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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(MARK ONE) ANNUAL REPORT PRUSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
[X] EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 000-50990
TOWER GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 13-3894120
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
120 BROADWAY, 14TH FLOOR
NEW YORK, NEW YORK 10271
(Address of principal executive offices) (Zip Code)
(212) 655-2000
(Registrant's telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, $0.0I PAR VALUE PER SHARE
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 Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes [ ] No [X]
As of March 14, 2005, the registrant had 19,737,168 shares of common stock
outstanding. The aggregate market value of the voting and non-voting common
equity held by non-affiliates as of December 31, 2004 was $202,602,672. This
value as of June 30, 2004 was not applicable as the registrant was not publicly
traded as of June 30, 2004.
DOCUMENTS INCORPORATED BY REFERENCE:
Part III of this Form 10-K incorporates by reference certain information
form the registrant's definitive Proxy Statement with respect to the
registrant's 2005 Annual Meeting of Shareholders, to be filed not later than 120
days after the close of the registrant's fiscal year (the "Proxy Statement").
TABLE OF CONTENTS
PAGE
PART I
Item 1. Business 3
Item 2. Properties 47
Item 3. Legal Proceedings 47
Item 4. Submission of Matters to a Vote of Security-Holders 47
PART II
Item 5. Market for The Registrant's Common Equity and Related Stockholder Matters 47
Item 6. Selected Consolidated Financial Data 49
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations 51
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 75
Item 8. Financial Statements and Supplementary Data 79
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure 116
Item 9A. Controls and Procedures 116
Item 9B. Other Information 116
PART III
Item 10. Directors and Executive Officers of the Registrant 117
Item 11. Executive Compensation 117
Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters 117
Item 13. Certain Relationships and Related Transactions 117
Item 14. Principal Accounting Fees and Services 117
PART IV
Item 15. Exhibits, Financial Statement 118
2
PART I
ITEM 1. BUSINESS
OVERVIEW
As used in this Form 10-K, references to the "Company", "we", "us", or
"our" refer to Tower Group, Inc. and its subsidiaries, including its insurance
company, Tower Insurance Company of New York ("TICNY"), and its managing general
agency, Tower Risk Management Corporation ("TRM"), unless the context suggests
otherwise.
Through our subsidiaries Tower Insurance Company of New York and Tower Risk
Management Corporation, we offer a broad range of specialized property and
casualty insurance products and services to small to mid-sized businesses and to
individuals in New York State and the surrounding areas. By targeting select
underserved market segments and expeditiously delivering needed products and
services, we position ourselves to obtain favorable policy terms, conditions and
pricing, thereby creating opportunities for favorable underwriting results.
TICNY provides coverage for many different market segments, including
nonstandard risks that do not fit the underwriting criteria of standard carriers
due to factors such as type of business, location and premium per policy. TRM,
through its managing general agency, produces business on behalf of other
insurance companies, referred to as "issuing companies", and primarily focuses
on commercial risks with higher per policy premium, including risks that TICNY
has not been able to target due to, among other things, licensing and surplus
limitations. TICNY also reinsures a modest amount of the premiums written by
TRM's issuing companies. Our commercial lines products provide insurance
coverage to businesses such as retail and wholesale stores, grocery stores,
restaurants, artisan contractors and residential and commercial buildings, while
our personal lines products currently focus on modestly valued homes and
dwellings.
Through the use of reinsurance in TICNY and other issuing companies that we
access through TRM's managing general agency, we have been able to create and
support a much larger premium base and insurance company infrastructure than
otherwise would have been possible given TICNY's pre-initial public offering
("IPO") surplus base. In addition, TRM earns fee revenues by providing claims
administration and reinsurance intermediary services to its issuing companies
and to other insurance companies.
On October 20, 2004, the Company sold 13,000,000 shares in its IPO at $8.50
per share. On the same date, the Company also effected a concurrent private
placement of 500,000 shares of its common stock to an affiliate of Friedman,
Billings, Ramsey & Co., Inc., the lead underwriter for the Company's IPO, at a
price of $8.50 per share. On November 10, 2004 the underwriters exercised their
30-day over-allotment option after the Company's IPO. Pursuant to this exercise,
the underwriters purchased 629,007 additional shares of common stock from the
Company and 1,320,993 shares of common stock from selling shareholders. The
Company received net cash proceeds of $107,845,000 from the offering and
concurrent private placement after the underwriting discounts, commissions and
offering expenses.
COMPETITIVE STRENGTHS
We believe that our competitive strengths position us to continue to expand
our business profitably. These strengths include:
o PROVEN PRODUCT DEVELOPMENT AND MARKETING EXPERTISE. We have
accomplished profitable growth by developing and expanding our product
line offering over time. Throughout our history, we have successfully
developed and positioned several commercial lines products that provide
property, liability, workers' compensation and auto insurance and
personal lines products such as homeowner's policies in response to
specific insurance needs in targeted market segments.
o OPPORTUNISTIC UNDERWRITING AND CAPITAL ALLOCATION. We target market
segments that we identify as underserved by other insurance companies
and allocate our capital and other resources opportunistically among
various market segments in response to changing market conditions. In
the five years ended December 31, 2004, TICNY's average net combined
ratio was 79.5%, and its average gross combined ratio over the same
period was 91.8%.
3
o COST-EFFECTIVE UNDERWRITING AND PROCESSING CAPABILITY. We believe our
systems and technology have resulted in a cost-effective underwriting
and processing capability that enables us to efficiently underwrite a
large number of small policies in urban areas such as New York City,
providing a competitive advantage over other insurance companies
lacking this capability. Despite the operational challenges of
underwriting and processing these policies, TICNY's gross underwriting
expense ratio was 31.0% in 2004.
o GENERATION OF COMMISSION AND FEE REVENUE. Our use of reinsurance
enables us to generate reinsurance ceding commission income on premiums
that we cede to our reinsurers, while access to issuing companies
through our managing general agency has expanded our capacity to
underwrite and produce premiums on which we earn fee income. This
strategy has enabled us to augment our return on equity. Our return on
average equity was 23.7% in 2004 and averaged 31.8% for the five years
ended December 31, 2004. The lower return on average equity in 2004
resulted from the significant increase in average shareholders' equity
as the IPO was completed in the fourth quarter.
o CLAIMS AND LEGAL DEFENSE APPROACH. Our claims staff and in-house
attorneys handle all of our claims and the majority of our lawsuits
internally. This enables us to maintain a high level of service to our
property policyholders and reduce the cost of claims to our casualty
policyholders by vigorously defending non-meritorious and frivolous
claims.
o PROVEN LEADERSHIP AND EXPERIENCED MANAGEMENT. Our senior management
team members have an average of over 20 years of insurance industry
experience. Michael H. Lee, our Chairman of the Board, President and
Chief Executive Officer, was a founder of the company in 1990 and has
an extensive knowledge and understanding of our business, having played
a key role in building several aspects of our operations, including
underwriting, finance, claims and systems.
STRATEGY
The business model that we have developed in the 14 years since we began
our operations has allowed us to succeed despite a limited pre-IPO capital base.
This model has enabled us to support a much larger premium base and create an
insurance company infrastructure otherwise not possible, ultimately leading to
the present stage of our development. With the infusion of the proceeds from our
IPO and the concurrent private placement in October 2004, we increased the
statutory surplus in our insurance company and are pursuing continued profitable
growth through the following strategies:
o REDUCING OUR DEPENDENCE ON REINSURANCE AND OTHER INSURANCE COMPANIES.
The additional capital from the IPO and the concurrent private
placement has allowed us to retain a greater percentage of our premium
writings and thereby reduce our use of quota share reinsurance in our
insurance company. It has also provided us with greater flexibility to
selectively retain a larger portion of the business previously placed
with other insurance companies while continuing to utilize TRM to
generate commissions on premiums placed with other insurance companies
and non-risk bearing, service income. Depending on our capital and
changing quota share reinsurance market conditions, we may ultimately
eliminate our use of quota share reinsurance.
o IMPROVING OUR RATING TO ATTRACT CUSTOMERS IN OTHER MARKET SEGMENTS. As
a result of the infusion of $98.0 million of the proceeds of the IPO
and concurrent private placement into our insurance company operation,
on October 26, 2004, TICNY received a rating upgrade from A.M. Best to
"A-" (Excellent) from "B++" (Very Good). Our A.M. Best rating reflects
A.M. Best's opinion of TICNY's financial strength and is not an
evaluation directed to investors in our common stock nor a
recommendation to buy, sell or hold our common stock. Ratings are an
increasingly important factor in establishing the competitive position
of insurance companies. There is no guarantee that TICNY will maintain
the improved rating. An increase in rating positions us to write
policies in rating-sensitive market segments that TICNY was not
previously able to access, especially policies written by TRM's issuing
companies. This rating increase should also enable TICNY to reinsure
other insurance companies, including TRM's issuing companies, and
assume a greater portion of profitable reinsurance business. By writing
these larger policies that TRM currently produces, TICNY also will be
able to lower its expense ratio since these larger policies entail
lower direct commission expense (13.9% in 2004 for TRM's business
compared with 16.7% for TICNY's business) as well as lower underwriting
cost relative to the premium per policy.
4
o EXPANDING TERRITORIALLY. Our insurance company subsidiary is presently
licensed in New York State. We believe that the insurance products and
services that we currently offer carry strong market demand beyond our
current core market of New York City and the adjacent areas of New York
State to areas of upstate New York and the surrounding states in the
Northeast. In January 2005, we entered into a stock purchase agreement
to acquire North American Lumber Insurance Company ("NALIC"), a shell
company with active licenses in the following nine states: New Jersey,
Connecticut, Massachusetts, Rhode Island, Vermont, Maryland, Delaware,
South Carolina and Wisconsin. While there is no guarantee this
transaction will close, in the event it does, this acquisition will
allow us to continue executing our plan to expand territorially first
in New Jersey after the close of the transaction, followed by expansion
into other states. We also expect to make similar shell acquisitions in
the future in order to offer products in various market segments in the
same territory. In addition, we recently formed a Program Underwriting
Unit to expand on our regional distribution approach and allow us
greater access to established, highly focused and narrowly defined
books of business with which we are familiar but which are typically
distributed over a broader geographical area. This program capability
should enable us to add greater value to our extensive network of
wholesale and retail agents by developing new program opportunities for
classes of businesses which we do not currently underwrite or in which
we have limited market penetration. See "Shell Acquisition" below.
o ACQUIRING BOOKS OF BUSINESS. We intend to continue to acquire books of
business that fit our underwriting competencies from competitors,
managing agents and other producers. In September 2004, the Company
entered into a Commercial Renewal Rights Agreement with OneBeacon
Insurance Group LLC and some of its insurance company subsidiaries
pursuant to which we have acquired OneBeacon's rights to seek to renew
a block of commercial lines insurance policies in New York State. See
"OneBeacon Renewal Rights Transaction" below.
o EXPANDING NON-RISK-BEARING FEE-GENERATING SERVICES. We plan to continue
to generate commission and fee income through our insurance services
operation by offering managing general underwriting, reinsurance
intermediary and claims administration services.
o CONTINUING IMPLEMENTATION OF TECHNOLOGICAL IMPROVEMENTS. We plan to
continue our implementation of technology-based initiatives such as
WebPlus, our web-based platform for quoting and capturing policy
submissions from our agents, in order to improve customer service and
further lower our underwriting expense ratio.
ONEBEACON RENEWAL RIGHTS TRANSACTION
In September 2004, we entered into a Commercial Renewal Rights Agreement
with OneBeacon Insurance Group LLC ("OneBeacon") and some of its insurance
company subsidiaries pursuant to which we have acquired OneBeacon's rights to
seek to renew a block of commercial lines insurance policies in New York State.
The subject policies consist of commercial multiple-peril, workers compensation,
commercial umbrella, commercial inland marine, commercial auto, fire and allied
lines and general liability coverages and generated more than $100 million in
gross written premiums for OneBeacon in 2003.
Under the terms of the agreement, we did not acquire any in-force business
or historical liabilities associated with the policies. In addition, we are not
obligated to renew any particular policies, but are free to seek to renew those
policies that meet our underwriting guidelines and on which we can charge a
satisfactory premium. The agents who produced the subject policies for OneBeacon
generally control the renewals; they are not obligated to produce the renewals
for us and can direct the renewals to other carriers if they choose. We have
appointed over 280 agencies located throughout New York State who have been
producing this business for OneBeacon. Based upon our initial review of the
subject policies and our current underwriting guidelines, we are seeking to
renew policies generating approximately $30 million to $40 million in annual
gross written premiums for the twelve months commencing December 1, 2004, but
there is no guarantee that we will be able to write any particular level of
renewals. Our estimate may change depending on agents' behavior and as we learn
more about the subject policies and apply our underwriting and pricing
guidelines to policies that are up for renewal.
5
We have agreed to pay OneBeacon a commission on the policies we renew, in
an amount equal to 5% of the direct premiums written resulting from our renewal
of any subject policies in the first year, 4% in the second year and 1% in the
third year, with no payments due after the third year. However, we are obligated
to pay OneBeacon a minimum commission of $2 million for policies we renew in the
first year, $2 million in the second year and $1 million in the third year. We
have posted letters of credit with OneBeacon to secure our minimum commission
obligations. OneBeacon has agreed not to compete with us until December 2006 in
writing the policies that are subject to the agreement.
We determined that two intangible assets were acquired in this transaction:
renewal rights and valuable agent contractual relationships with 280 new agents,
both of which were determined to be intangible assets with a finite useful life.
The renewal rights were recorded at $1,250,000 and will be amortized over ten
years in proportion to anticipated renewal premiums to be written during this
time period. The new agent contractual relationships have been recorded at
$3,750,000 and will be amortized over twenty years on a straight-line basis.
SHELL ACQUISITION
In January 2005, we entered into a stock purchase agreement to acquire
North American Lumber Insurance Company ("NALIC"), a shell company with active
licenses in the following nine states: New Jersey, Connecticut, Massachusetts,
Rhode Island, Vermont, Maryland, Delaware, South Carolina and Wisconsin. NALIC
will be initially capitalized with part of the $26.0 million raised through two
offerings of trust preferred securities in December 2004. According to the terms
of the agreement, all liabilities and assets of NALIC (which will be renamed)
will be transferred to a liquidating trust prior to closing with the exception
of its charter and insurance licenses. The transaction has received court
approval in Massachusetts and is expected to close in March or April 2005.
INDUSTRY BACKGROUND
Property and casualty insurance provides protection to insured parties from
damage to property (for example, damage to a building and its contents from
fire) and from claims by third parties (for example, injuries suffered by a
person on insured premises or as a result of actions or omissions by the insured
or its agents) arising from specified events. Property and casualty insurance
can be broadly classified into commercial lines, in which insurance is provided
to business enterprises, and personal lines, in which insurance is provided to
individuals.
The property and casualty insurance business has historically been subject
to cyclical fluctuations in pricing and availability of property and casualty
insurance. "Soft" markets are characterized by excess capital and underwriting
capacity, as well as pricing and policy terms and conditions generally being
less favorable to insurers, resulting in intense premium rate competition, an
erosion of underwriting discipline and poor operating performance. This market
condition is eventually followed by a period of diminished underwriting capacity
and greater underwriting discipline with insurance companies exiting
unprofitable areas of business and/or increasing their premium rates in order to
improve operating performance. This phase of the cycle is generally referred to
as a "hard" market.
Since we began operations in 1990 and continuing into 2000, the property
and casualty industry experienced a prolonged soft market characterized by
excess capacity as well as undisciplined underwriting. During this period, many
primary insurance companies and reinsurers lowered their rates, increased
coverage, increased commission rates paid and relaxed their underwriting
standards in order to compete for business.
We first began to notice the beginning of a hard market in late 2000, when
reinsurers began non-renewing unprofitable business, charging significantly
higher excess reinsurance rates and reducing ceding commissions paid on quota
share reinsurance business. The changes in the reinsurance market that began in
late 2000 were followed immediately by changes in the primary insurance market
in 2001, with many insurance companies and managing general agencies increasing
their rates, limiting policy terms and conditions and reducing commissions paid
to their producers. The September 11, 2001 terrorist attacks provided the
property and casualty industry with its single largest loss in its history,
estimated by A.M. Best to be between $30 and $40 billion. Despite our
geographical focus in New York City and the significant industry loss, our gross
and net losses from this catastrophe were limited to $1.2 million and $0.4
million, respectively. See "Item 1.--Underwriting" for further details. The
substantial loss of insurance and reinsurance capacity caused by these attacks
and by the downturn in global equity markets triggered an acceleration of the
rate increases and tightening of policy terms and conditions that began in late
2000. The industry combined ratio was 100.1% in 2003 and is estimated by A.M.
Best to decline to 97.6% in 2004 as a consequence of the compounded effects of
annual rate increases and tighter policy terms. However, beginning in the latter
half of 2004, the rates for property and casualty insurance products began to
moderate, and for certain products, rates began to decrease due to an increased
level of competition. A.M. Best estimates that industry wide growth in net
premiums written in the homeowner's line slowed in 2003 and 2004, and is
expected to slow further in 2005, while industry wide net premiums written in
commercial lines grew significantly less in 2004 than in 2003 and are projected
to decline slightly in 2005. These changes may signal the start of a "soft
market" cycle that could restrict or diminish our ability to obtain rate
increases as in the recent past. We cannot predict with any certainty the
direction the market will take during 2005 or thereafter. See "Item 1.-Risks
Related to Our Industry" and "Item 7.- Marketplace Conditions and Trends" for
further discussion on market conditions.
6
BUSINESS SEGMENTS
We operate in three business segments:
o Insurance. In our insurance segment, TICNY provides commercial lines
policies to businesses and personal lines policies to individuals in
New York State. TICNY's commercial lines products include commercial
multiple-peril, monoline general liability, commercial umbrella,
monoline property, workers' compensation and commercial automobile
policies. Its personal lines products consist of homeowners, dwelling
and other liability policies. See "Item 1.-Insurance Segment Products".
o Reinsurance. In our reinsurance segment, TICNY accepts or assumes
reinsurance directly from TRM's issuing companies or indirectly from
reinsurers that provide reinsurance coverage directly to these issuing
companies. As a reinsurer, TICNY assumes a modest amount of the risk on
the premiums that TRM produces. While this reinsurance business
historically has not been profitable, the commission income generated
by TRM on the production of this business has exceeded any underwriting
losses from the reinsurance assumed on this business. See "Item
1.-Insurance Services Segment Products and Services".
o Insurance Services. In our insurance services segment, TRM, as a
managing general agency, generates commission income by producing
premiums on behalf of its issuing companies and generates fees by
providing claims administration and reinsurance intermediary services.
TRM does not assume any risk on business produced by it. All of the
risk is written by the issuing companies and ceded to a variety of
reinsurers pursuant to reinsurance programs arranged by TRM working
with outside reinsurance intermediaries. Placing risks through TRM's
issuing companies allowed us to underwrite larger policies and gain
exposure to market segments unavailable to TICNY due to rating,
financial size or geographical licensing limitations, or other factors.
Through its issuing companies, TRM produces commercial package,
monoline general liability, monoline property, commercial automobile
and commercial umbrella products. See "Item 1.-Insurance Services
Segment Products and Services".
Prior to our IPO, TICNY's limited capital, rating and licensing constrained
its ability to write and retain large premium volume. Consequently, TICNY made
extensive use of quota share reinsurance to manage the level of risk it retains
in relation to its capital. In 1995, we formed TRM in order to produce business
for other insurance companies that TICNY was precluded from writing due to
TICNY's limited capital, rating and licensing. TRM also enabled us to earn fee
revenue and to lower our underwriting expense ratio by creating economies of
scale and sharing some of the cost of developing and maintaining a full
insurance infrastructure. In order for us to obtain reinsurance for TRM's
issuing companies, the reinsurers often require TICNY to assume reinsurance
premiums directly from TRM's issuing companies or from reinsurers that reinsure
the premiums written by these companies.
7
The following table summarizes the focus of our three segments:
INSURANCE (TICNY) REINSURANCE (TICNY) INSURANCE SERVICES (TRM)
----------------------- ------------------------- ------------------------
RISK BEARING RISK BEARING NON-RISK BEARING
PREMIUM SIZE Small (under $25,000 TICNY assumes a modest Small (under $25,000
premium per policy) portion of the premiums premium per policy)
written by TRM's issuing Medium ($25,000 to
companies on all business $100,000 premium per
produced by TRM. policy)
Large (over $100,000 per
policy)
PRICING TIER Standard and Non-Standard Preferred, Standard and
Non-Standard
EMPHASIZED CLASSES OF Retail and wholesale stores, Residential and
BUSINESS grocery stores, restaurants, commercial buildings
artisan contractors, apartment
buildings
Homeowners, dwelling and
other non-auto related
personal lines products
TERRITORY New York State New York, New Jersey,
Pennsylvania and
incidental locations
throughout the country,
but primarily in the
Northeast
COVERAGES Businessowners Policy Commercial Package Policy
Commercial Package Policy Monoline Commercial
Monoline Commercial Property
Property Monoline General Liability
Monoline General Liability Commercial Auto
Commercial Umbrella
Commercial Auto
Workers' Compensation
Homeowners and Dwelling
SERVICES Reinsurance intermediary
Claims administration
INSURANCE SEGMENT PRODUCTS
In our insurance segment, TICNY offers a broad array of commercial and
personal lines products. Our insurance segment products currently target low
severity, low frequency risks with an overall average annual premium in 2004 of
$3,091 per policy for commercial lines and $899 per policy for personal lines.
Typically, the liability coverage on these classes of business is not exposed to
long-tailed (i.e., many years may pass before claims are reported or settled),
complex or contingent risks, such as products liability, asbestos or
environmental claims. These risks are located in New York City and the adjacent
areas of New York State, a market that we feel, in our lines of business, level
of risk and premium size, has historically been overlooked by regional and
national insurance companies. With the OneBeacon renewal rights agreement, TICNY
is expanding its marketing territory to other areas of New York State, including
Long Island, the Hudson River Valley and Western New York. However, TICNY is
maintaining a targeted approach to underwriting, focusing on underserved markets
that we believe will permit us to achieve favorable premium rates.
8
The following table shows our gross premiums earned and loss ratio for the
insurance segment's products for the years ended December 31, 2004 and December
31, 2003.
YEAR ENDED DECEMBER 31, 2004 YEAR ENDED DECEMBER 31, 2003
GROSS GROSS GROSS GROSS
PREMIUMS LOSS PREMIUMS LOSS
EARNED RATIO EARNED RATIO
--------------- ------------ -------------- ------------
($ in thousands)
Commercial multiple-peril $ 77,917 63.1% $ 55,015 58.4%
Other liability 7,525 55.5% 5,728 60.8%
Workers compensation 14,101 61.8% 12,133 50.6%
Commercial auto 10,432 31.7% 8,133 65.4%
Homeowners 34,526 45.6% 33,809 67.3%
Fire and allied lines 6,709 55.2% 5,723 61.4%
-------- ---- -------- ----
ALL LINES $151,210 56.1% $120,541 60.9%
======== ==== ======== ====
Commercial Multiple-peril. Our commercial multiple-peril products include
commercial package policies, businessowners policies and landlord package
policies. Our commercial package policies provide property and casualty
coverages and focus on classes of business such as retail and wholesale stores,
grocery stores, restaurants and residential and commercial buildings. We have
written commercial package policies since TICNY commenced operations in 1990.
Our businessowners policies provide property and liability coverages to small
businesses. We introduced this product in 1997 to provide broader built-in
coverages for businesses in the standard and preferred pricing tiers at lower
rates than on commercial package policies. Our landlord package policy provides
property and casualty coverage for three- and four-family dwellings with a
maximum coverage limit of $700,000. As of December 31, 2004, approximately
32,126 commercial multiple-peril products were in place, including 16,746
commercial package policies and 11,477 landlord package policies and 3,903
businessowners policies.
Other Liability. We offer other liability products in personal and
commercial lines. Our commercial products are comprised of monoline commercial
general liability and commercial umbrella policies. We write commercial general
liability policies for risks that do not have property exposure or whose
property exposure is insured elsewhere. Primarily, we target residential and
commercial buildings, as well as artisan contractors for monoline general
liability. Our commercial umbrella policy, introduced in 2002, provides
additional liability coverage with limits of $1,000,000 to $5,000,000 to
policyholders who insure their primary general liability exposure with TICNY
through a business owners, commercial package policy, or commercial general
liability policy. We have the ability to offer limits of up to $10,000,000 with
facultative reinsurance. As of December 31, 2004, approximately 1,023 monoline
commercial general liability policies and 476 commercial umbrella policies were
in force. We also write monoline personal liability policies as an addition to
our dwelling fire policies. In addition, we acquired the renewal rights to a
block of comprehensive personal liability policies in the Empire renewal rights
transaction, but we are not currently issuing new comprehensive personal
liability policies. As of December 31, 2004, TICNY had approximately 1,636
comprehensive personal liability policies in force. We also write personal lines
excess liability or umbrella policies covering personal liability in excess of
the amounts covered under our homeowners and dwelling policies. We offer this
policy with a $1,000,000 limit. We do not market excess liability policies to
individuals unless we also write the underlying homeowner's policy. Further, the
excess liability is usually handled as an endorsement to the homeowner's policy.
Workers' Compensation. We introduced our workers' compensation product in
1995. Our underwriting focus is on businesses such as restaurants, retail
stores, offices, and clothing manufacturers that generally have a lower
potential for severe injuries to workers from exposure to dangerous machines,
elevated worksites and occupational diseases. This product is currently offered
on a guaranteed cost basis at the rates published by the New York State Workers'
Compensation Bureau. As of December 31, 2004, we had approximately 5,904
workers' compensation policies in force.
Commercial Automobile. Our commercial automobile product focuses on
non-fleet business such as contractor and wholesale food delivery vehicles. We
underwrite primarily medium and lightweight trucks (under 30,000 lbs. gross
vehicular weight). Historically unprofitable accounts for this segment of the
insurance industry such as livery, trucking for hire or long-haul trucking
operations are presently excluded under our underwriting guidelines. We
commenced writing commercial automobile business in 1998. As of December 31,
2004, approximately 1,032 commercial automobile policies were in force.
9
Homeowners. Our homeowner's policy is a multiple-peril policy providing
property and liability coverages for one- and two-family owner-occupied
residences. While we are expanding our marketing territories throughout New York
State, the homes we currently insure are located predominantly in the greater
New York City area. We market both a standard and preferred homeowner's product.
As of December 31, 2004, TICNY had approximately 38,237 homeowner's policies in
force.
Fire and Allied Lines. Our fire and allied lines policies consist of
dwelling policies and monoline commercial property policies. Our dwelling
product targets owner- occupied dwellings of no more than two families. The
dwelling policy provides optional coverages for personal property and can be
combined with an optional endorsement for liability insurance. This provides an
alternative to the homeowner's policy for the personal lines customer. As of
December 31, 2004, TICNY had approximately 13,724 dwelling policies in force. We
also write monoline commercial property policies for insureds that do not meet
our underwriting criteria for the liability portion of our commercial package
policies. The classes of business are the same as those utilized for commercial
package property risks. Generally, the rates charged on these policies are
higher than those for the same property exposure written on a commercial package
policy. As of December 31, 2004, approximately 84 monoline commercial property
policies were in force.
REINSURANCE SEGMENT PRODUCTS
In order for TRM to obtain reinsurance support for the business it produces
for its issuing companies, TICNY is often required to assume a limited amount of
reinsurance on this business from the issuing companies or the issuing
companies' reinsurers. By assuming risk, we align our interests with the issuing
companies and their reinsurers. While this assumed business has historically
been unprofitable, the direct commission income generated by TRM has
historically offset assumed losses. In 2004, TICNY assumed 3% of the business
produced by TRM, with gross written premiums assumed of $1.6 million,
representing 0.9% of TICNY's total gross premiums written and 2.9% of its net
premiums earned.
The profitability of the underlying assumed business improved in 2003 due
to re-underwriting and pricing increases that began in 2001. Prior to 2001,
assumed business was reinsured on a quota share basis, which required TICNY to
reinsure TRM's business on a proportional basis on any losses incurred up to a
certain limit of loss. For a part of 2001 and all of 2002, 2003 and 2004 TICNY
reinsured the assumed business on an excess of loss basis, which required TICNY
to assume losses in excess of specified loss ratio amounts as described in more
detail below. In addition to the change in the assumed reinsurance structure, we
also secured reinsurance protection on this assumed business by including this
business in the TICNY quota share reinsurance agreement from 2001 through 2002.
Assumed Reinsurance Coverage Terms. In 2003, TICNY assumed from State
National Insurance Company, Inc. ("State National") and Virginia Surety Company
("Virginia Surety") 100% of their liability above loss ratio caps of 92% for the
small business overflow program, 115% for the middle market and 125% for the
large lines general liability real estate program. TICNY also provided coverage
on a first dollar basis for losses arising out of excluded perils and coverage
in excess of certain sub-limits for perils such as terrorism, lead, mold, fungi,
and other microbes. Under an aggregate excess of loss retrocession agreement
relating to the large lines general liability real estate program, TICNY also
assumed from State National's and Virginia Surety's quota share reinsurer, PXRE
Reinsurance Company ("PXRE"), varying amounts of ultimate net loss based on
amounts of subject net premiums earned. With respect to Virginia Surety, the
large lines general liability real estate program began on August 1, 2003 and
expired on December 31, 2004, and the middle market program began on December 1,
2003 and expired on November 30, 2004. Therefore, the reinsurance terms
described above for 2003 were in effect during 2004.
In 2004, TICNY assumed from State National 100% of the liability above the
loss ratio caps under the 2004 State National Combined Quota Share Reinsurance
Agreement. These loss ratio caps were 95% for the small business overflow
program, 115% for the middle market program and 125% for the large lines general
liability real estate program. TICNY also assumed from State National the
liability for losses not covered under the original quota share reinsurance
treaties between State National and its other reinsurers. Pursuant to an
aggregate excess of loss reinsurance agreement, TICNY also assumed from two of
State National's quota share reinsurers 12.5% of losses in excess of a loss
ratio of 75% up to 115% under the middle market program and 12.5% of losses in
excess of a loss ratio of 60% up to 125% for the large lines general liability
real estate program.
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With respect to Virginia Surety, TICNY also assumed 100% of the liability
above the loss ratio caps under the 2004 Multiple Lines Quota Share Reinsurance
Agreement. These loss ratio caps were 95% for the small business program, 115%
for the middle market program and 125% for the large lines general liability
real estate program. TICNY also assumed from Virginia Surety the liability for
losses not covered under the original quota share reinsurance treaties between
Virginia Surety and its other reinsurers. Pursuant to an aggregate excess of
loss reinsurance agreement, TICNY also assumed from the two Virginia Surety's
quota share reinsurers 10.25% of losses in excess of a loss ratio of 68% under
the small market program, 15.25% of losses in excess of a loss ratio of 68%
under the middle market program and 19% of losses in excess of a loss ratio of
63% for the large lines general liability real estate program. The Virginia
Surety Multiple Lines Quota Share Reinsurance agreement began on December 1,
2004 and will expire on December 31, 2005.
INSURANCE SERVICES SEGMENT PRODUCTS AND SERVICES
TRM provides non-risk bearing managing general agency, reinsurance
intermediary and claims administration services that generate commission and fee
income for us. TRM also provides us with additional market capability to produce
business in other states, product lines and pricing tiers that TICNY cannot
currently access. TRM produces this business on behalf of its issuing companies,
which have higher ratings, greater financial resources and more licenses than
TICNY.
TRM provides underwriting, claims administration and reinsurance
intermediary services to its issuing companies by utilizing TICNY's staff,
facilities and insurance knowledge and skills. All of the business produced by
TRM for its issuing companies is ceded to reinsurers. TRM earns a commission,
equal to a specified percentage of ceded net premiums written, which is deducted
from the premiums paid to the issuing insurance companies. TRM's commission rate
varies from year to year depending on the loss experience of the business
produced by TRM. The commission rate in 2004 was 21.6%. TRM also performs claims
administration services on behalf of other insurance companies, including
companies for which TRM produced business in the past, but as to which it may no
longer act as an underwriting agent.
While TICNY has incurred underwriting losses from its assumed premiums to
support TRM's business, these losses were based upon assumed premiums that
represented only 3% of the total premiums produced by TRM on behalf of TRM's
issuing companies in 2004. TRM, as a managing general agency, however, generated
commissions on all of the premiums produced. As result, TRM has contributed to
both the profitability and the growth of our organization while at the same time
reducing TICNY's underwriting expense ratio through economies of scale and the
sharing of TICNY's operating costs. As consideration for the use of TICNY's
staff, equipment and facilities, TRM reimburses a portion of TICNY's
underwriting expenses through an expense sharing agreement. These reimbursements
were $3.0 million, $2.2 million and $1.6 million in 2004, 2003 and 2002,
respectively, representing 13.2%, 13.7% and 14.3%, respectively, of TICNY's
total other underwriting expenses in those years. TRM also reimburses TICNY for
the use of TICNY's claims and legal defense staff based upon the hourly billing
rates charged by TRM to its issuing companies. These reimbursements were $4.0
million, $3.6 million and $4.4 million in 2004, 2003 and 2002, respectively,
representing 4.8%, 4.9% and 8.0%, respectively, of TICNY's gross loss and loss
adjustment expenses in those periods. In addition to lowering TICNY's
underwriting expenses through expense reimbursement, TRM also contributes the
balance of its revenues after these expense reimbursements to our overall
pre-tax income. Those contributions were $2.0 million, $1.5 million and $3.0
million in 2004, 2003 and 2002, respectively.
In 2004 and 2003 TRM underwrote business on behalf of Virginia Surety and
State National. Virginia Surety is rated "A-" (Excellent) and State National is
rated "A" (Excellent) by A.M. Best. Virginia Surety and State National are each
licensed in all 50 states and the District of Columbia. Virginia Surety and
State National are expected to be TRM's issuing companies in 2005.
TRM's business is primarily sourced through wholesale and retail brokers.
See "Item 1.-Product Development and Marketing Strategy-Distribution" for
further detail on our producers. The business TRM writes for its issuing
companies is reinsured 100% to various reinsurers in addition to TICNY,
including Tokio Millennium Re Ltd., Hannover Reinsurance (Ireland) Ltd. and E+S
Reinsurance (Ireland) Ltd.. TRM acts as a reinsurance intermediary for its
issuing companies and arranges for all of the reinsurance ceded. For 2004, all
of the reinsurers providing reinsurance for TRM's issuing companies are rated
"A-" (Excellent) or better by A.M. Best. After A.M. Best downgraded the rating
of Converium Reinsurance (North America) Inc. to "B-" (Fair) and that company
was placed into runoff by its parent company in September 2004, Converium's
participation under our quota share treaty was novated to Tokio Millenium Re
Ltd., Hannover Reinsurance (Ireland) Ltd. and E+S Reinsurance (Ireland) Ltd.
effective January 1, 2004. See "Item 1.-Reinsurance-2004 Reinsurance Program"
for further detail.
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Managing General Agency
TRM produces business for its issuing companies through various programs,
as follows:
TRM Small Business Overflow Program. TRM's small business overflow program,
created in 2003, provides additional capacity and the ability to write risks
outside of New York for commercial lines products of the kind written by TICNY
(other than workers' compensation and landlord package policies), generating
annual premiums per policy of less than $25,000. All the rates, forms and
underwriting guidelines for this program are identical to those used by TICNY.
TRM Middle Market Program. TRM's middle market program enables us to access
commercial lines business for the same classifications of risk written by TICNY,
but having annual premiums per policy in excess of $25,000. The middle market
program also enables us to serve accounts that require a larger insurer than
TICNY or are located outside of New York. For risks that would otherwise qualify
for a commercial package policy, this program can offer monoline property or
general liability coverages where one of the coverage parts does not qualify due
to overly competitive pricing, lack of capacity, insufficient underwriting
expertise or a restricted underwriting classification.
This program focuses on mercantile, residential and commercial building
risks and offers property limits up to $30.0 million per location. Most of the
business is located in New York City, with some accounts in other areas of New
York State and New Jersey. Prior to 2001, the premium rates for the middle
market program were significantly lower than the rates offered by TICNY.
Beginning in 2001, the rates in this program were significantly increased, and
in 2004 they were not substantially different from those offered by TICNY.
TRM Large Lines General Liability Real Estate Program. This program, which
we began in 1996, provides monoline general liability policies for mercantile,
residential and commercial building risks primarily in New York City, generating
annual general liability premiums in excess of $100,000. From 2001 through 2003,
premium rates increased significantly on a cumulative basis from 2000 levels and
we re-underwrote this program. While the rate levels stabilized in 2004, we
continued to obtain modest premium changes.
TRM Claims Service
TRM's claims service division provides complete claims adjusting and
litigation management service for all commercial and personal property and
casualty lines of business to TRM's issuing insurance companies, reinsurers and
self-insureds. TRM presently bills its claims administration cost as a value
added service to its issuing companies and is reimbursed by the issuing
companies for the amounts billed. The fees earned by TRM help offset the total
expenses incurred by TICNY's claims staff and allow TICNY to maintain a larger
claims infrastructure than it would otherwise be able to support with its own
premium base. The amount of claims administration fees reimbursed by the issuing
companies was $4.0 million in 2004, $3.6 million in 2003 and $4.4 million in
2002.
In addition, TRM generates fees for a profit by providing claims
administration, audit and consulting services to self-insureds and other
insurance companies. While TRM has not actively marketed its claims service
division, its reputation in claims administration and litigation management has
brought several opportunities to act as a third-party claims administrator. For
this reason, we plan to expand our claims administration services for profit in
the future.
Tower Risk Reinsurance Intermediary Services
TRM's reinsurance intermediary services division provides reinsurance
intermediary services to TICNY and to TRM's issuing companies. Its revenue is
derived from a fee sharing agreement with an outside reinsurance intermediary on
the premium ceded to various reinsurers that reinsure TICNY and TRM's issuing
companies. Its revenue for performing these services was $0.7 million in 2004,
$1.1 million in 2003 and $3.2 million in 2002. Revenue in 2002 was higher due to
additional intermediary fees that we negotiated in that year in lieu of
commission for placing reinsurance on behalf of TICNY and TRM's issuing
companies.
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PRODUCT DEVELOPMENT AND MARKETING STRATEGY
We believe that many insurance companies develop and market their products
based on an underwriting focused approach in which they define products based
upon their underwriting guidelines and subsequently market those products to
producers whose needs fit within the bounds of their underwriting criteria.
Conversely, while we are a disciplined underwriting organization, our product
development and marketing strategy is to first identify needed products and
services from our producers and then to develop profitable products in response
to those needs. After positioning our products in this manner, we focus on
developing underwriting guidelines that enable us to make an underwriting
profit. This approach has allowed our organization to gain the reputation of
being responsive to market needs with a highly service oriented approach to our
producer base.
When we first began operations in 1990, our producers confirmed the need
for us to underwrite small commercial risks, such as apartment buildings,
restaurants and retail stores in urban areas such as New York City that other
insurance companies avoided due to a perceived lack of underwriting
profitability. In response to this need, we developed commercial package
policies that provided limited property and liability coverage customized to
meet the needs of this nonstandard market segment, as well as underwriting and
claims approaches that enabled us to achieve underwriting profitability. Since
then, we have continued to develop other commercial lines products such as
business owners, workers' compensation and commercial automobile policies, and
introduced personal lines products such as homeowners and dwelling policies, to
respond to the needs of our customers in other nonstandard segments as well as
customers in the preferred and standard market segments where we generally offer
lower rates and broader coverages for risks that we perceive to have more
desirable underwriting characteristics.
With the development of our broad product line offering, we have been able
to access markets with significant premium volume and opportunity for market
penetration. We have increased our market share in each of these lines of
business. We have been able to achieve profitable premium growth by keeping our
annual premium volume objectives in the various lines of business low relative
to the overall size of the market in those lines. This approach allows us to
remain selective in our underwriting and to avoid sacrificing profitability for
the sake of volume.
In marketing our products, we segment the market based upon industry,
location, pricing tiers and premium size. For commercial lines products, we have
generally focused on specific classes of business in the real estate, retail,
wholesale and service industries such as retail and wholesale stores,
residential and commercial buildings, restaurants and artisan contractors. We
target these underserved classes of business because we believe that they are
less complex, have reduced potential for loss severity and can be easily
screened and verified through physical or telephonic inspection.
We also have historically targeted risks located in urban areas such as New
York City that require special underwriting expertise and have generally been
avoided by other insurance companies. We have had success targeting markets in
geographical areas outside of New York City by focusing on classes of business
such as residential real estate buildings that other companies have avoided.
We have also expanded our product offering to various lines of business
within the preferred, standard and non-standard pricing segments. Within the
preferred, standard or non-standard market segment, we first develop different
pricing, coverages and underwriting guidelines. For example, the pricing for the
preferred risk segment is generally the lowest, followed by the standard and
non-standard risk segments. The underwriting guidelines are correspondingly
stricter for preferred risks in order to justify the lower premium rates charged
for these risks. Underwriting standards become progressively less restrictive
for standard and non-standard risks.
In addition to segmenting our products by industry, location and pricing
tiers, we further classify our products into the following premium size segments
under $25,000 (small), $25,000 to $100,000 (medium) and over $100,000 (large).
We have historically had more success in the small premium size segment due to
our focus on reducing our underwriting expenses by realizing economies of scale,
utilizing technology and developing efficient business processes. We believe
that due to the higher cost of underwriting small policies, other insurance
companies have not been able to price competitively in this premium size
segment. Our expense advantage has allowed us to maintain adequate rates through
industry cycles. With improved market conditions in recent years, we have seen
adequate pricing in the medium and large premium size segments as reflected by
improved underwriting performance by TRM, which has focused on these premium
size segments.
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Each year, we analyze various market segments and deliver products for each
line of business in those segments that present the best opportunity to earn an
underwriting profit based on the prevailing market conditions. As a result, the
segments on which we focus will vary from year to year as market conditions
change. We expand our product offerings in segments where we believe that we
have established the appropriate price, coverage and commission rate to generate
the desired underwriting profit. Conversely, we aim to reduce our product
offerings in market segments where competition has reduced opportunities for us
to earn an underwriting profit.
With the financial strength upgrade to "A-" (Excellent) we believe we are
positioned to expand our insurance product offering and marketing capability to
write policies generating premiums in excess of $25,000 within the preferred
tier. Prior to the upgrade, these risks were written only through TRM's issuing
companies. In addition, we believe we will be able to write preferred risks with
higher property limits than we have been able to write in TICNY prior to the
upgrade to an "A-" (Excellent) as well as products in other market segments.
There is no guarantee that TICNY will maintain the improved rating.
DISTRIBUTION
We generate business through independent wholesale and retail agents and
brokers who we refer to collectively as producers. These producers sell policies
for us as well as for other insurance companies. Prior to the renewal rights
agreement with OneBeacon, we had approximately 300 producers appointed to
generate new business. We also had approximately 400 producers who are
authorized to place only renewals of the business that we acquired in the Empire
renewal rights transaction in 2001. With the acquisition of the OneBeacon
business, we established agency agreements with an additional 280 agents
throughout New York State.
Approximately 49% of the total of TICNY's gross premiums written and
premiums produced by TRM on behalf of its issuing companies in 2004 were derived
from our top 10 producers. In 2004, Morstan General Agency, Davis Agency Inc.,
CRC Insurance and Simon Agency, Inc. produced 14%, 7%, 7% and 5%, respectively,
of the total of TICNY's gross premiums written and premiums produced by TRM on
behalf of its issuing companies. No other producer was responsible for more than
5% of TICNY's gross premiums written and premiums produced by TRM for its
issuing companies in 2004.
We carefully select our producers by evaluating several factors such as
their need for our products, premium production potential, loss history with
other insurance companies that they represent, product and market knowledge and
the size of the agency. We generally appoint producers with a total annual
premium volume greater than $5,000,000. We expect a new producer to be able to
produce at least $250,000 in annual premiums for us during the first year and
$500,000 in annual premiums after three years. The newly appointed producers
that were part of the OneBeacon transaction are providing access to the expiring
OneBeacon renewal policies, as well as producing new business within our
established underwriting guidelines and marketing appetite.
Commissions paid to producers in 2004 for TICNY averaged 16.7% of gross
premiums earned. For TRM business, average commissions in 2004 were 13.9%. Our
commission schedules are 1 to 1.5 points higher for wholesalers as compared to
retailers in recognition of the additional duties that wholesalers perform.
Also, TICNY has a profit sharing plan that added less than 1/4% to overall
commission rates in 2004.
Prior to the IPO, we were able to generate as much premium volume as
TICNY's surplus would support consistent with its A.M. Best rating. With the
additional capital infusion resulting from the IPO we have increased marketing
and business development efforts aimed at increasing premium volume in New York
City as well as other areas in New York State. This has been directed at the
orientation and training of the newly appointed agents. Additionally, with the
acquisition of additional state licenses, our focus has increased in developing
marketing capabilities and agency relationships in other northeastern states.
Currently, our activities are directed toward constructing a producer network in
New Jersey. In January 2005 we entered into a stock purchase agreement to
acquire North American Lumber Insurance Company, a shell company with active
licenses in nine states mostly on the east coast, including New Jersey,
Connecticut and various New England states. Additionally on March 1, 2005 we
announced the formation of a Programs Underwriting Unit to compliment our
regional distribution approach. The Program Underwriting Unit will allow us to
gain access to established highly focused and narrowly defined books of business
that are distributed over a broader geographical area not accessible through our
regional distribution approach. It will also enable us to add greater value to
our existing agents by developing new program opportunities for classes of
business that we do not currently underwrite or in which we have a limited
market penetration.
14
To ensure that we obtain profitable business from our producers, we attempt
to position ourselves as our producers' primary provider of the products that we
offer. We manage the results of our producers through a quarterly review to
monitor premium volume and profitability. At the end of each quarter, we produce
premium and loss history reports and develop actuarial ultimate accident year
factors in order to project the profitability of the producers. We continuously
monitor the producers in this manner so we can develop corrective action, if
necessary, at any time throughout the year.
UNDERWRITING
The underwriting strategy for controlling our loss ratio is to seek
diversification in our products and an appropriate business mix for any given
year, emphasizing profitable lines of business and de-emphasizing unprofitable
lines. At the beginning of each year, we establish the target loss ratios for
each line of business. We monitor the actual loss ratio throughout the year on a
monthly basis. If any line of business fails to meet its target loss ratio, a
cross-functional team comprised of personnel from the underwriting teams and the
corporate underwriting, actuarial, claims and loss control departments meets to
develop a corrective action plan that may involve revising underwriting
guidelines, non-renewing unprofitable segments or entire lines of business
and/or rate increases.
During the period of time that a corrective action plan is being
implemented with respect to any product line that fails to meet its target loss
ratio, premium for that product line is reduced or maintained depending upon its
effect on our total loss ratio. To offset the reduction or lack of growth in
premium volume for the products that are undergoing corrective action, we seek
to expand our premium writings in existing profitable lines of business or add
new lines of business with better underwriting profit potential.
We establish underwriting guidelines for all the products that we
underwrite to ensure a uniform approach to risk selection, pricing and risk
evaluation among our underwriters and to achieve underwriting profitability. Our
underwriting process involves securing an adequate level of underwriting
information from our producers, identifying and evaluating risk exposures and
then pricing the risks we choose to accept. For certain approved classes of
commercial risks and most personal lines policies, we allow our producers to
initially bind these risks utilizing rating criteria that we provide to them.
Also, our web-based platform WebPlus provides our producers with the capability
to submit and receive quotes over the Internet and contains our risk selection
and pricing logic, thereby enabling us to streamline our initial submission and
screening process. If the individual risk does not meet the initial submission
and screening parameters contained within WebPlus, the risk is automatically
referred to our assigned underwriter for specific offline review. See "Item
1.-Technology".
Once a risk is bound by our underwriter or producers, our internal or
outside loss control representatives conduct physical inspections of
substantially all of the insured premises to validate the information provided
by our producers and provide a loss control report to our underwriters to make a
final evaluation of the risk. With the exception of a few typically low risk
classes of business such as beauty parlors and offices, all of the new risks
that are bound are physically inspected or subject to a telephone survey,
generally within 60 days from the effective date of the policy. If the
inspection reveals that the risk insured under the policy does not meet our
established underwriting guidelines, the policy is generally cancelled within
the first 60 days from its effective date. If the inspection reveals that the
risk meets our established underwriting guidelines but the policy was bound with
incorrect rating information, the policy is amended through an endorsement based
upon the correct information. We supplement the inspection by using online data
sources to further evaluate the building value, claim experience, financial
history and catastrophe exposures of the insured. In addition, we specifically
tailor coverages to match the insured's exposure and premium requirements. We
complete internal file reviews and audits on a monthly, quarterly and annual
basis to confirm that underwriting standards and pricing programs are being
consistently followed.
Our gross and net losses from the World Trade Center terrorist attack of
September 11, 2001 were $1.2 million and $0.4 million, respectively. We believe
we avoided significant losses from this catastrophe due to the typical profile
of our property risks, which are generally comprised of residential buildings,
retail stores and restaurants covered under policies with low building and
content limits. We carefully underwrite potential catastrophe exposures to
terrorism losses. Our underwriting guidelines are designed to avoid properties
designated as or in close proximity to high profile or target risks, individual
buildings over 25 stories and any site within 500 feet of major transportation
centers, bridges, tunnels and other governmental or institutional buildings. In
addition, we monitor the concentration of employees insured under our workers'
compensation policies and avoid writing risks with more than 40 employees in any
one building. However, please see "Item 1.-Risks Related to Our Business-We may
face substantial exposure to losses from terrorism, we are currently required by
law to provide coverage against such losses, and the Terrorism Risk Insurance
Act of 2002 may expire on December 31, 2005", regarding the possible impact of
the scheduled expiration of the Terrorism Risk Insurance Act of 2002 on December
31, 2005. Our property limits profile and the premium size of our policies in
TICNY may, rise as a result of the increase in TICNY's statutory surplus due to
the capital contribution of $98 million of the proceeds from the IPO and the
rating upgrade to "A-" (Excellent) by A.M. Best.
15
We underwrite our products through four underwriting teams that are each
headed by an underwriting manager having an average of approximately 15 years of
industry experience in the property and casualty industry. We have the following
five business units: small commercial, middle market, commercial auto, personal
lines and programs. These business units perform underwriting functions and are
supported by professionals in the corporate underwriting, actuarial, operations,
business development and loss control departments. The corporate underwriting
department is responsible for managing and analyzing the profitability of our
entire book of business, supporting line underwriting with technical assistance,
developing underwriting guidelines, granting underwriting authority, training,
developing new products and monitoring underwriting quality control through
audits. The actuarial department is responsible for monitoring rate adequacy on
all of our products and analyzing loss data on a monthly basis. The underwriting
operations department is responsible for developing workflows, conducting
operational audits and providing technical assistance to the underwriting teams.
The loss control department conducts loss control inspections on nearly all new
commercial and personal lines business written, utilizing in-house loss control
representatives and outside vendors. The business development department works
with the underwriting teams to manage relationships with our producers.
PRICING
We price our products to make an acceptable underwriting profit. In
situations where rates for a particular line become insufficient to produce
satisfactory results, we control growth and reduce our premium volume in that
line.
We generally use actuarial loss costs promulgated by the Insurance Services
Office, a company providing statistical, actuarial and underwriting claims
information and related services to insurers, as a benchmark in the development
of pricing for our products. We further tailor pricing to each specific product
we underwrite (other than workers' compensation), taking into account our
historical loss experience and individual risk and coverage characteristics. For
workers' compensation policies, we use statistical information provided by the
New York Compensation Insurance Rating Board ("NYCRIB") as a benchmark in
developing our pricing.
If a particular business line is not performing well, we may seek rate
increases, which are subject to regulatory approval (See "Item 1.-Regulation")
and market acceptance. Recently, we have been successful in increasing our
rates. We increased our premiums on our commercial renewals as measured against
expiring premium by 6% in 2002, 9% in 2003 and 9% in 2004. In personal lines, we
increased premium by 2.6% in both 2002 and 2003, and 9.5% in 2004.
Beginning in the latter half of 2004, the rates for property and casualty
insurance products began to moderate, and for certain products, rates began to
decrease due to an increased level of competition. These changes may signal the
start of a "soft market" cycle that could restrict or diminish our ability to
obtain rate increases as in the recent past. We cannot predict with any
certainty the direction the market will take during 2005 or thereafter.
REINSURANCE
We purchase reinsurance to reduce our net liability on individual risks, to
protect against possible catastrophes, to achieve a target ratio of net premiums
written to policyholders' surplus and to expand our underwriting capacity.
Reinsurance coverage can be purchased on a facultative basis, where individual
risks are reinsured, or on a treaty basis, where a class or type of business is
reinsured. We purchase facultative reinsurance to provide limits in excess of
the limits provided by our treaty reinsurance. Treaty reinsurance falls into
three categories: quota share (also called pro rata), excess of loss and
catastrophe treaty reinsurance. Under our quota share reinsurance contracts, we
cede a predetermined percentage of each risk for a class of business to the
reinsurer and recover the same percentage of each loss and loss adjustment
expenses. We pay the reinsurer the same percentage of the original premium, less
a ceding commission. The ceding commission rate is based upon the ceded loss
ratio on the ceded quota share premiums earned. See "Item 7.-Critical Accounting
Policies-Ceding commissions earned". Under our excess of loss treaty
reinsurance, we cede all or a portion of the liability in excess of a
predetermined deductible or retention. We also purchase catastrophe treaty
reinsurance on an excess of loss basis to protect ourselves from an accumulation
of net loss exposures from a catastrophic event or series of events such as
terrorist acts, riots, windstorms, hailstorms, tornadoes, hurricanes,
earthquakes, blizzards and freezing temperatures. We do not receive any
commission for ceding business under excess of loss or catastrophe reinsurance
agreements.
16
The type, cost and limits of reinsurance we purchase can vary from year to
year based upon our desired retention levels and the availability of quality
reinsurance at an acceptable price. Our quota share contracts and excess of loss
reinsurance programs were renewed on January 1, 2005. Our catastrophe treaty
reinsurance was extended for two months through August 31, 2004 and renewed on
September 1, 2004 through June 30, 2005.
In recent years, the reinsurance industry has undergone very dramatic
changes. Soft market conditions created by years of inadequate pricing brought
poor results, which were exacerbated by the events of September 11, 2001. As a
result, market capacity was reduced significantly. Reinsurers exited lines of
business, significantly raised rates and imposed much tighter terms and
conditions where coverage was offered, to limit or reduce their exposure to
loss.
In an effort to maintain quota share capacity for our business with
favorable commission levels, we have been accepting loss ratio caps in our
reinsurance treaties. Loss ratio caps cut off the reinsurer's liability for
losses above a specified loss ratio. These provisions have been structured to
provide reinsurers with some limit on the amount of potential loss being
assumed, while maintaining the transfer of significant insurance risk with the
possibility of a significant loss to the reinsurer. We believe our reinsurance
arrangements qualify for reinsurance accounting in accordance with SFAS 113,
Accounting for Reinsurance Contracts. The loss ratio caps for our quota share
treaties are 95.0% for 2005, and were 95.0% in 2004, 92.0% in 2003, 97.5% in
2002 and 100.0% in 2001.
Recently, regulators and other governmental authorities have been
investigating certain types of insurance and reinsurance arrangements that they
allege are intended only to smooth an insured company or ceding insurer's
earnings rather than to transfer insurance risk. As noted above, we believe our
quota share reinsurance meets all requirements pertaining to risk transfer.
However, these investigations, the related legal actions and the accompanying
increased scrutiny of "non-traditional" reinsurance arrangements may lead to a
change in the applicable accounting standards or a reduction in the availability
of some types of reinsurance. In turn, these developments could produce higher
prices for reinsurance, an increase in the amount of risk we retain, reduced
ceding commission revenue, or other potentially adverse developments. In that
event, we may be required to restructure or reduce our use of quota share
reinsurance or reduce our premium writings. See "Item 1.-Regulation-Industry
Investigations".
Regardless of type, reinsurance does not legally discharge the ceding
insurer from primary liability for the full amount due under the reinsured
policies. However, the assuming reinsurer is obligated to indemnify the ceding
company to the extent of the coverage ceded. To protect our company from the
possibility of a reinsurer becoming unable to fulfill its obligations under the
reinsurance contracts, we attempt to select financially strong reinsurers with
an A.M. Best rating of "A-" (Excellent) or better and continue to evaluate their
financial condition and monitor various credit risks to minimize our exposure to
losses from reinsurer insolvencies.
To further minimize our exposure to reinsurance recoverables, effective
October 1, 2003, we have placed our quota share reinsurance treaty on a "funds
withheld" basis under which ceded premiums written are deposited in segregated
trust funds from which we receive payments for losses and ceding commission
adjustments. We also used the proceeds from the IPO and the concurrent private
placement to increase the capitalization of our insurance subsidiary. As a
result of this increase in capital, our insurance subsidiary has been able to
retain more of the risk on the business it writes, thereby reducing our need for
quota share reinsurance.
17
The following table summarizes our reinsurance exposures by reinsurer as of
December 31, 2004.
AMOUNTS
IN
TRUST
FUNDS HELD, ACCOUNTS
CEDED OR
RECOVERABLE ON PREPAID AND PAYABLE AND SECURED NET
A.M. ------------------- RETURN DEFERRED BY EXPOSURE
BEST PAID REINSURANCE COMMISSIONS CEDING LETTERS TO
REINSURER RATING LOSSES RESERVES PREMIUM RECEIVABLE COMMISSIONS OF CREDIT REINSURER
- ----------------------------------- ------ ------ -------- ----------- ----------- ----------- --------- ---------
($ in thousands)
PXRE Reinsurance Company A $3,804 $33,852 $ -- $ 8,329 $ (804) $ -- $ 46,789
American Re-Insurance Company(1) A 1,175 13,301 1,376 -- 278 -- 15,574
Platinum Underwriters Reinsurance,
Inc. A -- 659 250 -- 33 -- 876
SCOR Reinsurance Company B++ 9 1,322 -- -- -- -- 1,331
Lloyd's of London A -- -- -- -- (125) -- 125
Folksamerica Reinsurance Company A -- -- -- -- (41) -- 41
Odyssey America Reinsurance
Corporation A -- -- -- -- (34) -- 34
Erie Insurance Exchange A+ -- -- -- -- -- -- --
American Agricultural Insurance
Company A -- -- -- -- (14) -- 14
Endurance Specialty Insurance, Ltd. A 33 686 77 -- -- 796 --
Tokio Millenium Re Ltd. A++ 3,317 31,278 13,093 -- 44,520 3,168 --
Hannover Reinsurance (Ireland) Ltd. A 850 7,750 10,474 -- 17,814 1,260 --
E+S Reinsurance (Ireland) Ltd. A 212 1,937 2,619 -- 4,454 314 --
Hannover Rueckversicherungs AG A -- 988 502 -- 42 -- 1,448
------ ------- ------- ------- ------- ------ --------
Total $9,400 $91,773 $28,391 $ 8,329 $66,123 $5,538 $ 66,232
====== ======= ======= ======= ======= ====== ========
(1) Downgraded to "A" (Excellent) in January 2005.
2005 REINSURANCE PROGRAM
Quota Share Reinsurance. Effective January 1, 2005, TICNY entered into a
quota share treaty to reinsure against losses up to $1.0 million per occurrence
on the gross premiums written in the insurance segment. Under the terms of the
treaty, TICNY cedes 25% of its net premiums written and retains the remaining
75%. The provisional ceding commission under this treaty is 39.1% of ceded net
premiums written. Of the premium ceded, Tokio Millennium Re Ltd. ("Tokio
Millennium"), rated "A++" (Superior) by A.M. Best, reinsures 50%, Hannover
Reinsurance (Ireland) Ltd., rated "A" (Excellent) by A.M. Best, reinsures 40%
and E+S Reinsurance (Ireland) Ltd. (collectively "Hannover"), rated "A"
(Excellent) by A.M. Best, reinsures the remaining 10%. The 2005 quota share
treaty contains various exclusions and provides coverage for 100% of
extra-contractual obligations and losses in excess of policy limits. To reduce
TICNY's credit exposure to reinsurance, the quota share reinsurance has been
placed on a "funds withheld" basis. Under the terms of the reinsurance treaty,
TICNY guarantees to credit the reinsurers with a 3% annual effective yield on
the monthly balance of this account.
Effective January 1, 2005, TICNY entered into a quota share treaty to
reinsure against umbrella losses up to $5.0 million per occurrence. Under the
terms of the treaty TICNY cedes 95% of its premiums written and retains the
remaining 5%. The provisional ceding commission under this treaty is 30% of
ceded premium written. Of the premium ceded, Platinum Underwriters Reinsurance,
Inc., rated "A" (Excellent) by A.M. Best, reinsures 50% and Hannover
Ruckversicherungs AG, rated "A" (Excellent) by A.M. Best, reinsures 50%.
Excess of Loss Reinsurance. Effective January 1, 2005 we entered into an
excess of loss reinsurance treaty program with the same terms as the 2004 Excess
of Loss Reinsurance Treaty. The 2005 excess of loss reinsurance treaties were
placed with American Re-Insurance Company ("Am Re"), rated "A" (Excellent) by
A.M. Best, Platinum Underwriters Reinsurance, Inc., rated "A" (Excellent) by
A.M. Best, Endurance Specialty Insurance, Ltd., rated "A" (Excellent) by A.M.
Best, syndicates from Lloyd's of London, rated "A" (Excellent) by A.M. Best, and
Hannover Ruckversicherungs AG, rated "A" (Excellent) by A.M. Best.
Catastrophe Reinsurance. The 2004 Property Catastrophe Program provides
coverage for events occurring through June 30, 2005 and is expected to be
renewed on July 1, 2005 with a similar structure to the expiring program.
Terrorism Reinsurance. Pursuant to the Terrorism Risk Insurance Act of 2002
("The Terrorism Act"), TICNY must offer insureds the option to purchase coverage
for certified acts of terrorism for an additional premium or decline such
coverage. When the coverage is not purchased, we endorse the policy to exclude
coverage for certified acts of terrorism, but losses from an act of terrorism
that is not a certified event may be covered in any case. Also, even for
certified acts of terrorism, losses from fire following the act of terrorism are
covered.
18
The Terrorism Act reimburses up to 90% of the losses to commercial insurers
due to certified acts of terrorism in excess of a deductible. Our deductible in
2004 was 10% of our 2003 direct earned premium on commercial lines. Our
deductible in 2005 is 15% of our 2004 direct earned premiums on commercial
lines. Our quota share reinsurance treaty specifically provides terrorism
coverage. The amount of coverage is limited to 10% of the ceded earned premiums
for the applicable treaty year. Excess of loss reinsurance treaties for
multiple-line and workers' compensation contain various sublimits for terrorism
coverage.
The Federal assistance under the Terrorism Act is scheduled to expire at
the end of 2005 unless Congress extends it. Legislation has been introduced to
extend the Terrorism Act but we cannot predict whether or when any such
extension may be enacted and what the final terms of such legislation would be.
In the event that the Federal assistance under the Terrorism Act is not extended
or is altered (e.g., by increasing the deductible or reducing the amount of loss
that is reimbursed), our potential losses from a terrorist attack could be
substantially larger than previously expected. Policies we write in 2005 will
cover periods after the scheduled expiration of the Terrorism Act, and we are
taking the uncertainty regarding renewal of The Terrorism Act into account in
our pricing. Potential future changes to the Terrorism Act could also adversely
affect our ability to obtain reinsurance on favorable terms, including pricing,
and may affect our underwriting strategy, rating, and other elements of our
operation. See "Item 1.-Risks Related to Our Business-We may face substantial
exposure to losses from terrorism, we are currently required by law to provide
coverage against such losses, and the Terrorism Risk Insurance Act of 2002 may
expire on December 31, 2005".
In addition, in the event that the Terrorism Act is not extended, while we
would no longer be required to offer the insured the ability to purchase
coverage for Certified Acts of Terrorism the New York State Insurance Department
has not approved a terrorism exclusion so it is possible that we would not be
permitted to exclude losses resulting from terrorist acts in New York State for
accounts under $100,000 premium size.
2004 REINSURANCE PROGRAM
Quota Share Reinsurance. Effective January 1, 2004, TICNY entered into a
quota share treaty to reinsure against losses up to $1.0 million per occurrence
on the gross premiums written in the insurance segment. Under the terms of the
treaty, TICNY ceded 60% of its net premiums written and retained the remaining
40%. In accordance with treaty terms, TICNY elected to reduce the quota share
cession from 60% to 25% on October 1, 2004. The provisional ceding commission
under this treaty was 39.1% of ceded net premiums written. Of the premium ceded,
Tokio Millennium, rated "A++" (Superior), reinsured 33 1/3%; Converium
Reinsurance (North America) Inc. ("Converium), rated "A-" (Excellent) by A.M.
Best, reinsured 33 1/3%; Hannover Reinsurance (Ireland) Ltd., rated "A"
(Excellent) by A.M. Best, reinsured 26 2/3% and E+S Reinsurance (Ireland) Ltd.,
rated "A" (Excellent), reinsured the remaining 6 2/3%. The 2004 quota share
treaty contained various exclusions and provided coverage for 100% of
extra-contractual obligations and losses in excess of policy limits. To reduce
TICNY's credit exposure to reinsurance, the quota share reinsurance was placed
on a "funds withheld" basis. Under the terms of the reinsurance treaty, TICNY
guaranteed to credit the reinsurers with a 2.5% annual effective yield on the
monthly balance of this account.
In September 2004, A.M. Best downgraded the rating of Converium to "B-"
(Fair) and Converium was placed into run-off by its parent company. As a result,
on September 2, 2004, we delivered notice to Converium under our quota share
treaty of our intent to terminate their participation under the quota share
treaty on a cut-off basis effective November 1, 2004 (subsequently extended to
December 31, 2004). Subsequently we reached an agreement with Converium, Tokio
Millenium and Hannover to effect a novation of Converium's quota share treaty to
those other reinsurers effective January 1, 2004, as a result of which Tokio and
Hannover agreed to each take 50% of Converium's share under the quota share
treaty. In connection with the agreement, Tokio, Hannover and TICNY agreed to
fully release Converium for any liabilities under the quota share treaty. In
addition, we decided to retain the unearned premiums and risks as of December
31, 2004 that would have been ceded to Converium absent the novation.
Effective October 1, 2004, TICNY entered into a quota share treaty to
reinsure against equipment breakdown losses up to $35 million per occurrence.
Under the terms of the treaty, TICNY cedes 100% of its premium written to The
Hartford Steam Boiler Inspection and Insurance Company, rated "A++" (Superior)
by A.M. Best. The flat ceding commission under this treaty is 30%. A nominal
amount of premium was ceded to this treaty in 2004. The treaty is placed on a
continuous basis, therefore the above terms will be in effect during 2005.
19
Excess of Loss Reinsurance. Effective January 1, 2004 we entered into an
excess of loss reinsurance treaty program whereby our reinsurers were liable for
100% of the ultimate net losses in excess of $1 million for all lines of
business we write, up to $10 million of limit. The program provided coverage in
several layers. The first layer, which applied to multiple lines of business,
afforded coverage for property business up to $1 million in excess of $1 million
for each risk, with a per occurrence limit of $3 million, and for casualty
business and for workers' compensation losses, up to $1 million in excess of $1
million per occurrence. The excess of loss program then bifurcated into separate
workers' compensation and property layers. The workers' compensation layers
afforded coverage for workers' compensation business up to $3 million in excess
of $2 million for each occurrence, and for up to $5 million in excess of $5
million for each occurrence, with a maximum of $5 million for any one life. The
property layers afforded coverage for property business up to $3 million in
excess of $2 million for each risk, subject to a per occurrence limit of $6
million, and for up to $5 million in excess of $5 million for each risk, with a
maximum of $5 million for each occurrence. The excess of loss treaties contained
various sub-limits or exclusions for specific lines of business, provided
coverage for 90% of extra-contractual obligations and losses in excess of policy
limits, and allowed TICNY to recover allocated loss adjustment expenses on a pro
rata basis in proportion to net loss. The 2004 excess of loss reinsurance
treaties were placed with Am Re, rated "A" (Excellent) by A.M. Best, Platinum
Underwriters Reinsurance, Inc., rated "A" (Excellent) by A.M. Best, Endurance
Specialty Insurance, Ltd., rated "A" (Excellent) by A.M. Best, syndicates from
Lloyd's of London, rated "A" (Excellent) by A.M. Best, Hannover
Ruckversicherungs AG, rated "A" (Excellent) by A.M. Best, and Aspen Insurance UK
Limited, rated "A" (Excellent) by A.M. Best.
Catastrophe Reinsurance. Effective July 1, 2004, the 2003 Property
Catastrophe Program described below was extended until August 31, 2004 and
provided coverage in four layers on a per occurrence basis for losses up to $55
million, less our net retention of the first $5 million of losses. Effective
September 1, 2004, we entered into a property catastrophe reinsurance program
that provides coverage in five layers for losses up to $75 million, less our
retention of the first $15 million of losses through June 30, 2005. The program
covers aggregations of net exposures on our in force, new, renewal and assumed
personal and commercial property as well as auto physical damage and inland
marine business, subject to certain exclusions, including mold claims,
terrorists events and nuclear, chemical and biochemical attacks. In the event of
a catastrophic event that results in a loss under this program, we must
reinstate the amount of cover exhausted by the loss on a one-time basis by
paying an additional premium to the reinsurers. Each year we select the amount
of catastrophic reinsurance that we believe will be necessary to protect our
company against catastrophic events. We believe the amount of catastrophic
coverage is sufficient to cover our probable maximum loss from a once in a one
hundred year catastrophic event. Our catastrophic reinsurers include American
Agricultural Insurance Company, rated "A" (Excellent) by A.M. Best, Folksamerica
Reinsurance Company, rated "A" (Excellent) by A.M. Best, Odyssey America
Reinsurance Corporation, rated "A" (Excellent) by A.M. Best, PXRE Reinsurance
Company, rated "A" (Excellent) by A.M. Best, and syndicates from Lloyd's of
London, rated "A" (Excellent) by A.M. Best.
2003 REINSURANCE PROGRAM
Quota Share Reinsurance. In 2003, TICNY entered into two quota share
treaties to reinsure against losses and loss adjustment expenses up to $500,000
per occurrence incurred on the gross premiums written in the insurance segment.
The treaties contain provisions that reduce the obligations of the reinsurers at
certain loss ratios. Effective January 1, 2003, TICNY ceded 70.0% of the risks
it underwrote to PXRE Reinsurance Company ("PXRE New Jersey") and PMA
Reinsurance Company ("PMA"), with PXRE New Jersey reinsuring 75% and PMA 25% of
such cession.
In connection with the quota share treaty with PXRE New Jersey, we also
entered into an aggregate excess of loss reinsurance agreement with an affiliate
of PXRE New Jersey, PXRE Reinsurance (Barbados) Ltd. ("PXRE Barbados"), and
remitted $10,000,000 as deposit premium to PXRE Barbados as called for by the
contract. This aggregate excess of loss agreement covered 52.5% of the layer,
consisting of 18.48% of "ultimate net loss" (as defined in the contract) in
excess of 69.02% of ultimate net loss, and it inured solely to the benefit of
PXRE New Jersey (in that premiums and losses we paid to or received from PXRE
Barbados were deducted from premiums and losses we would have paid to or
received from PXRE New Jersey) in connection with its participation in the 2003
quota share agreement with TICNY.
20
After we entered into the quota share treaty, PMA's rating was lowered by
A.M. Best from "A" (Excellent) to "A-" (Excellent) and then to "B++" (Very
Good). Effective October 1, 2003, we commuted PMA's participation under the
reinsurance treaty. The effect of this commutation was to conclude PMA's
participation in the quota share treaty and to discharge PMA from future related
liabilities effective October 1, 2003. Loss related amounts recoverable from PMA
at the commutation date including ceded loss and loss adjustment expense reserve
liabilities of $2.7 million and ceded paid losses of $0.4 million that had not
yet been recovered from PMA were settled with a payment received from PMA of
$3.1 million. We also received $2.5 million for ceded unearned premium at the
commutation date resulting in a total cash settlement of $5.6 million. In
addition to commuting the treaty with PMA, we cancelled PXRE New Jersey's
participation under the quota share treaty on a cut-off basis effective October
1, 2003, to reduce the credit risk associated with having a significant amount
of reinsurance recoverables with PXRE New Jersey. As a result, PXRE New Jersey
is not obligated to indemnify us for losses occurring after September 30, 2003.
Effective October 1, 2003, we also commuted the aggregate excess of loss
reinsurance treaty with PXRE Barbados. As a result of the commutation of the
aggregate excess of loss treaty agreement, we recorded $1.5 million in ceding
commission income.
As a result of the commutation with PMA, we assumed exposure to a total of
$3.2 million in losses on earned premium that had previously been ceded to PMA.
In addition, TICNY's net exposure to any individual or catastrophe losses
incurred up to the $500,000 quota share limit increased from 30% prior to the
commutation to 47.5% on any business written during the period from January 1,
2003 to September 30, 2003 and premiums earned during this period. This
commutation also increased our leverage ratios, including net premiums written
to surplus, which potentially could have affected TICNY's rating with various
rating agencies. To replace PMA and PXRE New Jersey as quota share reinsurers
and to mitigate our net exposure, we entered into a new quota share treaty with
Tokio Millennium, which is rated "A++" (Superior) by A.M. Best. In the new quota
share treaty (the "October 1, 2003 Treaty"), we ceded 80% of the in force
business (premium unearned by TICNY on business written in the first nine months
of 2003 - i.e., Tokio Millennium is obligated to indemnify us for 80% of losses
occurring after September 30, 2003 with respect to the in force business ceded
to them), and 80% of the new and renewal business written by TICNY during
October, November and December of 2003, up to a maximum net premiums written of
$92.25 million, to Tokio Millennium, which will indemnify us for losses
occurring on or after October 1, 2003. If the net premiums written exceed $92.25
million, then the pro rata cession is subject to adjustment according to the
terms of the October 1, 2003 Treaty. The change in the reinsurance treaty
limited TICNY's net exposure to individual and catastrophe losses to 20% of
individual and catastrophe losses up to the $500,000 quota share limit in
respect of premiums earned after September 30, 2003 for business written during
the period January 1, 2003 to September 30, 2003 and all business written during
the period October 1, 2003 to December 31, 2003. This change in the reinsurance
treaty also reduced TICNY's financial ratios, including net premiums written to
surplus. Under our agreements with PXRE New Jersey and PMA, we earned a
provisional ceding commission of 34.2% of ceded premiums written in 2003. This
provisional ceding commission could increase or decrease depending upon a
sliding scale formula that links the commission rate with the loss ratio
incurred on the ceded premium. Under the October 1, 2003 Treaty with Tokio
Millennium, we earned a provisional ceding commission of 38.5% of ceded premiums
written, subject to the same sliding scale adjustments. The quota share treaty
with Tokio Millennium was placed on a "funds withheld" basis. Tokio Millennium
posted a letter of credit at December 31, 2003 and replaced it with a Regulation
114 trust during the first quarter of 2004. Under the terms of the reinsurance
treaty, TICNY guarantees to credit the reinsurers with a 2.5% annual effective
yield on the monthly balance of this account. TICNY's 2003 quota share treaties
contain various exclusions and provide coverage for 100% of extra-contractual
obligations and losses in excess of policy limits.
Excess of Loss Reinsurance. In 2003, we entered into an excess of loss
reinsurance treaty program that provides coverage in six layers by line of
business for losses up to $10 million net of our $712,500 net retention. The
program indemnifies us on a "per risk" basis, on property business and on a "per
occurrence" basis on casualty and workers' compensation. The first layer, which
applies to multiple lines of business, affords coverage up to $500,000 in
losses, and our retention, before the effect of the quota share reinsurance,
consists of 100% of the first $500,000 of losses and 42.5% of the next $500,000
of losses. The second layer, which applies to multiple lines of business,
affords coverage for the next $1 million in property losses on a per risk basis
and $1 million in casualty clash and workers' compensation losses on a per
occurrence basis. The excess of loss program then bifurcates into separate
property and workers' compensation layers that afford coverage at $3 million in
losses excess $2 million, and $5 million in losses excess $5 million. The excess
of loss treaties contain various sub-limits or exclusions for specific lines of
business, provide coverage for 90% of extra-contractual obligations and losses
in excess of policy limits, and allow TICNY to recover allocated loss adjustment
expenses on a pro rata basis in proportion to net loss. The 2003 excess of loss
reinsurance treaties were placed with Am Re, rated "A" (Excellent) by A.M. Best,
Endurance Specialty Insurance, Ltd., rated "A" (Excellent) by A.M. Best,
syndicates from Lloyd's of London, rated "A" (Excellent) by A.M. Best, SCOR
Reinsurance Company, rated "B++" (Very Good) by A.M. Best, and Aspen Insurance
UK Ltd., rated "A" (Excellent) by A.M. Best (formerly known as Wellington
Reinsurance Limited, U.K.).
21
Catastrophe Reinsurance. Effective July 1, 2003, we entered into a property
catastrophe reinsurance program that provides coverage in four layers on a per
occurrence excess of loss basis for losses up to $35 million, less our $3.5
million net retention. Our retention consists of 100% of the first $2.5 million
of losses and 40% of the next $2.5 million of losses. The contract covers
aggregations of net exposures on our in force, new, renewal and assumed personal
and commercial property as well as auto physical damage and inland marine
business, subject to certain exclusions, including mold claims, terrorists
events and nuclear, chemical and biochemical attacks. In the event of a
catastrophic event that results in a loss under this program, we must reinstate
the amount of cover exhausted by the loss on a one-time basis by paying an
additional premium to the reinsurers. Each year we select the amount of
catastrophe reinsurance that we believe will be necessary to protect our company
against catastrophic events. Based on this consultant's analysis, we believe the
amount of catastrophe coverage we purchased for 2003 is sufficient to cover our
probable maximum loss from a once in a one hundred year catastrophic event. Our
catastrophe reinsurers for 2003 included American Agricultural Insurance
Company, rated "A" (Excellent) by A.M. Best, Erie Insurance Exchange, rated "A+"
(Superior) by A.M. Best, Folksamerica Reinsurance Company, rated "A" (Excellent)
by A.M. Best, Odyssey America Reinsurance Corporation, rated "A" (Excellent) by
A.M. Best, PXRE Reinsurance Company, rated "A" (Excellent) by A.M. Best, and
syndicates from Lloyd's of London, rated "A" (Excellent) by A.M. Best.
INVESTMENTS
We derive investment income from our invested assets. We invest TICNY's
statutory surplus and funds to support its loss and loss adjustment expense
reserves and its unearned premium reserves. Due to historically limited amounts
of statutory surplus and net retention by TICNY, our net investment income has
not been significant. Our investment income, however, has increased beginning in
2002 as TICNY's invested assets increased due to TICNY's increased net premiums
written and surplus as well as from its $98.0 million of new investments as a
direct result of a capital contribution of a portion of the IPO proceeds. Our
net investment income was $5.1 million in 2004, compared to $2.3 million in
2003.
Our primary investment objectives are to preserve capital and maximize
after-tax investment income. Our strategy is to purchase debt securities in
sectors that represent the most attractive relative value and to maintain a
moderate equity exposure. As of December 31, 2004, the fixed maturity securities
represented approximately 98% of the fair market value of our investment
portfolio, equity securities represented approximately 1% and common trust
securities - statutory business trusts represented approximately 1%.
Historically, we have emphasized liquidity to meet our claims obligations and
debt service and to support our obligation to remit ceded premium (less ceding
commission and claims payments) to our quota share reinsurers on a quarterly
basis. Accordingly we have traditionally maintained between 8% and 10% of our
portfolio in cash and cash equivalents. As of December 31, 2004, cash and cash
equivalents represented approximately 19.0% of the total of fair market value of
our investment portfolio and cash and cash equivalents. The higher percentage
over what we traditionally maintain was due to the net proceeds from the
issuance of $26.8 million of subordinated debentures underlying trust preferred
securities in December 2004.
Our investments are managed by an outside asset management company,
Hyperion Capital Management, Inc., a New York based investment management firm.
Hyperion has authority and discretion to buy and sell securities for us, subject
to guidelines established by our Board of Directors. We may terminate our
agreement with Hyperion upon 30 days notice. Our investment policy is
conservative, as approximately 93.5% of the fixed income portion of our
investment portfolio is rated A or higher as of December 31, 2004 and up to 10%
of the investment portfolio may be invested in equities. The maximum allocation
to equities, which includes market appreciation, is 20% of the investment
portfolio. We monitor our investment results on a monthly basis to review the
performance of our investments, determine whether any investments have been
impaired and monitor market conditions for investments that would warrant any
revision to our investment guidelines. Hyperion also provides us with a
comprehensive quarterly report providing detailed information on our investment
results as well as prevailing market conditions. Our investment results are also
reviewed quarterly by the Board of Directors.
22
See "Item 7.-Investments" for further information on the composition and
results of our investment portfolio.
The following table shows the market values of various categories of
invested assets, the percentage of the total market value of our invested assets
represented by each category and the book yield based on market value of each
type as of the dates and for the periods indicated:
AS OF AND FOR THE YEAR ENDED DECEMBER 31,
2004 2003
----------------------------------- ----------------------------------
MARKET PERCENT MARKET PERCENT
VALUE OF TOTAL YIELD VALUE OF TOTAL YIELD
----------- ---------- -------- ---------- ----------- --------
CATEGORY ($ in thousands)
- --------
U.S. Treasury Securities $ 1,784 0.8% 4.05% $ 1,783 3.1% 3.75%
U.S. agency securities 19,636 8.6% 4.22% 5,738 10.0% 5.38%
Corporate fixed maturity securities 49,381 21.6% 4.60% 14,415 25.1% 5.71%
Mortgage-backed securities 64,159 28.1% 4.52% 19,756 34.4% 6.03%
Asset-backed securities 12,473 5.5% 4.92% 2,242 3.9% 5.56%
Other taxable fixed maturity securities 243 0.1% 4.96% 236 0.4% 4.96%
Municipal securities 76,847 33.6% 3.64% 10,375 18.1% 4.10%
Common stocks 2,368 1.0% 2,017 3.5%
Preferred stocks 117 0.1% 7.27% 167 0.3% 9.23%
Common trust securities - statutory
business trusts 1,426 0.6% 620 1.1%
The principal change in allocations in 2004 and 2003 was an increase in the
allocation to municipal bonds. The tax-equivalent yield on these securities was
more attractive than the yield on taxable securities and the allocation added
diversification to our portfolio. We also increased our allocation to
mortgage-backed securities due to favorable yield and fundamental credit quality
and reduced our allocation to corporate securities due to much tighter yield
spreads and less favorable total return opportunities.
During 2004, the most significant portfolio activity came during the fourth
quarter with the investment of the IPO proceeds of $98.0 million. In order to
increase the portfolio's overall tax-exempt allocation, approximately 60% of the
proceeds were invested into tax-exempt securities. Due to the steeper yield
curve in the tax-exempt market compared to the taxable market, the tax-exempt
purchases were focused in longer duration securities averaging approximately six
years. To offset these longer duration securities, the taxable bond purchases
were concentrated in short durations averaging two to three years.
In addition, during the fourth quarter of 2004, the effective duration of
the portfolio decreased to 4.17 years compared to 4.41 years as of September 30,
2004. The lower duration was primarily due to the significant cash increase from
the net proceeds from the issuance of $26.8 million of subordinated debentures
underlying trust preferred securities in December 2004. Therefore, the portfolio
duration is currently shorter than the Benchmark duration of 4.30 years as of
December 31, 2004. The total return on our fixed income and short-term duration
invested assets during 2004 was 4.9% on a pre-tax basis.
During 2003, our portfolio benefited from the increase in the weighted
average duration to approximately 5.1 years effected in late 2002. With interest
rates declining significantly during the first half of 2003, the longer duration
increased our total returns. During the first half of 2003, we reduced the
weighted average duration to approximately 4.4 years at June 30, 2003. This
change helped to protect the portfolio and reduced the impact of the sharp rise
in rates during the second half of the year. The total return on our fixed
income and short-term invested assets during 2003 was 6.5% on a pre-tax basis.
The following table shows the composition of our investment portfolio by
remaining time to maturity at December 31, 2004 and December 31, 2003. For
securities that are redeemable at the option of the issuer and have a market
price that is greater than par value, the maturity used for the table below is
the earliest redemption date. For securities that are redeemable at the option
of the issuer and have a market price that is less than par value, the maturity
used for the table below is the final maturity date. For mortgage-backed
securities, mortgage prepayment assumptions are utilized to project the expected
principal redemptions for each security, and the maturity used in the table
below is the average life based on those projected redemptions.
23
AS OF DECEMBER 31, AS OF DECEMBER 31,
2004 2003
------------------------------------- -------------------------------------
PERCENTAGE OF PERCENTAGE OF
REMAINING TIME TO MATURITY FAIR MARKET VALUE FAIR MARKET VALUE FAIR MARKET VALUE FAIR MARKET VALUE
- -------------------------- ----------------- ----------------- ----------------- -----------------
($ in thousands)
Less than one year $ 8,243 3.7% $ 1,931 3.5%
One to five years 54,924 24.5% 6,866 12.6%
Five to ten years 92,094 41.0% 9,356 17.2%
More than ten years 5,103 2.3% 14,394 26.4%
Mortgage-backed securities 64,159 28.5% 21,998 40.3%
-------- ----- -------- ---
TOTAL $224,523 100.0% $ 54,545 100%
======== ===== ======== ===
The average credit rating of our fixed maturity portfolio, using ratings
assigned to securities by Standard and Poor's, was AA+ at December 31, 2004 and
AA+ at December 31, 2003. The following table shows the ratings distribution of
our fixed income portfolio as of the end of each of the past two years.
AS OF DECEMBER 31, AS OF DECEMBER 31,
2004 2003
--------------------------------------- --------------------------------
PERCENTAGE OF FAIR FAIR MARKET PERCENTAGE OF
RATING FAIR MARKET VALUE MARKET VALUE VALUE FAIR MARKET VALUE
- ------------------------ ----------------- ------------------ ----------- -----------------
($ in thousands)
U.S. Treasury securities $ 1,784 0.8% $ 1,783 3.3%
AAA 140,460 62.6% 31,421 57.6%
AA 31,641 14.1% 6,143 11.3%
A 35,850 16.0% 7,755 14.2%
BBB 13,979 6.2% 4,581 8.4%
Below BBB 809 0.3% 2,862 5.2%
-------- ----- -------- -----
TOTAL $224,523 100.0% $ 54,545 100.0%
======== ===== ======== =====
We regularly review our portfolio for declines in value. If a decline in
value is deemed temporary, we record the decline as an unrealized loss in other
comprehensive net income on our consolidated statement of income and accumulated
other comprehensive net income on our consolidated balance sheet. If the decline
is deemed "other than temporary," we write down the carrying value of the
investment and record a realized loss in our consolidated statements of income.
As of December 31, 2004 and December 31, 2003, we had cumulative unrealized
gains/(losses) on our fixed maturity portfolio of $1.0 million and $1.3 million,