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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K/A

(Amendment No. 1 to Form 10-K)

(Mark One)

x   

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2012

 

Or

¨   

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES ACT OF 1934

For the transition period from              to             

Commission File Number: 000-50990

Tower Group, Inc.

(Exact name of registrant as specified in its charter)

 

  

Delaware

     

13-3894120

  
   (State or other jurisdiction of
incorporation or organization)
      (I.R.S. Employer Identification No.)   
  

120 Broadway, 31st Floor
New York, New York

     

10271

  
   (Address of principal executive offices)       (Zip Code)   

(212) 655-2000

 

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

 

   

Title of each class

      

Name of each exchange on which registered

    
  Common Stock, $0.01 par value per share      NASDAQ Global Select Market   

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of Securities

Act.    Yes  ¨    No  þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the

Act.    Yes  ¨    No  þ

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

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ¨

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

 

Large accelerated filer þ    Accelerated filer ¨   

Non-accelerated filer ¨

(Do not check if a smaller reporting company)

   Smaller reporting company ¨

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

The aggregate market value of the registrant’s common stock held by non-affiliates on June 30, 2012 (based on the closing price on the NASDAQ Global Select Market on such date) was $720,706,000.

As of March 8, 2013, the registrant had 38,379,597 shares of common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE:

Part III of this Form 10-K incorporates by reference certain information from the registrant’s definitive Proxy Statement with respect to the registrant’s 2013 Annual Meeting of Shareholders, to be filed not later than 120 days after the close of the registrant’s fiscal year (the “Proxy Statement”).


Table of Contents

EXPLANATORY NOTE

This Amendment No. 1 (the “Amendment”) to our Annual Report on Form 10-K for the year ended December 31, 2012, which was filed with the Securities and Exchange Commission (the “SEC”) on March 4, 2013 (the “Form 10-K”), is being filed to provide the conformed signature of PricewaterhouseCoopers LLP which was inadvertently omitted from the Report of Independent Registered Public Accounting Firm which appears at page F-2 of the Consolidated Financial Statements in the Form 10-K. The Company obtained a manually-signed copy of the signed report of PricewaterhouseCoopers LLP on March 4, 2013 before filing its Form 10-K on March 4, 2013.

No other changes have been made to the Form 10-K other than that described above. This Amendment does not reflect subsequent events occurring after the original filing date of the Form 10-K or modify or update in any way disclosures made in the Form 10-K. Among other things, forward-looking statements made in the Form 10-K have not been revised to reflect events that occurred or facts that became known to the Company after filing of the Form 10-K, and such forward-looking statements should be read in their historical context. Furthermore, this Form 10-K/A should be read in conjunction with the Form 10-K and with the Company’s filings with the SEC subsequent to the Form 10-K.


Table of Contents

TABLE OF CONTENTS

 

PART II

  

Item 8. Financial Statements And Supplementary Data

     F-1   

Item 9A. Controls And Procedures

     51   

PART IV

     53   

Item 15. Exhibits, Financial Statement Schedules

     53   


Table of Contents

Item 8. Financial Statements and Supplementary Data

Index to Consolidated Financial Statements

 

     Page  

 

 

Reports of Independent Registered Public Accounting Firm

     F-2   

Consolidated Balance Sheets as of December 31, 2012 and 2011

     F-3   

Consolidated Statements of Income and Comprehensive Income for the years ended December  31, 2012, 2011, and 2010

     F-5   

Consolidated Statements of Changes in Stockholders’ Equity for the years ended December  31, 2012, 2011, and 2010

     F-6   

Consolidated Statements of Cash Flows for the years ended December 31, 2012, 2011, and 2010

     F-7   

Notes to Consolidated Financial Statements

     F-8   

 

F-1


Table of Contents

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of Tower Group, Inc,

In our opinion, the accompanying consolidated balance sheets as of December 31, 2012 and 2011 and the related consolidated statements of income and comprehensive income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2012 present fairly, in all material respects, the financial position of Tower Group, Inc. and its subsidiaries (the “Company”) at December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing on page S-1 present fairly, in all material respects, the information set forth therein at December 31, 2012 and 2011, and for each of the years in the three year period ended December 31, 2012 when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/ PricewaterhouseCoopers LLP

New York, New York

March 4, 2013

 

F-2


Table of Contents

Part I – FINANCIAL INFORMATION

Item 1. Financial Statements

Tower Group, Inc.

Consolidated Balance Sheets

 

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

 

 

Assets

     

Investments - Tower

     

Available-for-sale investments, at fair value:

     

Fixed-maturity securities (amortized cost of $1,926,236 and $2,046,932)

   $       2,065,148       $       2,153,620   

Equity securities (cost of $144,204 and $91,069)

     140,695         87,479   

Short-term investments (cost of $4,749 and $0)

     4,750           

Other invested assets

     57,786         44,347   

Investments - Reciprocal Exchanges

     

Available-for-sale investments, at fair value:

     

Fixed-maturity securities (amortized cost of $263,950 and $288,180)

     280,563         300,054   

Equity securities (cost of $5,144 and $1,965)

     5,563         1,866   

 

 

Total investments

     2,554,505         2,587,366   

Cash and cash equivalents (includes $9,782 and $666 relating to Reciprocal Exchanges)

     100,293         114,098   

Investment income receivable (includes $2,610 and $2,978 relating to Reciprocal Exchanges)

     25,332         26,782   

Investment in unconsolidated affiliate

     70,830           

Premiums receivable (includes $44,285 and $44,171 relating to Reciprocal Exchanges)

     422,112         426,432   

Reinsurance recoverable on paid losses (includes $682 and $5,670 relating to Reciprocal Exchanges)

     17,609         23,903   

Reinsurance recoverable on unpaid losses (includes $52,389 and $11,253 relating to Reciprocal Exchanges)

     496,192         319,664   

Prepaid reinsurance premiums (includes $17,803 and $14,685 relating to Reciprocal Exchanges)

     63,923         54,037   

Deferred acquisition costs, net (includes $11,364 and $11,866 relating to Reciprocal Exchanges)

     180,941         168,858   

Intangible assets (includes $6,854 and $4,839 relating to Reciprocal Exchanges)

     106,768         114,920   

Goodwill

     241,458         241,458   

Funds held by reinsured companies

     137,545         69,755   

Other assets (includes $2,042 and $2,685 relating to Reciprocal Exchanges)

     331,506          306,295   

 

 

Total assets

   $ 4,749,014        $ 4,453,568   

 

 

Liabilities

     

Loss and loss adjustment expenses (includes $135,791 and $136,274 relating to Reciprocal Exchanges)

   $ 1,895,073       $ 1,632,113   

Unearned premium (includes $103,216 and $102,991 relating to Reciprocal Exchanges)

     920,859         893,176   

Reinsurance balances payable (includes $6,979 and $3,466 relating to Reciprocal Exchanges)

     40,569         20,794   

Funds held under reinsurance agreements (includes $500 and $0 relating to Reciprocal Exchanges)

     98,581         96,726   

Other liabilities (includes $21,054 and $10,035 relating to Reciprocal Exchanges)

     292,239         289,394   

Deferred income taxes (includes $19,818 and $18,906 relating to Reciprocal Exchanges)

     36,464         33,285   

Debt

     449,731         426,901   

 

 

Total liabilities

     3,733,516         3,392,389   

Contingencies (Note 17)

               

Stockholders’ equity

     

Common stock ($0.01 par value; 100,000,000 shares authorized, 46,820,959 and 46,448,341 shares issued, and 38,405,837 and 39,221,102 shares outstanding)

     469         465   

Treasury stock (8,415,122 and 7,227,239 shares)

     (181,435)         (158,185)   

Paid-in-capital

     780,097         772,938   

Accumulated other comprehensive income

     83,406         63,053   

Retained earnings

     298,299         355,528   

 

 

Tower Group, Inc. stockholders’ equity

     980,836         1,033,799   

 

 

Noncontrolling interests

     34,662         27,380   

 

 

Total stockholders’ equity

     1,015,498         1,061,179   

 

 

Total liabilities and stockholders’ equity

   $ 4,749,014       $ 4,453,568   

 

 

See accompanying notes to the consolidated financial statements.

 

F-3


Table of Contents

Tower Group, Inc.

Consolidated Statements of Operations

 

         Year Ended December 31,      
(in thousands, except per share amounts)    2012      2011      2010  

 

 

Revenues

        

Net premiums earned

   $     1,721,542       $     1,593,850       $     1,292,669   

Ceding commission revenue

     32,335         33,968         39,303   

Insurance services revenue

     3,420         1,570         2,169   

Policy billing fees

     12,615         10,534         6,255   

Net investment income

     127,165         126,474         107,265   

Net realized investment gains (losses):

        

Other-than-temporary impairments

     (9,919)         (3,509)         (14,930)   

Portion of loss recognized in other comprehensive income

     286         264         11,909   

Other net realized investment gains

     35,109         12,639         17,674   

 

 

Total net realized investment gains (losses)

     25,476         9,394         14,653   

 

 

Total revenues

     1,922,553         1,775,790         1,462,314   

Expenses

        

Loss and loss adjustment expenses

     1,253,860         1,055,249         784,023   

Direct and ceding commission expense

     359,710         309,826         267,872   

Other operating expenses

     316,645         280,447         231,381   

Acquisition-related transaction costs

     9,229         360         2,369   

Interest expense

     32,630         34,290         24,223   

 

 

Total expenses

     1,972,074         1,680,172         1,309,868   

Other income (expense)

        

Equity in income (loss) of unconsolidated affiliate

     (2,534)                   

 

 

Income (loss) before income taxes

     (52,055)         95,618         152,446   

Income tax expense (benefit)

     (26,720)         24,142         52,168   

 

 

Net income (loss)

   $ (25,335)       $ 71,476       $ 100,278   

Less: Net income (loss) attributable to Noncontrolling interests

     2,819         10,995         (6,078)   

 

 

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

   $ (28,154)       $ 60,481       $ 106,356   

 

 

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

        

Basic

   $ (0.73)       $ 1.48       $ 2.45   

Diluted

   $ (0.73)       $ 1.48       $ 2.44   

 

 

Weighted average common shares outstanding:

        

Basic

     38,795         40,833         43,462   

Diluted

     38,795         40,931         43,648   

 

 

Dividends declared and paid per common share

   $ 0.75       $ 0.69       $ 0.39   

 

 

See accompanying notes to the consolidated financial statements.

 

F-4


Table of Contents

Tower Group, Inc.

Consolidated Statements of Comprehensive Income

 

         Year Ended December 31,      
(in thousands)    2012      2011      2010  

 

 

Net income (loss)

     $    (25,335)         $    71,476         $    100,278   

Other comprehensive income (loss) before tax

        

Gross unrealized investment holding gains arising during periods

     63,326         50,851         45,912   

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

     (25,476)         (9,394)         (14,653)   

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

     (286)         (264)         (11,909)   

Cumulative translation adjustment

     1,852                 

Deferred gain (loss) on cash flow hedge

     (2,422)         (10,541)         3,223   

 

 

Other comprehensive income (loss) before tax

     36,994         30,652         22,573   

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

        

Unrealized investment holding gains (losses) arising during periods

     (22,896)         (9,430)         (14,081)   

Reclassification adjustment for (gains) losses included in net income

     8,917         1,742         4,494   

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

     100         49         3,652   

Cumulative translation adjustment

     (648)                 

Deferred gain (loss) on cash flow hedge

     571         1,955         (988)   

 

 

Other comprehensive income, net of income tax

     23,038         24,968         15,650   

 

 

Comprehensive income (loss)

   $ (2,297)       $ 96,444       $ 115,928   

 

 

Less: Comprehensive income (loss) attributable to Noncontrolling interests

     5,503         21,189         (3,432)   

 

 

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

   $ (7,800)       $ 75,255       $ 119,360   

 

 

See accompanying notes to consolidated financial statements.

 

F-5


Table of Contents

Tower Group, Inc.

Consolidated Statements of Changes in Stockholders’ Equity

 

    

 

Common Stock

    

Treasury

Stock

   

Paid-in

Capital

    Accumulated
Other
Comprehensive
Income (loss)
    

Retained

Earnings

   

Noncontrolling

Interests

   

Total
Stockholders’

Equity

 
(in thousands)    Shares      Amount                

 

 

Balance at December 31, 2009

     45,092        451        (1,995     751,878       35,275        233,136             1,018,745  

Dividends declared

                                      (16,551           (16,551

Stock based compensation

     650        6        (1,750     10,276                          8,532  

Repurchase of common stock

                   (88,034                              (88,034

Reciprocal Exchanges’ equity on July 1, 2010, date of consolidation

                                            7,622       7,622  

Equity component of convertible senior notes issuance, net of income tax and issue costs

                         7,055                          7,055  

Convertible senior notes hedge transactions, net of tax

                            (9,945                           (9,945

Warrants issued related to convertible senior notes issuance

                         3,800                          3,800  

Net income

                                      106,356       (6,078     100,278  

Other comprehensive income

                               13,004              2,646       15,650  

 

 

Balance at December 31, 2010

     45,742      $ 457      $ (91,779   $ 763,064     $ 48,279      $ 322,941     $ 4,190     $ 1,047,152  

 

 

Dividends declared

                                      (27,894           (27,894

Stock based compensation

     706        8        (1,834     10,657                          8,831  

Deferred taxes on stock option activity

                         (783                        (783

Repurchase of common stock

                   (64,572                              (64,572

Net income

                                      60,481       10,995       71,476  

Other comprehensive income

                               14,774              10,194       24,968  

Noncontrolling interest in acquired consolidated partnership

                                            2,001       2,001  

 

 

Balance at December 31, 2011

     46,448      $ 465      $ (158,185   $ 772,938     $ 63,053      $ 355,528     $ 27,380     $ 1,061,179  

 

 

Dividends declared

                                      (29,075           (29,075

Stock based compensation

     373        4        (2,263     8,937                          6,678  

Repurchase of common stock

                   (20,987                              (20,987

Net income

                                  (28,154     2,819       (25,335

Transfer of assets to Reciprocal Exchanges

                     (1,778                  1,778        

Other comprehensive income

                           20,353              2,685       23,038  

 

 

Balance at December 31, 2012

     46,821      $ 469      $ (181,435   $ 780,097     $ 83,406      $ 298,299     $ 34,662     $ 1,015,498  

 

 

See accompanying notes to the consolidated financial statements.

 

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Tower Group, Inc.

Consolidated Statements of Cash Flows

 

     Year Ended December 31,  
($ in thousands)    2012      2011      2010  

 

 

Cash flows provided by (used in) operating activities:

        

Net income (loss)

   $ (25,335)       $ 71,476       $ 100,278   

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

        

Net realized investment (gains) losses

     (25,476)         (9,394)         (14,653)   

Depreciation and amortization

     33,609         30,940         21,634   

Amortization of bond premium or discount

     11,447         9,239         2,237   

Amortization of restricted stock

     8,247         10,292         8,694   

Deferred income taxes

     (10,349)         16,145         61,352   

Changes in operating assets and liabilities:

        

Investment income receivable

     1,450         (2,912)         (3,598)   

Premiums receivable

     4,320         (20,232)         13,574   

Reinsurance recoverable

     (170,234)         (42,671)         (30,621)   

Prepaid reinsurance premiums

     (9,886)         23,590         45,024   

Deferred acquisition costs, net

     (12,083)         (4,735)         3,359   

Funds held by reinsured companies

     (67,790)         (66,176)         (3,579)   

Other assets

     (37,301)         13,452         (60,442)   

Increase (decrease) in liabilities:

        

Loss and loss adjustment expenses

     262,960         21,692         76,166   

Unearned premium

     27,683         21,150         (23,269)   

Reinsurance balances payable

     19,775         (14,243)         (61,249)   

Funds held under reinsurance agreements

     1,855         3,573         79,416   

Other liabilities

     94,345         21,568         (17,298)   

 

 

Net cash flows provided by operations

     107,237         82,754         197,025   

 

 

Cash flows provided by (used in) investing activities:

        

Net cash (used in) acquired from acquisitions

            2,274         (171,907)   

Purchase of fixed assets

     (44,951)         (53,568)         (36,905)  

Investment in unconsolidated affiliate

     (71,512)                 

Purchase - fixed-maturity securities

     (1,855,590)         (2,019,603)         (2,024,965)   

Purchase - equity securities

     (1,525,206)         (819,180)         (96,439)   

Short-term investments, net

     (4,750)         1,560         561,827   

Purchase of other invested assets

     (13,440)         (42,346)          

Sale of fixed-maturity securities

     1,813,628         1,859,282         1,347,096   

Maturity of fixed-maturity securities

     205,534         172,745         80,432   

Sale - equity securities

     1,442,225         793,886         80,746   

Change in restricted cash

     (35,000)                   

 

 

Net cash flows provided by (used in) investing activities

     (89,062)         (104,950)         (260,115)   

 

 

Cash flows provided by (used in) financing activities:

        

Proceeds from credit facility borrowings

     20,000         67,000         56,000   

Repayment of credit facility borrowings

            (17,000)         (56,000)   

Proceeds from capital lease financing

            39,839          

Proceeds from convertible senior notes

                   145,634   

Payments for convertible senior notes hedge

                   (15,300)   

Proceeds from issuance of warrants

                   3,800   

Proceeds from share-based payment arrangements

     345        534        288   

Treasury stock acquired-net employee share-based compensation

     (2,263)         (1,834)         (1,750)   

Repurchase of Common Stock

     (20,987)         (64,572)         (88,034)   

Dividends paid

     (29,075)         (27,894)         (16,551)   

 

 

Net cash flows provided by (used in) financing activities

     (31,980)         (3,927)         28,087   

 

 

Increase (decrease) in cash and cash equivalents

     (13,805)         (26,123)         (35,003)   

Cash and cash equivalents, beginning of period

     114,098         140,221         175,224   

 

 

Cash and cash equivalents, end of period

   $ 100,293       $ 114,098       $ 140,221   

 

 

Supplemental disclosures of cash flow information:

        

Cash paid for income taxes

   $      $ 3,000       $ 29,000   

Cash paid for interest

     20,917         25,880         19,834   

Schedule of non-cash investing and financing activities:

        

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

Note 1—Nature of Business

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

The Company operates three business segments as follows:

 

 

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

 

 

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

 

 

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

Note 2—Accounting Policies and Basis of Presentation

Basis of Presentation

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

The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All inter-company accounts and transactions have been eliminated in consolidation.

Use of Estimates

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

Intercompany transactions

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

Reclassifications

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

Accounting Policies

Net Premiums Earned

The insurance policies issued or reinsured by the Company are short-duration contracts. Accordingly, premium revenue, including direct business and reinsurance assumed, net of business ceded to reinsurers, is recognized on a pro-rata basis over the terms of the underlying policies. Unearned premiums represent premium applicable to the unexpired risk of in-force insurance contracts at each balance sheet date. Prepaid reinsurance premiums represent the unexpired portion of reinsurance premiums on risks ceded and are earned consistent with premiums. Mandatory reinstatement premiums are recognized and earned at the time a loss event occurs.

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Ceding Commission Revenue

Commissions on reinsurance premiums ceded are earned in a manner consistent with the recognition of the costs to acquire the underlying policies, generally on a pro-rata basis over the terms of the policies reinsured. Certain reinsurance agreements contain provisions whereby the ceding commission rates vary based on the loss experience of the policies covered by the agreements. The Company records ceding commission revenue based on its current estimate of losses on the reinsured policies subject to variable commission rates. The Company records adjustments to the ceding commission revenue in the period that changes in the estimated losses are determined.

Insurance Services Revenue

Direct commission revenue from the Company’s managing general underwriting services is recognized and earned as insurance policies are placed with the issuing companies of its managing general agencies. Fees relating to the provision of reinsurance intermediary services are earned when the Company’s insurance subsidiaries or the issuing companies of its managing general agencies cede premiums to reinsurers. Management fees earned by the management companies for services provided to the Reciprocal Exchanges are reported as management fee income within the segment but are eliminated in consolidation.

Policy Billing Fees

Policy billing fees are earned on a pro-rata basis over the terms of the underlying policies. These fees include installment and other fees related to billing and collections.

Loss and Loss Adjustment Expenses (“LAE”)

The liability for loss and LAE represents management’s best estimate of the ultimate cost and expense of all reported and unreported losses that are unpaid as of the balance sheet date. The liability for loss and LAE is recorded net of a tabular reserve discount for workers’ compensation and excess workers’ compensation claims in the amount of $8.4 million and $3.7 million at December 31, 2012 and 2011, respectively. The 2012 discount relates to $381.6 million of total net reserves for workers’ compensation. The projection of future claims payments and reporting is based on an analysis of the Company’s historical experience, supplemented by analyses of industry loss data. Management believes that the liability for loss and LAE is adequate to cover the ultimate cost of losses and claims to date; however, because of the uncertainty from various sources, including changes in reporting patterns, claims settlement patterns, judicial decisions, legislation, and economic conditions, actual loss experience may not conform to the assumptions used in determining the estimated amounts for such liability at the balance sheet date. As adjustments to these estimates become necessary, such adjustments are reflected in expense for the period in which the estimates are changed.

Tower estimates reserves separately for losses, allocated loss adjustment expenses, and unallocated loss adjustment expenses. Allocated loss adjustment expenses (“ALAE”) refers to costs of attorneys as well as miscellaneous costs such as investigators, witness fees and court costs attributable to specific claims that generally are in various stages of litigation. Unallocated loss adjustment expenses (“ULAE”) refers to costs for administering claims that are not related to attorney fees and miscellaneous costs associated with litigated claims. Tower estimates the ALAE liability separately for claims that are defended by in-house attorneys, claims that are handled by other attorneys that are not employees, and miscellaneous ALAE costs such as witness fees and court costs. Similarly, Tower estimates the ULAE liability separately for claims which are handled internally by our employees and for claims which are handled by third party administrators.

The Company determines a fixed fee per in-house litigated claim for ALAE stemming from defense by in-house attorneys and allocates to each of these litigated claims 50% of this fixed fee when litigation on a particular claim begins and 50% of the fee when the litigation is closed. The fee is determined actuarially based upon the projected number of litigated claims and expected closing patterns at the beginning of each year as well as the projected budget for the Company’s in-house attorneys, and these amounts are subject to adjustment each quarter based upon actual experience.

The Company determines a standard cost per claim for ULAE for each line of business that represents the ultimate average cost to administer that claim. For property lines, 50% of this standard cost is recorded as paid ULAE when a claim is opened, and 50% of this standard cost is recorded as paid ULAE when a claim is closed. For casualty lines, 75% of this standard cost is recorded as paid ULAE when a claim is opened, and 25% is recorded as paid ULAE when a claim is closed. The standard costs are determined actuarially and subject to adjustment each quarter. Calendar period costs for the claims function is recorded as paid ULAE each quarter.

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Reinsurance

The Company uses reinsurance to limit its exposure to certain risks. Management has evaluated its reinsurance arrangements and determined that significant insurance risk is transferred to the reinsurers. Reinsurance agreements have been determined to be short-duration prospective contracts and, accordingly, the costs of reinsurance are recognized over the life of the contracts in a manner consistent with the earning of premiums on the underlying policies subject to the reinsurance contract.

Reinsurance recoverable represents management’s best estimate of paid and unpaid loss and LAE recoverable from reinsurers. Ceded losses recoverable are estimated using techniques and assumptions consistent with those used in estimating the liability for loss and LAE. These techniques and assumptions are continually reviewed and updated with any resulting adjustments recorded in current earnings. Loss and LAE incurred as presented in the consolidated statement of income and comprehensive net income are net of reinsurance recoveries.

Management estimates uncollectible amounts receivable from reinsurers based on an assessment of a number of factors. The Company recorded no allowance for uncollectible reinsurance at December 31, 2012 or 2011. The Company did not write-off balances from reinsurers during the three year period ended December 31, 2012.

Cash and Cash Equivalents

Cash consists of cash in banks, generally in operating accounts. The Company maintains its cash balances at several financial institutions. Management monitors balances and believes they do not represent a significant credit risk to the Company.

The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. Cash and cash equivalents are presented at cost, which approximates fair value. Cash restricted as to use is included in Other Assets.

Investments

The Company’s fixed-maturity and equity securities are classified as available-for-sale and carried at fair value. The Company may sell its available-for-sale securities in response to changes in interest rates, risk/reward characteristics, liquidity needs or other factors.

Fair value for fixed-maturity securities and equity securities is primarily based on quoted market prices or a matrix pricing using observable inputs, with limited exceptions as discussed in “Note 7 – Fair Value Measurements”. Changes in unrealized gains and losses, net of tax effects, are reported as a separate component of other comprehensive income while cumulative unrealized gains and losses are reported net of tax effects within accumulated other comprehensive income in stockholders’ equity. Realized gains and losses are determined on the specific identification method. Investment income is recorded when earned and includes the amortization of premium and discount on investments.

The Company, along with its outside portfolio managers, regularly reviews its fixed-maturity and equity security 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 overall financial condition of the issuer, (ii) the current fair value compared to amortized cost or cost, as appropriate; (iii) the length of time the security’s fair value has been below amortized cost or cost; (iv) 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; (v) whether management intends to sell the security and, if not, whether it is not more likely than not that the Company will be required to sell the security before recovery of its cost or amortized cost basis; (vi) specific cash flow estimations for fixed-maturity securities and (vii) current economic conditions. If an other-than-temporary-impairment (“OTTI”) loss is determined for a fixed-maturity security (and management does not intend to sell the security or it is not more likely than not that the Company will be required to sell the security), the credit portion is recorded in the statement of income as net realized losses on investments and the non-credit portion is recorded in accumulated other comprehensive income. The credit portion results in a permanent reduction of the cost basis of the underlying investment. OTTI losses on fixed-maturity securities management has the intent to sell or it is more likely than not that the Company will be required to sell and on equity securities are reported in realized losses for the entire impairment.

The Company’s other invested assets consist of investments in limited partnerships accounted for using the equity method of accounting, real estate and certain securities for which the Company has elected the fair value option. In accounting for the partnerships, management uses the financial information provided by the general partners, which is on a three-month lag. As of December 31, 2012, the Company had future funding commitments of $29.7 million to these limited partnerships. For securities in which the Company has elected the fair value option, interest and dividends are reported in net investment income with the remaining change in overall fair value reported in other net realized investment gains (losses).

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Fair Value

GAAP establishes a three-level hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) followed by similar but not identical assets or liabilities (Level 2) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the assets or liabilities fall within different levels of the hierarchy, the classification is based on the lowest level input that is significant to the fair value measurement of the asset or liability. Classification of assets and liabilities within the hierarchy considers the markets in which the assets and liabilities are traded, including during periods of market disruption, and the reliability and transparency of the assumptions used to determine fair value. The hierarchy requires the use of observable market data when available.

The Company primarily uses outside pricing services to assist in determining fair values. For investments in active markets, the Company uses the quoted market prices provided by the outside pricing services to determine fair value. In circumstances where quoted market prices are unavailable, the pricing services utilize fair value estimates based upon other observable inputs including matrix pricing, benchmark interest rates, market comparables and other relevant inputs.

As management is responsible for the recorded fair values, the Company has processes in place to validate the market prices obtained from the outside pricing sources including, but not limited to, periodic evaluation of model pricing methodologies and analytical reviews of certain prices. The Company also periodically performs back-testing of selected sales activity to determine whether there are any significant differences between the market price used to value the security prior to sale and the actual sale price.

Premiums Receivable

Premiums receivable represent amounts due from insureds and reinsureds for insurance coverage and are presented net of an allowance for doubtful accounts of $5.5 million and $4.4 million at December 31, 2012 and 2011, respectively. The allowance for uncollectible amounts is based on an analysis of amounts receivable giving consideration to historical loss experience and current economic conditions and reflects an amount that, in management’s judgment, is adequate. Uncollectible premiums receivable of $4.8 million, $5.2 million and $1.8 million were written off in 2012, 2011 and 2010, respectively.

Deferred Acquisition Costs

Acquisition costs represent the costs of writing business that vary with, and are primarily related to, the successful production of insurance business (principally commissions, premium taxes and certain underwriting costs). Policy acquisition costs are deferred and recognized as expense as related premiums are earned. Deferred acquisition costs (“DAC”) presented in the balance sheet are net of deferred ceding commission revenue.

The value of business acquired (“VOBA”) is an intangible asset relating to the estimated fair value of the unexpired insurance policies acquired in a business combination. VOBA is determined at the time of a business combination and is reported on the consolidated balance sheet with DAC and is amortized in proportion to the timing of the estimated underwriting profit associated with the in force policies acquired. The Company considers anticipated investment income in determining the recoverability of these costs and believes they are fully recoverable. See “Note 9 – Deferred Acquisition Costs” for additional information regarding deferred acquisition costs.

Goodwill and Intangible Assets

In business combinations, including the acquisition of a group of assets, the Company allocates the purchase price to the net tangible and intangible assets acquired based on their relative fair values. Any portion of the purchase price in excess of this amount results in goodwill. Identifiable intangible assets with a finite useful life are amortized over the period that the asset is expected to contribute directly or indirectly to the future cash flows of the Company. Intangible assets with an indefinite life and goodwill are not amortized and are subject to annual impairment testing at the reporting unit level. For purposes of goodwill impairment testing, the Company defined its two segments, Commercial Insurance and Personal Insurance as reporting units. The Insurance Services segment does not carry goodwill.

To estimate the fair value of its reporting units, the Company may utilize a combination of widely accepted valuation techniques including a stock price and market capitalization analysis, discounted cash flow calculations and peer company price to earnings multiples analysis. The stock price and market capitalization analysis takes into consideration the quoted market price of the Company’s outstanding common stock and includes a control premium, derived from historical insurance industry acquisition activity, in determining the estimated fair value of the consolidated entity before allocating that fair value to individual reporting units. The discounted cash flow analysis utilizes long term assumptions for revenue growth, capital growth, earnings projections including those used in the Company’s strategic plan, and an appropriate discount rate. The peer company price to earnings multiples analysis takes into consideration the price earnings multiples of peer companies for each reporting unit and estimated income from the Company’s strategic plan.

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

The Company conducted the required annual goodwill and intangible asset impairment testing as of September 30 for 2012. Additionally, identifiable intangible assets and goodwill are tested for recoverability whenever events or changes in circumstances indicate that a carrying amount may not be recoverable. No impairment losses were recognized in 2012, 2011 or 2010.

Other Assets

Tower’s other assets balances are comprised primarily of fixed assets, capitalized software development costs, restricted cash, receivables for securities sold, receivables for the participation in involuntary pools and current tax receivables.

Fixed Assets

Furniture, leasehold improvements, computer equipment, and software, including internally developed software, are reported at cost less accumulated depreciation and amortization. Gross fixed assets were $194.0 million and $176.4 million as of December 31, 2012 and 2011, respectively. Capitalized leases of $44.0 million and $41.0 million were included in this amount as at December 31, 2012 and 2011, respectively. Accumulated depreciation and amortization of $54.7 million and $56.5 million were recorded as of December 31, 2012 and 2011, respectively. In 2012, the Company wrote off $21.5 million of fully depreciated fixed assets with no impact to net income. Depreciation and amortization is provided using the straight-line method over the estimated useful lives of the assets. The Company estimates the useful life for computer equipment to be three years, computer software, three to seven years, furniture and other equipment seven years and leasehold improvements is the term of the lease. Depreciation and amortization expense of $20.2 million, $22.0 million and $15.4 million were recorded for the years ended December 31, 2012, 2011 and 2010, respectively. Fixed assets are recorded in Other Assets on the balance sheet.

Other liabilities

Tower’s other liabilities balances are comprised primarily of accrued operating expenses, payables for securities purchased, accrued boards, bureaus and tax expenses, and capital lease obligations.

Variable Interest Entities

The Company consolidates the Reciprocal Exchanges as it has determined that these are variable interest entities and that the Company is the primary beneficiary. See “Note 5 – Variable Interest Entities” for more details.

Investment in unconsolidated affiliate

Although the Company owned less than 20% of the outstanding common stock of Canopius Group, Limited (“CGL”) at December 31, 2012, it recorded its investment in CGL under the equity method of accounting as it was able to significantly influence the operating and financial policies and decisions of CGL.

Income Taxes

Pursuant to a written tax agreement (the “Tax Sharing Agreement”), each of the Tower’s subsidiaries is required to make payments to Tower for federal income tax imposed on its taxable income in a manner consistent with filing a separate federal income tax return (but subject to certain limitations that are applied to the Tower consolidated group as a whole). The Reciprocal Exchanges are not subject to the Tax Sharing Agreement but file separate tax returns annually.

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and for operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that all or some portion of the deferred tax asset will not be realized.

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Treasury Stock

The Company accounts for the treasury stock at the repurchase price as a reduction to stockholders’ equity as it does not currently intend to retire the treasury stock held at December 31, 2012.

Stock-based Compensation

The Company accounts for restricted stock shares and options awarded at fair value at the date awarded and compensation expense is recorded over the requisite service period that has not been rendered. The Company amortizes awards with graded vesting on a straight-line basis over the requisite service period.

Assessments

Insurance related assessments are accrued in the period in which they have been incurred. The Company is subject to a variety of assessments. Among such assessments are state guaranty funds and workers’ compensation second injury funds. State guaranty fund assessments are used by state insurance oversight boards to cover losses of policyholders of insolvent insurance companies and for the operating expenses of such agencies. The Company uses estimates derived from state regulators and/or NAIC Tax and Assessments Guidelines.

Earnings per Share

The Company measures earnings per share at two levels: basic earnings per share and diluted earnings per share. Basic earnings per share is calculated by dividing net income attributable to Tower common stockholders by the weighted average number of common shares outstanding during the year. This weighted average number of shares includes unvested share-based awards that contain nonforfeitable rights to dividends or dividend equivalents whether paid or unpaid (“participating securities”). Diluted earnings per share is calculated by dividing net income attributable to Tower common stockholders by the weighted average number of common shares outstanding during the year, as adjusted for the potentially dilutive effects of stock options, warrants, unvested restricted stock and/or preferred stock that are not participating securities, unless such items are not dilutive.

Foreign currency

The Company’s reporting currency is the U.S. dollar. The Company holds an equity method investment in Canopius Group, Limited, which is denominated in British pounds sterling (“GBP”). The Company translates this investment to U.S. dollars at the exchange rate in effect at the balance sheet date. Tower’s portion of changes in translation adjustment, based on its percentage ownership in this investment, is included as a component of accumulated other comprehensive income.

Statutory Accounting Principles

The Company’s insurance subsidiaries are required to prepare statutory basis financial statements in accordance with practices prescribed or permitted by the state or country in which they are domiciled. See “Note 18 – Statutory Financial Information and Accounting Policies” for more details.

Concentration and Credit Risk

Financial instruments that potentially subject the Company to concentration and credit risk are primarily cash and cash equivalents, investments, interest rate swaps, premiums receivable and reinsurance recoverables. Investments are diversified through many industries and geographic regions through the use of money managers who employ different investment strategies. The Company limits the amount of credit exposure with any one financial institution and believes that no significant concentration of credit risk exists with respect to cash and investments. The interest rate swap contracts contain credit support annex agreements with collateral posting provisions which reduces counterparty non-performance risk. The premiums receivable balances are generally diversified due to the number of entities comprising the Company’s distribution network and its customer base, which is largely concentrated in the Northeast, Florida, Texas and California. To reduce credit risk, the Company performs ongoing evaluations of its distribution network’s and customers’ financial condition. The Company also has receivables from its reinsurers. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company periodically evaluates the financial condition of its reinsurers and, in certain cases, requires collateral from its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. As at December 31, 2012, the largest uncollateralized reinsurance recoverable balance from any one reinsurer was $47.8 million representing 8.3% of the Company’s total reinsurance recoverable balance. Management’s policy is to review all outstanding receivables at period end as well as the bad debt write-offs experienced in the past and establish an allowance for doubtful accounts, if deemed necessary.

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Our largest agent accounted for 7.5%, 10% and 12%, respectively, of the insurance subsidiaries’ premiums receivable balances at December 31, 2012, 2011 and 2010. Our largest agent accounted for 7%, 7% and 4% of the insurance subsidiaries’ direct premiums written in 2012, 2011 and 2010, respectively.

Accounting Pronouncements

Accounting guidance adopted in 2012

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

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

In September 2011, the FASB issued amended guidance on testing goodwill for impairment. This guidance was intended to reduce the cost and complexity of the annual goodwill impairment test by allowing an entity to utilize more qualitative factors. The Company considered this guidance in the performance of its goodwill impairment test in the fourth quarter as of September 30, 2012. See Note 8 – “Goodwill and Intangible Assets” for further discussion on goodwill impairment testing.

Accounting guidance not yet effective

In July 2012, the FASB issued amended guidance on testing indefinite lived intangible assets for impairment. This guidance is intended to reduce the cost and complexity of the annual impairment test by allowing an entity to utilize more qualitative factors. This guidance is effective for fiscal years beginning after September 15, 2012. This guidance will not affect the Company’s financial position, result of operations or cash flows.

Note 3—Investment in Canopius Group Limited and Exercise of Merger Option

On August 20, 2012, Tower closed on its $74.9 million acquisition of a 10.7% stake in Canopius Group Limited (“Canopius Group”), a privately owned Lloyd’s insurance holding company domiciled in Guernsey, Channel Islands. In connection with this acquisition, which was agreed to on April 25, 2012, Tower also entered into an agreement dated April 25, 2012 (the “Master Transaction Agreement”) under which Canopius Group committed to assist Tower with the establishment of a presence at Lloyd’s of London through a special purpose syndicate (“SPS Transaction Right and Acquisition Right”), subject to required approvals and granted Tower an option (the “Merger Option”) to combine with Canopius Holdings Bermuda Limited (“Canopius Bermuda”). On July 30, 2012, Tower announced that it had exercised the Merger Option and executed an Agreement and Plan of Merger (the “Original Merger Agreement”) with Canopius Bermuda pursuant to which a wholly-owned subsidiary of Canopius Bermuda will acquire all of Tower’s common stock. Under applicable accounting principles Tower will be regarded as the acquiring entity. Tower paid Canopius Group a fee of $1,000,000 to exercise the Merger Option. On November 8, 2012, the Original Merger Agreement was amended by Amendment No. 1 to the Agreement and Plan of Merger to reflect changes to the merger consideration to be received by Tower stockholders (the Original Merger Agreement as so amended, the “Merger Agreement”).

Under the Merger Agreement, Tower stockholders will receive, in exchange for each share of Tower’s common stock, a certain number of Canopius Bermuda common shares equal to a Stock Conversion Number (defined below). Canopius Group intends to sell its shares in Canopius Bermuda prior to the consummation of the merger in a private placement of those shares (the “Canopius Secondary Offering”) to a group of yet-to-be-identified institutional third party investors (the “Third Party Investors”). The “Stock Conversion Number” will be equal the quotient obtained by dividing (x) the price per share of Tower common stock at the market close on the date of the pricing of the Canopius Secondary Offering by (y) the Adjusted Canopius Bermuda Price Per Share (defined below).

The “Adjusted Canopius Bermuda Price Per Share” will be equal to the quotient obtained by dividing (i) the sum of (a) the Target TNAV Amount, which is the amount that Tower specifies in a written notice delivered to Canopius Group prior to the signing date of the purchase and sale agreements for the Canopius Secondary Offering, as the target amount of the tangible net asset value of Canopius Bermuda as of the closing date of the Canopius Secondary Offering, (b) the value of the retained business of Canopius Bermuda following its restructuring, (c) the aggregate amount of the placement fees received by the placement agents in connection with the Canopius Secondary Offering and (d) the aggregate amount, expressed in dollars, equal to the absolute

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

value of the discount from the closing price of Tower’s common stock on the pricing date of the Canopius Secondary Offering, or on another reasonably current date (as agreed by Tower, Canopius Bermuda and the Third Party Investors), that Tower, Canopius Bermuda and the Third Party Investors have agreed is necessary in order to effect the Canopius Secondary Offering, by (ii) the aggregate number of Canopius Bermuda common shares sold in the Canopius Secondary Offering. Because neither the restructuring of Canopius Bermuda nor the Canopius Secondary Offering is likely to occur until the first quarter of 2013 at the earliest, no assurances can be given as to the Target TNAV Amount or the Adjusted Canopius Bermuda Price Per Share. In determining the Target TNAV Amount, Tower will principally consider the amount of capital that it believes will be required to maintain its ratings and to operate the combined business. Tower believes this capital amount to be between $150 million and $180 million.

Although the Merger Agreement contains no conditions precedent to Tower’s obligations to consummate the merger, Tower will not proceed with the merger in the event that (1) the Canopius Secondary Offering cannot be effected, or can only be effected on terms that would make the Stock Conversion Number, and therefore the merger, unattractive to Tower, (2) the Adjusted Canopius Bermuda Price Per Share declines to a point that the Third Party Investors would own 20% or less of the merged entity’s fully diluted capital stock immediately following the closing of the merger, (3) Tower stockholders and option holders, as well as holders of Tower’s convertible senior notes, would own less than 76% of the fully diluted capital stock of Tower Ltd. immediately following the closing of the merger, (4) the parties to the Merger Agreement fail to obtain the necessary regulatory approvals on terms acceptable to Tower, (5) Tower’s stockholders fail to adopt the Merger Agreement and approve the merger, (6) Tower’s Board of Directors determines that the transactions contemplated by the Merger Agreement are not favorable to Tower or its stockholders and (7) Tower has not received an opinion of a nationally recognized law firm, in form and substance satisfactory to Tower, to the effect that the merger should not cause Tower Ltd. to be treated as a domestic corporation under Section 7874(b) of the Internal Revenue Code of 1986, as amended.

The consideration paid by Tower was allocated as follows based upon each of the acquired assets’ estimated fair values:

 

($ in thousands)       

 

 

Investment in Unconsolidated Affiliate

   $ 71,512   

Merger Option

     484   

SPS Transaction Right and Acquisition Right

     2,903   

 

 

Total

   $ 74,899   

 

 

Tower accounts for its 10.7% investment in Canopius Group using the equity method of accounting on a one quarter lag. Management has concluded it exerts significant influence over Canopius Group due to the following: Tower has a board seat on Canopius Group’s Board of Directors, Tower assumes approximately 6% of premiums written by Canopius Group, and Tower has certain rights in accordance with the Merger Option and SPS Transaction Right and Acquisition Right to cause Canopius Group to assist Tower as defined in the Master Transaction Agreement. For the year ended December 31, 2012, Tower recorded a reduction in its investment in Canopius Group by $0.7 million, of which $2.5 million is related to losses recorded in the statement of operations offset by a $1.8 million foreign currency translation adjustment which is recorded in other comprehensive income.

The Merger Option and SPS Transaction Right and Acquisition Right are reported in “Other assets” in the accompanying balance sheet at December 31, 2012.

Tower also participates in Canopius Group’s reinsurance program. For the year ended December 31, 2012, Tower had assumed earned premiums, losses and loss adjustment expenses and commission expense of $49.8 million, $32.3 million and $14.2 million, respectively, relating to business assumed from Canopius Group.

Note 4—Acquisitions

NAV PAC Division of Navigators Group, Inc. (“NAV PAC”)

On January 14, 2011, Tower obtained the renewal rights to the middle market commercial package and commercial automobile business underwritten through the NAV PAC division of Navigators Group, Inc. Tower pays Navigators Insurance Company a commission equal to 2% of the direct premiums written under this renewal rights arrangement. This business allowed us to expand our middle market commercial product offering into certain niche classes of business. This renewal rights acquisition represents the ability to write future insurance business and does not include the acquisition of any assets or liabilities of NAV PAC. Accordingly, this transaction was not accounted for as a business combination.

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Acquisition of the Renewal Rights of AequiCap Program Administrators Inc. (“AequiCap”)

On November 2, 2010, Tower acquired the renewal rights to the commercial automobile liability and physical damage business of AequiCap for $12 million (“AequiCap II”). The business subject to the agreement covers both trucking and taxi risks that are consistent with Tower’s current underwriting guidelines. The acquisition was accounted for as a business combination under GAAP. The distribution network was the only identifiable asset acquired and had a fair value of $11.3 million. No liabilities were assumed. $0.7 million of goodwill was recorded as a result of this transaction.

Acquisition of the OneBeacon Personal Lines Division

On July 1, 2010, Tower completed the OBPL acquisition pursuant to a definitive agreement (the “Agreement”) dated February 2, 2010 by and among the Company and OneBeacon Insurance Group (“OneBeacon”). This acquisition expanded Tower’s suite of personal lines insurance products to include private passenger automobile, homeowners, umbrella, and the signature package product, OneChoice CustomPac, which provides customers with one policy for all of their homeowners, auto and umbrella needs.

Under the terms of the Agreement, the Company acquired Massachusetts Homeland Insurance Company (“MHIC”), York Insurance Company of Maine (“York”) and two management companies (collectively the “Stock Companies”). The management companies are the attorneys-in-fact for the Reciprocal Exchanges. Tower purchased $102 million principal of surplus notes issued by the Reciprocal Exchanges (the “surplus notes”). In addition, Tower also reinsured the personal lines business written by other subsidiaries of OneBeacon not acquired by Tower. The total consideration paid for OBPL was $164.3 million.

Effective July 1, 2010, Tower entered into transition service agreements with OneBeacon whereby OneBeacon will provide certain information technology and operational support to Tower until such time that these processes are migrated to Tower. Expenses incurred under such transition service agreements were $20.3 million and $23.9 million for the years ended December 31, 2012 and 2011, respectively.

Tower consolidated OBPL as of July 1, 2010 and the purchase consideration has been allocated to the assets acquired and liabilities assumed, including separately identified intangible assets, based on their fair values as of the close of the acquisition, with the amounts exceeding the fair value recorded as goodwill. The goodwill consisted largely of the synergies and economies of scale expected from combining the operations of the Company and OBPL.

Direct costs of the acquisition are accounted for separately from the business combination and are expensed as incurred.

All goodwill associated with the OBPL acquisition has been allocated to the Personal Insurance segment.

Note 5—Variable Interest Entities (“VIEs”)

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

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

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

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

For the year ended December 31, 2012, the Reciprocal Exchanges recognized total revenues, total expenses and net income of $204.7 million, $201.9 million and $2.8 million, respectively. For the year ended December 31, 2011, the Reciprocal Exchanges recognized total revenues, total expenses and net income of $209.8 million, $198.8 million and $11.0 million, respectively.

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Note 6—Investments

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

 

($ in thousands)    Cost or
Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    

Fair

Value

     Unrealized
OTTI
Losses (1)
 

 

 

December 31, 2012

              

U.S. Treasury securities

   $ 183,462       $ 1,500       $ (13)       $ 184,949       $  

U.S. Agency securities

     98,502         4,351         (76)         102,777          

Municipal bonds

     633,373         52,914         (244)         686,043          

Corporate and other bonds

              

Finance

     233,849         21,293         (95)         255,047          

Industrial

     412,465         26,556         (868)         438,153          

Utilities

     51,698         2,958         (191)         54,465          

Commercial mortgage-backed securities

     211,819         30,375         (141)         242,053          

Residential mortgage-backed securities

              

Agency backed securities

     283,652         12,326         (262)         295,716          

Non-agency backed securities

     38,615         3,575         (34)         42,156         (6)   

Asset-backed securities

     42,751         1,615         (14)         44,352          

 

 

Total fixed-maturity securities

     2,190,186         157,463         (1,938)         2,345,711         (6)   

Preferred stocks, principally financial sector

     31,272         730         (481)         31,521          

Common stocks, principally financial and industrial sectors

     118,076         953         (4,292)         114,737          

Short-term investments

     4,749                       4,750          

 

 

Total, December 31, 2012

   $ 2,344,283       $ 159,147       $ (6,711)       $ 2,496,719       $ (6)   

 

 

Tower

   $ 2,075,189       $ 141,614       $ (6,210)       $ 2,210,593       $ (6)   

Reciprocal Exchanges

     269,094         17,533         (501)         286,126          

 

 

Total, December 31, 2012

   $ 2,344,283       $ 159,147       $ (6,711)       $ 2,496,719       $ (6)   

 

 

December 31, 2011

              

U.S. Treasury securities

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

U.S. Agency securities

     114,411         2,779                117,190          

Municipal bonds

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

Corporate and other bonds

              

Finance

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

Industrial

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

Utilities

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

Commercial mortgage-backed securities

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

Residential mortgage-backed securities

              

Agency backed securities

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

Non-agency backed securities

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

Asset-backed securities

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

 

 

Total fixed-maturity securities

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

Preferred stocks, principally financial sector

     24,083         317         (890)         23,510          

Common stocks, principally industrial and financial sectors

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

Short-term investments

                                  

 

 

Total, December 31, 2011

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

 

 

Tower

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

Reciprocal Exchanges

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

 

 

Total, December 31, 2011

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

 

 

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

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

As at December 31, 2012 and 2011, U.S. Treasury Notes and other securities with carrying values of $351.1 million and $226.8 million, respectively, were on deposit with various states to comply with the insurance laws in which the Company is licensed.

In addition, the Company had $481.5 million and $340.8 million of investments as of December 31, 2012 and 2011, respectively, held by counterparties as collateral or in trusts to support letter of credit issued on Tower’s behalf, reinsurance liabilities on certain assumed reinsurance treaties, and collateral posted for certain leases.

Major categories of net investment income are summarized as follows:

 

     Year Ended December 31,  
($ in thousands)    2012      2011      2010  

 

 

Income

        

Fixed-maturity securities

   $ 96,056       $ 105,533       $ 103,921   

Equity securities

     28,989         24,576         7,225   

Cash and cash equivalents

     1,112         695         732   

Other invested assets

     6,680         274          

Other

     387         643         539   

 

 

Total

     133,224         131,721         112,417   

Expenses

        

Investment expenses

     (6,059)         (5,247)         (5,152)   

 

 

Net investment income

   $ 127,165       $ 126,474       $ 107,265   

 

 

Tower

     121,907         120,083         105,506   

Reciprocal Exchanges

     12,575         12,846         5,118   

Elimination of interest on Reciprocal Exchange surplus notes

     (7,317)         (6,455)         (3,359)   

 

 

Net investment income

   $         127,165       $         126,474       $         107,265   

 

 

Proceeds from the sale of fixed-maturity securities were $1.8 billion, $2.0 billion and $1.4 billion for the year ended December 31, 2012, 2011 and 2010, respectively. Proceeds from the sale of equity securities were $1.4 billion, $793.9 million and $80.7 million for the year ended December 31, 2012, 2011 and 2010, respectively.

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

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

 

     Year Ended December 31,  
($ in thousands)    2012      2011      2010  

 

 

Fixed-maturity securities

        

Gross realized gains

   $ 59,319       $ 44,550       $ 31,587   

Gross realized losses

     (2,780)         (11,101)         (11,388)   

 

 
     56,539         33,449         20,199   

Equity securities

        

Gross realized gains

     13,090         8,328         482   

Gross realized losses

     (31,404)         (29,138)         (3,007)   

 

 
     (18,314)         (20,810)         (2,525)   

Other (1)

        

Gross realized gains

     3,432                   

Gross realized losses

     (6,548)                   

 

 
     (3,116)                   

 

 

Net realized gains on investments

     35,109         12,639         17,674   

 

 

Other-than-temporary impairment losses:

        

Fixed-maturity securities

     (1,320)         (580)         (3,021)   

Equity securities

     (8,313)         (2,665)           

 

 

Total other-than-temporary impairment losses recognized in earnings

     (9,633)         (3,245)         (3,021)   

 

 

Total net realized investment gains (losses)

   $ 25,476       $ 9,394       $ 14,653  

 

 

Tower

   $ 12,245       $ 6,980       $ 14,910   

Reciprocal Exchanges

     13,231         2,414         (257)   

 

 

Total net realized investment gains (losses)

   $ 25,476       $ 9,394       $ 14,653   

 

 

(1) Other gross realized gains and losses consists primarily of “debt and equity securities sold, not yet purchased,” which are reported with Other liabilities.

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

Impairment Review

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

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

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

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

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

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

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

The following table shows the amount of fixed-maturity and equity securities that were OTTI for the years ended December 31, 2012, 2011 and 2010. This resulted in recording impairment write-downs included in net realized investment gains (losses), and reduced the unrealized loss in other comprehensive net income:

 

     Year Ended December 31,  
($ in thousands)    2012      2011      2010  

 

 

Municipal bonds

   $ (113)       $       $   

Corporate and other bonds

     (1,029)                   

Commercial mortgage-backed securities

     (430)         (219)         (6,987)   

Residential mortgage-backed securities

     (34)         (235)         (6,164)   

Asset-backed securities

             (391)         (1,779)   

Equities

     (8,313)         (2,664)           

 

 

Other-than-temporary-impairments

     (9,919)         (3,509)         (14,930)   

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

     286         264         11,909   

 

 

Impairment losses recognized in earnings

   $ (9,633)       $ (3,245)       $ (3,021)   

 

 

Tower

   $ (9,919)       $ (3,245)       $ (3,021)   

Reciprocal Exchanges

     286                   

 

 

Impairment losses recognized in earnings

   $ (9,633)       $ (3,245)       $ (3,021)   

 

 

The following table provides a rollforward of the cumulative amount of credit related OTTI for securities still held showing the amounts that have been included in earnings on a pretax basis for the years ended 2012 and 2011 (none of such OTTI was included within the Reciprocal Exchanges):

 

     Year Ended December 31,  
($ in thousands)    2012      2011      2010  

 

 

Balance, January 1,

   $         12,666       $       18,075       $         41,904   

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

        

No OTTI has been previously recognized

     1,259         44         707   

OTTI has been previously recognized

     61         537         2,314   

Reductions due to:

        

Securities sold during the period (realized)

     (9,494)         (5,990)         (26,850)   

 

 

Balance, December 31,

   $ 4,492       $ 12,666       $ 18,075   

 

 

Unrealized Losses

There are 212 securities at December 31, 2012, including fixed maturities and equity securities, which account for the gross unrealized loss, none of which is deemed by management to be OTTI. Temporary losses on corporate and other bonds result from purchases made in a lower interest rate environment or lower yield spread environment. In addition, there have been some ratings downgrades on certain of these securities. After analyzing the credit quality, balance sheet strength and company outlook, management believes these securities will recover in value. The structured securities that had significant unrealized losses resulted primarily from declines in both residential and commercial real estate prices. To the extent projected cash flows on structured securities change adversely, they would be considered OTTI, and an impairment loss would be recognized in the current period. Management considered all relevant factors, including expected recoverability of cash flows, in assessing whether a loss was other-than-temporary. The Company does not intend to sell these fixed maturity securities, and it is not more likely than not that these securities will be sold before recovering their cost basis.

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

For all fixed-maturity securities in an unrealized loss position at December 31, 2012, the Company has received all contractual interest payments (and principal if applicable). Based on the continuing receipt of cash flow and the foregoing analyses, management expects continued timely payments of principal and interest and considers the losses to be temporary.

The unrealized loss position associated with the fixed-maturity portfolio was $1.9 million as of December 31, 2012, consisting primarily of corporate bonds and mortgage-backed securities of $1.6 million. The total fixed-maturity portfolio of gross unrealized losses included 182 securities which were, in aggregate, approximately 0.7% below amortized cost. Of the 182 fixed maturity investments identified, 31 have been in an unrealized loss position for more than 12 months. The total unrealized loss on these investments at December 31, 2012 was $0.3 million. Management does not consider these investments to be other-than-temporarily impaired.

For common stocks, there were 23 securities in a loss position at December 31, 2012 totaling $4.3 million. Management evaluated the financial condition of the common stock issuers, the severity and duration of the impairment, and our ability and intent to hold to recovery and determined these securities are not OTTI. The evaluation consisted of a detailed review, including but not limited to some or all of the following factors for each security: the current S&P rating, analysts’ reports, past earnings trends and analysts’ earnings expectations for the next 12 months, liquidity, near-term financing risk, and whether the company was currently paying dividends on its equity securities. Management does not consider these investments to be other-than-temporarily impaired.

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

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

 

     Less than 12 Months     12 Months or Longer     Total  
     Fair      Unrealized     Fair      Unrealized     Aggregate      Unrealized  
($ in thousands)    Value      Losses     Value      Losses     Fair Value      Losses  

 

 

December 31, 2012

               

U.S. Treasury securities

   $ 44,347      $ (13   $      $     $ 44,347      $ (13

U.S. Agency securities

     22,345        (76                  22,345        (76

Municipal bonds

     21,532        (235     251        (9     21,783        (244

Corporate and other bonds

               

Finance

     17,853        (95                  17,853        (95

Industrial

     53,576        (667     4,188        (202     57,764        (869

Utilities

     20,143        (191     7              20,150        (191

Commercial mortgage-backed securities

     23,223        (141     95              23,318        (141

Residential mortgage-backed securities

               

Agency backed

     59,009        (261     25        (1     59,034        (262

Non-agency backed

     815        (6     588        (28     1,403        (34

Asset-backed securities

     1,499        (2     4,232        (11     5,731        (13

 

 

Total fixed-maturity securities

     264,342        (1,687     9,386        (251     273,728        (1,938

Preferred stocks

     9,716        (155     5,724        (326     15,440        (481

Common stocks

     55,560        (4,292                  55,560        (4,292

 

 

Total, December 31, 2012

   $ 329,618      $ (6,134   $ 15,110      $ (577   $ 344,728      $ (6,711

 

 

Tower

   $ 271,609      $ (5,732   $ 13,338      $ (478   $ 284,947      $ (6,210

Reciprocal Exchanges

     58,009        (402     1,772        (99     59,781        (501

 

 

Total, December 31, 2012

   $ 329,618      $ (6,134   $ 15,110      $ (577   $ 344,728      $ (6,711

 

 

December 31, 2011

               

U.S. Treasury securities

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

U.S. Agency securities

                                       

Municipal bonds

     13,449        (255                  13,449        (255

Corporate and other bonds

               

Finance

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

Industrial

     57,357        (2,141     3,519        (146     60,876        (2,287

Utilities

     1,902        (61                  1,902        (61

Commercial mortgage-backed securities

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

Residential mortgage-backed securities

               

Agency backed

     19        (1     12              31        (1

Non-agency backed

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

Asset-backed securities

     29,624        (647     610        (8     30,234        (655

 

 

Total fixed-maturity securities

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

Preferred stocks

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

Common stocks

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

 

 

Total, December 31, 2011

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

 

 

Tower

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

Reciprocal Exchanges

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

 

 

Total, December 31, 2011

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

 

 

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

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Fixed-Maturity Investment—Time to Maturity

The following table shows the composition of the fixed-maturity portfolio by remaining time to maturity at December 31, 2012 and 2011. For securities that are redeemable at the option of the issuer and have a market price that is greater than par value, the maturity used for the table below is the earliest redemption date. For securities that are redeemable at the option of the issuer and have a market price that is less than par value, the maturity used for the table below is the final maturity date.

 

     Tower      Reciprocal Exchanges      Total  
($ in thousands)    Amortized
Cost
    

Fair

Value

     Amortized
Cost
    

Fair

Value

     Amortized
Cost
    

Fair

Value

 

 

 

December 31, 2012

                 

Remaining Time to Maturity

                 

Less than one year

   $ 30,082      $ 30,614      $ 2,678      $ 2,715      $ 32,760      $ 33,329  

One to five years

     489,939        510,523        45,576        47,275        535,515        557,798  

Five to ten years

     564,556        607,711        76,480        80,009        641,036        687,720  

More than 10 years

     346,410        380,045        57,628        62,542        404,038        442,587  

Mortgage and asset-backed securities

     495,249        536,255        81,588        88,022        576,837        624,277  

 

 

Total

   $ 1,926,236      $ 2,065,148      $ 263,950      $ 280,563      $ 2,190,186      $ 2,345,711  

 

 

December 31, 2011

                 

Remaining Time to Maturity

                 

Less than one year

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

One to five years

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

Five to ten years

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

More than 10 years

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

Mortgage and asset-backed securities

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

 

 

Total

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

 

 

Other Invested Assets

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

 

($ in thousands)    2012      2011  

 

 

Limited partnerships, equity method

   $ 23,864      $ 12,459  

Real estate, amortized cost

     7,422        6,888  

Securities reported under the fair value option

     25,000        25,000  

Other

     1,500         

 

 

Total

   $         57,786      $         44,347  

 

 

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

Note 7—Fair Value Measurements

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

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

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

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

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

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

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

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

 

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

 

 

December 31, 2012

          

Fixed-maturity securities

          

U.S. Treasury securities

   $ -      $ 184,949     $ -      $ 184,949  

U.S. Agency securities

     -        102,777       -        102,777  

Municipal bonds

     -        686,043       -        686,043  

Corporate and other bonds

     -        747,665       -        747,665  

Commercial mortgage-backed securities

     -        242,053       -        242,053  

Residential mortgage-backed securities

     -        -       -        -  

Agency

     -        295,716       -        295,716  

Non-agency

     -        42,156       -        42,156  

Asset-backed securities

     -        44,352       -        44,352  

 

 

Total fixed-maturities

     -        2,345,711       -        2,345,711  

Equity securities

     146,258        -       -        146,258  

Short-term investments

     -        4,750       -        4,750  

 

 

Total investments at fair value

     146,258        2,350,461       -        2,496,719  

Other invested assets (1)

     -        -       25,000        25,000  

Other liabilities

     -        -       -        -  

Interest rate swap contracts

     -        (9,016     -        (9,016

Debt and equity securities sold, not yet purchased

     -        (17,101     -        (17,101

 

 

Total, December 31, 2012

   $ 146,258      $ 2,324,344     $ 25,000      $ 2,495,602  

 

 

Tower

   $ 140,695      $ 2,043,780     $ 25,000      $ 2,209,475  

Reciprocal Exchanges

     5,563        280,564       -        286,127  

 

 

Total, December 31, 2012

   $ 146,258      $ 2,324,344     $ 25,000      $ 2,495,602  

 

 

December 31, 2011

          

Fixed-maturity securities

          

U.S. Treasury securities

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

U.S. Agency securities

     -        117,190       -        117,190  

Municipal bonds

     -        736,714       -        736,714  

Corporate and other bonds

     -        777,723       -        777,723  

Commercial mortgage-backed securities

     -        253,167       -        253,167  

Residential mortgage-backed securities

     -        -       -        -  

Agency

     -        320,276       -        320,276  

Non-agency

     -        31,609       -        31,609  

Asset-backed securities

     -        60,853       -        60,853  

 

 

Total fixed-maturities

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

Equity securities

     89,345        -       -        89,345  

Short-term investments

     -        -       -        -  

 

 

Total investments

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

Other invested assets (2)

     -        -       25,000        25,000  

Other liabilities

     -        -       -        -  

Interest rate swap contracts

     -        (7,384     -        (7,384

 

 

Total, December 31, 2011

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

 

 

Tower

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

Reciprocal Exchanges

     1,866        300,054       -        301,920  

 

 

Total, December 31, 2011

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

 

 

(1) $25.0 million of the $57.8 million Other invested assets reported on the consolidated balance sheet at December 31, 2012 is reported at fair value. The remaining $32.8 million of Other invested assets is reported under the equity method of accounting or at amortized cost.

(2) $25.0 million of the $44.3 million Other invested assets reported on the consolidated balance sheet at December 31, 2011 is reported at fair value. The remaining $19.3 million of Other invested assets is reported under the equity method of accounting or at amortized cost.

As of December 31, 2012, substantially all of the investment portfolio recorded at fair value was priced based upon quoted market prices or other observable inputs. For investments in active markets, we used the quoted market prices provided by the outside pricing services to determine fair value. In circumstances where quoted market prices were unavailable, we used fair

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

value estimates based upon other observable inputs including matrix pricing, benchmark interest rates, market comparables and other relevant inputs. When observable inputs were adjusted to reflect management’s best estimate of fair value, such fair value measurements are considered a lower level measurement in the GAAP fair value hierarchy.

Our process to validate the market prices obtained from the outside pricing sources includes, but is not limited to, periodic evaluation of model pricing methodologies and analytical reviews of certain prices. We also periodically perform testing of the market to determine trading activity, or lack of trading activity, as well as market prices. Several securities sold during the quarter were “back-tested” (i.e., the sales price is compared to the previous month end reported market price to determine reasonableness of the reported market price). If management believes that the price provided from the pricing source is distressed, management will use a valuation method that reflects an orderly transaction between market participants, generally a discounted cash flow method that incorporates relevant interest rate, risk and liquidity factors.

The ability to observe stable prices and inputs may be reduced for highly-customized and illiquid instruments which had been the case for certain non-agency residential and commercial mortgage-backed securities and asset-backed securities in previous periods.

Substantially all of the portfolio valuations at December 31, 2012 classified as Level 1 or Level 2 in the above table is priced by utilizing the services of several independent pricing services that provide the Company with a price quote for each security. There were no adjustments made to the prices obtained from the independent pricing sources and dealers on securities classified as Level 1 or Level 2.

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

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

The fair values of the debt and equity securities sold, not yet purchased were derived by using quoted prices for similar securities in active markets. These instruments resulted in net realized gains (losses) of $(2.1) million for the year ended December 31, 2012.

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

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

There were no changes in Level 3 assets measured at fair value for the years ended December 31, 2012 and 2011.

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

The following table summarizes changes in Level 3 assets measured at fair value for the year ended December 31, 2012 and 2011 for Tower (the Reciprocal Exchanges have no Level 3 assets):

 

     Year Ended December 31,  
($ in thousands)    2012      2011     2010  

 

 

Beginning balance, January 1

   $         25,000      $       2,058     $         13,595  

Total gains (losses)-realized / unrealized

       

Included in net income

     -        (1,067     (32

Included in other comprehensive income (loss)

     -        -       (6,229

Purchases, issuances and settlements

     -        25,000       -  

Net transfers into (out of) Level 3

     -        (991     (5,276

 

 

Ending balance, December 31,

   $ 25,000      $ 25,000     $ 2,058  

 

 

Note 8—Goodwill and Intangible Assets

Goodwill

Goodwill is calculated as the excess of purchase price over the net fair value of assets acquired. See Note 4 – “Acquisitions” for information regarding the calculation of goodwill related to the recent acquisitions. The following is a summary of goodwill by reporting units:

 

($ in thousands)    Commercial
Insurance
    Personal
Insurance
    Total  

 

 

Balance, January 1, 2011 as reported

   $       189,121     $       56,427     $       245,548  

Adjustments (a)

     (3,203     (887     (4,090

 

 

Balance, January 1, as adjusted

     185,918       55,540       241,458  

Adjustments

     -       -       -  

 

 

Balance, January 1, 2012

     185,918       55,540       241,458  

Adjustments

     -       -       -  

 

 

Total, December 31, 2012

   $ 185,918     $ 55,540     $ 241,458  

 

 

(a) In 2012, the Company identified deferred tax assets that should have been recorded in purchase accounting for certain acquisitions. The Company increased deferred tax assets by $4,090 and reduced goodwill to properly report 2010 and prior items as of the earliest period presented.

Goodwill impairment testing

The Company performs an impairment test for each of our reporting units with goodwill annually or whenever events or circumstances indicate that the value of goodwill may be impaired. In performing Step 1 of the impairment test, management compared the fair value of the reporting units to their carrying value including goodwill. If the carrying value including goodwill were to exceed the fair value of a reporting unit, Step 2 of the test would be performed. Step 2 of the impairment test requires the carrying value of goodwill to be reduced to its fair value, if lower, as of the test date. For Step 1 of the test, the Company estimated the reporting unit’s fair value using an average of five standard valuation techniques, which include a market multiples based on (i) book value; (ii) tangible book value; (ii) estimates of projected results for 2013 and 2014; and, (iv) a valuation technique using discounted cash flows (“DCF”) to be generated by the reporting unit, which include a terminal value.

The market multiples techniques are based on book value; tangible book value; and estimates of projected future results were derived from selected guideline companies, which write products similar to those issued by us and are of comparable size, and were adjusted for the return on equity and the return on tangible equity. The DCF valuation and market multiples are based on projected future results involve a number of estimates that require broad assumptions and significant judgment by management regarding future performance. The key assumptions used in these methods are as follows:

 

     Commercial Insurance   Personal Insurance

 

Discounting interest rate

   10%   10%

Growth rate – near term

   8-14%   10-23%

Terminal growth rate

   3%   3%

Combined ratio(*)

   94%-98%   94%-98%

* In the determination of the terminal value we considered a combined ratio of 94% as reasonable for Commercial Insurance and Personal Insurance.

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

The Company also compared the aggregate fair value of the reporting units to Tower’s overall market capitalization. The aggregate fair value of the reporting units exceeded Tower’s book value by 1% and market capitalization by 42%; management believes that the implied premium of the aggregate fair value over market capitalization is a reasonable valuation for an acquisition control premium (the price in excess of a stock’s market price that investors would typically pay to gain control of an entity).

For the Commercial Insurance reporting unit, the Company determined in Step 1 that the reporting unit’s fair value was less than its carrying value, primarily driven by the overall market capitalization. Accordingly, recoverability was evaluated assuming fair value was allocated to assets and liabilities as if the reporting unit had been acquired in a business combination. In Step 2, the implied value of the Commercial Insurance reporting unit’s goodwill was greater than its goodwill carrying value by $5 million considering an acquisition control premium of 42%; therefore, goodwill was not impaired and no write-down was required; however, the Step 1 comparison indicates a greater risk of future impairment for this reporting unit’s goodwill.

For the Personal Insurance reporting unit, management determined in Step 1 that the reporting unit’s fair value was in excess of its carrying value by 9% or $21 million considering an acquisition control premium of 42%; and therefore goodwill was not impaired.

In November and December 2012, Tower’s market capitalization was negatively impacted by what management believes was the uncertainty about the results of Superstorm Sandy coupled with the uncertainty as to the timing of the merger with Canopius: therefore, despite a temporary decline in the Company’s share price, management determined that there were no events or material changes in circumstances that indicated that a material change in the fair value of the Company’s reporting units had occurred.

Subsequent goodwill assessments could result in impairment due to the impact of a volatile financial market on earnings, discount assumptions, liquidity and market capitalization, as well as our assessment of segment organization upon the completion of the proposed merger with the Canopius Bermuda Operations. Management will continue to monitor its goodwill for possible future impairments.

Intangible Assets

Intangible assets consist of finite and indefinite life assets. Finite life intangible assets include customer relationships and trademarks. Insurance company licenses and management contracts are considered indefinite life intangible assets subject to annual impairment testing.

The components of intangible assets and their useful lives, accumulated amortization, and net carrying value as of December 31, 2012 and 2011 are as follows:

 

          December 31, 2012      December 31, 2011  
($ in thousands)    Useful
Life
(in-yrs)
   Gross
Carrying
Amount
     Accumulated
Amortization
    Net
Carrying
Amount
     Gross
Carrying
Amount
     Accumulated
Amortization
    Net
Carrying
Amount
 

 

 

Insurance licenses

   -    $ 19,003      $ -     $ 19,003      $ 19,003      $ -     $ 19,003  

Management contracts

   -      54,600        -       54,600        54,600        -       54,600  

Customer relationships

   10-25      57,890        (26,754     31,136        57,890        (19,427     38,463  

Trademarks

   5      5,290        (3,261     2,029        5,290        (2,436     2,854  

 

 

Total

      $     136,783      $     (30,015   $     106,768      $     136,783      $     (21,863   $     114,920  

 

 

Tower

      $ 128,283      $ (28,369   $ 99,914      $ 130,883      $ (20,802   $ 110,081  

Reciprocal Exchanges

        8,500        (1,646     6,854        5,900        (1,061     4,839  

 

 

Total

      $ 136,783      $ (30,015   $ 106,768      $ 136,783      $ (21,863   $ 114,920  

 

 

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

The activity in the components of intangible assets for the years ended December 31, 2012 and 2011 consisted of intangible assets acquired from business combinations and amortization expense as shown in the table below:

 

($ in thousands)    Insurance
Licenses
     Management
Contracts
     Customer
Relationships
    Trademarks     Total  

 

 

Balance, January 1, 2011

   $ 19,003      $ 54,600      $ 46,492     $ 3,725     $ 123,820  

Additions

     -        -        -       -       -  

Deductions (a)

     -        -        (8,029     (871     (8,900

 

 

Balance, December 31, 2011

   $       19,003      $     54,600      $     38,463     $     2,854     $       114,920  

 

 

Tower

   $ 18,603      $ 54,600      $ 35,594     $ 1,284     $ 110,081  

Reciprocal Exchanges

     400        -        2,869       1,570       4,839  

 

 

Total, December 31, 2011

   $ 19,003      $ 54,600      $ 38,463     $ 2,854     $ 114,920  

 

 

Additions

     -        -        -       -       -  

Deductions (a)

     -        -        (7,327     (825     (8,152

 

 

Balance, December 31, 2012

   $ 19,003      $ 54,600      $ 31,136     $ 2,029     $ 106,768  

 

 

Tower

   $ 16,003      $ 54,600      $ 28,600     $ 711     $ 99,914  

Reciprocal Exchanges (b)

     3,000        -        2,536       1,318       6,854  

 

 

Total, December 31, 2012

   $ 19,003      $ 54,600      $ 31,136     $ 2,029     $ 106,768  

 

 

(a) Amortization

(b) In 2012, Tower transferred a licensed insurance subsidiary shell to the Reciprocal Exchanges, as discussed in Note 2-Accounting Policies and Basis of Presentation. This resulted in classifying $2.6 million insurance licenses out of Tower and into the Reciprocal Exchange.

Intangible asset impairment testing and amortization

The Company performs an analysis annually as of September 30 to identify potential impairment of intangible assets with both definite and indefinite lives and measures the amount of any impairment loss that may need to be recognized. Intangible asset impairment testing requires an evaluation of the estimated fair value of each identified intangible asset to its carrying value. An impairment charge could be recorded if the estimated fair value is less than the carrying amount of the intangible asset. No impairments have been identified in the years ended December 31, 2012, 2011 and 2010.

The Company recorded amortization expense related to intangible assets with definite lives of $8.2 million, $8.9 million and $6.6 million in the years ended December 31, 2012, 2011 and 2010, respectively. The estimated amortization expense associated with these intangible assets for each of the next five years is:

 

($ in thousands)    Tower      Reciprocal
Exchanges
     Total  

 

 

2013

   $       6,791      $       517      $       7,308  

2014

     2,804        466        3,270  

2015

     2,253        405        2,658  

2016

     1,932        354        2,286  

2017

     1,716        311        2,027  

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Note 9—Deferred Acquisition Costs (“DAC”)

Acquisition costs incurred and policy-related ceding commission revenue are deferred and amortized to income on property and casualty business for the year ended December 31, 2012, 2011 and 2010 as follows:

 

     Year Ended December 31,  
     2012     2011     2010  
($ in thousands)    Tower     Reciprocal
Exchanges
    Total     Tower     Reciprocal
Exchanges
    Total     Tower     Reciprocal
Exchanges
    Total  

 

 

Deferred acquisition costs, net, January 1

   $ 156,992     $ 11,866     $ 168,858     $ 145,917     $ 18,206     $ 164,123     $ 126,307     $     $ 126,307  

Acquisition date value of business acquired (“VOBA”) of acquired entities

                                         23,492       17,301       40,793  

Cost incurred and deferred:

                  

Commissions and brokerage

     298,444       31,266       329,710       279,699       31,837       311,536       240,428       20,465       260,893  

Other underwriting and acquisition costs

     68,238       7,467       75,705       64,416       5,896       70,312       87,715       13,500       101,215  

Ceding commission revenue

     (25,052     (15,878     (40,930     (20,082     (11,446     (31,528     (32,526     (7,232     (39,758

 

 

Net costs incurred and deferred

     341,630       22,855       364,485       324,033       26,287       350,320       295,617       26,733       322,350  

Amortization

     (329,045     (23,357     (352,402     (312,958     (32,627     (345,585     (299,499     (25,828     (325,327

 

 

Deferred acquisition costs, net, December 31,

   $ 169,577     $ 11,364     $ 180,941     $ 156,992     $ 11,866     $ 168,858     $ 145,917     $ 18,206     $ 164,123  

 

 

Note 10—Reinsurance

The Company utilizes various excess of loss, quota share and catastrophe reinsurance programs to limit its exposure to a maximum loss on any one risk.

Under the terms of the excess of loss programs in 2012, Tower was at risk of loss for $5.0 million on property, $3.5 million on workers’ compensation and $2.5 million on umbrella. The Company then had reinsurance coverage up to $30 million for property, $60 million for workers’ compensation, and $5 million for umbrella. In addition, the Company also had “clash coverage” in effect for 2012 for a limit of $5 million in excess of $5 million which applies to the aggregate liability for liability losses from multiple insureds involved in the same occurrence.

Tower’s 2012 quota share reinsurance cedes 35.5% of the homeowners business written by the companies obtained in the OBPL transaction. This coverage has a $288 million per occurrence cap.

The Company also purchases property catastrophe reinsurance on an excess of loss basis above a specified retention to protect itself from an accumulation of losses resulting from a catastrophic event. At the July 1, 2012 renewal of its property catastrophe program, the Company maintained a retention of $75 million per catastrophe, had 100% catastrophe protection for the next $75 million of loss above the $75 million, 70% catastrophe protection for the next $75 million of loss over $150 million and 100% catastrophe protection for the next $700 million of loss in excess of $225 million.

In 2012 Tower purchased an Original Insured Market Loss Warranty basis, whereby the Company can recover up to the limit of the contract for its ultimate net loss arising from the windstorm peril in the Northeast in an event where the insured market loss exceeds a specified threshold.

In 2011, Tower was at risk of loss for the first $5.0 million on property, $2.5 million on workers’ compensation and $2.5 million on umbrella. The Company then had reinsurance coverage up to $30 million for property, $50 million for workers’ compensation, and $5 million for umbrella. In addition, the Company also had “clash coverage” in effect for 2012 for a limit of $5 million in excess of $5 million which applies to the aggregate liability for liability losses from multiple insureds involved in the same occurrence. The property catastrophe program renewed on July 1, 2011 had a retention of $75 million per catastrophe, had 60% catastrophe protection for the next $50 million of loss above the $75 million, and 100% percent catastrophe protection for the next $775 million of loss in excess of $125 million.

The Company maintains funds held liabilities under the liability quota share reinsurance agreements written in 2010 and prior years and is required to credit interest to the reinsurers with annual effective yields ranging from 2.5% to 4.0% on the monthly balance in the funds held liability accounts. The amounts credited for 2012, 2011 and 2010 were $3.9 million, $3.6 million and $2.7 million, respectively, and have been recorded as interest expense.

The Reciprocal Exchanges are not party to the reinsurance agreements discussed above, except for the homeowners quota share treaty whereby they cede 35.5% of homeowners business written. The Reciprocal Exchanges were covered under this treaty in 2012, 2011 and 2010. The Reciprocal Exchanges are also protected under a property catastrophe reinsurance cover placed on an excess of loss basis. In 2012, 2011 and 2010, this coverage was for 100% of $150 million in excess of a $10 million retention.

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Impact of Reinsurance on Premiums

The table below shows direct, assumed and ceded premiums for the years ended December 31, 2012, 2011 and 2010:

 

($ in thousands)    Direct     Assumed     Ceded     Net  

 

 

2012

        

Premiums written

   $         1,755,157     $         215,915     $         231,691     $         1,739,382  

Change in unearned premiums

     3,647       (31,370     (9,884     (17,840

 

 

Premiums earned

   $ 1,758,804     $ 184,545     $ 221,807     $ 1,721,542  

 

 

2011

        

Premiums written

   $ 1,692,282     $ 118,642     $ 172,333     $ 1,638,591  

Change in unearned premiums

     (8,262     (12,890     23,589       (44,741

 

 

Premiums earned

   $ 1,684,020     $ 105,752     $ 195,922     $ 1,593,850  

 

 

2010

        

Premiums written

   $ 1,432,177     $ 64,194     $ 182,307     $ 1,314,064  

Change in unearned premiums

     (2,927     26,195       44,663       (21,395

 

 

Premiums earned

   $ 1,429,250     $ 90,389     $ 226,970     $ 1,292,669  

 

 

Reinsurance Balances

As of December 31, 2012 and 2011, the Company had $532.6 million and $314.0 million, respectively, of reinsurance recoverables with reinsurers rated A- or higher by A.M. Best. These represented 92.2% and 91.0%, respectively, of the Company’s total reinsurance recoverables as of those dates. As of December 31, 2012 and 2011, the largest reinsurance recoverable balance with any one reinsurer was approximately 8.3% and 9.1% of the Company’s stockholders’ equity.

The Company did not record any modifications of its reinsurance recoverables on paid or unpaid losses in the years ended December 31, 2012, 2011 or 2010. The Company recorded no allowance for credit losses on its reinsurance recoverables on paid or unpaid losses as of December 31, 2012 or 2011. The Company did not consider that any of its undisputed reinsurance recoverables on paid or unpaid losses as of years ended December 31, 2012 and 2011 to be past due. As discussed in “Note 17 – Contingencies”, certain reinsurance agreements are subject to legal proceedings.

Under certain reinsurance agreements, collateral and letters of credit (“collateral”) are held to secure performance of reinsurers in meeting their obligations. The amount of such collateral was $189.6 million and $161.9 million at December 31, 2012 and 2011, respectively. The collateral we hold does not apply to our entire outstanding reinsurance recoverable. Rather, collateral is provided on an individual basis. For each individual reinsurer, the collateral held may exceed or fall below the total outstanding recoverable from that individual reinsurer.

Ceding Commission Revenue

The Company earns ceding commission revenue under certain quota share reinsurance agreements. In addition, the commission revenue earned on prior reinsurance agreements continue to be adjusted based on a sliding scale of commission rates and ultimate treaty year loss ratios on the policies reinsured under each of these agreements. The sliding scale includes minimum and maximum commission rates in relation to specified ultimate loss ratios. The commission rate and ceding commissions earned increase when the estimated ultimate loss ratio decreases, and conversely, the commission rate and ceding commissions earned decrease when the estimated ultimate loss ratio increases.

The estimated ultimate loss ratios are the Company’s best estimate based on facts and circumstances known at the end of each period that losses are estimated. The estimation process is complex and involves the use of informed estimates, judgments and actuarial methodologies relative to future claims severity and frequency, the length of time for losses to develop to their ultimate level, possible changes in law and other external factors. The same uncertainties associated with estimating loss and loss adjustment expense reserves affect the estimates of ceding commissions earned. The Company monitors and adjusts the ultimate loss ratio on a quarterly basis to determine the effect on the commission rate and ceding commissions earned. The decrease in estimated ceding commission income relating to prior years recorded in 2012, 2011 and 2010 was $4.5 million, $0.1 million and $2.2 million, respectively.

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Note 11—Loss and Loss Adjustment Expense

The components of the liability for loss and LAE expenses and related reinsurance recoverables for the years ended December 31, 2012 and 2011 are as follows:

 

     Tower      Reciprocal Exchanges      Total  
($ in thousands)    Gross
Liability
     Reinsurance
Recoverable
     Gross
Liability
     Reinsurance
Recoverable
     Gross
Liability
     Reinsurance
Recoverable
 

 

 

December 31, 2012

                 

Case-basis reserves

   $ 913,411      $ 79,911      $ 63,465      $ 10,160      $ 976,876      $ 90,071  

IBNR reserves

     845,871         363,892         72,326         42,229         918,197         406,121   

Recoverable on paid losses

     -        16,927        -        682        -        17,609  

 

 

Total, December 31, 2012

   $ 1,759,282       $ 460,730      $ 135,791       $ 53,071      $ 1,895,073      $ 513,801  

 

 

December 31, 2011

                 

Case-basis reserves

   $ 766,275      $ 135,686      $ 82,203      $ 7,916      $ 848,478      $ 143,602  

IBNR reserves

     729,564        172,725        54,071        3,337        783,635        176,062  

Recoverable on paid losses

     -        18,233        -        5,670        -        23,903  

 

 

Total, December 31, 2011

   $       1,495,839      $       326,644      $       136,274      $       16,923      $       1,632,113      $       343,567  

 

 

The following tables provide a reconciliation of the beginning and ending consolidated balances for unpaid losses and LAE for the years ended December 31, 2012, 2011 and 2010:

 

     Year Ended December 31,  
     2012     2011  
($ in thousands)    Tower     Reciprocal
Exchanges
    Total     Tower     Reciprocal
Exchanges
    Total  

 

 

Balance at January 1,

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

Less reinsurance recoverables on unpaid losses

     (308,411     (11,253     (319,664     (271,298     (11,384     (282,682

 

 
     1,187,428       125,021       1,312,449       1,167,808       159,931       1,327,739  

Net reserves, at fair value, of acquired entities

     -       -       -       -       -       -  

Incurred related to:

            

Current year

     1,066,411       118,099       1,184,510       933,791       142,254       1,076,045  

Prior years unfavorable/(favorable) development

     78,231       (8,881     69,350       17,039       (37,835     (20,796

 

 

Total incurred

     1,144,642       109,218       1,253,860       950,830       104,419       1,055,249  

Paid related to:

            

Current year

     431,437       98,682       530,119       337,268       59,078       396,346  

Prior years

     585,154       52,155       637,309       593,942       80,251       674,193  

 

 

Total paid

     1,016,591       150,837       1,167,428       931,210       139,329       1,070,539  

 

 

Net balance at end of period

     1,315,479       83,402       1,398,881       1,187,428       125,021       1,312,449  

Add reinsurance recoverables on unpaid losses

     443,803       52,389       496,192       308,411       11,253       319,664  

 

 

Balance at December 31,

   $       1,759,282     $       135,791     $       1,895,073     $       1,495,839     $       136,274     $       1,632,113  

 

 

 

     2010  
($ in thousands)    Tower     Reciprocal
Exchanges
    Total  

 

 

Balance at January 1,

   $       1,131,989     $ -     $       1,131,989  

Less reinsurance recoverables on unpaid losses

     (199,687     -       (199,687

 

 
     932,302       -       932,302  

Net reserves, at fair value, of acquired entities

     193,484       158,652       352,136  

Incurred related to:

      

Current year

     724,254       72,059       796,313  

Prior years unfavorable/(favorable) development

     (2,433     (9,857     (12,290

 

 

Total incurred

     721,821       62,202       784,023  

Paid related to:

      

Current year

     278,859       46,276       325,135  

Prior years

     400,940       14,647       415,587  

 

 

Total paid

     679,799       60,923       740,722  

 

 

Net balance at end of period

     1,167,808       159,931       1,327,739  

Add reinsurance recoverables on unpaid losses

     271,298       11,384       282,682  

 

 

Balance at December 31,

   $ 1,439,106     $ 171,315     $ 1,610,421  

 

 

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Incurred losses and LAE for the year ended December 31, 2012 attributable to insured events of prior years increased by $69.3 million. Excluding the Reciprocal Exchanges the incurred losses and LAE increased by $78.2 million.

The consolidated net loss ratio, which includes the Reciprocal Exchanges, was 72.8% and 66.2% for the years ended December 31, 2012 and 2011, respectively. Excluding the Reciprocal Exchanges, the net loss ratio was 73.5% and 67.6% for the years ended December 31, 2012 and 2011, respectively. The Reciprocal Exchanges’ net loss ratio was 66.7% and 55.8% for the years ended December 31, 2012 and 2011, respectively.

Excluding the Reciprocal Exchanges, the 2012 net loss and loss adjustment expenses included $101.0 million from claims related to Superstorm Sandy.

Excluding the Reciprocal Exchanges, there was net adverse loss development of $78.2 million for the year ended December 31, 2012 comprised of adverse development in Personal Insurance of $4.0 million and adverse development in Commercial Insurance of $74.2 million.

The net adverse development in Commercial Insurance included $52.1 million in workers compensation, $20.8 million in commercial automobile liability and $1.3 million in other lines. The net adverse development in Personal Insurance was comprised mainly of $4.6 million for homeowners, $1.2 million for other liability, and $5.4 million for other lines, partially offset by $7.2 million for amortization of reserves risk premium, principally relating to reserves acquired in the OBPL transaction.

For the Reciprocal Exchanges, the favorable development was $8.9 million, comprised of favorable development of $3.1 million for homeowners, $1.6 million for private passenger automobile liability, $1.7 million for other lines, and $2.5 million for amortization of reserves risk premium.

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

Incurred losses and LAE for the years ended December 31, 2012 and 2011 included reductions in loss and loss expense reserves pertaining to the amortization of the reserve risk premium on loss reserves recorded in connection with the Company’s acquisitions in prior years. Excluding the Reciprocal Exchanges these reductions in loss reserves were $7.2 million and $3.7 million, respectively, for 2012 and 2011. The Reciprocal Exchanges had reductions in loss reserves of $2.5 million and $1.2 million, respectively, for 2012 and 2011.

Loss and loss adjustment expense reserves. The reserving process for loss and LAE reserves provides management’s best estimate at a particular point in time of the ultimate unpaid cost of all losses and LAE incurred, including settlement and administration of losses, and is based on facts and circumstances then known and including losses that have been incurred but not yet reported. The process includes using actuarial methodologies to assist in establishing these estimates, judgments relative to estimates of future claims severity and frequency, the length of time before losses will develop to their ultimate level and the possible changes in the law and other external factors that are often beyond our control. There are various actuarial methods that are appropriate for the different lines of business, and our actuaries’ use of a particular method or weighting of methods depends in part on the maturity of each accident year by line of business, the limits of liability covered under the policies, the presence or absence of large claims in the experience, and other considerations. In general, the various actuarial methods can be grouped into three categories: loss ratio projection, loss development methods, and the Bornhuetter-Ferguson (“B-F”) method. For the most recent accident year, and especially for liability lines of business, the actuarial method given the most weight is usually the loss ratio method, since the percentage of ultimate claims reported to date is expected to be low and the immature reported claims experience is not a reliable indicator of ultimate losses for that accident year. For property lines of business for the most recent accident year, the B-F method is usually given the most weight, because experience typically shows that there is a small percentage of claims reported in the subsequent period due to normal lags in reporting and processing of claims in these lines of business that can be relatively reliably estimated as a percentage of premiums, which is reflected in the B-F method. For each line

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

of business, the actuarial reserving method usually given the most weight shifts from the loss ratio projection to the B-F method to the incurred loss projection as each accident year matures. These methods are described in “Business—Loss and Loss Adjustment Expense Reserves.”

This process helps management set carried loss reserves based upon the actuaries’ best estimates, using estimates made by segment, product or line of business, territory, and accident year. The actuaries also separately estimate loss reserves from LAE reserves and within LAE reserves estimates are made for defense and cost containment expenses or Allocated Loss Adjustment Expenses (“ALAE”) and for other claims adjusting expenses or Unallocated Loss Adjustment Expenses (“ULAE”). The amount of loss and LAE reserves for reported claims is based primarily upon a case-by-case evaluation of coverage, liability, injury severity, and any other information considered pertinent to estimating the exposure presented by the claim. The amounts of loss and LAE reserves for unreported claims are determined using historical information by line of business as adjusted to current conditions. Due to the inherent uncertainty associated with the reserving process, the ultimate liability may differ, perhaps substantially, from the original estimate. Such estimates are regularly reviewed and updated, and any resulting adjustments are included in the current year’s results. Reserves are closely monitored and are recomputed periodically using the most recent information on reported claims and a variety of statistical techniques. Specifically, on at least a quarterly basis, we review, by line of business, existing reserves, new claims, changes to existing case reserves and paid losses with respect to the current and prior years. See “Business—Loss and Loss Adjustment Expense Reserves” for additional information regarding our loss and LAE reserves.

We segregate our data for estimating loss reserves. The property lines include Fire and Allied Lines, Homeowners-property, Commercial Multi-peril Property, Multi-Family Dwellings, Inland Marine and Automobile Physical Damage. The casualty lines include Homeowners-liability, Commercial Multi-peril Liability, Other Liability, Workers’ Compensation, Commercial Automobile Liability, and Personal Automobile Liability. Commercial Insurance segment reserves are estimated separately from Personal Insurance segment reserves. For the Commercial Insurance segment we analyze reserves by line of business and, where appropriate, we further segregate the data for analysis purposes between small, middle and large policies sizes and by state or region. We also analyze various producers’ business separately where the volume of business from those producers is considered significant and the characteristics of the business from those particular producers are perceived to be different. Within the Personal Insurance segment, we estimate loss and loss expenses reserves separately for the Reciprocal Exchanges, which we manage, and for our owned companies. We utilize line of business breakdowns and, where appropriate, analyze results separately by state.

Two key assumptions that materially impact the estimate of loss reserves are the loss ratio estimate for the current accident year and the loss development factor selections for all accident years. The loss ratio estimate for the current accident year is selected after reviewing historical accident year loss ratios adjusted for rate and price changes, trend, mix of business, and other factors. In addition, as the year matures and, depending upon the line of business, we utilize B-F methods or loss development methods for the current accident year.

In most cases, our data are sufficiently credible to determine loss development factors utilizing our own data. In some cases, we supplement our own loss development experience with industry data and utilize historical loss development experience for particular books of business, programs or treaties obtained from our sources. The loss development factors are reviewed at least annually, and whenever there is a significant change in the underlying business. Each quarter we test the loss development by analyzing actual emerging claims compared to expected development.

Because of the nature of the business historically written, the Company’s management believes that the Company has limited exposure to environmental claim liabilities.

We estimate ALAE reserves separately for claims that are defended by in-house attorneys, claims that are handled by other attorneys that are not employees, and miscellaneous ALAE costs such as investigators, witness fees and court costs.

For claims that are defended by in-house attorneys, we estimate the defense cost per claim, and we attribute to each of these claims a fixed fee for defense work. We allocate to each of these litigated claims 50% of the fixed fee when litigation on a particular claim begins and 50% of the fee when the litigation is closed. The fee is determined actuarially based upon the projected number of litigated claims and expected closing patterns at the beginning of each year as well as the projected budget for our in-house attorneys, and these amounts are calibrated to reimburse our in-house legal department for all of their costs.

ULAE for claims that are handled in-house by our claims adjusters utilize a similar process to that described above for ALAE. We determine fixed fees per claim by line of business, and assign these costs to line of business and accident year. For property lines, 50% of the fixed fee is attributed to claims when a claim is opened and 50% is attributed to claims when they are closed. For casualty lines, 75% of the fixed fee is attributed to the claim when a claim is opened and 25% is attributed to the claims when the claim is closed. The IBNR portion of ULAE for these claims is based upon 50% of the fixed fee per claims for in-house ULAE multiplied by the number of claims open and by 100% of the fixed fee multiplied by the estimated number of claims to be reported for prior accident dates.

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

For some types of claims and for some programs where we utilize third-party administrators (“TPA”) to adjust claims, we pay them fees which are included in ULAE. In some cases, we arrange for fixed percentages of premiums earned to be the fee for claims administration, and in other cases we arrange for fixed fees per claim or hourly charges for ULAE services. The reserves for ULAE for these situations is estimated based upon the particular arrangement for these types of claims by product or program.

Note 12—Stockholders’ Equity

Shares of Common Stock Issued

For the years ended December 31, 2012 and 2011, 0 and 34,612 new common shares, respectively, were issued as the result of employee stock option exercises and 372,618 and 654,180 new common shares, for the same periods, respectively, were issued as the result of restricted stock grants.

For the years ended December 31, 2012 and 2011, 103,599 and 78,732 shares, respectively, of common stock were purchased from employees in connection with the vesting of restricted stock issued under the 2004 Long Term Equity Compensation Plan (the “Plan”). The shares were withheld at the direction of employees as permitted under the Plan in order to pay the expected amount of tax liability owed by the employees from the vesting of those shares. In addition, for the years ended December 31, 2012 and 2011, 25,166 and 18,841 shares, respectively, of common stock were surrendered as a result of restricted stock forfeitures.

Share Repurchase Program

The Board of Directors of Tower approved a $100 million share repurchase program on March 3, 2011. This authorization is in addition to the $100 million share repurchase program approved on February 26, 2010. Purchases under both programs can be made from time to time in the open market or in privately negotiated transactions in accordance with applicable laws and regulations. The new share repurchase program will expire on March 4, 2013. In the year ended December 31, 2012, 1.1 million shares of common stock were purchased under these programs at an aggregate consideration of $21.0 million. In the year ended December 31, 2011, 2.9 million shares were purchased under these programs at an aggregate consideration of $64.6 million. As of December 31, 2012, the original $100 million share purchase program had been fully utilized and $26.4 million remained available for future share repurchases under the new program.

Dividends Declared

Dividends on common stock of $29.1 million, $27.9 million and $16.6 million for the years ended December 31, 2012, 2011 and 2010, respectively, were declared and paid.

On January 30, 2013, the Board of Directors approved a quarterly dividend of $0.1875 per share payable on February 28, 2013 to stockholders of record as of February 14, 2013.

Note 13—Debt

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

 

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

Carrying

Value

    

Fair

Value

    

Carrying

Value

    

Fair

Value

 

 

 

Credit facility

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

Convertible senior notes

     144,673         152,063        141,843         150,743   

Subordinated debentures

     235,058         232,678        235,058         234,550   

 

 

Total

   $ 449,731       $ 454,741      $             426,901       $             435,293   

 

 

The fair value of the convertible senior notes are determined utilizing recent transaction prices for these securities between third-party market participants and the fair value of the subordinated debentures are based on discounted cash flow analysis. The significant inputs used for fair value are considered Level 2 in the fair value hierarchy.

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Aggregate Scheduled Maturities and Interest Expense

Aggregate scheduled maturities of the Company’s borrowings at December 31, 2012 are:

 

($ in thousands)       

 

 

2013

   $ 70,000   

2014

     150,000  (a) 

2033

     20,620   

2034

     25,775   

2035

     13,403   

2036

     123,713   

2037

     51,547   

 

 
   $             455,058   

 

 

(a) Amount reflected in balance sheet for convertible senior notes is net of unamortized original issue discount of $5.3 million

Total interest expense incurred, including interest expense on the funds held liabilities disclosed in “Note 10 – Reinsurance”, was $32.6 million, $34.3 million and $24.2 million for the years ended December 31, 2012, 2011 and 2010, respectively.

Subordinated Debentures

The Company and its wholly-owned subsidiaries have issued trust preferred securities through wholly-owned Delaware statutory business trusts. The trusts use the proceeds of the sale of the trust preferred securities and common securities that the Company acquired from the trusts to purchase junior subordinated debentures from the Company with terms that match the terms of the trust preferred securities. Interest on the junior subordinated debentures and the trust preferred securities is payable quarterly. In some cases, the interest rate is fixed for an initial period of five years after issuance and then floats with changes in the London Interbank Offered Rate (“LIBOR”) and in other cases the interest rate floats with LIBOR without any initial fixed-rate period. The principal terms, before any effects of interest rate swaps, of the outstanding trust preferred securities, including those which were assumed by the Company through acquisitions, are summarized in the following table:

 

($ in millions)

Issue Date

   Issuer    Maturity Date   

Early

Redemption

   Interest Rate    Amount of
Investment
in Common
Securities
of Trust
     Principal
Amount of
Junior
Subordinated
Debenture
Issued to
Trust
 

 

 

May 2003

   Tower Group Statutory Trust I    May 2033    At our option at par on or after May 15, 2008    Three-month LIBOR plus 410 basis points    $ 0.3       $ 10.3   

 

 

September 2003

   Tower Group Statutory Trust II    September 2033    At our option at par on or after September 30, 2008    Three-month LIBOR plus 400 basis points    $ 0.3       $ 10.3   

 

 

May 2004

   Preserver Capital Trust I    May 2034    At our option at par on or after May 24, 2009    Three-month LIBOR plus 425 basis points    $ 0.4       $ 12.4   

 

 

December 2004

   Tower Group Statutory Trust III    December 2034    At our option at par on or after December 15, 2009    Three-month LIBOR plus 340 basis points    $ 0.4       $ 13.4   

 

 

December 2004

   Tower Group Statutory Trust IV    March 2035    At our option at par on or after March 15, 2010    Three-month LIBOR plus 340 basis points    $ 0.4       $ 13.4   

 

 

March 2006

   Tower Group Statutory Trust V    April 2036    At our option at par on or after April 7, 2011    Three-month LIBOR plus 330 basis points    $ 0.6       $ 20.6   

 

 

January 2007

   Tower Group Statutory Trust VI    March 2037    At our option at par on or after March 15, 2012    8.16% until March 14, 2012; three-month LIBOR plus 300 basis points thereafter    $ 0.6       $ 20.6   

 

 

September 2007

   CastlePoint Bermuda Capital Trust I    December 2037    At our option at par on or after December 15, 2012    8.39% until December 14, 2012; three-month LIBOR plus 350 basis points thereafter.    $ 0.9       $ 30.9   

 

 

December 2006

   CastlePoint Management Statutory Trust II    December 2036    At our option at par on or after December 15, 2011    Three-month LIBOR plus 350 basis points    $ 1.6       $ 51.6   

 

 

December 2006

   CastlePoint Management Statutory Trust I    December 2036    At our option at par on or after December 15, 2011    Three-month LIBOR plus 350 basis points    $ 1.6       $ 51.6   

 

 

Total

               $ 7.1       $ 235.1   

 

 

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Interest Rate Swaps

In October 2010, the Company entered into interest rate swap contracts (the “Swaps”) with $190 million notional value to manage interest costs and cash flows associated with the floating rate subordinated debentures. The Swaps have terms of five years. The majority of the Swaps is forward starting and become effective when the respective subordinated debentures change from fixed to floating rates and convert the subordinated debentures to fixed rates ranging from 5.1% to 5.9%. As of December 31, 2012 and 2011, the Swaps had a fair value of $9.0 million and $7.4 million, respectively, in a liability position and are reported in Other Liabilities.

The Company has designated and accounts for the Swaps as cash flow hedges. The Swaps are considered to have no ineffectiveness and changes in their fair values will be recorded in Accumulated Other Comprehensive Income (“AOCI”), net of tax. For the years ended December 31, 2012, 2011 and 2010, $1.6 million, $0.4 million and $18,000, respectively, was reclassified from AOCI to interest expense for the effects of the hedges. As of December 31, 2012 and 2011, the Company had collateral on deposit with the counterparty amounting to $9.1 million and $7.0 million, respectively, pursuant to its Credit Support Annex.

Credit Facility

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

On November 26, 2012, the Company further amended its credit facility whereby the lenders provided consent to the proposed merger of the Company with a subsidiary of Canopius Holdings Bermuda Limited that the Company expects to consummate (see “Note 3-Investment in Canopius Group Limited and Exercise of Merger Option”). The second amendment also increases the Company’s maximum revolving commitment by $70 million to $220 million upon the effectiveness of the Merger and the satisfaction of certain other conditions set forth in the Second Amendment.

The credit facility contains customary covenants for facilities of this type, including restrictions on indebtedness and liens, limitations on mergers, dividends and the sale of assets, and requirements to maintain certain consolidated net worth, debt to capitalization ratios, minimum risk-based capital and minimum statutory surplus. The credit facility also provides for customary events of default, including failure to pay principal when due, failure to pay interest or fees within three days after becoming due, failure to comply with covenants, any representation or warranty made by the Company being false in any material respect, default under certain other indebtedness, certain insolvency or receivership events affecting the Company and its material subsidiaries, the occurrence of certain material judgments, or a change in control of the Company, and upon an event of default the administrative agent (subject to the consent of the requisite percentage of the lenders) may immediately terminate the obligations to make loans and to issue letters of credit, declare the Company’s obligations under the credit facility to become immediately due and payable, and require the Company to deposit in a collateral account cash collateral with a value equal to the then outstanding amount of the aggregate face amount of any outstanding letters of credit. The Company was in compliance with or has obtained waivers for all covenants under the credit facility at December 31, 2012.

Fees payable by the Company under the credit facility include a fee on the daily unused portion of each letter of credit, a letter of credit fronting fee with respect to each fronted letter of credit and a commitment fee.

The Company had $70.0 million and $50.0 million outstanding as of December 31, 2012 and 2011, respectively. The weighted average interest rate on the amount outstanding as of December 31, 2012 and 2011 was 2.0% and 3.5%, respectively.

Convertible Senior Notes

In September 2010, the Company issued $150.0 million principal amount of 5.0% convertible senior notes (“the Notes”), which mature on September 15, 2014. Interest on the Notes is payable semi-annually in arrears on March 15 and September 15 of each year, commencing March 15, 2011. Holders may convert their Notes into cash or common shares, at the Company’s option, at any time on or after March 15, 2014 or earlier under certain circumstances determined by: (i) the market price of the Company’s stock, (ii) the trading price of the Notes, or (iii) the occurrence of specified corporate transactions. Upon conversion, the Company intends to settle its obligation either entirely or partially in cash.

The adjusted conversion rate at December 31, 2012 is 37.1689 shares of common stock per $1,000 principal amount of the Notes (equivalent to a conversion price of $26.90 per share), subject to further adjustment upon the occurrence of certain events,

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

including the following: if Tower issues shares of common stock as a dividend or distribution on shares of the common stock , or if Tower effects a share split or share combination; if Tower issues to all or substantially all holders of common stock any rights, options or warrants entitling them, for a period of not more than 45 calendar days after the announcement date of such issuance, to subscribe for or purchase shares of the common stock at a price per share that is less than the average of the last reported sales price of the common stock for the ten consecutive trading day period ending on the date of announcement of such issuance; if Tower distributes shares of its capital stock, other indebtedness, other assets or property of Tower or rights, options or warrants to acquire capital stock or other securities of Tower, to all or substantially all holders of capital stock; if any cash dividend or distribution is made to all or substantially all holders of the common stock, other than a regular quarterly cash dividend that does not exceed $0.125 per share; if Tower makes a payment in respect of a tender offer or exchange offer for common stock, and the cash and value of any other consideration included in the payment per share of common stock exceeds the last reported sale price of the common stock on the trading day next succeeding the last day on which the tenders or exchange may be made. In February 2013, the conversion rate was adjusted to 37.2895, equivalent to a conversion price of $26.82 per share.

Additionally, in the event of a fundamental change, the holders may require the Company to repurchase the Notes for a cash price equal to 100% of the principal plus any accrued and unpaid interest.

The proceeds from the issuance of the Notes were allocated to the liability component and the embedded conversion option, or equity component. The equity component was reported as an adjustment to paid-in-capital, net of tax, and is reflected as an original issue discount (“OID”). The OID of $11.5 million and $5.0 million of deferred origination costs relating to the liability component are being amortized into interest expense over the term of the Notes. After considering the contractual interest payments and amortization of the original issue discount, the Notes’ effective interest rate is 7.2%. Transaction costs of $0.4 million associated with the equity component were netted with the equity component in paid-in-capital. Interest expense, including amortization of deferred origination costs, recognized on the Notes was $11.6 million for the year ended December 31, 2012.

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

 

     December 31,  
($ in thousands)    2012      2011  

 

 

Liability component

     

Outstanding principal

   $           150,000       $           150,000   

Unamortized OID

     (5,327)         (8,157)   

 

 

Liability component

     144,673         141,843   

 

 

Equity component, net of tax

   $ 7,469       $ 7,469   

 

 

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

Convertible Senior Notes Hedge and Warrant Transactions

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

In September 2010, the Company paid $15.3 million for the Note Hedges which cover 5.5 million shares of common stock at a strike price of $26.90 per share at December 31, 2012, subject to anti-dilution provisions, and are exercisable upon conversion of the Notes. The Note Hedges have been accounted for as an adjustment to the Company’s paid-in-capital, net of deferred taxes.

In September 2010, the Company received $3.8 million for Warrants sold to the financial institutions. The Warrants provide for the acquisition of 5.5 million shares of common stock at a strike price of $32.71 per share at December 31, 2012, subject to anti-dilution adjustments. The Warrants have been accounted for as an adjustment to the Company’s paid-in-capital.

To the extent the Company’s common stock price is above $26.90 but below the Warrant strike price of $32.71, there is no dilutive effect to common stockholders’ equity because the Note Hedge offsets any shares to be issued under the Notes. If the market value per share of the Company’s common stock exceeds the strike price of the Warrants, the Warrants will have a dilutive effect on the Company’s net income per share.

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Note 14—Stock Based Compensation

2008 Long-Term Equity Compensation Plan (“2008 LTEP”)

In 2008, the Company’s Board of Directors adopted and its stockholders approved the 2008 LTEP, which amended and revised the 2004 Long-Term Equity Compensation Plan.

The 2008 LTEP provides for the granting of non-qualified stock options, incentive stock options (within the meaning of Section 422 of the Code), stock appreciation rights (“SARs”), restricted stock and restricted stock unit awards, performance shares and other cash or share-based awards. The maximum amount of share-based awards authorized is 2,325,446 of which 230,943 are available for future grants as of December 31, 2012.

2013 Long-Term Incentive Plan (“2013 LTIP”)

The Compensation Committee of the Board of Directors has established, beginning in 2013 and subject to stockholder approval, a new Long Term Incentive Plan (the “2013 LTIP”), to replace the Company’s existing 2008 Long Term Equity Compensation Plan.

Shares and Options Granted

The following table provides information with respect to the stock options and shares of the Company’s common stock issued (i) to the Company’s employees under the 2004 LTEP and (ii) to employees and directors of companies acquired by the Company in exchange for the options and shares owned by such employees and directors in such companies at the time of acquisition.

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

     Year Ended December 31,  
     2012      2011      2010  

 

 

Granted under the Plan (excludes shares and options issued with respect to acquisitions)

        

Restricted stock

     372,618        654,180        355,539  

Stock options, at fair value

     -        -        -  

 

 
     372,618        654,180        355,539  

Issued restricted stock and stock options from acquisitions

     -        -        -  

 

 

Total

     372,618        654,180        355,539  

 

 

Restricted Stock

The following table provides an analysis of restricted stock activity for the years ended December 31, 2012, 2011 and 2010:

 

     Year Ended December 31,  
     2012      2011      2010  

 

 
            Weighted             Weighted             Weighted  
            Average             Average             Average  
     Number of      Grant Date      Number of      Grant Date      Number of      Grant Date  
     Shares      Fair Value      Shares      Fair Value      Shares      Fair Value  

 

 

Outstanding, January 1

     988,607       $ 23.44        591,675       $ 23.10        474,023       $ 24.64  

Granted

     372,618         22.40        654,180         23.80        355,539         21.84  

Vested

     (439,410)         23.72        (238,407)         23.55        (209,054)         24.44  

Forfeitures

     (25,166)         23.44        (18,841)         23.61        (28,833)         23.20  

 

 

Outstanding, December 31,

     896,649       $ 23.09        988,607       $ 23.44        591,675       $ 23.10  

 

 

Stock Options

The following table provides an analysis of stock option activity for the years ended December 31, 2012, 2011 and 2010:

 

     Year Ended December 31,  
     2012      2011      2010  

 

 
            Average             Average             Average  
     Number of      Exercise      Number of      Exercise      Number of      Exercise  
     Shares      Price      Shares      Price      Shares      Price  

 

 

Outstanding, January 1

     855,530      $ 20.14        917,155       $ 20.01        1,387,019       $ 19.62  

Exercised

     -        -        (34,612)         10.74        (242,169)         6.64  

Forfeitures and expirations

     -        -        (27,013)         27.59        (227,695)         31.88  

 

 

Outstanding, December 31

     855,530      $ 20.14        855,530       $ 20.14        917,155       $ 20.01  

 

 

Exercisable, December 31

     855,530      $ 20.14        855,530       $ 20.14        861,941       $ 20.09  

 

 

All options outstanding as of December 31, 2012 are fully exercisable as shown on the following table:

 

     Options Outstanding      Options Exercisable  
            Average                       
            Remaining      Average             Average  
     Number of      Contractual      Exercise      Number of      Exercise  
Range of Exercise Prices    Shares      Life (Years)      Price      Shares      Price  

 

 

$10.01 - $20.00

     687,410        3.6      $ 18.50        687,410      $ 18.50  

$20.01 - $30.00

     166,254        5.1        26.78        166,254        26.78  

$30.01 - $40.00

     1,866        2.1        34.39        1,866        34.39  

 

 

Total Options

     855,530        3.9      $ 20.14        855,530      $ 20.14  

 

 

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

The fair value of the options granted to replace the CastlePoint options was estimated using the Black-Scholes pricing model as of February 5, 2009, the date of conversion from CastlePoint stock options to the Company’s stock options, with the following weighted average assumptions: risk free interest rate of 1.46% to 1.83%, dividend yield of 0.8%, volatility factors of the expected market price of the Company’s common stock of 43.8% to 45.3%, and a weighted-average expected life of the options of 3.3 to 5.3 years.

The fair value of the options granted to replace the SUA options was estimated using the Black-Scholes pricing model as of November 13, 2009, the date of conversion from SUA stock options to the Company’s stock options, with the following weighted average assumptions: risk free interest rate of 1.66%, dividend yield of 1.2%, volatility factors of the expected market price of the Company’s common stock of 43.8%, and a weighted-average expected life of the options of 1.4 years.

The fair value measurement objective of the relevant GAAP guidance is achieved using the Black-Scholes model as the model (a) is applied in a manner consistent with the fair value measurement objective and other requirements of GAAP, (b) is based on established principles of financial economic theory and generally applied in that field and (c) reflects all substantive characteristics of the instrument.

Stock Based Compensation Expense

The following table provides an analysis of stock based compensation expense for the years ended December 31, 2012, 2011 and 2010:

 

     Year Ended December 31,  
($ in thousands)    2012      2011      2010  

 

 

Restricted stock

        

Expense, net of tax

   $ 6,043      $ 6,126      $ 3,792  

Value of shares vested

     9,485        5,622        4,673  

Value of unvested shares

     15,967        19,940        15,147  

Stock options

        

Expense, net of tax

     -        105        293  

Intrinsic value of outstanding options

     1,149        1,150        5,408  

Intrinsic value of vested outstanding options

     1,149        1,150        5,025  

Unrecognized compensation expense

        

Non-vested stock options, net of tax

     -        -        105  

Unvested restricted stock, net of tax

     8,262        9,617        6,097  

Weighted average years expense will be recognized

     2.1        2.3        3.1  

Note 15—Income Taxes

The Company files a consolidated Federal income tax return. The Reciprocal Exchanges are not included in the Company’s consolidated tax return as the Company does not have an ownership interest in the Reciprocal Exchanges, and they are not a part of the consolidated tax sharing agreement.

The provision for Federal, state and local income taxes consist of the following components for the years ended December 31, 2012, 2011 and 2010:

 

     Year ended December 31,  
     2012      2011      2010  
            Reciprocal                    Reciprocal                    Reciprocal         
($ in thousands)    Tower      Exchanges      Total      Tower      Exchanges      Total      Tower      Exchanges      Total  

 

 

Current Federal income tax expense (benefit)

   $ (16,855)       $ 284       $ (16,571)       $ 6,744       $ 1,510      $ 8,254       $ (8,096)       $ (2,380)       $ (10,476)   

Current state income tax expense (benefit)

     200                200         (257)         -        (257)         1,292                1,292   

Deferred Federal and state income tax (benefit)

     (7,828)         (2,521)         (10,349)         14,473         1,672        16,145         60,435         917         61,352   

 

 

Provision for income taxes

   $ (24,483)       $ (2,237)       $ (26,720)       $ 20,960       $ 3,182      $ 24,142       $ 53,631       $ (1,463)       $ 52,168   

 

 

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 provided benefits from 100% accelerated depreciation of fixed assets. As a result, the Company’s current Federal income tax benefit for the year ended December 31, 2011 includes a refund from prior year overpayments and benefits from the 100% acceleration of depreciation of

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

fixed assets placed in service after September 8, 2010 as allowed by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. This 100% acceleration provision expired on December 31, 2011, and the Company is back to a 50% acceleration of depreciation of fixed assets.

Deferred tax assets and liabilities are determined using the enacted tax rates applicable to the period the temporary differences are expected to be recovered. Accordingly, the current period income tax provision can be affected by the enactment of new tax rates. The net deferred income taxes on the balance sheet reflect temporary differences between the carrying amounts of the assets and liabilities for financial reporting purposes and income tax purposes. Significant components of the consolidated deferred tax assets and liabilities are as follows:

 

     December 31,  
     2012      2011  
            Reciprocal                    Reciprocal         
($ in thousands)    Tower      Exchanges      Total      Tower      Exchanges      Total  

 

 

Deferred tax assets:

                 

Claims reserve discount

   $ 43,283       $ 1,747       $ 45,030       $ 41,058       $ 2,691       $ 43,749   

Unearned premium

     55,134         5,928         61,062         53,337         6,139         59,476   

Equity compensation plans

     6,072                 6,072         5,806                 5,806   

Investment impairments

     2,316         15         2,331         3,754         78         3,832   

Net operating loss carryforwards

     20,964         4,731         25,695         16,312         2,729         19,041   

Convertible senior note and note hedge OID

     618                 618         1,333                 1,333   

AMT credits

     6,575         508         7,083         197                 197   

Fair value of interest rate swap

     3,155                 3,155         2,584                 2,584   

Bad debt reserves

     1,943         22         1,965         1,346         21         1,367   

Deferred rent

     1,905                 1,905         74                 74   

Merger Option, SPS Transaction Right and Acquisition Right

     3,710                 3,710                           

Other

     1,489         993         2,482         423         1,071         1,494   

 

 

Total gross deferred tax assets

     147,164         13,944         161,108         126,224         12,729         138,953   

Less: valuation allowance

     1,896          4,726         6,622         1,896          5,065         6,961   

 

 

Total deferred tax assets

     145,268         9,218         154,486         124,328         7,664         131,992   

 

 

Deferred tax liabilities:

                 

Deferred acquisition costs net of deferred ceding commission revenue

     59,387         3,864         63,251         54,947         4,034         58,981   

Depreciation and amortization

     44,919         2,357         47,276         41,058         789         41,847   

Net unrealized appreciation of securities and deferred intercompany gains

     47,303         5,791         53,094         36,085         4,003         40,088   

Accrual of bond discount

     5,034                 5,034         5,537                 5,537   

Surplus notes

     1,800         17,024         18,824         1,080         17,744         18,824   

Unconsolidated affiliate

     3,471                 3,471                           

Other

                                               

 

 

Total deferred tax liabilities

     161,914         29,036         190,950         138,707         26,570         165,277   

 

 

Net deferred income tax asset (liability)

   $ (16,646)       $ (19,818)       $ (36,464)       $ (14,379)       $ (18,906)       $ (33,285)   

 

 

In assessing the valuation of deferred tax assets, the Company considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible.

Preserver Group, Inc. (“PGI”), acquired by the Company in 2007 and CastlePoint , acquired in 2009, have net operating tax loss carryforwards (“NOLs”). Section 382 of the Internal Revenue Code (“Section 382”) limits ability of a corporation to offset income using NOLs generated prior to a “change in ownership”. We will perform a Section 382 limitation calculation if require based on the change of ownership resulting from the anticipated merger with Canopius. The Company expects the NOLs will be used in the future, subject to change of ownership limitations pursuant to Section 382. As of December 31, 2012, the Tower NOL totaled $58.0 million related. This included PGI and CastlePoint NOLs as follows: $33.4 million and $7.1 million, respectively. In addition, the Reciprocal Exchanges have NOLs of $13.9 million. Additionally, Tower and the Reciprocal Exchanges have an AMT credit that can be carried over indefinitely.

 

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Table of Contents

Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Section 382 imposes annual limitations on a corporation’s ability to utilize its NOLs if it experiences an “ownership change.” As a result of the acquisitions, PGI and CastlePoint’s NOLs are subject to annual limitations of $2.8 million and $11.1 million, respectively. Any unused annual limitation may be carried over to later years. The NOLs will expire in years 2019 through 2029.

Additionally, Tower and the Reciprocal Exchanges have an AMT credit of $6.5 million and $0.5 million, respectively, that can be carried over indefinitely.

The Company believes it is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax assets, including the NOLs, except for those associated with the Reciprocal Exchanges. The Company has recorded a valuation allowance of $4.7 million and $5.1 million at December 31, 2012 and 2011, respectively, to reflect the amount of the Reciprocal Exchanges’ deferred taxes that may not be realized.

As of December 31, 2012 and 2011, the Company had no material uncertain tax positions and no adjustments to liabilities or operations were required.

The Internal Revenue Service performed an audit of The Company’s 2006 and 2007 tax years and closed these audits in 2011 with no changes. Additionally, in 2011 the IRS performed an audit of CastlePoint and subsidiary’s federal income tax return for the period ended February 2009 and closed this audit with no changes. CastlePoint’s federal excise tax for the 2009 and 2010 tax years were examined by the IRS in 2012. This audit was closed in 2012 with no changes. One of the Reciprocal Exchanges is currently under an IRS excise tax examination for the 2011 tax year. We expect to close this examination in 2013 with no changes.

The provision for Federal income taxes incurred is different from that which would be obtained by applying the Federal income tax rate to net income before taxes. The items causing this difference at the consolidated level are as follows:

 

     Year Ended December 31,  
     2012      2011      2010  
            Reciprocal                    Reciprocal                    Reciprocal         
($ in thousands)    Tower      Exchanges      Total      Tower      Exchanges      Total      Tower      Exchanges      Total  

 

 

Federal income tax expense at

                          

U.S. statutory rate

   $ (18,423)       $ 198       $ (18,225)       $ 28,309       $ 4,820       $ 33,129       $ 55,763       $ (2,519)       $ 53,244   

Tax exempt interest

     (7,374)         (901)         (8,275)         (6,823)         (418)         (7,241)         (4,685)         (193)         (4,878)   

State income taxes net of Federal benefit

     130                 130         488                 488         840                 840   

Acquisition-related transaction costs

     2,261                 2,261         100                 100         655                 655   

Prior period adjustment

     (1,065)         (471)        (1,536)                                                   

Valuation Allowance

             (1,072)         (1,072)                 (1,757)         (1,757)                 1,059         1,059   

Other

     (12)                (3)         (1,114)         537         (577)         1,058         190         1,248   

 

 

Provision for income taxes

   $ (24,483)       $ (2,237)       $ (26,720)       $ 20,960       $ 3,182       $ 24,142       $ 53,631       $ (1,463)       $ 52,168   

 

 

Note 16—Employee Benefit Plans

The Company maintains a defined contribution Employee Pretax Savings Plan (401(k) Plan) for its employees. The Company matches 50% of each participant’s contribution up to 8% of the participant’s eligible contribution. The Company incurred $3.5 million, $3.2 million, and $2.7 million of expense in 2012, 2011 and 2010, respectively, related to the 401(k) Plan.

Supplemental Executive Retirement Plan (“SERP”)

The SERP is a non-qualified defined contribution plan effective as of January 1, 2009 that is intended to enhance retirement benefits for the Company’s most senior executives and certain other key employees. Eligibility to participate in the SERP generally requires three years of prior employment with the Company for Executive Vice Presidents and Senior Vice Presidents and between five and 10 years of prior employment with the Company for other key employees. In 2012, all of the Named Executive Officers, as well as certain other key executives selected at the discretion of the Compensation Committee, participated in the SERP. Subject to the approval of the Compensation Committee, the Company may make annual contributions to the SERP on behalf of each participant. The SERP is not a defined benefit plan and such target benefit level cannot be guaranteed. For all participants, the amount of the annual contribution is presently equal to 5.0% of their annual cash compensation. Company contributions for each participant remain unvested until such participant has completed 10 years of service with the Company, and vest in full upon completion of 10 years of service. The Compensation Committee has discretion to terminate the SERP at any time or to adjust upward or downward the level of the Company’s contribution each year.

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Note 17—Contingencies

Legal Proceedings

On May 28, 2009, Munich Reinsurance America, Inc. (“Munich”) commenced an action against Tower Insurance Company of New York (“TICNY”), a wholly-owned subsidiary of Tower Group, Inc., in the United States District Court for the District of New Jersey seeking, inter alia, to recover $6.1 million under various retrocessional contracts pursuant to which TICNY reinsures Munich. On June 22, 2009, TICNY filed its answer, in which it, inter alia, asserted two separate counterclaims seeking to recover $2.8 million under various reinsurance contracts pursuant to which Munich reinsures TICNY. (A separate action commenced by Munich against TICNY on June 17, 2009 in the United States District Court for the District of New Jersey seeking a declaratory judgment that Munich is entitled to access to TICNY’s books and records pertaining to various quota share agreements, to which TICNY filed its answer on July 7, 2009, was subsequently dismissed pursuant to the stipulation of the parties on March 17, 2010). On July 15, 2011, TICNY paid $3.3 million to Munich to resolve a portion of the dispute. On December 22, 2011, the court granted partial summary judgment with respect to certain of the claims and defenses in the litigation. On March 23, 2012, the Court ruled that Munich was entitled to approximately $168,000 from TICNY in pre-judgment interest on the amount of $3.3 million that TICNY had paid to Munich on July 15, 2011, which was expensed in the first quarter of 2012. Trial was scheduled for October 15, 2012, but during the third quarter of 2012, the parties have reached a settlement of the action for $2.9 million after-tax which is included as a charge in other operating expenses. On October 9, 2012, the Court entered an order dismissing certain claims with prejudice and other claims without prejudice.

On May 12, 2010, Mirabilis Ventures, Inc. (“Mirabilis”) commenced an action against Specialty Underwriters’ Alliance Insurance Co. (“SUA”, now known as CastlePoint National Insurance Company (“CNIC”), a subsidiary of Tower Group, Inc.) and Universal Reinsurance Co., Ltd., an unrelated entity, in the United States District Court for the Middle District of Florida. The Complaint is based upon a Worker’s Compensation/Employer’s Liability policy issued by SUA to AEM, Inc. (“AEM”), to whose legal rights Mirabilis is alleged to have succeeded as a result of the Chapter 11 bankruptcy of AEM. The Complaint, which includes claims against SUA for breach of contract and breach of the duty of good faith, alleges that SUA failed to properly audit AEM’s operations to determine AEM’s worker’s compensation exposure for two policy years, in order to compute the premium owed by AEM, such that SUA owes Mirabilis the principal sum of $3.4 million for one policy year and $0.6 million for the other policy year, plus interest and costs. On July 30, 2010, CNIC answered the Complaint and asserted nine separate counterclaims, to which Mirabilis responded on September 3, 2010. Since that time, Mirabilis has filed an amended complaint that failed to add any defenses against Mirabilis, and CNIC subsequently filed a motion for summary judgment on all of Mirabilis’ claims. On March 15, 2012, Mirabilis and CNIC entered into a settlement agreement and mutual release, pursuant to which Mirabilis agreed to withdraw all of its claims against CNIC and CNIC agreed to withdraw its counterclaims against Mirabilis. Neither party was required to pay any money under the terms of the settlement. On March 20, 2012, the Court ordered dismissal of the case. On March 26, 2012, CNIC filed a stipulation of final order and the case was dismissed with prejudice and terminated.

Leases

The Company has various lease agreements for office space, furniture and equipment. The terms of the office space lease agreements provide for annual rental increases and certain lease incentives including initial free rent periods and cash allowances for leasehold improvements.

The Company amortizes scheduled annual rental increases and lease incentives ratably over the term of the lease. The Company’s future minimum lease payments are as follows:

 

     Operating      Capital         
($ in thousands)    Leases      Leases      Total  

 

 

2013

   $ 9,654      $ 9,466      $ 19,120  

2014

     10,278        11,022        21,300  

2015

     10,167        15,865        26,032  

2016

     9,981        1,533        11,514  

2017

     8,926        1,671        10,597  

Thereafter

     32,904        54        32,958  

 

 
   $ 81,910      $ 39,611      $ 121,521  

 

 

Total rental expense was $9.7 million, $11.1 million and $10.0 million in 2012, 2011 and 2010, respectively.

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Assessments

Tower’s insurance subsidiaries are also 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. The insurance subsidiaries are subject to assessments in New York, Florida, New Jersey, Georgia, California and other states for various purposes, including the provision of funds necessary to fund the operations of the New York Insurance Department and the New York Property/Casualty Insurance Security Fund, which pays covered claims under certain policies provided by impaired, insolvent or failed insurance companies and various funds administered by the New York Workers’ Compensation Board, which pays covered claims under certain policies provided by impaired, insolvent or failed insurance companies.

The Company paid $4.8 million, $5.1 million and $4.8 million in 2012, 2011 and 2010, respectively, for its proportional share of the operating expenses of the New York Insurance Department. Property casualty insurance company insolvencies or failures may result in additional security fund assessments to the Company at some future date. At this time the Company is unable to estimate the possible amounts, if any, of such assessments. Accordingly, the Company is unable to determine the impact, if any; such assessments may have on financial position or results of operations of the Company. The Company is permitted to assess premium surcharges on workers’ compensation policies that are based on statutorily enacted rates. Actual assessments have resulted in differences to the original estimates based on permitted surcharges of $0 million, $1.1 million and $4.1 million in 2012, 2011 and 2010, respectively. The Company estimates its liability for future assessments based on actual written premiums and historical rates and available information. As of December 31, 2012, the liability for the various workers’ compensation funds, which includes amounts assessed on workers’ compensation policies, was $7.5 million. This amount is expected to be paid over an eighteen month period ending June 30, 2013. As of December 31, 2011, the liability for the various workers’ compensation funds was $8.2 million.

Note 18—Statutory Financial Information and Accounting Policies

United States

For regulatory purposes, the Company’s insurance subsidiaries, excluding CastlePoint Reinsurance Company, Ltd. (“CastlePoint Re”) which, as discussed below, is Bermuda domiciled, prepare their statutory basis financial statements in accordance with practices prescribed or permitted by the state they are domiciled in (“statutory basis” or “SAP”). The more significant SAP variances from GAAP are as follows:

 

 

Policy acquisition costs are charged to operations in the year such costs are incurred, rather than being deferred and amortized as premiums are earned over the terms of the policies.

 

 

Ceding commission revenues are earned when ceded premiums are written except for ceding commission revenues in excess of anticipated acquisition costs, which are deferred and amortized as ceded premiums are earned. GAAP requires that all ceding commission revenues be earned as the underlying ceded premiums are earned over the term of the reinsurance agreements.

 

 

Certain assets including certain receivables, a portion of the net deferred tax asset, prepaid expenses and furniture and equipment are not admitted.

 

 

Investments in fixed-maturity securities are valued at NAIC value for statutory financial purposes, which is primarily amortized cost. GAAP requires investments in fixed-maturity securities classified as available for sale, to be reported at fair value.

 

 

Loss and LAE reserves are reported net of ceded reinsurance within the statutory basis financial statements. GAAP requires the reserve and reinsurance amounts to be shown gross.

 

 

For SAP purposes, changes in deferred income taxes relating to temporary differences between net income for financial reporting purposes and taxable income are recognized as a separate component of gains and losses in surplus rather than included in income tax expense or benefit as required under GAAP.

State insurance laws restrict the ability of our insurance subsidiaries to declare dividends. State insurance regulators require insurance companies to maintain specified levels of statutory capital and surplus. Generally, dividends may only be paid out of earned surplus, and the amount of an insurer’s surplus following payment of any dividends must be reasonable in relation to the insurer’s outstanding liabilities and adequate to meet its financial needs. Further, prior approval of the insurance department of its state of domicile is required before any of our insurance subsidiaries can declare and pay an “extraordinary dividend” to the Company.

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

For the years ended December 31, 2012, 2011 and 2010, the Company’s insurance subsidiaries had SAP net income (loss) of $(29.6), $52.0 million and $76.0 million, respectively. At December 31, 2012 and 2011 the Company’s insurance subsidiaries had reported SAP surplus as regards policyholders of $619.9 million and $686.8 million, respectively, as filed with the insurance regulators.

The Company’s insurance subsidiaries paid $14.0 million, $35.0 million and $4.7 million in dividends and or return of capital to Tower in 2012, 2011 and 2010, respectively. As of December 31, 2012, the maximum distribution that Tower’s insurance subsidiaries could pay without prior regulatory approval was $33.5 million and the maximum return of capital available from CastlePoint Re without Bermuda regulatory permission was $43.0 million.

Bermuda

CastlePoint Re is registered as a Class 3 reinsurer under The Insurance Act 1978 (Bermuda), amendments thereto and related regulations (the “Insurance Act”). Under the Insurance Act, CastlePoint Re is required to prepare Statutory Financial Statements and to file a Statutory Financial Return. The Insurance Act also requires CastlePoint Re to maintain minimum share capital and surplus, and it has met these requirements as of December 31, 2012.

CastlePoint Re is also subject to dividend limitations imposed by Bermuda. Under the Companies Act 1981 of Bermuda, as amended (the “Companies Act”), we may declare or pay a dividend out of distributable reserves only if we have reasonable grounds for believing that we are, or would after the payment, be able to pay our liabilities as they become due and if the realizable value of our assets would thereby not be less than the aggregate of our liabilities and issued share capital and share premium accounts.

For the year ended December 31, 2012, CastlePoint Re had statutory net income of $0.9 million and at December 31, 2012, had statutory surplus of $277.0 million.

For Bermuda registered companies, there are some differences between financial statements prepared in accordance with GAAP and those prepared on a statutory basis. Certain assets are non-admitted under Bermuda regulations. Accordingly, for Bermuda statutory reporting, deferred policy acquisition costs have been fully expensed to income and prepaid expenses and fixed assets have been removed from the statutory balance sheet.

Note 19—Fair Value of Financial Instruments

GAAP guidance requires all entities to disclose the fair value of financial instruments, both assets and liabilities recognized and not recognized in the balance sheet, for which it is practicable to estimate fair value. The Company uses the following methods and assumptions in estimating its fair value disclosures for financial instruments:

Fixed maturity and equity securities: Fair value disclosures for investments are included in “Note 7—Fair Value Measurements.”

Other invested assets: The fair value of securities which are reported under the fair value option are included in “Note 7—Fair Value Measurements.

Premiums receivable and reinsurance recoverable: The carrying values reported in the accompanying balance sheets for these financial instruments approximate their fair values.

Debt: Fair value disclosures for debt are included in “Note 13—Debt.” The Company uses a discounted cash flow model to fair value the subordinated debentures. Market quotes are used to fair value the senior convertible notes.

Reinsurance balances payable and funds held under reinsurance contracts: The carrying value reported in the balance sheet for these financial instruments approximates fair value.

Note 20—Earnings (loss) per Share

Undistributed net earnings (loss) (net income less dividends declared during the period) are allocated to both common stock and unvested share-based payment awards (“unvested restricted stock”). Because the common shareholders and unvested restricted

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

stock holders share in dividends on a 1:1 basis, the earnings per share on undistributed earnings is equivalent. Undistributed earnings are allocated to all outstanding share-based payment awards, including those for which the requisite service period is not expected to be rendered.

The following table shows the computation of the earnings per share:

 

     Year Ended December 31,  
(in thousands, except per share amounts)    2012      2011      2010  

 

 

Numerator

        

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

   $ (28,154    $ 60,481      $ 106,356  

 

 

Denominator

        

Weighted average common shares outstanding

     38,795        40,833        43,462  

Effect of dilutive securities:

        

Stock options

     -         94        174  

Other

     -         4        12  

 

 

Weighted average common and potential dilutive shares outstanding

     38,795        40,931        43,648  

 

 

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

        

Common stock:

        

Distributed earnings

   $ 0.75      $ 0.69      $ 0.39  

Undistributed earnings

     (1.48      0.79        2.06  

 

 

Total

     (0.73      1.48        2.45  

 

 

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

   $ (0.73    $ 1.48      $ 2.44  

 

 

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

The computation of diluted earnings (loss) per share excludes outstanding options and other common stock equivalents in periods where inclusion of such potential common stock instruments would be anti-dilutive. For the years ended December 31, 2012, 2011 and 2010, 0, 166,700 and 193,000, respectively, options and other common stock equivalents to purchase Tower shares were excluded from the computation of diluted earnings (loss) per share because the exercise price of the options was greater than the average market price.

Note 21—Segment Information

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

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

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

Business segments results are as follows:

 

     Year Ended December 31,  
($ in thousands)    2012      2011      2010  

 

 

Commercial Insurance Segment

        

Revenues

        

Premiums earned

   $ 1,224,303       $ 1,087,911       $ 941,015   

Ceding commission revenue

     7,702         14,786         33,247   

Policy billing fees

     5,467         4,345         2,742   

 

 

Total revenues

     1,237,472         1,107,042         977,004   

 

 

Expenses

        

Loss and loss adjustment expenses

     902,784         736,474         589,322   

Underwriting expenses

     432,660         361,890         347,497   

 

 

Total expenses

     1,335,444         1,098,364         936,819   

 

 

Underwriting profit (loss)

   $ (97,972    $ 8,678       $ 40,185   

 

 

Personal Insurance Segment

        

Revenues

        

Premiums earned

   $ 497,239       $ 505,939       $ 351,654   

Ceding commission revenue

     24,633         19,182         6,056   

Policy billing fees

     7,148         6,189         3,513   

 

 

Total revenues

     529,020         531,310         361,223   

 

 

Expenses

        

Loss and loss adjustment expenses

     351,076         318,775         194,701   

Underwriting expenses

     238,548         226,836         159,573   

 

 

Total expenses

     589,624         545,611         354,274   

 

 

Underwriting profit (loss)

   $ (60,604    $ (14,301    $ 6,949   

 

 

Tower

   $ (42,060    $ (19,681    $ 16,177   

Reciprocal Exchanges

     (18,544      5,380         (9,228

 

 

Total underwriting profit (loss)

   $ (60,604    $ (14,301    $ 6,949   

 

 

Insurance Services Segment

        

Revenues

        

Management fee income

   $ 30,150       $ 29,303       $ 17,752   

Other revenue

     3,420         1,570         2,171   

 

 

Total revenues

     33,570         30,873         19,923   

 

 

Expenses

        

Direct commission expense paid to producers

        

Other expenses

     23,695         19,331         5,760   

 

 

Total expenses

     23,695         19,331         5,760   

 

 

Insurance services pretax income

   $ 9,875       $ 11,542       $ 14,163   

 

 

 

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Tower Group, Inc.

Notes to Consolidated Financial Statements

 

The following table reconciles revenue by segment to consolidated revenues:

 

     Year Ended December 31,  
($ in thousands)    2012      2011      2010  

 

 

Commercial insurance segment

   $ 1,237,472       $ 1,107,042       $ 977,004   

Personal insurance segment

     529,020         531,310         361,223   

Insurance services segment

     33,570         30,873         19,923   

 

 

Total segment revenues

     1,800,062         1,669,225         1,358,150   

Elimination of management fee income

     (30,150)         (29,303)         (17,754)   

Net investment income

     127,165         126,474         107,265   

Net realized gains (losses) on investments, including other-than-temporary impairments

     25,476         9,394         14,653   

 

 

Consolidated revenues

   $ 1,922,553       $ 1,775,790       $ 1,462,314   

 

 

The following table reconciles the results of the Company’s individual segments to consolidated income before income taxes:

 

     Year Ended December 31,  
($ in thousands)    2012      2011      2010  

 

 

Commercial insurance segment underwriting profit (loss)

   $ (97,972)       $ 8,678       $ 40,185   

Personal insurance segment underwriting profit (loss)

     (60,604)         (14,301)         6,949   

Insurance services segment pretax income

     9,875         11,542         14,163   

Net investment income

     127,165         126,474         107,265   

Net realized gains on investments, including other-than-temporary impairments

     25,476         9,394         14,653   

Corporate expenses

     (11,602)         (11,519)         (4,177)   

Acquisition-related transaction costs

     (9,229)         (360)         (2,369)   

Interest expense

     (32,630)         (34,290)         (24,223)   

Other income (expense)

     (2,534)                 

 

 

Income (loss) before income taxes

   $ (52,055)       $ 95,618       $ 152,446   

 

 

Note 22—Unaudited Quarterly Financial Information

The following table presents the unaudited quarterly financial information for the Company:

 

     2012  
($ in thousands, except per share amounts)    First      Second     Third      Fourth     Total  

 

 

Revenues

   $ 466,223      $ 506,392     $ 474,891      $ 475,047     $ 1,922,553  

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

     19,166        (16,809     21,629        (52,140     (28,154

Net income (loss) per share attributable to Tower stockholders:

            

Basic (1)

   $ 0.49      $ (0.43   $ 0.56      $ (1.36   $ (0.73

Diluted (1)

   $ 0.49      $ (0.43   $ 0.56      $ (1.36   $ (0.73

 

     2011  
     First      Second      Third     Fourth      Total  

 

 

Revenues

   $ 430,719      $ 434,855      $ 455,295     $ 454,921      $ 1,775,790  

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

     26,521        24,407        (15,733     25,286        60,481  

Net income (loss)) per share attributable to Tower stockholders:

             

Basic (1)

   $ 0.63      $ 0.59      $ (0.39   $ 0.64      $ 1.48  

Diluted (1)

   $ 0.63      $ 0.59      $ (0.39   $ 0.64      $ 1.48  

(1) Since the weighted-average shares for the quarters are calculated independently of the weighted-average shares for the year, quarterly earnings per share may not total to annual earnings per share.

 

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Item 9A. Controls and Procedures

(a) Disclosure Controls and Procedures

The Company’s principal executive officer and its principal financial officer, based on their evaluation of the Company’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)), concluded that the Company’s disclosure controls and procedures were effective for the purposes set forth in the definition thereof in Exchange Act Rule 13a-15(e) as of December 31, 2012.

(b) Management’s Report on Internal Control over Financial Reporting

The management of Tower Group, Inc. and its subsidiaries is responsible for establishing and maintaining adequate internal control over financial reporting for Tower as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934.

Our internal control over financial reporting is a process designed by or under the supervision of our principal executive and principal financial officers to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of management and the directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on our financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree or compliance with the policies or procedures may deteriorate.

Management has assessed its internal controls over financial reporting as of December 31, 2012 in relation to criteria for effective internal control over financial reporting described in Internal Control—Integrated Framework Issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment under those criteria, Tower’s management concluded that its internal control over financial reporting was effective as of December 31, 2012.

(c) Attestation report of the Company’s registered public accounting firm

PricewaterhouseCoopers LLP, an independent registered public accounting firm, which audited and reported on the consolidated financial statements contained in this Form 10-K, has issued its written attestation report on the Company’s internal control over financial reporting which appears on page F-2 of this report.

(d) Remediation Steps to Address the Material weakness

Management previously reported a material weakness in the Company’s internal control over financial reporting, related to recording an out of period income tax adjustment arising from the Castlepoint Inc. acquisition, in Amendment No. 1 on Form 10-Q/A for the quarterly period ended March 31, 2012 (filed on January 16, 2013), Amendment No. 1 on Form 10-Q/A for the quarterly period ended June 30, 2012 (filed on January 16, 2013) and most recently in Amendment No. 1 on Form 10-Q/A for the quarterly period ended September 30, 2012 (filed on January 17, 2013). A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis.

The Company made the following changes to its internal controls over financial reporting to remediate the material weakness reported most recently in Amendment No. 1 on Form 10-Q/A for the quarter ended September 30, 2012:

 

  1. The Company formalized its cross-functional communications and holds quarterly meetings to identify transactions that may have a tax impact. Senior management has formalized its role in the oversight of the reporting of deferred taxes on business combinations.

 

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  2. The Company instituted a more rigorous approach to addressing deferred tax accounting matters in business combinations and the related tax impact on purchase price allocation, opening GAAP balance sheet and subsequent adjustments to those items. A more robust analysis process has been implemented which includes the involvement of the Chief Accounting Officer, in consultation with external tax specialists to review the new accounting basis as a result of business combination accounting.

The company completed the documentation and testing of the corrective processes described above and, as of December 31, 2012, has concluded that the steps taken have remediated the material weakness related to accounting for income taxes previously disclosed in Amendment No. 1 to the Company’s 2012 Forms 10-Q/As.

(e) Changes in internal control over financial reporting

Other than the items mentioned above to remediate the material weakness, there were no other changes in the Company’s internal control over financial reporting that occurred during the quarter ended December 31, 2012 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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PART IV

Item 15. Exhibits, Financial Statement Schedules

 

A.      (1)        The financial statements and notes to financial statements are filed as part of this report in “Item 8. Financial Statements and Supplementary Data.”
   (2)    The financial statement schedules are listed in the Index to Consolidated Financial Statement Schedules.
   (3)    The exhibits are listed in the Index to Exhibits

The following entire exhibits are included:

 

Exhibit 21.1    Subsidiaries of Tower Group, Inc.
Exhibit 23.1    Consent of PricewaterhouseCoopers LLP
Exhibit 31.1    Certification of CEO to Section 302(a)
Exhibit 31.2    Certification of CFO to Section 302(a)
Exhibit 32    Certification of CEO and CFO to Section 906

The following exhibits are filed electronically herewith:

 

EX-101    INSTANCE DOCUMENT
EX-101    SCHEMA DOCUMENT
EX-101    CALCULATION LINKBASE DOCUMENT
EX-101    LABELS LINKBASE DOCUMENT
EX-101    PRESENTATION LINKBASE DOCUMENT
EX-101    DEFINITION LINKBASE DOCUMENT

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 

Tower Group, Inc.

  Registrant
Date: March 12, 2013    

  /s/ Michael H. Lee

   

Michael H. Lee

Chairman of the Board,

President and Chief Executive Officer

Pursuant to the requirements of the Securities Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities indicated.

 

Signature    Title    Date

/s/    MICHAEL H. LEE

Michael H. Lee

   Chairman of the Board, President and Chief Executive Officer (Principal Executive Officer)    March 12, 2013

/s/    WILLIAM E. HITSELBERGER

William E. Hitselberger

   Executive Vice President, Chief Financial Officer (Principal Financial Officer, Principal Accounting Officer)    March 12, 2013

/s/    CHARLES A. BRYAN

Charles A. Bryan

  

Director

   March 4, 2013

/s/    WILLIAM W. FOX, JR.

William W. Fox, Jr.

  

Director

   March 4, 2013

/s/    WILLIAM A. ROBBIE

William A. Robbie

  

Director

   March 4, 2013

/s/    STEVEN W. SCHUSTER

Steven W. Schuster

  

Director

   March 4, 2013

/s/    ROBERT S. SMITH

Robert S. Smith

  

Director

   March 4, 2013

/s/    JAN R. VAN GORDER

Jan R. Van Gorder

  

Director

   March 4, 2013

/s/    AUSTIN P. YOUNG, III

Austin P. Young, III

  

Director

   March 4, 2013

 

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Tower Group, Inc.

Index to Financial Statement Schedules

 

Schedules

        Pages
I    Summary of Investments—other than investments in related parties    S-2
II    Condensed Financial Information of the Registrant as of and for the years ended December 31, 2012 and 2011    S-3
III    Supplementary Insurance Information for the years ended December 31, 2012, 2011, and 2010    S-8
IV    Reinsurance for the years ended December 31, 2012, 2011, and 2010    S-9
V    Valuation and Qualifying Accounts for the years ended December 31, 2012, 2011, and 2010    S-10
VI    Supplemental Information Concerning Insurance Operations for the years ended December 31, 2012, 2011, and 2010    S-11

 

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Tower Group, Inc.

Schedule I—Summary of Investments—Other Than Investments in Related Parties

 

     December 31, 2012  
($ in thousands)    Cost      Fair
Value
     Amount
Reflected on
Balance Sheet
 

 

 

Fixed maturities:

        

Available for sale:

        

U.S. Treasury securities and obligations of U.S. Government agencies

   $ 281,964      $ 287,726      $ 287,726  

Corporate securities

     698,012        747,665        747,665  

Mortgage-backed securities

     576,837        624,277        624,277  

Municipal securities

     633,373        686,043        686,043  

 

 

Total fixed maturities

     2,190,186        2,345,711        2,345,711  

Preferred stocks

     31,272        31,521        31,521  

Common stock:

        

Public utilities, industrial and other

     118,076        114,737        114,737  

 

 

Total equities

     149,348        146,258        146,258  

 

 

Short-term investments

     4,749        4,750        4,750  

 

 

Other invested assets

     57,786        57,786        57,786  

 

 

Total investments

   $ 2,402,069      $ 2,554,505      $ 2,554,505  

 

 

 

     December 31, 2011  
($ in thousands)    Cost      Fair
Value
     Amount
Reflected on
Balance Sheet
 

 

 

Fixed maturities:

        

Available for sale:

        

U.S. Treasury securities and obligations of U.S. Government agencies

   $ 268,841      $ 273,332      $ 273,332  

Corporate securities

     750,220        777,723        777,723  

Mortgage-backed securities

     627,859        665,905        665,905  

Municipal securities

     688,192        736,714        736,714  

 

 

Total fixed maturities

     2,335,112        2,453,674        2,453,674  

Preferred stocks

     24,083        23,510        23,510  

Common stock:

        

Public utilities, industrial and other

     68,951        65,835        65,835  

 

 

Total equities

     93,034        89,345        89,345  

 

 

Other invested assets

     44,347        44,347        44,347  

 

 

Total investments

   $ 2,472,493      $ 2,587,366      $ 2,587,366  

 

 

 

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Tower Group, Inc.

Schedule II—Condensed Financial Information of the Registrant

Condensed Balance Sheets

 

     December 31,  
($ in thousands)    2012      2011  

 

 

Assets

     

Fixed-maturity securities, available-for-sale, at fair value (amortized cost of $7,656 and $5,938)

   $ 8,121      $ 5,937  

Equity securities, available-for-sale, at fair value (cost of $0 and $9,649)

     -         9,960  

Other invested assets

     2,045        10,458  

Cash and cash equivalents

     17,130        12,882  

Investment in subsidiaries

     1,282,278        1,271,266  

Investment in unconsolidated affiliate

     70,830        -   

Deferred income taxes

     15,879        2,714  

Investment in statutory business trusts, equity method

     2,664        2,664  

Due from affiliate

     -         1,231  

Other assets

     69,172        46,100  

 

 

Total assets

   $ 1,468,119       $ 1,363,212   

 

 

Liabilities

     

Accounts payable and accrued expenses

   $ 25,622      $ 16,293  

Due to affiliates

     75,823        27,542   

Deferred rent liability

     4,537        5,071  

Federal and state income taxes payable

     0        0   

Debt

     381,301        280,507  

 

 

Total liabilities

     487,283        329,413  

 

 

Stockholders’ equity

     980,836        1,033,799  

 

 

Total liabilities and stockholders’ equity

   $ 1,468,119      $ 1,363,212  

 

 

The condensed financial information should be read in conjunction with the notes to the condensed financial information of the registrant and the consolidated financial statements and the notes thereto.

 

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Tower Group, Inc.

Schedule II—Condensed Financial Information of the Registrant

Condensed Statements of Income

 

     Year Ended December 31,  
($ in thousands)    2012      2011      2010  

 

 

Revenues

        

Net realized gains (losses) on investments

   $ (1,570)       $ (264)       $ 201   

Investment income

     815         1,394         1,000   

Equity in net earnings of subsidiaries

     890         77,727         120,675   

 

 

Total revenues

     135         78,857         121,876   

Expenses

        

Other operating expenses

     11,754         10,067         2,891   

Interest expense

     18,782         17,843         9,685   

 

 

Total expenses

     30,536         27,910         12,576   

Other Income

        

Equity income in unconsolidated affiliate

     (2,534)                 

Gain on investment in acquired unconsolidated affiliate

                    

Acquisition related transaction costs

     (  9,229)         (360)         (2,369)   

 

 

Income before income taxes

     (42,164)         50,587         106,931   

Provision/(benefit) for income taxes

     (14,010)         (9,894)         575   

 

 

Net income

   $ (28,154)       $ 60,481       $ 106,356   

 

 

The condensed financial information should be read in conjunction with the notes to the condensed financial information of the registrant and the consolidated financial statements and the notes thereto.

 

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Tower Group, Inc.

Schedule II—Condensed Financial Information of the Registrant

Condensed Statements of Comprehensive Income

 

     Year Ended December 31,  
($ in thousands)    2012      2011      2010  

 

 

Net income (loss)

   $ (28,154)       $ 60,481       $ 106,356   

Other comprehensive income (loss) before tax, includes Registrant and consolidated entities

        

Gross unrealized investment holding gains (losses) arising during the period

     63,325         50,851         45,912   

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

     (25,475)         (9,394)         (14,653)   

Portion of other-than-temporary impairment losses included in net income

     (286)         (264)         (11,909)   

Cumulative translation adjustment

     1,852                 

Deferred gain (loss) on cash flow hedge

     (2,422)         (10,541)         3,223   

 

 

Other comprehensive income (loss) before tax

     36,994         30,652         22,573   

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

        

Unrealized investment holdings gains (losses) arising during periods

     (22,896)         (9,430)         (14,081)   

Reclassification adjustment for (gains) losses included in net income

     8,917         1,742         4,494   

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

     100         49         3,652   

Cumulative translation adjustment

     (648)                 

Deferred gain (loss) on cash flow hedge

     571         1,955         (988)   

 

 

Other comprehensive income (loss) net of tax

     23,038         24,968         15,650   

Less amount attributable to Reciprocal Exchanges

     2,684         10,194         2,646   

 

 

Comprehensive income (loss)

   $ (7,800)       $ 75,255       $ 119,360   

 

 

The condensed financial information should be read in conjunction with the notes to the condensed financial information of the registrant and the consolidated financial statements and the notes thereto. These condensed statements of comprehensive income were prepared using investments and other financial instruments held by the Registrant and its consolidated entities.

 

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Tower Group, Inc.

Schedule II—Condensed Financial Information of the Registrant

Condensed Statements of Cash Flows

 

     Year Ended December 31,  
($ in thousands)    2012      2011      2010  

 

 

Cash flows provided by (used in) operating activities:

        

Net income

   $ (28,154)       $ 60,481       $ 106,356   

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

        

(Gain) loss on sale of investments

     1,570         264         (201)   

Dividends received from consolidated subsidiaries

     22,954         55,400         12,200   

Equity in undistributed net income of subsidiaries

     (2,928)        (78,235)         (119,293)   

Depreciation and amortization

     4,388         3,362         1,627   

Amortization of debt issuance costs

     2,830         2,635         711   

Amortization of restricted stock

     9,283         10,292         8,694   

Deferred income tax

     (13,165)         (3,836)         6,032   

Excess tax benefits from share-based payment arrangements

     (345)         (162)         1,302   

Change in operating assets and liabilities

        

Change in carrying value of unconsolidated affiliate

     682                    

Investment income receivable

            173         (315)   

Federal and state income tax recoverable

     (18,409)         15,998         (8,817)   

Other assets

     (20,639)         (16,763)         (14,482)   

Accounts payable and accrued expenses

     57,610         6,089         158   

Deferred rent

     (534)         (581)         (380)   

 

 

Net cash flows provided by operations

     15,143         55,117         (6,408)   

Cash flows provided by (used in) investing activities:

        

Investment in unconsolidated affiliate

     (71,512)                   

Acquisition of AequiCap II

                   (12,000)   

Sale or maturity—fixed-maturity securities

     3,947         58,367         65,292   

Purchase—fixed-maturity securities

     (6,117)         (46,848)         (90,200)   

Purchase—equity securities

             (4,224)          

Net change in other invested assets

     8,413          (10,458)          

Sale—equity securities

     8,390         1,304          

 

 

Net cash flows used in investing activities

     (56,879)         (1,859)         (36,908)   

Cash flows provided by (used in) financing activities:

        

Proceeds from credit facility borrowings

     20,000         67,000         56,000   

Repayment of credit facility borrowings

            (17,000)         (56,000)   

Proceeds from convertible senior notes

                   145,634   

Proceeds from intercompany borrowings

     77,968                    

Payment for convertible senior notes hedge

                   (15,300)   

Proceeds from issuance of warrants

                   3,800   

Exercise of stock options and warrants

     (2,263)         373         1,590   

Excess tax benefits from share-based payment arrangements

     345         161         (1,302)   

Treasury stock acquired-net employee share-based compensation

     (4)        (1,834)         (1,750)   

Repurchase of common stock

     (20,987)         (64,572)         (88,034)   

Dividends paid

     (29,075)         (27,894)         (16,551)   

 

 

Net cash flows provided by (used in) financing activities

     45,984          (43,766)         28,087   

 

 

Increase (decrease) in cash and cash equivalents

     4,248          9,492         (15,229)   

Cash and cash equivalents, beginning of year

     12,882         3,390         18,619   

 

 

Cash and cash equivalents, end of year

   $ 17,130       $ 12,882      $ 3,390   

 

 

The condensed financial information should be read in conjunction with the notes to the condensed financial information of the registrant and the consolidated financial statements and the notes thereto.

 

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Tower Group, Inc.

Schedule II – Condensed Financial Information of the Registrant

Notes to Condensed Financial Information

The accompanying condensed financial statements of Tower Group, Inc. (parent company) should be read in conjunction with the consolidated financial statements and notes thereto of Tower Group, Inc.

Note 1 – Debt

The information relating to debt is incorporated by reference from “Note 13 – Debt” in the consolidated financial statements.

Note 2 – Income Taxes

Tower Group, Inc. files a consolidated Federal income tax return. The Reciprocal Exchanges are not included in Tower Group, Inc’s consolidated tax return as it does not have an ownership interest in the Reciprocal Exchanges, and they are not a part of the consolidated tax sharing agreement. The Federal income tax provision represents an allocation under the consolidated tax sharing agreement.

Note 3 – Reclassifications

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

 

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Tower Group, Inc.

Schedule III—Supplementary Insurance Information

 

($ in thousands)    Deferred
Acquisition
Cost, Net of
Deferred
Ceding
Commission
Revenue
    

Gross

Future

Policy
Benefits,
Losses and
Loss
Expenses

     Gross
Unearned
Premiums
     Net
Earned
Premiums
     Benefits,
Losses and
Loss
Expenses
     Amortization
of DAC
    Operating
Expenses
     Net
Premiums
Written
 

 

 

2012

                      

Commercial Insurance

   $ 128,909      $ 1,465,595      $ 594,560       $ 1,224,303      $ 902,784      $ (249,781   $ 184,180      $ 1,225,625  

Personal Insurance

     52,032        429,478        326,299         497,239        351,076        (102,612     127,318        513,757  

 

 

Total

   $ 180,941      $ 1,895,073      $ 920,859       $ 1,721,542      $ 1,253,860      $ (352,393   $ 311,498      $ 1,739,382  

 

 

2011

                      

Commercial Insurance

   $ 120,655      $ 1,218,681      $ 588,436      $ 1,087,911      $ 736,474      $ (242,412   $ 153,277      $ 1,152,299  

Personal Insurance

     48,203        413,432        304,740        505,939        318,775        (103,173     125,866        486,292  

 

 

Total

   $ 168,858      $ 1,632,113      $ 893,176      $ 1,593,850      $ 1,055,249      $ (345,585   $ 279,143      $ 1,638,591  

 

 

2010

                      

Commercial Insurance

   $ 131,966      $ 1,197,065      $ 541,809      $ 941,015      $ 589,322      $ (283,949   $ 155,569      $ 987,260  

Personal Insurance

     32,157        413,356        330,217        351,654        194,701        (41,378     84,501        326,804  

 

 

Total

   $ 164,123      $ 1,610,421      $ 872,026      $ 1,292,669      $ 784,023      $ (325,327   $ 240,070      $ 1,314,064  

 

 

 

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Tower Group , Inc.

Schedule IV—Reinsurance

 

($ in thousands)    Gross
Amount
     Ceded to
Other
Companies
    

Assumed

from Other
Companies

    

Net

Amount

     Percentage
of Amount
Assumed
to Net
 

 

 

Year ended December 31, 2012

              

Premiums

              

Property and casualty insurance

   $ 1,758,804      $ 221,807      $ 184,545      $ 1,721,542        10.7%   

Accident and health insurance

     -         -         -         -         -   

 

 

Total Premiums

   $ 1,758,804      $ 221,807      $ 184,545      $ 1,721,542        10.7%   

 

 

Year ended December 31, 2011

              

Premiums

              

Property and casualty insurance

   $ 1,684,020      $ 195,922      $ 105,752      $ 1,593,850        6.6%   

Accident and health insurance

     -         -         -         -         -   

 

 

Total Premiums

   $ 1,684,020      $ 195,922      $ 105,752      $ 1,593,850        6.6%   

 

 

Year ended December 31, 2010

              

Premiums

              

Property and casualty insurance

   $ 1,429,250      $ 226,970      $ 90,389      $ 1,292,669        7.0%   

Accident and health insurance

     -         -         -         -         -   

 

 

Total Premiums

   $ 1,429,250      $ 226,970      $ 90,389      $ 1,292,669        7.0%   

 

 

 

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Tower Group, Inc.

Schedule V—Valuation and Qualifying Accounts

 

($ in thousands)    Balance,
Beginning
of Period
     Additions      Deletions     Balance,
End of
Period
 

 

 

Year ended December 31, 2012

          

Premiums receivable

   $ 4,383      $ 5,916      $ (4,790   $ 5,509  

Deferred income taxes, net

     6,961        -         (339     6,622  

 

 

Year ended December 31, 2011

          

Premiums receivable

     2,119        5,269        (3,005     4,383  

Deferred income taxes, net

     11,824        -         (4,863     6,961  

 

 

Year ended December 31, 2010

          

Premiums receivable

     1,272        3,735        (2,888     2,119  

Deferred income taxes, net

     1,896         9,928        -        11,824  

 

 

 

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Tower Group, Inc.

Schedule VI—Supplemental Information Concerning Insurance Operations

 

         

 

Reserves

                           

Claims and Claims

Adjustment Expenses

Incurred and Related to

                   
          For Unpaid                                              
          Claims and                                   Prior Year*           Paid Claims        
    Deferred     Claim                       Net           Includes     Amortization     and Claim     Net  
    Acquisition     Adjustment     Discount on     Unearned     Earned     Investment     Current     PXRE     of     Adjustment     Premiums  
$ in thousands)   Cost     Expenses     Reserves     Premium     Premium     Income     Year     Commutation     DAC     Expenses     Written  

 

 

2012

                     

Consolidated Insurance Subsidiaries

  $ 180,941     $ 1,895,073     $ 8,354     $ 920,859     $ 1,721,542     $ (6,059   $ 1,184,510     $ 69,350     $ (352,402   $ 1,167,428     $ 1,739,382  

2011

                     

Consolidated Insurance Subsidiaries

    168,858       1,632,113       3,674       893,176       1,593,850       126,474       1,076,045       (20,796     (345,585     1,070,539       1,638,591  

2010

                     

Consolidated Insurance Subsidiaries

    164,123       1,610,421       3,674       872,026       1,292,669       107,265       796,313       (12,290     (325,327     740,722       1,314,064  

 

 

 

S-11