underwriting profit (loss) $ 440 $ (766) $ 347 $ (729) ============ ============ ============ ============= Insurance Services Segment Revenues Direct commission revenue from managing general agency $ 572 $ 1,105 $ 1,060 $ 1,911 Claims administration revenue 535 922 1,100 1,884 Other administration revenue 347 - 598 - Reinsurance intermediary fees 185 174 341 235 Policy billing fees - 2 - 5 ------------ ------------ ------------ ------------- Total revenues 1,639 2,203 3,099 4,035 ------------ ------------ ------------ ------------- Expenses Direct commissions expense paid to producers 144 731 151 1,334 Other insurance services expenses 358 305 615 542 Claims expense reimbursement to TICNY 533 911 1,098 1,869 ------------ ------------ ------------ ------------- Total expenses 1,035 1,947 1,864 3,745 ------------ ------------ ------------ ------------- Insurance services pre-tax income $ 604 $ 256 $ 1,235 $ 290 ============ ============ ============ =============
14 Underwriting expenses in the insurance segment are net of expense reimbursements that are made by the insurance services segment pursuant to an expense sharing agreement between TRM, TNIC and TICNY. In accordance with terms of this agreement, TRM reimburses TICNY for a portion of TICNY's underwriting and other expenses resulting from TRM's use of TICNY's personnel, facilities and equipment in underwriting insurance on behalf of TRM's issuing companies. The reimbursement for underwriting and other expenses is calculated as a minimum reimbursement of 5% of the premiums produced by TRM and is adjustable according to the terms of the agreement based on the number of policies in force and additional expenses that may be incurred by TRM. The amount of this reimbursement was $0.4 million and $0.6 million for the three and six months ended June 30, 2007, respectively, and $0.3 million and $0.5 million for the three and six months ended June 30, 2006, 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 $0.5 million and $1.1 million for the three and six months ended June 30, 2007, respectively, and $0.9 million and $1.9 million for the three and six months ended June 30, 2006, respectively. TICNY is also reimbursed, at cost, for other administrative services provided to CastlePoint pursuant to the terms of the service and expense sharing agreement which were $0.3 million and $0.6 million during the three and six months ended June 30, 2007, respectively, and $0.3 million for the three months and six months ended June 30, 2006 when CastlePoint was still in formation. The following table reconciles revenue by segment to consolidated revenues:
Three Months Ended Six Months Ended, June 30, June 30, ----------------------- ------------------------- 2007 2006 2007 2006 ----------- ----------- ----------- ------------- ($ in thousands) Reconciliation Revenues Insurance segment $ 89,962 $ 56,320 $ 162,248 $ 120,478 Reinsurance segment 1,648 13,316 4,281 13,983 Insurance services segment 1,639 2,203 3,099 4,035 ----------- ----------- ----------- ------------- Total segment revenue 93,249 71,839 169,628 138,496 Investment income 9,446 5,292 17,401 9,952 Realized capital gains (losses) 89 29 72 (116) ----------- ----------- ----------- ------------- Consolidated revenues $ 102,784 $ 77,160 $ 187,101 $ 148,332 =========== =========== =========== =============
15 The following table reconciles the results of the Company's individual segments to consolidated income before taxes:
Three Months Ended Six Months Ended, June 30, June 30, ----------------------------------------------------- 2007 2006 2007 2006 -------------- ----------- ------------ ------------- ($ in thousands) Insurance segment underwriting profit $ 10,587 $ 3,935 $ 19,152 $ 11,861 Reinsurance segment underwriting profit (loss) 440 (766) 347 (729) -------------- ----------- ------------ ------------- Total underwriting profit 11,027 3,169 19,499 11,132 Insurance services segment pre- tax income 604 256 1,235 290 Net investment income 9,446 5,292 17,401 9,952 Net realized investment gains (losses) 89 29 72 (116) Corporate expenses (233) (482) (591) (1,496) Interest expense (2,446) (1,853) (4,530) (3,203) Other Income * 734 12,434 4,128 12,434 -------------- ----------- ------------ ------------- Income before taxes $ 19,221 $ 18,845 $ 37,214 $ 28,993 ============== =========== ============ =============
* See note on investment in unconsolidated affiliate-CastlePoint Subsequent Events On July 26, 2007, the Company's Board of Directors approved a quarterly dividend of $0.025 per share payable September 27, 2007 to stockholders of record as of September 14, 2007. 16 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 Quarterly Report on Form 10-Q may include forward-looking statements that reflect our current views with respect to future events and financial performance. These statements include forward-looking statements both with respect to us specifically and the insurance sector in general. Statements that include the words "expect," "intend," "plan," "believe," "project," "estimate," "may," "should," "anticipate," "will" and similar statements of a future or forward-looking nature identify forward-looking statements for purposes of the Federal securities laws or otherwise. All forward-looking statements address matters that involve risks and uncertainties. Accordingly, there are or will be important factors that could cause our actual results to differ materially from those indicated in these statements. We believe that these factors include, but are not limited to, the following: o ineffectiveness or obsolescence of our business strategy due to changes in current or future market conditions; o developments that may delay or limit our ability to enter new markets as quickly as we anticipate; o increased competition on the basis of pricing, capacity, coverage terms or other factors; o greater frequency or severity of claims and loss activity, including as a result of natural or man-made catastrophic events, than our underwriting, reserving or investment practices anticipate based on historical experience or industry data; o the effects of acts of terrorism or war; o developments in the world's financial and capital markets that adversely affect the performance of our investments; o changes in regulations or laws applicable to us, our subsidiaries, brokers or customers; o acceptance of our products and services, including new products and services; o changes in the availability, cost or quality of reinsurance and failure of our reinsurers to pay claims timely or at all; o changes in the percentage of our premiums written that we cede to reinsurers; o decreased demand for our insurance or reinsurance products; o loss of the services of any of our executive officers or other key personnel; o the effects of mergers, acquisitions and divestitures; o changes in rating agency policies or practices; o changes in legal theories of liability under our insurance policies; o changes in accounting policies or practices; and o changes in general economic conditions, including inflation, interest rates and other factors. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included in this Quarterly Report on 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. 17 Consolidated Results of Operations
Three Months Ended Six Months Ended June 30, June 30, ----------------------------------------------------- 2007 2006 2007 2006 ----------------------------------------------------- ($ in thousands) Revenues Earned premiums Gross premiums earned $ 130,621 $ 95,567 $ 239,248 $ 172,183 Less: ceded premiums earned (56,586) (36,281) (104,830) (55,641) ----------------------------------------------------- Net premiums earned 74,035 59,286 134,418 116,542 ----------------------------------------------------- Total commission and fee income 19,214 12,553 35,210 21,954 Net investment income 9,446 5,292 17,401 9,952 Net realized investment gains 89 29 72 (116) ----------------------------------------------------- Total revenues 102,784 77,160 187,101 148,332 ----------------------------------------------------- Expenses Net loss and loss adjustment expenses 40,611 41,424 74,521 74,634 Operating expenses 41,240 27,472 74,964 53,936 Interest expenses 2,446 1,853 4,530 3,203 ----------------------------------------------------- Total expenses 84,297 70,749 154,015 131,773 ----------------------------------------------------- Other Income: Equity in income (loss) of unconsolidated affiliate 734 (54) 1,423 (54) Gain from issuance of common stock by unconsolidated affiliate - 7,883 2,705 7,883 Warrant received from unconsolidated affiliate - 4,605 - 4,605 ----------------------------------------------------- Income before taxes 19,221 18,845 37,214 28,993 Federal and state income taxes 6,842 6,560 13,207 10,198 ----------------------------------------------------- Net Income $ 12,379 $ 12,285 $ 24,007 $ 18,795 ===================================================== Key Measures Return on Average Equity 17.2% 31.8% 21.7% 24.7% =====================================================
On April 10, 2007 we acquired 100% of the issued and outstanding common stock of Preserver pursuant to the stock purchase agreement, dated November 13, 2006, by and among the Company, Preserver and the Sellers named therein the "Agreement". The acquisition was accounted for using the purchase method in accordance with FASB SFAS No. 141, Business Combinations ("SFAS No. 141"). Under the terms of the Agreement, the Company acquired Preserver for approximately $64.9 million comprised of $34.1 million in cash considerations to the Sellers and a contribution of $30.8 million to the capital of Preserver to enable Preserver to repay the principal and accrued interest on indebtedness held by certain of the Sellers. The Company's consolidated results were consolidated for the three and six month periods ended June 30, 2007 and include the results of Preserver for the period April 11, 2007 to June 30, 2007. Preserver's contribution to net income during the three months ending June 30, 2007 was $1.7 million. During the three months ended June 30, 2006 a number of significant events affected the consolidated results of operations. We executed commutation and novation agreements between us and PXRE Reinsurance Company ("PXRE") in order to eliminate our exposure to uncollateralized reinsurance recoverables from PXRE. We recorded a charge as a result of these agreements of $5.5 million. In addition, we realized gains on our investment in CastlePoint as a result of the sale by CastlePoint of unissued CastlePoint shares in a private offering, which resulted in a $7.9 million gain. In addition, we received a warrant to purchase additional CastlePoint shares that was valued at $4.6 million resulting in additional income of that amount in exchange for sponsorship services, which included management, organizational and industry expertise. Lastly, we entered into three multi-year quota share reinsurance agreements and a service and expense sharing agreement with CastlePoint. 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 as of April 1, 2006. 18 Consolidated Results of Operations Three Months Ended June 30, 2007 and 2006 Total revenues. Total revenues increased by 33.2% to $102.8 million for the three months ended June 30, 2007 compared to $77.2 million for the same period in 2006. The acquisition of Preserver added $18.6 million to total revenues in the second quarter of 2007. The total revenue increase is primarily due to the increase in earned premiums, total commission and fee income and net investment income. Net premiums earned represented 72.0% of total revenues for the three months ended June 30, 2007 compared to 76.8% for the same period in 2006. Net investment income, excluding realized capital gains, represented 9.2% and 6.9% of total revenues for the three months ended June 30, 2007 and 2006, respectively. Total commission and fee income increased for the three months ended June 30, 2007 to $19.2 million, or 18.7% of total revenues, compared to $12.6 million, or 16.3% of total revenues, for the same period in 2006. We entered into three multi-year quota share reinsurance agreements with CastlePoint Reinsurance on April 6, 2006. As of April 1, 2007, CPIC was added as a reinsurer under one of these reinsurance agreements. In order to achieve our targeted net retention that is consistent with our hybrid business model, we increased the quota share ceding percentage to CastlePoint to 49% in 2007, compared to 30% for the three months ended June 30, 2006. The increase in the quota share ceding percentage, as well as the acquisition of Preserver, contributed to the increase in commission and fee income during the second quarter of 2007. Premiums earned. Net premiums earned increased by 24.9% to $74.0 million for the three months ended June 30, 2007 compared to $59.3 million for the same period in 2006. The acquisition of Preserver added $16.6 million in net premiums earned in the second quarter of 2007. In 2006, we executed novation agreements with PXRE, which added $11.4 million of net premiums earned in the second quarter of 2006. Consideration received under novation agreements is recorded as premiums written and earned. The increase in net premiums earned in the second quarter of 2007 was due to the acquisition of Preserver, but was partially offset by ceded premiums earned for the three months ended June 30, 2007 arising from the increased quota share ceding percentage in 2007. In the three months ended June 30, 2006 the quota share ceding percentage was 30% as compared to 49% in the three months ended June 30, 2007. During the three months ended June 30, 2007, we ceded $45.4 million of our premiums earned to CastlePoint compared to $20.4 million in the three months ended June 30, 2006. Commission and fee income. Total commission and fee income increased by 53.1% to $19.2 million in the second quarter of 2007 compared to $12.6 million in the second quarter of 2006. The acquisition of Preserver added $0.8 million in commission and fee income in the second quarter of 2007. The increase in the ceding commission revenue earned was a result of the overall increase in ceded premiums earned as discussed above. In addition, commission and fee income includes other administration revenue of $0.3 million from services provided to and reimbursed by CastlePoint. As a result of the commutation and novation agreements with PXRE in the second quarter of 2006, we recorded a charge of $3.1 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 three months ended June 30, 2007, 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 $462,000, compared to $544,000 in the same period last year. Net investment income and realized gains. Net investment income increased by 78.5% to $9.4 million for the three months ended June 30, 2007 compared to $5.3 million for the same period in 2006. The acquisition of Preserver added $1.2 million of net investment income in the second quarter of 2007. This growth resulted from an increase in invested assets to $625.6 million as of June 30, 2007 compared to $395.4 million as of June 30, 2006. Net cash flows provided by operations was $9.6 million and contributed to the increase in invested assets during the three months ended June 30, 2007. The increase in invested assets in the second quarter of 2006 resulted from net cash flow provided by operations of $47.8 million that included $37.0 million of cash received from PXRE resulting from the commutations and novation transactions, partially offset by the payment of $20.3 million ceded premiums written to CastlePoint Reinsurance. On a tax equivalent basis the yield was 5.8% as of June 30, 2007 compared to 5.4% as of June 30, 2006. Net realized capital gains were $89,000 for the three months ended June 30, 2007 compared to net realized capital gains of $29,000 for the same period in 2006. There was no impact on net realized gains attributable to adjustments for other than temporary impairment of securities held during the three months ending June 30, 2007 or during the same period in 2006. 19 We have approximately $30 million at fair value of investments in the subprime mortgage backed securities category including $17.3 million in a diversified fund consisting of various asset-backed investment grade securities. Our total investment in subprime mortgages consists of highly rated securities of which approximately 99% are investment grade, with an average rating of A and a duration of approximately 1 year. Unrealized losses on these securities as of June 30, 2007 as included in other comprehensive income were approximately $1.2 million, net of taxes. Unrealized losses as of July 31, 2007 were estimated to be $2.0 million, net of taxes. There was no rating activity relating to these positions during July. We actively manage our subprime mortgage assets through our conservative investment management guidelines. We have the ability to hold these securities to maturity. Considering the combination of relevant factors, including the quality of the securities and the absence of indications of ratings downgrades or credit watch, we consider the market decline below cost to be temporary. 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 June 30, 2007 were $66.8 million and 51.2%, respectively, compared to $58.6 million and 61.3%, respectively, for the same period in 2006. The net loss ratio for the combined segments was 54.9% for the three months ended June 30, 2007, as compared to 69.9% in the same period of 2006. For the second quarter of 2006, the net loss ratio for the combined segments reflected a $1.6 million charge resulting from the commutation and novation agreements with PXRE that added 12.2 percentage points to the net loss ratio for the combined segments for the three months ended June 30, 2006. Operating expenses. Operating expenses increased by 50.1% to $41.2 million for the three months ended June 30, 2007 from $27.5 million for the same period in 2006. The increase was due primarily to the increase in underwriting expenses resulting from the growth in gross premiums earned. The acquisition of Preserver added $7.1 million of operating expenses for the three months June 30, 2007. Cost reductions were realized as part of the Preserver integration and Preserver's expense ratio was reduced by 7% from pre-acquisition levels. Interest expense. Interest expense increased for the three months ended June 30, 2007 to $2.4 million compared to $1.9 million for the same period in 2006. The increase resulted from $0.4 million of interest expense from the $20.6 million of subordinated debentures issued on January 25, 2007 and $0.2 million from the $12.0 million of outstanding junior subordinated notes of Preserver, partially offset by a decrease of $0.1 million as a result of crediting reinsurers on funds withheld in segregated trusts as collateral for reinsurance recoverables. Other income. For the three months ended June 30, 2007 and 2006 we recorded other income of $0.7 million and $12.4 million, respectively. The $0.7 million of other income for the three months ended June 30, 2007 represents our equity in CastlePoint's 2007 net income for the three months ended June 30, 2007. The 2006 other income reflects a gain of $7.9 million which resulted from the sale by CastlePoint of unissued shares and $4.6 million of other income representing the value of the warrant that we received from CastlePoint for our sponsorship and formation activities. We also recorded a $54,000 loss representing our 8.6% equity in CastlePoint's net loss for the three months ended June 30, 2006. Income tax expense. Our income tax expense was $6.8 million for the three months ended June 30, 2007 compared to $6.6 million for the same period in 2006. The increase was due primarily to the increase in income before income taxes, as well as an increase in state and local income taxes. The effective income tax rate was 35.6% for the three months ending June 30, 2007 compared to 34.8% for the same period in 2006. Net income and return on average equity. Our net income and annualized return on average equity was $12.4 million and 17.2%, respectively, for the three months ended June 30, 2007 compared to $12.3 million and 31.8%, respectively, for the same period in 2006. For the second quarter of 2007, the return was calculated by dividing annualized net income of $49.5 million by an average stockholders' equity of $287.6 million. For the second quarter of 2006, the return was calculated by dividing annualized net income of $49.1 million by an average stockholders' equity of $154.4 million. The effects of the commutation and novation transactions and the gains recorded on the CastlePoint investment and warrant added $4.6 million to our net income and 11.6 percentage points to our annualized return on average equity for the second quarter of 2006. 20 Consolidated Results of Operations Six Months Ended June 30, 2007 and 2006 Total revenues. Total revenues increased by 26.1% to $187.1 million for the six months ended June 30, 2007 compared to $148.3 million for the same period in 2006. The acquisition of Preserver added $18.6 million to total revenues in the six months ended June 30, 2007. The increase is primarily due to the increase in earned premiums, total commission and fee income and net investment income, excluding net realized investment gains. Net premiums earned represented 71.8% of total revenues for the six months ended June 30, 2007 compared to 78.6% for the same period in 2006. Net investment income, excluding realized capital losses, represented 9.3% and 6.7% of total revenues for the six months ended June 30, 2007 and June 30, 2006, respectively. Total commission and fee income increased to $35.2 million or 18.8% of total revenues for the six months ended June 30, 2007 compared to $22.0 million, or 14.8% of total revenues, for the same period in 2006. We did not place quota share reinsurance for policies written during the first quarter of 2006 in expectation that CastlePoint Reinsurance, post formation, would agree to enter into a multi-year quota share reinsurance agreement with us. Therefore, the consolidated results of operations and the Insurance Segment underwriting results for the first quarter of 2006 reflect net underwriting results without quota share reinsurance with respect to policies that began in 2006. We entered into three multi-year quota share reinsurance agreements with CastlePoint Reinsurance on April 6, 2006. As of April 1, 2007 CPIC was added as a reinsurer under one of these reinsurance agreements. On January 1, 2007, in order to achieve our targeted net retention that is consistent with our hybrid business model, we increased the quota share ceding percentage to CastlePoint Reinsurance from 40% to 49%. The increase in the quota share ceding percentage contributed to the increase in commission and fee income in the first six months of 2007. Premiums earned. Net premiums earned increased by 15.3% to $134.4 million for the six months ended June 30, 2007 compared to $116.5 million for the same period in 2006. The acquisition of Preserver added $16.6 million in net premiums earned in the six months ended June 30, 2007. The increase in net premiums earned was due to the 38.9% increase in gross premiums written for the six months ended June 30, 2007 compared to the same period last year offset by an 88.4% increase in ceded premiums earned for the six months ended June 30, 2007 compared to the same period last year. Also, in 2006 we had executed novation agreements with PXRE, which added $11.4 million of net premiums earned in the second quarter. During the six months ended June 30, 2007 we ceded $82.9 million of our premiums earned to CastlePoint, compared to $20.4 million in 2006. Commission and fee income. Total commission and fee income increased by 60.4% to $35.2 million in the six months ended June 30, 2007 compared to $22.0 million in the same period of 2006. The increase in the ceding commission revenue earned was a result of the overall increase in ceded premiums earned as discussed above. In addition, commission and fee income includes other administration revenue of $0.6 million from services provided to and reimbursed by CastlePoint. For the six months ended June 30, 2007 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 $1.0 million compared to $0.6 million in the same period last year. Net investment income and realized gains. Net investment income increased by 74.8% to $17.4 million for the six months ended June 30, 2007 compared to $10.0 million for the same period in 2006. The acquisition of Preserver added $1.2 million of net investment income for the six months ended June 30, 2007. The increase in net investment income resulted from an increase in invested assets to $625.6 million as of June 30, 2007 compared to $395.4 million as of June 30, 2006. Net cash flows provided by operations of $29.9 million contributed to the increase in invested assets during the six months ended June 30, 2007 as well as cash flow provided by financing activities of $69.7 million as a result of our net proceeds from the issuance of subordinated debentures on January 25, 2007, an equity offering on January 26, 2007 and the exercise of the underwriters' over-allotment option on February 5, 2007 partially offset by the redemption of preferred stock. The net cash flow used in investing activities was $151.8 million for the six months ended June 30, 2007 and includes $66.2 million for the purchase of Preserver. On a tax equivalent basis, the yield was 5.8% as of June 30, 2007 and 5.4% as of June 30, 2006. Net realized capital gains were $72,000 in the six months ended June 30, 2007 compared to net realized capital losses of $116,000 for the same period in 2006. There was no impact on net realized gains attributable to adjustments for other than temporary impairment of securities held during the six months ended June 30, 2007 or during the same period in 2006. 21 We have approximately $30 million at fair value of investments in the subprime mortgage backed securities category including $17.3 million in a diversified fund consisting of various asset-backed investment grade securities. Our total investment in subprime mortgages consists of highly rated securities of which approximately 99% are investment grade, with an average rating of A and a duration of approximately 1 year. Unrealized losses on these securities as of June 30, 2007 as included in other comprehensive income were approximately $1.2 million, net of taxes. Unrealized losses as of July 31, 2007 were estimated to be $2.0 million, net of taxes. There was no rating activity relating to these positions during July. We actively manage our subprime mortgage assets through our conservative investment management guidelines. We have the ability to hold these securities to maturity. Considering the combination of relevant factors, including the quality of the securities and the absence of indications of ratings downgrades or credit watch, we consider the market decline below cost to be temporary. 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 six months ended June 30, 2007 were $124.2 million and 51.9%, respectively, compared to $101.9 million and 59.2%, respectively, for the same period in 2006. The net loss ratio for the combined segments was 55.4% for the six months ended June 30, 2007 as compared to 64.0% in the same period of 2006. For the second quarter of 2006, the net loss ratio for the combined segments reflected a $1.6 million charge resulting from the commutation and novation agreements with PXRE that added 6.1 percentage points to the net loss ratio for the combined segments for the six months ended June 30, 2006. Operating expenses. Operating expenses increased by 39.0% to $75.0 million for the six months ended June 30, 2007 from $53.9 million for the same period in 2006. The acquisition of Preserver added $7.1 million of operating expenses for the six months ended June 30, 2007. The increase was due primarily to the increase in underwriting expenses resulting from the growth in premiums earned and additional staffing and facility expenses. Interest expense. Our interest expense increased for the six months ended June 30, 2007 to $4.5 million compared to $3.2 million for the same period in 2006. The increase resulted from $0.7 million of interest expense from the $20.6 million of subordinated debentures issued on January 25, 2007, $0.5 million resulting from an increase in interest rates on the floating rate portions of our subordinated debentures and $0.2 million from $12.0 million of outstanding junior subordinated notes of Preserver, partially offset by a decrease of $0.2 million as a result of crediting reinsurers on funds withheld in segregated trusts as collateral for reinsurance recoverables. Other income. For the six months ended June 30, 2007 and 2006 we recorded other income of $4.1 million and $12.4 million, respectively. The $4.1 million of other income for the six months ended June 30, 2007 represents our equity in CastlePoint's 2007 net income for the six months ended June 30, 2007 as well as a $2.7 million gain which resulted from our investment in CastlePoint as a result of their initial public offering which occurred in the first quarter of 2007. See discussion above regarding "Other Income" for the three months ended June 30, 2007. Income tax expense. Our income tax expense was $13.2 million for the six months ended June 30, 2007 compared to $10.2 million for the same period in 2006. The increased income tax expense was due primarily to the increase in income before income taxes, as well as an increase in state and local income taxes. The effective income tax rate was 35.5% for the six months ending June 30, 2007 compared to 35.2% for the same period in 2006. Net income and return on average equity. Our net income and annualized return on average equity was $24.0 million and 21.7%, respectively, for the six months ended June 30, 2007 compared to $18.8 million and 24.7%, respectively, for the same period in 2006. For the six months ended June 30, 2007, the return was calculated by dividing annualized net income of $47.4 million by an average stockholders' equity of $218.8 million. As a result of the significant increase in stockholders' equity from our offering and over-allotment exercise in the first quarter, average common stockholders' equity for the six months ended June 30, 2007 was calculated using a quarterly average for the six months ended June 30, 2007. For the six months ended June 30, 2006, the return was calculated by dividing annualized net income of $37.6 million by an average stockholders' equity of $152.4 million. 22 Insurance Segment Results of Operations
Three Months Ended Six Months Ended June 30, June 30, ------------------------------------------------- 2007 2006 2007 2006 ------------------------------------------------- ($ in thousands) Revenues Premiums earned Gross premiums earned $ 128,961 $ 82,234 $ 234,921 $ 158,156 Less: ceded premiums earned (56,576) (36,263) (104,786) (55,596) ------------------------------------------------- Net premiums earned 72,385 45,971 130,135 102,560 Ceding commission revenue 17,034 10,077 31,268 17,379 Policy billing fees 543 272 845 539 ------------------------------------------------- Total 89,962 56,320 162,248 120,478 Expenses Loss and loss adjustment expenses Gross loss and loss adjustment expenses 66,391 45,577 122,268 88,493 Less: ceded loss and loss adjustment expenses (26,176) (17,368) (49,583) (27,451) ------------------------------------------------- Net loss and loss adjustment expenses 40,215 28,209 72,685 61,042 Underwriting expenses Direct commission expense 21,071 13,915 38,755 26,240 Other underwriting expenses 18,089 10,261 31,656 21,335 ------------------------------------------------- Total underwriting expenses 39,160 24,176 70,411 47,575 ------------------------------------------------- Underwriting Profit $ 10,587 $ 3,935 $ 19,152 $ 11,861 ================================================= Key Measures Premiums written Gross premiums written $ 148,605 $ 107,825 $ 259,499 $ 191,256 Less: ceded premiums written (79,150) (78,941) (141,995) (83,436) ------------------------------------------------- Net premiums written $ 69,455 $ 28,884 $ 117,504 $ 107,820 ================================================= Loss Ratios Gross 51.5% 55.4% 52.0% 56.0% Net 55.6% 61.4% 55.9% 59.5% Accident Year Loss Ratio Gross 51.6% 55.0% 52.2% 56.2% Net 54.3% 58.2% 55.0% 58.6% Underwriting Expense Ratios Gross 29.9% 29.1% 29.6% 29.7% Net 29.8% 30.1% 29.4% 28.9% Combined Ratios Gross 81.4% 84.5% 81.6% 85.7% Net 85.4% 91.5% 85.3% 88.4%
Insurance Segment Results of Operations Three Months Ended June 30, 2007 and 2006 Gross premiums. Gross premiums written increased by 37.8% to $148.6 million for the three months ended June 30, 2007 compared to $107.8 million for the same period in 2006. Gross premiums earned increased by 56.8% to $129.0 million for the three months ended June 30, 2007 compared to $82.2 million for the same period in 2006. The acquisition of Preserver on April 10, 2007 added $19.0 million and $19.1 million to the increase in gross premiums written and earned, respectively. The remaining increase resulted from organic growth in our homeowners, commercial multi-peril and other liability lines of business. Policies in force, before the effect of the Preserver acquisition, increased by 17.5% as of June 30, 2007 compared to June 30, 2006. Preserver's policies in force decreased by 2.0% as of June 30, 2007 compared to June 30, 2006. Additionally, during the second quarter of 2007, premium increases on renewed business before the effects of the Preserver acquisition averaged 12.5% in personal lines and 0.9% in commercial lines. Premium increases on renewed business for Preserver during the quarter averaged 2.1% in personal lines and 2.0% in commercial lines. The retention rate, before excluding the effects of the Preserver acquisition, was 91% for personal lines and 80% for commercial lines. The Preserver retention rate was 73% in personal lines and 79% in commercial lines. Gross premiums earned increased 56.8% as a result of the increase in gross premiums written and premiums earned by Preserver. 23 Ceded premiums. Ceded premiums written increased by 0.3% to $79.2 million for the three months ended June 30, 2007 compared to $78.9 million for the same period in 2006. During the second quarter of 2007 we ceded $69.6 million of quota share reinsurance to CastlePoint of which $8.8 million was ceded by the Preserver insurance companies. Separately, under our excess of loss and property catastrophe reinsurance programs, $1.7 million and $0.4 million of premiums were ceded to CastlePoint, for the three months ended June 30, 2007 and 2006, respectively. Additionally, effective April 1, 2007, under the brokerage business quota share agreement CastlePoint paid us $1.6 million, which represented a 30% share of our catastrophe reinsurance costs. Overall, catastrophe ceded premiums were $3.9 million in the second quarter of 2007 as compared to $1.3 million in the second quarter of last year. In April 2006, we entered into three multi-year quota share reinsurance agreements with CastlePoint Reinsurance. As of April 1, 2007, CPIC was added as a reinsurer under one of these reinsurance agreements. Since we did not place quota share reinsurance in the first quarter of 2006, pending the formation of CastlePoint, ceded premiums written were increased for the three months ended June 30, 2006 and we ceded $70.9 million of premiums to CastlePoint Reinsurance including $40.9 million of unearned premiums as of April 1, 2006. Quota share cessions reflected a 49% quota share ceding percentage in 2007 as compared to 30% in 2006. Ceded premiums earned increased 56.0% during the three months ending June 30, 2007 as compared to the same period last year as a result of the increase in gross premiums earned and the aforementioned changes in quota share ceding percentages and higher catastrophe premiums. Net premiums. Net premiums written increased by 140.5% to $69.5 million for the three months ended June 30, 2007 compared to $28.9 million for the same period in 2006. This increase resulted from the $40.9 million cession of unearned premiums to CastlePoint Reinsurance in the second quarter of 2006, as discussed above. The effect of this cession reduced the amount of net premiums written in that period. We did not pool any business in the second quarter of 2007. Accordingly, we maintained a 49% quota share ceding percentage consistent with our hybrid business model as compared to 30% in the same period in 2006. The increased percentage of ceded premiums reduced net premiums written during the quarter. Net premiums earned increased by 57.5% to $72.4 million in the three months ended June 30, 2007 compared to $46.0 million in the same period in 2006 driven primarily by the increase in gross premiums earned offset, in part, by the increase in the quota share ceding percentage to 49% in 2007 from 30% in 2006. Both net premiums written and earned were affected by the increase in catastrophe premiums. Ceding commission revenue. Ceding commission revenue increased by 69.0% to $17.0 million for the three months ended June 30, 2007 compared to $10.1 million for the same period in 2006 largely due to the 56.0% increase in ceded premiums earned offset, in part, by a lower quota share ceding commission rate of 34.5% as compared to a ceding commission rate of 39.1% in 2006. Also, as a result of the commutation agreements with PXRE, we recorded a charge of $3.2 million to ceding commission revenue in the second quarter of 2006. Ceding commission revenue increased by $0.4 million in 2006 as a result of a decrease in the ceded loss ratios on prior years' quota share treaties in the second quarter of 2006. Loss and loss adjustment expenses and loss ratio. Gross and net loss and loss adjustment expenses were $66.4 million and $40.2 million, respectively, for the three months ended June 30, 2007 compared with $45.6 million and $28.2 million, respectively, for the same period in 2006. Our gross loss ratio was 51.5% for the three months ended June 30, 2007 as compared with 55.4% for the same period in 2006. The net loss ratio was 55.6% for the three months ended June 30, 2007 compared to 61.4% in the same period of 2006. The acquisition of Preserver added 1.3 percentage points to the gross loss ratio and reduced the net loss ratio by 1.0 percentage points for the three months ended June 30, 2007. For the second quarter of 2006, the net loss ratio for the combined segments reflected a $1.6 million charge resulting from the commutation agreements with PXRE that added 3.5 percentage points to the net loss ratio for the Insurance Segment for the three months ended June 30, 2006. The decrease in the net loss ratio in the second quarter of 2007 compared to the same period in 2006, excluding the impact of PXRE, was due to a decrease in the gross loss ratio resulting from the continuing effects of strong premium increases in personal lines and moderate premium increases in commercial lines. However the effect on the net loss ratio was offset in part by higher ceded catastrophe premiums. We ceded catastrophe reinsurance premiums equal to 5.1% of net premiums earned during the three months ended June 30, 2007 as compared to 2.8% in the same period in 2006. There was unfavorable development of $0.9 million on a net basis in the second quarter of 2007 compared to favorable development of $0.2 million on prior years' net loss reserves in the same period of 2006 excluding $1.6 million of losses incurred as a result of the commutation with PXRE. The 2007 accident year loss ratio for the Preserver book of business was comparable to Tower's. Loss and loss adjustment expenses are net of reimbursements for loss and loss adjustment expenses made by TRM pursuant to the expense sharing between TICNY and TRM. See "Insurance Services Segment Results of Operations" for the amounts of loss and loss adjustment expense reimbursements. 24 Underwriting expenses and underwriting expense ratio. Underwriting expenses, which include direct commission expenses and other underwriting expenses, were $39.2 million for the three months ended June 30, 2007 as compared with $24.2 million for the same period in 2006. Our gross expense ratio was 29.9% for the three months ended June 30, 2007 as compared with 29.1% for the same period in 2006. The acquisition of Preserver added 1.0 percentage points to the gross expense ratio for the three months ended June 30, 2007. 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 three months ended June 30, 2007, compared to 16.9% for the same period in 2006. The acquisition of Preserver added 0.2 percentage points to the commission portion of the gross expense ratio. The lower ratio was attributable primarily to an increase in the number of retail producers including relationships that began with the OneBeacon renewal rights transaction in September 2004, as well as growth in our workers' compensation and commercial auto lines which carry lower commission rates than other lines of business. The underwriting expense portion of the gross expense ratio was 13.6% for the three months ended June 30, 2007 as compared to 12.2% for the same period in 2006. The increase in costs is partially related to the acquisition of Preserver. Gross expenses also increased due to facilities and staff related costs. The acquisition of Preserver added 0.8 percentage points to the gross underwriting expense ratio for the three months ended June 30, 2007. The net underwriting expense ratio, which reflects the benefit of ceding commission revenue that lowers the gross expense ratio, was 29.8% for the three months ended June 30, 2007 as compared to 30.1% for the same period in 2006. The acquisition of Preserver added 2.4 percentage points to the net underwriting expense ratio for the three months ended June 30, 2007. Underwriting profit and combined ratio. The underwriting profit, which reflects our underwriting results on a net basis after the effects of reinsurance, was $10.6 million in the second quarter of 2007 and $3.9 million in the same period in 2006. Preserver's contribution to underwriting profit was $1.7 million in the second quarter of 2007. The gross combined ratio was 81.4% for the three months ended June 30, 2007 as compared with 84.5% for the same period in 2006. The decrease in the gross combined ratio in the second quarter of 2007 resulted primarily from a decrease in the gross loss ratio. The net combined ratio was 85.4% for the three months ended June 30, 2007 as compared to 91.5% for the same period in 2006. The net combined ratio for 2006 was increased by 10.6% due to the effects of the commutation with PXRE, but the net combined ratio in the second quarter of 2006 also benefited from the significant increase in ceded premiums earned and the resulting significant increase in ceding commission revenue which lowered the net expense ratio to 23% excluding the effects of the PXRE commutation. The acquisition of Preserver added 2.3 and 1.4 percentage points to the gross and net combined ratios, respectively. Insurance Segment Results of Operations Six Months Ended June 30, 2007 and 2006 Gross premiums. Gross premiums written increased by 35.7% to $259.5 million for the six months ended June 30, 2007 compared to $191.3 million for the same period in 2006. Gross premiums earned increased by 48.5% to $234.9 million for the six months ended June 30, 2007 compared to $158.2 million for the same period in 2006. The acquisition of Preserver on April 10, 2007 added $19.0 million and $19.1 million in gross premiums written and earned, respectively. The remaining increase resulted from organic growth in our homeowners, commercial multi-peril and other liability lines of business. Policies in force, before the impact of the Preserver acquisition, increased by 17.5% as of June 30, 2007 compared to June 30, 2006. Preserver's policies in force decreased by 2.0% as of June 30, 2007 compared to June 30, 2006. Additionally, during the six months ended June 30, 2007, premium increases on renewed business before the effects of the Preserver acquisition averaged 12.0% in personal lines and 0.8% in commercial lines. Premium increases on renewed business for Preserver averaged 1.0% in personal lines and 1.2% in commercial lines. The retention rate, before the effects of the Preserver acquisition, was 89% for personal lines and 79% for commercial lines. The Preserver retention rate was 70% for personal lines and 79% for commercial lines. Gross premiums earned increased 48.5% resulting from the increase in gross premiums written and premiums earned by Preserver. 25 Ceded premiums. Ceded premiums written increased by 70.2% to $142.0 million for the six months ended June 30, 2007 compared to $83.4 million for the same period in 2006. During the six months ended June 30, 2007 we ceded $120.7 million of quota share reinsurance to CastlePoint, of which $8.8 million was ceded by the Preserver insurance companies. Separately, under our excess of loss and property catastrophe reinsurance programs, $2.9 million and $0.4 million of premiums were ceded to CastlePoint, for the three months ended June 30, 2007 and 2006, respectively. Additionally, effective April 1, 2007, under the brokerage business quota share agreement CastlePoint paid us $1.6 million, which represented a 30% share of our catastrophe reinsurance costs. Overall, catastrophe ceded premiums were $7.3 million in the six months ended June 30, 2007 as compared to $2.5 million in the same period in 2006. In April 2006, we entered into three multi-year quota share reinsurance agreements with CastlePoint Reinsurance. As of April 1, 2007, CPIC was added as a reinsurer under one of these reinsurance agreements. Since we did not place quota share reinsurance in the first quarter of 2006, pending the formation of CastlePoint, for the three months ended June 30, 2006, we ceded $70.9 million of premiums written to CastlePoint Reinsurance including $40.9 million of unearned premiums as of April 1, 2006. Quota share cessions reflected a 49% quota share ceding percentage in 2007 as compared to 30% in 2006. Ceded premiums earned increased 88.5% during the six months ending June 30, 2007 as compared to the same period last year. This was due primarily to the 70.2% increase in ceded premiums written in 2007 and slightly lower ceded premiums earned in 2006 since we did not cede any premiums in the first quarter of 2006. Net premiums. Net premiums written increased by 9.0% to $117.5 million for the six months ended June 30, 2007 compared to $107.8 million for the same period in 2006. This increase was less than the 35.7% increase in gross premiums written as a result of the increased quota share ceding percentage mentioned above. We did not pool any business in the first six months of 2007. Accordingly, we maintained a 49% quota share ceding percentage consistent with our hybrid business model as compared to 30% in the second quarter of 2006. Net premiums earned increased by 26.9% to $130.1 million in the six months ended June 30, 2007 compared to $102.6 million in the same period in 2006. The growth was driven primarily by the increase in gross premiums earned offset, in part, by the increase in the quota share ceding percentage to 49% in 2007 from 30% in 2006. Ceding commission revenue. Ceding commission revenue increased by 79.9% to $31.3 million for the six months ended June 30, 2007 compared to $17.4 million for the same period in 2006 largely due to the 88.5% increase in ceded premiums earned offset, in part, by a lower quota share ceding commission rate of 34.3% as compared to a ceding commission rate of 40.1% in 2006. Also, as a result of the commutation agreements with PXRE, we recorded a charge of $3.2 million to ceding commission revenue in 2006. Ceding commission revenue increased by $3,000 and $0.8 million in 2007 and 2006 as a result of an improvement in the ceded loss ratios on prior years' quota share treaties. Loss and loss adjustment expenses and loss ratio. Gross and net losses and loss adjustment expenses were $122.3 million and $72.7 million, respectively, for the six months ended June 30, 2007 compared with $88.5 million and $61.0 million, respectively, for the same period in 2006. Our gross loss ratio was 52.0% for the six months ended June 30, 2007 as compared with 56.0% for the same period in 2006. Our net loss ratio was 55.9% for the six months ended June 30, 2007 as compared with 59.5% for the same period in 2006. For the six months ended June 30, 2006, the net loss ratio for the combined segments reflected a $1.6 million charge resulting from the commutation agreements with PXRE that added 1.5 percentage points to the net loss ratio for the Insurance Segment for the three months ended June 30, 2006. The acquisition of Preserver added 0.6 percentage points to the gross loss ratio and reduced the net loss ratio by 0.5 percentage points for the six months ended June 30, 2007. The decrease in the net loss ratio in the six months ended June 30, 2007 compared to the same period in 2006 was due to a decrease in the gross loss ratio. However, the effect of the decrease on the net loss ratio was offset in part by higher ceded catastrophe premiums. We ceded catastrophe reinsurance premiums equal to 5.3% of premiums earned during the six months ended June 30, 2007 as compared to 2.4% in the same period in 2006. There was unfavorable development of $1.1 million on a net basis in the six months ended June 30, 2007 compared to favorable development of $0.4 million on prior years' net loss reserves in the same period of 2006 excluding the $1.6 million of losses incurred as a result of the commutation with PXRE. 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. 26 Underwriting expenses and underwriting expense ratio. Underwriting expenses, which include direct commission expenses and other underwriting expenses, were $70.4 million for the six months ended June 30, 2007 as compared with $47.6 million for the same period in 2006. Our gross expense ratio was 29.6% for the six months ended June 30, 2007 as compared with 29.7% for the same period in 2006. The acquisition of Preserver added 0.5 percentage points to the gross expense ratio for the six months ended June 30, 2007. 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 16.5% for the six months ended June 30, 2007, compared to 16.6% for the same period in 2006. The acquisition of Preserver added 0.1 percentage points to the commission portion of the gross expense ratio. The underwriting expense portion of the gross expense ratio was 13.1% for the six months ended June 30, 2007 as compared to 13.2% for the same period in 2006. Although underwriting expenses increased due to the growth in premium volume, the gross underwriting expense ratio excluding the effects of Preserver declined as gross premiums earned increased more rapidly than underwriting expenses. The acquisition of Preserver added 0.4 percentage points to the gross underwriting expense ratio for the six months ended June 30, 2007. The net underwriting expense ratio was 29.4% for the six months ended June 30, 2007 as compared to 28.9% for the same period in 2006. The acquisition of Preserver added 1.2 percentage points to the net underwriting expense ratio for the six months ended June 30, 2007. The net expense ratio for 2006 was affected by the reduction in ceding commissions of $3.2 million resulting from the commutations with PXRE which added 3.1 percentage points to the net expense ratio. Although ceding commission revenue in the first six months of 2007 increased 79.9% as compared to the same period last year the ceding commission rate was lower this quarter than in 2006. The increase in net premiums earned of 26.9% was affected by higher catastrophe ceded premiums. Together these factors reduced the benefit of ceding commission revenue on the net 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 $19.2 million in the first six months of 2007 and $11.9 million in the same period in 2006. The gross combined ratio was 81.6% for the six months ended June 30, 2007 as compared with 85.7% for the same period in 2006. The decrease in the gross combined ratio in the first six months of 2006 resulted primarily from a decrease in the gross loss ratio. The net combined ratio was 85.3% for the six months ended June 30, 2007 as compared to 88.4% for the same period in 2006. Preserver's contribution to underwriting profit was $1.7 million in the six months ended June 30, 2007. The decrease in the net combined ratio resulted from a decrease in the net loss ratio. The effects of the commutations reduced underwriting profits in 2006 by $4.8 million and added 4.6 percentage points to the net combined ratio. The acquisition of Preserver added 1.1 and 0.7 percentage to the gross and net combined ratios, respectively. Reinsurance Segment Results of Operations
Three Months Ended Six Months Ended June 30, June 30, --------------------------------------------- 2007 2006 2007 2006 --------------------------------------------- ($ in thousands) Revenues Premiums earned Gross premiums earned $ 1,660 $ 13,334 $ 4,327 $ 14,028 Less: ceded premiums earned (10) (18) (44) (45) --------------------------------------------- Net premiums earned 1,650 13,316 4,283 13,983 Ceded commission revenue (2) - (2) - --------------------------------------------- Total 1,648 13,316 4,281 13,983 Expenses Loss and loss adjustment expenses Gross loss and loss adjustment expenses 435 12,985 1,900 13,381 Ceded loss and loss adjustment expenses (39) 231 (64) 212 --------------------------------------------- Net loss and loss adjustment expenses 396 13,216 1,836 13,593 Underwriting expenses Ceding commission expense 592 618 1,537 770 Other underwriting expenses 220 248 561 349 --------------------------------------------- Total underwriting expenses 812 866 2,098 1,119 --------------------------------------------- Underwriting (Loss) Profit $ 440 $ (766) $ 347 $ (729) ============================================= Key Measures Premiums written Gross premiums written $ 231 $ 16,589 $ 217 $ 20,531 Less: ceded premiums written (2) - (5) - --------------------------------------------- Net premiums written $ 229 $ 16,589 $ 212 $ 20,531 ============================================= Loss Ratios Gross 26.2% 97.4% 43.9% 95.4% Net 24.0% 99.2% 42.9% 97.2% Accident Year Loss Ratios Gross 78.3% 99.5% 67.7% 97.6% Net 78.8% 99.5% 68.4% 97.6% Underwriting Expense Ratios Gross 48.9% 6.5% 48.5% 8.0% Net 49.3% 6.5% 49.0% 8.0% Combined Ratios Gross 75.1% 103.9% 92.4% 103.4% Net 73.3% 105.8% 91.9% 105.2%
27 Reinsurance Segment Results of Operations Three Months Ended June 30, 2007 and 2006 Gross premiums. Gross premiums written decreased to $0.2 million for the three months ended June 30, 2007 and represents endorsements and other additional premiums on policies assumed in 2006 and produced by TRM as compared to $16.6 million for the same period in 2006. Gross premiums written of $16.6 million in the three months ended June 30, 2006 included $11.4 million dollars of gross premium written and earned which resulted from novation agreements with PXRE and $5.2 million of premiums produced by TRM. We have not produced any policies in TRM in 2007 as such business was written by TICNY in our Insurance Segment. Novation transactions are recorded by including the consideration as premiums written and earned and the liabilities assumed as losses incurred. Gross premiums earned decreased to $1.7 million from $13.3 million in the second quarter of 2006 due to the novation agreements with PXRE. Net premiums. The variances for net premiums are the same as for gross premiums. Loss and loss adjustment expenses and loss ratio. Gross loss and loss adjustment expenses were $0.4 million for the three months ended June 30, 2007 as compared to $13.0 million for the same period in 2006. Net losses were $0.4 million for the three months ended June 30, 2006 as compared to $13.2 million for the same period in 2006. The gross and net loss ratios were 26.2% and 24.0%, respectively for the three months ended June 30, 2007 as compared to 97.4% and 99.2%, respectively, in the same period in 2006. The effects of the novation agreements added 56.7 percentage points and 45.9 percentage points to the gross and net loss ratios for the second quarter of 2006, respectively. There was favorable development of $0.9 million on a net basis on prior years' net reserves in the second quarter of 2007 mostly due to favorable run-of of the PXRE novation. This compares to favorable development of $34,000 on prior years' net loss reserves in the same period of 2006. 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 deceased for the three months ended June 30, 2007 to $0.8 million compared to $0.9 in the same period in 2006. The gross and net underwriting expense ratios were 48.9% and 49.3% for the three months ended June 30, 2007 compared to 6.5%, respectively, for the same period in 2006. The lower gross and net underwriting expense ratios in 2006 were the direct result of the $11.4 million of additional gross and net premiums earned from the PXRE novation which did not incur a commission expense. The effects of the PXRE novation reduced the gross and net underwriting expense ratios by 39.2 percentage points and 39.6 percentage points, respectively. Underwriting profit and combined ratio. The underwriting profit from assumed reinsurance for the second quarter of 2007 was $0.4 million compared to an underwriting loss from assumed reinsurance of $0.8 million for the second quarter of 2006 which included a charge of $0.8 million resulting from the novation agreements with PXRE. The net combined ratio was 73.3% for the second quarter of 2007 compared to 105.8% for the second quarter of 2006. The higher net combined ratio for the second quarter of 2006 was due to both the charge resulting from the novation agreements with PXRE and the favorable loss development in 2007. The novation agreements from PXRE added 6.2 percentage points to the 2006 net combined ratio. 28 The gross combined ratio decreased to 75.1% in the second quarter of 2007 compared to 103.9% in the same period last year due to an increase in the gross loss ratio to the novation agreements with PXRE and the favorable loss development in 2007 as discussed above. The effect of the novation agreements with PXRE added 17.5 percentage points and 6.2 percentage points to the gross and net combined ratios in the second quarter of 2006. Reinsurance Segment Results of Operations Six Months Ended June 30, 2007 and 2006 Gross premiums. Gross premiums written decreased to $0.2 million for the six months ended June 30, 2007 as compared to $20.5 million for the same period in 2006. In addition to the premiums produced by TRM in the second quarter of 2006, we entered into novation agreements with PXRE which increased gross premiums written and earned by $11.4 million. Gross premiums earned decreased to $4.3 million for the six months ended June 30, 2007 from $14.0 million in the six months ended June 30, 2006 due to the significant increase in gross premiums written and the novation agreements with PXRE in 2006. Net premiums. Net premiums written decreased to $0.2 million for the six months ended June 30, 2007 as compared to $20.5 million for the same period in 2006. The decrease in net premiums written was due to an decrease in gross premiums as discussed above. Loss and loss adjustment expenses and loss ratio. Gross loss and loss adjustment expenses were $1.9 million for the six months ended June 30, 2007 as compared to $13.4 million for the same period in 2006. Net losses were $1.8 million for the six months ended June 30, 2007 as compared to $13.6 million for the same period in 2006. Both gross and net losses for the six months ended June 30, 2006 were increased by $12.2 million as a result of the novation agreements with PXRE. The gross and net loss ratios were 43.9% and 42.9%, respectively for the six months ended June 30, 2007 as compared to 95.4% and 97.2%, respectively in the same period in 2006. The effect of the novation agreements added 50.3 percentage points and 43.0 percentage points to the gross and net loss ratio, respectively, for the six months ending June 30, 2006. There was favorable development of $1.1 million on a net basis on prior years' net reserves for the six months ended June 30, 2007 mostly due to favorable run-of of the PXRE novation. This compares to favorable development of $58,000 on prior years' net loss reserves in the same period of 2006. Underwriting expenses and underwriting expense ratio. Gross underwriting expenses increased for the six months ended June 30, 2007 to $2.1 million as compared to $1.1 million for the same period in 2006. The gross and net underwriting expense ratios were 48.5% and 49.0%, respectively, for the six months ended June 30, 2007 compared to 8.0% and 8.0%, respectively, for the same period last year. The lower gross and net underwriting expense ratios in 2006 were the direct result of the $11.4 million of additional gross and net premiums earned from the PXRE novation which did not incur a commission expense. The effects of the PXRE novation reduced the gross and net underwriting expense ratios by 35.3 percentage points and 36.0 percentage points, respectively, for the six months ended June 30, 2006. Underwriting profit and combined ratio. The underwriting profit from assumed reinsurance for the six months ended June 30, 2007 was $0.3 million compared to underwriting loss of $0.7 million for the same period of 2006 which includes the charge of $0.8 million resulting from the novation agreements with PXRE. The net combined ratio was 91.9% for the six months ended June 30, 2007 compared to 105.2% for the same period of 2006. The lower net combined ratio for the first six months of 2007 was the result of the decreased net loss ratio offset by the increase in the net underwriting expense ratio as explained above. The gross combined ratio decreased to 92.4% for the six months ended June 30, 2007 compared to 103.4% for the same period of 2006 due to the decrease in the gross loss ratio offset by an increase in the gross underwriting expense ratio as explained above. The effects of the novation agreements added 15.1 percentage points and 7.0 percentage points to the gross and net combined ratios for the six months ended June 30, 2006. 29 Insurance Services Segment Results of Operations
Three Months Ended Six Months Ended June 30, June 30, ------------------------ ----------------------- 2007 2006 2007 2006 ------------ ----------- ----------- ----------- ($ in thousands) Revenues Direct commission revenue from managing general agency $ 572 $ 1,105 $ 1,060 $ 1,911 Claims administration revenue 535 922 1,100 1,884 Other administrative revenue (1) 347 - 598 - Reinsurance intermediary fees(2) 185 174 341 235 Policy billing fees - 2 - 5 ------------ ----------- ----------- ----------- Total Revenues 1,639 2,203 3,099 4,035 Expenses Direct commissions expense paid to producers 144 731 151 1,334 Other insurance services expenses(3) 358 305 615 542 Claims expense reimbursement to TICNY 533 911 1,098 1,869 ------------ ----------- ----------- ----------- Total Expenses 1,035 1,947 1,864 3,745 ------------ ----------- ----------- ----------- Insurance Services Pre-tax Income $ 604 $ 256 $ 1,235 $ 290 ============ =========== =========== =========== Premium produced by TRM on behalf of issuing companies $ 716 $ 4,834 $ 661 $ 8,862 ============ =========== =========== ===========
(1)The other administration revenue includes amounts reimbursed by CastlePoint Reinsurance for services rendered pursuant to a service and expense sharing agreement. (2)The reinsurance intermediary fees include commissions earned for placement of reinsurance on behalf of TICNY and TNIC. (3)Consists of underwriting expenses reimbursed to TICNY pursuant to an expense sharing agreement and to CastlePoint Reinsurance pursuant to a service and expense sharing agreement. Insurance Services Segment Results of Operations Three Months Ended June 30, 2007 and 2006 Total revenues. Total revenues for the insurance services segment were $1.6 million for the three months ended June 30, 2007 as compared with $2.2 million for the same period in 2006. The principal components of total revenues for our insurance services segment are direct commission revenue, claims administration revenue, other administration revenue and reinsurance intermediary fees. The decrease in total revenues was primarily due to direct commission revenue that decreased by 48.2 % to $572,000 for the second quarter of 2007 compared to $1.1 million for the second quarter of 2006. Claims administration revenues decreased to $535,000 in the second quarter of 2007 compared to $922,000 in the same period of last year as a result of fewer hours associated with claims handled on behalf of issuing carriers. Reinsurance intermediary fees increased by 6.3% to $185,000 for the second quarter of 2007 as compared to $174,000 for the second quarter of 2006 from increased reinsurance premiums. Other administrative revenue was $347,000 for the second quarter of 2007 and includes reimbursements from CastlePoint per our service and expense sharing agreement to provide underwriting, claims, legal and other corporate services, such as human resources and information technology. Direct commission revenue is dependent upon the premiums and losses on business produced by TRM on behalf of its issuing companies. For the second quarter of 2007 direct commission revenues decreased by 48.2% to $572,000 compared to $1.1 million for the second quarter of 2006 as a result of our decision to renew policies in our Insurance Segment that were previously produced in the Insurance Services Segment. Premiums produced by TRM decreased by 85.2% to $716,000 in the second quarter of 2007 as compared to $4.8 million of premiums produced in the same period last year. During the second quarter TRM produced $480,000 of premium for CastlePoint Insurance Company. In addition there was an increase in commission revenue of $520,000 in the second quarter of 2007 as a result of favorable loss development on the premiums produced in prior years compared to an increase of $136,000 in the same period of last year. Direct commission expense. TRM's direct commission expense rate was 20.1% for the second quarter of 2007 compared to 15.1% for the second quarter of 2006. The direct commission expense rate increased in 2007 as a result of producing a larger proportion of the business through wholesale agents which carry a higher commission rate. In 2006 the direct commission expense rate was lower as a larger proportion of policies with larger premiums had lower commission rates. 30 Other insurance services expenses. The amount of reimbursement for underwriting expenses by TRM to TICNY in the second quarter of 2007 was $358,000 as compared to $305,000 in the second quarter of 2006. 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 second quarter of 2007 was $533,000 as compared to $911,000 in the second quarter of 2006 due to a decrease in the number of claims handled. Pre-tax income. Pre-tax income in the second quarter of 2007 increased by 135.9% to $604,000 as compared to $256,000 in the second quarter of 2006. The increase was due to the favorable adjustment in direct commission revenue and increases in other administration revenue as explained above, offset by the decrease in premiums produced in the three months ended June 30, 2007 as compared to the same period last year. Insurance Services Segment Results of Operations Six Months Ended June 30, 2007 and 2006 Total revenues. Total revenues for the insurance services segment were $3.1 million for the six months ended June 30, 2007 as compared with $4.0 million for the same period in 2006. The principal components of total revenues for our insurance services segment are direct commission revenue, claims administration revenue, other administration revenue and reinsurance intermediary fees. The decrease in total revenues was primarily due to direct commission revenue that decreased by 44.5 % to $1.1 million for the six months ending June 30, 2007 compared to $1.9 million for the same period last year. Claims administration revenues decreased to $1.1 million for the six months ending June 30, 2007 compared to $1.9 million in the same period of last year as a result of fewer hours associated with claims handled on behalf of issuing carriers. Reinsurance intermediary fees revenue increased by 45.1% to $341,000 for the six months ending June 30, 2007 as compared to $235,000 for the same period last year from increased reinsurance premiums. Other administrative revenue was $598,000 for the six months ended June 30, 2007 and includes reimbursements from CastlePoint per our service and expense sharing agreement that we entered into in 2006 to provide underwriting, claims, legal and other corporate services, such as human resources and information technology. For the first six months of 2007, direct commission revenues decreased as compared to last year as a result of the 92.5% decrease in premiums produced by TRM to $661,000 from $8.9 million as more policies were renewed in the Insurance Segment. In addition there was an increase in commission revenue of $1.1 million the six months ended June 30, 2007 as a result of favorable loss development on the premiums produced in prior years compared to a reduction of commission income of $0.2 million resulting from unfavorable loss development on premiums produced in prior periods for the six months ended June 30, 2006. Direct commission expense. TRM's direct commission expense rate was 22.8% for the first six months of 2007 compared to 15.1% for the same period last year. The direct commission expense rate increased in 2007 as a result of producing a larger proportion of the business through wholesale agents which carry a higher commission rate. In 2006 the direct commission expense rate was lower as a larger proportion of policies with larger premiums had lower commission rates. Other insurance services expenses. The amount of reimbursement for underwriting expenses by TRM to TICNY in the first six months of 2007 was $615,000 as compared to $542,000 in the same period last year. 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 six months of 2007 was $1.1 million as compared to $1.9 million in the same period last year due to a decrease in the number of claims handled. Pre-tax income. Pre-tax income in the first six months of 2007 increased by 325.9% to $1.2 million as compared to $290,000 in the same period last year. The increase was due to the favorable adjustment in direct commission revenue and increases in other administration revenue as explained above, offset by the decrease in premiums produced in the six months ended June 30, 2007 as compared to the same period last year. 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 $101.0 million of subordinated debentures. Cash and cash equivalents at June 30, 2007 were $65.0 million as compared to $100.6 million at December 31, 2006. Cash equivalents increased in December 2006 as a result of raising $48 million through the issuance of $40 million of perpetual preferred stock and $8 million from the sale of Tower Indemnity Company of America. At the time we raised these funds the yield curve was relatively flat. At December 31, 2006, we had $65 million of cash equivalents invested in agency backed discount notes and commercial paper that had interest yields between 5.14% and 5.25%. Our belief then was that longer term interest rates would rise in 2007. Cash and cash equivalents at June 30, 2007 include $10 million from the acquisition of Preserver and $25 million of corporate funds which remain from the follow-on offering after paying for the Preserver acquisition. 31 During the second quarter of 2007, interest rates rose and increased the gross unrealized investment loss by $11.7 million and $11.1 million for the three month and six month ending June 30, 2007, as reflected in other comprehensive income. Changes in interest rates directly impact the fair value for our fixed maturity portfolio. We regularly review both our fixed-maturity and equity portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. We have determined that we did not hold any investments that would have been considered other than temporarily impaired and that the recent increase in the gross unrealized investment loss was caused by an increase in interest rates. We expect cash flows from operations to be sufficient to meet our liquidity requirements. We intend, and we believe we have the ability, to hold these investments until a recovery in value, which may be at maturity. For the three and six months ended June 30, 2007, net cash provided by operating activities was $9.6 million and $29.9 million, respectively. Net cash provided by operations was $47.8 million and $86.6 million, respectively for the same period in 2006. The decrease in cash flow for 2007 was a result of federal income tax payments of $14.1 million and $15.2 million for the three months and six months ended June 30, 2007. The net cash provided by operating activities for 2006 included $37.0 million received from PXRE which resulted from the commutation and novation transactions. The remaining increase in net cash provided by operations for the three months and six months ended June 30, 2006 resulted primarily from an increase in collected premiums as a result of the growth in gross premiums written partially offset by the partial payment of $20.2 million for ceded unearned premiums and the quota share reinsurance ceded to CastlePoint Reinsurance Company. The net cash flows used in investing activities for the three months ended June 30, 2007 was $109.8 million and $151.8 million, respectively. The three months and six months ended June 30, 2007 included the acquisition of Preserver Group, Inc. for $66.2 million. The net cash flows provided by financing activity for the three months ended June 30, 2007 was $1.3 million. The net cash flow provided by financial activity for the six months ended June 30, 2007 was $69.7 million and included the net proceeds from the issuance of $20.6 million in subordinated debentures on January 25, 2007, the $89.4 million of net proceeds from the January 26, 2007 equity offering and the related exercise of the underwriters' over-allotment option. For the three months and six months ended June 30, 2006, we had $0.9 million and $20.5 million, respectively, of net cash flows provided by financing activities. 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. Our insurance companies are subject to significant regulatory restrictions limiting their ability to declare and pay dividends. As of June 30, 2007, the maximum amount of distributions that our insurance companies could pay to its parent without approval of their domiciliary Insurance Department was approximately $22.4 million. Subordinated Debentures On January 25, 2007, 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 VI (the "Trust"), an affiliated Delaware trust formed on January 11, 2007. 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 8.155% for the first five years and will then reset quarterly for changes in the three-month London Interbank Offered Rate ("LIBOR") plus 300 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 2037 issued by us. We do not consolidate interest in statutory business trusts for which we hold 100% of the common trust securities because we are not the primary beneficiary of the trusts. We report the outstanding subordinated debentures owed to the statutory business trusts as a liability. The net proceeds we received from the sale of the debenture to the Trust and $20.0 million of the net proceeds from our common stock offering in the three months ended March 31, 2007 were used to redeem our perpetual preferred stock. We incurred $0.4 million of fees related to the issuance of these subordinated debentures. 32 Investments 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 June 30, 2007, 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. We determined that we did not hold any investments that would have been considered other than temporarily impaired. Item 3. Quantitative and Qualitative Disclosures About Market Risk Market risk relates to changes in the value of financial instruments that arise from adverse movements in factors such as interest rates and equity prices. We are exposed mainly to changes in interest rates that affect the fair value of our investments in securities. Sensitivity Analysis Sensitivity analysis is a measurement of potential loss in future earnings, fair values or cash flows of market sensitive instruments resulting from one or more selected hypothetical changes in interest rates and other market rates or prices over a selected time. In our sensitivity analysis model, we select a hypothetical change in market rates that reflects what we believe are reasonably possible near-term changes in those rates. The term "near-term" means a period of time going forward up to one year from the date of the consolidated financial statements. Actual results may differ from the hypothetical change in market rates assumed in this disclosure, especially since this sensitivity analysis does not reflect the results of any action that we may take to mitigate such hypothetical changes in fair value. In this sensitivity analysis model, we use fair values to measure our potential loss. The sensitivity analysis model includes fixed maturities and short-term investments. For invested assets, we use modified duration modeling to calculate changes in fair values. Durations on invested assets are adjusted for call, put and interest rate reset features. Durations on tax-exempt securities are adjusted for the fact that the yield on such securities is less sensitive to changes in interest rates compared to Treasury securities. Invested asset portfolio durations are calculated on a market value weighted basis, including accrued investment income, using holdings as of June 30, 2007. 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 June 30, 2007:
Estimated Increase Estimated Percentage (Decrease) in Fair Value Increase (Decrease) Change in Interest Rate ($ in thousands) in Fair Value - ----------------------- -------------------------- -------------------------- 300 basis point rise (71,961) -12.7% 200 basis rise (49,027) -8.6% 100 basis rise (24,975) -4.4% As of June 30, 2007 0 0.0% 50 basis point decline 12,581 2.2% 100 basis point decline 24,940 4.4%
The sensitivity analysis model used by us produces a predicted pre-tax loss in fair value of market-sensitive instruments of $25.0 million or 4.4% based on a 100 basis point increase in interest rates as of June 30, 2007. This loss amount only reflects the impact of an interest rate increase on the fair value of our fixed maturities, which constituted approximately 89.2% of our total invested assets as of June 30, 2007. 33 As of June 30, 2007 we had a total of $36.1 million of outstanding floating rate debt, all of which is outstanding subordinated debentures underlying 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. On April 10, 2007, we completed our acquisition of Preserver. As a result, the Preserver operations have been excluded from our review of the internal controls under Section 404 of the Sarbanes Oxley Act of 2002. Preserver has not previously been subject to a review of internal controls under the Sarbanes Oxley Act of 2002. We will begin the process of integrating Preserver's operations including internal controls and processes and extending our Section 404 compliance program to Preserver's operations. Preserver accounts for 19.6% of assets and 7.0% of net income. See the Notes to the Consolidated Financial Statements in item 1 for discussion of the acquisition and related financial data. Part II - OTHER INFORMATION Item 4. Submission of Matters to a Vote of Security Holders (a) The Company held its annual meeting on May 17, 2007. (c) Francis M. Colalucci was re-elected as a director with 19,363,110 shares voting for his election and 2,628,559 shares withheld. Charles A. Bryan was re-elected director with 20,960,543 shares voting for his election and 1,031,126 withheld. The security holders voted to approve the appointment of Johnson Lambert & Co. as the Company's independent registered public accounting firm for the year 2007 with 21,976,438 shares voting for appointment, 7,080 voting against and 8,051 abstaining. Item 6. Exhibits 31.1 Certification of Chief Executive Officer pursuant to Sarbanes-Oxley Act of 2002 Section 302 31.2 Certification of Chief Financial Officer pursuant to Sarbanes-Oxley Act of 2002 Section 302 32 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Sarbanes-Oxley Act of 2002 Section 906 34 Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Tower Group, Inc. --------------------------------- Registrant Date: August 3, 2007 /s/ Michael H. Lee -------------- ---------------------------------------------- Michael H. Lee Chairman of the Board, President and Chief Executive Officer Date: August 3, 2007 /s/ Francis M. Colalucci -------------- ---------------------------------------------- Francis M. Colalucci Senior Vice President, Chief Financial Officer and Treasurer 35 EX-31.1 2 a5462691ex31_1.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 June 30, 2007 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 the Company, 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 second quarter of 2007 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 August 3, 2007 36 EX-31.2 3 a5462691ex31_2.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 June 30, 2007 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 the Company, 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 second quarter of 2007 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 August 3, 2007 37 EX-32 4 a5462691ex32.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 FOF 2002 In connection with the Quarterly Report of Tower Group, Inc. (the "Company") on Form 10-Q for the period ending June 30, 2007, 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 results of operations of the Company. /s/ Michael H. Lee - ---------------------------- Michael H. Lee President and Chief Executive Officer August 3, 2007 /s/ Francis M. Colalucci - ---------------------------- Francis M. Colalucci Senior Vice President, Chief Financial Officer and Treasurer August 3, 2007 38 -----END PRIVACY-ENHANCED MESSAGE-----