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EX-99.1 - EX-99.1 - Tower Group International, Ltd. | y86391exv99w1.htm |
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UNITED STATES SECURITIES AND EXCHANGE
COMMISSION
COMMISSION
Washington, D.C. 20549
FORM 8-K
CURRENT REPORT
Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
Date of Report (Date of earliest event reported): September 10, 2010
Tower Group, Inc.
(Exact name of registrant as specified in its charter)
Delaware | 000-50990 | 13-3894120 | ||
(State or other jurisdiction of incorporation) |
(Commission File Number) | (I.R.S. Employer Identification No.) |
120 Broadway, 31st Floor
New York, NY 10271
New York, NY 10271
(Address of principal executive offices)
(212) 655-2000
(Registrants telephone number, including area code)
Check the appropriate box below if the Form 8-K filing is intended to simultaneously satisfy
the filing obligation of the registrant under any of the following provisions (see General
Instruction A.2. below):
o | Written communications pursuant to Rule 425 under the Securities Act (17 CFR 230.425) | |
o | Soliciting material pursuant to Rule 14a-12 under the Exchange Act (17 CFR 240.14a-12) | |
o | Pre-commencement communications pursuant to Rule 14d-2(b) under the Exchange Act (17 CFR 240.14d-2(b)) | |
o | Pre-commencement communications pursuant to Rule 13e-4(c) under the Exchange Act (17 CFR 240.13e-4(c)) |
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Item 1.01. Entry Into A Material Definitive Agreement | ||||||||
Item 8.01. Other Events | ||||||||
Item 9.01. Financial Statements and Exhibits | ||||||||
SIGNATURES | ||||||||
EX-99.1 |
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Item 1.01. Entry Into A Material Definitive Agreement
On September 10, 2010, Tower Group, Inc. (Tower) entered into an amendment to the Credit
Agreement, dated as of May 14, 2010 (the Credit Agreement), among Tower, Bank of America, N.A.,
as Administrative Agent, Fronting Bank and L/C Administrator, JPMorgan Chase Bank, N.A. and KeyBank
National Association, as Co-Syndication Agents, and the lender parties thereto, with lenders
representing a majority of the commitments under the Credit Agreement. The amendment permits Tower
to enter into specified types of convertible note hedge transactions and to satisfy Towers
obligations with respect to such transactions, subject to the terms of the amendment. The amendment
further provides that Towers delivery of cash, shares of Towers common stock or a combination
thereof to holders of convertible notes upon conversion will not constitute restricted payments
under the Credit Agreement.
Item 8.01. Other Events
An investment in our securities involves risks. You should carefully consider the following
information about these risks in considering whether to invest in or hold our securities.
Additional risks not presently known to us, or that we currently deem immaterial may also impair
our business or results of operations. If any of the described risks actually were to occur, our
business, financial condition or results of operations could be affected materially and adversely.
The risk factors below update and supplement the risks disclosed under Item 1ARisk Factors in
our Annual Report on Form 10-K for the year ended December 31, 2009. In this report, the terms
we, us and our refer to Tower and its subsidiaries, unless otherwise noted or indicated by
context.
Risks related to
our business
If our actual
loss and loss adjustment expenses exceed our loss reserves, our
financial condition and results of operations could be
significantly adversely affected.
Our results of operations and financial condition depend upon
our ability to estimate the potential losses associated with the
risks that we insure and reinsure. We estimate loss and loss
adjustment expense reserves to cover our estimated liability for
the payment of all losses and loss adjustment expenses incurred
under the policies that we write. Loss reserves include case
reserves, which are established for specific claims that have
been reported to us, and reserves for claims that have been
incurred but not reported (or IBNR). To the extent
that loss and loss adjustment expenses exceed our estimates, we
will be required to immediately recognize the less favorable
experience and increase loss and loss adjustment expense
reserves, with a corresponding reduction in our net income in
the period in which the deficiency is identified. For example,
over the past ten years we have experienced adverse development
of reserves for losses and loss adjustment expenses incurred in
prior years.
Although loss reserves on property lines of business tend to be
relatively predictable from an actuarial standpoint, the
reserving process for losses on the liability coverage portions
of our commercial and personal lines policies possesses
characteristics that make case and IBNR reserving inherently
less susceptible to accurate actuarial estimation. Unlike
property losses, liability losses are claims made by third
parties of which the policyholder may not be aware and therefore
may be reported a significant amount of time, sometimes years,
after the occurrence. As liability claims most often involve
claims of bodily injury, assessment of the proper case reserve
is a far more subjective process than claims involving property
damage. In addition, the determination of a case reserve for a
liability claim is often without the benefit of information,
which develops slowly over the life of the claim and can subject
the case reserve to substantial modification well after the
claim was first reported. Numerous factors impact the liability
case reserving process, including venue, the amount of monetary
damage, the permanence of the injury and the age of the claimant
among other factors.
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Estimating an appropriate level of loss and loss adjustment
expense reserves is an inherently uncertain process.
Accordingly, actual loss and loss adjustment expenses paid will
likely deviate, perhaps substantially, from the reserve
estimates reflected in our consolidated financial statements. It
is possible that claims could exceed our loss and loss
adjustment expense reserves and have a material adverse effect
on our financial condition or results of operations.
Many of our quota share reinsurance agreements contain
provisions for a ceding commission under which the commission
rate that we receive varies inversely with the loss ratio on the
ceded premiums, with higher commission rates corresponding to
lower loss ratios and vice versa. The loss ratio depends on our
estimate of the loss and loss adjustment expense reserves on the
ceded business. As a result, the same uncertainties associated
with estimating loss and loss adjustment expense reserves affect
the estimates of ceding commissions earned. If and to the extent
that we have to increase our reserves on the business that is
subject to these reinsurance agreements, we may have to reduce
the ceding commission rate, which would amplify the reduction in
our net income in the period in which the increase in our
reserves is made.
A substantial
amount of our business currently comes from a limited
geographical area. Any single catastrophe or other condition
affecting losses in this area could adversely affect our results
of operations.
Our Insurance Subsidiaries currently write the bulk of their
business in the Northeast United States. As a result, a single
catastrophe occurrence, destructive weather pattern, terrorist
attack, regulatory development or other condition or general
economic trend affecting the region within which we conduct our
business could adversely affect our financial condition or
results of operations more significantly than that of other
insurance companies that conduct business across a broader
geographical area. During our history, we have experienced only
one catastrophic event that significantly affected our results
of operations. During the first quarter of 2010, we recognized a
$17.5 million pre-tax loss as a result of the severe winter
storms that affected the northeastern United States during the
period from March 13 to March 15, 2010. This loss added 6.5
points to our first quarter 2010 loss ratio.
The incidence and severity of catastrophes are inherently
unpredictable and our losses from catastrophes could be
substantial. The occurrence of claims from catastrophic events
is likely to result in substantial volatility in our financial
condition or results of operations for any fiscal quarter or
year and could have a material adverse effect on our financial
condition or results of operations and our ability to write new
business. Increases in the values and concentrations of insured
property may increase the severity of such occurrences in the
future. Although we attempt to manage our exposure to such
events, including through the use of reinsurance, the frequency
or severity of catastrophic events could exceed our estimates.
As a result, the occurrence of one or more catastrophic events
could have a material adverse effect on our financial condition
or results of operations.
If we cannot
obtain adequate reinsurance protection for the risks we have
underwritten, we may be exposed to greater losses from these
risks or we may reduce the amount of business we underwrite,
which will reduce our revenues.
Under state insurance law, insurance companies are required to
maintain a certain level of capital in support of the policies
they issue. In addition, rating agencies will reduce an
insurance companys ratings if the companys premiums
exceed specified multiples of its capital. As a result, the
level of our Insurance Subsidiaries statutory surplus and
capital limits the amount of premiums that they can write and on
which they can retain risk. Historically, we have utilized
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reinsurance to expand our capacity to write more business than
our Insurance Subsidiaries surplus would have otherwise
supported.
From time to time, market conditions have limited, and in some
cases have prevented, insurers from obtaining the types and
amounts of reinsurance that they consider adequate for their
business needs. These conditions could produce unfavorable
changes in prices, reduced ceding commission revenue or other
potentially adverse changes in the terms of reinsurance.
Accordingly, we may not be able to obtain our desired amounts of
reinsurance. In addition, even if we are able to obtain such
reinsurance, we may not be able to obtain such reinsurance from
entities with satisfactory creditworthiness or negotiate terms
that we deem appropriate or acceptable.
Even if we are
able to obtain reinsurance, our reinsurers may not pay losses in
a timely fashion, or at all, which may cause a substantial loss
and increase our costs.
As of June 30, 2010, we had a net balance due us from our
reinsurers of $320.6 million, consisting of
$238.0 million in reinsurance recoverables on unpaid
losses, $14.7 million in reinsurance recoverables on paid
losses and $67.9 million in prepaid reinsurance premiums.
Since October 1, 2003, we have sought to manage our
exposure to our reinsurers by placing our quota share
reinsurance on a funds withheld basis and requiring
any non-admitted reinsurers to collateralize their share of
unearned premium and loss reserves. However, we have
recoverables from our pre-October 1, 2003 reinsurance
arrangements that are uncollateralized, in that they are not
supported by letters of credit, trust accounts, funds
withheld arrangements or similar mechanisms intended to
protect us against a reinsurers inability or unwillingness
to pay. Our net exposure to our reinsurers totaled
$137.4 million as of June 30, 2010. As of
June 30, 2010, our largest net exposure to any one
reinsurer was approximately $42.8 million, related to
OneBeacon Insurance Group Ltd. Because we remain primarily
liable to our policyholders for the payment of their claims, in
the event that one of our reinsurers under an uncollateralized
treaty became insolvent or refused to reimburse us for losses
paid, or delayed in reimbursing us for losses paid, our cash
flow and financial results could be materially and adversely
affected. As of June 30, 2010, our largest balance due from
any one reinsurer was approximately $93.0 million, which
was due from Swiss Reinsurance America Corp.
A decline in
the ratings assigned to our insurance subsidiaries could affect
our standing among brokers, agents and insureds and cause our
sales and earnings to decrease.
Ratings have become an increasingly important factor in
establishing the competitive position of insurance companies.
There is no assurance that any additional U.S. licensed
insurance companies that we may acquire will receive ratings
comparable to the current ratings of our Insurance Subsidiaries.
These ratings are subject to, among other things, the rating
agencies evaluation of our capitalization and performance
on an ongoing basis including our management of terrorism and
natural catastrophe risks, loss reserves and expenses, and there
is no guarantee that our Insurance Subsidiaries will maintain
their respective ratings.
Our ratings are subject to periodic review by, and may be
revised downward or revoked at the sole discretion of, the
rating agencies. A decline in a companys ratings
indicating reduced financial strength or other adverse financial
developments can cause concern about the viability of the
downgraded insurer among its agents, brokers and policyholders,
resulting in a movement of business away from the downgraded
carrier to other stronger or more highly rated carriers. Because
many of our agents and brokers (whom we refer to as
producers) and policyholders purchase our policies
on the basis of our current ratings, the loss or reduction of
any of our ratings will adversely impact our ability to retain
or expand our policyholder base.
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The objective of the rating agencies rating systems is to
provide an opinion of an insurers financial strength and
ability to meet ongoing obligations to its policyholders. Our
ratings reflect the rating agencies opinion of our
financial strength and are not evaluations directed to investors
in our common stock, nor are they recommendations to buy, sell
or hold our common stock.
The failure of
any of the loss limitation methods we employ could have a
material adverse effect on our financial condition or our
results of operations.
Various provisions of our policies, such as limitations or
exclusions from coverage or choice of forum, which have been
negotiated to limit our risks, may not be enforceable in the
manner we intend. At the present time we employ a variety of
endorsements to our policies that limit exposure to known risks,
including but not limited to exclusions relating to coverage for
lead paint poisoning, asbestos and most claims for bodily injury
or property damage resulting from the release of pollutants.
In addition, the policies we issue contain conditions requiring
the prompt reporting of claims to us and our right to decline
coverage in the event of a violation of that condition. Our
policies also include limitations restricting the period in
which a policyholder may bring a breach of contract or other
claim against us, which in many cases is shorter than the
statutory limitations for such claims in the states in which we
write business. While these exclusions and limitations reduce
the loss exposure to us and help eliminate known exposures to
certain risks, it is possible that a court or regulatory
authority could nullify or void an exclusion or legislation
could be enacted modifying or barring the use of such
endorsements and limitations in a way that would adversely
effect our loss experience, which could have a material adverse
effect on our financial condition or results of operations.
We may face
substantial exposure to losses from terrorism and we are
currently required by law to provide coverage against such
losses.
Our location and amount of business written in New York City and
adjacent areas by our Insurance Subsidiaries may expose us to
losses from terrorism. U.S. insurers are required by state
and Federal law to offer coverage for terrorism in certain lines.
Although our Insurance Subsidiaries are protected by the
federally funded terrorism reinsurance, there is a substantial
deductible that must be met, the payment of which could have an
adverse effect on our results of operations. As a consequence of
this legislation, potential losses from a terrorist attack could
be substantially larger than previously expected, 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.
The effects of
emerging claim and coverage issues on our business are
uncertain.
As industry practices and legal, judicial, social and other
environmental conditions change, unexpected and unintended
issues related to claims and coverage may emerge. These issues
may adversely affect our business by either extending coverage
beyond our underwriting intent or by increasing the number or
size of claims. In some instances, these changes may not become
apparent until some time after we have issued insurance or
reinsurance contracts that are affected by the changes. As a
result, the full extent of liability under our insurance or
reinsurance contracts may not be known for many years after a
contract is issued.
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Since we
depend on a core of selected producers for a large portion of
our revenues, loss of business provided by any one of them could
adversely affect us.
Our products are marketed by independent producers. In our
Brokerage Insurance segment, these independent producers are
comprised of retail agents and wholesale agents who aggregate
business from retail agents. In our Specialty Business segment,
these independent producers are comprised of managing general
agencies who handle various underwriting and policy issuance
tasks on our behalf and who generally accept submissions from
various other independent producers.
Other insurance companies compete with us for the services and
allegiance of these producers. These producers may choose to
direct business to our competitors, or may direct less desirable
risks to us. In our Brokerage Insurance segment, approximately
45% of the 2009 gross premiums written, including premiums
produced by TRM on behalf of its issuing companies, were
produced by our top 18 producers, representing 1.3% of our
active agents and brokers. These producers each have annual
written premiums of $5.0 million or more. As we build a
broader territorial base, the number of producers with
significant premium volumes with Tower in each of our segments
is increasing.
Our largest producers in 2009 were Northeast Agencies and
Morstan General Agency. In the year ended December 31,
2009, these producers accounted for 9% and 8%, respectively, of
the total of our gross premiums written. No other producer was
responsible for more than 3% of our gross premiums written.
With the closing of the CastlePoint transactions and the SUA
transaction, we have also added program underwriting agents who
may become significant producers. A significant decrease in
business from, or the entire loss of, our largest producer or
several of our other large producers would cause us to lose
premium and require us to seek alternative producers or to
increase submissions from existing producers. In the event we
are unable to find replacement producers or increase business
produced by our existing producers, our premium revenues would
decrease and our business and results of operations would be
materially and adversely affected.
Our reliance
on producers subjects us to their credit risk.
With respect to the premiums produced by TRM for its issuing
companies and a limited amount of premium volume written by our
Insurance Subsidiaries, producers collect premium from the
policyholders and forward them to TRM and our Insurance
Subsidiaries. In most jurisdictions, when the insured pays
premiums for these policies to producers for payment over to TRM
or our Insurance Subsidiaries, the premiums are considered to
have been paid under applicable insurance laws and regulations
and the insured will no longer be liable to us for those
amounts, whether or not we have actually received the premiums
from the producer. Consequently, we assume a degree of credit
risk associated with producers. Although producers
failures to remit premiums to us have not caused a material
adverse impact on us to date, there have been instances where
producers collected premium but did not remit it to us, and we
were nonetheless required under applicable law to provide the
coverage set forth in the policy despite the absence of premium.
Because the possibility of these events is dependent in large
part upon the financial condition and internal operations of our
producers, which in most cases is not public information, we are
not able to quantify the exposure presented by this risk. If we
are unable to collect premiums from our producers in the future,
our financial condition and results of operations could be
materially and adversely affected.
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We operate in
a highly competitive environment. If we are unsuccessful in
competing against larger or more well-established rivals, our
results of operations and financial condition could be adversely
affected.
The property and casualty insurance industry is highly
competitive and has historically been characterized by periods
of significant pricing competition alternating with periods of
greater pricing discipline, during which competition focuses on
other factors. Beginning in 2000, the market environment was
increasingly favorable as rates increased significantly. During
the latter part of 2004 and throughout 2005, increased
competition in the marketplace became evident and, as a result,
average annual rate increases became moderate. The catastrophe
losses of 2004 and 2005 produced increased pricing and reduced
capacity for insurance of catastrophe-exposed property. However,
since 2006, a softening of the non-catastrophe-exposed market
has led to more aggressive pricing in specific segments of the
commercial lines business, particularly in those lines of
business and accounts with larger annual premiums. The Insurance
Information Institute indicates that the industry-wide change in
net premiums written in the Property & Casualty
industry in 2007 decreased to a zero growth (0.0 percent)
condition. A.M. Best Company reported that the
industry-wide change in net premiums written in the property and
casualty industry was -2.0% in 2008 compared to -0.7% in
2007 and is estimated to have declined -4.2% in 2009.
The new capacity that had entered the market had placed more
pressure on production and profitability targets. A.M. Best
had stated that industry policyholder surplus grew for five
consecutive years;
2003-2007,
but declined in 2008. However, policyholder surplus is estimated
to have increased by 9.4% in 2009 to $519.3 billion from
2008. This places the
premium-to-surplus
ratio at 0.8:1.0 at year-end 2009.
Competition driven by strong earnings and capital gains can be
projected to moderate as economic conditions impacting those
sources deteriorate. Overall capacity and declining underwriting
profits may result in a lessening of competitive pressure from
other insurers that previously sought to expand the types or
amount of business they write. This may cause a shift in focus
by some insurers from an interest in market share to increase
their concentration on underwriting discipline. We attempt to
compete based primarily on products offered, service,
experience, the strength of our client relationships,
reputation, speed of claims payment, financial strength,
ratings, scope of business, commissions paid and policy and
contract terms and conditions. There are no assurances that in
the future we will be able to retain or attract customers at
prices which we consider to be adequate.
In our commercial and personal lines admitted business segments,
we compete with major U.S. insurers and certain
underwriting syndicates, including large national companies such
as Travelers Companies, Inc., Allstate Insurance Company and
State Farm Insurance; regional insurers such as Selective
Insurance Company, Harleysville Insurance Company, Hanover
Insurance and Peerless Insurance Company and smaller, more local
competitors such as Greater New York Mutual, Magna Carta
Companies and Utica First Insurance Company. Our non-admitted
binding authority and brokerage business with general agents
competes with Scottsdale Insurance Company, Admiral Insurance
Company, Mt. Hawley Insurance Company, Navigators Group, Inc.,
Essex Insurance Company, Colony Insurance Company, Century
Insurance Group, Nautilus Insurance Group, RLI Corp., United
States Liability Insurance Group and Burlington Insurance Group,
Inc. In our program business, we compete against competitors
that write program business such as QBE Insurance Group Limited,
Delos Insurance Group, Am Trust Financial Services, Inc.,
RLI Corp., Chartis Inc., W.R. Berkley Corporation, Markel
Corporation, Great American Insurance Group and Philadelphia
Insurance Companies.
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Many of these companies have greater financial, marketing and
management resources than we do. Many of these competitors also
have more experience, better ratings and more market recognition
than we do. We seek to distinguish ourselves from our
competitors by providing a broad product line offering and
targeting those market segments that provide us with the best
opportunity to earn an underwriting profit. We also compete with
other companies by quickly and opportunistically delivering
products that respond to our producers needs.
In addition to competition in the operation of our business, we
face competition from a variety of sources in attracting and
retaining qualified employees. We also face competition because
of entities that self-insure, primarily in the commercial
insurance market. From time to time, established and potential
customers may examine the benefits and risks of self-insurance
and other alternatives to traditional insurance.
We may
experience difficulty in expanding our business, which could
adversely affect our results of operations and financial
condition.
In addition to our recent acquisitions of Hermitage,
CastlePoint, AequiCap, SUA and the OneBeacon Personal Lines
Division, we plan to continue to expand our licensing or acquire
other insurance companies with multi-state property and casualty
licensing in order to expand our product and service offerings
geographically. We also intend to continue to acquire books of
business that fit our underwriting competencies from
competitors, managing agents and other producers and to acquire
other insurance companies. This expansion strategy may present
special risks:
| We have achieved our prior success by applying a disciplined approach to underwriting and pricing in select markets that are not well served by our competitors. We may not be able to successfully implement our underwriting, pricing and product strategies in companies or books of business we acquire or over a larger operating region; |
| We may not be successful in obtaining the required regulatory approvals to offer additional insurance products or expand into additional states; and |
| We may have difficulty in efficiently combining an acquired company or block of business with our present financial, operational and management information systems. |
We cannot assure you that we will be successful in expanding our
business or that any new business will be profitable. If we are
unable to expand our business or to manage our expansion
effectively, our results of operations and financial condition
could be adversely affected.
Our
acquisitions could result in integration difficulties,
unexpected expenses, diversion of managements attention
and other negative consequences.
As part of our growth strategy, we have made numerous
acquisitions in recent years. Assuming we have access to
adequate levels of debt and equity capital, we plan to continue
to acquire complementary businesses as a key element of our
growth strategy. We must integrate the technology, operations,
systems and personnel of acquired businesses with our own and
attempt to grow the acquired businesses as part of our company.
The integration of other businesses is a complex process and
places significant demands on our management, financial,
technical and other resources. The successful integration of
businesses we have acquired in the past and may acquire in the
future is critical to our future success. If we are unsuccessful
in integrating these
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businesses, our financial and operating performance could
suffer. The risks and challenges associated with the acquisition
and integration of acquired businesses include:
| We may be unable to efficiently consolidate our financial, operational and administrative functions with those of the businesses we acquire; |
| Our managements attention may be diverted from other business concerns; |
| We may be unable to retain and motivate key employees of an acquired company; |
| We may enter markets in which we have little or no prior direct experience; |
| Litigation, indemnification claims and other unforeseen claims and liabilities may arise from the acquisition or operation of acquired businesses; |
| The costs necessary to complete integration may exceed our expectations or outweigh some of the intended benefits of the transactions we complete; |
| We may be unable to maintain the customers or goodwill of an acquired business; and |
| The costs necessary to improve or replace the operating systems, products and services of acquired businesses may exceed our expectations. |
We may be unable to integrate our acquisitions successfully with
our operations on schedule or at all. We can provide no
assurances that we will not incur large expenses in connection
with business units we acquire. Further, we can provide no
assurances that acquisitions will result in cost savings or
sufficient revenues or earnings to justify our investment in, or
our expenses related to, these acquisitions.
In recent
years we have successfully created shareholder value through
acquisitions of insurance entities. We may not be able to
continue to create shareholder value through such transactions
in the future.
In the past several years, we have completed numerous
acquisitions of insurance entities, many of which have
contributed significantly to our growth in book value. Failure
to identify and complete future acquisition opportunities could
limit our ability to achieve our target returns. Even if we were
to identify and complete future acquisition opportunities, there
is no assurance that such acquisitions will ultimately achieve
their anticipated benefits.
Failure to
complete, or complete on a timely basis, a pending merger or
acquisition may negatively impact our business, financial
condition, results of operation, prospects and stock
price.
We regularly evaluate merger and acquisition opportunities, and
as a result, future mergers or acquisitions may occur at any
time. A pending merger or acquisition is typically subject to
the satisfaction or waiver of a number of conditions, including
the receipt of required regulatory approvals, satisfactory due
diligence and other customary closing conditions. There can be
no assurance that the conditions to the completion of a pending
merger or acquisition will be satisfied or waived. If a pending
merger or acquisition is delayed or not completed, we would not
realize the anticipated benefits of having completed, or having
completed on a timely basis, as the case may be, such merger or
acquisition, which may adversely affect our business, financial
condition, results of operation, prospects and stock price.
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We could be
adversely affected by the loss of one or more principal
employees or by an inability to attract and retain
staff.
Our success will depend in substantial part upon our ability to
attract and retain qualified executive officers, experienced
underwriting talent and other skilled employees who are
knowledgeable about our business. We rely substantially upon the
services of our executive management team. If we were to lose
the services of members of our key management team, our business
could be adversely affected. We believe we have been successful
in attracting and retaining key personnel throughout our
history. We have employment agreements with Michael H. Lee, our
Chairman of the board of directors, President and Chief
Executive Officer, and other members of our senior management
team. We do not currently maintain key man life insurance
policies with respect to our employees except for Michael H. Lee.
Our investment
performance may suffer as a result of adverse capital market
developments or other factors, which may affect our financial
results and ability to conduct business.
We invest the premium we receive from policyholders until it is
needed to pay policyholder claims or other expenses. At
June 30, 2010, our invested assets consisted of
$1.7 billion in fixed maturity securities and
$36.8 million in equity securities at fair value.
Additionally, we held $348.5 million in cash and cash
equivalents and short-term investments. In 2009, we earned
$74.9 million of net investment income representing 7.6% of
our total revenues and 44.7% of our pre-tax income. At
June 30, 2010, we had unrealized gains of
$90.5 million which could change significantly depending on
changes in market conditions. Our funds are invested by outside
professional investment advisory management firms under the
direction of our management team in accordance with detailed
investment guidelines set by us. Although our investment
policies stress diversification of risks, conservation of
principal and liquidity, our investments are subject to a
variety of investment risks, including risks relating to general
economic conditions, market volatility, interest rate
fluctuations, liquidity risk and credit and default risk.
(Interest rate risk is discussed below under the heading,
We may be adversely affected by interest rate
changes.) In particular, the volatility of our claims may
force us to liquidate securities, which may cause us to incur
capital losses. If we do not structure our investment portfolio
so that it is appropriately matched with our insurance and
reinsurance liabilities, we may be forced to liquidate
investments prior to maturity at a significant loss to cover
such liabilities. Investment losses could significantly decrease
our asset base and statutory surplus, thereby affecting our
ability to conduct business. We recognized net realized capital
gains for 2009 which amounted to $1.5 million yet included
other than temporary impairment (OTTI) charges of
$23.5 million. The OTTI charges were primarily the result
of mortgage-backed securities and, to a lesser extent, corporate
bonds. As a result of the market volatility, we may experience
difficulty in determining accurately the value of our various
investments.
We may be
adversely affected by interest rate changes.
Our operating results are affected, in part, by the performance
of our investment portfolio. General economic conditions affect
the markets for interest-rate-sensitive securities, including
the level and volatility of interest rates and the extent and
timing of investor participation in such markets. Unexpected
changes in general economic conditions could create volatility
or illiquidity in these markets in which we hold positions and
harm our investment return. Our investment portfolio contains
interest rate sensitive instruments, such as bonds, which may be
adversely affected by changes in interest rates. A significant
increase in interest rates could have a material adverse effect
on our financial condition or results of operations. Generally,
bond prices decrease as interest rates rise. Changes in interest
rates could also have an adverse effect
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on our investment income and results of operations. For example,
if interest rates decline, investment of new premiums received
and funds reinvested may earn less than expected.
As of June 30, 2010, mortgage-backed securities constituted
approximately 22.72% of our invested assets, including cash and
cash equivalents. As with other fixed income investments, the
fair market value of these securities fluctuates depending on
market and other general economic conditions and the interest
rate environment. Changes in interest rates can expose us to
prepayment risks on these investments. When interest rates fall,
mortgage-backed securities may be prepaid more quickly than
expected and the holder must reinvest the proceeds at lower
interest rates. Certain of our mortgage-backed securities
currently consist of securities with features that reduce the
risk of prepayment, but there is no guarantee that we will not
invest in other mortgage-backed securities that lack this
protection. In periods of increasing interest rates,
mortgage-backed securities are prepaid more slowly, which may
require us to receive interest payments that are below the
interest rates then prevailing for longer than expected.
Interest rates are highly sensitive to many factors, including
governmental monetary policies, domestic and international
economic and political conditions and other factors beyond our
control.
We may require
additional capital in the future, which may not be available or
may only be available on unfavorable terms.
Our future capital requirements depend on many factors,
including our ability to write new business successfully and to
establish premium rates and reserves at levels sufficient to
cover losses. To the extent that our present capital is
insufficient to meet future operating requirements or cover
losses, we may need to raise additional funds through financings
or curtail our growth. Based on our current operating plan, we
believe our current capital will support our operations without
the need to raise additional capital. However, we cannot provide
any assurance in that regard, since many factors will affect our
capital needs and their amount and timing, including our growth
and profitability, our claims experience and the availability of
reinsurance, as well as possible acquisition opportunities,
market disruptions and other unforeseeable developments. If we
had to raise additional capital, equity or debt financing may
not be available at all or may be available only on terms that
are not favorable to us. In the case of equity financings,
dilution to our stockholders could result, and in any case such
securities may have rights, preferences and privileges that are
senior to those of holders of our common stock. Historically, we
have raised additional capital through the offering of trust
preferred securities. As a result of the recent crisis in the
global capital markets, financing through the offering of trust
preferred securities may not be available at all or may be
available only on terms that are not favorable to us. If we
cannot obtain adequate capital on favorable terms or at all, our
business, liquidity needs, financial condition or results of
operations could be materially adversely affected.
The regulatory
system under which we operate, and potential changes thereto,
could have a material adverse effect on our
business.
Our Insurance Subsidiaries are subject to comprehensive
regulation and supervision in their respective jurisdictions of
domicile. The purpose of the insurance laws and regulations is
to protect insureds, not our stockholders. These regulations are
generally administered by the Insurance Departments in which the
individual insurance companies are domiciled and relate to,
among other things:
| standards of solvency, including risk based capital measurements; |
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| restrictions on the nature, quality and concentration of investments; |
| required methods of accounting; |
| rate and form regulation pertaining to certain of our insurance businesses; |
| mandating certain insurance benefits; |
| potential assessments for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies; and |
| transactions with affiliates. |
Significant changes in these laws and regulations could make it
more expensive to conduct our business. The Insurance
Subsidiaries domiciliary state Insurance Departments, and,
with respect to the acquisition of CastlePoint, the Bermuda
Monetary Authority, also conduct periodic examinations of the
affairs of their domiciled insurance companies and require the
filing of annual and other reports relating to financial
condition, holding company issues and other matters. These
regulatory requirements may adversely affect or inhibit our
ability to achieve some or all of our business objectives.
Our Insurance Subsidiaries may not be able to obtain or maintain
necessary licenses, permits, authorizations or accreditations in
new states we intend to enter, or may be able to do so only at
significant cost. In addition, we may not be able to comply
fully with or obtain appropriate exemptions from, the wide
variety of laws and regulations applicable to insurance
companies or holding companies. Failure to comply with or to
obtain appropriate authorizations or exemptions under any
applicable laws could result in restrictions on our ability to
do business or engage in certain activities that are regulated
in one or more of the jurisdictions in which we operate and
could subject us to fines and other sanctions, which could have
a material adverse effect on our business. In addition, changes
in the laws or regulations to which our operating subsidiaries
are subject could adversely affect our ability to operate and
expand our business or could have a material adverse effect on
our financial condition or results of operations.
In recent years, the U.S. insurance regulatory framework
has come under increased Federal scrutiny, and some state
legislators have considered or enacted laws that may alter or
increase state regulation of insurance and reinsurance companies
and holding companies. Moreover, state insurance regulators
regularly re-examine existing laws and regulations, often
focusing on modifications to holding company regulations,
interpretations of existing laws and the development of new
laws. Changes in these laws and regulations or the
interpretation of these laws and regulations could have a
material adverse effect on our financial condition or results of
operations. The highly publicized investigations of the
insurance industry by state and other regulators and government
officials in recent years have led to, and may continue to lead
to, additional legislative and regulatory requirements for the
insurance industry and may increase the costs of doing business.
The activities of TRM, CPM and CPRMFL are subject to licensing
requirements and regulation under the laws of New York, New
Jersey and other states where they do business. The businesses
of TRM, CPM and CPRMFL depend on the validity of, and continued
good standing under, the licenses and approvals pursuant to
which they operate, as well as compliance with pertinent
regulations. As of February 5, 2009, the date of closing of
our acquisition of CastlePoint, our activities became subject to
certain licensing requirements and regulation under the laws of
Bermuda.
Licensing laws and regulations vary from jurisdiction to
jurisdiction. In all jurisdictions, the applicable licensing
laws and regulations are subject to amendment or interpretation
by
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regulatory authorities. Generally such authorities are vested
with relatively broad and general discretion as to the granting,
renewing and revoking of licenses and approvals. Licenses may be
denied or revoked for various reasons, including the violation
of such regulations, conviction of crimes and the like. Possible
sanctions which may be imposed include the suspension of
individual employees, limitations on engaging in a particular
business for specified periods of time, revocation of licenses,
censures, redress to clients and fines. In some instances, TRM
follows practices based on its or its counsels
interpretations of laws and regulations, or those generally
followed by the industry, which may prove to be different from
those of regulatory authorities.
As industry practices and legal, judicial, social and other
environmental conditions change, unexpected issues related to
claims and coverage may emerge. These issues may adversely
affect us by either extending coverage beyond our underwriting
intent or by increasing the number or size of claims. In some
instances, these changes may not become apparent until some time
after we have issued insurance or reinsurance contracts that are
affected by the changes. As a result, the full extent of
liability under our insurance or reinsurance contracts may not
be known for many years after a contract is issued. The effects
of this and other unforeseen emerging claim and coverage issues
are extremely hard to predict and could adversely affect us.
If the
assessments we are required to pay are increased drastically,
our results of operations and financial condition will
suffer.
Our Insurance Subsidiaries are required to participate in
various mandatory insurance facilities or in funding mandatory
pools, which are generally designed to provide insurance
coverage for consumers who are unable to obtain insurance in the
voluntary insurance market. Our Insurance Subsidiaries are
subject to assessments in the states where we do business for
various purposes, including the provision of funds necessary to
fund the operations of the Insurance Department and insolvency
funds. In 2009, the Insurance Subsidiaries were assessed
approximately $11.8 million by various state
insurance-related agencies. These assessments are generally set
based on an insurers percentage of the total premiums
written in a state within a particular line of business. The
Company is permitted to assess premium surcharges on
workers compensation policies that are based on
statutorily enacted rates. As of June 30, 2010, the
liability for the various workers compensation funds,
which includes amounts assessed on workers compensation
policies, was $3.8 million for our Insurance Subsidiaries.
As our company grows, our share of any assessments may increase.
However, we cannot predict with certainty the amount of future
assessments because they depend on factors outside our control,
such as insolvencies of other insurance companies. Significant
assessments could have a material adverse effect on our
financial condition or results of operations.
Our ability to
meet ongoing cash requirements and pay dividends may be limited
by our holding company structure and regulatory
constraints.
Tower is a holding company and, as such, has no direct
operations of its own. Tower does not expect to have any
significant operations or assets other than its ownership of the
shares of its operating subsidiaries. Dividends and other
permitted payments from Towers operating subsidiaries are
expected to be Towers primary source of funds to meet
ongoing cash requirements, including any future debt service
payments and other expenses, and to pay dividends, if any, to
Towers stockholders. As of June 30, 2010, the maximum
amount of distributions that our operating subsidiaries could
pay to Tower without approval was $64.5 million. The
inability of our operating subsidiaries to pay dividends and
other permitted payments in an amount sufficient to enable Tower
to meet its cash requirements at the holding company level would
have a material adverse effect on our operations and
Towers ability to pay dividends to our
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stockholders. Accordingly, if you require dividend income you
should carefully consider these risks before making an
investment in our company.
Although we
have paid cash dividends in the past, we may not pay cash
dividends in the future.
We have a history of paying dividends to our stockholders when
sufficient cash is available, and we currently intend to pay
dividends in each quarter of 2010. However, future cash
dividends will depend upon our results of operations, financial
condition, cash requirements and other factors, including the
ability of our subsidiaries to make distributions to us, which
ability is restricted in the manner previously discussed in this
section. Also, there can be no assurance that we will continue
to pay dividends even if the necessary financial conditions are
met and if sufficient cash is available for distribution.
We rely on our
information technology and telecommunications systems to conduct
our business.
Our business is dependent upon the functioning of our
information technology and telecommunication systems. We rely
upon our systems, as well as the systems of our vendors to
underwrite and process our business, make claim payments,
provide customer service, provide policy administration
services, such as, endorsements, cancellations and premium
collections, comply with insurance regulatory requirements and
perform actuarial and other analytical functions necessary for
pricing and product development. Our operations are dependent
upon our ability to timely and efficiently process our business
and protect our information and telecommunications systems from
physical loss, telecommunications failure or other similar
catastrophic events, as well as from security breaches. While we
have implemented business contingency plans and other reasonable
and appropriate internal controls to protect our systems from
interruption, loss or security breaches, a sustained business
interruption or system failure could adversely impact our
ability to process our business, provide customer service, pay
claims in a timely manner or perform.
Integrating
the OneBeacon Personal Lines Division may be more difficult than
expected.
The acquisition of the OneBeacon Personal Lines Division closed
on July 1, 2010. The acquired business and operations will
be combined with Towers existing personal lines operations
with the goal of achieving various benefits, including, among
other things, improvement in profitability and financial
flexibility, expanding Towers suite of personal lines
insurance products to add private passenger automobile and
personal package policies and achieving cross-selling of
products to both producer bases. Achieving the anticipated
benefits of the acquisition is subject to a number of
uncertainties, including whether Tower and the OneBeacon
Personal Lines Division are integrated in an efficient and
effective manner, and general competitive factors in the
marketplace. In addition, we expect to be highly dependent on
OneBeacon Insurance Group, Ltd. for transition services
including technology, operations and finance services for a
period of time until we can replace and migrate the operations
completely. Failure to achieve anticipated benefits and
operational migration could result in increased costs, decreases
in the amount of expected revenues and diversion of
managements time and energy and could negatively impact
our business, financial condition, results of operations,
prospects and stock price. In addition, employees and producers
may experience uncertainty about their future roles with Tower,
which might adversely affect our ability to retain key
executives, managers and other employees and producers.
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We may be
unable to collect amounts due from reciprocals through our
ownership of surplus notes.
We provide management services for a fee to two reciprocal
insurance exchanges, which we refer to as reciprocals. The
reciprocals are capitalized entirely with surplus notes that we
acquired from OneBeacon Insurance Group, Ltd. for
$96.9 million. Reciprocals are policyholder-owned insurance
carriers organized as unincorporated associations. We have no
ownership interest in these reciprocals. Under current
accounting rules, our consolidated financial statements will
include the results of these reciprocals, and therefore, the
surplus notes and any accrued interest will be eliminated in
consolidation. Payments of principal and interest on notes of
reciprocals are subject to regulatory approval. If either of the
reciprocals are unable to obtain insurance regulatory approval
to repay us, we would be unable to collect amounts owed under
the related surplus note, which would impact the statutory
capital of the Insurance Subsidiaries that own the surplus notes
and impair their ability to pay dividends to Tower.
Adverse
economic factors including recession, inflation, periods of high
unemployment or lower economic activity could result in the
combined company selling fewer policies than expected or an
increase in premium defaults which, in turn, could affect the
combined companys growth and profitability.
Negative economic factors may also affect the combined
companys ability to receive the appropriate rate for the
risk it insures with its policyholders and may impact its policy
flow. In an economic downturn, the degree to which prospective
policyholders apply for insurance and fail to pay all balances
owed may increase. Existing policyholders may exaggerate or even
falsify claims to obtain higher claims payments. These outcomes
would reduce the combined companys underwriting profit to
the extent these effects are not reflected in the rates charged
by the combined company.
Currently
pending or future litigation or governmental proceedings could
result in material adverse consequences, including injunctions,
judgments or settlements.
We are and from time to time become involved in lawsuits,
regulatory inquiries and governmental and other legal
proceedings arising out of the ordinary course of its business.
Many of these matters raise difficult and complicated factual
and legal issues and are subject to uncertainties and
complexities. The timing of the final resolutions to these types
of matters is often uncertain. Additionally, the possible
outcomes or resolutions to these matters could include adverse
judgments or settlements, either of which could require
substantial payments, adversely affecting our business,
financial condition, results of operations, prospects and stock
price.
The method for
accounting for costs associated with acquiring or renewing
insurance contracts is under review by the FASB and the proposed
changes, if adopted, would result in a significant charge to our
earnings.
In November 2009, the Emerging Issues Task Force of the FASB
issued an exposure draft of Issue No. 09-G,
Accounting for Costs Associated with Acquiring or Renewing
Insurance Contracts. At issue is how the definition of
acquisition costs should be interpreted in assessing whether
certain costs relating to the acquisition of new or renewal
insurance contracts qualify as deferred acquisition costs. In
July 2010, the Task Force reached a final consensus-for-exposure
that acquisition costs that qualify as deferrable should include
only those costs that are directly related to the acquisition of
insurance contracts by applying a model similar to the
accounting for loan origination costs. That definition would not
include, for example, any costs incurred in the acquisition of
new or renewal contracts related to unsuccessful contract
acquisitions. This
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pending guidance is expected to be effective for annual and
interim periods beginning after December 15, 2011 and would
allow, but not require, retrospective application. The final
vote by the FASB on this guidance is expected to occur on
September 15, 2010. As of June 30, 2010, we had
recorded $58.8 million of other deferred acquisition
expenses as part of Deferred acquisition costs, net
of deferred ceding commission revenue on our consolidated
balance sheet. The amount included in the category other
deferred acquisition expenses may be significantly reduced
as a result of the adoption of this guidance. If the FASB adopts
this guidance, we intend to implement this guidance, and apply
it retrospectively, for the year ended December 31, 2010.
We expect that this would result in our recording a significant
non-cash
charge to either beginning retained earnings or operating
results for the year ended December 31, 2010. If the FASB
were to fail to adopt this guidance, there can be no assurance
that we would not in any case modify our accounting for deferred
acquisition costs in the future, which could have an adverse
affect on our future results.
Risks related to
our industry
The threat of
terrorism and military and other actions may adversely affect
our investment portfolio and may result in decreases in our net
income, revenue and assets under management.
The threat of terrorism, both within the United States and
abroad, and military and other actions and heightened security
measures in response to these types of threats, may cause
significant volatility and declines in the equity markets in the
United States, Europe and elsewhere, as well as loss of life,
property damage, additional disruptions to commerce and reduced
economic activity. Some of the assets in our investment
portfolio may be adversely affected by declines in the equity
markets and economic activity caused by the continued threat of
terrorism, ongoing military and other actions and heightened
security measures.
We can offer no assurances that terrorist attacks or the threat
of future terrorist events in the United States and abroad or
military actions by the United States will not have a material
adverse effect on our business, financial condition or results
of operations.
Our results of
operations and revenues may fluctuate as a result of many
factors, including cyclical changes in the insurance
industry.
The results of operations of companies in the property and
casualty insurance industry historically have been subject to
significant fluctuations and uncertainties. Our profitability
can be affected significantly by:
| competition; |
| rising levels of loss costs that we cannot anticipate at the time we price our products; |
| volatile and unpredictable developments, including man-made, weather-related and other natural catastrophes or terrorist attacks; |
| changes in the level of reinsurance capacity and insurance capacity; |
| changes in the amount of loss and loss adjustment expense reserves resulting from new types of claims and new or changing judicial interpretations relating to the scope of insurers liabilities; and |
| fluctuations in equity markets and interest rates, inflationary pressures, conditions affecting the credit markets, segments thereof or particular asset classes and other changes in the |
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investment environment, which affect returns on invested assets and may impact the ultimate payout of losses. |
The supply of insurance is related to prevailing prices, the
level of insured losses and the level of industry surplus which,
in turn, may fluctuate in response to changes in rates of return
on investments being earned in the insurance and reinsurance
industry. As a result, the insurance business historically has
been a cyclical industry characterized by periods of intense
price competition due to excessive underwriting capacity
alternating with periods when shortages of capacity permitted
favorable premium levels. Significant amounts of new capital
flowing into the insurance and reinsurance sectors could lead to
a significant reduction in premium rates, less favorable policy
terms and fewer submissions for our underwriting services. In
addition to these considerations, changes in the frequency and
severity of losses suffered by insureds and insurers may affect
the cycles of the insurance business significantly, and we
expect to experience the effects of such cyclicality.
This cyclicality could have a material adverse effect on our
results of operations and revenues.
Changing
climate conditions may adversely affect our financial condition
or profitability.
There is an emerging scientific consensus that the earth is
getting warmer. Climate change, to the extent it produces rising
temperatures and changes in weather patterns, may affect the
frequency and severity of storms and other weather events, the
affordability, availability and underwriting results of
homeowners and commercial property insurance and, if frequency
and severity patterns increase, could negatively affect our
financial results.
Risks related to
disruptions in the financial markets
Adverse
capital and credit market conditions may significantly affect
our ability to meet liquidity needs, access to capital and cost
of capital.
The capital and credit markets have been experiencing volatility
and disruption in certain market sectors.
We need liquidity to pay claims, reinsurance premiums, operating
expenses, interest on our debt and dividends on our capital
stock. Without sufficient liquidity, we will be forced to
curtail our operations, and our business will suffer. The
principal sources of our liquidity are insurance premiums,
reinsurance recoveries, ceding commissions, fee revenues, cash
flow from our investment portfolio and other assets, consisting
mainly of cash or assets that are readily convertible into cash.
Other sources of liquidity in normal markets also include a
variety of instruments, including medium- and long-term debt,
junior subordinated debt securities and stockholders
equity.
In the event current resources do not satisfy our needs, we may
have to seek additional financing. The availability of
additional financing will depend on a variety of factors such as
market conditions, the general availability of credit, the
volume of trading activities, the overall availability of credit
to the financial services industry, our credit ratings and
credit capacity, as well as the possibility that customers or
lenders could develop a negative perception of our long- or
short-term financial prospects if we incur large investment
losses or if the level of our business activity decreased due to
a market downturn. Similarly, our access to funds may be
impaired if regulatory authorities or rating agencies take
negative actions against us. Our internal sources of liquidity
may prove to be insufficient, and in such case, we may not be
able to successfully obtain additional financing on favorable
terms, or at all.
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Disruptions, uncertainty or volatility in the capital and credit
markets may also limit our access to capital required to operate
our business. Such market conditions may limit our ability to
satisfy statutory capital requirements, generate fee income and
access the capital necessary to grow our business. As such, we
may be forced to delay raising capital, issue shorter tenor
securities than we prefer, or bear an unattractive cost of
capital which could decrease our profitability and significantly
reduce our financial flexibility. Our results of operations,
financial condition, cash flows and statutory capital position
could be materially adversely affected by disruptions in the
financial markets.
Difficult
conditions in the global capital markets and the economy
generally may materially adversely affect our business and
results of operations and we do not expect these conditions to
improve in the near future.
Our results of operations are materially affected by conditions
in the capital markets and the economy generally. The stress
experienced by capital markets that began in the second half of
2007 continued throughout 2009 and has continued into 2010.
Recently, concerns over inflation or deflation, energy costs,
geopolitical issues, the availability and cost of credit, the
mortgage market and a declining real estate market have
contributed to increased volatility and diminished expectations
for the economy and markets going forward. These concerns and
the continuing market upheavals may have an adverse effect on
us. Our revenues may decline in such circumstances and our
profit margins could erode. In addition, in the event of extreme
prolonged market disruptions we could incur significant losses.
Even in the absence of a market downturn, we are exposed to
substantial risk of loss due to market volatility.
Factors such as consumer spending, business investment,
government spending, the volatility and strength of the capital
markets and inflation or deflation all affect the business and
economic environment and, ultimately, the amount and
profitability of our business. In an economic downturn
characterized by higher unemployment, lower family income, lower
corporate earnings, lower business investment and lower consumer
spending, the demand for our insurance products could be
adversely affected. In addition, we may experience an elevated
incidence of claims. Adverse changes in the economy could affect
earnings negatively and could have a material adverse effect on
our business, results of operations and financial condition. The
current mortgage crisis has also raised the possibility of
future legislative and regulatory actions that could further
impact our business. We cannot predict whether or when such
actions may occur, or what impact, if any, such actions could
have on our business, results of operations and financial
condition.
The impairment
of other financial institutions could adversely affect
us.
We have exposure to many different industries and
counterparties, and routinely execute transactions with
counterparties in the financial services industry, including
brokers and dealers, commercial banks, investment banks,
reinsurers and other institutions. Many of these transactions
expose us to credit risk in the event of default of our
counterparty. We also have exposure to various financial
institutions in the form of unsecured debt instruments and
equity investments and unsecured debt instruments issued by
various state and local municipal authorities. There can be no
assurance that any such losses or impairments to the carrying
value of these assets would not materially and adversely affect
our business and results of operations.
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We are exposed
to significant financial and capital markets risk which may
adversely affect our results of operations, financial condition
and liquidity, and our net investment income can vary from
period to period.
We are exposed to significant financial and capital markets
risk, including changes in interest rates, credit spreads,
equity prices, real estate values, market volatility, the
performance of the economy in general, the performance of the
specific obligors included in our portfolio and other factors
outside our control. Our exposure to interest rate risk relates
primarily to the market price and cash flow variability
associated with changes in interest rates. A rise in interest
rates will increase the net unrealized loss position of our
investment portfolio. Our investment portfolio contains interest
rate sensitive instruments, such as fixed income securities,
which may be adversely affected by changes in interest rates
from governmental monetary policies, domestic and international
economic and political conditions and other factors beyond our
control. A rise in interest rates would increase the net
unrealized loss position of our investment portfolio, offset by
our ability to earn higher rates of return on funds reinvested.
Conversely, a decline in interest rates would decrease the net
unrealized loss position of our investment portfolio, offset by
lower rates of return on funds reinvested.
Our exposure to credit spreads primarily relates to market price
associated with changes in credit spreads. A widening of credit
spreads will increase the net unrealized loss position of the
investment portfolio and, if issuer credit spreads increase
significantly or for an extended period of time, would likely
result in higher
other-than-temporary
impairments. Credit spread tightening will reduce net investment
income associated with new purchases of fixed maturities. Our
investment portfolio also has significant exposure to risks
associated with mortgage-backed securities. As with other fixed
income investments, the fair market value of these securities
fluctuates depending on market and other general economic
conditions and the interest rate environment.
In addition, market volatility can make it difficult to value
certain of our securities if trading becomes less frequent. As
such, valuations may include assumptions or estimates that may
have significant period to period changes which could have a
material adverse effect on our consolidated results of
operations or financial condition. Continuing challenges include
continued weakness in the real estate market and increased
mortgage delinquencies, investor anxiety over the economy,
rating agency downgrades of various structured products and
financial issuers, unresolved issues with structured investment
vehicles, deleveraging of financial institutions and hedge funds
and a serious dislocation in the inter-bank market. If
significant, continued volatility, changes in interest rates,
changes in credit spreads and defaults, a lack of pricing
transparency, market liquidity and declines in equity prices,
individually or in tandem, could have a material adverse effect
on our results of operations, financial condition or cash flows
through realized losses, impairments and changes in unrealized
positions.
Our valuation
of fixed maturity and equity securities may include
methodologies, estimations and assumptions which are subject to
differing interpretations and could result in changes to
investment valuations that may materially adversely affect our
results of operations or financial condition.
We have categorized our fixed maturity and equity securities
into a three-level hierarchy, based on the priority of the
inputs to the respective valuation technique. The fair value
hierarchy gives the highest priority to quoted prices in active
markets for identical assets or liabilities
(Level 1) and the lowest priority to unobservable
inputs (Level 3). An asset or liabilitys classification within the fair value hierarchy is based on the
lowest level of significant input to its valuation. The relevant
GAAP guidance defines the input levels as follows:
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Level 1Inputs to the valuation methodology are
quoted prices (unadjusted) for identical assets or liabilities
traded in active markets. Included are those investments traded
on an active exchange, such as the NASDAQ Global Select Market.
Level 2Inputs to the valuation methodology
include quoted prices for similar assets or liabilities in
active markets, quoted prices for identical or similar assets or
liabilities in markets that are not active, inputs other than
quoted prices that are observable for the asset or liability and
market-corroborated inputs. Included are investments in
U.S. Treasury securities and obligations of
U.S. government agencies, together with municipal bonds,
corporate debt securities, commercial mortgage and asset-backed
securities and certain residential mortgage-backed securities
that are generally investment grade.
Level 3Inputs to the valuation methodology are
unobservable for the asset or liability and are significant to
the fair value measurement. Material assumptions and factors
considered in pricing investment securities may include
projected cash flows, collateral performance including
delinquencies, defaults and recoveries, and any market clearing
activity or liquidity circumstances in the security or similar
securities that may have occurred since the prior pricing
period. Included in this valuation methodology are investments
in certain mortgage-backed and asset-backed securities.
At June 30, 2010, approximately 2.1%, 97.4% and 0.5% of
these securities represented Level 1, Level 2 and
Level 3, respectively. The availability of observable
inputs varies and is affected by a wide variety of factors. When
the valuation is based on models or inputs that are less
observable or unobservable in the market, the determination of
fair value requires significantly more judgment. The degree of
judgment exercised by management in determining fair value is
greatest for investments during periods of market disruption
including periods of significantly rising or high interest
rates, rapidly widening credit spreads or illiquidity, it may be
difficult to value certain of our securities, for example,
non-agency residential mortgage backed securities if trading
becomes less frequent or market data becomes less observable.
There may be certain asset classes that were in active markets
with significant observable data that become illiquid due to the
current financial environment. In such cases, more securities
may fall to Level 3 and thus require more subjectivity and
management judgment. As such, valuations may include inputs and
assumptions that are less observable or require greater
estimation as well as valuation methods which are more
sophisticated or require greater estimation thereby resulting in
values which may be less than the value at which the investments
may be ultimately sold. Further, rapidly changing and
unprecedented credit and equity market conditions could
materially impact the valuation of securities as reported within
our consolidated financial statements and the
period-to-period
changes in value could vary significantly. Decreases in value
may have a material adverse effect on our results of operations
or financial condition.
Some of our
investments are relatively illiquid and are in asset classes
that have been experiencing significant market valuation
fluctuations.
We hold certain investments that may lack liquidity, such as
non-agency residential mortgage backed securities, subprime
mortgage backed securities and certain commercial mortgage
backed securities, rated below AA. These asset classes
represented 5.3% of the carrying value of our total cash and
invested assets as of June 30, 2010.
The reported values of our less liquid asset classes described
in the paragraph above do not necessarily reflect the lowest
current market price for the asset. If we were forced to sell
certain of our assets in the current market, there can be no assurance
that we would be able to sell them for the prices at which we
have recorded them and we may be forced to sell them at lower
prices.
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The
determination of the amount of impairments taken on our
investments is highly subjective and could materially impact our
results of operations or financial position.
The determination of the amount of allowances and impairments
varies by investment type and is based upon our periodic
evaluation and assessment of known and inherent risks associated
with the respective asset class. Such evaluations and
assessments are revised as conditions change and new information
becomes available. Management updates its evaluations regularly
and reflects changes in allowances and impairments in operations
as such evaluations are revised. There can be no assurance that
our management has accurately assessed the level of impairments
taken in our financial statements. Furthermore, additional
impairments may need to be taken in the future. Historical
trends may not be indicative of future impairments.
For example, the cost of our fixed maturity and equity
securities is adjusted for impairments in value deemed to be
other-than-temporary
in the period in which the determination is made. The assessment
of whether impairments have occurred is based on
managements
case-by-case
evaluation of the underlying reasons for the decline in fair
value.
Our management regularly reviews our fixed-maturity and equity
securities portfolios to evaluate the necessity of recording
impairment losses for
other-than-temporary
declines in the fair value of investments. In evaluating
potential impairment, management considers, among other
criteria: (i) the current fair value compared to amortized
cost or cost, as appropriate; (ii) the length of time the
securitys fair value has been below amortized cost or
cost; (iii) specific credit issues related to the issuer
such as changes in credit rating, reduction or elimination of
dividends or non-payment of scheduled interest payments;
(iv) managements intent and ability to retain the
investment for a period of time sufficient to allow for any
anticipated recovery in value to cost; (v) specific cash
flow estimations for certain mortgage-backed securities; and
(vi) current economic conditions.
Gross
unrealized losses may be realized or result in future
impairments.
Our gross unrealized losses on fixed maturity securities at
June 30, 2010 were $8.3 million pre-tax, and the
amount of gross unrealized losses on securities that have been
in an unrealized loss position for twelve months or more is
approximately $6.0 million pre-tax. Realized losses or
impairments may have a material adverse impact on our results of
operation and financial position.
If our
business does not perform well, we may be required to recognize
an impairment of our goodwill, intangible or other long-lived
assets or to establish a valuation allowance against the
deferred income tax asset, which could adversely affect our
results of operations or financial condition.
Goodwill represents the excess of the amounts we paid to acquire
subsidiaries and other businesses over the fair value of their
net assets at the date of acquisition. We test goodwill at least
annually for impairment. Impairment testing is performed based
upon estimates of the fair value of the reporting units to which
the goodwill relates. The estimated fair value of the acquired
net assets is impacted by the ongoing performance of the related
business. If it is determined that the goodwill has been
impaired, we must write down the goodwill by the amount of the impairment, with a corresponding charge to income.
Such write downs could have a material adverse effect on our
results of operations or financial position.
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Intangible assets represent the amount of fair value assigned to
certain assets when we acquire a subsidiary or a book of
business. Intangible assets are classified as having either a
finite or an indefinite life. We test the recoverability of
indefinite life intangibles at least annually. We test the
recoverability of finite life intangibles whenever events or
changes in circumstances indicate that the carrying value of a
finite life intangible may not be recoverable. An impairment is
recognized if the carrying value of an intangible asset is not
recoverable and exceeds its fair value in which circumstances we
must write down the intangible asset by the amount of the
impairment, with a corresponding charge to income. Such write
downs could have a material adverse effect on our results of
operations or financial position.
Deferred income tax represents the tax effect of the differences
between the book and tax basis of assets and liabilities.
Deferred tax assets are assessed periodically by management to
determine if they are realizable. Factors in managements
determination include the performance of the business including
the ability to generate taxable capital gains. If based on
available information, it is more likely than not that the
deferred income tax asset will not be realized, then a valuation
allowance must be established with a corresponding charge to net
income. Such charges could have a material adverse effect on our
results of operations or financial position.
Risks related to
our common stock
Insurance laws
and regulations, delaware law, our charter documents and terms
of our indebtedness may impede or discourage
a takeover, which could cause the market price of our shares to
decline.
We currently have insurance subsidiaries in Florida, New York,
California, Illinois, New Jersey, New Hampshire, Maine and
Massachusetts. The insurance company change of control laws in
each of those states require written approval from the
superintendent or commissioner of the insurance department of
such state before a third party can acquire control of us.
Control is presumed to exist if any person, directly or
indirectly, controls or holds with the power to vote more than
10% (or 5% in the case of Florida) of our voting securities.
In addition, our articles of incorporation and bylaws contain
provisions that may prevent or deter a third party from
acquiring us, even if such acquisition could benefit you. These
provisions may limit our shareholders ability to approve a
transaction that our shareholders may think is in their best
interests. Such provisions include (i) classifying our
board of directors with staggered three-year terms, which may
lengthen the time required to gain control of our board of
directors; (ii) prohibiting stockholder action by written
consent, thereby requiring all stockholder actions to be taken
at a meeting of the stockholders; (iii) limiting who may
call special meetings of stockholders; (iv) establishing
advance notice requirements for nominations of candidates for
election to our board of directors or for proposing matters that
can be acted upon by stockholders at stockholder meetings; and
(v) the existence of authorized and unissued Tower common stock which would allow our board of directors to
issue shares to persons friendly to current management.
We are a Delaware corporation, and the anti-takeover provisions
of Delaware law impose various impediments to the ability of a
third party to acquire control of us, even if a change in
control would be beneficial to our existing stockholders. In
addition, our board of directors has the power, without
stockholder approval, to designate the terms of one or more
series of preferred stock and issue shares of preferred stock.
Our revolving credit facility also has provisions that give rise
to events of default on the occurrence of a change of control.
Insurance laws and regulations, the ability of our board of
directors to create and issue a new series of preferred stock,
certain provisions of Delaware law and our certificate of
incorporation and bylaws and certain terms of our
indebtedness could impede a merger, takeover or other
business combination involving us or discourage a potential
acquirer from making a tender offer for our common stock, which,
under certain circumstances, could reduce the market price of
our common stock.
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We can issue
preferred stock without stockholder approval, which could
materially adversely affect the rights of common
stockholders.
Our amended and restated certificate of incorporation authorizes
us to issue blank check preferred stock, the
designation, rights, preferences and any qualifications,
limitations or shares of which may be fixed or altered from time
to time by our board of directors. Accordingly, our board of
directors has the authority, without stockholder approval, to
issue preferred stock with rights that could materially
adversely affect the voting power or other rights of the common
stockholders or the market value of the common stock.
Convertible note hedge and warrant transactions may affect the
value of our common stock.
In connection with the previously announced offering of
convertible senior notes due 2014,
which we refer to as convertible senior notes,
we expect to enter
into convertible note hedge transactions with
certain financial institutions, which we refer to herein as the hedge
counterparties. We also expect to enter into warrant
transactions with the hedge counterparties. The convertible note
hedge transactions are intended to reduce potential dilution to
our common stock and to offset potential cash payments in excess
of the principal amount of the convertible senior notes, as the case may be, upon
conversion of the convertible senior notes. However, the warrant transactions will
separately have a dilutive effect on our earnings per share to
the extent that the market price per share of our common stock
exceeds the strike price of the warrants.
In connection with establishing their initial hedges of the
convertible note hedge and warrant transactions, the hedge
counterparties or their respective affiliates expect to enter
into various derivative transactions with respect to our common
stock concurrently with or shortly after the pricing of the
convertible senior notes. These activities could increase (or reduce the size of
any decrease in) the market price of our common stock
concurrently with or shortly after the pricing of the convertible senior notes.
In addition, the hedge counterparties or their respective
affiliates are likely to modify their hedge positions by
entering into or unwinding various derivatives with respect to
our common stock and purchasing or selling our common stock or
other securities of ours in secondary market transactions
following the pricing of the convertible senior notes and prior to the maturity of
the convertible senior notes. In particular, such hedge modification transactions
are likely to occur on or around any conversion date and during
any observation period related to a conversion of convertible
senior notes.
In addition, if any such convertible note hedge and warrant
transactions fail to become effective, whether or not the
offering of convertible senior notes is completed, the hedge counterparties or
their respective affiliates are likely to unwind their hedge
positions with respect to our common stock, which could
adversely affect the value of our common stock.
The effect, if any, of any of these transactions and activities
on the market price of our common stock or the convertible senior notes will depend
in part on market conditions and cannot be ascertained at this
time, but any of these activities could adversely affect the
value of our common stock.
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We are subject
to counterparty risk with respect to the convertible note hedge
transactions.
The hedge counterparties are financial institutions or
affiliates of financial institutions, and we will be subject to
the risk that these hedge counterparties may default or
otherwise fail to perform, or may exercise certain rights to
terminate their obligations, under the convertible note hedge
transactions. Our exposure to the credit risk of the hedge
counterparties will not be secured by any collateral. Recent
global economic conditions have resulted in the actual or
perceived failure or financial difficulties of many financial
institutions. If one or more of the hedge counterparties to one
or more of our convertible note hedge transactions becomes
subject to insolvency proceedings, we will become an unsecured
creditor in those proceedings with a claim equal to our exposure
at the time under those transactions. Our exposure will depend
on many factors but, generally, an increase in our exposure will
be correlated to an increase in the market price of our common
stock or in volatility of our common stock. In addition, upon a
default or other failure to perform by, or a termination of the
obligations of, one of the hedge counterparties, we may suffer
adverse tax consequences as well as dilution with respect to our
common stock. We can provide no assurances as to the financial
stability or viability of any of the hedge counterparties.
Repurchases by
us of our common stock may affect the value of our
common stock.
We expect to use approximately $50 million of the net proceeds from the previously announced offering of convertible senior notes to repurchase shares of our common stock, of which we anticipate using up to $40 million to repurchase shares from
institutional investors through one or more of the initial
purchasers or their respective affiliates as our agent
concurrently with the offering in privately-negotiated
transactions. Any such concurrent repurchases may raise or maintain the market
price of our common stock above market levels that otherwise
would have prevailed, or prevent or reduce a decline in the
market price of our common stock, concurrently with, or shortly
after, the pricing of the convertible senior notes.
We have in the past, and may from time to time in the future,
engage in additional repurchases of our common stock by means of
open market repurchases or privately-negotiated transactions,
using available funds or debt financing.
Conversion of
the convertible senior notes may dilute the ownership interest of our existing
stockholders.
The conversion of some or all of the convertible senior notes may dilute the
ownership interests of our existing stockholders despite the
expected reduction of such potential dilution as a result of the
convertible note hedge transactions. For example, we may elect
to settle a conversion solely in shares of our common stock, in
which case we would generally only be entitled to receive a
number of shares under the convertible note hedge transactions
corresponding to the amount, if any, by which the shares we are
required to deliver upon conversion of the convertible senior notes have a value
that exceeds the principal amount of converted convertible senior notes. In
addition, in certain circumstances, such as a conversion of convertible senior
notes where we have elected to settle our conversion obligation
solely in shares of our common stock or a conversion of
convertible senior notes in
connection with a make-whole fundamental change, the value of
cash, shares of our common stock or combination thereof, we are
entitled to receive under the convertible note hedge
transactions may be less than the value of cash, shares of our
common stock or combination thereof, in excess of the principal
amount of the convertible senior notes that we are obligated to deliver upon
conversion of the convertible senior notes. Furthermore, the warrant transactions
will separately have a dilutive effect on our common stock to
the extent that the market value per share of our common stock
exceeds the applicable strike price of the warrants. Any sales
in the public market of any or our common stock issuable upon
such conversion could adversely affect prevailing market prices
of our common stock. In addition, the anticipated conversion of
the convertible senior notes into shares of our common stock or a combination of
cash and shares of our common stock could depress the price of
our common stock.
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Item 9.01. Financial Statements and Exhibits
(d) Exhibits
Number | Description | |
99.1
|
First Amendment to Credit Agreement, dated as of September 10, 2010. |
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SIGNATURES
Pursuant to the requirement of the Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned hereunto duly authorized.
Tower Group, Inc. | ||||
Registrant |
||||
Date: September 14, 2010 | /s/ William E. Hitselberger | |||
WILLIAM E. HITSELBERGER | ||||
Senior Vice President &
Chief Financial Officer |
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