XNAS:TWGP Tower Group International Ltd Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

 

  þ Quarterly Report Pursuant To Section 13 or 15(d) of the Securities

   Exchange Act Of 1934

   For the quarterly period ended June 30, 2012

 

  ¨ Transition Report Pursuant to Section 13 or 15(d) of the Securities

   Exchange Act of 1934

   For the transition period from                                  to                                 

Commission file no. 000-50990

 

Tower Group, Inc.

(Exact name of registrant as specified in its charter)

 

 

Delaware

   

13-3894120

 
 

(State or other jurisdiction of incorporation

or organization)

    (I.R.S. Employer Identification No.)  
 

120 Broadway, 31st Floor

New York, NY

   

10271

 
  (Address of principal executive offices)     (Zip Code)  

 

                                (212) 655-2000                              

(Registrant’s telephone number, including area code

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   þ  Yes   ¨  No

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

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

Large accelerated filer þ  Accelerated filer ¨  Non-accelerated filer ¨  Smaller reporting company ¨

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 38,377,091 shares of common stock, par value $0.01 per share, as of August 1, 2012.

 

 

 


Table of Contents

Tower Group, Inc.

Quarterly Report on Form 10-Q

For the Period Ended June 30, 2012

INDEX

 

     Page  

PART I FINANCIAL INFORMATION

  

Item 1. Financial Statements of Tower Group, Inc.

  

Consolidated Balance Sheets (Unaudited) – June 30, 2012 and December 31, 2011

     1   

Consolidated Statements of Operations (Unaudited) – Three and Six Months Ended June  30, 2012 and 2011

     2   

Consolidated Statements of Comprehensive Income (Unaudited) – Three and Six Months Ended June  30, 2012 and 2011

     3   

Consolidated Statements of Changes in Stockholders’ Equity (Unaudited) – Six Months Ended June 30, 2012 and 2011

     4   

Consolidated Statements of Cash Flows (Unaudited) – Six Months Ended June 30, 2012 and 2011

     5   

Notes to Consolidated Financial Statements (Unaudited)

     6   

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

     30   

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     52   

Item 4. Controls and Procedures

     54   

PART II OTHER INFORMATION

  

Item 1. Legal Proceedings

     54   

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

     54   

Item 6. Exhibits

     55   

SIGNATURES

     56   


Table of Contents

Part I – FINANCIAL INFORMATION

Item 1. Financial Statements

Tower Group, Inc.

Consolidated Balance Sheets

(Unaudited)

 

($ in thousands, except par value and share amounts)    June 30,
2012
    December 31,
2011
 

Assets

    

Investments - Tower

    

Available-for-sale investments, at fair value:

    

Fixed-maturity securities (amortized cost of $1,937,174 and $2,046,932)

   $     2,060,802     $     2,153,620  

Equity securities (cost of $126,685 and $91,069)

     128,490       87,479  

Other invested assets

     52,333       44,347  

Investments - Reciprocal Exchanges

    

Available-for-sale investments, at fair value:

    

Fixed-maturity securities (amortized cost of $280,843 and $288,180)

     299,172       300,054  

Equity securities (cost of $6,840 and $1,965)

     7,903       1,866  
                  

Total investments

     2,548,700       2,587,366  

Cash and cash equivalents (includes $6,906 and $666 relating to Reciprocal Exchanges)

     199,005       114,098  

Investment income receivable (includes $3,078 and $2,978 relating to Reciprocal Exchanges)

     27,233       26,782  

Premiums receivable (includes $38,662 and $41,290 relating to Reciprocal Exchanges)

     381,983       408,626  

Reinsurance recoverable on paid losses (includes $1,799 and $5,670 relating to Reciprocal Exchanges)

     19,076       23,903  

Reinsurance recoverable on unpaid losses (includes $19,661 and $11,253 relating to Reciprocal Exchanges)

     301,620       319,664  

Prepaid reinsurance premiums (includes $16,419 and $14,685 relating to Reciprocal Exchanges)

     55,691       54,037  

Deferred acquisition costs, net (includes $12,758 and $11,866 relating to Reciprocal Exchanges)

     185,507       168,858  

Intangible assets (includes $7,146 and $4,839 relating to Reciprocal Exchanges)

     110,918       114,920  

Goodwill

     250,103       250,103  

Funds held by reinsured companies

     133,968       69,755  

Other assets (includes $4,021 and $2,685 relating to Reciprocal Exchanges)

     269,838       304,083  
                  

Total assets

   $ 4,483,642     $ 4,442,195  
                  

Liabilities

    

Loss and loss adjustment expenses (includes $133,547 and $136,274 relating to Reciprocal Exchanges)

   $ 1,701,833     $ 1,632,113  

Unearned premium (includes $103,408 and $102,991 relating to Reciprocal Exchanges)

     926,456       893,176  

Reinsurance balances payable (includes $4,875 and $3,466 relating to Reciprocal Exchanges)

     14,418       20,794  

Funds held under reinsurance agreements

     91,142       96,726  

Other liabilities (includes $7,700 and $7,154 relating to Reciprocal Exchanges)

     194,901       266,155  

Deferred income taxes (includes $3,392 and $4,511 relating to Reciprocal Exchanges)

     33,058       29,337  

Debt

     448,291       426,901  
                  

Total liabilities

     3,410,099       3,365,202  

Contingencies (Note 12)

     -        -   

Stockholders’ equity

    

Common stock ($0.01 par value; 100,000,000 shares authorized, 46,769,519 and 46,448,341 shares issued, and 38,377,091 and 39,221,102 shares outstanding)

     468       465  

Treasury stock (8,392,428 and 7,227,239 shares)

     (181,324     (158,185

Paid-in-capital

     775,542       772,938  

Accumulated other comprehensive income

     75,866       62,244  

Retained earnings

     347,521       356,680  
                  

Tower Group, Inc. stockholders’ equity

     1,018,073       1,034,142  
                  

Noncontrolling interests

     55,470       42,851  
                  

Total stockholders’ equity

     1,073,543       1,076,993  
                  

Total liabilities and stockholders’ equity

   $ 4,483,642     $ 4,442,195  
                  

See accompanying notes to the unaudited consolidated financial statements.

 

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Table of Contents

Tower Group, Inc.

Consolidated Statements of Operations

(Unaudited)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
(in thousands, except per share amounts)    2012     2011     2012     2011  

Revenues

        

Net premiums earned

   $     460,153     $     393,530     $     880,311     $     773,325  

Ceding commission revenue

     10,080       10,655       15,243       18,836  

Insurance services revenue

     1,359       (73     1,856       529  

Policy billing fees

     3,000       2,659       6,134       4,837  

Net investment income

     31,781       31,798       65,724       64,176  

Net realized investment gains (losses):

        

Other-than-temporary impairments

     (2,525     (210     (5,246     (378

Portion of loss recognized in other comprehensive income

     286       -        286       24  

Other net realized investment gains

     2,003       (2,104     8,307       5,400  
                                  

Total net realized investment gains (losses)

     (236     (2,314     3,347       5,046  
                                  

Total revenues

     506,137       436,255       972,615       866,749  

Expenses

        

Loss and loss adjustment expenses

     349,775       240,846       617,268       481,022  

Direct and ceding commission expense

     95,186       76,210       174,871       152,813  

Other operating expenses

     78,100       69,749       157,071       136,088  

Acquisition-related transaction costs

     720       -        1,982       12  

Interest expense

     7,902       8,257       15,478       16,357  
                                  

Total expenses

     531,683       395,062       966,670       786,292  
                                  

Income (loss) before income taxes

     (25,546     41,193       5,945       80,457  

Income tax expense (benefit)

     (7,239     12,877       (5,389     25,635  
                                  

Net income (loss)

   $ (18,307   $ 28,316     $ 11,334     $ 54,822  

Less: Net income (loss) attributable to Noncontrolling interests

     (3,194     4,195       5,813       5,016  
                                  

Net income (loss) attributable to Tower Group, Inc.

   $ (15,113   $ 24,121     $ 5,521     $ 49,806  
                                  

Earnings (loss) per share attributable to Tower Group, Inc. stockholders:

        

Basic

   $ (0.39   $ 0.58     $ 0.14     $ 1.20  

Diluted

   $ (0.39   $ 0.58     $ 0.14     $ 1.20  
                                  

Weighted average common shares outstanding:

        

Basic

     39,117       41,303       39,206       41,404  

Diluted

     39,117       41,395       39,268       41,518  
                                  

Dividends declared and paid per common share

   $ 0.19     $ 0.19     $ 0.38     $ 0.32  
                                  

See accompanying notes to the unaudited consolidated financial statements.

 

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Table of Contents

Tower Group, Inc.

Consolidated Statements of Comprehensive Income

(Unaudited)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
(in thousands)    2012     2011     2012     2011  

Net income (loss)

   $     (18,307   $ 28,316     $ 11,334     $ 54,822  

Other comprehensive income (loss) before tax

        

Gross unrealized investment holding gains arising during periods

     8,524           25,755           33,585           24,430  

Less: Reclassification adjustment for investment (gains) losses included in net income

     236       2,290       (3,347     (5,046

Portion of other-than-temporary impairment losses recognized in other comprehensive income

     (286     -        (286     (24

Deferred gain (loss) on cash flow hedge

     (1,160     (4,583     (1,391     (3,645
                                  

Other comprehensive income before tax

     7,314       23,462       28,561       15,715  

Income tax benefit (expense) related to items of other comprehensive income (loss)

     (2,629     (8,218     (9,911     (5,459
                                  

Other comprehensive income, net of income tax

   $ 4,685     $ 15,244       18,650       10,256  
                                  

Comprehensive income (loss)

   $ (13,622   $ 43,560     $ 29,984     $ 65,078  
                                  

Less: Comprehensive income (loss) attributable to Noncontrolling interests

     (1,006     6,775       10,841       8,411  
                                  

Comprehensive income (loss) attributable to Tower Group, Inc.

   $ (12,616   $ 36,785     $ 19,143     $ 56,667  
                                  

See accompanying notes to the unaudited consolidated financial statements.

 

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Table of Contents

Tower Group, Inc.

Consolidated Statements of Changes in Stockholders’ Equity

(Unaudited)

 

    Common Stock     Treasury     Paid-in     Accumulated
Other
Comprehensive
    Retained     Noncontrolling     Total
Stockholders’
 
(in thousands)   Shares     Amount     Stock     Capital     Income (loss)     Earnings     Interests     Equity  

Balance at December 31, 2010

        45,742     $  457     $  (91,779   $  763,064     $  48,883     $  324,376     $  22,837     $  1,067,838  

Dividends declared

    -        -        -        -        -        (12,855     -        (12,855

Stock based compensation

    656       7       (1,640     5,377       -        -        -        3,744  

Repurchase of common stock

    -        -        (19,990     -        -        -        -        (19,990

Net income

    -        -        -        -        -        49,806       5,016       54,822  

Other comprehensive income

    -        -        -        -        6,861       -        3,395       10,256  
                                                                 

Balance at June 30, 2011

    46,398     $     464     $     (113,409   $     768,441     $ 55,744     $ 361,327     $ 31,248     $ 1,103,815  
                                                                 

Balance at December 31, 2011

    46,448     $ 465     $ (158,185   $ 772,938     $     62,244     $ 356,680     $ 42,851     $ 1,076,993  

Dividends declared

    -        -        -        -        -        (14,680     -        (14,680

Stock based compensation

    321       3       (2,152     4,382       -        -        -        2,233  

Repurchase of common stock

    -        -        (20,987     -        -        -        -        (20,987

Net income

    -        -        -        -        -        5,521       5,813       11,334  

Transfer of assets to Reciprocal Exchanges

    -        -        -        (1,778     -        -        1,778       -   

Other comprehensive income

    -        -        -        -        13,622       -        5,028       18,650  

Balance at June 30, 2012

    46,769     $ 468     $ (181,324   $ 775,542     $ 75,866     $     347,521     $     55,470     $     1,073,543  

See accompanying notes to the unaudited consolidated financial statements.

 

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Table of Contents

Tower Group, Inc.

Consolidated Statements of Cash Flows

(Unaudited)

 

     Six Months Ended
June 30,
 
($ in thousands)    2012     2011  

Cash flows provided by operating activities:

    

Net income

   $ 11,334     $ 54,822  

Adjustments to reconcile net income to net cash provided by (used in) operations:

    

Net realized investment (gains) losses

     (3,347     (5,046

Depreciation and amortization

     15,985       13,145  

Amortization of bond and debt premium or discount

     5,377       3,124  

Amortization of restricted stock

     4,382       5,041  

Deferred income taxes

     (7,481     9,010  

Changes in operating assets and liabilities:

    

Investment income receivable

     (451     (2,296

Premiums receivable

     26,643       1,762  

Reinsurance recoverable

     22,871       (4,421

Prepaid reinsurance premiums

     (1,654     27,916  

Deferred acquisition costs, net

     (16,649     (3,373

Other assets

     (68,724     (21,746

Loss and loss adjustment expenses

     69,720       (25,722

Unearned premium

     33,280       (12,228

Reinsurance balances payable

     (6,376     (15,250

Funds held under reinsurance agreements

     (5,584     8,395  

Other liabilities

     (6,889     20,329  

Net cash flows provided by operations

     72,437       53,462  

Cash flows (used in) investing activities:

    

Purchase of fixed assets

     (19,426     (11,705

Purchase - fixed-maturity securities

     (997,657         (965,648

Purchase - equity securities

     (802,154     (296,441

Short-term investments, net

     -        (3,438

Change in other invested assets

     (7,986     -   

Sale or maturity - fixed-maturity securities

         1,111,663       945,867  

Sale - equity securities

     745,618       285,322  

Net cash flows provided by (used in) investing activities

     30,058       (46,043

Cash flows (used in) financing activities:

    

Proceeds from credit facility borrowings

     20,000       17,000  

Repayment of credit facility borrowings

     -        (17,000

Issuance of common stock under stock-based compensation programs

     3       343  

Excess tax benefits from share-based payment arrangements

     228       (147

Treasury stock acquired-net employee share-based compensation

     (2,152     (1,640

Repurchase of Common Stock

     (20,987     (19,990

Dividends paid

     (14,680     (12,855

Net cash flows (used in) financing activities

     (17,588     (34,289

Increase (decrease) in cash and cash equivalents

     84,907       (26,870

Cash and cash equivalents, beginning of period

     114,098       140,221  

Cash and cash equivalents, end of period

   $ 199,005     $ 113,351  

See accompanying notes to the unaudited consolidated financial statements.

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

Note 1—Nature of Business

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

The Company operates three business segments as follows:

 

 

Commercial Insurance (“Commercial”) Segment offers a broad range of standard and specialty commercial lines property and casualty insurance products to businesses distributed through a network of retail and wholesale agents and program underwriting agents on both an admitted and non-admitted basis. This segment also includes assumed reinsurance;

 

 

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

 

 

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

Note 2—Accounting Policies and Basis of Presentation

Basis of Presentation

The accompanying unaudited consolidated financial statements include the accounts of Tower and its insurance subsidiaries, managing general agencies and management companies. The unaudited consolidated financial statements also include the accounts of Adirondack Insurance Exchange, a New York reciprocal insurer, and New Jersey Skylands Insurance Association, a New Jersey reciprocal insurer (together, the “Reciprocal Exchanges”). The Company does not own the Reciprocal Exchanges but manages their business operations through its wholly owned management companies.

The accompanying unaudited consolidated financial statements included in this report have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Securities and Exchange Commission (“SEC”) Form 10-Q and Article 10 of SEC Regulation S-X. The principles for condensed interim financial information do not require the inclusion of all the information and footnotes required by GAAP for complete financial statements. Therefore, these financial statements should be read in conjunction with the consolidated financial statements as of and for the year ended December 31, 2011 and notes thereto included in the Annual Report on Form 10-K filed on February 29, 2012. The accompanying consolidated financial statements have not been audited by an independent registered public accounting firm in accordance with standards of the Public Company Accounting Oversight Board (United States) but, in the opinion of management, such financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the Company’s financial position, results of operations and cash flows. All inter-company transactions have been eliminated in consolidation.

Use of Estimates

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

Moreover, the results of operations for the six months ended June 30, 2012 may not be indicative of the results that may be expected for the year ending December 31, 2012.

Intercompany transactions

In the first quarter 2012, Tower transferred a licensed insurance subsidiary shell to the Reciprocal Exchanges and received cash for its statutory book value. At the date of the transfer, Tower’s GAAP carrying basis in this subsidiary exceeded the statutory book value and the transfer resulted in a loss to Tower of $1.8 million. Since this was a non-recurring transaction between entities under common control, assets are transferred at historical book value. Any difference in the consideration paid and the book value of the assets transferred is treated as an adjustment to equity. This transaction had no effect on consolidated stockholders’ equity.

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

Reclassifications and Adjustments

Certain reclassifications have been made to prior years’ financial information to conform to the current year presentation.

Cash amounts presented on the consolidated statements of cash flows for the six months ended June 30, 2011 have been revised to present book overdrafts representing outstanding checks in excess of funds on deposit with individual financial institutions within Other liabilities. These balances have previously been reported in Cash and cash equivalents. This revision increased Cash and cash equivalents and Other liabilities by $52.9 million as of June 30, 2011 and Net cash flows provided by operations by $15.6 million for the six months ended June 30, 2011. Management concluded this adjustment is not material to previously issued annual and quarterly consolidated financial statements.

Comprehensive income attributable to Noncontrolling interests and Comprehensive income attributable to Tower Group, Inc. for the three and six months ended June 30, 2011 have been revised. The revision increased Comprehensive income attributable to Noncontrolling interests and decreased Comprehensive income attributable to Tower Group, Inc. for the three and six months ended June 30, 2011 by $4.2 million and $5.0 million, respectively. This revision had no effect on consolidated Comprehensive income. The change corrected a classification error and is not considered material to the previously issued quarterly financial statements.

In the first quarter of 2012, the Company recorded an out of period adjustment that decreased income tax expense by $7.1 million. The adjustment increased consolidated net income by $7.1 million and increased net income available to common shareholders by $2.6 million for the six months ended June 30, 2012. This out of period adjustment had no effect on tax expense or consolidated net income for the three months ended June 30, 2012. The adjustment corrected our deferred income tax liability as reported at December 31, 2011. Management concluded this adjustment is not material to previously issued annual and quarterly consolidated financial statements.

Accounting Pronouncements

Accounting guidance adopted in 2012

In May 2011, the Financial Accounting Standards Board (“FASB”) issued new guidance concerning fair value measurement and disclosure. This new guidance requires additional disclosure about fair value measurements categorized as Level 3. This guidance had no effect on the Company’s financial position, results of operations or cash flows. The Company’s fair value disclosures have been revised effective January 1, 2012 to comply with this guidance.

In June 2011 (and as amended in December 2011), the FASB issued new guidance concerning the presentation of comprehensive income. The Company adopted this new guidance retrospectively on January 1, 2012 and now reports its comprehensive income in a separate consolidated financial statement immediately following the statement of operations.

In September 2011, the FASB issued amended guidance on testing goodwill for impairment. This guidance was intended to reduce the cost and complexity of the annual goodwill impairment test by allowing an entity to utilize more qualitative factors. The Company will consider this guidance when it performs its goodwill impairment test, which is done annually as of September 30. This guidance will not affect the Company’s financial position, result of operations or cash flows.

Accounting guidance not yet effective

In July 2012, the FASB issued amended guidance on testing indefinite lived intangible assets for impairment. This guidance is intended to reduce the cost and complexity of the annual impairment test by allowing an entity to utilize more qualitative factors. This guidance will not affect the Company’s financial position, result of operations or cash flows.

Note 3—Variable Interest Entities (“VIEs”)

Through its management companies, Tower is the attorney-in-fact for the Reciprocal Exchanges and has the ability to direct their activities. The Reciprocal Exchanges are policyholder-owned insurance carriers organized as unincorporated associations. Each policyholder insured by the Reciprocal Exchanges shares risk with the other policyholders.

In the event of dissolution, policyholders would share any residual unassigned surplus in the same proportion as the amount of insurance purchased but are not subject to assessment for any deficit in unassigned surplus of the Reciprocal Exchanges. Tower receives management fee income for the services provided to the Reciprocal Exchanges. The assets of the Reciprocal Exchanges can be used only to settle the obligations of the Reciprocal Exchanges and general creditors to their liabilities have no recourse to Tower as the primary beneficiary.

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

In addition, Tower holds the surplus notes issued by the Reciprocal Exchanges when they were originally capitalized. The obligation to repay principal and interest on the surplus notes is subordinated to the Reciprocal Exchanges’ other liabilities including obligations to policyholders and claimants for benefits under insurance policies. Principal and interest on the surplus notes are payable only with regulatory approval. The Company has no ownership interest in the Reciprocal Exchanges.

The Company determined that each of the Reciprocal Exchanges qualifies as a VIE and that the Company is the primary beneficiary as it has both the power to direct the activities of the Reciprocal Exchanges that most significantly impact their economic performance and the risk of economic loss through its ownership of the surplus notes. Accordingly, the Company consolidates these Reciprocal Exchanges and eliminates all intercompany balances and transactions with Tower.

For the three months ended June 30, 2012, the Reciprocal Exchanges recognized total revenues, total expenses and net loss of $47.4 million, $50.6 million and $(3.2) million, respectively. For the three months ended June 30, 2011, the Reciprocal Exchanges recognized total revenues, total expenses and net income of $56.0 million, $51.8 million and $4.2 million, respectively.

For the six months ended June 30, 2012, the Reciprocal Exchanges recognized total revenues, total expenses and net income of $99.4 million, $93.6 million and $5.8 million, respectively. For the six months ended June 30, 2011, the Reciprocal Exchanges recognized total revenues, total expenses and net income of $105.3 million, $100.3 million and $5.0 million, respectively.

Note 4—Investments

The cost or amortized cost and fair value of the Company’s investments in fixed maturity and equity securities, gross unrealized gains and losses, and other-than-temporary impairment losses as of June 30, 2012 and December 31, 2011 are summarized as follows:

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

($ in thousands)    Cost or
Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair Value      Unrealized
OTTI
Losses (1)
 

June 30, 2012

             

U.S. Treasury securities

   $ 120,783      $ 1,591      $ (7   $ 122,367      $ -   

U.S. Agency securities

     77,690        3,592        -        81,282        -   

Municipal bonds

     742,736        54,076        (435     796,377        -   

Corporate and other bonds

             

Finance

     263,167        16,167        (215     279,119        -   

Industrial

     389,693        22,394        (1,181     410,906        -   

Utilities

     28,254        2,637        (26     30,865        -   

Commercial mortgage-backed securities

     223,358        27,643        (576     250,425        (365

Residential mortgage-backed securities

             

Agency backed securities

     313,648        14,760        (135     328,273        -   

Non-agency backed securities

     17,100        1,147        (123     18,124        (73

Asset-backed securities

     41,588        810        (162     42,236        -   
                                             

Total fixed-maturity securities

     2,218,017        144,817        (2,860     2,359,974        (438

Preferred stocks, principally financial sector

     33,803        2,656        (157     36,302        -   

Common stocks, principally financial and industrial sectors

     99,722        3,607        (3,238     100,091        -   
                                             

Total, June 30, 2012

   $ 2,351,542      $ 151,080      $ (6,255   $ 2,496,367      $ (438
                                             

Tower

   $ 2,063,859      $ 131,351      $ (5,918   $ 2,189,292      $ (412

Reciprocal Exchanges

     287,683        19,729        (337     307,075        (26
                                             

Total, June 30, 2012

   $ 2,351,542      $ 151,080      $ (6,255   $ 2,496,367      $ (438
                                             

December 31, 2011

             

U.S. Treasury securities

   $ 154,430      $ 1,725      $ (13   $ 156,142      $ -   

U.S. Agency securities

     114,411        2,779        -        117,190        -   

Municipal bonds

     688,192        48,777        (255     736,714        -   

Corporate and other bonds

             

Finance

     331,917        9,201        (4,615     336,503        -   

Industrial

     388,139        22,198        (2,287     408,050        -   

Utilities

     30,164        3,067        (61     33,170        -   

Commercial mortgage-backed securities

     232,877        22,854        (2,564     253,167        (483

Residential mortgage-backed securities

             

Agency backed securities

     304,876        15,401        (1     320,276        -   

Non-agency backed securities

     29,907        2,603        (901     31,609        (695

Asset-backed securities

     60,199        1,309        (655     60,853        -   
                                             

Total fixed-maturity securities

     2,335,112        129,914        (11,352     2,453,674        (1,178

Preferred stocks, principally financial sector

     24,083        317        (890     23,510        -   

Common stocks, principally industrial and financial sectors

     68,951        1,078        (4,194     65,835        -   
                                             

Total, December 31, 2011

   $     2,428,146      $     131,309      $     (16,436   $     2,543,019      $     (1,178
                                             

Tower

   $ 2,138,001      $ 118,173      $ (15,075   $ 2,241,099      $ (1,178

Reciprocal Exchanges

     290,145        13,136        (1,361     301,920        -   
                                             

Total, December 31, 2011

   $ 2,428,146      $ 131,309      $ (16,436   $ 2,543,019      $ (1,178
                                             

 

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

As at June 30, 2012 and December 31, 2011, U.S. Treasury Notes and other securities with carrying values of $395.9 million and $226.8 million, respectively, were on deposit with various states to comply with the insurance laws in which the Company is licensed.

In addition, the Company had $324.3 million and $340.8 million of investments as of June 30, 2012 and December 31, 2011, respectively, held by counterparties as collateral or in trusts to support letters of credit issued on Tower’s behalf, reinsurance liabilities on certain assumed reinsurance treaties, collateral posted for certain leases and other purposes.

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

Major categories of net investment income are summarized as follows:

 

                                                                                                   
     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
($ in thousands)    2012     2011     2012     2011  

Income

        

Fixed-maturity securities

   $     24,511     $      26,154     $     49,924     $      55,264  

Equity securities

     6,603       6,565       14,239       10,977  

Cash and cash equivalents

     448       216       738       347  

Other, primarily from other invested assets

     1,573       117       3,555       248  
                                  

Total

     33,135       33,052       68,456       66,836  

Expenses

        

Investment expenses

     (1,354     (1,254     (2,732     (2,660
                                  

Net investment income

   $ 31,781     $ 31,798     $ 65,724     $ 64,176  
                                  

Tower

     30,267       30,401       62,525       61,106  

Reciprocal Exchanges

     3,177       3,051       6,526       6,396  

Elimination of interest on Reciprocal Exchange surplus notes

     (1,663     (1,654     (3,327     (3,326
                                  

Net investment income

   $ 31,781     $ 31,798     $ 65,724     $ 64,176  
                                  

Proceeds from the sale of fixed-maturity securities were $980.0 million and $911.8 million for the six months ended June 30, 2012 and 2011, respectively. Proceeds from the sale of equity securities were $745.6 million and $285.3 million for the six months ended June 30, 2012 and 2011, respectively.

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

 

                                                                                                   
     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
($ in thousands)    2012     2011     2012     2011  

Fixed-maturity securities

        

Gross realized gains

   $     12,354     $ 4,551     $ 25,162     $ 19,657  

Gross realized losses

     (609     (1,326     (2,551     (7,333
                                  
     11,745       3,225       22,611       12,324  

Equity securities

        

Gross realized gains

     2,685       2,228       4,179       4,570  

Gross realized losses

     (9,808     (7,557     (16,160         (11,494
                                  
     (7,123     (5,329         (11,981     (6,924

Other

        

Gross realized gains

     555       -        1,790       -   

Gross realized losses

     (3,174     -        (4,113     -   
                                  
     (2,619     -        (2,323     -   
                                  

Net realized gains (losses) on investments

     2,003       (2,104     8,307       5,400  
                                  

Other-than-temporary impairment losses:

        

Fixed-maturity securities

     (765     (210     (882     (354

Equity securities

     (1,474     -        (4,078     -   
                                  

Total other-than-temporary impairment losses recognized in earnings

     (2,239     (210     (4,960     (354
                                  

Total net realized investment gains (losses)

   $ (236   $     (2,314   $ 3,347     $ 5,046  
                                  

Tower

   $ 1,421     $ (2,857   $ 1,028     $ 5,380  

Reciprocal Exchanges

     (1,657     543       2,319       (334
                                  

Total net realized investment gains (losses)

   $ (236   $ (2,314   $ 3,347     $ 5,046  
                                  

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

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

Impairment Review

Management regularly reviews the Company’s fixed-maturity and equity security portfolios in accordance with its impairment policy to evaluate the necessity of recording impairment losses for OTTI. The determination of OTTI is a subjective process and different judgments and assumptions could affect the timing of loss realization.

Management, in conjunction with its outside portfolio managers, analyzes its non-agency residential mortgage-backed securities (“RMBS”) using default loss models based on the performance of the underlying loans. Performance metrics include delinquencies, defaults, foreclosures, anticipated cash flow prepayments and cumulative losses incurred. The expected losses for a mortgage pool are compared to the break-even loss, which represents the point at which the Company’s tranche begins to experience losses.

The commercial mortgage-backed securities (“CMBS”) holdings are evaluated using analytical techniques and various metrics including the level of subordination, debt-service-coverage ratios, loan-to-value ratios, delinquencies, defaults and foreclosures.

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

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

The evaluation of equity securities includes management’s intent and ability to hold the security to recovery. Management will record OTTI in those situations where it does not intend to hold the security to recovery or if the security is not expected to recover in value in a period that is other-than-temporary.

The following table shows the amount of fixed-maturity and equity securities that were OTTI for the three and six months ended June 30, 2012 and 2011. This resulted in recording impairment write-downs included in net realized investment gains (losses), and reduced the unrealized loss in other comprehensive net income:

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

                                                                           
     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
($ in thousands)    2012     2011     2012     2011  

Corporate and other bonds

   $ (648   $ -      $ (737   $ -   

Commercial mortgage-backed securities

     (403     (66     (403     (163

Residential mortgage-backed securities

     -        -        (28     (71

Asset-backed securities

     -        (144     -        (144

Equities

     (1,474     -        (4,078     -   
                                  

Other-than-temporary-impairments

     (2,525     (210     (5,246     (378

Portion of loss recognized in accumulated other comprehensive income (loss)

     286       -        286       24  
                                  

Impairment losses recognized in earnings

   $ (2,239   $ (210   $ (4,960   $ (354
                                  

Tower

   $ (2,239   $ (210   $ (4,960   $ (354

Reciprocal Exchanges

     -        -        -        -   
                                  

Impairment losses recognized in earnings

   $     (2,239   $     (210   $     (4,960   $        (354
                                  

The following table provides a rollforward of the cumulative amounts of credit OTTI for securities still held showing the amounts that have been included in earnings on a pretax basis for the three months ended June 30, 2012 and 2011:

 

     Three Months Ended June 30,  
($ in thousands)    2012     2011  

Balance, April 1,

   $ 6,084     $ 15,124  

Additional credit losses recognized during the period, related to securities for which:

    

No OTTI has been previously recognized

     765       44  

OTTI has been previously recognized

     -        166  

Reductions due to:

    

Securities sold during the period (realized)

     (730     (1,888
                  

Balance, June 30,

   $              6,119     $             13,446  
                  

The following table provides a rollforward of the cumulative amounts of credit OTTI for securities still held showing the amounts that have been included in earnings on a pretax basis for the six months ended June 30, 2012 and 2011:

 

     Six Months  Ended
June 30,
 
($ in thousands)    2012     2011  

Balance, January 1,

   $ 12,666     $ 18,075  

Additional credit losses recognized during the period, related to securities for which:

    

No OTTI has been previously recognized

     854       44  

OTTI has been previously recognized

     28       310  

Reductions due to:

    

Securities sold during the period (realized)

     (7,429     (4,983
                  

Balance, June 30,

   $               6,119     $             13,446  
                  

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

Unrealized Losses

There are 249 securities at June 30, 2012, including fixed maturities and equity securities, which account for the gross unrealized loss, none of which is deemed by management to be OTTI. Temporary losses on corporate and other bonds result from purchases made in a lower yield spread environment. In addition, there have been some ratings downgrades on certain of these securities. After analyzing the credit quality, balance sheet strength and company outlook, management believes these securities will recover in value. The structured securities that had significant unrealized losses resulted primarily from declines in both residential and commercial real estate prices. To the extent projected cash flows on structured securities change adversely, they would be considered OTTI, and an impairment loss would be recognized in the current period. Management considered all relevant factors, including expected recoverability of cash flows, in assessing whether a loss was other-than-temporary. The Company does not intend to sell these fixed maturity securities, and it is not more likely than not that these securities will be sold before recovering their cost basis.

For all fixed-maturity securities in an unrealized loss position at June 30, 2012, the Company has received all contractual interest payments (and principal if applicable). Based on the continuing receipt of cash flow and the foregoing analyses, management expects continued timely payments of principal and interest and considers the losses to be temporary.

The unrealized loss position associated with the fixed-maturity portfolio was $2.9 million as of June 30, 2012, consisting primarily of corporate bonds and mortgage-backed securities of $2.3 million. The total fixed-maturity portfolio of gross unrealized losses included 228 securities which were, in aggregate, approximately 1.1% below amortized cost. Of the 228 fixed maturity investments identified, 42 have been in an unrealized loss position for more than 12 months. The total unrealized loss on these investments at June 30, 2012 was $0.8 million. Management does not consider these investments to be other-than-temporarily impaired.

For common stocks, there were 15 securities in a loss position at June 30, 2012 totaling $3.2 million. Management evaluated the financial condition of the common stock issuers, the severity and duration of the impairment, and our ability and intent to hold to recovery. The evaluation consisted of a detailed review, including but not limited to some or all of the following factors for each security: the current S&P rating, analysts’ reports, past earnings trends and analysts’ earnings expectations for the next 12 months, liquidity, near-term financing risk, and whether the company was currently paying dividends on its equity securities. Management does not consider these investments to be other-than-temporarily impaired.

The following table presents information regarding invested assets that were in an unrealized loss position at June 30, 2012 and December 31, 2011 by amount of time in a continuous unrealized loss position:

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

     Less than 12 Months     12 Months or Longer     Total  
($ in thousands)   

Fair

Value

     Unrealized
Losses
   

Fair

Value

     Unrealized
Losses
    Aggregate
Fair Value
     Unrealized
Losses
 

June 30, 2012

               

U.S. Treasury securities

   $ 65,714      $ (7   $ -       $ -      $ 65,714      $ (7

Municipal bonds

     41,456        (431     990        (4     42,446        (435

Corporate and other bonds

               

Finance

     22,784        (169     752        (46     23,536        (215

Industrial

     46,687        (990     6,465        (191     53,152        (1,181

Utilities

     3,425        (24     394        (2     3,819        (26

Commercial mortgage-backed securities

     16,036        (138     16,053        (438     32,089        (576

Residential mortgage-backed securities

               

Agency backed

     21,134        (134     21        -        21,155        (134

Non-agency backed

     6        (3     2,666        (121     2,672        (124

Asset-backed securities

     12,333        (117     1,680        (45     14,013        (162
                                                     

Total fixed-maturity securities

     229,575        (2,013     29,021        (847     258,596        (2,860

Preferred stocks

     6,263        (45     6,019        (112     12,282        (157

Common stocks

     39,868        (3,183     913        (55     40,781        (3,238
                                                     

Total, June 30, 2012

   $ 275,706      $ (5,241   $ 35,953      $ (1,014   $ 311,659      $ (6,255
                                                     

Tower

   $ 254,853      $ (4,959   $ 34,232      $ (959   $ 289,085      $ (5,918

Reciprocal Exchanges

     20,853        (282     1,721        (55     22,574        (337
                                                     

Total, June 30, 2012

   $ 275,706      $ (5,241   $ 35,953      $     (1,014   $ 311,659      $ (6,255
                                                     

December 31, 2011

               

U.S. Treasury securities

   $ 92,001      $ (13   $ -       $ -      $ 92,001      $ (13

Municipal bonds

     13,449        (255     -         -        13,449        (255

Corporate and other bonds

               

Finance

     138,986        (4,610     251        (5     139,237        (4,615

Industrial

     57,357        (2,141     3,519        (145     60,876        (2,286

Utilities

     1,902        (61     -         -        1,902        (61

Commercial mortgage-backed securities

     26,130        (2,564     -         -        26,130        (2,564

Residential mortgage-backed securities

               

Agency backed

     19        (1     12        -        31        (1

Non-agency backed

     13,294        (318     4,609        (583     17,903        (901

Asset-backed securities

     29,624        (647     610        (9     30,234        (656
                                                     

Total fixed-maturity securities

     372,762        (10,610     9,001        (742     381,763        (11,352

Preferred stocks

     17,773        (644     1,303        (246     19,076        (890

Common stocks

     44,132        (4,194     -         -        44,132        (4,194
                                                     

Total, December 31, 2011

   $     434,667      $     (15,448   $     10,304      $ (988   $     444,971      $     (16,436
                                                     

Tower

   $ 398,989      $ (14,160   $ 8,264      $ (915   $ 407,253      $ (15,075

Reciprocal Exchanges

     35,678        (1,288     2,040        (73     37,718        (1,361
                                                     

Total, December 31, 2011

   $ 434,667      $ (15,448   $ 10,304      $ (988   $ 444,971      $ (16,436
                                                     

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

Fixed-Maturity Investment—Time to Maturity

The following table shows the amortized cost and fair value of the fixed-maturity portfolio by contractual time to maturity at June 30, 2012 and December 31, 2011:

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

     Tower      Reciprocal Exchanges      Total  
($ in thousands)   

Amortized

Cost

    

Fair

Value

    

Amortized

Cost

    

Fair

Value

    

Amortized

Cost

    

Fair

Value

 

June 30, 2012

                 

Remaining Time to Maturity

                 

Less than one year

   $ 41,638      $ 42,094      $ 2,000      $ 2,080      $ 43,638      $ 44,174  

One to five years

     413,347        429,544        30,452        31,722        443,799        461,266  

Five to ten years

     536,091        572,698        64,358        68,066        600,449        640,764  

More than 10 years

     434,622        468,693        99,816        106,020        534,438        574,713  

Mortgage and asset-backed securities

     511,476        547,773        84,217        91,284        595,693        639,057  
                                                       

Total, June 30, 2012

   $     1,937,174      $     2,060,802      $     280,843      $     299,172      $     2,218,017      $     2,359,974  
                                                       

December 31, 2011

                 

Remaining Time to Maturity

                 

Less than one year

   $ 40,201      $ 40,529      $ 44,238      $ 44,942      $ 84,439      $ 85,471  

One to five years

     479,721        491,904        81,566        83,743        561,287        575,647  

Five to ten years

     563,830        593,838        21,522        22,797        585,352        616,635  

More than 10 years

     427,357        458,536        48,818        51,480        476,175        510,016  

Mortgage and asset-backed securities

     535,823        568,813        92,036        97,092        627,859        665,905  
                                                       

Total, December 31, 2011

   $ 2,046,932      $ 2,153,620      $ 288,180      $ 300,054      $ 2,335,112      $ 2,453,674  
                                                       

Other Invested Assets

The following table shows the composition of the other invested assets as of June 30, 2012 and December 31, 2011:

 

($ in thousands)   

June 30,

2012

     December 31,
2011
 

Limited partnerships, equity method

   $ 19,279      $ 12,459  

Real estate, amortized cost

     8,054        6,888  

Securities reported under the fair value option

     25,000        25,000  
                   

Total

   $     52,333      $     44,347  
                   

In December 2011, the Company purchased two securities for which it elected the fair value option. This election was made to simplify the accounting for these instruments which contain embedded derivatives and other features.

The fair value of the limited partnerships in the table above approximates their carrying value under the equity method of accounting. The significant inputs used to determine fair value of these limited partnerships are considered Level 3 pursuant to the fair value hierarchy. See “Note 5 – Fair Value Measurements” below. As of June 30, 2012, the Company had future funding commitments of $25.9 million to these limited partnerships.

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

Note 5—Fair Value Measurements

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

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

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

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

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

As at June 30, 2012 and December 31, 2011, the Company’s financial instruments carried at fair value are allocated among levels as follows:

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

($ in thousands)    Level 1      Level 2     Level 3      Total  

June 30, 2012

          

Fixed-maturity securities

          

U.S. Treasury securities

   $ -       $ 122,367     $ -       $ 122,367  

U.S. Agency securities

     -         81,282       -         81,282  

Municipal bonds

     -         796,377       -         796,377  

Corporate and other bonds

     -         720,890       -         720,890  

Commercial mortgage-backed securities

     -         250,425       -         250,425  

Residential mortgage-backed securities

          

Agency

     -         328,273       -         328,273  

Non-agency

     -         18,124       -         18,124  

Asset-backed securities

     -         42,236       -         42,236  
                                    

Total fixed-maturities

     -         2,359,974       -         2,359,974  

Equity securities

     136,393        -        -         136,393  
                                    

Total investments at fair value

     136,393        2,359,974       -         2,496,367  

Other invested assets (1)

     -         -        25,000        25,000  

Other liabilities

             -   

Interest rate swap contracts

     -         (8,775     -         (8,775

Foreign currency forward contract

     -         (2,042     -         (2,042

Debt and equity securities sold, not yet purchased

     -         (17,506     -         (17,506
                                    

Total, June 30, 2012

   $     136,393      $     2,331,651     $     25,000      $     2,493,044  
                                    

Tower

   $ 128,490      $ 2,032,479     $ 25,000      $ 2,185,969  

Reciprocal Exchanges

     7,903        299,172       -         307,075  
                                    

Total, June 30, 2012

   $ 136,393      $ 2,331,651     $ 25,000      $ 2,493,044  
                                    

December 31, 2011

          

Fixed-maturity securities

          

U.S. Treasury securities

   $ -       $ 156,142     $ -       $ 156,142  

U.S. Agency securities

     -         117,190       -         117,190  

Municipal bonds

     -         736,714       -         736,714  

Corporate and other bonds

     -         777,723       -         777,723  

Commercial mortgage-backed securities

     -         253,167       -         253,167  

Residential mortgage-backed securities

          

Agency

     -         320,276       -         320,276  

Non-agency

     -         31,609       -         31,609  

Asset-backed securities

     -         60,853       -         60,853  
                                    

Total fixed-maturities

     -         2,453,674       -         2,453,674  

Equity securities

     89,345        -        -         89,345  
                                    

Total investments

     89,345        2,453,674       -         2,543,019  

Other invested assets (2)

     -         -        25,000        25,000  

Interest rate swap contracts

     -         (7,384     -         (7,384
                                    

Total, December 31, 2011

   $ 89,345      $ 2,446,290     $ 25,000      $ 2,560,635  
                                    

Tower

   $ 87,479      $ 2,146,236     $ 25,000      $ 2,258,715  

Reciprocal Exchanges

     1,866        300,054       -         301,920  
                                    

Total, December 31, 2011

   $ 89,345      $ 2,446,290     $ 25,000      $ 2,560,635  
                                    

 

(1) $25.0 million of the Other invested assets balance at June 30, 2012 is reported at fair value. $27.3 million of Other invested assets is reported under the equity method of accounting or at amortized cost.
(2) $25.0 million of the Other invested assets balance at December 31, 2011 is reported at fair value. $19.3 million of Other invested assets is reported under the equity method of accounting or at amortized cost.

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

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

Substantially all of the portfolio valuations at June 30, 2012 classified as Level 1 or Level 2 in the above table is priced by utilizing the services of several independent pricing services that provide the Company with a price quote for each security. There were no adjustments made to the prices obtained from the independent pricing sources and dealers on securities classified as Level 1 or Level 2.

In 2012, there were no transfers of investments between Level 1 and Level 2 or between Level 2 and Level 3.

The fair values of the interest rate swaps were derived by using an industry standard swap valuation model with market based inputs for swaps having similar characteristics.

The fair value of the foreign currency forward contract was derived by multiplying the notional amount of the contract by the difference between the forward exchange rate at the anticipated settlement date of the contract and the spot rate as of June 30, 2012. The Company entered into the foreign currency forward contract as protection against currency risk on its expected purchase of 10.7 percent of Canopius Group, Ltd. This purchase is expected to close in the third quarter 2012 with the majority of purchase price denominated in British pound sterling. The Company recorded in net realized gains (losses) a $2.0 million loss in fair value on this contract.

The fair values of the debt and equity securities sold, not yet purchased were derived by using quoted prices for similar securities in active markets. These instruments resulted in net realized gains (losses) of $(2.6) million and $(0.3) million for the three and six months ended June 30, 2012, respectively.

In December 2011, the Company purchased two securities which are reported in other invested assets and have been classified as Level 3 of the fair value hierarchy. Management utilizes a discounted flow analysis to derive the fair values. For one security, which matures in 2015 and whose cash flows are supported by underlying short-term loans, the significant unobservable inputs include the underlying short-term loans’ probability of default and loss severity, and a discount for the security’s lack of marketability. Increases in the probability of default and loss severity assumptions (which generally move directionally with each other) would have the effect of decreasing the fair value of this security. The Company obtains credit ratings on the underlying short-term loans quarterly and considers these ratings when updating its assumptions. The second security is an equity instrument which entitles the Company to residual interests of a finite life special purpose vehicle. The significant unobservable inputs include the estimated losses to be incurred by the vehicle and the equity instrument’s lack of marketability. The Company obtains quarterly financial data from the vehicle and evaluates the estimated incurred loss figure. An increase in the vehicle’s estimated incurred losses would have the effect of decreasing the instrument’s fair value.

Management is responsible for the determination of the value of the investments carried at fair value and the supporting methodologies and assumptions. Management has reviewed the pricing techniques and methodologies of the independent pricing sources and believes that their policies adequately consider market activity, either based on specific transactions for the issue valued or based on modeling of securities with similar credit quality, duration, yield and structure that were recently traded. Management monitors security-specific valuation trends and discusses material changes or the absence of expected changes with the portfolio managers to understand the underlying factors and inputs and to validate the reasonableness of pricing. Management also back-tests the prices on numerous sales of securities during the year to validate the previous pricing provided as well as utilizes other pricing sources to validate the pricing provided by our primary provider of the majority of the non-U.S. Treasury securities and non-agency securities included in Level 2.

The following table summarizes changes in Level 3 assets measured at fair value for the three months ended June 30, 2012 and 2011 for Tower (the Reciprocal Exchanges have no Level 3 assets):

 

                             
     Three Months Ended
June 30,
 
($ in thousands)    2012        2011    

Beginning balance, April 1,

   $       24,914      $                 -   

Total gains (losses)-realized / unrealized

     

Included in net income

     86        -   

Included in other comprehensive income (loss)

     -         -   

Purchases, issuances and settlements

     -         -   

Net transfers into (out of) Level 3

     -         -   
                   

Ending balance, June 30,

   $ 25,000      $ -   
                   

The following table summarizes the changes in Level 3 assets measured at fair value for the six months ended June 30, 2012 and 2011:

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

     Six Months Ended
June 30,
 
($ in thousands)    2012      2011  

Beginning balance, January 1

   $       25,000      $          2,058  

Total gains (losses)-realized / unrealized

     

Included in net income

     -             (1,067

Included in other comprehensive income (loss)

     -         -   

Purchases, issuances and settlements

     -         -   

Net transfers into (out of) Level 3

     -         (991
                   

Ending balance, June 30,

   $ 25,000      $ -   
                   

Note 6 – Loss and Loss Adjustment Expense

The following table provides a reconciliation of the beginning and ending consolidated balances for unpaid losses and loss adjustment expense (“LAE”) for the six months ended June 30, 2012 and 2011:

 

                                                                                                                 
     Six Months Ended June 30,  
     2012     2011  
($ in thousands)    Tower     Reciprocal
Exchanges
    Total     Tower     Reciprocal
Exchanges
    Total  

Balance at January 1,

   $     1,495,839     $     136,274     $     1,632,113     $     1,439,106     $     171,315     $     1,610,421  

Less reinsurance recoverables on unpaid losses

     (308,411     (11,253     (319,664     (271,298     (11,384     (282,682
                                                  
     1,187,428       125,021       1,312,449       1,167,808       159,931       1,327,739  

Incurred related to:

            

Current year

     487,837       57,430       545,267       422,866       61,404       484,270  

Prior years unfavorable/(favorable) development

     78,254       (6,253     72,001       7,551       (10,799     (3,248
                                                  

Total incurred

     566,091       51,177       617,268       430,417       50,605       481,022  

Paid related to:

            

Current year

     153,792       31,369       185,161       173,061       30,347       203,408  

Prior years

     313,400       30,943       344,343       271,247       28,285       299,532  
                                                  

Total paid

     467,192       62,312       529,504       444,308       58,632       502,940  
                                                  

Net balance at end of period

     1,286,327       113,886       1,400,213       1,153,917       151,904       1,305,821  

Add reinsurance recoverables on unpaid losses

     281,959       19,661       301,620       263,619       15,259       278,878  
                                                  

Balance at June 30,

   $ 1,568,286     $ 133,547     $ 1,701,833     $ 1,417,536     $ 167,163     $ 1,584,699  
                                                  

Incurred losses and LAE for the six months ended June 30, 2012 attributable to events of prior years were $72.0 million. Excluding the Reciprocal Exchanges, the incurred losses and LAE from prior accident years were $78.3 million, comprised of net adverse loss development of $74.0 million in Commercial Insurance and $4.3 million in Personal Insurance for the six months ended June 30, 2012. During the quarter, the Company performed a comprehensive reserve study to respond to higher than expected reported losses observed in the first and second quarters of 2012, resulting in increases in ultimate loss estimates primarily for accident years 2009, 2010 and 2011 within Commercial Insurance. The Commercial Insurance adverse development of $62 million during the quarter is comprised of approximately $39 million in Workers Compensation, $22 million in Commercial Automobile Liability, and smaller changes in other lines. Approximately $51 million of the adverse development pertains to various programs, many of which have been terminated.

The Reciprocal Exchanges reported favorable development on prior accident years of $6.3 million during the six months ended June 30, 2012.

The consolidated net loss ratio, which includes the Reciprocal Exchanges, was 70.1% and 62.2% for the six months ended June 30, 2012 and 2011, respectively. Excluding the Reciprocal Exchanges, the net loss ratio was 71.1% and 63.5% for the six months ended June 30, 2012 and 2011, respectively. The Reciprocal Exchanges’ net loss ratio was 60.9% and 52.7% for the six months ended June 30, 2012 and 2011, respectively.

Prior year development is based upon numerous estimates by line of business and accident year. No additional premiums or return premiums have been accrued as a result of the prior year effects, although we recorded changes in ceding commissions on reinsurance treaties that we purchase where commissions are adjustable based on loss experience. The Company’s management continually monitors claims activity to assess the appropriateness of carried case and incurred but not reported (“IBNR”) reserves, giving consideration to Company and industry trends.

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

As of June 30, 2012, unamortized reserve for risk premium of $3.6 million and $1.3 million related to Tower and the Reciprocal Exchanges, respectively, were included in unpaid losses and LAE. As of December 31, 2011, unamortized reserve for risk premium of $7.2 million and $2.5 million related to Tower and the Reciprocal Exchanges, respectively, were included in unpaid losses and LAE.

Loss and loss adjustment expense reserves. The reserving process for loss and LAE reserves provides for the Company’s best estimate at a particular point in time of the ultimate unpaid cost of all losses and LAE incurred, including settlement and administration of losses, and is based on facts and circumstances then known and including losses that have been incurred but not yet reported. The process includes using actuarial methodologies to assist in establishing these estimates, judgments relative to estimates of future claims severity and frequency, the length of time before losses will develop to their ultimate level and the changes in the law and other external factors that are often beyond the Company’s control. The actuarial methods include loss ratio projections, loss development projections, and Bornhuetter-Ferguson (“B-F”) method projections. The actuaries’ best estimates are the result of numerous analyses made by line of business, accident year, and for loss, allocated loss adjustment expense (“ALAE”) and unallocated loss adjustment expense (“ULAE”), and the actuarial analyses also consider input from underwriting and claims managements about the nature of the underlying risks, claims and other trends in the business.

Management sets the Company’s carried reserves based upon the actuaries’ best estimates and other considerations, and the difference between the Company’s estimates of loss and LAE and reported losses is recorded in IBNR. The amount of loss and LAE reserves for reported claims is based primarily upon a case-by-case evaluation of coverage, liability, injury severity, and any other information considered pertinent to estimating the exposure presented by the claim. The amounts of loss and LAE reserves for unreported claims are determined using historical information by line of insurance as adjusted to current conditions.

Included in the reserves for the loss and LAE reserves at June 30, 2012 and December 31, 2011 is $8.6 million and $3.7 million, respectively, of tabular reserve discount for workers’ compensation and excess workers’ compensation claims.

The Company has long defended third-party liability claims utilizing attorneys who are employees of the Company and has realized significant savings in defense costs as compared with claims defended by outside attorneys. For third-party liability claims defended by employed attorneys, the Company allocates to each of these litigated claims 50% of the fixed fee when litigation on a particular claim begins and 50% of the fee when the litigation is closed. The standard fee is calculated based upon the projected number of litigated claims and expected closing patterns at the beginning of each year, as well as the projected budget for the Company’s in-house attorneys, and these amounts are subject to adjustment each quarter based upon actual experience. Because of the cost advantage for ALAE utilizing employed attorneys, the Company has been increasing the number of employed attorneys. Currently, the Company is handling over 85% of new litigated third-party claims utilizing attorneys who are employees of the Company.

Due to the inherent uncertainty associated with the reserving process, the ultimate liability for losses and LAE may differ, perhaps substantially, from the Company’s estimate. Loss and LAE reserve estimates are regularly reviewed and updated and any resulting adjustments are included in the current year’s results. Loss and LAE reserves are closely monitored and are recomputed periodically using the most recent information on reported claims and a variety of statistical techniques. Specifically, on at least a quarterly basis, the Company reviews, by line of business, existing reserves, new claims, changes to existing case reserves and paid losses with respect to the current and prior accident years.

The Company segregates data for estimating loss and LAE reserves into lines of business. Property lines include Fire, Homeowners, CMP Property, Multi-Family Dwellings, Fire and Allied Lines, Inland Marine and Automobile Physical Damage Casualty lines include CMP Liability, Other Liability, Workers’ Compensation, Commercial Automobile Liability, and Personal Automobile Liability. The Company also analyzes and records loss and LAE reserves separately for Commercial Insurance and Personal Insurance.

Two key assumptions that materially impact the estimate of loss and LAE reserves are the loss ratio estimate for the current accident year and the loss development factor selections for all accident years. The loss ratio estimate for the current accident year is selected after reviewing historical accident year loss ratios adjusted for rate changes, trend, and mix of business. As an accident year matures, the ultimate loss and LAE is estimated by giving more weight to reported loss and LAE by utilizing the B-F method or loss development methods.

Note 7—Stockholders’ Equity

Shares of Common Stock Issued

For the three and six months ended June 30, 2012, no new common shares were issued as the result of employee stock option exercises. For the three and six months ended June 30, 2012, 0 and 321,178 new common shares, respectively, were issued as the

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

result of restricted stock grants. For the three and six months ended June 30, 2011, 7,612 and 31,112 new common shares, respectively, were issued as the result of employee stock option exercises and 7,498 and 621,000 new common shares, respectively, were issued as the result of restricted stock grants.

For the three and six months ended June 30, 2012, 495 and 97,356 shares, respectively, of common stock were purchased from employees in connection with the vesting of restricted stock issued under the 2004 Long Term Equity Compensation Plan (the “Plan”). For the three and six months ended June 30, 2011, 10,897 and 69,315 shares, respectively, of common stock were purchased from employees in connection with the vesting of restricted stock issued under the Plan. The shares were withheld at the direction of employees as permitted under the Plan in order to pay the expected amount of tax liability owed by the employees from the vesting of those shares. In addition, for the three and six months ended June 30, 2012, 4,432 and 8,715 shares, respectively, of common stock were surrendered as a result of restricted stock forfeitures. For the three and six months ended June 30, 2011, 1,596 and 2,914 shares, respectively, of common stock were surrendered as a result of restricted stock forfeitures.

Share Repurchase Program

The Board of Directors of Tower approved a $100 million share repurchase program on March 3, 2011. This authorization is in addition to the $100 million share repurchase program approved on February 26, 2010. Purchases under both programs can be made from time to time in the open market or in privately negotiated transactions in accordance with applicable laws and regulations. The new share repurchase program will expire on March 4, 2013. In the six months ended June 30, 2012 and 2011, 1.1 million and 0.8 million shares, respectively, of common stock were purchased under these programs at an aggregate consideration of $21.0 million and $20.0 million, respectively. As of June 30, 2012, the original $100 million share purchase program had been fully utilized and $26.4 million remained available for future share repurchases under the new program.

Dividends Declared

Dividends on common stock of $7.3 million and $7.7 million for the three months ended June 30, 2012 and 2011, respectively, were declared. Dividends on common stock of $14.7 million and $12.9 million for the six months ended June 30, 2012 and 2011, respectively, were declared.

On August 1, 2012, the Board of Directors approved a quarterly dividend of $0.1875 per share payable on September 21, 2012 to stockholders of record as of September 10, 2012.

Note 8—Debt

The Company’s borrowings consisted of the following at June 30, 2012 and December 31, 2011:

 

     June 30, 2012      December 31, 2011  
($ in thousands)    Carrying
Value
     Fair Value      Carrying
Value
     Fair Value  

Credit facility

   $ 70,000      $ 70,000      $ 50,000      $ 50,000  

Convertible senior notes

         143,233            157,875            141,843            150,743  

Subordinated debentures

     235,058        236,478        235,058        234,550  
                                     

Total

   $ 448,291      $ 464,353      $ 426,901      $ 435,293  
                                     

The fair value of the convertible senior notes in the table above are determined utilizing pricing for similar instruments in active markets and the fair value of the subordinated debentures in the table above are based on discounted cash flow analysis. The significant inputs used for fair value are considered Level 2 in the fair value hierarchy.

Total interest expense incurred, including interest expense on the funds held liabilities was $7.9 million and $8.3 million for the three months ended June 30, 2012 and 2011, respectively, and was $15.5 million and $16.4 million for the six months ended June 30, 2012 and 2011, respectively.

Subordinated Debentures

The Company and its wholly-owned subsidiaries have issued trust preferred securities through wholly-owned Delaware statutory business trusts. The trusts use the proceeds of the sale of the trust preferred securities and common securities that the Company acquired from the trusts to purchase junior subordinated debentures from the Company with terms that match the terms of the trust preferred securities. Interest on the junior subordinated debentures and the trust preferred securities is payable quarterly. In

 

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Notes to Consolidated Financial Statements (Unaudited)

 

 

some cases, the interest rate is fixed for an initial period of five years after issuance and then floats with changes in the London Interbank Offered Rate (“LIBOR”) and in other cases the interest rate floats with LIBOR without any initial fixed-rate period. As of June 30, 2012, The Company had outstanding par of $235.1 million relating to the subordinated debentures.

Interest Rate Swaps

In October 2010, the Company entered into interest rate swap contracts (the “Swaps”) with $190 million notional value to manage interest costs and cash flows associated with the floating rate subordinated debentures. The Swaps have terms of five years. The Swaps convert the subordinated debentures to rates ranging from 5.1% to 5.9%. As of June 30, 2012 and December 31, 2011, the Swaps had a fair value of $8.8 million and $7.4 million in a liability position, respectively, and are reported in Other Liabilities.

The Company has designated and accounts for the Swaps as cash flow hedges. The Swaps are considered to have no ineffectiveness and changes in their fair values will be recorded in Accumulated other comprehensive income (“AOCI”), net of tax. For the six months ended June 30, 2012 and 2011, $0.8 million and $0.1 million, respectively, was reclassified from AOCI to interest expense for the effects of the hedges. As of June 30, 2012, the Company had collateral on deposit with the counterparty amounting to $8.7 million pursuant to a Credit Support Annex.

Credit Facility

On February 15, 2012, the Company amended its $125.0 million credit facility by increasing borrowing capacity up to $150 million, extending the maturity date to February 15, 2016, and resetting borrowing fees to more favorable current market terms. The credit facility is used for general corporate purposes. The original credit facility was entered into on May 14, 2010 and had an expiration date of May 14, 2013.

The Company may request that the facility be increased by an amount not to exceed $50 million. The credit facility contains customary covenants for facilities of this type, including restrictions on indebtedness and liens, limitations on mergers, dividends and the sale of assets, and requirements to maintain certain consolidated net worth, debt to capitalization ratios, minimum risk-based capital and minimum statutory surplus. The credit facility also provides for customary events of default, including failure to pay principal when due, failure to pay interest or fees within three days after becoming due, failure to comply with covenants, any representation or warranty made by the Company being false in any material respect, default under certain other indebtedness, certain insolvency or receivership events affecting the Company and its material subsidiaries, the occurrence of certain material judgments, or a change in control of the Company, and upon an event of default, the administrative agent (subject to the consent of the requisite percentage of the lenders) may immediately terminate the obligations to make loans and to issue letters of credit, declare the Company’s obligations under the credit facility to become immediately due and payable, and require the Company to deposit in a collateral account cash collateral with a value equal to the then outstanding amount of the aggregate face amount of any outstanding letters of credit. The Company was in compliance with all covenants under the credit facility at June 30, 2012.

The Company had $70.0 million and $50.0 million outstanding as of June 30, 2012 and December 31, 2011, respectively. The weighted average interest rate on the amount outstanding as of June 30, 2012 was 2.0%.

Convertible Senior Notes

In September 2010, the Company issued $150.0 million principal amount of 5.0% convertible senior notes (“the Notes”), which mature on September 15, 2014. Interest on the Notes is payable semi-annually in arrears on March 15 and September 15 of each year, commencing March 15, 2011. Holders may convert their Notes into cash or common shares, at the Company’s option, at any time on or after March 15, 2014 or earlier under certain circumstances determined by: (i) the market price of the Company’s stock, (ii) the trading price of the Notes, or (iii) the occurrence of specified corporate transactions. Upon conversion, the Company intends to settle its obligation either entirely or partially in cash. The conversion rate at June 30, 2012 is 36.9105 shares of common stock per $1,000 principal amount of the Notes (equivalent to a conversion price of $27.09 per share), subject to adjustment upon the occurrence of certain events. Additionally, in the event of a fundamental change, the holders may require the Company to repurchase the Notes for a cash price equal to 100% of the principal plus any accrued and unpaid interest.

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

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

including amortization of deferred origination costs, recognized on the Notes was $5.7 million for the six months ended June 30, 2012.

The following table shows the amounts recorded for the Notes as of June 30, 2012 and December 31, 2011:

 

($ in thousands)    June 30,
2012
    December 31,
2011
 

Liability component

    

Outstanding principal

   $     150,000     $ 150,000  

Unamortized OID

     (6,767     (8,157
                  

Liability component

     143,233       141,843  
                  

Equity component, net of tax

   $ 7,469     $ 7,469  
                  

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

Convertible Senior Notes Hedge and Warrant Transactions

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

In September 2010, the Company paid $15.3 million for the Note Hedges which cover 5.5 million shares of common stock at a strike price of $27.09 per share at June 30, 2012, subject to anti-dilution provisions, and are exercisable upon conversion of the Notes. The Note Hedges have been accounted for as an adjustment to the Company’s paid-in-capital, net of deferred taxes.

In September 2010, the Company received $3.8 million for Warrants sold to the financial institutions. The Warrants provide for the acquisition of 5.5 million shares of common stock at a strike price of $32.94 per share at June 30, 2012, subject to anti-dilution adjustments. The Warrants have been accounted for as an adjustment to the Company’s paid-in-capital.

To the extent the Company’s common stock price is above $27.09 but below the Warrant strike price of $32.94, there is no dilutive effect to common stockholders’ equity because the Note Hedge offsets any shares to be issued under the Notes. If the market value per share of the Company’s common stock exceeds the strike price of the Warrants, the Warrants will have a dilutive effect on the Company’s net income per share.

Note 9—Stock Based Compensation

2004 Long-Term Equity Compensation Plan

In 2004, the Company’s Board of Directors adopted and its stockholders approved a long-term incentive plan (the “Plan”).

The plan provides for the granting of non-qualified stock options, incentive stock options (within the meaning of Section 422 of the Code), stock appreciation rights (“SARs”), restricted stock and restricted stock unit awards, performance shares and other cash or share-based awards.

Restricted Stock

The following table provides an analysis of restricted stock activity for the six months ended June 30, 2012 and 2011:

 

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Notes to Consolidated Financial Statements (Unaudited)

 

 

                                                                                       
     Six Months Ended June 30,  
     2012      2011  
      Number of
Shares
    Weighted
Average
Grant Date
Fair Value
     Number of
Shares
    Weighted
Average
Grant Date
Fair Value
 

Outstanding, January 1

     988,607     $     23.44        591,675     $     23.10  

Granted

     321,178       23.08        621,000       23.90  

Vested

     (388,115     23.87        (227,580     23.59  

Forfeitures

     (8,715     23.60        (2,914     22.88  

Outstanding, June 30,

     912,955     $ 23.09        982,181     $ 23.49  

Stock Options

The following table provides an analysis of stock option activity for the six months ended June 30, 2012 and 2011:

 

                                                                                       
     Six Months Ended June 30,  
     2012      2011  
      Number of
Shares
     Average
    Exercise    
Price
    

Number of

Shares

    Average
Exercise
Price
 

Outstanding, January 1

     855,530      $     20.14        917,155     $     19.62  

Exercised

     -         -         (31,112     10.99  

Forfeitures and expirations

     -         -         (22,981     26.48  

Outstanding, June 30

     855,530      $ 20.14        863,062     $ 20.16  

Exercisable, June 30

     855,530      $ 20.14        808,115     $ 20.26  

Stock Based Compensation Expense

The following table provides an analysis of stock based compensation expense for the six months ended June 30, 2012 and 2011:

 

                                           
     Six Months Ended
June 30,
 
($ in thousands)    2012      2011  

Restricted stock

     

Expense, net of tax

   $ 896       $ 3,035  

Value of shares vested

     8,576        5,391  

Value of unvested shares

         19,257            23,396  

Stock options

     

Intrinsic value of outstanding options

     1,632        3,715  

Intrinsic value of vested outstanding options

     1,632        3,432  

Unrecognized compensation expense

     

Non-vested stock options, net of tax

     -         42  

Unvested restricted stock, net of tax

     12,791        19,150  

Weighted average years over which expense will be recognized

     2.5        2.6  

Note 10—Earnings (Loss) per Share

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

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

 

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Notes to Consolidated Financial Statements (Unaudited)

 

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
(in thousands, except per share amounts)    2012     2011      2012     2011  

Numerator

         

Net income (loss) attributable to Tower Group, Inc.

   $ (15,113   $ 24,121      $ 5,521     $ 49,806  

Denominator

         

Weighted average common shares outstanding

         39,117           41,303            39,206           41,404  

Effect of dilutive securities:

         

Stock options

     -        88        62       111  

Other

     -        4        -        3  

Weighted average common and potential dilutive shares outstanding

     39,117       41,395        39,268       41,518  

Earnings (loss) per share attributable to Tower stockholders - basic

         

Common stock:

         

Distributed earnings

   $ 0.19     $ 0.19      $ 0.38     $ 0.32  

Undistributed earnings

     (0.58     0.39        (0.24     0.88  

Total

     (0.39     0.58        0.14       1.20  

Earnings (loss) per share attributable to Tower stockholders - diluted

   $ (0.39   $ 0.58      $ 0.14     $ 1.20  

The computation of diluted earnings per share excludes outstanding options and other common stock equivalents in periods where inclusion of such potential common stock instruments would be anti-dilutive. For the three and six months ended June 30, 2012 855,500 and, 168,100, respectively, options and other common stock equivalents to purchase Tower shares were excluded from the computation of diluted earnings per share because the exercise price of the options was greater than the average market price. For the three and six months ended June 30, 2011 170,800 and, 170,800, respectively, options and other common stock equivalents to purchase Tower shares were excluded from the computation of diluted earnings per share because the exercise price of the options was greater than the average market price.

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

Note 11—Segment Information

The accounting policies of the segments are the same as those described in the summary of significant accounting policies in the Annual Report on Form 10-K for the year ended December 31, 2011.

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

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

 

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Notes to Consolidated Financial Statements (Unaudited)

 

 

Business segment results are as follows:

 

     Three Months Ended
June  30,
    Six Months Ended
June  30,
 
($ in thousands)    2012     2011     2012     2011  

Commercial Insurance Segment

        
Revenues         

Premiums earned

   $     337,650     $     263,735     $     635,485     $     515,503  

Ceding commission revenue

     3,894       4,710       3,904       8,728  

Policy billing fees

     1,390       1,114       2,903       1,878  

Total revenues

     342,934       269,559       642,292       526,109  
Expenses         

Loss and loss adjustment expenses

     281,209       166,597       482,647       331,087  

Underwriting expenses

     113,954       86,633       217,750       173,861  

Total expenses

     395,163       253,230       700,397       504,948  

Underwriting profit (loss)

   $ (52,229   $ 16,329     $ (58,105   $ 21,161  

Personal Insurance Segment

        
Revenues         

Premiums earned

   $ 122,503     $ 129,795     $ 244,826     $ 257,822  

Ceding commission revenue

     6,186       5,945       11,339       10,108  

Policy billing fees

     1,610       1,545       3,231       2,959  

Total revenues

     130,299       137,285       259,396       270,889  
Expenses         

Loss and loss adjustment expenses

     68,566       74,249       134,621       149,935  

Underwriting expenses

     59,059       59,250       113,457       113,523  

Total expenses

     127,625       133,499       248,078       263,458  

Underwriting profit (loss)

   $ 2,674     $ 3,786     $ 11,318     $ 7,431  

Tower

   $ 6,481     $ (650   $ 15,373     $ 2,564  

Reciprocal Exchanges

     (3,807     4,436       (4,055     4,867  

Total underwriting profit (loss)

   $ 2,674     $ 3,786     $ 11,318     $ 7,431  

Insurance Services Segment

        
Revenues         

Management fee income

   $ 7,965     $ 7,704     $ 14,827     $ 14,399  

Other revenue

     1,359       (73     1,856       529  

Total revenues

     9,324       7,631       16,683       14,928  
Expenses         

Other expenses

     5,079       4,977       9,542       10,018  

Total expenses

     5,079       4,977       9,542       10,018  

Insurance services pretax income

   $ 4,245     $ 2,654     $ 7,141     $ 4,910  

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements (Unaudited)

 

 

The following table reconciles revenue by segment to consolidated revenues:

 

                                                                                       
     Three Months Ended
June 30,