10-K 1 d692054d10k.htm FORM 10-K Form 10-K
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

þ   

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

EXCHANGE ACT OF 1934

   For the fiscal year ended December 31, 2013 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: 001-35834

Tower Group International, Ltd.

(Exact name of registrant as specified in its charter)

 

Bermuda     N/A

(State or other jurisdiction of incorporation

or organization)

   

 

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

Bermuda Commercial Bank Building
19 Par-la-Ville Road
Hamilton, HM 11
    N/A
(Address of principal executive offices)     (Zip Code)

 

     (441) 279-6610     
   (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, $0.0l 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 ¨ No þ

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 ¨ No þ

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 ¨ Smaller reporting company ¨

(Do not check if a 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 Tower Group International, Ltd’s common stock held by non-affiliates on June 30, 2013 (based on the closing price on the NASDAQ Global Select Market on such date) was $1,107,799,000.

As of April 30, 2014, the registrant had 57,305,726 shares of common stock outstanding.

As of such date, Tower Group International, Ltd. was not a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.


Table of Contents

TABLE OF CONTENTS

 

PART I     
Item 1.  

Business

     1   
Item 1A.  

Risk Factors

     28   
Item 1B.  

Unresolved Staff Comments

     52   
Item 2.  

Properties

     52   
Item 3.  

Legal Proceedings

     52   
Item 4.  

Mine Safety Disclosure

     54   
PART II        54   
Item 5.  

Market For Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities

     54   
Item 6.  

Selected Consolidated Financial Information

     57   
Item 7.  

Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

     58   
Item 7A.  

Quantitative And Qualitative Disclosures About Market Risk

     103   
Item 8.  

Financial Statements And Supplementary Data

     F-1   
Item 9.  

Changes In And Disagreements With Accountants On Accounting And Financial Disclosure

     175   
Item 9A.  

Controls And Procedures

     175   
Item 9B.  

Other Information

     177   
PART III        177   
Item 10.  

Directors And Executive Officers Of The Registrant

     177   
Item 11.  

Executive Compensation

     186   
Item 12.  

Security Ownership Of Certain Beneficial Owners And Management And Related Shareholder Matters

     206   
Item 13.  

Certain Relationships And Related Transactions, And Director Independence

     207   
Item 14.  

Principal Accountant Fees And Services

     209   
PART IV        210   
Item 15.  

Exhibits, Financial Statement Schedules

     210   


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Item 1. Business

Overview

The Annual Report on Form 10-K is being filed by Tower Group International, Ltd. (“TGIL”) on behalf of and as successor to Tower Group, Inc. (“TGI”). TGIL is deemed to be the successor to TGI pursuant to Rule 12g-3(a) under the Exchange Act. On March 13, 2013, TGI completed a merger transaction with TGIL, formerly known as Canopius Holdings Bermuda Limited (“Canopius Bermuda”). Canopius Bermuda was re-named Tower Group International, Ltd. and became the ultimate parent company (the “Canopius Merger Transaction”). TGIL is the successor issuer to TGI, succeeding to the attributes of TGI as registrant, including TGI’s SEC file number. TGIL’s Common Shares (as defined below) trade on the same exchange, the NASDAQ Global Select Market, and under the same trading symbol, “TWGP,” that the shares of TGI common stock traded on and under prior to the Canopius Merger Transaction.

As used in this Form 10-K, unless the context requires otherwise, references to “Tower”, the “Company”, “we”, “us”, or “our” (i) with respect to any period, event or occurrence prior to March 13, 2013, are to Tower Group, Inc. and (ii) with respect to any subsequent period, event or occurrence, are to Tower Group International, Ltd., and, in each case, include the Company’s insurance subsidiaries, managing general agencies and management companies. Tower is also the attorney-in-fact (“AIF”) for 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 have an ownership interest in the Reciprocal Exchanges but is required to consolidate their results for financial reporting purposes. A full listing of the subsidiaries of Tower is included as Exhibit 21.1 to this Form 10-K.

Through the Company’s insurance subsidiaries, Tower offers a range of general commercial, specialty commercial and personal property and casualty insurance products and services to businesses in various industries and to individuals throughout the United States. We provide these products on both an admitted and an excess and surplus (“E&S”) lines basis. Insurance companies writing on an admitted basis are licensed by the states in which they sell policies and are required to offer policies using premium rates and forms that are filed with state insurance regulators. Non-admitted carriers writing in the E&S market are not bound by most of the rate and form regulations imposed on standard market companies, allowing them the flexibility to change the coverage offered and the rate charged without the time constraints and financial costs associated with the filing process.

Proposed Merger with ACP Re

On January 3, 2014, Tower entered into an Agreement and Plan of Merger (“ACP Re Merger Agreement”) with ACP Re Ltd. (“ACP Re”), and a wholly-owned subsidiary of ACP Re (“Merger Sub”), pursuant to which, subject to the satisfaction or waiver of the conditions therein, Merger Sub would merge with and into Tower, with Tower as the surviving corporation in the merger and a wholly owned subsidiary of ACP Re. The transaction would close in the summer of 2014, subject to the satisfaction or waiver of the closing conditions contained in the ACP Re Merger Agreement. ACP Re is a Bermuda based reinsurance company. The controlling shareholder of ACP Re is a trust established by the founder of AmTrust Financial Services, Inc. (“AmTrust”), National General Holdings Corporation (“NGHC”) and Maiden Holdings, Ltd. Notwithstanding any other statement in this Form 10-K or any other document, many of the conditions for closing the ACP Re Merger Agreement remain outstanding and there can be no assurance that they will be satisfied or that the transaction will be consummated or when it may close.

Pursuant to the terms of the ACP Re Merger Agreement, at the effective time of the merger, each outstanding share of Tower’s common stock, par value $0.01 per share (the “Common Shares”), following the settlement of all outstanding equity awards, will be converted into the right to receive $3.00 in cash, with an aggregate value of approximately $172.1 million.

Each of the parties has made representations and warranties in the ACP Re Merger Agreement. Tower has agreed to certain covenants and agreements, including, among others, (i) to conduct its business in the ordinary course of business, consistent with past practice, during the period between the execution of the ACP Re Merger Agreement and the closing of the merger, (ii) not to solicit alternate transactions, subject to a customary “fiduciary out” provision which allows Tower under certain circumstances to provide information to and participate in discussions with third parties with respect to unsolicited alternative acquisition proposals that Tower’s Board of Directors has determined, in its good faith judgment, is appropriate in furtherance of the best interests of Tower, and (iii) to call and hold a special shareholders’ meeting and recommend adoption of the ACP Re Merger Agreement.

Concurrently with the execution of the ACP Re Merger Agreement, several subsidiaries of Tower have entered into two Cut-Through Reinsurance Agreements, pursuant to which a subsidiary of AmTrust and a subsidiary of NGHC will provide 100% quota share reinsurance and a cut-through endorsement to cover all eligible new and renewal commercial and personal lines business, respectively, and at their option, losses incurred on or after January 1, 2014 on not less than 60% of the in-force business. Tower received confirmation on January 16, 2014 from AmTrust and NGHC that they would exercise such option to reinsure on a cut-through basis losses incurred on or after January 1, 2014 under in-force policies with respect to (1) in the case of

 

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AmTrust, approximately 65.7% of Tower’s unearned premium reserves as of December 31, 2013 with respect to its ongoing commercial lines business, and (2) in the case of NGHC, 100% of Tower’s unearned premium reserves as of December 31, 2013 with respect to its personal lines segment business. Tower will receive a 20% ceding commission from AmTrust or NGHC on all Tower unearned premiums that are subject to the Cut-Through Reinsurance Agreements and a 22% ceding commission on 2014 ceded premiums.

Concurrently with the execution of the ACP Re Merger Agreement, the controlling shareholder of ACP Re has provided to Tower a guarantee for the payment of the merger consideration, effective upon the closing of the merger.

The ACP Re Merger Agreement was unanimously approved by the respective Boards of Directors of ACP Re and Tower, and is conditioned, among other things, on: (i) the approval of Tower’s shareholders, (ii) receipt of governmental approvals, including antitrust and insurance regulatory approvals (on January 30, 2014, the Company was granted early termination of the Hart-Scott-Rodino waiting period, which requires persons contemplating certain mergers or acquisitions to give the Federal Trade Commission and the Assistant Attorney General advanced notice and to wait designated periods before consummation of such plans), (iii) the absence of any law, order or injunction prohibiting the merger, (iv) the accuracy of each party’s representations and warranties (subject to customary materiality qualifiers), and (v) each party’s compliance with its covenants and agreements contained in the ACP Re Merger Agreement. In addition, ACP Re’s obligation to consummate the merger is subject to the non-occurrence of any material adverse effect on Tower, as well as the absence of any insolvency-related event affecting Tower. The transaction is also conditioned on holders of not more than 15% of Tower’s common stock dissenting to the merger.

There is no financing condition to consummation of the transactions contemplated by the ACP Re Merger Agreement.

The ACP Re Merger Agreement provides certain termination rights for each of Tower and ACP Re, and further provides that upon termination of the ACP Re Merger Agreement, under certain circumstances, Tower will be obligated to reimburse ACP Re for certain of its transaction expenses, subject to a cap of $2 million, and to pay ACP Re a termination fee of $8.18 million, net of any transaction expenses it has reimbursed.

Michael H. Lee, the former Chairman, President and Chief Executive Officer of Tower, who beneficially owns approximately 4.2% of the issued and outstanding common stock of Tower as of January 3, 2014, has entered into a support agreement pursuant to which he has agreed to vote his shares in favor of the merger.

Significant Business Developments and Risks and Uncertainties

Loss reserve increase, goodwill and fixed asset impairment and deferred tax valuation allowance

Loss and loss adjustment expenses for the twelve months ended December 31, 2013, recorded in the statement of operations included an increase of $533.0 million, excluding the Reciprocal Exchanges, relating to reserve increases associated with losses from prior accident years. This unfavorable loss development arose primarily from accident years 2008-2012 within the workers’ compensation, commercial multi-peril liability (“CMP”), other liability and commercial auto liability lines of business partially offset by a modest amount of favorable development from more recent years within the short tail property lines of business. The Company performed comprehensive updates to its internal reserve study in response to continued observance in the second, third and fourth quarters of 2013 of higher than expected reported loss development. In conjunction with its comprehensive internal reviews, the Company also retained a consulting actuary to perform an independent reserve study in the fourth quarter of 2013 for lines of business comprising over 98% of the Company’s loss reserves. Since 2010, the Company has changed the mix of business by reducing the amount of program and middle market workers’ compensation and liability business that it underwrites.

The 2013 reserve increase was viewed by the Company as an event or circumstance that required the Company to perform a detailed quantitative analysis of whether its recorded goodwill was impaired. After performing the quantitative analysis in the second quarter of 2013, it was determined that $214.0 million of goodwill, which represents all of the goodwill allocated to the Commercial Insurance reporting unit, was impaired. In the third quarter of 2013, management in its judgment concluded that the remaining $55.5 million of goodwill, all of which was allocated to the Personal Insurance reporting unit, was impaired. In addition, $1.9 million of additional goodwill resulting from the acquisition of marine and energy business in July of 2013 was fully impaired as of September 30, 2013. Additionally, in 2013, the Company impaired $125.8 million of fixed assets. At December 31, 2013, there was no goodwill remaining on the balance sheet. See “Note 7 – Goodwill, Intangible and Fixed Asset Impairments” for additional detail on the goodwill and fixed asset impairments.

As a result of the reserve increase and goodwill and fixed assets impairment charges, the Company’s U.S. based operations have a pre-tax loss for 2013, which results in a three-year cumulative tax loss position on its U.S. subsidiaries. After considering this negative evidence and uncertainty regarding the Company’s ability to generate sufficient future taxable income in the United States, the Company concluded that it should not recognize any net deferred tax assets (comprised principally of net operating loss carryforwards). The Company, therefore, has provided a full valuation allowance against its deferred tax asset at December 31, 2013.

 

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Reinsurance Agreements

In the third quarter of 2013, Tower entered into agreements with three reinsurers, Arch Reinsurance Ltd. (“Arch”), Hannover Re (Ireland) Plc. (“Hannover”) and Southport Re (Cayman), Ltd. (“Southport Re”). These agreements provided for surplus enhancement and improved certain financial leverage ratios, while increasing the Company’s financial flexibility. The agreements with Arch and Hannover each consisted of one reinsurance agreement while the arrangement with Southport Re consists of several agreements. Each of these is described below.

The first agreement was between Tower Insurance Company of New York (“TICNY”), on its behalf and on behalf of each of its pool participants, and Arch. Under this multi-line quota share agreement, TICNY ceded 17.5% on a quota share of certain commercial automobile liability, commercial multi-peril property, commercial multi-peril liability and brokerage other liability (mono line liability) businesses. The agreement covers losses occurring on or after July 1, 2013 for policies in-force as of June 30, 2013 and policies written or renewed from July 1, 2013 to December 31, 2013.

The second agreement was between TICNY, on its behalf and on behalf of each of its pool participants, and Hannover. Under this multi-line quota share agreement, TICNY ceded 14% on a quota share of certain brokerage commercial automobile liability, brokerage commercial multi-peril property, brokerage commercial multi-peril liability, brokerage other liability (mono line liability) and brokerage workers’ compensation businesses. The agreement covers losses occurring on or after July 1, 2013 for policies in-force as of June 30, 2013 and policies written or renewed from July 1, 2013 to December 31, 2013.

The third arrangement with Southport Re consisted of two separate agreements with TICNY, on its behalf and on behalf of each of its pool participants, and a third agreement with Tower Reinsurance, Ltd. (“TRL”). Under the first of the agreements with TICNY, TICNY ceded to Southport Re a 30% quota share of its workers’ compensation and employer’s liability business (the “Southport Quota Share”). The Southport Quota Share covers losses occurring on or after July 1, 2013 for policies in force at June 30, 2013 and policies written or renewed during the term of the agreement and has been accounted for using deposit accounting treatment. Deposit assets of $28.7 million as of December 31, 2013 related to the Southport Quota Share are reflected in Other assets in the consolidated balance sheet. Under the second of these agreements with TICNY, an aggregate excess of loss agreement, Southport Re assumed a portion of the losses incurred by TICNY on its workers’ compensation and employer’s liability business between January 1, 2011 and June 30, 2013, but paid by TICNY on or after June 1, 2013 (the “TICNY/Southport Re ADC”). Finally, TRL, a wholly-owned Bermuda-domiciled reinsurance subsidiary of Tower, also entered into an aggregate excess of loss agreement with Southport Re, in which Southport Re assumed a portion of the losses incurred by TRL on its assumed workers’ compensation and employer’s liability business between January 1, 2011 and June 30, 2013, but paid by TRL on or after June 1, 2013 (the “TRL/Southport Re ADC”, or, collectively, the “Southport Re ADCs”). The Southport Re ADCs were accounted for as retroactive reinsurance.

The reinsurance agreements with Arch and Hannover resulted in ceded premiums earned, ceding commission revenue and ceded loss and loss adjustment expenses of $76.8 million, $22.3 million and $41.1 million, respectively, for the year ended December 31, 2013.

As a result of the announced merger agreement with ACP Re, it was decided that the Southport treaties should be commuted. As a result of a negotiation between the Company and Southport, all of these treaties were commuted effective as of February 19, 2014, with the result of the commutation being that all premiums paid to Southport by the Company were returned to the Company, and all liabilities assumed by Southport were cancelled, and such liabilities became the obligation of the Company. In 2014, the Company will record a gain of approximately $6.4 million resulting from the terminations.

A.M. Best, Fitch and Demotech Downgrade the Company’s Financial Strength and Issuer Credit Ratings

On December 20, 2013, A.M. Best lowered the financial strength ratings of each of Tower’s insurance subsidiaries from “B++” (Good) to “B” (Fair) (the seventh highest of fifteen rating levels), as well as the issuer credit ratings of each of Tower’s insurance subsidiaries from “bbb” to “bb”. Previously, on October 8, 2013, A.M. Best had downgraded the financial strength rating of each of Tower’s insurance subsidiaries to “B++” (Good) and their respective issuer credit ratings to “bbb” from “a-”. In addition, on December 20, 2013 A.M. Best downgraded the issuer credit rating of TGI as well as the debt rating on its $147.7 million 5.00% senior convertible notes due 2014 (the “Notes”) to “b-” from “bb”. On the same date, A.M. Best also downgraded the financial strength rating of CastlePoint Reinsurance Company, Ltd. (Bermuda) to “B” (Fair) from “B++” (Good) and its issuer credit rating to “bb” from “bbb” and downgraded the issuer credit rating of Tower Group International, Ltd. to “b-” from “bb”. TGI and each of its insurance subsidiaries currently are and will continue to be under review with negative implications pending further discussions between A.M. Best and management. In downgrading Tower’s ratings, A.M. Best stated that its actions “consider the magnitude of the charges taken and the material adverse impact on Tower’s risk-adjusted capitalization, financial leverage, liquidity and coverage ratios,” “consider the reduced financial flexibility [of the Company] given [its] delay in earnings, the decline in shareholder confidence and the corresponding decline in share price” and “reflect the potential for further adverse reserve development, increased competitive challenges and due to the ratings downgrade, potential actions taken by third party reinsurers and lenders.” Following the announcement of the ACP Re merger, on January 10, 2014, A.M. Best maintained the under review status of Tower’s financial strength and issuer credit ratings and revised the implications from “negative” to

 

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“developing” for all of these ratings. A.M. Best stated that, “[t]he under review status with developing implications reflects the potential benefits to be garnered from the transaction as well as the potential downside from any additional adverse reserve development and/or any unforeseen events that might transpire up until the close of the transaction…”

On January 2, 2014, Fitch downgraded Tower’s issuer default rating from “B” to “CC” and the insurer strength ratings of its insurance subsidiaries from “BB” to “B”. On October 7, 2013, Fitch downgraded Tower’s issuer default rating to “B” (the sixth highest of 11 such ratings) from “BBB” and the insurer strength ratings of its insurance subsidiaries to “B” (the fifth highest of Fitch Ratings’ nine such ratings) from “A-”. In downgrading such ratings, Fitch stated that it “is concerned that Tower’s competitive position has been materially damaged, negatively impacting the Company’s financial flexibility and ability to write new business” and that “the magnitude of the second quarter charges was large enough to cause several key ratios to fall well outside of previously established ratings downgrade triggers, which resulted in the multi-notch downgrade.” On January 6, 2014, Fitch revised Tower’s rating watch status to “evolving” from “negative” following the ACP Re merger announcement, and stated that “[t]he Evolving Watch reflects that the ratings could go up if the merger closes; however, ratings could be lowered if the merger does not occur and [the Company] is unsuccessful in addressing upcoming debt maturity or if additional reserve deficiencies develop.”

On December 24, 2013, Demotech, Inc. (“Demotech”) announced the withdrawal of its Financial Stability Ratings® (FSRs) assigned to the following insurance subsidiaries: Kodiak Insurance Company, Massachusetts Homeland Insurance Company, Tower Insurance Company of New York and York Insurance Company of Maine. Concurrently, Demotech advised that the FSRs assigned to Adirondack Insurance Exchange, Mountain Valley Indemnity Company, New Jersey Skylands Insurance Association and New Jersey Skylands Insurance Company remain under review.

Previously, on October 7, 2013, Demotech had lowered its rating on TICNY and three other U.S. based insurance subsidiaries (Kodiak Insurance Company, Massachusetts Homeland Insurance Company and York Insurance Company of Maine) from A’ (A prime) to A (A exceptional). In addition, Demotech removed its previous A’ (A prime) rating on six other U.S. based insurance subsidiaries (CastlePoint Florida Insurance Company, CastlePoint Insurance Company, CastlePoint National Insurance Company, Hermitage Insurance Company, North East Insurance Company and Preserver Insurance Company). Demotech also affirmed its A ratings on Adirondack Insurance Exchange, New Jersey Skylands Insurance Association, New Jersey Skylands Insurance Company and Mountain Valley Indemnity Company.

Management expects these rating actions, in combination with other items that have impacted the Company in 2013, to result in a significant decrease in the amount of premiums the insurance subsidiaries are able to write. Direct written premiums were $1,606.2 million for the twelve months ended December 31, 2013. Business written through certain program underwriting agents requires an A.M. Best rating of A- or greater.

Tower’s products include the following lines of business: commercial multiple-peril packages, other liability, workers’ compensation, commercial automobile, fire and allied lines, inland marine, personal package, homeowners, personal automobile and assumed reinsurance. These products are sold, primarily, through retail agencies, wholesale agencies, program underwriting agents, and reinsurance brokerage units. With the exception of the personal automobile insurance written through retail agencies and wholesale agencies, which represented $98.1 million of written premiums (excluding the Reciprocal Exchanges) for the year ended December 31, 2013, management believes the Company will be unable to continue writing the majority of its business following the second A.M. Best rating downgrade on December 20, 2013. The total effect of these ratings actions on the Company’s financial position, results of operations or liquidity is not determinable at this stage.

In January 2014, Tower’s Board of Directors approved Tower’s merger with ACP Re. In light of the adverse ratings actions, concurrent with entering into its merger agreement with ACP Re, Tower entered into cut-through reinsurance treaties with affiliates of ACP Re. As a result of this merger, if it closes, and the execution of the cut-through reinsurance treaties, Tower believes its insurance subsidiaries will retain significant portions of their business. (See “Note 9 - Reinsurance” for a discussion of the cut-through reinsurance treaties).

In addition, one of Tower’s ceding companies requested as a result of contractual provisions that $26.3 million of additional collateral be provided to support the recoverability of their reinsurance receivable from Tower. The $26.3 million was funded in October 2013. Tower’s U.S. based insurance subsidiaries are also required to post collateral for various statutory purposes, and such requests are received from time to time from various regulatory authorities.

Statutory Capital

The Company is required to maintain minimum capital and surplus for each of its insurance subsidiaries.

U.S. based insurance companies are required to maintain capital and surplus above Company Action Level, which is a calculated capital and surplus number using a risk-based formula adopted by the state insurance regulators. The basis for this formula is the National Association of Insurance Commissioners’ (“NAIC’s”) risk-based capital (“RBC”) system and is designed to measure the adequacy of a U.S. regulated insurer’s statutory capital and surplus compared to risks inherent in its business. If an insurance

 

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entity falls into Company Action Level, its management is required to submit a comprehensive financial plan that identifies the conditions that contributed to the financial condition. This plan must contain proposals to correct the financial problems and provide projections of the financial condition, both with and without the proposed corrections. The plan must also outline the key assumptions underlying the projections and identify the quality of, and problems associated with, the underlying business. Depending on the level of actual capital and surplus in comparison to the Company Action Level, the state insurance regulators could increase their regulatory oversight, restrict the placement of new business, or place the company under regulatory control. Bermuda based insurance entities minimum capital and surplus requirements are calculated from a solvency formula prescribed by the Bermuda Monetary Authority (the “BMA”).

Tower has in place several intercompany reinsurance transactions between its U.S. based insurance subsidiaries and its Bermuda based insurance subsidiaries. The U.S. based insurance subsidiaries have historically reinsured on a quota share basis obligations to CastlePoint Reinsurance Company (“CastlePoint Re”), one of its Bermuda based insurance subsidiaries. The 2013 obligations that CastlePoint Re assumes from the U.S. based insurance subsidiaries are then retroceded to TRL, Tower’s other Bermuda based insurance subsidiary. In addition, CastlePoint Re also entered into a loss portfolio transaction with TRL where its reserves associated with the U.S. insurance subsidiary business for underwriting years prior to 2013 were all transferred to TRL. CastlePoint Re is required to collateralize $648.9 million of its assumed reserves in a reinsurance trust for the benefit of TICNY, the lead pool company of the U.S. insurance companies. On February 5, 2014, the BMA approved the transfer of $167.3 million in unencumbered liquid assets from TRL to CastlePoint Re, allowing CastlePoint Re to increase the funding in the reinsurance trust for the benefit of TICNY. The New York State Department of Financial Services (the “NYDFS”) has confirmed this will be acceptable for the purpose of admitted surplus and capital on TICNY’s 2013 statutory basis financial statements. For the 2013 statutory basis financial statements, CastlePoint Re reported $581.7 million in its reinsurance trust.

Based on RBC calculations as of December 31, 2013, six of Tower’s ten U.S. based insurance subsidiaries have capital and surplus below Company Action Level and do not meet the minimum capital and surplus requirements of their respective state regulators. As a result, management has discussed the ACP Re Merger Agreement and the Cut-Through Reinsurance Agreement and provided its 2014 RBC forecasts to the regulators to document the Company’s business plan to bring two of these U.S based insurance subsidiaries’ capital and surplus levels above Company Action Level.

As a result of the recognition of the coding commission relating to the Cut-Through Reinsurance Agreements executed with AmTrust and NGHC in January 2014, the U.S. based insurance subsidiaries’ capital and surplus will increase significantly from December 31, 2013 to January 1, 2014, as the U.S. based subsidiaries will transfer a significant portion of their commercial lines unearned premium to a subsidiary of AmTrust and all of their personal lines unearned premiums to a subsidiary of NGHC. Accordingly, as of January 1, 2014, the effect of the Cut-Through Reinsurance Agreements increased the surplus of two of the U.S. based insurance subsidiaries such that their capital and surplus levels exceeded Company Action Level.

In 2013, the NYDFS issued orders for seven of Tower’s insurance subsidiaries, subjecting them to heightened regulatory oversight, which includes providing the NYDFS with increased information with respect to the insurance subsidiaries’ business, operations and financial condition. In addition, the NYDFS has placed limitations on payments and transactions outside the ordinary course of business and material changes in the insurance subsidiaries’ management and related matters. Tower’s management and Board of Directors have held discussions with the NYDFS, and Tower has been complying with the orders and oversight.

On April 21, 2014, the NYDFS issued additional orders for two of Tower’s insurance subsidiaries instructing them to provide plans to address weaknesses in such insurance subsidiaries’ risk based capital levels as shown in their statutory annual financial statements, and imposing further enhanced reporting and prior approval requirements and limitations on writings of new business. On the same date, the NYDFS issued a letter pertaining to one of Tower’s insurance subsidiaries requiring the submission of a plan to address weaknesses in risk based capital levels.

The Massachusetts Division of Insurance (“MDOI”) and Tower management have agreed to certain restrictions on the operations of Tower’s two Massachusetts domiciled insurance subsidiaries. Tower management has agreed to cause these subsidiaries to provide the MDOI with increased information with respect to their business, operations and financial condition, as well as limitations on payments and transactions outside the ordinary course of business and material changes in their management and related matters.

The Maine Bureau of Insurance entered a Corrective Order imposing certain conditions on Maine domestic insurers York Insurance Company of Maine (“YICM”) and North East Insurance Company (“NEIC”). The Corrective Order imposes increased reporting obligations on YICM and NEIC with respect to business operations and financial condition and imposes restrictions on payments or other transfers of assets from YICM and NEIC outside the ordinary course of business.

On April 11, 2014, the New Jersey Department of Banking and Insurance imposed an enhanced reporting requirement on the intercompany transactions involving Tower’s two New Jersey domiciled insurance subsidiaries and Tower’s New Jersey managed insurer. Such companies are now required to submit for prior approval any transactions with affiliates, even transactions that would otherwise not be reportable under the applicable holding company act.

 

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As of December 31, 2013, TRL and CastlePoint Re had capital and surplus that did not meet the minimum solvency requirements of the BMA. Management has discussed the ACP Re Merger Agreement and provided 2014 solvency forecasts to the BMA.

The BMA has issued directives for TRL and CastlePoint Re, subjecting them to heightened regulatory oversight and requiring BMA approval before certain transactions can be executed. Tower has been complying with the directives issued by the BMA.

Liquidity

TGI was the obligor under the bank credit facility agreement dated as of February 15, 2012, as amended, with Bank of America, N.A. and other lenders named therein and is the obligor under the $150 million Convertible Senior Notes (“Notes”) due September 15, 2014. The indebtedness of TGI is guaranteed by TGIL, and for purposes of the credit facility was also guaranteed by several of TGIL’s non-insurance subsidiaries.

On December 13, 2013, TGI paid in full the $70.0 million outstanding on the bank credit facility and the bank credit facility has been terminated. The $70.0 million was provided, primarily, from the sale of Tower’s 10.7% ownership in Canopius Group Limited (“Canopius Group”) on December 13, 2013.

The Company’s plan to repay the Notes is related to the closing of the ACP Re Merger Agreement. In the event that the ACP Re Merger Agreement does not close, the Company would evaluate a combination of using proceeds from the sale of assets held at TGI, including but not limited to, renewal rights on its commercial and personal lines of business and certain of its insurance companies to pay down the principal of the Notes. The Company can provide no assurance that it will be successful in finalizing the liquidation of the assets held at TGI or selling certain of its operating assets to satisfy repayment of the Notes.

As of December 31, 2013, there were $235.1 million of subordinated debentures outstanding. The subordinated debentures do not have financial covenants that would cause an acceleration of their stated maturities. The earliest stated maturity date is on a $10 million debenture, which matures in May 2033. The Company has the ability to defer interest payments on its subordinated debentures for up to twenty quarters. If an event of default occurs and is continuing, the entire principal and the interest accrued on the affected subordinated indenture may be declared to be due and payable immediately.

The merger with ACP Re is expected to close in the summer of 2014, and there are contractual termination rights available to each of Tower and ACP Re under various circumstances. There can be no assurance that the merger will close, or that it will close under the same terms and conditions contained in the ACP Re Merger Agreement, or as to when it may close.

Resignation of Tower’s Chairman of the Board, President and Chief Executive Officer and Appointment of New Chairman of the Board and New President and Chief Executive Officer

On February 6, 2014, Tower and Michael H. Lee entered into a Separation and Release Agreement in connection with the resignation of Mr. Lee from his positions as Chairman of the Board of Directors, President and Chief Executive Officer, effective as of February 6, 2014. Mr. Lee’s employment with the Company was terminated effective as of February 6, 2014. In connection with his resignation, Mr. Lee received on March 31, 2014 a severance payment of approximately $3.3 million calculated pursuant to terms of his employment agreement.

Jan R. Van Gorder, who is the lead independent director of the Board and a member of the Board’s Audit Committee, Compensation Committee and Corporate Governance and Nominating Committee, was appointed on February 9, 2014 to succeed Mr. Lee as Chairman of the Board. William W. Fox, Jr., who had served as a member of the Board and of the Board’s Audit Committee and Corporate Governance and Nominating Committee until his resignation from the Board on December 31, 2013, succeeded Mr. Lee as President and Chief Executive Officer of Tower effective as of February 14, 2014.

Expense Control Initiative

On November 22, 2013, the Company announced the implementation of an expense control initiative to streamline its operations and focus resources on its most profitable lines of business. As part of this initiative, the Company has implemented a workforce reduction affecting approximately 10% of the total employee population of approximately 1,400. The areas that are most significantly impacted are commercial lines underwriting as well as operations. This workforce reduction is expected to result in annualized cost savings of approximately $21.0 million. The Company currently recognized pre-tax charges of $5.5 million in the fourth quarter of 2013 for severance and other one-time termination benefits and other associated costs.

 

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Other

Tower received a document request from the U.S. Securities and Exchange Commission (the “SEC”) dated January 13, 2014, as part of an informal inquiry (the “SEC Request”). The SEC Request asks for documents related to Tower’s financial statements, accounting policies, and analysis. Tower is cooperating with the SEC’s inquiry and has provided the requested information.

The Company and certain of its current and former senior officers have been named as defendants in several class action lawsuits instituted against them by certain shareholders. In addition, the Company and certain of its current and former directors, along with certain other parties, have been named as defendants in a putative class action lawsuit instituted against them by another purported shareholder. See “Note 17 – Contingences” for additional detail on such litigation.

Business Segments

The Company presents its business results through three business segments: Commercial Insurance, Assumed Reinsurance, and Personal Insurance segments. Each of these segments is described below.

For a summary of the Company’s revenue, expenses and underwriting income by reportable business segment, see “Note 21 – Segment Information” of the notes to the Company’s consolidated financial statements.

Commercial Insurance Segment

Our Commercial Insurance segment offers property and casualty insurance products through several business units that serve customers in general commercial and specialty commercial markets. Using our broad product line offering, we are able to provide a comprehensive product solution to our producers. We provide commercial lines products comprised of commercial package, general liability, workers’ compensation, commercial automobile, fire and allied, inland marine and commercial umbrella policies to businesses across different industries.

These products are underwritten and serviced through our 20 offices and distributed through approximately 995 retail agents, approximately 183 wholesale agents and 13 program underwriting agents. Approximately 73% of the direct premiums written by the Commercial Insurance segment in 2013 were from the northeastern U.S. As of December 31, 2013, the west contributed 15% and the southeast 12% of the Commercial Insurance direct written premiums.

Through our general commercial business units, we offer a broad and diversified range of property and casualty insurance products and services primarily to small to mid-sized businesses throughout the U.S. We classify our business into different pricing and coverage tiers to meet the specific needs of our customers. We offer our products on an admitted basis in the preferred, standard, and non-standard pricing and coverage tiers and on a non-admitted basis using our E&S coverage and pricing tier. For each of the preferred, standard, non-standard and E&S coverage and pricing tiers, we have developed different coverage and underwriting guidelines. The pricing for the preferred risk sector is generally the most competitive, followed by the pricing for the standard, non-standard and E&S lines of business. Underwriting guidelines are stricter for preferred risks in order to justify the lower premium rates charged for these risks with the respective guidelines for standard, non-standard and E&S appropriately structured for their increased risk and exposure to loss. We generally distribute policies for risks with preferred and standard underwriting characteristics through our retail agents and policies for risks with non-standard and E&S underwriting characteristics through our wholesale agents. In addition to categorizing our products into various pricing and coverage tiers, we further classify our products into the following premium size classes: under $25,000 (small), $25,000 to $150,000 (medium) and over $150,000 (large). We currently provide coverage for businesses in the real estate, retail, wholesale and service industries, such as retail and wholesale stores, residential and commercial buildings, restaurants and artisan contractors.

Through our specialty commercial business units, we also offer insurance covering narrowly defined, homogeneous classes of business including Transportation, Professional Employers Organizations, Commercial Construction, Auto Dealerships and Lawyers Professional produced through a select number of program underwriting agents. Our focus in the specialty market is on those classes of business traditionally underserved by standard property and casualty insurers due to the complex business knowledge, awareness of regional market conditions and investment required.

On December 20, 2013, A.M. Best lowered the financial strength ratings of each of Tower’s insurance subsidiaries from “B++” (Good) to “B” (Fair). Previously, on the financial strength ratings of each of Tower’s insurance subsidiaries to “B++”. These downgrades resulted in a decline in direct written premiums in the fourth quarter of 2013 since much of our commercial business requires a higher financial strength rating.

Assumed Reinsurance Segment

Through our Assumed Reinsurance business, we generally provide coverage on a “quota share” basis to our customers, who are other insurance carriers or reinsurers. Under this type of arrangement, we generally receive an agreed upon proportion of premiums written by the insurance carrier, and share in all losses in the same proportion as the premiums received.

 

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On the “whole account” portion of our Lloyd’s business, all of the reinsurance purchased by each syndicate for the Year(s) of Account (“YoA”) on which we participate inures to the benefit of our quota share result, as well. Consequently, we believe that we share a close alignment of interests with our clients on this portion of our business.

Historically, a significant majority of our Assumed Reinsurance business has been collateralized for the benefit of the cedant. As is customary for all whole account quota shares of Lloyd’s syndicates, this collateral consists of Funds at Lloyd’s (“FAL”) with the amount of FAL required determined by formulas established by Lloyd’s Performance Management unit.

Since we established the Assumed Reinsurance unit in 2011, we have also provided quota share support to one fully-collateralized property catastrophe reinsurer. The amount of collateral provided for each underwriting year is an amount sufficient, when added to premiums received for the covers written, to equal the total limits we support for the underwriting year.

The October 8, 2013 announcement of A.M. Best’s downgrade of the financial strength ratings of Tower’s insurance subsidiaries to “B++” did not have a material impact on the 2013 written premiums of the Assumed Reinsurance segment because the majority of its business was collateralized. The termination of the Company’s letter of credit facility (the “LOC Facility”) in November 2013, however, had a significant adverse impact on 2013 Assumed Reinsurance writings as the termination resulted in the commutation or cancellation of reinsurance contracts projected to account for annualized writings exceeding $130 million. In addition, due to the termination of the LOC Facility, the Assumed Reinsurance segment limited its projected 2014 writings to three contracts with premiums of approximately $80 million with the treaty contracts. The ACP Re Merger Agreement, if the merger closes, is likely to further reduce the segment’s 2014 projected writings, as the Company would likely to seek to terminate its relationship with most, if not all, of its reinsured customers at or prior to the conclusion of the merger.

Personal Insurance Segment

We offer a broad range of personal lines products including package, mono line homeowners, mono line automobile insurance, and ancillary personal lines coverage (renters, condo, dwelling fire, scheduled articles, umbrella and boats). Package policies include homeowners and auto and may also include ancillary coverage.

The Personal Insurance segment is designed to fit the insurance needs of most personal lines customers. Our products are distributed through a network of approximately 500 retail agents, wholesale agents, national brokers and other insurance companies. Our customers are concentrated in the northeastern United States with 86% of the premium volume produced by agents in this region, including NY (41%), NJ (15%), and MA (11%). Mono line homeowners in CA make up 8.4% of our premium. Personal lines includes the business written in the Reciprocal Exchanges and Tower stock companies.

For our retail agency business, we offer three levels of coverage under our OneChoice® product including OneChoice Security Plus, Security Plus Elite, and our new Premier product for affluent customers. In addition, customers can also purchase our CustomPac® package product which provides additional policyholder benefits.

Our wholesale mono line homeowners business is primarily written in NY, NJ, and CA. The product for wholesale agents is designed to accommodate customers in underserved markets and provides broad underwriting eligibility and processing simplicity for distributors. We offer standard and non-standard policies through wholesale agents.

On December 20, 2013, A.M. Best lowered Tower’s issuer credit, as well as its financial strength ratings from “B++” (Good) to “B” (Fair). In connection with the ACP Merger Agreement, the Company has executed a Cut-Through Reinsurance Agreement with NGHC for personal lines business. The Company believes an expected reduction in the volume of written premiums in 2014 attributed to the A.M. Best rating downgrade will be somewhat mitigated by the Cut-Through Reinsurance Agreement. As of December 31, 2013, NGHC’s A.M. Best financial strength rating was “A-.”

Our Personal Insurance segment also generates fees from performing various aspects of insurance company functions for the Reciprocal Exchanges. We manage the day-to-day operations of the Reciprocal Exchanges for a management fee. This model allows us to use capital more efficiently and provides the company with a steady flow of fee income.

Products and Services

Our diversified business platform allows us to provide a range of products. Our products include the following:

 

   

Commercial Multiple-peril Packages. Coverage offered under our commercial package and business owners policies combines property, liability (including general liability and products and completed operations), business interruption, equipment breakdown, fidelity and inland marine coverages tailored for commercial businesses and enterprises. Commercial packages and business owners policies are offered by our Commercial Insurance segment.

 

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Other Liability. In our Commercial Insurance and Personal Insurance segments, we write liability policies for individuals and business owners including mono line commercial general liability (generally for risks that do not have property exposure or whose property exposure is insured elsewhere) and commercial umbrella policies. Also, in our Commercial Insurance segment, we write General Liability policies for businesses in programs that are tailored to narrowly defined industry classes.

 

   

Workers’ Compensation. In our Commercial Insurance segment, we write workers’ compensation policies, which are a statutory coverage requirement in almost every state to protect employees in case of injury on the job, and the employers from liability for an accident involving an employee. We write workers’ compensation policies generally for small and medium-sized businesses as well as in programs targeted to specific industry classes.

 

   

Commercial Automobile. In our Commercial Insurance segment, we write coverage for automobiles by providing automobile liability, physical damage insurance including commercial and personal automobile policies for both fleet and non-fleet risks (our personal automobile business is described in the bullet below). We write commercial automobile policies that focus on business automobiles and small trucks for businesses other than transportation companies as well as for trucking businesses and other specialty transportation businesses.

 

   

Fire and Allied Lines and Inland Marine. We write fire and allied lines policies for individuals and businesses. Individual dwelling policies generally include personal property with optional liability coverage that provides an alternative to the homeowners policy for the personal lines customer. Commercial fire and allied lines policies provide protection for damage to commercial buildings and their contents, and these policies may be utilized in selected circumstances as an alternative to a commercial package policy. We write inland marine insurance protection for the property of businesses that is not at a fixed location, for items of personal property that are easily transportable, and for properties that are under construction. Coverages offered typically include builders risk, contractors’ equipment and installation, domestic transit and transportation, fine arts, property floaters and leased property. These products are offered by our Commercial Insurance and Personal Insurance segments through their respective distribution systems.

Gross premiums written by product line for the years ended December 31, 2013, 2012 and 2011 are as follows:

 

     Year ended December 31,  
($ in millions)    2013      2012      2011  

Tower

        

Commercial multiple-peril

   $ 331.4      $ 352.1      $ 365.8  

Commercial other liability

     93.2        117.9        194.6  

Workers’ compensation

     318.1        419.1        359.0  

Commercial automobile

     157.6        193.1        179.7  

Homeowners and umbrella

     335.0        335.6        266.9  

Fire and allied lines and inland marine

     70.8        64.7        48.7  

Personal automobile

     98.1        125.2        113.7  

Assumed Reinsurance

     100.5        148.0        73.2  

Total Tower

     1,504.7        1,755.7        1,601.6  

Reciprocals

        

Fire and allied lines and inland marine

     13.9        14.2        31.2  

Homeowners and umbrella

     97.8         90.1        86.7  

Personal automobile

     111.3        111.1        91.4  

Total Reciprocals

     223.0        215.4        209.3  

Consolidated totals

   $       1,727.7      $       1,971.1      $       1,810.9  

Organizational Structure

Our organizational structure is divided into three strategic centers: a corporate center, a service center and a profit center. The corporate center functions are performed from our headquarters located in New York and are comprised of Corporate Legal and Audit, Corporate Marketing and Communications, Finance, Human Resources and Corporate Administration, and Actuarial and Risk Management. The service center functions encompass Operations, Technology and Claims and Legal Defense. The profit center functions include the three business centers: Underwriting, Distribution and Operations.

 

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In 2010, we established East and West zones to provide business development, underwriting, policyholders services and claims functions to the Commercial Insurance and Personal Insurance segments. The East zone is comprised of New England, the Mid-Atlantic and Southeast regions. The West zone includes our West, Southwest and Midwest regions. The following table shows the states that comprise each of our zones and regions:

 

East Zone

New England Region

  

Mid-Atlantic Region

  

Southeast Region

Connecticut    New Hampshire    Delaware    New Jersey    Alabama    North Carolina
Maine    Rhode Island    District of Columbia    New York    Florida    South Carolina
Massachusetts    Vermont    Maryland    Pennsylvania    Georgia    Tennessee
            Mississippi    Virginia
               West Virginia

West Zone

Midwest Region

  

Southwest Region

  

West Region

Illinois    Minnesota    Arkansas    New Mexico    Alaska    Idaho
Indiana    Missouri    Colorado    Oklahoma    Arizona    Montana
Iowa    North Dakota    Kansas    Texas    California    Nevada
Kentucky    Ohio    Louisiana    Utah    Hawaii    Oregon
Michigan    South Dakota    Nebraska    Wyoming       Washington
   Wisconsin            

The East zone is headquartered in New York and has ten branches. The West zone is headquartered in Irvine, California, and has four branches. Claims processing functions are located in New York, New Jersey, Maine, Massachusetts, Illinois, California, Texas and Florida, and service both the East and West zones. In addition, we have five legal defense offices located in the East zone.

Our Assumed premiums were produced from our Bermuda platform, which was developed with the merger with Canopius Holdings Bermuda Limited in March 2013.

The following table shows the direct premiums written by region, premiums assumed and gross premiums written for the years ended December 31, 2013, 2012 and 2011:

 

     Year Ended December 31,  
($ in millions)    2013      Percent     2012      Percent     2011      Percent  

East zone direct premiums written

               

New England

   $ 229.2        13.3   $ 228.0        11.6   $ 217.8        12.0

Mid-Atlantic

     860.2         49.8     917.9        46.6     905.0        50.0

Southeast

     142.0        8.2     138.1        7.0     135.8        7.5

West zone direct premiums written

               

Midwest

     33.5        1.9     39.4        2.0     45.8        2.5

Southwest

     82.6        4.8     85.3        4.3     37.7        2.1

West

     258.4        15.0     346.5        17.5     349.9        19.3

Assumed premiums

     121.8         7.0     215.9        11.0     118.9        6.6

Total gross premiums written

   $       1,727.7            100.0   $       1,971.1            100.0   $       1,810.9            100.0

Distribution

We generate business through independent retail, wholesale and program underwriting agents (collectively, our “producers”). These producers sell policies for us as well as for other insurance companies. We select our producers by evaluating several factors such as their need for our products, premium production potential, loss history with other insurance companies that they represent, product and market knowledge, and the size of the agency. We generally appoint producers with a total annual insurance premium volume greater than $10 million and we expect a new producer to be able to produce at least $500,000 in annual premiums for us during the first year and $1 million or more in annual premiums after three years. We select our program underwriting agents based upon their underwriting expertise in specific niche markets, type of business, size and profitability of the existing book of business.

Commission expense in 2013 and 2012 averaged 18.1% and 18.7% (excluding the Reciprocal Exchanges) of gross premiums earned, respectively. Our commission schedules are 1 to 2.5 points higher for wholesalers as compared to retail agents. Our

 

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commissions are also higher for program underwriting agents that perform additional underwriting and processing services on our behalf, including premium collection, policy issuance and data collection and from other insurance companies and Lloyd’s syndicates from which we have been assuming business. In our Commercial Insurance segment we also have a profit sharing plan that added 1/2 of 1 percent to overall commission based on the loss ratio performance of qualifying agencies. In our Personal Insurance segment, we have a profit sharing plan that added 3/4 of 1 percent to overall commission rates in the past several years.

We attempt to position ourselves as our producers’ primary provider within the product segments that we offer. We manage the results of our producers through periodic reviews to monitor premium volume and profitability. We have access to online premium and loss ratio reports by producer, and we estimate each producer’s profitability at least annually using actuarial techniques. We continuously monitor the performance of our producers by assessing leading indicators and metrics that signal the need for corrective action. Corrective action may include increased frequency of producer meetings and more detailed business planning. If loss ratio issues arise, we increase the monitoring of individual risks and consider reducing that producer’s binding authority. Review and enforcement of the agency agreement requirements can be used to address inadequate adherence to administrative duties and responsibilities. Noncompliance can lead to reduction of authority and potential termination.

In 2013, 42.0% of the Company’s total business (exclusive of assumed reinsurance) was generated by retail agents, 38.5% by wholesalers and 19.5% by program underwriting agents.

Our largest producers (exclusive of assumed reinsurance brokers) in 2013 were Northeast Agencies, Risk Transfer and Morstan General Agency. In the year ended December 31, 2013, these producers accounted for 8.6%, 5.2%, and 4.2%, respectively, of the total of our gross premiums written. No other producer was responsible for more than 3% of our gross premiums written. Approximately 45% of the 2013 gross premiums written in the Commercial Insurance segment were produced by our top 19 active producers representing 2% of our active retail and wholesale producers. These producers each have annual written premiums of $5 million or more.

The number of agencies and program underwriting agents from which we receive business is shown in the following table:

 

     December 31,  
     2013      2012      2011  

Retail Agencies

     995        1,017        1,128  

Wholesale Agencies

     183        220        221  

Program Underwriting Agents

     13        15        8  

Total

     1,191        1,252        1,357  

Underwriting

Our underwriting strategy is to seek diversification in our products and an appropriate business mix for any given year that will emphasize profitable business and de-emphasize business that is not meeting profit targets. At the beginning of each year, we establish target premium levels and loss ratios for each line of business, which we monitor throughout the year on a regular basis. If any line of business fails to meet its target loss ratio, a cross-functional team comprised of personnel from segment underwriting, corporate underwriting, actuarial, claims and loss control will generally meet to develop corrective action plans that may involve revising underwriting guidelines, non-renewing unprofitable segments or entire lines of business and/or implementing rate increases. During the period of time that a corrective action plan is being implemented with respect to any product line that fails to meet its target loss ratio, premium for that product line is reduced or maintained depending upon its effect on our total loss ratio. To offset the reduction or lack of growth in premium volume for the products that are undergoing corrective action, we seek to expand our premium writings in existing profitable business or add new business with better underwriting profit potential.

For lines of business other than workers’ compensation, we generally use actuarial loss costs developed by the Insurance Services Office (ISO), a company providing statistical, actuarial and underwriting and claims information and related services to insurers, as a benchmark in the development of pricing for our products. For workers’ compensation policies, we use loss costs or rates developed by the National Council on Compensation Insurance, Inc. (NCCI) or state-administered rates or loss costs. We further tailor pricing to each specific product we underwrite, taking into account our historical loss experience and individual risk and coverage characteristics. This may result in proprietary rates and forms for select classes and territories.

Commercial Insurance business

With respect to the business written on a direct basis through our Commercial Insurance segment, we establish underwriting guidelines for all the products that we underwrite to ensure a uniform approach to risk selection, pricing and risk evaluation among our underwriters and to achieve underwriting profitability. The rules and guidelines may be customized for a particular region to recognize territorial differences. Our underwriting process involves securing an adequate level of underwriting

 

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information from our producers, inspections and surveys to identify and evaluate risk exposures, which provides information necessary for pricing the risks we choose to accept. For certain approved classes of commercial risks, we allow our producers to initially bind these risks utilizing rating criteria that we provide to them. Our web-based platforms, webPlus® (“webPlus”) and Preserver Online, provide our producers with the capability to submit and receive quotes over the Internet and contain our risk selection and pricing logic, thereby enabling us to streamline our initial submission and screening process. If the individual risk does not meet the initial submission and screening parameters contained within webPlus or Preserver Online, the risk is automatically referred to an assigned underwriter for specific offline review.

New business is subject to post-bind inspection and is evaluated based on size, hazard and territory. These inspections generally take place within 60 days from the effective date of the policy, and are generally reviewed by underwriting within that period. If the inspection reveals that the risk insured under the policy does not meet our established underwriting guidelines, the policy is typically cancelled. If the inspection reveals that the risk meets our established underwriting guidelines but the policy was bound with incorrect rating information, the policy is amended through an endorsement based upon the correct information. We supplement the inspection by using online data sources to further evaluate the building value, claim experience, financial history and catastrophe exposures of the insured. In addition, we specifically tailor coverage to match the insured’s exposure and premium requirements. We complete internal file reviews and audits on a monthly, quarterly and annual basis to confirm that underwriting standards and pricing programs are being consistently followed. Our property risks are generally comprised of residential buildings, retail stores and restaurants covered under policies with low building and content limits. We underwrite potential risks to limit our exposure to terrorism losses. Our underwriting guidelines are designed to avoid properties designated as, or in close proximity to, high profile or target risks, individual buildings over 25 stories and any site within 500 feet of major transportation centers, bridges, tunnels and other governmental or institutional buildings. In addition, we monitor the concentration of employees insured under our workers’ compensation policies and avoid writing risks with more than 100 employees in any location at a given time. Please see “Risk Factors-Risks Related to Our Business.” We may face substantial exposure to losses from terrorism, and we are currently required by law to offer coverage against such losses.

We underwrite our products through our underwriting business units that are each headed by an underwriting manager. These underwriting units are supported by professionals in the corporate underwriting, actuarial, operations, business development and loss control departments. The corporate underwriting department is responsible for managing and analyzing the profitability of our entire book of business, supporting segment underwriting with technical assistance, developing underwriting guidelines, granting underwriting authority, training, developing new products and monitoring underwriting quality control through audits. The underwriting operations department is responsible for developing workflows, conducting operational audits and providing technical assistance to the underwriting teams. The loss control department manages the inspection and risk improvement process on commercial and personal lines business written, utilizing in-house loss control representatives and outside vendors. The business development department works with the underwriting teams to manage relationships with our producers.

The underwriting process utilized for the Commercial Insurance segment’s program business is based on our understanding of best industry practices. We consider the appropriateness of delegating authority to the Program Underwriting Agent by evaluating the quality of its management, risk management strategy and track record. In addition, we require each program that we underwrite to include significant information regarding the nature of the perils to be included and detailed aggregate information pertaining to the location(s) of the risks covered. We obtain available information on the client’s loss history for the perils being insured or reinsured, together with relevant underwriting considerations. In conjunction with testing each proposed program against our underwriting criteria, our underwriters evaluate the proposal in terms of its risk/reward profile to assess the adequacy of the proposed pricing and its potential impact on our overall return on capital and corporate risk objectives. Our underwriting process integrates the actuarial, finance, operations, information technology, claims, legal and underwriting disciplines. We utilize our in-house actuarial staff as well as outside consultants, as necessary. The actuarial and underwriting estimates that we develop in our pricing analyses are explicitly tracked by program on a continuous basis through our underwriting audit and actuarial reserving processes. We require significant amounts of data from our clients and only accept business for which the data provided to us is sufficient for us to make an appropriate analysis. We may supplement the data provided to us by our clients with information from the ISO, the NCCI, other advisory rate-making associations and other organizations that provide projected loss cost data to their members.

Assumed Reinsurance business

Our Assumed Reinsurance business is predicated on the concepts of underwriting control and alignment of interests between the Company and its clients. In practice, this means that we have consciously limited our book of business to a small number of reinsurance contracts written in support of carefully selected clients. For 2013, we supported nine clients versus seven in 2012. It also means that virtually all of our business has been written on a quota share basis, where the principal incentive for the underwriters we support is the potential for reinsurance profit commissions rather than the existence of substantial reinsurance commission overrides unrelated to underwriting performance.

A majority of our Assumed Reinsurance business has been derived from supporting leading syndicates at Lloyd’s of London. For 2013, Lloyd’s syndicates comprised six of our nine clients. We divide this book into two groups: (1) pure property catastrophe quota shares, where the only line we support is property catastrophe business; and (2) syndicate whole account quota shares where we, like the syndicates we are reinsuring, benefit from all of the reinsurance purchased by the syndicate to protect the given Year of Account.

 

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Due to the benefit from the inuring reinsurance, syndicate ‘whole account’ business is measurably less volatile than pure property catastrophe quota share business. As a consequence of this reduced volatility, underwriting margins on ‘whole account’ business are attractive, although typically lower, but a greater amount of this business can be written while maintaining prudent levels of probable maximum loss (“PML”) across a range of modeled catastrophic events.

The remainder of our business not derived from Lloyd’s consisted of reinsurance of U.S. or Bermuda insurers or reinsurers, one of which was also a property catastrophe quota share cover.

The October 8, 2013 announcement of A.M. Best’s downgrade of the financial strength ratings of Tower’s insurance subsidiaries to “B++” did not have a material impact on the 2013 written premiums of the Assumed Reinsurance segment because the majority of its business was collateralized. The termination of the Company’s LOC Facility in November 2013, however, had a significant adverse impact on 2013 Assumed Reinsurance writings as the termination resulted in the commutation or cancellation of reinsurance contracts projected to account for annualized writings exceeding $130 million. In addition, due to the termination of the LOC Facility, the Assumed Reinsurance segment limited its projected 2014 writings to three contracts with premiums of approximately $80 million. The ACP Re Merger Agreement is likely to further reduce the segment’s 2014 projected writings, as the Company would likely seek to terminate its relationship with most, if not all, of its reinsured customers at or prior to the conclusion of the merger, if it closes.

Personal Insurance business

Our broad range of personal lines products are developed using multivariate rating plans, allowing us to calculate adequate prices for a broad range of customers. We invest in external data and services to insure our business is correctly classified for rating and underwriting including motor vehicle reports, household driver reports, CLUE reports, credit reports, protection class, brush underwriting, property inspections, and catastrophe modeling.

We use sophisticated techniques to monitor catastrophe exposures. We underwrite and price each new business application using exposure-level average annual loss estimates, reinsurance costs, and capital costs. If a new business policy does not allow us to achieve our target returns, the business is declined by our underwriting platform. As we expand to new states, our portfolio of homeowner exposures will be priced and underwritten to cover reinsurance and capital costs and to achieve our accumulation targets.

We have made a significant investment to modernize our personal lines technology platform, Advantage Policy Processing System (“APPS”), which includes policy administration, billing, claims, and data warehouse systems. With our new APPS technology platform, we are able to reduce costs by eliminating legacy systems and related service agreements, improving distributor engagement through broader functionality and more efficient transactions and providing real-time quote and policy issuance. This real-time underwriting platform validates and integrates data from external sources, determines eligibility, develops final rate, provides agency and policyholder documentation, and provides the agency with a once-and-done transaction.

We offer different products, coverage levels, underwriting eligibility, and rating plans through varying company structures depending on the state, distribution channel, and customer segment we are serving.

As Attorney-in-Fact (“AIF”) for the Reciprocal Exchanges, we work with the Reciprocal Exchanges to expand their business. Growing our business through our management agreement with the Reciprocal Exchanges offers us significant advantages. First, income from premium written in the Reciprocal Exchanges will generate management fees (rather than underwriting income). This management fee income is more predictable year-to-year versus underwriting income. Second, because we can operate at higher premium to surplus ratios in the Reciprocal Exchanges, our target combined ratio can be higher in the Reciprocal Exchanges resulting in more competitive rates. Finally, placing homeowners business in Reciprocal Exchanges leverages our partnerships with reinsurers who have benefited from our consistent track record of underwriting income from the homeowners business in the Reciprocal Exchanges.

Claims Management

We manage the claims function through our regional claims offices throughout the U.S. On a limited basis, we also utilize third party administrators who specialize in handling certain types of claims, generally for our program business.

Our claims adjusters are assigned to cases based upon their expertise for various types of claims, and we monitor the results of the adjusters handling the claims using peer reviews and claim file audits. We monitor claims adjusting performed by third-party administrators similarly to how we monitor claims adjusting conducted by our own personnel. We maintain databases of the claims experience of each of our products, territories and programs results, and our claims managers work with our underwriters and actuaries to assess results and trends.

 

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We establish case loss reserves for each claim based upon our judgment of all of the facts available at the time to record our best estimate of the ultimate loss exposure for each claim. For third-party claims, we also establish reserves on a case-by-case basis for estimated defense and cost containment expenses, sometimes referred to as allocated loss adjustment expense reserves.

Competition

The insurance industry is highly competitive. Each year we attempt to assess and project market conditions when we develop prices for our products, but we cannot fully know our results until all claims have been reported and settled.

We compete with many insurance companies in each segment in which we write business, and we compete within our producers’ offices to write the types of business that we desire. Many of our competitors have more, and in some cases substantially more, capital and greater marketing and management resources than we have, and some of our competitors have greater name and brand recognition than we have, especially outside of the northeastern United States where we have more experience.

Competition in the types of business that we underwrite and intend to underwrite is based on many factors, including:

 

 

reputation;

 

 

multiple solution capability;

 

 

strength of client and distribution relationships;

 

 

perceived financial strength and financial ratings assigned by independent rating agencies;

 

 

management’s experience in the product, territory, or program;

 

 

premiums charged and other terms and conditions offered;

 

 

services provided, products offered and scope of business, both by size and geographic location; and

 

 

claims handling.

Increased competition could result in fewer applications for coverage, lower premium rates and less favorable policy terms, which could adversely affect us. We are unable to predict the extent to which new, proposed or potential initiatives may affect the demand for our products or the risks that may be available for us to consider underwriting.

Within our admitted commercial and personal lines business, we compete with major U.S. insurers and certain underwriting syndicates, including large national companies such as Travelers Companies, Inc., Hartford, CNA, Liberty Mutual, AIG, Allstate Insurance Company, GEICO, Progressive Corporation and State Farm Insurance; regional insurers such as Philadelphia Insurance Companies, Selective Insurance Company, Erie and Hanover Insurance and smaller, more local competitors such as Greater New York Mutual, Magna Carta Companies, MMG Insurance Company, Arbella, Quincy Mutual Fire Insurance Company and Utica First Insurance Company. Our non-admitted binding authority and submit business with general agents competes with Scottsdale Insurance Company, Navigators Group, Inc., Essex Insurance Company, Colony Insurance Company, Century Insurance Group, RLI Corp., United States Liability Insurance Group, Burlington Insurance Group, Inc., W.R. Berkley Corporation, Western World and Lloyds. In our program business, we compete against companies that write program business such as QBE Insurance Group Limited, Am Trust Financial Services, Inc., RLI Corp., W.R. Berkley Corporation, Markel Corporation and Great American Insurance Group.

Loss and Loss Adjustment Expense Reserves

We are required to establish reserves for incurred losses that are unpaid, including reserves for claims and loss adjustment expenses, which represent the expenses of settling and adjusting those claims. These reserves are balance sheet liabilities representing estimates of future amounts required to pay losses and loss expenses for insured and/or reinsured claims that have occurred at or before the balance sheet date, whether already known to us or not yet reported. Our policy is to establish these losses and loss reserves after considering all information known to us as of the date they are recorded.

Loss reserves fall into two categories: case reserves for reported losses and loss expenses associated with a specific reported insured claim, and reserves for incurred but not reported (“IBNR”) losses and loss adjustment expenses. We establish these two categories of loss reserves as follows:

 

 

Reserves for reported losses - When a claim is received from an insured, broker or ceding company, or claimant we establish a case reserve for the estimated amount of its ultimate settlement and its estimated loss expenses. We establish

 

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case reserves based upon the known facts about each claim at the time the claim is reported and may subsequently increase or reduce the case reserves as our claims department deems necessary based upon the development of additional facts about the claim.

 

 

IBNR reserves - We also estimate and establish reserves for loss and loss adjustment expense (“LAE”) amounts incurred but not yet reported, including expected development of reported claims. IBNR reserves are calculated as ultimate losses and LAE less reported losses and LAE. Ultimate losses are projected by using generally accepted actuarial techniques.

Loss reserves represent our best estimate, at a given point in time, of the unpaid ultimate settlement and administration cost of claims incurred. For workers’ compensation, our reserves are discounted for claims that are settled or expected to be settled as long-term annuity payments, and as of December 31, 2013 the total amount of this discount was $7.2 million on a gross of reinsurance basis and $5.5 million on a net of reinsurance basis, which relates to $244.3 million in total net reserves for workers’ compensation. To estimate loss reserves, we utilize information from our pricing analyses, actuarial analysis of claims experience by product and segment, and relevant insurance industry information such as loss settlement patterns for the type of business being reserved.

Since the process of estimating loss reserves requires significant judgment about a number of variables, such as fluctuations in inflation, judicial trends and changes in claims handling procedures, our ultimate liability may exceed or be less than these estimates. We revise reserves for losses and loss expenses as additional information becomes available and reflect adjustments, if any, in earnings in the periods in which they are determined.

We engaged independent external actuarial specialists to provide evaluations of a substantial majority of the unpaid loss and loss adjustment expense reserves. These analyses were conducted quarterly beginning with the June 30, 2013 evaluation.

A reconciliation of loss and LAE reserves from the beginning of the year to the end of the year for the three years ended December 31, 2013, 2012 and 2011 is included in the footnotes to the financial statements included in this Form 10-K.

Loss and Loss Adjustment Expenses / Reserve Development

Our claims reserving practices are designed to set reserves that in the aggregate are adequate to pay all claims at their ultimate settlement value. Shown below is the loss reserve development for business written each year from 2003 through 2013. The table portrays the changes in our loss and LAE reserves in subsequent years from the prior loss estimates based on experience as of the end of each succeeding year.

The first line of the table shows, for the years indicated, our net reserve liability including the reserve for incurred but not reported losses as originally estimated. For example, as of December 31, 2003 we estimated that $24.4 million would be a sufficient reserve to settle all claims not already settled that had occurred prior to December 31, 2003 whether reported or unreported to us. The next section of the table shows, by year, the cumulative amounts of losses and loss adjustment expenses paid as of the end of each succeeding year. For example, with respect to the net losses and loss expense reserve of $24.4 million as of December 31, 2003, by December 31, 2013 (ten years later) $30.3 million had actually been paid in settlement of the claims (including the impact of reinsurance commutations).

The next section of the table sets forth the re-estimations in later years of incurred losses, including payments, for the years indicated. For example, as reflected in that section of the table, the original reserve of $24.4 million was re-estimated to be $34.5 million at December 31, 2013. The increase from the original estimate is caused by a combination of factors, including: (1) claims being settled for amounts different than originally estimated, (2) reserves being increased or decreased for claims remaining open as more information becomes known about those individual claims, (3) more or fewer claims being reported after December 31, 2003 than anticipated and (4) the impact of commuting existing reinsurance coverage.

The “cumulative redundancy/ (deficiency)” represents, as of December 31, 2013, the difference between the latest re-estimated liability and the reserves as originally estimated. A redundancy means the original estimate was higher than the current estimate; a deficiency means that the current estimate is higher than the original estimate. For example, as of December 31, 2013 and based upon updated information, we re-estimated that the reserves which were established as of December 31, 2012 had a $538.1 million deficiency as compared to the original net liability estimated at December 31, 2012.

 

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The bottom part of the table shows the impact of reinsurance reconciling the net reserves shown in the upper portion of the table to gross reserves.

 

      Year ended December 31,  
($ in millions)    2003     2004     2005     2006      2007      2008     2009     2010     2011     2012     2013  

Original Net Liability

     24.4       36.9       101.7       192.5        311.7        312.8       932.3       1,333.4       1,339.9       1,436.2       1,510.4  

Cumulative payments as of:

                        

One year later

     7.5       10.9       13.7       49.5        102.4        111.4       415.6       674.2       637.3       729.1    

Two years later

     11.9       4.5       36.7       90.9        163.8        178.4       492.6       868.2       1,081.4      

Three years later

     2.9       16.8       60.6       120.0        205.7        210.1       769.6       1,140.2        

Four years later

     11.7       30.2       73.9       137.7        229.1        262.3       902.0          

Five years later

     17.8       34.9       82.1       144.9        258.2        304.6            

Six years later

     20.8       39.1       87.2       158.5        276.2               

Seven years later

     24.4       39.5       95.3       162.5                  

Eight years later

     24.9       41.8       95.7                    

Nine years later

     30.0       41.3                      

Ten years later

     30.3                        

Net liability re-estimated as of:

                        

One year later

     24.2       36.6       101.0       191.1        303.9        312.5       943.0       1,333.5       1,419.2       1,974.3    

Two years later

     24.8       40.7       101.5       178.3        288.1        326.0       983.3       1,325.8       1,860.2      

Three years later

     29.0       48.3       99.5       171.4        293.0        347.5       980.1       1,556.3        

Four years later

     36.2       45.3       96.6       173.4        303.5        333.8       1,107.4          

Five years later

     33.6       40.2       97.9       176.0        296.9        359.8            

Six years later

     27.9       41.6       102.6       173.4        308.4               

Seven years later

     29.8       43.6       103.0       177.9                  

Eight years later

     31.9       44.8       104.9                    

Nine years later

     33.0       46.8                      

Ten years later

     34.5                        

Cumulative Net redundancy/ (deficiency)

     (10.1     (9.9     (3.2     14.6        3.3        (47.0     (175.1     (222.9     (520.3     (538.1  

Reinsurance Commutations

                        

Cumulative net redundancy/ (deficiency) excluding

     10.3       10.2       10.3       -         -         -        -        -        -        -     

Reinsurance Commutations

     0.2       0.4       7.1       14.6        3.3        (47.0     (175.1     (222.9     (520.3     (538.1  

Net reserves

     24.4       36.9       101.7       192.5        311.7        312.8       932.3       1,333.4       1,339.9       1,436.2       1,510.4  

Ceded reserves

     75.1       91.8       97.0       110.0        189.5        222.2       199.7       277.0       292.2       459.5       570.9  

Gross reserves

     99.5       128.7       198.7       302.5        501.2        535.0       1,132.0       1,610.4       1,632.1       1,895.7       2,081.3  

Net re-estimated

     34.5       46.8       104.9       177.9        308.4        359.8       1,107.4       1,556.3       1,860.2       1,974.3    

Ceded re-estimated

     69.1       83.6       83.2       89.2        162.0        204.5       84.6       112.5       (87.9     612.8    

Gross re-estimated

     103.6       130.4       188.1       267.1        470.4        564.3       1,192.0       1,668.8       1,772.3       2,587.1    

Cumulative gross redundancy/ (deficiency)

     (4.1     (1.7     10.6       35.4        30.8        (29.3     (60.0     (58.4     (140.2     (691.4  

 

(1) The cumulative payments, net liabilities and net deficiencies are affected by commutations. We commuted several reinsurance treaties in 2002. These commutations had the effect of lowering the cumulative payments by $10.3 million in 2003, $10.2 million in 2004 and $10.3 million in 2005.
(2) The net reserve increases reflected in the above table for 2008 to 2012 resulted primarily from reserve increase in the workers’ compensation, commercial multi-peril liability, other liability, and auto liability lines partially offset by a modest amount of favorable development in the property lines. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion.
(3) Reciprocal Exchanges net reserves of $83.4 million and $91.9 million are included in the ending reserves at December 31, 2012 and 2013, respectively.

 

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Analysis of Reserves

The following table shows our estimated net outstanding case loss reserves and IBNR for loss and LAE by line of business as of December 31, 2013 and 2012:

 

     2013      2012  
($ in millions)    Case Loss
Reserves
     IBNR      Total      Case Loss
Reserves
     IBNR      Total  

Tower

                 

Commercial multiple-peril

   $ 202.5      $ 198.8      $ 401.3      $ 210.4      $ 139.3      $ 349.7  

Commercial other liability

     156.4        181.9        338.3        134.3        84.7        219.0  

Workers’ compensation

     63.9        180.4        244.3        228.8        165.1        393.9  

Commercial automobile

     137.9        149.8        287.7        114.7        102.8        217.5  

Fire and allied lines

     7.9        11.0        18.9        16.2        1.1        17.3  

Homeowners and umbrella

     34.6        27.1        61.7        38.8        38.5        77.3  

Personal automobile

     45.5        20.8        66.3        54.3        23.8        78.1  

Total Tower

     648.7        769.8        1,418.5        797.5        555.3        1,352.8  

Reciprocal Exchanges

                 

Fire and allied lines

     0.3        0.9        1.2        1.4        2.0        3.4  

Homeowners and umbrella(1)

     10.6        9.3        19.9        2.5        6.2        8.7  

Personal automobile

     44.3        26.5        70.8        49.7        21.6        71.3  

Total Reciprocal Exchanges

     55.2        36.7        91.9        53.6        29.8        83.4  

Consolidated total, all lines

   $       703.9      $       806.5      $       1,510.4      $       851.1      $       585.1      $       1,436.2  

 

(1) The Reciprocal Exchanges 2012 Fire and Allied lines reserves include reserves related to Other Liability/Umbrella which in 2013 is included in Homeowners and Umbrella.

In 2013, we recognized a reserve increase in our net losses from prior accident years of $538.1 million, comprised of $533.0 million of reserve increases excluding the reciprocals and $5.1 million of reserve increases in the Reciprocal Exchanges. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion.

We monitor our gross, ceded and net loss reserves by segment and line of business to ensure that they are adequate, since a deficiency in reserves may result in or indicate inadequate pricing on our products and may impact our financial condition.

The following table shows the net loss and LAE ratios by line of business for the years ended December 31, 2013, 2012 and 2011:

 

     2013     2012     2011  
      Tower     Reciprocal
Exchanges
    Total     Tower     Reciprocal
Exchanges
    Total     Tower     Reciprocal
Exchanges
    Total  

Commercial multiple-peril

     126.8     n/a        126.8     70.1     n/a        70.1     64.6     n/a        64.6

Commercial other liability

     112.8     n/a        115.8     45.8     n/a        45.8     63.2     n/a        63.2

Workers’ compensation

     108.9     n/a        108.9     82.4     n/a        82.4     74.4     n/a        74.4

Commercial automobile

     151.4     n/a        151.4     86.5     n/a        86.5     71.9     n/a        71.9

Fire and allied lines

     31.9     38.1     32.7     76.1     -14.8     71.4     78.6     34.2     76.0

Homeowners and umbrella(1)

     50.5     58.8     49.6     69.9     57.6     67.8     65.0     64.8     65.0

Personal automobile

     82.6     80.6     81.6     78.5     77.9     78.2     62.7     52.6     58.2

All lines

     103.9     71.3     100.5     74.1     66.7     73.4     69.1     55.8     67.6

 

(1) The Reciprocal Exchanges 2012 Fire and Allied lines reserves include reserves related to Other Liability/Umbrella which in 2013 is included in Homeowners and Umbrella.

2012 and 2011 Fire and Allied lines and Homeowners and Umbrella ratios are not comparable to 2013 ratios for the Reciprocal Exchanges.

Our actuaries utilize standard methods common in the insurance industry to project losses and corresponding reserves, which predominantly consist of loss ratio projections, loss development methods and the Bornhuetter-Ferguson (“B-F”) method. Our actuaries also discuss and review their analyses with our underwriting and claims management, so that cross functional input is considered in the loss and LAE analyses. Based upon these inputs and methods, our actuaries determine a best estimate of the loss and LAE reserves. Loss development factors are derived from our data, as well as in some cases from claims experience obtained from other carriers or based upon industry experience, and the loss development factors are utilized in each of the actuarial methods. The loss ratio projection method applies loss development factors to older accident years and projects the loss ratio to the most recent periods based upon trend factors for inflation and pricing changes. Generally, the loss ratio projection method is given the most weight for the recent accident year when there is high volatility in the development patterns, since this

 

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method gives little or no weight to immature claims experience that may be unrepresentative of ultimate loss activity. The B-F method combines the loss ratio method and the loss development method to determine loss reserves by adding an expected development (loss ratio times premium times percent unreported) to the reported reserves, and is generally given less weight as each accident year matures. The loss development methods utilize reported paid and incurred claims experience and loss development factors, and these methods are given increasing weight as each accident year matures.

The table below shows the range of the reserve estimates by line of business. The ranges were derived based upon the use of alternative actuarial methods for each line of business, which we believe reflects reasonably likely outcomes, although even further variation could result based upon other changes in loss development patterns, variation in expected loss ratios or variation from external impacts that might affect claims payouts. We believe the results of the range analysis, which are summarized in the table below, constitute a reasonable range of expected outcomes of our reserves for net loss and LAE at December 31, 2013:

 

     Range of Reserve Estimates  
($ in millions)    High      Low      Carried  

Tower

        

Commercial multiple-peril

   $ 482.3      $ 320.3      $ 401.3  

Commercial other liability

     395.0        256.1        338.3  

Workers’ compensation

     310.3        174.2        244.3  

Commercial automobile

     338.4        226.0        287.7  

Fire and allied lines

     27.5        15.6        18.9  

Homeowners and umbrella

     83.1        41.5        61.7  

Personal automobile

     74.1        52.6        66.3  

Total Tower

   $ 1,710.7      $ 1,086.3      $ 1,418.5  

Reciprocal Exchanges

        

Fire and allied lines

     1.4        1.1        1.2  

Homeowners and umbrella

     22.1        17.7        19.9  

Personal automobile

     78.5        63.0        70.8  

Workers’ compensation

     -         -         -   

Total Reciprocal Exchanges

     102.0        81.8        91.9  

Consolidated total

   $       1,812.7      $       1,168.1      $       1,510.4  

If the Company had recorded reserves at the high end of the range, net reserves would have increased by $302.3 million, or 20.0%, which is greater than the Company’s consolidated shareholders’ equity as of December 31, 2013. If the Company had recorded reserves at the low end of the range, net reserves would have decreased by $342.2 million, or 22.7%.

While our reserves are set based upon our current best estimates, there are no assurances that future loss development and trends will be consistent with our past loss development history or those estimates, and so the reserve increase will remain a risk factor to our business. See “Risk Factors—Risks Related to Our Business—If our actual loss and LAE exceed our loss and LAE reserves, our financial condition and results of operations could be significantly adversely affected.” See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies—Loss and Loss Adjustment Expense Reserves.”

Investments

Our investment policy and guidelines specify minimum criteria for overall credit quality of our investment portfolio and include limitations on the size of particular holdings, as well as restrictions on investments in different asset classes. We utilize several independent investment advisors to effect investment transactions and provide investment advice. We also have retained and may retain other investment advisors to manage or advise us regarding portions of our overall investment portfolio.

The Company’s investment strategy is intended to manage investment risk based on the organization’s ability to accept such risk. The investment strategy is intended to:

 

 

Maintain adequate liquidity and capital to meet the organization’s responsibility to policyholders;

 

 

Provide a consistent level of income to support the Company’s profitability and contribute to the growth of capital;

 

 

Seek to grow the value of assets over time, thereby increasing the Company’s capital strength; and

 

 

Mitigate investment risk, including managing duration, credit quality, market and currency risk and issuer and industry concentrations.

 

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We monitor the quality of investments, duration, sector mix, and actual and expected investment returns. Investment decision-making is guided by general economic conditions as well as management’s forecast of our cash flows, including the nature and timing of our expected liability payouts and the possibility that we may have unexpected cash demands, for example, to satisfy claims due to catastrophic losses. We expect our investment portfolio will continue to consist mainly of highly rated and liquid fixed-income securities; however, we may invest a portion of our funds in other asset types including common equity investments, real estate, preferred securities, partnerships, hedge funds, other pooled investments and non-investment grade bonds.

Our investment guidelines require compliance with applicable government regulations and laws. Without the approval of our board of directors, we cannot purchase financial futures, options or other derivatives. We expect the majority of our investment holdings to continue to be denominated in U.S. dollars.

Regulatory Matters

Our insurance subsidiaries are subject to extensive governmental regulation and supervision in the U.S., and our Bermuda based subsidiaries are subject to governmental regulation in Bermuda. Most insurance regulations are designed to protect the interests of policyholders rather than shareholders and other investors. These regulations, generally administered by a department of insurance in each jurisdiction relate to, among other things:

 

 

approval of policy forms and premium rates for our primary insurance operations;

 

 

standards of solvency, including risk-based capital measurements;

 

 

licensing of insurers and their agents;

 

 

restrictions on the nature, quality and concentration of investments;

 

 

restrictions on the ability to pay dividends to us;

 

 

restrictions on transactions between insurance company subsidiaries and their affiliates;

 

 

restrictions on the size of risks insurable under a single policy;

 

 

requiring deposits for the benefit of policyholders;

 

 

requiring certain methods of accounting;

 

 

periodic examinations of our operations and finances;

 

 

establishment of trust funds for the protection of policyholders;

 

 

prescribing the form and content of records of financial condition required to be filed; and

 

 

requiring reserves for unearned premium, losses and other purposes.

Our insurance subsidiaries also are subject to state laws and regulations that require diversification of investment portfolios and that limit types of permitted investments and the amount of investments in certain investment categories. Failure to comply with these laws and regulations may cause non-conforming investments to be treated as non-admitted assets for purposes of measuring statutory capital and surplus and, in some instances, would require divestiture.

Insurance departments also conduct periodic examinations of the affairs of insurance companies and require the filing of annual and other reports relating to financial condition, holding company issues and other matters.

In addition, regulatory authorities have relatively broad discretion to deny or revoke insurance licenses for various reasons, including the violation of regulations. We base some of our practices on our interpretations of regulations or practices that we believe are generally followed by the industry. These practices may turn out to be different from the interpretations of regulatory authorities. If we do not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, insurance regulatory authorities could preclude or temporarily suspend us from carrying on some or all of our activities or otherwise penalize us. This could adversely affect us. Further, changes in the level of regulation of the insurance or reinsurance industry or changes in laws or regulations themselves or interpretations by regulatory authorities could adversely affect us.

In 2013, the NYDFS issued orders for seven of Tower’s insurance subsidiaries, subjecting them to heightened regulatory oversight, which includes providing the NYDFS with increased information with respect to the insurance subsidiaries’ business, operations and financial condition. In addition, the NYDFS has placed limitations on payments and transactions outside the

 

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ordinary course of business and material changes in the insurance subsidiaries’ management and related matters. Tower’s management and Board of Directors have held discussions with the NYDFS, and Tower has been complying with the orders and oversight.

On April 21, 2014, the NYDFS issued additional orders for two of Tower’s insurance subsidiaries instructing them to provide plans to address weaknesses in such insurance subsidiaries’ risk based capital levels as shown in their statutory annual financial statements, and imposing further enhanced reporting and prior approval requirements and limitations on writings of new business. On the same date, the NYDFS issued a letter pertaining to one of Tower’s insurance subsidiaries requiring the submission of a plan to address weaknesses in risk based capital levels.

The Massachusetts Division of Insurance (“MDOI”) and Tower management have agreed to certain restrictions on the operations of Tower’s two Massachusetts domiciled insurance subsidiaries. Tower management has agreed to cause these subsidiaries to provide the MDOI with increased information with respect to their business, operations and financial condition, as well as limitations on payments and transactions outside the ordinary course of business and material changes in their management and related matters.

The Maine Bureau of Insurance entered a Corrective Order imposing certain conditions on Maine domestic insurers York Insurance Company of Maine (“YICM”) and North East Insurance Company (“NEIC”). The Corrective Order imposes increased reporting obligations on YICM and NEIC with respect to business operations and financial condition and imposes restrictions on payments or other transfers of assets from YICM and NEIC outside the ordinary course of business.

On April 11, 2014, the New Jersey Department of Banking and Insurance imposed an enhanced reporting requirement on the intercompany transactions involving Tower’s two New Jersey domiciled insurance subsidiaries and Tower’s New Jersey managed insurer. Such companies are now required to submit for prior approval any transactions with affiliates, even transactions that would otherwise not be reportable under the applicable holding company act.

As of December 31, 2013, TRL and CastlePoint Re had capital and surplus that did not meet the minimum solvency requirements of the BMA. Management has discussed the ACP Re Merger Agreement and provided 2014 solvency forecasts to the BMA.

The BMA has issued directives for TRL and CastlePoint Re, subjecting them to heightened regulatory oversight and requiring BMA approval before certain transactions can be executed. Tower has been complying with the directives issued by the BMA.

Regulation

U.S. Insurance Holding Company Regulation of Tower

Tower, as the parent of the insurance subsidiaries and parent of the managers of the managed insurers, is subject to the insurance holding company laws of New York, Florida, Illinois, Maine, Massachusetts, New Hampshire and New Jersey, the domestic jurisdictions of the insurance subsidiaries and the managed insurers, and California, in which two of such insurance subsidiaries are considered to be commercially domiciled under the laws of that state. These laws generally require the insurance subsidiaries and managed insurers to register with their respective domiciliary state Insurance Department (“Insurance Department”) and to furnish annually financial and other information about the operations of companies within the holding company system. Generally under these laws, all material transactions among companies in the holding company system to which an insurance subsidiary or a managed insurer is a party, including sales, loans, reinsurance agreements and service agreements, must be fair and reasonable and, if material or of a specified category, require prior notice and approval or non-disapproval by the Insurance Department.

Changes of Control

Before a person can acquire control of an insurance subsidiary or a managed insurer, prior written approval must be obtained from the Superintendent or the Commissioner of the Insurance Department (“Superintendent”) of the insurance subsidiary’s or managed insurer’s domestic jurisdiction or jurisdiction of commercial domicile. Prior to granting approval of an application to acquire control of an insurer, the Superintendent considers such factors as: the financial strength of the applicant, the integrity and management of the applicant’s Board of Directors and executive officers, the acquirer’s plans for the future operations of the domestic insurer and any anti-competitive results that may arise from the consummation of the acquisition of control. Pursuant to insurance holding company laws, “control” means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of the company, whether through the ownership of voting securities, by contract (except a commercial contract for goods or non-management services) or otherwise. Control is presumed to exist if any person, directly or indirectly, owns, controls or holds with the power to vote a certain threshold percentage of the voting securities of the company. In the domestic jurisdictions of all the managed insurers and all but one of the insurance subsidiaries, the threshold percentage of voting securities that triggers a presumption of control is 10% or more. In Florida, the threshold percentage that triggers a presumption of control is 5% of the voting securities. The Insurance Department, after notice and a hearing, may determine that a

 

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person or entity which, directly or indirectly, owns, controls or holds with the power to vote less than the threshold percentage of the voting securities of the company, or with respect to the managed insurers, the management companies, “controls” the company. Because a person acquiring 10% or more of our common stock would indirectly control the same percentage of the stock of the insurance subsidiaries or the membership interests of the management companies, the insurance company change of control laws of New York, California, Illinois, New Jersey, New Hampshire, Maine and Massachusetts would likely apply to such a transaction. The insurance company change of control laws of Florida would likely apply to an acquisition of 5% or more of our voting stock.

Insurance Regulatory Information System Ratios

The Insurance Regulatory Information System (“IRIS”) was developed by the NAIC and is intended primarily to assist state Insurance Departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. IRIS identifies thirteen industry ratios and specifies “Usual Values” for each ratio. Departure from the Usual Values on four or more of the ratios can lead to inquiries from individual state insurance commissioners as to certain aspects of an insurer’s business.

In 2013, all of Tower’s insurance subsidiaries that participate in the insurance pool had seven or more ratios departing from the Usual Values. All other Tower insurance subsidiaries had none, one or two ratios departing from the Usual Values.

The common ratios outside the Usual Values for Tower’s insurance subsidiaries in the insurance pool were the following: (i) net written premiums to surplus (ii) two-year overall operating ratio, (iii) gross change in policyholders’ surplus, (iv) change in adjusted policyholders’ surplus, (v) one year reserve development to policyholder surplus, (vi) two year development to policyholder surplus and (vii) estimated current reserve deficiency to policyholders’ surplus. These insurance subsidiaries’ ratios outside the Usual Values were driven primarily by the reserve increases the Company recorded in 2013 and in 2012.

The Reciprocal Exchange entities also had ratios outside the Usual Values. The commons ratios outside the Usual Values were: (i) two-year overall operating ratio and (ii) change in adjusted policyholders’ surplus. The reasons for these ratios being outside the Usual Values were driven primarily by the losses incurred in 2012 due to Superstorm Sandy and higher operating expenses primarily due to technology costs associated with policy administration and claims processing systems.

Statutory Accounting Principles (“SAP”)

Each U.S. insurance company is required to file quarterly and annual statements that conform to SAP. SAP is a basis of accounting developed to assist insurance regulators in monitoring and regulating the solvency of insurance companies. It is primarily concerned with measuring an insurer’s surplus as regards policyholders. Accordingly, statutory accounting focuses on valuing assets and liabilities of insurers at financial reporting dates in accordance with appropriate insurance law and regulatory provisions applicable in each insurer’s domiciliary state.

U.S. generally accepted accounting principles (“GAAP”) are concerned with a company’s solvency, but it is also concerned with other financial measurements, such as income and cash flows. Accordingly, GAAP gives more consideration to appropriate matching of revenue and expenses than does SAP. As a direct result, different assets and liabilities and different amounts of assets and liabilities will be reflected in financial statements prepared in accordance with GAAP as opposed to SAP.

Statutory accounting practices established by the NAIC and adopted, in part, by the state regulators determine, among other things, the amount of statutory surplus and statutory net income of the insurance subsidiaries and thus determine, in part, the amount of funds that are available to pay dividends.

Loss Reserve Specialist and Statements of Actuarial Opinion

Each U.S. insurance company is required to submit a Statement of Actuarial Opinion concerning the adequacy of its loss and loss expense reserves. Similarly, the Bermuda-based insurance subsidiaries are required to submit an opinion of their approved loss reserve specialist with their statutory financial return in respect of its loss and LAE provisions.

Statements of Actuarial Opinion are prepared and signed by the designated actuary for each U.S. company, and by the loss reserve specialist in the case of a Bermuda company. The designated actuary and loss reserve specialist normally is a qualified casualty actuary, and in the case of the Bermuda companies, must be approved by the Bermuda Monetary Authority.

An independent external actuarial firm provides Statements of Actuarial Opinions for all of our insurance subsidiaries. This firm utilizes qualified Members of the Casualty Actuarial Society and Members of the American Academy of Actuaries to provide the service necessary for the Statements of Actuarial Opinion.

 

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Guaranty Associations

In most of the jurisdictions where the insurance subsidiaries are currently licensed to transact business there is a requirement that property and casualty insurers participate in guaranty associations, which are organized to pay contractual benefits owed pursuant to insurance policies issued by impaired, insolvent or failed insurers. These associations levy assessments, up to prescribed limits, on all member insurers in a particular state on the basis of the proportionate share of the premium written by member insurers in the lines of business in which the impaired, insolvent or failed insurer is engaged. Some states permit member insurers to recover assessments paid through full or partial premium tax offsets.

In none of the past five years has the assessment in any year levied against our insurance subsidiaries been material. Property and casualty insurance company insolvencies or failures may result in additional security fund assessments to our insurance subsidiaries at some future date. At this time we are unable to determine the possible amounts and any impact such assessments may have on the consolidated financial position or results of operations. Accordingly, we have not established liabilities for guaranty fund assessments, with the exception of various New York State workers compensation pre-assessment guaranty funds. See “Note 17 —Contingencies” in the notes to our audited consolidated financial statements included elsewhere in this report.

Residual Market Plans

Our insurance subsidiaries are required to participate in various mandatory insurance facilities or in funding mandatory pools, which are generally designed to provide insurance coverage for consumers who are unable to obtain insurance in the voluntary insurance market. These pools generally provide insurance coverage for workers’ compensation, personal and commercial automobile and property-related risks.

Management Companies

The activities of our managing general agencies and management companies are subject to licensing requirements and regulation under the laws of New York, Delaware, Florida and other states where they do business. The businesses of these companies depend on the validity of, and continued good standing under, the licenses and approvals pursuant to which they operate, as well as compliance with pertinent regulations.

Reinsurance

We purchase reinsurance to reduce our net liability on individual risks, to protect against possible catastrophes, to achieve a target ratio of net premiums written to policyholders’ surplus or to expand our underwriting capacity. Reinsurance coverage can be purchased on a facultative basis when individual risks are reinsured or on a treaty basis when a class or type of business is reinsured. We may purchase facultative reinsurance to provide limits in excess of the limits provided by our treaty reinsurance. Treaty reinsurance falls into three categories: quota share (also called pro rata), excess of loss and catastrophe treaty reinsurance. Under our quota share reinsurance contracts, we cede a predetermined percentage of each risk for a class of business to the reinsurer and recover the same percentage of losses and LAE on the business ceded. We pay the reinsurer the same percentage of the original premium, less a ceding commission. The ceding commission rate is based upon the ceded loss ratio on the ceded quota share premiums earned and in certain contracts is adjusted for loss experience under those contracts. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Estimates – Ceding commissions earned.” Under our excess of loss treaty reinsurance, we cede all or a portion of the liability in excess of a predetermined deductible or retention. We also purchase catastrophe reinsurance on an excess of loss basis to protect ourselves from an accumulation of certain net loss exposures from a catastrophic event or series of events such as windstorms, hailstorms, tornadoes, hurricanes, earthquakes, blizzards, freezing temperatures, riots and terrorist acts (for personal lines business). A portion of the protection we purchase is on an Original Insured Market Loss Warranty basis, whereby we can recover up to the limit of the contract for our ultimate net loss arising from the Windstorm Peril in the Northeast in an event where the Insured Market Loss exceeds a specified threshold. We generally do not receive any commission for ceding business under excess of loss or catastrophe reinsurance agreements.

The type, cost and limits of reinsurance we purchase can vary from year to year based upon our desired retention levels and the availability of quality reinsurance at acceptable prices, terms and conditions. Our excess of loss reinsurance and quota share programs were effective in 2013 and renewed or extended on January 1, 2014. Our catastrophe reinsurance program was renewed July 1, 2013.

In an effort to maintain capacity for our business with favorable commission levels, we have in the past accepted loss ratio caps in certain of our reinsurance treaties and currently accept per occurrence loss limitations on catastrophe-exposed property quota share treaties. Loss ratio caps curtail a reinsurer’s liability for losses above a specified loss ratio. Occurrence loss limitations impose a limit upon a reinsurer’s liability for aggregate losses incurred under multiple policies in a single occurrence. These provisions have been structured to provide reinsurers with some limit on the amount of potential loss being assumed, while maintaining the transfer of significant insurance risk with the possibility of a significant loss to the reinsurers.

 

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Regardless of type, reinsurance does not legally discharge the ceding insurer from primary liability for the full amount due under the reinsured policies. However, the assuming reinsurer is obligated to indemnify the ceding company to the extent of the coverage ceded. To protect our company from the possibility of a reinsurer becoming unable to fulfill its obligations under the reinsurance contracts, we attempt to select financially strong reinsurers with an A.M. Best rating of A- (Excellent) or better and continue to evaluate their financial condition and monitor various credit risks to minimize our exposure to losses from reinsurer insolvencies.

To further minimize our exposure to reinsurance recoverables, certain of our reinsurance agreements were placed on a “funds withheld” basis under which ceded premiums written are deposited in segregated trust funds from which we receive payments for losses and ceding commission adjustments. Our reinsurance receivables from non-admitted reinsurers are collateralized either by Letter of Credit or New York Regulation 114 compliant trust accounts.

To increase its financial flexibility, on July 1, 2013, the Company entered into three new quota share agreements and an aggregate excess of loss agreement to protect its commercial lines business. The first agreement was between Tower Insurance Company of New York (“TICNY”), on its behalf and on behalf of each of its pool participants, and Arch. The second agreement was between TICNY, on its behalf and on behalf of each of its pool participants, and Hannover. The third arrangement with Southport Re consisted of two separate agreements with TICNY, on its behalf and on behalf of each of its pool participants, and a third agreement with Tower Reinsurance, Ltd. (“TRL”). The Southport Quota Share has been accounted for using deposit accounting treatment. Deposit assets of $28.7 million as of December 31, 2013 related to the Southport Quota Share are reflected in Other assets in the consolidated balance sheet. As a result of a negotiation between the Company and Southport, all of the Company’s treaties with Southport were commuted effective as of February 19, 2014, with the result of the commutation being that all premiums paid to Southport by the Company were returned to the Company, and all liabilities assumed by Southport were cancelled, and such liabilities became the obligation of the Company.

Following the announcement of the merger with ACP Re on January 6, 2014, the Company announced that several of its subsidiaries had entered into two quota share reinsurance agreements with two affiliates of ACP Re. that provide a cut-though endorsement for selected personal and commercial lines policies and bolster the Company’s ability to retain business following the downgrades by the rating agencies.

Terrorism Reinsurance

In 2002, in response to the tightening of supply in certain insurance and reinsurance markets resulting from, among other things, the September 11, 2001 terrorist attacks, the Terrorism Risk Insurance Act (“TRIA”) was enacted. TRIA is designed to ensure the availability of insurance coverage for foreign terrorist acts in the United States of America. This law established a federal assistance program through the end of 2005 to help the commercial property and casualty insurance industry cover claims related to future terrorism-related losses and requires such companies to offer coverage for certain acts of terrorism.

On December 17, 2005, Congress passed a two-year extension of TRIA through December 31, 2007 with the passage of the Terrorism Risk Insurance Extension Act (“TRIEA”). Under the terms of TRIEA, the minimum size of the triggering event increased and Tower’s deductible increased. Under TRIEA, federal assistance for insured terrorism losses has been reduced as compared to the assistance previously available under TRIA. As a consequence of these changes, potential losses from a terrorist attack could be substantially larger than previously expected.

On December 26, 2007, the President signed the Terrorism Risk Insurance Program Reauthorization Act of 2007 (the “2007 Act”) which extends TRIEA for seven years through December 31, 2014. The 2007 Act maintains the same triggering event size of $100 million, company deductible of 20%, industry retention of $27.5 billion, federal share of 85% and program aggregate insured loss limit of $100 billion put in place by TRIEA. The 2007 Act extends coverage to domestic terrorism and requires additional notice to policyholders regarding the $100 billion program limit. There is no certainty that this reinsurance protection will be extended beyond 2014.

Employees

As of December 31, 2013, we had 1,396 full-time employees. None of these employees are covered by a collective bargaining agreement. We have employment agreements with certain senior executive officers. The remainder of our employees are “at-will” employees.

 

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On November 22, 2013, the Company announced the implementation of an expense control initiative to streamline its operations and focus resources on its most profitable lines of business. As part of this initiative, the Company is completing a workforce reduction affecting approximately 10% of the total employee population.

Available Information

We file periodic reports, proxy statements and other information with the SEC. Such reports, proxy statements and other information may be viewed at the SEC’s website at www.sec.gov or viewed or obtained at the SEC Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information pertaining to the operation of the Public Reference Room can be obtained by calling 1-800-SEC-0330.

The address for our internet website is www.twrgrpintl.com. We make available, free of charge, through our internet site, our annual report on Form 10-K, annual report to shareholders, quarterly reports on Form 10-Q and current reports on Form 8-K and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such materials with, or furnish it to, the SEC.

Glossary of Selected Insurance Terms

 

Accident year    The year in which an event occurs, regardless of when any policies covering it are written, when the event is reported, or when the associated claims are closed and paid.
Acquisition expense    The cost of acquiring both new and renewal insurance business, including commissions to agents or brokers and premium taxes.
Adverse Development Cover    A reinsurance arrangement whereby a reinsurer agrees, in return for a premium, to cover the ultimate settled amount of a specified block of business above a certain pre-agreed amount.
Agent    One who negotiates insurance contracts on behalf of an insurer. The agent receives a commission for placement and other services rendered. Retail agents serve as intermediaries between the individual insureds and an insurer, managing general agent or wholesale broker to secure coverage for the insured. Wholesale agents serve as intermediaries between retail agents and the insurer and do not deal directly with individual insureds.
Attorney-in-fact    A person or corporate entity who holds power of attorney, and therefore is legally designated to transact business and execute documents on behalf of another person or, in Tower’s case, administers the Reciprocal Exchanges, including paying losses, investing premium inflows, recruiting new members, underwriting the inflow of new business, underwriting renewal business, receiving premiums, and exchanging reinsurance contracts.
Broker    One who negotiates insurance or reinsurance contracts between parties. An insurance broker negotiates on behalf of an insured and a primary insurer. A reinsurance broker negotiates on behalf of a primary insurer or other reinsured and a reinsurer. The broker receives a commission for placement and other services rendered.
Case reserves    Loss reserves established by claims personnel with respect to individual reported claims.
Casualty insurance and/or reinsurance    Insurance and/or reinsurance that is concerned primarily with the losses caused by injuries to third persons (in other words, persons other than the policyholder) and the legal liability imposed on the insured resulting there from.
Catastrophe reinsurance    A form of excess of loss property reinsurance that, subject to a specified limit, indemnifies the ceding company for the amount of loss in excess of a specified retention with respect to an accumulation of losses resulting from a catastrophic event.
Cede; ceding company    When an insurance company reinsures its risk with another, it “cedes” business and is referred to as the “ceding company.”
Clash coverage    A form of reinsurance that covers the cedant’s exposure to multiple retentions that may occur when two or more of its insureds suffer a loss from the same occurrence. This reinsurance covers the additional retentions.
CLUE    Comprehensive Loss Underwriting Exchange (“CLUE”) is a claims history database that enables insurance companies to access consumer claims information when they are underwriting or rating an insurance policy.

 

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Combined ratio    The sum of losses and LAE, acquisition expenses, operating expenses and policyholders’ dividends, all divided by net premiums earned.
Cut-Through Endorsement    A cut-through endorsement is a separate agreement between the reinsurer and the direct insured that becomes a part of the original reinsurance agreement.
Direct premiums written    The amounts charged by a primary insurer for the policies that it underwrites.
Excess and surplus lines    Excess insurance refers to coverage that attaches for an insured over the limits of a primary policy or a stipulated self-insured retention. Policies are bound or accepted by carriers not licensed in the jurisdiction where the risk is located, and generally are not subject to regulations governing premium rates or policy language. Surplus lines risks are those risks not fitting normal underwriting patterns, involving a degree of risk that is not commensurate with standard rates and/or policy forms, or that will not be written by standard carriers because of general market conditions.
Excess of loss reinsurance    The generic term describing reinsurance that indemnifies the reinsured against all or a specified portion of losses on underlying insurance policies in excess of a specified dollar amount, called a “layer” or “retention.” Also known as non-proportional reinsurance.
Expense ratio    Expense ratio is equal to underwriting expenses divided by earned premiums.
Funds held    The holding by a ceding company of funds usually representing the unearned premium reserve or the outstanding loss reserves applied to the business it cedes to a reinsurer.
Gross premiums written    Total premiums for direct insurance and reinsurance assumed during a given period.
Incurred but not reported (“IBNR”) reserves    Loss reserves for estimated losses that have been incurred but not yet reported to the insurer or reinsurer.
Incurred losses    The total losses sustained by an insurance company under a policy or policies, whether paid or unpaid. Incurred losses include a provision for claims that have occurred but have not yet been reported to the insurer (“IBNR”).
Lloyd’s syndicate    A group of names at Lloyd’s of London who have entrusted their assets to a team of underwriters who underwrite on behalf of the group.
Loss adjustment expenses (“LAE”)    The expenses of settling claims, including legal and other fees and the portion of general expenses allocated to claim settlement costs.
Loss and LAE ratio    Loss and LAE ratio is equal to losses and LAE incurred divided by earned premiums.
Loss reserves    Liabilities established by insurers and reinsurers to reflect the estimated cost of claims payments that the insurer or reinsurer believes it will ultimately be required to pay with respect to insurance or reinsurance it has written. Reserves are established for losses and for LAE and consist of case reserves and IBNR. The process of estimating loss reserves requires significant judgment. Reserves are not, and cannot be, an exact measure of an insurers’ ultimate liability.
Managing general agent    A person or firm authorized by an insurer to transact insurance business who may have authority to bind the insurer, issue policies, appoint producers, adjust claims and provide administrative support for the types of insurance coverage pursuant to an agency agreement.
Net premiums earned    The portion of net premiums written that is earned during a period and recognized for accounting purposes as revenue.
Net premiums written    Gross premiums written for a given period less premiums ceded to reinsurers or retrocessionaires during such period.
Primary insurer    An insurance company that issues insurance policies to consumers or businesses on a first dollar basis, sometimes subject to a deductible.
Pro rata, or quota share, reinsurance    A form of reinsurance in which the reinsurer shares a proportional part of the ceded insurance liability, premiums and losses of the ceding company. Pro rata, or quota share, reinsurance also is known as proportional reinsurance or participating reinsurance.
Program underwriting agent    An insurance intermediary that underwrites program business by aggregating business from retail and wholesale agents and performs certain functions on behalf of insurance companies, including underwriting, premium collection, policy form design and other administrative functions to policyholders.

 

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Property insurance and/or reinsurance    Insurance and/or reinsurance that indemnifies a person with an insurable interest in tangible property for his property loss, damage or loss of use.
Reciprocal exchange    Unincorporated association with each insured insuring the other insureds within the association. (Thus, each participant in this pool is both an insurer and an insured.) An attorney-in-fact administers the exchange. Members share profits and losses in the same proportion as the amount of insurance purchased from the exchange by that member.
Reinsurance    A transaction whereby the reinsurer, for consideration, agrees to indemnify the reinsured company against all or part of the loss the company may sustain under the policy or policies it has issued. The reinsured may be referred to as the original or primary insurer or the ceding company.
Renewal retention rate    The current period renewal premium, excluding pricing, exposure and policy form changes, as a percentage of the total premium available for renewal.
Retention, retention layer    The amount or portion of risk that an insurer or reinsurer retains for its own account. Losses in excess of the retention layer are reimbursed to the insurer or reinsurer by the reinsurer or retrocessionaire. In proportional treaties, the retention may be a percentage of the original policy’s limit. In excess of loss business, the retention is a dollar amount of loss, a loss ratio or a percentage.
Retrocession; retrocessionaire    A transaction whereby a reinsurer cedes to another reinsurer, known as a retrocessionaire, all or part of the reinsurance it has assumed. Retrocession does not legally discharge the ceding reinsurer from its liability with respect to its obligations to the reinsured
Statutory accounting principles (“SAP”)    Recording transactions and preparing financial statements in accordance with the rules and procedures prescribed or permitted by state insurance regulatory authorities and the NAIC.
Statutory or policyholders’ surplus; statutory capital and surplus    The excess of admitted assets over total liabilities (including loss reserves), determined in accordance with SAP.
Third party administrator    A service group who provides various claims administration, risk management, loss prevention and related services, primarily to self-insured clients under a fee arrangement or to insurance carriers on an unbundled basis. No insurance risk is undertaken in the arrangement.
Treaty reinsurance    The reinsurance of a specified type or category of risks defined in a reinsurance agreement (a “treaty”) between a primary insurer or other reinsured and a reinsurer. Typically, in treaty reinsurance, the primary insurer or reinsured is obligated to offer and the reinsurer is obligated to accept a specified portion of all agreed-upon types or categories of risks originally written by the primary insurer or reinsured.
Underwriting    The insurer’s/reinsurer’s process of reviewing applications submitted for insurance coverage, deciding whether to accept all or part of the coverage requested and determining the applicable premiums.
Unearned premium    The portion of a premium representing the unexpired portion of the exposure period as of a certain date.
Unearned premium reserve    Liabilities established by insurers and reinsurers to reflect unearned premiums which are usually refundable to policyholders if an insurance or reinsurance contract is canceled prior to expiration of the contract term.

Note on Forward-Looking Statements

Some of the statements under “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business” and elsewhere in this Form 10-K may include forward-looking statements that reflect our current views with respect to future events and financial performance. These statements include forward-looking statements both with respect to us specifically and to the insurance sector in general. Statements that include the words “expect,” “intend,” “plan,” “believe,” “project,” “estimate,” “may,” “should,” “anticipate,” “will” and similar statements of a future or forward-looking nature identify forward-looking statements for purposes of the Federal securities laws or otherwise.

 

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All forward-looking statements address matters that involve risks and uncertainties. Accordingly, there are, or will be, important factors that could cause our actual results to differ materially from those indicated in these statements. We believe that these factors include, but are not limited to, those described under “Risk Factors” and the following:

 

   

changes in our financial strength or credit ratings could impact our ability to write new business, the cost of, and our ability to obtain, capital or our ability to attract and retain brokers, agents and customers;

 

   

further decreases in the capital and surplus of our insurance subsidiaries and their ability to meet minimum capital and surplus requirements;

 

   

changes in our ability to access our credit facilities or raise additional capital;

 

   

the implementation and effectiveness of our capital improvement strategy;

 

   

Tower’s ability to continue operating as a going concern;

 

   

changes in our ability to meet ongoing cash requirements and pay dividends;

 

   

greater frequency or severity of claims and loss activity, including as a result of natural or man-made catastrophic events, than our underwriting, reserving or investment practices anticipate based on historical experience or industry data;

 

   

changes in the availability, cost or quality of reinsurance and failure of our reinsurers to pay claims timely or at all;

 

   

changes in the availability, cost or quality of reinsurance or retrocessional coverage;

 

   

decreased demand for our insurance or reinsurance products;

 

   

increased competition on the basis of pricing, capacity, coverage terms or other factors;

 

   

ineffectiveness or obsolescence of our business strategy due to changes in current or future market conditions;

 

   

currently pending or future litigation or governmental proceedings;

 

   

developments that may delay or limit our ability to enter new markets as quickly as we anticipate;

 

   

loss of the services of any of our executive officers or other key personnel;

 

   

changes in acceptance of our products and services, including new products and services;

 

   

developments in the world’s financial and capital markets that could adversely affect the performance of our investments;

 

   

the effects of acts of terrorism or war;

 

   

changes in general economic conditions, including inflation, interest rates and other factors which could impact our performance and the performance of our investment portfolio;

 

   

changes in accounting policies or practices;

 

   

changes in legal theories of liability under our insurance policies;

 

   

changes in rating agency policies or practices;

 

   

declining demand for reinsurance due to increased retentions by cedents and other factors;

 

   

a lack of opportunities to increase writings in Tower’s reinsurance lines of business and in specific areas of the reinsurance market;

 

   

changes in the percentage of our premiums written that we cede to reinsurers;

 

   

changes in regulations or laws applicable to us, our subsidiaries, brokers or customers, including regulatory limitations and restrictions on the declaration and payment of dividends and capital adequacy standards;

 

   

the Bermudian regulatory system, and potential changes thereto;

 

   

risks and uncertainties associated with technology, data security or outsourced services that could negatively impact our ability to conduct our business or adversely impact our reputation;

 

   

the effects of mergers, acquisitions or divestitures;

 

   

disruptions in Tower’s business arising from the integration of acquired businesses into Tower and the anticipation of potential or pending acquisitions or mergers; and

 

   

any changes concerning the conditions, terms, termination, or closing of the merger with ACP Re.

The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included in this Form 10-K. We undertake no obligation to publicly update or review any forward-looking statement, whether as a result of new information, future developments or otherwise.

If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may vary materially from what we project. Any forward-looking statements you read in this Form 10-K reflect our views

 

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as of the date of this Form 10-K with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, growth strategy and liquidity. All subsequent written and oral forward-looking statements attributable to us or individuals acting on our behalf are expressly qualified in their entirety by this paragraph. Before making an investment decision, you should specifically consider all of the factors identified in this Form  10-K that could cause actual results to differ.

Item 1A. Risk Factors

An investment in our common stock involves a number of risks. You should carefully consider the following information. Additional risks not presently known to us or that we currently deem immaterial may also impair our business, financial condition or results of operations. Any of the risks described below could result in a significant or material adverse effect on our business, financial condition or results of operations, and a corresponding decline in the market price of our common shares and other securities.

This Form 10-K also contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of certain factors, including the risks described below. See “Business—Note on Forward-Looking Statements.”

Risks Related to the Proposed Merger with ACP Re

Failure to complete the proposed merger with ACP Re could adversely affect our ability to continue as a going concern.

There is no assurance that the closing of our proposed merger with ACP Re will occur or that it will close under the same terms and conditions contained in the ACP Re Merger Agreement. Consummation of the merger is subject to various conditions, including, among other things, the approval of the ACP Re Merger Agreement and the merger by the holders of a majority of our outstanding common shares, and certain other customary conditions, including, among other things, the absence of laws or judgments prohibiting or restraining the merger and the receipt of certain regulatory approvals. We cannot predict with certainty whether and when any of these conditions will be satisfied. In addition, the ACP Re Merger Agreement may be terminated under certain specified circumstances, including if the merger is not consummated on or before September 30, 2014 or if the special meeting of our shareholders is not convened and held on or prior to August 15, 2014. If the ACP Re Merger Agreement is not approved by our shareholders or if the merger is not consummated for any other reason, our shareholders will not receive any payment for their shares in connection with the merger. Instead, we will remain an independent public company and we would intend that the common shares continue to be listed and traded on NASDAQ. There is, however, substantial doubt about our ability to continue as a going concern. Recent declines in our financial strength and issuer credit ratings have materially adversely affected our ability to write new business. See “There is substantial doubt about the Company’s ability to continue as a going concern.” and “Recent declines in the ratings assigned to us and our insurance subsidiaries by A.M. Best, Fitch and Demotech, as well as any future ratings downgrades, will affect our ability to write new business, our standing among brokers, agents and insureds and cause our sales and earnings to decrease.”

In addition, TGI’s $147.7 million 5.00% senior convertible notes mature on September 15, 2014 and we currently do not have, and do not anticipate obtaining, any commitments with respect to raising additional capital or liquidating investments that will provide sufficient funds to pay the principal of the Notes when they mature. See “We may be unable to implement our proposed capital improvement strategy or, if implemented, it may not achieve its anticipated benefits, either of which could have a material adverse effect on our business, financial condition or results of operations.” Also, under specified circumstances, the ACP Re Merger Agreement may require us to reimburse ACP Re for its expenses or pay ACP Re a fee with respect to the termination of the ACP Re Merger Agreement, which would further impact our ability to continue as a going concern if the merger is not completed.

Risks Related to Our Business

There is substantial doubt about the Company’s ability to continue as a going concern.

There is substantial doubt about the Company’s ability to remain as a going concern. As such, any potential investor or lender may be unlikely or unwilling to provide additional capital or loans to the Company. Should the Company no longer continue to support its capital or liquidity needs, or should the Company be unable to successfully execute its capital improvement strategy, raise additional capital, execute any strategic alternatives (including the ACP Re merger) or sell certain investments in an orderly manner, such failures would have a material adverse effect on the Company’s business, results of operations and financial position.

 

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Recent declines in the ratings assigned to us and our insurance subsidiaries by A.M. Best, Fitch and Demotech, as well as any future ratings downgrades, will affect our ability to write new business, our standing among brokers, agents and insureds and cause our sales and earnings to decrease.

Financial strength ratings are an important factor influencing the competitive position of insurance companies. The objective of the rating agencies’ rating systems is to provide an opinion of an insurer’s financial strength and ability to meet ongoing obligations to its policyholders. Our insurance subsidiaries’ ratings reflect the rating agencies’ opinion of our financial strength and are not evaluations directed to investors in our securities, nor are they recommendations to buy, sell or hold our securities. Our ratings are subject to periodic review by, and may be revised downward or revoked at the sole discretion of, the rating agencies.

Our ability to write business is significantly influenced by our rating from A.M. Best. On December 20, 2013, A.M. Best lowered the financial strength ratings of each of our insurance subsidiaries from “B++” (Good) to “B” (Fair) (the seventh highest of fifteen rating levels), as well as the issuer credit ratings of each of our insurance subsidiaries from “bbb” to “bb”. Previously, on October 8, 2013, A.M. Best had downgraded the financial strength rating of each of our insurance subsidiaries to “B++” (Good) and their respective issuer credit ratings to “bbb” from “a-”. In addition on December 20, 2013, A.M. Best downgraded the issuer credit rating of TGI as well as the debt rating on its $147.7 million 5.00% senior convertible notes due 2014 (the “Notes”) to “b-” from “bb”. On the same date, A.M. Best also downgraded the financial strength rating of CastlePoint Reinsurance Company, Ltd. (Bermuda) to “B” (Fair) from “B++” (Good) and its issuer credit rating to “bb” from “bbb” and downgraded the issuer credit rating of Tower Group International, Ltd. to “b-” from “bb”. We, TGI and each of our insurance subsidiaries currently are and will continue to be under review with negative implications pending further discussions between A.M. Best and our management. In downgrading our ratings, A.M. Best stated that its actions “consider the magnitude of the charges taken and the material adverse impact on Tower’s risk-adjusted capitalization, financial leverage, liquidity and coverage ratios,” “consider the reduced financial flexibility [of the Company] given [its] delay in earnings, the decline in shareholder confidence and the corresponding decline in share price” and “reflect the potential for further adverse reserve development, increased competitive challenges and due to the ratings downgrade, potential actions taken by third party reinsurers and lenders.” Following the announcement of the ACP Re merger, on January 10, 2014, A.M. Best maintained the under review status of our financial strength and issuer credit ratings and revised the implications from “negative” to “developing” for all of these ratings. A.M. Best stated that, “[t]he under review status with developing implications reflects the potential benefits to be garnered from the transaction as well as the potential downside from any additional adverse reserve development and/or any unforeseen events that might transpire up until the close of the transaction…”

TGIL and our insurance subsidiaries also are rated by Fitch Ratings Ltd. (“Fitch”). Fitch insurer financial strength ratings are assigned to an insurer’s policyholder obligations and are an assessment of relative financial strength. Insurer financial strength ratings assess the ability of an insurer to meet policyholder and related obligations, relative to the “best” credit risk in a given country across all industries and obligation types. Fitch Ratings’ credit ratings provide an opinion on the relative ability of an entity to meet financial commitments, such as interest, preferred dividends, repayment of principal, insurance claims or counterparty obligations. On January 2, 2014, Fitch downgraded our issuer default rating from “B” to “CC” and the insurer strength ratings of our insurance subsidiaries from “BB” to “B”. On October 7, 2013, Fitch downgraded our issuer default rating to “B” (the sixth highest of 11 such ratings) from “BBB” and the insurer strength ratings of our insurance subsidiaries to “B” (the fifth highest of Fitch Ratings’ nine such ratings) from “A-”. In downgrading such ratings, Fitch stated that it “is concerned that Tower’s competitive position has been materially damaged, negatively impacting the Company’s financial flexibility and ability to write new business” and that “the magnitude of the second quarter charges was large enough to cause several key ratios to fall well outside of previously established ratings downgrade triggers, which resulted in the multi-notch downgrade.” On January 6, 2014, Fitch revised our rating watch status to “evolving” from “negative” following the ACP Re merger announcement, and stated that “[t]he Evolving Watch reflects that the ratings could go up if the merger closes; however, ratings could be lowered if the merger does not occur and [the Company] is unsuccessful in addressing upcoming debt maturity or if additional reserve deficiencies develop.”

The Reciprocal Exchanges also are rated by Demotech, which ratings are based upon a series of quantitative ratios and qualitative considerations that together comprise a financial stability analysis model (certain of our insurance subsidiaries were rated by Demotech until December 24, 2013). On December 24, 2013, Demotech announced the withdrawal of its Financial Stability Ratings (“FSRs”) assigned to our following subsidiaries: Kodiak Insurance Company, Massachusetts Homeland Insurance Company, Tower Insurance Company of New York and York Insurance Company of Maine. Concurrently, Demotech advised that the FSRs assigned to Adirondack Insurance Exchange, Mountain Valley Indemnity Company, New Jersey Skylands Insurance Association and New Jersey Skylands Insurance Company remain under review. On October 7, 2013, Demotech lowered its rating on Tower Insurance Company of New York and three other U.S. based insurance subsidiaries (Kodiak Insurance Company, Massachusetts Homeland Insurance Company and York Insurance Company of Maine) from “A’ (A prime)” to “A (A exceptional)”. In addition, Demotech removed its previous “A’ (A prime)” rating on six other U.S. based insurance subsidiaries (CastlePoint Florida Insurance Company, CastlePoint Insurance Company, CastlePoint National Insurance Company, Hermitage Insurance Company, North East Insurance Company and Preserver Insurance Company). Demotech also affirmed its “A” ratings on Adirondack Insurance Exchange, New Jersey Skylands Insurance Association, New Jersey Skylands Insurance Company and Mountain Valley Indemnity Company.

 

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Management expects these rating actions, in combination with other items that have impacted the Company in 2013, to result in a decrease in the amount of premiums the insurance subsidiaries are able to write. Such rating actions also have and may continue to cause concern among our agents, brokers and policyholders, resulting in a movement of business away from our insurance subsidiaries to other stronger or more highly rated insurance carriers. Because many of our agents and brokers (whom we refer to as “producers”) and policyholders purchase our policies on the basis of our current ratings, any reduction of our ratings could materially and adversely affect our ability to retain or expand our policyholder base. Similarly, the reduction of our financial strength ratings could have the effect of materially increasing the number or amount of policy surrenders by policyholders, requiring us to reduce prices for certain of our products and services to remain competitive, adversely affecting our ability to attract and retain our more profitable books of business, and adversely affecting our ability to obtain reinsurance at reasonable prices, or at all.

Such rating actions, and any further ratings downgrades also will negatively impact our ability to raise capital and have had and will have a negative impact on our overall liquidity. Because lenders and reinsurers will use our A.M. Best ratings as a factor in deciding whether to transact business with us, the failure of our insurance subsidiaries to maintain their financial strength ratings may dissuade a financial institution or reinsurance company from conducting any business with us or may increase our interest or reinsurance costs. For example, many of our ceded reinsurance contracts, including those entered into in September 2013, as disclosed in our Current Report on Form 8-K, dated September 23, 2013, have ratings triggers, which permit the assuming reinsurer to terminate their agreement to reinsure us if our A.M. Best rating is below “A-”.

It is possible that A.M. Best, Fitch or Demotech could downgrade our ratings further or remove such ratings, which would materially adversely affect our business, financial condition and results of operations.

If our reciprocal business does not perform well or is downgraded, we may be required to recognize further impairment of our intangible assets, which could adversely affect our results of operations.

Intangible assets represent the amount of fair value assigned to certain assets when we acquire a subsidiary or a book of business. Intangible assets are classified as having either a finite or an indefinite life. We test the recoverability of indefinite life intangibles at least annually. We test the recoverability of finite life intangibles whenever events or changes in circumstances indicate that the carrying value of a finite life intangible may not be recoverable. An impairment is recognized if the carrying value of an intangible asset is not recoverable and exceeds its fair value, in which circumstance we write down the intangible asset by the amount of the impairment, with a corresponding charge to income. If our reciprocal business does not perform well or the reciprocal exchanges are downgraded, we may be required to recognize an impairment of our intangible assets. Such write downs could have a material adverse effect on our results of operations.

A decrease in the capital and surplus of our insurance subsidiaries may result in a further downgrade of our credit and insurer financial strength ratings.

In any particular year, our statutory surplus amounts and risk based capital (“RBC”) ratios may increase or decrease depending on a variety of factors, including the amount of statutory income or losses generated by our insurance subsidiaries, the amount of additional capital our insurance subsidiaries must hold to support business growth, changes in reserving requirements, the value of certain fixed-income and equity securities in our investment portfolio, changes in interest rates, as well as changes to the National Association of Insurance Commissioners’ (“NAIC”) RBC formulas. See “Our insurance subsidiaries are subject to minimum capital and surplus requirements. Failure to meet these requirements could subject us to regulatory action” below. Most of these factors are outside of our control. Our credit and insurer financial strength ratings are significantly influenced by our statutory surplus amounts and RBC ratios. In addition, rating agencies may implement changes to their internal models that have the effect of increasing or decreasing the amount of statutory capital we must hold in order to maintain our current ratings. Increases in reserves reduce the statutory surplus used in calculating our RBC ratios. To the extent that our statutory capital resources are deemed to be insufficient to maintain a particular rating by one or more rating agencies, we may seek to raise additional capital through one or more financings, which may be unavailable or on terms not as favorable as in the past. Alternatively, if we were not to raise additional capital in such a scenario, either at our discretion or because we were unable to do so, our financial strength and credit ratings might be further reduced by one or more rating agencies, which would have a material adverse effect on our business, financial condition and results of operations. For more information on risks regarding our ability to raise capital, as well as our ratings, see “We may be unable to implement our proposed capital improvement strategy or, if implemented, it may not achieve its anticipated benefits, either of which could have a material adverse effect on our business, financial condition or results of operations” below and “Recent declines in the ratings assigned to us and our insurance subsidiaries by A.M. Best, Fitch and Demotech, as well as any future ratings downgrades, could affect our ability to write new business, our standing among brokers, agents and insureds and cause our sales and earnings to decrease” above.

We may be unable to implement our proposed capital improvement strategy or, if implemented, it may not achieve its anticipated benefits, either of which could have a material adverse effect on our business, financial condition or results of operations.

If the Company does not close on the ACP Re Merger Agreement prior to September 15, 2014, the Company’s plan to repay the Notes includes a combination of using proceeds from the sale of assets held at TGI as well as using proceeds generated by other strategic alternatives and to the extent necessary, issuing debt or equity securities to pay down the principal of the Notes. The Company can provide no assurance that it will be successful in generating sufficient funds to repay the Notes by selling assets held at TGI, pursuing other strategic alternatives or issuing new debt or equity securities.

There can be no assurances that the Company will be able to remedy its current statutory capital deficiencies in certain of its insurance subsidiaries or maintain adequate levels of statutory capital in the future. Consequently, there is substantial doubt about the Company’s ability to continue as a going concern. See “There is substantial doubt about the Company’s ability to continue as a going concern.” Should the Company no longer continue to support its capital or liquidity needs, or should the Company be unable to successfully execute the above mentioned initiatives, such failures would have a material adverse effect on its business, results of operations and financial position.

 

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There can be no assurance that we will execute our capital improvement strategy or sell new debt or equity securities in a timely manner or at all. In addition, we may face unanticipated difficulties or costs in pursuing the capital improvement strategy or the sale of new debt or equity securities and, even if implemented, the capital improvement strategy or the sale of new debt or equity securities may not achieve its anticipated benefits. For example, any such transaction (or related transaction) may result in diversion of management’s attention from other business concerns, a failure to achieve our financial or operating objectives, potential loss of policyholders or key employees, and volatility in the prices of our securities. The occurrence of any of these events could have a material adverse effect on our business, financial condition or results of operations.

Our ability to meet ongoing cash requirements and pay dividends may be limited by our holding company structure and regulatory constraints.

TGIL is a holding company and, as such, has no direct operations of its own. We do not expect TGIL to have any significant operations or assets other than its ownership of the shares of its operating subsidiaries. Dividends and other permitted payments from our operating subsidiaries are expected to be our primary source of funds to meet ongoing cash requirements, including any future debt service payments and other expenses, and to pay dividends, if any, to our shareholders. As of December 31, 2013 and as of the date hereof, none of our insurance subsidiaries could pay to us any distributions without approval.

The ability of our insurance subsidiaries to pay ordinary and extraordinary dividends must be considered in relation to the impact on key financial measurement ratios, including RBC ratios and A.M. Best’s Capital Adequacy Ratio, which in turn could affect our A.M. Best rating. As a result, at times, we may not be able to receive dividends from our insurance subsidiaries in amounts necessary to meet our ongoing cash requirements, including any future debt service payments and other expenses, and to pay dividends to our shareholders. Furthermore, as a result of our recent reserve increases, we incurred a material loss and decrease in our insurance subsidiaries’ capital and surplus, which will reduce their dividend paying capacity until they once again generate a profit and rebuild their surplus levels. See “Although we have paid cash dividends in the past, we did not pay a dividend in the fourth quarter of 2013 and we likely will not pay cash dividends in the near future” below. Accordingly, if you require dividend income you should carefully consider these risks before making an investment in our Company. If we are not able to receive dividends and other permitted payments from our operating subsidiaries in amounts necessary to meet our ongoing cash requirements, such inability could adversely affect the Company’s business, results of operation and financial position. See “There is substantial doubt about the Company’s ability to continue as a going concern.

Although we have paid cash dividends in the past, we did not pay a dividend in the fourth quarter of 2013 and we likely will not pay cash dividends in the near future.

On November 14, 2013, the Company announced that its Board of Directors determined that it would not declare and pay a dividend to shareholders in the fourth quarter of 2013.

We are precluded from paying dividends without the consent of ACP Re pursuant to the ACP Re Merger Agreement. We do not intend to pay any dividends prior to the consummation of the merger.

Future cash dividends would only be considered if the merger agreement were not consummated, and future cash dividends will depend upon our results of operations, financial condition, cash requirements and other factors, including the ability of our subsidiaries to make distributions to us, which ability is restricted in the manner previously discussed in this section. There can be no assurance that we will resume paying dividends in the future even if the necessary financial conditions are met and if sufficient cash is available for distribution.

Our insurance subsidiaries are subject to minimum capital and surplus requirements. Failure to meet these requirements could subject us to regulatory action.

The Company is required to maintain minimum capital and surplus for each of its insurance subsidiaries.

U.S. based insurance companies are required to maintain capital and surplus above Company Action Level, which is a calculated capital and surplus number using a risk-based formula adopted by the state insurance regulators. The basis for this formula is the National Association of Insurance Commissioners’ (“NAIC’s”) risk-based capital (“RBC”) system and is designed to measure the adequacy of a U.S. regulated insurer’s statutory capital and surplus compared to risks inherent in its business. If an insurance entity falls into Company Action Level, its management is required to submit a comprehensive financial plan that identifies the conditions that contributed to the financial condition. This plan must contain proposals to correct the financial problems and provide projections of the financial condition, both with and without the proposed corrections. The plan must also outline the key assumptions underlying the projections and identify the quality of, and problems associated with, the underlying business. Depending on the level of actual capital and surplus in comparison to the Company Action Level, the state insurance regulators could increase their regulatory oversight, restrict the placement of new business, or place the company under regulatory control. Bermuda based insurance entities minimum capital and surplus requirements are calculated from a solvency formula prescribed by the Bermuda Monetary Authority (the “BMA”).

Tower has in place several intercompany reinsurance transactions between its U.S. based insurance subsidiaries and its Bermuda based insurance subsidiaries. The U.S. based insurance subsidiaries have historically reinsured on a quota share basis obligations to CastlePoint Reinsurance Company (“CastlePoint Re”), one of its Bermuda based insurance subsidiaries. The 2013 obligations that CastlePoint Re assumes from the U.S. based insurance subsidiaries are then retroceded to TRL, Tower’s other Bermuda

 

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based insurance subsidiary. In addition, CastlePoint Re also entered into a loss portfolio transaction with TRL where its reserves associated with the U.S. insurance subsidiary business for underwriting years prior to 2013 were all transferred to TRL. CastlePoint Re is required to collateralize $648.9 million of its assumed reserves in a reinsurance trust for the benefit of TICNY, the lead pool company of the U.S. insurance companies. On February 5, 2014, the BMA approved the transfer of $167.3 million in unencumbered liquid assets from TRL to CastlePoint Re, allowing CastlePoint Re to increase the funding in the reinsurance trust for the benefit of TICNY. The New York State Department of Financial Services (the “NYDFS”) has confirmed this will be acceptable for the purpose of admitted surplus and capital on TICNY’s 2013 statutory basis financial statements. For the 2013 statutory basis financial statements, CastlePoint Re reported $581.7 million in its reinsurance trust.

Based on RBC calculations as of December 31, 2013, six of Tower’s ten U.S. based insurance subsidiaries have capital and surplus below Company Action Level and do not meet the minimum capital and surplus requirements of their respective state regulators. As a result, management has discussed the ACP Re Merger Agreement and the Cut- Through Reinsurance Agreement and provided its 2014 RBC forecasts to the regulators to document the Company’s business plan to bring two of these U.S based insurance subsidiaries’ capital and surplus levels above Company Action Level.

As a result of the recognition of the ceding commission relating to the Cut-Through Reinsurance Agreements executed with AmTrust and NGHC in January 2014, the U.S. based insurance subsidiaries’ capital and surplus will increase significantly from December 31, 2013 to January 1, 2014, as the U.S. based subsidiaries will transfer a significant portion of their commercial lines unearned premium to a subsidiary of AmTrust and all of their personal lines unearned premiums to a subsidiary of NGHC. Accordingly, as of January 1, 2014, the effect of the Cut-Through Reinsurance Agreements increased the surplus of two of the U.S. based insurance subsidiaries such that their capital and surplus levels exceeded Company Action Level.

In 2013, the NYDFS issued orders for seven of Tower’s insurance subsidiaries, subjecting them to heightened regulatory oversight, which includes providing the NYDFS with increased information with respect to the insurance subsidiaries’ business, operations and financial condition. In addition, the NYDFS has placed limitations on payments and transactions outside the ordinary course of business and material changes in the insurance subsidiaries’ management and related matters. Tower’s management and Board of Directors have held discussions with the NYDFS, and Tower has been complying with the orders and oversight.

On April 21, 2014, the NYDFS issued additional orders for two of Tower’s insurance subsidiaries instructing them to provide plans to address weaknesses in such insurance subsidiaries’ risk based capital levels as shown in their statutory annual financial statements, and imposing further enhanced reporting and prior approval requirements and limitations on writings of new business. On the same date, the NYDFS issued a letter pertaining to one of Tower’s insurance subsidiaries requiring the submission of a plan to address weaknesses in risk based capital levels.

The Massachusetts Division of Insurance (“MDOI”) and Tower management have agreed to certain restrictions on the operations of Tower’s two Massachusetts domiciled insurance subsidiaries. Tower management has agreed to cause these subsidiaries to provide the MDOI with increased information with respect to their business, operations and financial condition, as well as limitations on payments and transactions outside the ordinary course of business and material changes in their management and related matters.

The Maine Bureau of Insurance entered a Corrective Order imposing certain conditions on Maine domestic insurers York Insurance Company of Maine (“YICM”) and North East Insurance Company (“NEIC”). The Corrective Order imposes increased reporting obligations on YICM and NEIC with respect to business operations and financial condition and imposes restrictions on payments or other transfers of assets from YICM and NEIC outside the ordinary course of business.

On April 11, 2014, the New Jersey Department of Banking and Insurance imposed an enhanced reporting requirement on the intercompany transactions involving Tower’s two New Jersey domiciled insurance subsidiaries and Tower’s New Jersey managed insurer. Such companies are now required to submit for prior approval any transactions with affiliates, even transactions that would otherwise not be reportable under the applicable holding company act.

As of December 31, 2013, TRL and CastlePoint Re had capital and surplus that did not meet the minimum solvency requirements of the BMA. Management has discussed the ACP Re Merger Agreement and provided 2014 solvency forecasts to the BMA.

The BMA has issued directives for TRL and CastlePoint Re, subjecting them to heightened regulatory oversight and requiring BMA approval before certain transactions can be executed. Tower has been complying with the directives issued by the BMA.

If our actual unpaid loss and loss adjustment expenses as of a particular point in time exceed our loss reserves or we determine that our estimates with respect to such loss reserves are inadequate, our business, financial condition and results of operations could be significantly adversely affected.

Our business, financial condition and results of operations depend upon our ability to estimate the potential losses associated with the risks that we insure and reinsure. We estimate loss and loss adjustment expense reserves to cover our estimated liability for the payment of all losses and loss adjustment expenses incurred under the policies that we write. Loss reserves include case reserves, which are established for specific claims that have been reported to us, and reserves for claims that have been incurred but not reported (“IBNR”).

 

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Establishing an aggregate level of loss and loss adjustment expense reserves involves estimations, opinions and judgments and is, accordingly, an inherently uncertain process. For example, the reserving process for losses on the liability coverage portions of our commercial and personal lines policies possesses characteristics that make case and IBNR reserving inherently less susceptible to accurate actuarial estimation. Liability losses are claims made by third parties of which the policyholder may not be aware and therefore may be reported a significant amount of time, sometimes years, after the occurrence. As liability claims most often involve claims of bodily injury, assessment of the proper case reserve is a subjective process. In addition, the determination of a case reserve for a liability claim is often without the benefit of information, which develops slowly over the life of the claim and can subject the case reserve to substantial modification well after the claim was first reported. Numerous factors impact the liability case reserving process, including venue, the amount of monetary damage, the permanence of the injury, and the age of the claimant among other factors.

To the extent that loss and loss adjustment expenses exceed our estimates, we likely would be required to increase loss and loss adjustment expense reserves, with a corresponding reduction in our net income in the period in which the deficiency is identified. Actual loss and loss adjustment expenses paid may deviate, perhaps substantially, from the reserve estimates reflected in our consolidated financial statements. It is possible that claims could exceed our loss and loss adjustment expense reserves. In such case, any required reserve increase would be recognized as an expense during the period or periods in which these determinations are made, thereby adversely affecting our business, financial condition or results of operations. Depending on the severity and timing of any changes in these estimated losses, such determinations could have a material adverse effect on our business, financial condition, results of operations or cash flows.

As noted above, we increased our loss reserves by $539.8 million with respect to the Commercial Insurance segment as of December 31, 2013, which resulted in an unfavorable effect on net income. This reserve increase has had a material adverse effect on our business, financial condition and results of operations. See “Note 10-Loss and Loss Adjustment Expense” to the Notes to the Consolidated Financial Statements. Given the contingencies and uncertainties described above, there can be no assurance that we have accurately estimated our loss and loss adjustment reserves, and further revisions to these estimates may occur in the future, which may require us to further increase these reserves. If increases to our loss and loss adjustment reserves become necessary, this may have a material adverse effect on our business, financial condition, results of operations and cash flows.

In addition, many of our quota share reinsurance agreements contain provisions for a ceding commission under which the commission rate that we receive varies inversely with the loss ratio on the ceded premiums, with higher commission rates corresponding to lower loss ratios and vice versa. The loss ratio depends on our estimate of the loss and loss adjustment expense reserves on the ceded business. As a result, the same uncertainties associated with estimating loss and loss adjustment expense reserves affect the estimates of ceding commissions earned. If and to the extent that we have to increase our reserves on the business that is subject to these reinsurance agreements, we may have to reduce the ceding commission rate, which would amplify the reduction in our net income in the period in which the increase in our reserves is made. For example, in connection with our December 31, 2013 reserve increase, the related decrease in our ceding commission rate resulted in additional loss for the year ended December 31, 2013 of $9.6 million.

A substantial amount of our business currently comes from a limited geographical area. Any single catastrophe or other condition affecting losses in this area could adversely affect our business, financial condition or results of operations.

Our insurance subsidiaries currently write a substantial amount of their business in the Northeast United States. As a result, a single catastrophe occurrence, destructive weather pattern, terrorist attack, regulatory development or other condition or general economic trend affecting the region within which we conduct our business could adversely affect our business, financial condition or results of operations more significantly than that of other insurance companies that conduct business across a broader geographical area. We may incur catastrophe losses in excess of: (1) those experienced in prior years, (2) the average expected level used in pricing, (3) our current reinsurance coverage limits, or (4) our estimate of loss from external hurricane and earthquake models at various levels of probability. We may be exposed to catastrophes that could have a material adverse effect on operating results and financial condition. Our liquidity could be constrained by a catastrophe, or multiple catastrophes, which result in extraordinary losses or a downgrade of our credit issuer or financial strength ratings.

The incidence and severity of catastrophes are inherently unpredictable and our losses from catastrophes could be substantial. The occurrence of claims from catastrophic events is likely to result in substantial volatility in our business, financial condition or results of operations for any fiscal quarter or year and could have a material adverse effect on our business, financial condition or results of operations and our ability to write new business. Increases in the values and concentrations of insured property may increase the severity of such occurrences in the future. Although we attempt to manage our exposure to such events, including through the use of reinsurance, the frequency or severity of catastrophic events could exceed our estimates. As a result, the occurrence of one or more catastrophic events could have a material adverse effect on our business, financial condition or results of operations.

 

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If we cannot obtain adequate reinsurance protection for the risks we have underwritten, we may be exposed to greater losses from these risks or we may reduce the amount of business we underwrite, which will reduce our revenues.

Under state insurance law, insurance companies are required to maintain a certain level of capital in support of the policies they issue. In addition, rating agencies will reduce an insurance company’s ratings if the Company’s premiums exceed specified multiples of its capital. As a result, the level of our insurance subsidiaries’ statutory surplus and capital limits the amount of premiums that they can write and on which they can retain risk. Historically, we have utilized reinsurance to expand our capacity to write more business than our insurance subsidiaries’ surplus would have otherwise supported.

From time to time, market conditions have limited, and in some cases have prevented, insurers from obtaining the types and amounts of reinsurance that they consider adequate for their business needs. These conditions could produce unfavorable changes in prices, reduced ceding commission revenue or other potentially adverse changes in the terms of reinsurance. Accordingly, we may not be able to obtain our desired amounts of reinsurance. In addition, even if we are able to obtain such reinsurance, we may not be able to obtain such reinsurance from entities with satisfactory creditworthiness or negotiate terms that we deem appropriate or acceptable. Similarly, our business, reputation, ratings and financial condition affect our ability to obtain reinsurance on favorable terms. Accordingly, at times we may be forced to incur additional expenses for reinsurance or may not be able to obtain sufficient reinsurance on acceptable terms, which could adversely affect our ability to write future business or result in the assumption of more risk with respect to those policies we issue.

Even if we are able to obtain reinsurance, our reinsurers may not pay losses in a timely fashion, or at all, which may cause a substantial loss and increase our costs.

As of December 31, 2013, we had a net balance due us from our reinsurers of $826.4 million, consisting of $570.9 million in reinsurance recoverables on unpaid losses, $69.0 million in reinsurance recoverables on paid losses and $186.5 million in prepaid reinsurance premiums. Since 2003, we have sought to manage our exposure to our reinsurers by placing our quota share reinsurance on a “funds withheld” basis and requiring any non-admitted reinsurers to collateralize their share of unearned premium and loss reserves. Our net exposure (which considers collateral available to the Company) to our reinsurers totaled $185.3 million as of December 31, 2013. As of December 31, 2013, our largest net exposure to any one reinsurer was $56.4 million, related to ACE Property and Casualty Insurance Company which is rated A++ by A.M. Best. As of December 31, 2013, our largest balance due from any one reinsurer (before considering any collateral) was $348.0 million, which was due from Southport Re which is not rated. This balance was settled in the first quarter of 2014 upon cancellation of the Southport Re agreements.

Because we remain primarily liable to our policyholders for the payment of their claims, in the event that one of our reinsurers under an uncollateralized treaty became insolvent or refused to reimburse us for losses paid, or delayed in reimbursing us for losses paid, our cash flow and financial results could be materially and adversely affected.

We operate in a highly competitive environment. If we are unsuccessful in competing against larger or more well-established rivals, our business, financial condition and results of operations could be adversely affected.

The property and casualty insurance industry is highly competitive and has historically been characterized by periods of significant pricing competition alternating with periods of greater pricing discipline, during which competition focuses on other factors. Beginning in 2000, the market environment was increasingly favorable as rates increased significantly. During the latter part of 2004 and throughout 2005, increased competition in the marketplace became evident and, as a result, average annual rate increases became moderate. The catastrophe losses of 2004 and 2005 produced increased pricing and reduced capacity for insurance of catastrophe-exposed property. However, a softening of the non-catastrophe-exposed market in 2006 through 2009 has led to more aggressive pricing in specific segments of the commercial lines business, particularly in those lines of business and accounts with larger annual premiums.

The new capacity that had entered the market had placed more pressure on production and profitability targets. A.M. Best had stated that industry policyholder surplus grew annually from 2003-2012 except for declines in 2008 and 2011. However, industry policyholder surplus increased by 10.4% to $666.3 billion in 2013 from 2012. This places the premium-to-surplus ratio at 0.73:1.0 as of December 31, 2013.

We also face competition because of entities that self-insure, primarily in the commercial insurance market. From time to time, established and potential customers may examine the benefits and risks of self-insurance and other alternatives to traditional insurance.

In our commercial and personal lines admitted business segments, we have historically competed with major U.S. insurers and certain underwriting syndicates, including large national companies such as Travelers Companies, Inc., Allstate Insurance Company, GEICO, Progressive Corporation and State Farm Insurance; regional insurers such as Selective Insurance Company, Hanover Insurance and Peerless Insurance Company and smaller, more local competitors such as Greater New York Mutual,

 

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Magna Carta Companies, MMI Insurance Company, Quincy Mutual Fire Insurance Company and Utica First Insurance Company. Our non-admitted binding authority and commercial business with general agents historically competed with Scottsdale Insurance Company, Admiral Insurance Company, Mt. Hawley Insurance Company, Navigators Group, Inc., Essex Insurance Company, Colony Insurance Company, Century Insurance Group, Nautilus Insurance Group, RLI Corp., United States Liability Insurance Group and Burlington Insurance Group, Inc. In our program business, we competed against competitors that write program business such as QBE Insurance Group Limited, Delos Insurance Group, Am Trust Financial Services, Inc., RLI Corp., W.R. Berkley Corporation, Markel Corporation, Great American Insurance Group and Philadelphia Insurance Companies.

Many of these companies have greater financial, marketing and management resources and better access to the capital markets than we do and also have more experience, better ratings and more market recognition than we do. In addition, our recent need to significantly increase our reserves, the booking of goodwill and fixed asset impairment charges and A.M. Best’s, Fitch’s and Demotech’s related ratings actions, together with our delay in filing on a timely basis the Form 10-Qs for the periods ended June 30, 2013 and September 30, 2013 and this Form 10-K for the year ended December 31, 2013, our decision to restate our Form 10-K for the year ended December 31, 2012 and revise our Form 10-Q for the period ended March 31, 2013 have had a material adverse effect on the Company’s ability to compete for insurance and assumed reinsurance business. In addition, such actions have had a material adverse effect on the Company’s ability to raise capital. Such actions and events also may cause concern among our agents, brokers and policyholders, resulting in a movement of business away from our insurance subsidiaries to other stronger or more highly rated insurance carriers, which will further adversely affect our competitive position.

Because of these competitive pressures, there can be no assurance that we can compete effectively with our industry rivals, or that such pressures will not have a further material adverse effect on our business, operating results or financial condition. This includes competition for our producers. See “Since we depend on a core of selected producers for a large portion of our revenues, loss of business provided by any one of them could adversely affect us.” In the event we are unable to attract and retain these producers or they are unable to attract and retain customers for our products, growth and retention could be materially affected. Furthermore, certain competitors operate using a mutual insurance company structure and therefore may have dissimilar profitability and return targets.

In addition to competition in the operation of our business, we face competition from a variety of sources in attracting and retaining qualified employees. Our ability to operate may also be impaired if we are not effective in filling critical leadership positions, in developing the talent and skills of our human resources, in assimilating new executive talent into our organization, or in deploying human resource talent consistently with our business goals.

Currently pending or future litigation, regulatory inquiries or governmental proceedings could result in material adverse consequences, including injunctions, judgments or settlements.

We are, and from time to time become, involved in lawsuits (including class-action suits), regulatory inquiries and governmental and other legal proceedings arising out of the ordinary course of our business. Our pending legal and regulatory actions include proceedings specific to us and others generally applicable to business practices in the industries in which we operate. In connection with our insurance operations, plaintiffs’ lawyers may bring or are bringing class actions and individual suits alleging, among other things, issues relating to sales or underwriting practices, claims payments and procedures, product design, disclosure, administration, denial or delay of benefits and breaches of fiduciary or other duties to customers. Plaintiffs in class action and other lawsuits against us may seek very large and/or indeterminate amounts, including punitive and treble damages. Many of these matters raise difficult and complicated factual and legal issues and are subject to uncertainties and complexities. The timing of the final resolutions of these types of matters is often uncertain. The possible outcomes or resolutions of these matters could include adverse judgments or settlements, either of which could require substantial payments or changes in the manner in which we conduct our business, and could materially adversely affect our business, financial condition or results of operations. We are also subject to various regulatory inquiries, such as information requests, subpoenas and books and record examinations, from state and federal regulators and other authorities.

On February 21, 2013, the DFS announced that it was investigating certain insurers, including our largest insurance subsidiary, TICNY, for unacceptable claims practices in New York related to Superstorm Sandy. In connection with such investigation, the DFS previously issued an Insurance Law Section 308 letter to TICNY, which directed TICNY to provide information and supporting documentation and to which TICNY, as a New York-domiciled insurer, is legally required to respond. We are cooperating with the DFS in connection with such inquiry. We have responded to the DFS that the allegations in this matter do not constitute a pattern or practice. The investigation is still ongoing. Although we do not believe that the investigation will have a material adverse effect on our business, financial condition or results of operations or that we will be subject to material sanctions or other penalties, we are unable to predict the outcome of the investigation or whether Superstorm Sandy-related claims practices will result in additional regulatory inquiries or legal proceedings.

We are also involved in a number of putative securities class action lawsuits brought by alleged shareholders alleging violations of the federal securities laws in connection with, among other things, purported false and misleading statements concerning our loss reserve estimates. We are also involved in a number of lawsuits alleging violations of federal and Bermuda law in

 

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connection with Tower’s entry into the ACP Re Merger Agreement and the related proxy statement. We believe that it is not probable that these lawsuits will result in a loss and if they would result in a loss, that the amount of any loss cannot be reasonably estimated.

There can be no assurances that a favorable final outcome will be obtained in these cases, and defending any lawsuit is costly and can impose a significant burden on management and employees. Any litigation to which we are a party may result in an onerous or unfavorable judgment that may not be reversed upon appeal or in payments of substantial monetary damages, or we may decide to settle lawsuits on similarly unfavorable terms, which could adversely affect our business, financial condition or results of operations.

We have identified material weaknesses in our internal control over financial reporting, which have resulted in material misstatements in our financial statements and required us to restate our financial results and, if such material weaknesses are not remediated or additional weaknesses are identified in the future, could result in future material misstatements or omissions in our financial statements.

As disclosed in Item 9A of this Annual Report on Form 10-K and Amendment No. 2 to the Annual Report on Form 10-K for the year ended December 31, 2012 and Item 4 of Amendment No. 1 to the Quarterly Report on Form 10-Q for the period ended March 31, 2013, Tower’s management concluded the Company did not maintain an effective monitoring of its controls and resources. The Company was not effective in executing the documented controls, monitoring the control performance and identifying and responding to control deficiencies. The material weakness in monitoring of controls and resources contributed to the following material weaknesses:

 

(1) We did not maintain effective controls over the effectiveness of the loss reserve estimation process. Specifically, the Company did not maintain effective control to effectively review and approve all significant assumptions, methodologies and data used to determine the actuarial central estimate.

 

(2) We did not maintain effective controls over the premium receivable account reconciliation. Specifically, the Company did not maintain effective controls to effectively investigate and resolve reconciling items on a timely basis.

 

(3) We did not maintain effective controls over the impairment process of the long-lived tangible and intangible assets. Specifically, the Company did not evaluate all the triggering events indicating that the carrying value of its long-lived tangible and intangible assets may not be recoverable during 2013. The long-lived tangible and intangible assets include furniture, leasehold improvements, computer equipment, software, including internally developed software, and agency force lists.

 

(4) We did not maintain effective controls over the effectiveness of the tax valuation allowance estimation process. Specifically, the Company did not determine and monitor its valuation allowance of net deferred tax asset and the accuracy of its deferred taxes.

 

(5) We did not maintain effective control over certain information technology general controls. Specifically, the Company did not design and maintain effective controls with respect to segregation of duties, restricted access to programs and data, and change management activities. Consequently, controls that were dependent on the effective operation of information technology were not effectively designed to include adequate review of system generated data used in the operation of the controls and were determined not to be operating effectively and therefore could result in material misstatement of substantially all financial statement line items.

 

(6) We did not maintain effective controls over the period-end financial reporting process. Specifically, the company did not maintain sufficient personnel to perform its period-end financial reporting process effectively, including preparation and review of account reconciliations and evaluation of the accounting requirements resulting from recent events and circumstances. This in turn affected the timely preparation and review of interim and annual consolidated financial statements.

Tower’s management is implementing measures to remediate the material weaknesses in internal controls over financial reporting described above. Specifically, management is seeking to improve communications among its actuarial, underwriting, financial and claims personnel involved on the loss reserve committee regarding the importance of documentation of its assessments and conclusions of its meetings, as well as supporting analyses. Management also continues to improve its systems to facilitate the gathering of underlying data used in the actuarial reserving process. Until such time as management and the Board have concluded that this process is performing effectively, management intends to engage external consulting resources that will perform a quarterly actuarial study to assist the Company in estimating its loss reserves, and reviewing and critiquing the loss reserve committee documentation during the financial reporting process

In addition,

 

(i) the Company has obtained additional resources and enhanced the production of key reports to improve the accuracy of the elements used in its premiums receivable reconciliation process and timely evaluation and disposal of the reconciling items noted during the premiums reconciliation process, and

 

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(ii) Management is designing enhanced controls to ensure long-lived tangible and intangible assets are evaluated timely for recoverability whenever events or changes in circumstances indicate that their carrying amount may not be recoverable.

 

(iii) Management is developing a more formal recertification process for its information technology group that encompasses privilege at a financially significant level rather that at an application level.

 

(iv) Management will explicitly incorporate the duration of tax assets and liabilities into its valuation allowance calculation and will work to improve the accuracy of the reconciliations of tax bases and statutory/GAAP bases.

 

(v) Management is evaluating and realigning the resource allocation within the financial processes, including the use of consulting specialists, to ensure appropriate and timely completion and review of account reconciliations and the evaluation of unique accounting situations that arise from recent events.

As a result of the material weaknesses described above, in the past, the Company’s disclosure controls and procedures were not effective to timely prevent or detect inadvertent errors in its consolidated financial statements which led to the need to restate or revise its financial statements, as well as delays in some of its filings. If the Company’s efforts to remediate the weaknesses identified are not successful, or if other deficiencies occur, these weaknesses or deficiencies could also result in future misstatements of the Company’s results of operations, which could, among other things, result in additional restatements or revisions of the Company’s consolidated financial statements and/or further delays in the Company’s filings, and could have a material and adverse effect on the Company’s business, results of operations or financial condition.

As a result of the merger transaction between Tower Group, Inc. and Canopius Holdings (Bermuda) Limited, the Company will continue to incur additional direct and indirect costs.

The Company will continue to incur additional costs and expenses in connection with and as a result of the merger transaction between TGI and CHBL in March 2013. These costs and expenses include professional fees to comply with Bermuda corporate and tax laws and financial reporting requirements, costs and expenses incurred in connection with holding meetings of the Company’s Board of Directors and certain executive management meetings outside of the United States, as well as any additional costs the Company may incur going forward as a result of its new corporate structure. There can be no assurance that these costs will not exceed the costs historically borne by TGI and CHBL.

We may be adversely affected by foreign currency fluctuations.

We report our financial information in U.S. dollars. We limit, when possible, capital levels in local currencies, subject to the satisfaction of minimum regulatory requirements and the support of our local insurance operations. In addition, we enter into reinsurance and insurance contracts where we are obligated to pay losses in currencies other than U.S. dollars. The principal currency currently creating foreign exchange risk is the British pound sterling. Currently, less than 5 percent of our net assets are denominated in foreign currencies. We may experience losses resulting from fluctuations in the values of non-U.S. currencies, which could adversely affect our results of operations and financial condition.

The Bermudian regulatory system, and potential changes thereto, could have a material adverse effect on the Company’s business.

Bermuda statutes, regulations and policies of the BMA, require Bermuda reinsurers to maintain minimum levels of statutory capital, surplus and liquidity, to meet solvency standards, to obtain prior approval of ownership and transfer of shares (in certain circumstances) and to submit to certain periodic examinations of its financial condition. These statutes and regulations may, in effect, restrict the ability of Bermuda-based reinsurance subsidiaries of the Company, such as TRL, to write insurance and reinsurance policies, to make certain investments and to distribute funds. See “Our insurance subsidiaries are subject to minimum capital and surplus requirements. Failure to meet these requirements could subject us to regulatory action.” and “The regulatory system under which we operate, and potential changes thereto, could have a material adverse effect on our business.

The failure of any of the loss limitation methods we employ could have a material adverse effect on our financial condition or our results of operations.

Various provisions of our policies, including, but not limited to, limitations or exclusions from coverage or choice of forum, which have been negotiated to limit our risks, may not be enforceable in the manner we intend. At the present time we employ a variety of endorsements to our policies that limit exposure to known risks, including but not limited to exclusions relating to coverage for lead paint poisoning, asbestos and most claims for bodily injury or property damage resulting from the release of pollutants.

In addition, the policies we issue contain conditions requiring the prompt reporting of claims to us and our right to decline coverage in the event of a violation of that condition. Our policies also include limitations restricting the period in which a

 

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policyholder may bring a breach of contract or other claim against us, which in many cases is shorter than the statutory limitations for such claims in the states in which we write business. While these exclusions and limitations reduce the loss exposure to us and help eliminate known exposures to certain risks, it is possible that a court or regulatory authority could nullify or void an exclusion or legislation could be enacted modifying or barring the use of such endorsements and limitations in a way that would adversely affect our loss experience, which could have a material adverse effect on our financial condition or results of operations.

We may face substantial exposure to losses from terrorism, and we are currently required by law to provide coverage against such losses.

Our location and amount of business written in New York City and adjacent areas by our insurance subsidiaries may expose us to losses from terrorism. U.S. insurers are required by state and Federal law to offer coverage for terrorism in certain lines.

Although our insurance subsidiaries are protected by the federally funded terrorism reinsurance, there is a substantial deductible that must be met, the payment of which could have an adverse effect on our results of operations. See “Business — Reinsurance.” As a consequence of this legislation, potential losses from a terrorist attack could be substantially larger than previously expected, could also adversely affect our ability to obtain reinsurance on favorable terms, including pricing, and may affect our underwriting strategy, rating, and other elements of our operation. Also, there can be no assurance that this federally funded terrorism reinsurance will be available after 2014.

The effects of emerging claim and coverage issues on our business are uncertain.

As industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to claims and coverage may emerge. These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until some time after we have issued insurance or reinsurance contracts that are affected by the changes. As a result, the full extent of liability under our insurance or reinsurance contracts may not be known for many years after a contract is issued.

Since we depend on a core of selected producers for a large portion of our revenues, loss of business provided by any one of them could adversely affect us.

Our products are marketed by independent producers. In our Commercial segment, these independent producers are comprised of retail agents, wholesale agents who aggregate business from retail agents and program underwriting agents. In our Personal segment, these independent producers are comprised of retail and wholesale agents and managing general agencies who handle various underwriting and policy issuance tasks on our behalf and who generally accept submissions from various other independent producers.

Other insurance companies compete with us for the services and allegiance of these producers. These producers may choose to direct business to our competitors, or may direct less desirable risks to us. In our Commercial segment, approximately 45% of the 2013 gross premiums written, including premiums produced by our managing general agency subsidiaries on behalf of their issuing companies, were produced by our top 19 producers, representing 2% of our active agents and brokers. These producers each have annual written premiums of $5 million or more. As we build a broader territorial base, the number of producers with significant premium volumes with Tower in each of our segments is increasing.

Our largest producers (exclusive of assumed reinsurance brokers) in 2013 were Northeast Agencies, Risk Transfer and Morstan General Agency. In the year ended December 31, 2013, these producers accounted for 8.8%, 5.2% and 4.2%, respectively, of the total of our gross premiums written. No other producer was responsible for more than 3% of our gross premiums written.

A significant decrease in business from any of our largest producers would cause us to lose premium and require us to seek alternative producers or to increase submissions from existing producers. In the event we are unable to find replacement producers or increase business produced by our existing producers, our premium revenues would decrease and our business and results of operations would be materially and adversely affected.

Our reliance on producers subjects us to their credit risk.

With respect to the premiums produced by one of our managing general agents (“MGA”) for its issuing companies and a limited amount of premium volume written by our insurance subsidiaries, producers collect premiums from the policyholders and forward them to our MGA and our insurance subsidiaries. In most jurisdictions, when the insured pays premiums for these policies to producers for payment over to our MGA or our insurance subsidiaries, the premiums are considered to have been paid under applicable insurance laws and regulations, and the insured will no longer be liable to us for those amounts whether or not we have actually received the premiums from the producer. Consequently, we assume a degree of credit risk associated with producers. Although producers’ failures to remit premiums to us have not caused a material adverse impact on us to date, there have been instances where producers collected premiums but did not remit them to us, and we were nonetheless required under applicable law to provide the coverage set forth in the policy despite the absence of premiums. Because the possibility of these

 

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events is dependent in large part upon the financial condition and internal operations of our producers, which in most cases is not public information, we are not able to quantify the exposure presented by this risk. If we are unable to collect premiums from our producers in the future, our financial condition and results of operations could be materially and adversely affected.

Our acquisitions could result in integration difficulties, unexpected expenses, diversion of management’s attention and other negative consequences.

We have made numerous acquisitions in recent years. We attempt to integrate the technology, operations, systems and personnel of acquired businesses with our own and attempt to grow the acquired businesses as part of our company. The integration of other businesses is a complex process and places significant demands on our management, financial, technical and other resources. If we are unsuccessful in integrating these businesses, our financial and operating performance could suffer. The risks and challenges associated with the acquisition and integration of acquired businesses include:

 

 

We may be unable to efficiently consolidate our financial, operational and administrative functions with those of the businesses we have acquired;

 

 

Our management’s attention may be diverted from other business concerns;

 

 

We may be unable to retain and motivate key employees of an acquired company;

 

 

Litigation, indemnification claims and other unforeseen claims and liabilities may arise from the acquisition or operation of acquired businesses;

 

 

The costs necessary to complete integration exceed our expectations or outweigh some of the intended benefits of the transactions we complete;

 

 

We may be unable to maintain the customers or goodwill of an acquired business; and

 

 

The costs necessary to improve or replace the operating systems, products and services of acquired businesses may exceed our expectations.

We have not fully integrated several of our recent acquisitions, and this failure has led to delays in financial reporting and material weaknesses in our internal controls (see “We have identified material weaknesses in our internal control over financial reporting, which have resulted in material misstatements in our financial statements and required us to restate our financial results and, if such material weaknesses are not remediated or additional weaknesses are identified in the future, could result in future material misstatements or omissions in our financial statements” for additional information). We may not be able to integrate our acquisitions successfully with our operations on schedule or at all. There can be no assurances that we will not incur large expenses in connection with business units we acquire. Further, there can be no assurances that acquisitions will result in cost savings or sufficient revenues or earnings to justify our investment in, or our expenses related to, these acquisitions.

We could be adversely affected by the loss of one or more principal employees or by an inability to attract and retain staff.

Our success will depend in substantial part upon our ability to attract and retain qualified executive officers, experienced underwriting talent and other skilled employees who are knowledgeable about our business. We rely substantially upon the services of our executive management team. If we were to lose the services of members of our key management team, our business could be adversely affected. While we believe we have been successful in attracting and retaining key personnel throughout our history, we have recently experienced the departure of a number of employees. We have employment agreements with William W. Fox, Jr., our President and Chief Executive Officer, and other members of our senior management team. We do not currently maintain key man life insurance policies with respect to our employees.

Our investment performance may suffer as a result of adverse capital market developments or other factors, which may affect our financial results and ability to conduct business.

We invest the premiums we receive from policyholders until they are needed to pay policyholder claims or other expenses. At December 31, 2013, our invested assets, including the Reciprocal Exchanges’, consisted of $1.6 billion in fixed maturity securities and $106.7 million in equity securities at fair value. Additionally, we held $396.0 million in cash and cash equivalents, short-term investments, and other invested assets. In 2013, we earned $107.5 million of net investment income representing 6.3% of our total revenues. At December 31, 2013, we had unrealized gains of $64.1 million, which could change significantly depending on changes in market conditions. Our funds are primarily invested by outside professional investment advisory management firms under the direction of our management team in accordance with detailed investment guidelines set by us. Although our investment policies stress diversification of risks, conservation of principal and liquidity, our investments are subject to a variety of investment risks, including risks relating to general economic conditions, market volatility, interest rate fluctuations, liquidity risk and credit and default risk. (Interest rate risk is discussed below under the heading, “We may be adversely affected by interest rate changes.”) In particular, negative revenue and liquidity issues in various states and municipalities and future legislative changes could have unfavorable implications on our $1.6 billion bond portfolio.

 

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The volatility of our claims may force us to liquidate securities, which may cause us to incur capital losses. If we do not structure our investment portfolio so that it is appropriately matched with our insurance and reinsurance liabilities, we may be forced to liquidate investments prior to maturity at a significant loss to cover such liabilities. Investment losses could significantly decrease our asset base and statutory surplus, thereby affecting our ability to conduct business. We recognized net realized capital gains for 2013 of $25.0 million which included other-than-temporary-impairment (“OTTI”) charges of $13.4 million. The OTTI charges were primarily the result of write-downs of our securities. As a result of the market volatility, we may experience difficulty in determining accurately the value of our various investments.

We may be adversely affected by interest rate changes.

Our operating results are affected, in part, by the performance of our investment portfolio. General economic conditions affect the markets for interest rate sensitive securities, including the level and volatility of interest rates and the extent and timing of investor participation in such markets. Unexpected changes in general economic conditions could create volatility or illiquidity in these markets in which we hold positions and harm our investment return. Our investment portfolio is primarily comprised of interest rate sensitive instruments, such as bonds, which may be adversely affected by changes in interest rates. A significant increase in interest rates could have a material adverse effect on our financial condition or results of operations. Generally, bond prices decrease as interest rates rise. Changes in interest rates could also have an adverse effect on our investment income and results of operations. For example, if interest rates decline, investment of new premiums received and funds reinvested may earn less than expected.

In addition to the normal market risk, mortgage-backed securities contain prepayment and extension risk that differ from other financial instrument and constituted 14.1% of our invested assets, including cash and cash equivalents as of December 31, 2013. As with other fixed income investments, the fair market value of these securities fluctuates depending on market and other general economic conditions and the interest rate environment. Changes in interest rates can also expose us to prepayment risks on these investments. When interest rates fall, mortgage-backed securities may be prepaid more quickly than expected and the holder must reinvest the proceeds at lower interest rates. Certain of our mortgage-backed securities currently consist of securities with features that reduce the risk of prepayment, but there is no guarantee that we will not invest in other mortgage-backed securities that lack this protection. In periods of increasing interest rates, mortgage-backed securities are prepaid more slowly, which may require us to receive interest payments that are below the interest rates then prevailing for longer than expected.

Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control.

The regulatory system under which we operate, and potential changes thereto, could have a material adverse effect on our business.

Our insurance subsidiaries are subject to comprehensive regulation and supervision in their respective jurisdictions of domicile. The purpose of the insurance laws and regulations is to protect insureds, not our shareholders. These regulations are generally administered by the insurance departments in which the individual insurance companies are domiciled and relate to, among other things:

 

 

standards of solvency, including risk- based capital measurements;

 

 

restrictions on the nature, quality and concentration of investments;

 

 

required methods of accounting;

 

 

rate and form regulation pertaining to certain of our insurance businesses;

 

 

mandating certain insurance benefits;

 

 

potential assessments for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies; and

 

 

transactions with affiliates.

Significant changes in these laws and regulations could make it more expensive to conduct our business. The insurance subsidiaries’ domiciliary state insurance departments, and, with respect to CastlePoint and TRL, the BMA, also conduct periodic examinations of the affairs of their domiciled insurance companies and require the filing of annual and other reports relating to financial condition, holding company issues and other matters. These regulatory requirements may adversely affect or inhibit our ability to achieve some or all of our business objectives.

 

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Our insurance subsidiaries may not be able to obtain or maintain necessary licenses, permits, authorizations or accreditations in new states we intend to enter, or may be able to do so only at significant cost. In addition, we may not be able to comply fully with or obtain appropriate exemptions from the wide variety of laws and regulations applicable to insurance companies or holding companies. Failure to comply with or to obtain appropriate authorizations and/or exemptions under any applicable laws could result in restrictions on our ability to do business or engage in certain activities that are regulated in one or more of the jurisdictions in which we operate and could subject us to fines and other sanctions, which could have a material adverse effect on our business. In addition, changes in the laws or regulations to which our operating subsidiaries are subject could adversely affect our ability to operate and expand our business or could have a material adverse effect on our financial condition or results of operations.

In recent years, the U.S. insurance regulatory framework has come under increased federal scrutiny, and some state legislatures have considered or enacted laws that may alter or increase state regulation of insurance and reinsurance companies and holding companies. Moreover, state insurance regulators regularly re-examine existing laws and regulations, often focusing on modifications to holding company regulations, interpretations of existing laws and the development of new laws. Changes in these laws and regulations or the interpretation of these laws and regulations could have a material adverse effect on our financial condition or results of operations. The highly publicized investigations of the insurance industry by state and other regulators and government officials in recent years have led to, and may continue to lead to, additional legislative and regulatory requirements for the insurance industry and may increase the costs of doing business.

The activities of our MGAs are subject to licensing requirements and regulation under the laws of New York, New Jersey, Florida and other states where they do business. The businesses of our MGAs depend on the validity of, and continued good standing under, the licenses and approvals pursuant to which they operate, as well as compliance with pertinent regulations. The businesses of the attorneys-in-fact depend on the validity of, and continued good standing under, the licenses and approvals pursuant to which the Reciprocal Exchanges operate, as well as compliance with pertinent regulations. As of February 5, 2009, the date of closing of our acquisition of CastlePoint, our activities became subject to certain licensing requirements and regulation under the laws of Bermuda.TRL, a Bermuda-domiciled subsidiary of Tower, is also subject to licensing requirements and regulation under the laws of Bermuda.

Licensing laws and regulations vary from jurisdiction to jurisdiction. In all jurisdictions, the applicable licensing laws and regulations are subject to amendment and interpretation by regulatory authorities. Generally, such authorities are vested with relatively broad and general discretion as to the granting, renewing and revoking of licenses and approvals. Licenses may be denied or revoked for various reasons, including the violation of such regulations, conviction of crimes and the like. Possible sanctions which may be imposed include the suspension of individual employees, limitations on engaging in a particular business for specified periods of time, revocation of licenses, censures, redress to clients and fines. In some instances, our MGAs follow practices based on its or its counsel’s interpretations of laws and regulations, or those generally followed by the industry, which may prove to be different from those of regulatory authorities.

As industry practices and legal, judicial, social and other environmental conditions change, unexpected issues related to claims and coverage may emerge. These issues may adversely affect us by either extending coverage beyond our underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until some time after we have issued insurance or reinsurance contracts that are affected by the changes. As a result, the full extent of liability under our insurance or reinsurance contracts may not be known for many years after a contract is issued. The effects of this and other unforeseen emerging claim and coverage issues are extremely hard to predict and could adversely affect us or our business.

In addition, we are currently under heightened regulatory oversight by the insurance departments in certain states. As a result, we must, among other actions, provide increased information to such insurance departments and adhere to limitations on certain payments and transactions. The effects of this and other potential future actions by the insurance departments are extremely hard to predict and could adversely affect us.

If the assessments we are required to pay are increased drastically, our results of operations and financial condition will suffer.

Our insurance subsidiaries are required to participate in various mandatory insurance facilities or in funding mandatory pools, which are generally designed to provide insurance coverage for consumers who are unable to obtain insurance in the voluntary insurance market. Our insurance subsidiaries are subject to assessments in the states where we do business for various purposes, including the provision of funds necessary to fund the operations of the insurance department and insolvency funds. In 2013, the insurance subsidiaries were assessed $13.1 million by various state insurance-related agencies. These assessments are generally determined by an insurer’s percentage of the total premiums written in a state within a particular line of business. The Company is permitted to assess premium surcharges on workers’ compensation policies that are based on statutorily enacted rates. As of December 31, 2013, the liability for the various workers’ compensation funds, which includes amounts assessed on workers’

 

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compensation policies, was $0.8 million for our insurance subsidiaries. Our share of any assessments could increase. However, we cannot predict with any degree of certainty the amount of future assessments, because they depend on factors outside our control, such as insolvencies of other insurance companies. Significant assessments, or a drastic increase thereof, could have a material adverse effect on our financial condition or results of operations.

We rely on our information technology and telecommunications systems to conduct our business.

Our business is dependent upon the functioning of our information technology and telecommunication systems. We rely upon our systems, as well as the systems of our vendors to underwrite and process our business, make claim payments, provide customer service, provide policy administration services such as endorsements, cancellations and premium collections, comply with insurance regulatory requirements and perform actuarial and other analytical functions necessary for pricing and product development. Our operations are dependent upon our ability to timely and efficiently process our business and protect our information and telecommunications systems from physical loss, telecommunications failure or other similar catastrophic events, as well as from security breaches. While we have implemented business contingency plans and other reasonable and appropriate internal controls to protect our systems from interruption, loss or security breaches, a sustained business interruption or system failure could adversely impact our ability to process our business, provide customer service, pay claims in a timely manner or perform other related functions.

The operations and maintenance of our policy, billing, claims administration systems, and data warehouse have been operating in one production data center environment and one disaster recovery environment which are located in two separate regions. The development and implementation of new claims, billing and policy issuance systems have begun. Until these systems are fully migrated and implemented, we must depend on existing technology platforms that require more manual or duplicate processing.

In addition, while the Transition Services Agreement (the “TSA”) between OneBeacon and us will terminate as of June 30, 2014, there can be no assurance that our IT systems will be able to support the applicable business following the expiration of the TSA.

In addition, as disclosed in Item 9A of this Annual Report on Form 10-K, we did not effectively maintain certain information technology general controls. Specifically, the Company did not design and maintain effective controls with respect to segregation of duties, restricted access to programs and data, and change management activities. Consequently, controls that were dependent on the effective operation of information technology were not effectively designed to include adequate substantive review of system generated data. These controls were determined not to be operating effectively and therefore could result in a material misstatement of substantially all financial line items.

The failure in cyber- or other information security systems, as well as the occurrence of events unanticipated in our disaster recovery systems and management continuity planning could result in a loss or disclosure of confidential information, damage to our reputation and impairment of our ability to conduct business effectively.

Our business is highly dependent upon the effective operation of our computer systems. We retain confidential and proprietary information on our computer systems and we rely on sophisticated technologies to maintain the security of that information. Our computer systems have been, and will likely continue to be, subject to computer viruses or other malicious codes, unauthorized access, cyber-attacks or other computer-related penetrations. While, to date, we have not experienced a material breach of cyber-security, administrative and technical controls and other preventive actions we take to reduce the risk of cyber-incidents and protect our information technology may be insufficient to prevent physical and electronic break-ins, cyber-attacks or other security breaches to our computer systems.

In addition, in the event of a disaster such as a natural catastrophe, epidemic, industrial accident, blackout, computer virus, terrorist attack, cyber-attack or war, unanticipated problems with our disaster recovery systems could have a material adverse impact on our business, financial condition or results of operations, particularly if those problems affect our computer-based data processing, transmission, storage and retrieval systems and destroy valuable data. In addition, in the event that a significant number of our managers were unavailable following a disaster, our ability to effectively conduct business could be severely compromised. These interruptions also may interfere with our suppliers’ ability to provide goods and services and our employees’ ability to perform their job responsibilities.

The failure of our computer systems and/or our disaster recovery plans for any reason could cause significant interruptions in our operations and result in a failure to maintain the security, confidentiality or privacy of sensitive data, including personal information relating to our customers. Such a failure could harm our reputation, subject us to regulatory sanctions and legal claims, lead to a loss of customers and revenues and otherwise adversely affect our business and financial results.

We may be unable to collect amounts due from the Reciprocal Exchanges through our ownership of surplus notes.

We provide management services for a fee to the Reciprocal Exchanges. The Reciprocal Exchanges are capitalized entirely with surplus notes that we acquired from OneBeacon Insurance Group, Ltd. for $96.9 million. Reciprocals are policyholder-owned insurance carriers organized as unincorporated associations. We have no ownership interest in the Reciprocal Exchanges. Under current accounting rules, our consolidated financial statements include the results of the Reciprocal Exchanges, and therefore, the surplus notes and any accrued interest are eliminated in consolidation. Payments of principal and interest on notes of the Reciprocal Exchanges are subject to regulatory approval. If either of the Reciprocal Exchanges is unable to obtain insurance regulatory approval to repay us, we would be unable to collect amounts owed under the related surplus note, which would impact the statutory capital of the insurance subsidiaries that own the surplus notes and impair their ability to pay dividends to Tower.

 

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Adverse economic factors including recession, inflation, periods of high unemployment or lower economic activity could result in the Company selling fewer policies than expected and/or an increase in premium defaults which, in turn, could affect the Company’s growth and profitability.

Negative economic factors may also affect the Company’s ability to receive the appropriate rate for the risk it insures with its policyholders and may impact its policy flow. In an economic downturn, the degree to which prospective policyholders apply for insurance and fail to pay all balances owed may increase. Existing policyholders may exaggerate or even falsify claims to obtain higher claims payments. These outcomes would reduce the Company’s underwriting profit to the extent these effects are not reflected in the rates charged by the Company.

Risk Factors Relating to Disruptions in the Financial Markets

We could be forced to sell investments to meet our liquidity requirements.

We invest the premiums we receive from customers until they are needed to pay policyholder claims or until they are recognized as profits. Consequently, we seek to match the duration of our investment portfolio with the duration of our loss and loss adjustment expense reserves to ensure strong liquidity and avoid having to liquidate securities to fund claims. Risks such as inadequate loss and loss adjustment reserves or unfavorable trends in litigation could potentially result in the need to sell investments to fund these liabilities. Such sales could result in significant realized losses depending on the conditions of the general market, interest rates and credit issues with individual securities.

Our risk management policies and procedures may leave us exposed to unidentified or unanticipated risk, which could negatively affect our business.

Our policies and procedures may not be comprehensive and may not identify every risk to which we are exposed. Many of our methods for managing risk and exposures are based upon the use of observed historical market behavior or statistics based on historical models. As a result, these methods may not fully predict future exposures, which can be significantly greater than our historical measures indicate. Other risk management methods depend upon the evaluation of information regarding markets, clients, catastrophe occurrence or other matters that is publicly available or otherwise accessible to us. This information may not always be accurate, complete, up-to-date or properly evaluated.

If our business does not perform well, we may be required to recognize an impairment of our intangible or other long-lived assets, or to establish a valuation allowance against the deferred income tax asset, which could adversely affect our business, financial condition or results of operations.

Intangible assets represent the amount of fair value assigned to certain assets when we acquire a subsidiary or a book of business. Intangible assets are classified as having either a finite or an indefinite life. We test the recoverability of indefinite life intangibles at least annually. We test the recoverability of finite life intangibles whenever events or changes in circumstances indicate that the carrying value of a finite life intangible may not be recoverable. An impairment is recognized if the carrying value of an intangible asset is not recoverable and exceeds its fair value, in which circumstances we must write down the intangible asset by the amount of the impairment, with a corresponding charge to income. Such write downs could have a material adverse effect on our business, financial condition or results of operations.

In 2013, the Company performed an impairment analysis in which the implied fair value of the fixed assets was determined to be lower than the carrying value. Management in its judgment concluded the fixed assets were impaired as of September 30, 2013 and recorded a non-cash charge to earnings of $125.8 million.

Deferred income tax represents the tax effect of the differences between the book and tax basis of assets and liabilities. Deferred tax assets are assessed periodically by management to determine if they are realizable. Factors in management’s determination include the performance of the business including the ability to generate taxable capital gains. If, based on available information, it is more likely than not that the deferred income tax asset will not be realized, then a valuation allowance must be established with a corresponding charge to net income. Such charges could have a material adverse effect on our business, financial condition or results of operations.

The Company’s U.S. based operations have a pre-tax loss for 2013, which results in a three-year cumulative tax loss position on its U.S. subsidiaries. After considering this negative evidence and uncertainty regarding the Company’s ability to generate sufficient future taxable income in the United States, the Company concluded that it should not recognize any net deferred tax assets (comprised principally of net operating loss carryforwards). The Company, therefore, has provided a full valuation allowance against its deferred tax asset at December 31, 2013.

 

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Changes in accounting standards issued by the Financial Accounting Standards Board (the “FASB”) or other standard-setting bodies may adversely affect our financial statements.

Our financial statements are subject to the application of accounting principles generally accepted in the United States of America, which is periodically revised and/or expanded. Accordingly, from time to time we are required to adopt new or revised accounting standards issued by recognized authoritative bodies, including the FASB. The impact of accounting pronouncements that have been issued but not yet implemented is disclosed in our reports filed with the SEC. See Note 1 of the Notes to the Consolidated Financial Statements included in this Annual Report on Form 10-K. An assessment of proposed standards, including standards on insurance contracts and accounting for financial instruments, is not provided as such proposals are subject to change through the exposure process and official positions of the FASB are determined only after extensive due process and deliberations. Therefore, the effects on our financial statements cannot be meaningfully assessed. The required adoption of future accounting standards could have a material adverse effect on our business, financial condition or results of operations, including on our net income.

Our associates could take excessive risks which could negatively affect our financial condition and business.

As an insurance enterprise, we are in the business of accepting certain risks. The associates who conduct our business, including executive officers and other members of management, sales managers, investment professionals, product managers, sales agents, and other associates, as well as managing general agents and other agents with binding authority over the issuance of our policies do so in part by making decisions and choices that involve exposing us to risk. These include decisions such as setting underwriting guidelines and standards, product design and pricing, determining what assets to purchase for investment and when to sell them, which business opportunities to pursue, and other decisions. We endeavor, in the design and implementation of our compensation programs and practices, to avoid giving our associates incentives to take excessive risks; however, associates may take such risks regardless of the structure of our compensation programs and practices. Similarly, although we employ controls and procedures designed to monitor associates’ business decisions and prevent us from taking excessive risks, these controls and procedures may not be effective. If our associates take excessive risks, the impact of those risks could have a material adverse effect on our financial condition and business operations.

Insurance laws and regulations, our bye-laws and the terms of our indebtedness may impede or discourage a takeover, which could cause the market price of our shares to decline.

We currently have insurance subsidiaries in Florida, New York, California, Illinois, New Jersey, New Hampshire, Maine and Massachusetts. The insurance company change of control laws in each of those states requires written approval from the superintendent or commissioner of the insurance department of such state before a third party can acquire control of us. Control is presumed to exist if any person, directly or indirectly, controls or holds the power to vote more than 10% (or 5% in the case of Florida) of our voting securities.

In addition, our bye-laws contain provisions that may entrench directors and make it more difficult for shareholders to replace directors even if the shareholders consider it beneficial to do so. In addition, these provisions could delay or prevent a change of control that a shareholder might consider favorable. For example, these provisions may prevent a shareholder from receiving the benefit from any premium over the market price of the Company’s common shares offered by a bidder in a potential takeover. Even in the absence of an attempt to effect a change in management or a takeover attempt, these provisions may adversely affect the prevailing market price of the Company’s common shares if they are viewed as discouraging changes in management and takeover attempts in the future.

There is uncertainty regarding the application of the U.S. Foreign Account Tax Compliance Act (“FATCA”) to the Company and its subsidiaries.

FATCA requires certain foreign financial institutions and other foreign entities to undertake due diligence procedures to identify and provide information about shareholders and accounts held by US persons. In cases of non-compliance, a 30% withholding tax may be imposed. The impact of FATCA on the Company, its subsidiaries and their operations is uncertain.

Adverse capital and credit market conditions may significantly affect our ability to meet liquidity needs, access to capital and cost of capital.

The capital and credit markets have experienced and continue to experience volatility and disruption in certain market sectors.

We need liquidity to pay claims, reinsurance premiums, operating expenses, and interest on our debt. Without sufficient liquidity, we will be forced to curtail our operations and our business will suffer. The principal sources of our liquidity are insurance premiums, reinsurance recoveries, ceding commissions, fee revenues, cash flow from our investment portfolio and other assets, consisting mainly of cash or assets that are readily convertible into cash. Other sources of liquidity in normal markets also include a variety of instruments, including medium- and long-term debt, junior subordinated debt securities and shareholders’ equity.

In the event current resources do not satisfy our needs, we may have to seek additional financing. The availability of additional financing will depend on a variety of factors such as market conditions, the general availability of credit, the volume of trading

 

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activities, the overall availability of credit to the financial services industry, our credit ratings and credit capacity, as well as the possibility that customers or lenders could develop a negative perception of our long- or short-term financial prospects if we incur large investment losses or if the level of our business activity decreased due to a market downturn. Similarly, our access to funds may be impaired if regulatory authorities or rating agencies take further actions against us. Our internal sources of liquidity may prove to be insufficient, and in such case, we may not be able to successfully obtain additional financing on favorable terms, or at all.

Disruptions, uncertainty or volatility in the capital and credit markets may also limit our access to capital required to operate our business. Such market conditions may limit our ability to satisfy statutory capital requirements, generate fee income and access the capital necessary to grow our business. As such, we may be forced to delay raising capital, issue shorter tenor securities than we would prefer, or bear an unattractive cost of capital which could decrease our profitability and significantly reduce our financial flexibility. Our results of operations, financial condition, cash flows and statutory capital position could be materially adversely affected by disruptions in the financial markets.

In addition, even absent market volatility, the Company is subject to a contractual prohibition on accessing the capital markets pursuant to the ACP Re Merger Agreement, which could adversely affect our ability to meet liquidity needs.

Difficult conditions in the global capital markets and the economy generally may materially adversely affect our business and results of operations, and we do not expect these conditions to improve in the near future.

Our results of operations are materially affected by conditions in the capital markets and the economy generally. Recently, concerns over inflation, energy costs, geopolitical issues, the availability and cost of credit, the mortgage market and a declining real estate market have contributed to increased volatility and diminished expectations for the economy and markets going forward. These concerns and the continuing market upheavals may have an adverse effect on us. Our revenues may decline in such circumstances and our profit margins could erode. In addition, in the event of extreme prolonged market disruptions we could incur significant losses. Even in the absence of a market downturn, we are exposed to substantial risk of loss due to market volatility.

Factors such as consumer spending, business investment, government spending, the volatility and strength of the capital markets, and inflation all affect the business and economic environment and, ultimately, the amount and profitability of our business. In an economic downturn characterized by higher unemployment, lower family income, lower corporate earnings, lower business investment and lower consumer spending, the demand for our insurance products could be adversely affected. In addition, we may experience an elevated incidence of claims. Adverse changes in the economy could affect earnings negatively and could have a material adverse effect on our business, results of operations and financial condition. The current mortgage crisis has also raised the possibility of future legislative and regulatory actions that could further impact our business. We cannot predict whether or when such actions may occur, or what impact, if any, such actions could have on our business, results of operations and financial condition.

The impairment of other financial institutions could adversely affect us.

We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, investment banks, reinsurers and other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty. We also have exposure to various financial institutions in the form of unsecured debt instruments and equity investments and unsecured debt instruments issued by various state and local municipal authorities. There can be no assurance that any such losses or impairments to the carrying value of these assets would not materially and adversely affect our business and results of operations.

We are exposed to significant financial and capital markets risk which may adversely affect our results of operations, financial condition and liquidity, and our net investment income can vary from period to period.

We are exposed to significant financial and capital markets risk, including changes in interest rates, credit spreads, equity prices, real estate values, market volatility, the performance of the economy in general, the performance of the specific obligors included in our portfolio and other factors outside our control. Our exposure to interest rate risk relates primarily to the market price and cash flow variability associated with changes in interest rates. A rise in interest rates will increase the net unrealized loss position of our investment portfolio. Our investment portfolio contains interest rate sensitive instruments, such as fixed income securities, which may be adversely affected by changes in interest rates from governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control. A rise in interest rates would increase the net unrealized loss position of our investment portfolio, which would be offset by our ability to earn higher rates of return on funds reinvested. Conversely, a decline in interest rates would decrease the net unrealized loss position of our investment portfolio, which would be offset by lower rates of return on funds reinvested.

Our exposure to credit spreads primarily relates to market price associated with changes in credit spreads. A widening of credit spreads will increase the net unrealized loss position of the investment portfolio and, if issuer credit spreads increase significantly

 

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or for an extended period of time, would likely result in higher other-than-temporary impairments. Credit spread tightening will reduce net investment income associated with new purchases of fixed maturities. Our investment portfolio also has significant exposure to risks associated with mortgage-backed securities. As with other fixed income investments, the fair market value of these securities fluctuates depending on market and other general economic conditions and the interest rate environment.

In addition, market volatility can make it difficult to value certain of our securities if trading becomes less frequent. As such, valuations may include assumptions or estimates that may have significant period to period changes which could have a material adverse effect on our consolidated results of operations or financial condition. Continuing challenges include continued weakness in the real estate market and increased mortgage delinquencies, investor anxiety over the economy, rating agency downgrades of various structured products and financial issuers, unresolved issues with structured investment vehicles, deleveraging of financial institutions and hedge funds and a serious dislocation in the inter-bank market. Continued volatility, changes in interest rates, changes in credit spreads and defaults, a lack of pricing transparency, market liquidity and declines in equity prices, individually or in tandem, could have a material adverse effect on our results of operations, financial condition or cash flows through realized losses, impairments, and changes in unrealized positions.

Our valuation of fixed maturity and equity securities may include methodologies, estimations and assumptions which are subject to differing interpretations and could result in changes to investment valuations that may materially adversely affect our results of operations or financial condition.

We have categorized our fixed maturity, equity securities and short-term investments into a three-level hierarchy, based on the priority of the inputs to the respective valuation technique. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). An asset or liability’s classification within the fair value hierarchy is based on the lowest level of significant input to its valuation. The relevant GAAP guidance defines the input levels as follows:

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

Level 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 securities and obligations of U.S. government agencies, together with municipal bonds, corporate debt securities, commercial mortgage and asset-backed securities, and certain residential mortgage-backed securities that are generally investment grade.

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

At December 31, 2013, 6.0%, 91.0% and 3.0% of these securities represented Level 1, Level 2 and Level 3, respectively. The availability of observable inputs varies and is affected by a wide variety of factors. When the valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires significantly more judgment. The degree of judgment exercised by management in determining fair value is greatest for investments categorized as Level 3. For investments in this category, we consider prices and inputs that are current as of the measurement date.

During periods of market disruption including periods of significantly rising or high interest rates, rapidly widening credit spreads or illiquidity, it may be difficult to value certain of our securities, for example, non-agency residential mortgage-backed securities, if trading becomes less frequent and/or market data becomes less observable. There may be certain asset classes that were in active markets with significant observable data that become illiquid due to the current financial environment. In such cases, more securities may fall to Level 3 and thus require more subjectivity and management judgment. As such, valuations may include inputs and assumptions that are less observable or require greater estimation as well as valuation methods which are more sophisticated or require greater estimation, thereby resulting in values which may be less than the value at which the investments may be ultimately sold. Further, rapidly changing and unprecedented credit and equity market conditions could materially impact the valuation of securities as reported within our consolidated financial statements and the period-to-period changes in value could vary significantly. Decreases in value may have a material adverse effect on our results of operations or financial condition.

 

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Some of our investments are relatively illiquid and are in asset classes that have been experiencing significant market valuation fluctuations.

We hold certain investments that may lack liquidity, such as non-agency residential mortgage-backed securities, subprime mortgage-backed securities, certain commercial mortgage-backed securities, rated below AA, and our other invested assets. These asset classes represented 28.0% of the carrying value of our total cash and invested assets as of December 31, 2013.

The reported values of our less liquid asset classes described in the paragraph above do not necessarily reflect the lowest current market price for the asset. If we were forced to sell certain of our assets in the current market, there can be no assurance that we would be able to sell them for the prices at which we have recorded them and we may be forced to sell them at lower prices.

The determination of the amount of impairments taken on our investments is highly subjective and could materially impact our results of operations or financial position.

The determination of the amount of allowances and impairments varies by investment type and is based upon our periodic evaluation and assessment of known and inherent risks associated with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available. Management updates its evaluations regularly and reflects changes in allowances and impairments in operations as such evaluations are revised. There can be no assurance that our management has accurately assessed the level of impairments taken in our financial statements. Furthermore, additional impairments may need to be taken in the future. Historical trends may not be indicative of future impairments.

For example, the cost of our fixed maturity and equity securities is adjusted for impairments in value deemed to be other-than-temporary in the period in which the determination is made. The assessment of whether impairments have occurred is based on management’s case-by-case evaluation of the underlying reasons for the decline in fair value.

Our management regularly reviews our fixed maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. In evaluating potential impairment, management considers, among other criteria: (i) the current fair value compared to amortized cost or cost, as appropriate; (ii) the length of time the security’s fair value has been below amortized cost or cost; (iii) specific credit issues related to the issuer such as changes in credit rating, reduction or elimination of dividends or non-payment of scheduled interest payments; (iv) management’s intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in value to cost; (v) specific cash flow estimations for certain mortgage-backed securities; and (vi) current economic conditions.

Gross unrealized losses may be realized or result in future impairments.

Our gross unrealized losses on fixed maturity securities at December 31, 2013 were $23.6 million pre-tax, and the amount of gross unrealized losses on fixed maturity securities that have been in an unrealized loss position for twelve months or more was $4.2 million pre-tax. Realized losses or impairments may have a material adverse impact on our results of operation and financial position.

Risks Related to Our Industry

The threat of terrorism and military and other actions may adversely affect our investment portfolio and may result in decreases in our net income, revenue and assets under management.

The threat of terrorism, both within the United States and abroad, and military and other actions and heightened security measures in response to these types of threats, may cause significant volatility and declines in the equity markets in the United States, Europe and elsewhere, as well as loss of life, property damage, additional disruptions to commerce and reduced economic activity. Some of the assets in our investment portfolio may be adversely affected by declines in the equity markets and economic activity caused by the continued threat of terrorism, ongoing military and other actions and heightened security measures.

There can be no assurances that terrorist attacks or the threat of future terrorist events in the United States and abroad or military actions by the United States will not have a material adverse effect on our business, financial condition or results of operations.

Our results of operations and revenues may fluctuate as a result of many factors, including cyclical changes in the insurance industry, which may cause the price of Tower securities issued to investors to be volatile.

The results of operations of companies in the property and casualty insurance industry historically have been subject to significant fluctuations and uncertainties. Our profitability can be affected significantly by:

 

 

competition;

 

 

rising levels of loss costs that we cannot anticipate at the time we price our products;

 

 

volatile and unpredictable developments, including man-made, weather-related and other natural catastrophes or terrorist attacks;

 

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changes in the level of reinsurance capacity and insurance capacity;

 

 

changes in the amount of loss and loss adjustment expense reserves resulting from new types of claims and new or changing judicial interpretations relating to the scope of insurers’ liabilities; and

 

 

fluctuations in equity markets and interest rates, inflationary pressures, conditions affecting the credit markets, segments thereof or particular asset classes and other changes in the investment environment, which affect returns on invested assets and may impact the ultimate payout of losses.

The supply of insurance is related to prevailing prices, the level of insured losses and the level of industry surplus which, in turn, may fluctuate in response to changes in rates of return on investments being earned in the insurance and reinsurance industry. As a result, the insurance business historically has been a cyclical industry characterized by periods of intense price competition due to excessive underwriting capacity alternating with periods when shortages of capacity permitted favorable premium levels. Significant amounts of new capital flowing into the insurance and reinsurance sectors could lead to a significant reduction in premium rates, less favorable policy terms and fewer submissions for our underwriting services. In addition to these considerations, changes in the frequency and severity of losses suffered by insureds and insurers may affect the cycles of the insurance business significantly, and we expect to experience the effects of such cyclicality.

This cyclicality could have a material adverse effect on our results of operations and revenues, which may cause the price of Tower securities issued to investors to be volatile.

Changing climate conditions may adversely affect our financial condition or profitability.

There is an emerging scientific consensus that the earth is getting warmer. Climate change, to the extent it produces rising temperatures and changes in weather patterns, may affect the frequency and severity of storms and other weather events, the affordability, availability and underwriting results of homeowners and commercial property insurance, and, if frequency and severity patterns increase, could negatively affect our financial results.

Risk Relating to Our Common Shares

The rights of our shareholders are governed by Bermuda law, which has material and sometimes adverse differences relative to the corporate law of other jurisdictions, including Delaware.

The rights of our shareholders are governed by applicable Bermuda law, including the Bermuda Companies Act of 1981 (the “Companies Act”), and by the Company’s memorandum of association and amended and restated bye-laws (the “Company’s bye-laws”).

The Companies Act differs in some material respects from laws generally applicable to Delaware corporations and their shareholders. Set forth below is a summary of certain significant provisions of the Companies Act, which includes, where relevant, information on modifications adopted under the Company’s bye-laws that differ in certain respects from Delaware corporate law. Because the following statements are summaries, they do not discuss all aspects of Bermuda law that may be relevant to the Company and its shareholders.

Interested Directors. Under Bermuda law and the Company’s bye-laws, a transaction entered into by the Company, in which a director has an interest, will not be voidable by the Company, and such director will not be accountable to the Company for any benefit realized under that transaction, provided the nature of the interest is disclosed at the first opportunity at a meeting of the Board of Directors, or in writing, to the Board of Directors. In addition, the Company’s bye-laws allow a director to be taken into account in determining whether a quorum is present and to vote on a transaction in which that director has an interest following a declaration of the interest under the Companies Act, unless the majority of the disinterested directors determine otherwise. By contrast, under Delaware law, the transaction would not be voidable if:

 

   

the material facts as to the interested director’s relationship or interests were disclosed or were known to the Board and the Board in good faith authorized the transaction by the affirmative vote of a majority of the disinterested directors;

 

   

the material facts were disclosed or were known to the shareholders entitled to vote on such transaction and the transaction was specifically approved in good faith by vote of the majority of shares entitled to vote thereon; or

 

   

the transaction was fair as to the corporation at the time it was authorized, approved or ratified.

Business Combinations with Large Shareholders or Affiliates. As a Bermuda company, the Company may enter into business combinations with its large shareholders or one or more wholly owned subsidiaries, including asset sales and other transactions in which a large shareholder or a wholly owned subsidiary receives, or could receive, a financial benefit that is greater than that

 

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received, or to be received, by other shareholders or other wholly owned subsidiaries, without obtaining prior approval from the Company’s shareholders and without special approval from the Company’s Board of Directors. Under Bermuda law, amalgamations and mergers require the approval of the Board of the Directors, and except in the case of amalgamations or mergers with and between wholly owned subsidiaries, shareholder approval. However, when the affairs of a Bermuda company are being conducted in a manner that is oppressive or prejudicial to the interests of some shareholders, one or more shareholders may apply to a Bermuda court, which may make an order as it sees fit, including an order regulating the conduct of the company’s affairs in the future or ordering the purchase of the shares of any shareholders by other shareholders or the company. If the Company were a Delaware company, it would need prior approval from the Board of Directors or a supermajority of its shareholders to enter into a business combination with an interested shareholder for a period of three years from the time the person became an interested shareholder, unless the Company opted out of the relevant Delaware statute. Bermuda law and the Company’s bye-laws would require the Board’s approval and, in some instances, shareholder approval of such transactions.

Shareholders’ Suits. The rights of shareholders under Bermuda law are not as extensive as the rights of shareholders in many U.S. jurisdictions. Class actions and derivative actions are generally not available to shareholders under the laws of Bermuda. However, the Bermuda courts ordinarily would be expected to follow English case law precedent, which would permit a shareholder to commence a derivative action in the Company’s name to remedy a wrong done to the Company where an act is alleged to be beyond its corporate power, is illegal or would result in the violation of its memorandum of association or bye-laws. Furthermore, consideration would be given by the court to acts that are alleged to constitute (i) fraud against the minority shareholders or (ii) an act that required the approval of a greater percentage of the Company’s shareholders than actually approved it. The prevailing party in such an action generally would be able to recover a portion of attorneys’ fees incurred in connection with the action. The Company’s bye-laws provide that shareholders waive all claims or rights of action that they might have, individually or in the right of the Company, against any director or officer for any act or failure to act in the performance of such director’s or officer’s duties, except with respect to any fraud or dishonesty of the director or officer or to recover any gain, personal profit or advantage to which the director or officer is not legally entitled. In contrast, under Delaware law, class actions and derivative actions generally are available to shareholders for, among other things, breach of fiduciary duty, corporate waste and actions not taken in accordance with applicable law. In such actions, the court has discretion to permit the winning party to recover attorneys’ fees incurred in connection with the action.

Indemnification of Directors and Officers. Under Bermuda law and the Company’s bye-laws, the Company is required to indemnify its directors, officers, any other person appointed to a committee of the Board (and their respective heirs, executors or administrators) to the fullest extent permitted by law against all liabilities, actions, costs, charges, losses, damages and expenses, incurred or sustained by such persons by reason of any act done, concurred in or omitted in the (actual or alleged) conduct of the Company’s business or in the discharge of their duties; provided that such indemnification shall not extend to any matter that would render such indemnification void under the Companies Act. Under Delaware law, a corporation may indemnify a director or officer of the corporation against expenses (including attorneys’ fees), judgments, fines and amounts paid in settlement actually and reasonably incurred in defense of an action, suit or proceeding by reason of such position if (i) such director or officer acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation and (ii) with respect to any criminal action or proceeding, such director or officer had no reasonable cause to believe his conduct was unlawful.

Anti-takeover provisions in the Company’s bye-laws could delay or deter a takeover attempt that shareholders might consider to be desirable and may make it more difficult to replace members of the Company’s Board of Directors.

The Company’s bye-laws contain provisions that may entrench directors and make it more difficult for shareholders to replace directors even if the shareholders consider it beneficial to do so. In addition, these provisions could delay or prevent a change of control that a shareholder might consider favorable. For example, these provisions may prevent a shareholder from receiving the benefit from any premium over the market price of the Company’s common shares offered by a bidder in a potential takeover. Even in the absence of an attempt to effect a change in management or a takeover attempt, these provisions may adversely affect the prevailing market price of the Company’s common shares if they are viewed as discouraging changes in management and takeover attempts in the future.

The Company’s shareholders may have difficulty effecting service of process on the Company or enforcing judgments against the Company in the United States.

The Company is organized under the laws of Bermuda and a portion of the Company’s business will be based in Bermuda. In addition, certain of the Company’s directors and officers may reside in Bermuda or other jurisdictions outside of the United States. As such, the Company has been advised that there is doubt as to whether a holder of the Company common shares would be able to (i) enforce, in the courts of Bermuda, judgments of U.S. courts against persons who reside in Bermuda based upon the civil liability provisions of the U.S. federal securities laws or (ii) bring an original action in the Bermuda courts to enforce liabilities against the Company or its directors and officers who reside outside of the United States, based solely upon the civil liability provisions of the U.S. federal securities laws.

 

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Further, the Company has been advised that there is no treaty in effect between the United States and Bermuda providing for the enforcement of judgments of U.S. courts, and there are grounds upon which Bermuda courts may not enforce judgments of U.S. courts. Because judgments of U.S. courts are not automatically enforceable in Bermuda, it may be difficult for the Company’s shareholders to recover against the Company based on such judgments.

U.S. Federal and Bermuda Tax Risks Related to Purchasing and Owning Shares of the Company.

The merger with Canopius may have adverse U.S. federal income tax consequences on the Company under certain circumstances.

Section 7874 of the Internal Revenue Code (the “Code”) addresses “inversion” transactions, which refer in relevant part to transactions in which a U.S. corporation becomes a subsidiary of a foreign corporation. This section provides that in certain instances such foreign corporation may be treated as a domestic corporation for U.S. federal income tax purposes.

Because the former holders of TGI common stock did not acquire 80 percent or more of the stock (by vote or value) of the Company by reason of the merger (the “ownership test”), we believe that the Company should not be treated as a domestic corporation under section 7874 of the Code. Nevertheless, it is possible that the IRS could assert that section 7874 of the Code applies to treat the Company as a domestic corporation following the merger. Such IRS position, if sustained, would result in significant tax liability to the Company and other adverse tax consequences. There is limited guidance regarding the application of the section 7874 provisions, including the ownership test. Moreover, new statutory and/or regulatory provisions under section 7874 of the Code (or otherwise) could be enacted or promulgated that adversely affect the Company’s status as a foreign corporation for U.S. federal tax purposes, and any such provisions could have retroactive application to the Company.

The Company and the Company’s Bermuda subsidiaries may become subject to Bermuda taxes after March 31, 2035.

Bermuda currently imposes no income tax on corporations. The Company has obtained an assurance from the Bermuda Minister of Finance under The Exempted Undertakings Tax Protection Act 1966 of Bermuda, that if any legislation is enacted in Bermuda that would impose tax computed on profits or income, or computed on any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance tax, then the imposition of any such tax will not be applicable to the Company or its Bermuda subsidiaries, until March 31, 2035. There can be no assurance that the Company or its Bermuda subsidiaries will not be subject to any Bermuda tax after that date.

The Company and the Company’s non-U.S. subsidiaries may be subject to U.S. tax, which may have a material adverse effect on the Company’s financial condition and operating results.

We believe that the Company and its non-U.S. subsidiaries have operated, and intend to continue to operate, in such a manner as to minimize the risk that we or our subsidiaries would be considered to be engaged in a trade or business in the United States (and, in the case of those non-U.S. subsidiaries qualifying for treaty protection, in such a manner as to minimize the risk that any of such non-U.S. subsidiaries would be considered to be doing business through a permanent establishment in the United States), and therefore subject to U.S. federal net income taxes or branch profits taxes. However, because there is uncertainty as to the activities that constitute being engaged in a trade or business within the United States, and what constitutes a permanent establishment under the applicable tax treaties, there can be no assurance that the IRS will not contend successfully that the Company or one or more of its non-U.S. subsidiaries is or has been engaged in a trade or business, or is or has been carrying on business through a permanent establishment, in the United States.

Dividends paid by the Company’s U.S. subsidiaries to the Company will be subject to a 30 percent withholding tax.

Foreign corporations are generally subject to U.S. income tax imposed by withholding on certain “fixed or determinable annual or periodic gains, profits and income” derived from sources within the U.S. (such as dividends and certain interest), subject to exemption under the Code or reduction by applicable treaties. The income tax treaty between the United States of America and Bermuda, as amended, does not reduce the U.S. withholding rate on such U.S.-source income. The non-treaty rate of U.S. withholding tax is currently 30 percent. Accordingly, dividends and interest, if any, paid by the Company’s U.S. subsidiaries to the Company will be subject to a 30 percent U.S. withholding tax.

The reinsurance agreements between the Company and the Company’s U.S. subsidiaries may be subject to recharacterization or other adjustment for U.S. federal income tax purposes, which may have a material adverse effect on the Company’s financial condition and operating results.

Under section 845 of the Code, the IRS may allocate income, deductions, assets, reserves, credits and any other items related to a reinsurance agreement among certain related parties, recharacterize such items, or make any other adjustment, in order to reflect the proper source, character or amount of the items for each party. In addition, if a reinsurance contract has a significant tax avoidance effect on any party to the contract, the IRS may make adjustments with respect to such party to eliminate the tax avoidance effect. No regulations have been issued under section 845 of the Code. Accordingly, the application of such provisions to the Company and its subsidiaries is uncertain and we cannot predict what impact, if any, such provisions may have on the Company or its subsidiaries.

 

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If the Company is classified as a passive foreign investment company (a “PFIC”) your taxes could increase.

If the Company is classified as a PFIC, such classification would have material adverse tax consequences for U.S. persons that directly or indirectly own the Company’s shares, including subjecting such U.S. persons to a greater tax liability than might otherwise apply. We believe that the Company should not be, and currently do not expect the Company to become, a PFIC for U.S. federal income tax purposes; however, no assurance can be given that the Company is not and will not become a PFIC.

There are currently no regulations regarding the application of the PFIC provisions to an insurance company. New regulations or pronouncements interpreting or clarifying these provisions may be forthcoming. We cannot predict what impact, if any, such guidance would have on persons subject to U.S. federal income tax that directly or indirectly own the Company’s shares. Moreover, if the Company is a PFIC for any years in which dividends are paid or for the preceding year, such dividends will not be eligible for the reduced rates of U.S. federal income tax applicable to “qualified dividends.”

If you own or are treated as owning 10 percent or more of the Company’s shares and the Company or one or more of its non-U.S. subsidiaries is classified as a controlled foreign corporation (a “CFC”), your taxes could increase.

Each United States person (as defined in section 957(c) of the Code) who (i) owns (directly, indirectly through non-U.S. persons, or constructively by application of certain attribution rules (“constructively”)) 10 percent or more of the total combined voting power of all classes of shares of a non-U.S. corporation at any time during a taxable year (a “10 percent U.S. Shareholder”) and (ii) owns (directly or indirectly through non-U.S. persons) shares of such non-U.S. corporation on the last day of such taxable year, must include in its gross income for U.S. federal income tax purposes its pro rata share of the CFC’s “subpart F income,” even if the subpart F income is not distributed, if such non-U.S. corporation has been a CFC for an uninterrupted period of 30 days or more during such taxable year. A non-U.S. corporation is considered a CFC if 10 percent U.S. Shareholders own (directly, indirectly through non-U.S. persons, or constructively) more than 50 percent of the total combined voting power of all classes of voting shares of such non-U.S. corporation or more than 50 percent of the total value of all shares of such corporation. For purposes of taking into account subpart F insurance income, a CFC also generally includes a non-U.S. insurance company in which more than 25 percent of the total combined voting power of all classes of shares or more than 25 percent of the total value of all shares is owned (directly, indirectly through non-U.S. persons or constructively) by 10 percent U.S. Shareholders, on any day during the taxable year of such corporation. We cannot assure you that the Company or its non-U.S. subsidiaries will not be classified as CFCs. Furthermore, due to the attribution provisions of the Code regarding determination of beneficial ownership, you may be a 10 percent U.S. Shareholder even though you do not directly own 10 percent or more of the total combined voting power of the Company.

If one or more of the Company’s non-U.S. subsidiaries is determined to have related person insurance income (“RPII”), you may be subject to U.S. taxation on your pro rata share of such income.

If the Company is directly, indirectly through non-U.S. persons or constructively owned 25 percent or more by U.S. persons and the RPII of any of the Company’s non-U.S. insurance subsidiaries were to equal or exceed 20 percent of such subsidiary’s gross insurance income in any taxable year and direct or indirect insureds (and persons related to such insureds within the meaning of section 953(c)(6) of the Code) owned, directly or indirectly through entities (including the Company), 20 percent or more of the voting power or value of such non-U.S. insurance subsidiary, then a U.S. person who owns any of the Company’s shares (directly or indirectly through non-U.S. persons) on the last day of the taxable year would be required to include in its income for U.S. federal income tax purposes such person’s pro rata share of such subsidiary’s RPII for the entire taxable year, generally determined as if such RPII were distributed proportionately only to U.S. persons at that date regardless of whether such income is distributed. The amount of RPII earned by the Company’s non-U.S. insurance subsidiaries (generally, premium and related investment income from the direct or indirect insurance or reinsurance of any direct or indirect U.S. holder of common shares or any person related to such holder within the meaning of section 953(c)(6) of the Code) will depend on a number of factors, including the identity of persons directly or indirectly insured or reinsured by such non-U.S. insurance subsidiaries. The gross RPII of each of the Company’s non-U.S. insurance subsidiaries is not expected in the foreseeable future to equal or exceed 20 percent of such subsidiary’s gross insurance income. No assurance can be given that this will be the case because some of the factors that determine the existence or extent of RPII may be beyond the Company’s knowledge and/or control.

The RPII rules provide that if a U.S. person disposes of shares in a non-U.S. insurance corporation in which U.S. persons own 25 percent or more of the shares (even if the amount of RPII is less than 20 percent of such corporation’s gross insurance income and the ownership of its shares by direct or indirect insureds and related persons is less than the 20 percent threshold), any gain from the disposition will generally be treated as ordinary income to the extent of such U.S. person’s share of the corporation’s undistributed earnings and profits that were accumulated during the period that such U.S. person owned the shares (whether or not such earnings and profits are attributable to RPII). In addition, such U.S. person will be required to comply with certain reporting requirements, regardless of the number of shares owned by such U.S. person. Although the Company will not itself be directly engaged in the insurance business, TRL will be so engaged and other non-U.S. subsidiaries of the Company may be so

 

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engaged. As a result, it is possible that these RPII rules will apply to disposition of the Company shares. The RPII provisions have never been interpreted by the courts or the U.S. Treasury Department in final regulations, and regulations interpreting the RPII provisions of the Code exist only in proposed form. It is not certain whether these regulations will be adopted in their proposed form or what changes or clarifications might ultimately be made thereto or whether any such changes, as well as any interpretation or application of RPII by the IRS, the courts or otherwise, might have retroactive effect. The U.S. Treasury Department has authority to impose, among other things, additional reporting requirements with respect to RPII. Accordingly, the meaning of the RPII provisions and the application of those provisions to the Company and its non-U.S. subsidiaries are uncertain.

U.S. tax-exempt organizations that own the Company’s shares may recognize unrelated business taxable income.

A U.S. tax-exempt organization may recognize unrelated business taxable income if a portion of the Company’s non-U.S. subsidiaries’ insurance income is attributed to such organization. In general, insurance income will be attributed to a U.S. tax-exempt shareholder if either the Company is a CFC and such tax-exempt shareholder is a 10 percent U.S. Shareholder or there is RPII and the exceptions described above do not apply.

U.S. tax-exempt investors should consult their tax advisors as to the U.S. tax consequences of an investment in the Company’s shares.

Changes in U.S. federal income tax law could be retroactive and may subject the Company or its non-U.S. subsidiaries to U.S. federal income taxation.

Legislation has been introduced in the U.S. Congress intended to eliminate certain perceived tax advantages of companies (including insurance companies) that have legal domiciles outside the United States but have certain U.S. connections. There are currently pending legislative proposals which, if enacted, could have a material adverse effect on the Company and its shareholders. It is possible that broader-based or new legislative proposals could emerge in the future that could have an adverse effect on the Company, its non-U.S. subsidiaries and its shareholders.

The tax laws and interpretations regarding whether a company is engaged in a U.S. trade or business or whether a company is a CFC or PFIC or has RPII or subject to the inversion tax rules are subject to change, possibly on a retroactive basis. There are currently no regulations regarding the application of the PFIC rules to an insurance company. Additionally, the regulations regarding RPII are still in proposed form and the regulations regarding inversion transactions are in temporary form. New regulations or pronouncements interpreting or clarifying such rules will likely be forthcoming from the IRS. We are not able to predict if, when or in what form such guidance will be provided and whether such guidance will be applied on a retroactive basis.

Item 1B. Unresolved Staff Comments

None.

Item 2. Properties

We lease 407,096 rentable square feet across the United States, most notably 107,282 rentable square feet at 120 Broadway in New York City, NY and 76,892 at Harborside Plaza II in Jersey City, New Jersey. In addition to this space, we also lease 13,718 rentable square feet at 100 William Street in New York, New York.

The remainder of our leased space is in Irvine, California; New Haven, Connecticut; Ft. Lauderdale, Florida; Maitland, Florida; Atlanta, Georgia; Chicago, Illinois; Quincy, Massachusetts; Westborough, Massachusetts; Portland, Maine; Moorestown, New Jersey; Melville, New York; Williamsville, New York; Irving, Texas and Petaluma, California.

We also lease 5,680 rentable square feet in Bermuda.

Item 3. Legal Proceedings

On August 20, 2013, Robert P. Lang, a purported shareholder of Tower Group International Ltd. (“Tower”), filed a purported class action complaint (the “Lang Complaint”) against Tower and certain of its current and former officers in the United States District Court for the Southern District of New York. The Lang Complaint purports to be asserted on behalf of a class of persons who purchased Tower stock between July 30, 2012 and August 8, 2013. The Lang Complaint alleges that Tower and certain of its current and former officers violated federal securities laws and seeks unspecified damages. On September 3, 2013, a second purported shareholder class action complaint was filed by Dennis Feighay, another purported Tower shareholder, containing similar allegations to those set forth in the Lang Complaint (the “Feighay Complaint”). The Feighay Complaint purports to be asserted on behalf of a class of persons who purchased Tower stock between May 9, 2011 and August 7, 2013. On October 4,

 

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2013, a third complaint was filed by Sanju Sharma (the “Sharma Complaint”). The Sharma Complaint names as defendants Tower and certain of its current and former officers, and purports to be asserted on behalf of a plaintiff class who purchased Tower stock between May 10, 2011 and September 17, 2013. On October 18, 2013, an amended complaint was filed in the Sharma case (the “Sharma Amended Complaint”). The Sharma Amended Complaint alleges additional false and misleading statements, and purports to be asserted on behalf of a plaintiff class who purchased Tower stock between March 1, 2011 and October 7, 2013. On October 21, 2013, a number of motions were filed seeking to consolidate the shareholder class actions into one matter and for appointment of a lead plaintiff. The Company believes that it is not probable that the Lang and Feighay Complaints and the Sharma Amended Complaint will result in a loss, and if they would result in a loss, that the amount of any such loss cannot reasonably be estimated.

On October 18, 2013, Cinium Financial Services Corporation (“Cinium”) and certain other affiliated parties (collectively, “Plaintiffs”) commenced an action against, among others, Tower, CastlePoint Insurance Company (“CastlePoint”), an indirect wholly owned subsidiary of Tower, and certain officers of Tower (the “New York Action”) in New York State Supreme Court. CastlePoint is a party to a Securityholders’ Agreement, dated as of June 14, 2012 (the “Securityholders’ Agreement”), among certain parties including Plaintiffs, and is also the holder of a senior note issued by Cinium dated May 15, 2012 that is convertible into shares of Cinium common stock (the “Senior Note”). On October 29, 2013, Plaintiffs filed a complaint which revised their initial pleading (the “Complaint”). Plaintiffs seek, among other things, (i) a declaratory judgment that CastlePoint has no right to exercise any control over Cinium under the Securityholders’ Agreement or to convert the Senior Note without prior regulatory approval; (ii) rescission of the Senior Note and Securityholders’ Agreement based on alleged fraudulent misrepresentations by Tower at the time these agreements were entered into; and (iii) damages of $150 million for alleged breach of fiduciary duties to Cinium and its shareholders by certain directors, and for alleged lender liability and fraudulent misrepresentation by the Company.

On April 22, 2014, counsel for Plaintiffs notified counsel for Defendants of its intent to file a stipulation of discontinuance without prejudice of the New York Action within thirty days.

Tower received a document request from the U.S. Securities and Exchange Commission (the “SEC”) dated January 13, 2014, as part of an informal inquiry (the “SEC Request”). The SEC Request asks for documents related to Tower’s financial statements, accounting policies, and analysis. Tower is cooperating with the SEC’s inquiry and has provided the requested information.

On January 14, 2014, Derek Wilson, a purported shareholder of Tower, filed a purported class action complaint (the “Wilson Complaint”) against Tower, certain of its current and former directors, ACP Re Ltd. (“ACP Re”), London Acquisition Company Limited (“Merger Sub”), and AmTrust Financial Services, Inc. (“AmTrust”) in the United States District Court for the Southern District of New York. The Wilson Complaint alleges that the members of the Company’s Board of Directors breached their fiduciary duties owed to the shareholders of Tower under Bermuda law by approving Tower’s entry into the ACP Re Merger Agreement and failing to take steps to maximize the value of Tower to its public shareholders, and that Tower, ACP Re, Merger Sub, and AmTrust aided and abetted such breaches of fiduciary duties. The Wilson Complaint also alleges, among other things, that the proposed transaction undervalues Tower, that the process leading up to the ACP Re Merger Agreement was flawed, and that certain provisions of the ACP Re Merger Agreement improperly favor ACP Re and discourage competing offers for the Company. The Wilson Complaint further alleges oppressive conduct against Tower’s shareholders in violation of Bermuda law. The Wilson Complaint seeks, among other things, declaratory and injunctive relief concerning the alleged fiduciary breaches, injunctive relief prohibiting the defendants from consummating the proposed transaction, rescission of the ACP Re Merger Agreement to the extent already implemented, and other forms of equitable relief. On February 27, 2014, the same shareholder filed an amended complaint alleging, in addition, that the defendants disseminated a materially false and misleading preliminary proxy statement regarding the ACP Re Merger Agreement in violation of Sections 14(a) and 20(a) of the Exchange Act and Rule 14a-9 promulgated thereunder (the “Wilson Amended Complaint”).

On March 3, 2014, another purported shareholder filed a purported class action complaint against the Company, certain of its current and former officers and directors, ACP Re, Merger Sub, and AmTrust, also in the United States District Court for the Southern District of New York (the “Raul Complaint”). The Raul Complaint alleges that the defendants disseminated a materially false and misleading preliminary proxy statement regarding the ACP Re Merger Agreement in violation of sections 14(a) and 20(a) of the Exchange Act and Rule 14a-9.

On March 24, 2014, two purported shareholders of the Company filed a purported class action and shareholder derivative complaint against the Company, certain of its current and former officers and directors, and Tower Group, Inc., in the Supreme Court of the State of New York, County of New York (the “Bekkerman Complaint” and, together with the Wilson Amended Complaint and the Raul Complaint, the “Merger Complaints”). The Bekkerman Complaint alleges, among other things, that the members of the Company’s board of directors breached their fiduciary duties owed to the shareholders of the Company by failing to exercise appropriate oversight over the conduct of the Company’s business, awarding Michael Lee excessive compensation, approving the Company’s entry into the ACP Re Merger Agreement, failing to take steps to maximize the value of the Company to its public shareholders, and misrepresenting or omitting material information in connection with the proposed transaction, and that the Company and Tower Group, Inc., aided and abetted such breaches of fiduciary duties. The Bekkerman Complaint also

 

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alleges, among other things, that Lee was unjustly enriched as a result of the compensation he received while allegedly breaching his fiduciary duties and by selling stock while in the possession of material, adverse, non-public information. The Bekkerman Complaint seeks, among other things, an award of money damages, declaratory and injunctive relief concerning the alleged fiduciary breaches, injunctive relief prohibiting the defendants from consummating the proposed transaction, rescission of the ACP Re Merger Agreement to the extent already implemented, and other forms of equitable relief. The Company believes that it is not probable that the Merger Complaints will result in a loss, and if they would result in a loss, that the amount of any such loss cannot reasonably be estimated.

From time to time, the Company is involved in other various legal proceedings in the ordinary course of business. The Company does not believe that the resolution of any currently pending legal proceedings, either individually or taken as a whole, will have a material adverse effect on its business, results of operations or financial condition.

Item 4. Mine Safety Disclosure

Not applicable.

PART II

Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities.

Shareholders

Our common stock is traded on the NASDAQ Global Select Market (“NASDAQ”) under the ticker symbol “TWGP”. We have one class of authorized common stock for 150,000,000 shares at a par value of $0.01 per share.

As of April 30, 2014, there were 57,305,726 common shares issued and outstanding that were held by 172 shareholders of record.

Price Range of Common Stock and Dividends Declared

The high and low sales prices for quarterly periods from January 1, 2012 through December 31, 2013 were as follows:

 

      High      Low      Common
Stock
Dividends
Declared
 

2013

        

First quarter

   $     18.98      $     15.89      $     0.165  

Second quarter

     20.85        17.47        0.165  

Third quarter

     22.30        6.58        0.165  

Fourth quarter

     8.10        2.41        -   

2012

        

First quarter

     20.68        17.86        0.165  

Second quarter

     20.06        16.66        0.165  

Third quarter

     19.16        15.69        0.165  

Fourth quarter

     17.96        14.84        0.165  

Dividend Policy

On November 14, 2013, the Company announced that its Board of Directors determined that it would not declare and pay a dividend to shareholders in the fourth quarter of 2013. The Company paid quarterly dividends of $0.165 per share on February 28, 2013, June 21, 2013 and September 20, 2013.

Any future determination to pay dividends will be at the discretion of our Board of Directors and will be dependent upon our results of operations and cash flows, our financial position and capital requirements, general business conditions, legal, tax, regulatory and any contractual restrictions on the payment of dividends and any other factors our Board of Directors deems relevant.

 

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Tower is a holding company and has no direct operations. Its ability to pay dividends depends, in part, on the ability of our insurance subsidiaries and management companies to pay dividends to it. Our insurance subsidiaries are subject to significant regulatory restrictions limiting their ability to declare and pay dividends. Currently, our insurance subsidiaries are unable to pay dividends or make return of capital payments without insurance regulatory approval. See “Business—Regulation”, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and Note 18, Statutory Financial Information and Accounting Policies” in the Notes to the Consolidated Financial Statements.

Pursuant to the terms of the subordinated debentures underlying our trust preferred securities, we and our subsidiaries cannot declare or pay any dividends if we are in default of or if we have elected to defer payments of interest on those debentures. The Company declared dividends on common stock as follows:

 

(in $ thousands)    2013      2012  

Common stock dividends declared

   $ 26,151      $ 29,075  

In 2013, the Company purchased 345,946 shares of its common stock from employees in connection with the vesting of restricted stock issued in connection with its 2004 Long Term Equity Compensation Plan (the “Plan”). The shares were withheld at the direction of the employees as permitted under the Plan in order to pay the minimum amount of tax liability owed by the employee from the vesting of those shares.

Common Stock Repurchase Program

The Board of Directors of Tower approved a $100 million share repurchase program on March 3, 2011. This authorization was in addition to the $100 million share repurchase program approved on February 26, 2010. Purchases under both programs could be made from time to time in the open market or in privately negotiated transactions in accordance with applicable laws and regulations. In the year ended December 31, 2012, 1.2 million shares of common stock were purchased under these programs at an aggregate consideration of $21.0 million. The March 3, 2011 and February 26, 2010 share repurchase programs were terminated in March 2013.

As part of Tower’s capital management strategy, Tower’s Board of Directors approved a $50 million share repurchase program on May 7, 2013. Purchases under this program can be made from time to time in the open market or in privately negotiated transactions in accordance with applicable laws and regulations. In the twelve months ended December 31, 2013 no shares of common stock were purchased under this program.

 

Period   

Total

Number

of Shares

Purchased (1)

    

Average

Price Paid
per Share (2)

    

Total Number

of Shares

Purchased as Part

of Publically

Announced Repurchase

Plans or Programs

    

Maximum Number

(or Approximate

Dollar Value) of

Shares that May Yet

be Purchased Under

the Repurchase Plans

 

January 1 - 31, 2013

     -       $ -         -       $     26,399,490  

February 1 - 28, 2013

     -         -         -         26,399,490  

March 1 - 31, 2013

     340,707            17.18        -         26,399,490  

Subtotal first quarter

     340,707        17.18        -         26,399,490  

April 1 - 30, 2013

     -         -         -         -   

May 1 - 31, 2013

     891        19.40        -         50,000,000  

June 1 - 30, 2013

     -         -         -         50,000,000  

Subtotal second quarter

     891        19.40        -         50,000,000  

July 1 - 31, 2013

     269        21.32        -         50,000,000  

August 1 - 31, 2013

     -         -         -         50,000,000  

September 1 - 30, 2013

     -         -         -         50,000,000  

Subtotal third quarter

     269        21.32        -         50,000,000  

October 1 - 31, 2013

     -         -         -         50,000,000  

November 1 - 30, 2013

     4,079        3.77        -         50,000,000  

December 1 - 31, 2013

     -         -         -         50,000,000  

Subtotal fourth quarter

     4,079        3.77        -         50,000,000  

Total year ended December 31, 2013

     345,946      $ 17.03        -       $ 50,000,000  

 

(1) Includes 345,946 shares withheld to satisfy tax withholding amounts due from employees upon the receipt of previously restricted shares.
(2) Including commissions.

 

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Performance Graph

Set forth below is a line graph comparing the dollar change in the cumulative total shareholder return on Tower Group International Ltd. Common Shares from December 31, 2008, through December 31, 2013, as compared to the cumulative total return of the Standard & Poor’s 500 Stock Index and the cumulative total return of the Standard & Poor’s Property-Casualty Insurance Index. The cumulative total shareholder return is a concept used to compare the performance of a company’s stock over time and is the ratio of the stock price change plus the cumulative amount of dividends over the specified time period (assuming dividend reinvestment), to the stock price at the beginning of the time period. The chart depicts the value on December 31, 2009, 2010, 2011, 2012, and 2013, of a $100 investment made on December 31, 2008, with all dividends reinvested.

 

LOGO

 

      12/31/2008      12/31/2009      12/31/2010      12/31/2011      12/31/2012      12/31/2013  

Tower Group International, Ltd.

     100         84         93         76         69         15   

S&P 500

     100         126         146         149         172         228   

S&P 500 P&C

     100         112         122         122         147         203   

 

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Item 6. Selected Consolidated Financial Information

The selected consolidated income statement data for the years ended December 31, 2013, 2012 and 2011, and the balance sheet data as of December 31, 2013 and 2012 are derived from our audited financial statements included elsewhere in this document, which have been prepared in accordance with GAAP. You should read the following selected consolidated financial information along with the information contained in this document, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes included elsewhere in this Form 10-K.

 

     Year ended December 31,  
($ in millions, except per share amounts)    2013     2012     2011     2010     2009  

Income Statement Data

          

Gross premiums written

   $     1,727.7     $     1,971.1     $     1,810.9     $     1,496.4     $     1,070.7  

Ceded premiums written

     495.0       231.7       172.3       182.3       184.5  

Net premiums written

     1,232.7       1,739.4       1,638.6       1,314.1       886.2  

Net premiums earned

     1,512.9       1,721.9       1,593.9       1,292.7       854.7  

Ceding commission revenue

     81.4       32.3       34.0       39.3       42.7  

Insurance services revenue

     1.2       3.4       1.6       2.2       5.1  

Policy billing fees

     12.3       12.6       10.5       6.3       3.0  

Net investment income

     109.2       127.2       126.5       107.3       74.9  

Net realized gains (losses) on investments

     25.0       25.5       9.4       14.7       0.3  

Total revenues

     1,742.0       1,922.9       1,775.8       1,462.5       980.7  

Losses and loss adjustment expenses

     1,519.8       1,263.8       1,077.0       789.7       475.5  

Operating expenses:

          

Commission expenses

     365.0       359.3       309.8       267.9       204.7  

Other operating expenses (1)

     369.9       317.5       284.9       229.8       157.4  

Acquisition-related transaction costs

     21.3       9.2       0.4       2.4       14.0  

Interest expense

     33.6       32.6       34.3       24.2       17.6  

Total expenses

     2,309.6       1,982.4       1,706.3       1,314.0       869.2  

Other income (expense)

          

Earnings in unconsolidated affiliate

     6.9       (1.5     -        -        (0.8

Gain on investment in acquired unconsolidated affiliate

     -        -        -        -        7.4  

Gain on bargain purchase

     -        -        -        -        12.7  

Goodwill and fixed asset impairment

     (397.2     -        -        -        -   

Other

     5.0       -        -        -        -   

Income (loss) before income taxes

     (952.9     (61.0     69.5       148.5       130.8  

Income tax expense (benefit)

     8.4       (29.1     14.1       49.6       42.5  

Net income (loss)

   $ (961.3   $ (31.9   $ 55.4     $ 98.9     $ 88.3  

Less: Net income (loss) attributable to Noncontrolling Interests

     (18.7     2.3       11.0       (6.1     -   

Net income (loss) attributable to Tower Group International, Ltd.

   $ (942.6   $ (34.2   $ 44.4     $ 105.0     $ 88.3  

Per Share Data (6)

          

Basic earnings (loss) per share attributable to Tower shareholders

   $ (17.37   $ (0.81   $ 0.96     $ 2.13     $ 2.05  

Diluted earnings (loss) per share attributable to Tower shareholders

   $ (17.37   $ (0.81   $ 0.96     $ 2.12     $ 2.04  

Weighted average outstanding (in thousands):

          

Basic

     54,297       42,902       45,226       48,561       44,598  

Diluted

     54,297       42,902       45,337       48,772       44,844  

Selected Insurance Ratios

          

Net loss ratio (2)

     100.5     73.4     67.6     61.1     55.6

Net underwriting expense ratio (3)

     41.0     36.4     34.4     35.6     35.0

Net combined ratio (4)

     141.5     109.8     102.0     96.7     90.6

 

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     As of December 31,  
($ in millions, except per share amounts)    2013      2012      2011      2010      2009  

Summary Balance Sheet Data

              

Cash and cash equivalents

   $ 293.9      $ 83.8      $ 107.1      $ 140.2      $ 175.2  

Investments

         1,851.4            2,553.5            2,587.4            2,474.5            1,896.8  

Premiums receivable

     309.5        412.0        416.4        402.0        291.1  

Reinsurance recoverable

     639.8        477.1        315.7        294.8        214.1  

Deferred acquisition costs, net

     95.1        181.2        168.9        164.1        126.3  

Intangible assets

     79.9        106.8        114.9        123.8        53.4  

Goodwill

     -         241.5        241.5        241.5        241.5  

Total assets

     3,955.5        4,712.5        4,417.5        4,179.2        3,243.4  

Loss and loss adjustment expenses

     2,081.3        1,895.7        1,632.1        1,610.4        1,132.0  

Unearned premium

     763.1        921.3        893.2        872.0        658.9  

Debt

     382.8        449.7        426.9        374.3        235.1  

Tower Group International, Ltd. shareholders’ equity

     95.6        950.1        1,009.8        1,035.0        1,012.2  

Per Share Data (6):

              

Book value per share (5)

   $ 1.67      $ 21.83      $ 24.34      $ 22.02      $ 19.86  

Dividends declared per share-common stock

   $ 0.50      $ 0.66      $ 0.61      $ 0.34      $ 0.23  

 

(1) Includes insurance contract acquisition expenses and other underwriting expenses (which are general administrative expenses related to underwriting operations in our insurance subsidiaries), other insurance services expenses (which are general administrative expenses related to insurance services operations) and other corporate related expenses.
(2) The net loss ratio is calculated by dividing net losses and loss adjustment expenses by net premiums earned.
(3) The net underwriting expense ratio is calculated by dividing net underwriting expenses (consisting of direct commission expenses and other underwriting expenses net of policy billing fees and ceding commission revenue) by net premiums earned.
(4) The net combined ratio is the sum of the net loss ratio and the net underwriting expense ratio.
(5) Book value per share is based on Tower Group International, Ltd. shareholders’ equity divided by common shares outstanding at year end.
(6) Per Share Data has been retroactively restated to reflect the TGI’s reverse acquisition transaction with Canopius Holdings Bermuda Limited, which was completed on March 13, 2013. This reverse acquisition resulted in shareholders converting their shares at a 1.1330 conversion ratio.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated audited financial statements and accompanying notes which appear elsewhere in this Form 10-K. It contains forward-looking statements that involve risks and uncertainties. See “Business—Note on Forward-Looking Statements” for more information. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Form 10-K, particularly under the headings “Business—Risk Factors” and “Business—Note on Forward-Looking Statements”.

Overview

Tower, through its subsidiaries, offers a range of general commercial, specialty commercial and personal property and casualty insurance products and services to businesses in various industries and to individuals throughout the United States. We provide these products on both an admitted and an excess and surplus (“E&S”) lines basis. Insurance companies writing on an admitted basis are licensed by the states in which they sell policies and are required to offer policies using premium rates and forms that are filed with state insurance regulators. Non-admitted carriers writing in the E&S market are not bound by most of the rate and form regulations imposed on standard market companies, allowing them the flexibility to change the coverage offered and the rate charged without the time constraints and financial costs associated with the filing process.

 

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Because we do not manage our invested assets by segments, our investment income is not allocated among our segments. Operating expenses incurred by each segment are recorded in such segment directly. Our home office related expenses not directly allocable to an individual segment (for example, accounting, finance and general legal costs) are allocated based upon the methodology deemed to be most appropriate which may include employee head count, policy count and premiums earned in each segment.

Our commercial lines products include commercial multiple-peril (provides both property and liability insurance), mono line general liability (insures bodily injury or property damage liability), commercial umbrella, mono line property (insures buildings, contents or business income), workers’ compensation, fire and allied lines, inland marine, commercial automobile policies and assumed reinsurance. Our personal lines products consist of homeowners, personal automobile and umbrella policies and also include management fees primarily from the services provided by management companies to the Reciprocal Exchanges. Tower also writes assumed reinsurance, which is reported in the Assumed Reinsurance segment.

Loss reserve increase, goodwill and fixed asset impairment and deferred tax valuation allowance

Loss and loss adjustment expenses for the twelve months ended December 31, 2013 recorded in the statement of operations included an increase of $533.0 million, excluding the Reciprocal Exchanges, relating to reserve increases associated with losses from prior accident years. This unfavorable loss development arose primarily from accident years 2008 through 2012 within the workers’ compensation, commercial multi-peril liability (“CMP”), other liability and commercial auto liability lines of business partially offset by a modest amount of favorable development from more recent years within the short tail property lines of business. The Company performed comprehensive updates to its internal reserve study in response to continued observance in the second, third and fourth quarters of 2013 of higher than expected reported loss development. In conjunction with its comprehensive internal reviews, the Company also retained a consulting actuary to perform an independent reserve study in the fourth quarter of 2013 covering lines of business comprising over 98% of the Company’s loss reserves. Since 2010, the Company has changed the mix of business by reducing the amount of program and middle market workers’ compensation and liability business that it underwrites.

The 2013 reserve increase was viewed by the Company as an event or circumstance that required the Company to perform a detailed quantitative analysis of whether its recorded goodwill was impaired. After performing the quantitative analysis in the second quarter of 2013, it was determined that $214.0 million of goodwill, which represents all of the goodwill allocated to the Commercial Insurance reporting unit, was impaired. In the third quarter of 2013, management in its judgment concluded that the remaining $55.5 million of goodwill, all of which was allocated to the Personal Insurance reporting unit, was impaired. In addition, $1.9 million of additional goodwill resulting from the acquisition of marine and energy business in July of 2013 was fully impaired as of September 30, 2013. Additionally, in 2013, the Company impaired $125.8 million of fixed assets. At December 31, 2013, there was no goodwill remaining on the balance sheet. See “Note 7 – Goodwill, Intangible and Fixed Assets Impairments” for additional detail on the goodwill and fixed asset impairments.

As a result of the reserve increase and goodwill and fixed assets impairment charges, the Company’s U.S. based operations have a pre-tax loss for 2013, which results in a three-year cumulative tax loss position on its U.S. subsidiaries. After considering this negative evidence and uncertainty regarding the Company’s ability to generate sufficient future taxable income in the United States, the Company concluded that it should not recognize any net deferred tax assets (comprised principally of net operating loss carryforwards). The Company, therefore, has provided a full valuation allowance against its deferred tax asset at December 31, 2013.

Reinsurance Agreements

In the third quarter of 2013, Tower entered into agreements with three reinsurers, Arch Reinsurance Ltd. (“Arch”), Hannover Re (Ireland) Plc. (“Hannover”) and Southport Re (Cayman), Ltd. (“Southport Re”). These agreements provided for surplus enhancement and improved certain financial leverage ratios, while increasing the Company’s financial flexibility. The agreements with Arch and Hannover each consisted of one reinsurance agreement while the arrangement with Southport Re consists of several reinsurance agreements. Each of these is described below.

The first agreement was between Tower Insurance Company of New York (“TICNY”), on its behalf and on behalf of each of its pool participants, and Arch. Under this multi-line quota share agreement, TICNY ceded 17.5% on a quota share of certain commercial automobile liability, commercial multi-peril property, commercial multi-peril liability and brokerage other liability (mono line liability) businesses. The agreement covers losses occurring on or after July 1, 2013 for policies in-force as of June 30, 2013 and policies written or renewed from July 1, 2013 to December 31, 2013.

The second agreement was between TICNY, on its behalf and on behalf of each of its pool participants, and Hannover. Under this multi-line quota share agreement, TICNY ceded 14% on a quota share of certain brokerage commercial automobile liability, brokerage commercial multi-peril property, brokerage commercial multi-peril liability, brokerage other liability (mono line liability) and brokerage workers’ compensation businesses. The agreement covers losses occurring on or after July 1, 2013 for policies in-force as of June 30, 2013 and policies written or renewed from July 1, 2013 to December 31, 2013.

 

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The third arrangement with Southport Re consisted of two separate reinsurance agreements with TICNY, on its behalf and on behalf of each of its pool participants, and a third reinsurance agreement with Tower Reinsurance, Ltd. (“TRL”). Under the first of the agreements with TICNY, TICNY ceded to Southport Re a 30% quota share of its workers’ compensation and employer’s liability business (the “Southport Quota Share”). The Southport Quota Share covered losses occurring on or after July 1, 2013 for policies in force at June 30, 2013 and policies written or renewed during the term of the agreement. The Southport Quota Share has been accounted for using deposit accounting treatment. Deposit assets of $28.7 million as of December 31, 2013 related to the Southport Quota Share are reflected in Other assets in the consolidated balance sheet. Under the second of these agreements with TICNY, an aggregate excess of loss agreement, Southport Re assumed a portion of the losses incurred by TICNY on its workers’ compensation and employer’s liability business between January 1, 2011 and June 30, 2013, but paid by TICNY on or after June 1, 2013 (the “TICNY/Southport Re ADC”). Finally, TRL, a wholly-owned Bermuda-domiciled reinsurance subsidiary of Tower, also entered into an aggregate excess of loss agreement with Southport Re, in which Southport Re assumed a portion of the losses incurred by TRL on its assumed workers’ compensation and employer’s liability business between January 1, 2011 and June 30, 2013, but paid by TRL on or after June 1, 2013 (the “TRL/Southport Re ADC”, or, collectively, the “Southport Re ADCs”).

The reinsurance agreements with Arch and Hannover resulted in ceded premiums earned, ceding commission revenue and ceded loss and loss adjustment expenses of $76.8 million, $22.3 million, and $41.1 million for the year ended December 31, 2013.

As a result of the announced merger agreement with ACP Re, it was decided that the Southport treaties should be commuted. As a result of a negotiation between the Company and Southport, all of these treaties were commuted effective as of February 19, 2014, with the result of the commutation being that all premiums paid to Southport by the Company were returned to the Company, and all liabilities assumed by Southport were cancelled, and such liabilities became the obligation of the Company. In 2014, the company will record a gain of approximately $6.4 million resulting from the terminations.

A.M. Best, Fitch and Demotech Downgrade the Company’s Financial Strength and Issuer Credit Ratings

On December 20, 2013, A.M. Best lowered the financial strength ratings of each of Tower’s insurance subsidiaries from “B++” (Good) to “B” (Fair) (the seventh highest of fifteen rating levels), as well as the issuer credit ratings of each of Tower’s insurance subsidiaries from “bbb” to “bb”. Previously, on October 8, 2013, A.M. Best had downgraded the financial strength rating of each of Tower’s insurance subsidiaries to “B++” (Good) and their respective issuer credit ratings to “bbb” from “a-”. In addition, on December 20, 2013 A.M. Best downgraded the issuer credit rating of TGI as well as the debt rating on its $147.7 million 5.00% senior convertible notes due 2014 (the “Notes”) to “b-” from “bb”. On the same date, A.M. Best also downgraded the financial strength rating of CastlePoint Reinsurance Company, Ltd. (Bermuda) to “B” (Fair) from “B++” (Good) and its issuer credit rating to “bb” from “bbb” and downgraded the issuer credit rating of Tower Group International, Ltd. to “b-” from “bb”. TGI and each of its insurance subsidiaries currently are and will continue to be under review with negative implications pending further discussions between A.M. Best and management. In downgrading Tower’s ratings, A.M. Best stated that its actions “consider the magnitude of the charges taken and the material adverse impact on Tower’s risk-adjusted capitalization, financial leverage, liquidity and coverage ratios,” “consider the reduced financial flexibility [of the Company] given [its] delay in earnings, the decline in shareholder confidence and the corresponding decline in share price” and “reflect the potential for further adverse reserve development, increased competitive challenges and due to the ratings downgrade, potential actions taken by third party reinsurers and lenders.” Following the announcement of the ACP Re merger, on January 10, 2014 A.M. Best maintained the under review status of Tower’s financial strength and issuer credit ratings and revised the implications from “negative” to “developing” for all of these ratings. A.M. Best stated that, “[t]he under review status with developing implications reflects the potential benefits to be garnered from the transaction as well as the potential downside from any additional adverse reserve development and/or any unforeseen events that might transpire up until the close of the transaction…”

On January 2, 2014, Fitch downgraded Tower’s issuer default rating from “B” to “CC” and the insurer strength ratings of its insurance subsidiaries from “BB” to “B”. On October 7, 2013, Fitch downgraded Tower’s issuer default rating to “B” (the sixth highest of 11 such ratings) from “BBB” and the insurer strength ratings of its insurance subsidiaries to “B” (the fifth highest of Fitch Ratings’ nine such ratings) from “A-”. In downgrading such ratings, Fitch stated that it “is concerned that Tower’s competitive position has been materially damaged, negatively impacting the Company’s financial flexibility and ability to write new business” and that “the magnitude of the second quarter charges was large enough to cause several key ratios to fall well outside of previously established ratings downgrade triggers, which resulted in the multi-notch downgrade.” On January 6, 2014, Fitch revised Tower’s rating watch status to “evolving” from “negative” following the ACP Re merger announcement, and stated that “[t]he Evolving Watch reflects that the ratings could go up if the merger closes; however, ratings could be lowered if the merger does not occur and [the Company] is unsuccessful in addressing upcoming debt maturity or if additional reserve deficiencies develop.”

On December 24, 2013, Demotech, Inc. (“Demotech”) announced the withdrawal of its Financial Stability Ratings® (FSRs) assigned to the following insurance subsidiaries: Kodiak Insurance Company, Massachusetts Homeland Insurance Company, Tower Insurance Company of New York and York Insurance Company of Maine. Concurrently, Demotech advised that the FSRs assigned to Adirondack Insurance Exchange, Mountain Valley Indemnity Company, New Jersey Skylands Insurance Association and New Jersey Skylands Insurance Company remain under review.

 

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Previously, on October 7, 2013, Demotech had lowered its rating on TICNY and three other U.S. based insurance subsidiaries (Kodiak Insurance Company, Massachusetts Homeland Insurance Company and York Insurance Company of Maine) from A’ (A prime) to A (A exceptional). In addition, Demotech removed its previous A’ (A prime) rating on six other U.S. based insurance subsidiaries (CastlePoint Florida Insurance Company, CastlePoint Insurance Company, CastlePoint National Insurance Company, Hermitage Insurance Company, North East Insurance Company and Preserver Insurance Company). Demotech also affirmed its A ratings on Adirondack Insurance Exchange, New Jersey Skylands Insurance Association, New Jersey Skylands Insurance Company and Mountain Valley Indemnity Company.

Management expects these rating actions, in combination with other items that have impacted the Company in 2013, to result in a significant decrease in the amount of premiums the insurance subsidiaries are able to write. Direct written premiums were $1,606.2 million twelve months ended December 31, 2013. Business written through certain program underwriting agents requires an A.M. Best rating of A- or greater.

Tower’s products include the following lines of business: commercial multiple-peril packages, other liability, workers’ compensation, commercial automobile, fire and allied lines, inland marine, personal package, homeowners, personal automobile and assumed reinsurance. These products are sold, primarily, through retail agencies, wholesale agencies, program underwriting agents, and reinsurance brokerage units. With the exception of the personal automobile insurance written through retail agencies and wholesale agencies, which represents $98.1 million of written premiums (excluding the Reciprocal Exchanges) for the year ended December 31, 2013, management believes the Company will be unable to continue writing the majority of its business following the second A.M. Best rating downgrade on December 20, 2013. The total effect of these ratings actions on the Company’s financial position, results of operations or liquidity is not determinable at this stage.

In January 2014, Tower’s Board of Directors approved Tower’s merger with ACP Re. In light of the adverse ratings actions, concurrent with entering into its merger agreement with ACP Re, Tower entered into cut-through reinsurance treaties with affiliates of ACP Re. As a result of this merger if it closes, and the execution of the cut-through reinsurance treaties, Tower believes its insurance subsidiaries will retain significant portions of their business. (See “Note 9 – Reinsurance” for a discussion of the cut-through reinsurance treaties).

In addition, one of Tower’s ceding companies requested as a result of contractual provisions that $26.3 million of additional collateral be provided to support the recoverability of their reinsurance receivable from Tower. The $26.3 million was funded in October 2013. Tower’s U.S. based insurance subsidiaries are also required to post collateral for various statutory purposes, and such requests are received from time to time from various regulatory authorities.

Statutory Capital

The Company is required to maintain minimum capital and surplus for each of its insurance subsidiaries.

U.S. based insurance companies are required to maintain capital and surplus above Company Action Level, which is a calculated capital and surplus number using a risk-based formula adopted by the state insurance regulators. The basis for this formula is the National Association of Insurance Commissioners’ (“NAIC’s”) risk-based capital (“RBC”) system and is designed to measure the adequacy of a U.S. regulated insurer’s statutory capital and surplus compared to risks inherent in its business. If an insurance entity falls into Company Action Level, its management is required to submit a comprehensive financial plan that identifies the conditions that contributed to the financial condition. This plan must contain proposals to correct the financial problems and provide projections of the financial condition, both with and without the proposed corrections. The plan must also outline the key assumptions underlying the projections and identify the quality of, and problems associated with, the underlying business. Depending on the level of actual capital and surplus in comparison to the Company Action Level, the state insurance regulators could increase their regulatory oversight, restrict the placement of new business, or place the company under regulatory control. Bermuda based insurance entities minimum capital and surplus requirements are calculated from a solvency formula prescribed by the Bermuda Monetary Authority (the “BMA”).

Tower has in place several intercompany reinsurance transactions between its U.S. based insurance subsidiaries and its Bermuda based insurance subsidiaries. The U.S. based insurance subsidiaries have historically reinsured on a quota share basis obligations to CastlePoint Reinsurance Company (“CastlePoint Re”), one of its Bermuda based insurance subsidiaries. The 2013 obligations that CastlePoint Re assumes from the U.S. based insurance subsidiaries are then retroceded to TRL, Tower’s other Bermuda based insurance subsidiary. In addition, CastlePoint Re also entered into a loss portfolio transaction with TRL where its reserves associated with the U.S. insurance subsidiary business for underwriting years prior to 2013 were all transferred to TRL. CastlePoint Re is required to collateralize $648.9 million of its assumed reserves in a reinsurance trust for the benefit of TICNY, the lead pool company of the U.S. insurance companies. On February 5, 2014, the BMA approved the transfer of $167.3 million in unencumbered liquid assets from TRL to CastlePoint Re, allowing CastlePoint Re to increase the funding in the reinsurance trust for the benefit of TICNY. The New York State Department of Financial Services (the “NYDFS”) has confirmed this will be acceptable for the purpose of admitted surplus and capital on TICNY’s 2013 statutory basis financial statements. For the 2013 statutory basis financial statements, CastlePoint Re reported $581.7 million in its reinsurance trust.

 

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Based on RBC calculations as of December 31, 2013, six of Tower’s ten U.S. based insurance subsidiaries have capital and surplus below Company Action Level and do not meet the minimum capital and surplus requirements of their respective state regulators. As a result, management has discussed the ACP Re Merger Agreement and the Cut-Through Reinsurance Agreement and provided its 2014 RBC forecasts to the regulators to document the Company’s business plan to bring two of these U.S based insurance subsidiaries’ capital and surplus levels above Company Action Level.

As a result of the recognition of the ceding commission relating to the Cut-Through Reinsurance Agreements executed with AmTrust and NGHC in January 2014, the U.S. based insurance subsidiaries’ capital and surplus will increase significantly from December 31, 2013 to January 1, 2014, as the U.S. based subsidiaries will transfer a significant portion of their commercial lines unearned premium to a subsidiary of AmTrust and all of their personal lines unearned premiums to a subsidiary of NGHC. Accordingly, as of January 1, 2014, the effect of the Cut-Through Reinsurance Agreements increased the surplus of two of the U.S. based insurance subsidiaries such that their capital and surplus levels exceeded Company Action Level.

In 2013, the NYDFS issued orders for seven of Tower’s insurance subsidiaries, subjecting them to heightened regulatory oversight, which includes providing the NYDFS with increased information with respect to the insurance subsidiaries’ business, operations and financial condition. In addition, the NYDFS has placed limitations on payments and transactions outside the ordinary course of business and material changes in the insurance subsidiaries’ management and related matters. Tower’s management and Board of Directors have held discussions with the NYDFS, and Tower has been complying with the orders and oversight.

On April 21, 2014, the NYDFS issued additional orders for two of Tower’s insurance subsidiaries instructing them to provide plans to address weaknesses in such insurance subsidiaries’ risk based capital levels as shown in their statutory annual financial statements, and imposing further enhanced reporting and prior approval requirements and limitations on writings of new business. On the same date, the NYDFS issued a letter pertaining to one of Tower’s insurance subsidiaries requiring the submission of a plan to address weaknesses in risk based capital levels.

The Massachusetts Division of Insurance (“MDOI”) and Tower management have agreed to certain restrictions on the operations of Tower’s two Massachusetts domiciled insurance subsidiaries. Tower management has agreed to cause these subsidiaries to provide the MDOI with increased information with respect to their business, operations and financial condition, as well as limitations on payments and transactions outside the ordinary course of business and material changes in their management and related matters.

The Maine Bureau of Insurance entered a Corrective Order imposing certain conditions on Maine domestic insurers York Insurance Company of Maine (“YICM”) and North East Insurance Company (“NEIC”). The Corrective Order imposes increased reporting obligations on YICM and NEIC with respect to business operations and financial condition and imposes restrictions on payments or other transfers of assets from YICM and NEIC outside the ordinary course of business.

On April 11, 2014, the New Jersey Department of Banking and Insurance imposed an enhanced reporting requirement on the intercompany transactions involving Tower’s two New Jersey domiciled insurance subsidiaries and Tower’s New Jersey managed insurer. Such companies are now required to submit for prior approval any transactions with affiliates, even transactions that would otherwise not be reportable under the applicable holding company act.

As of December 31, 2013, TRL and CastlePoint Re had capital and surplus that did not meet the minimum solvency requirements of the BMA. Management has discussed the ACP Re Merger Agreement and provided 2014 solvency forecasts to the BMA.

The BMA has issued directives for TRL and CastlePoint Re, subjecting them to heightened regulatory oversight and requiring BMA approval before certain transactions can be executed. Tower has been complying with the directives issued by the BMA.

Liquidity

TGI was the obligor under the bank credit facility agreement dated as of February 15, 2012, as amended, with Bank of America, N.A. and other lenders named therein and is the obligor under the $150 million Convertible Senior Notes (“Notes”) due September 15, 2014. The indebtedness of TGI is guaranteed by TGIL and for purposes of the credit facility was also guaranteed by several of TGIL’s non-insurance subsidiaries.

On December 13, 2013, TGI paid in full the $70.0 million outstanding on the bank credit facility and the bank credit facility has been terminated. The $70.0 million was provided, primarily, from the sale of Tower’s 10.7% ownership in Canopius Group Limited (“Canopius Group”) on December 13, 2013.

 

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The Company’s plan to repay the Notes is related to the closing of the ACP Re Merger Agreement. In the event that the ACP Re Merger Agreement does not close prior to September 15, 2014, the Company would evaluate a combination of using proceeds from the sale of assets held at TGI, including but not limited to, renewal rights on its commercial and personal lines of business and certain of its insurance companies to pay down the principal of the Notes. The Company can provide no assurance that it will be successful in finalizing the liquidation of the assets held at TGI or selling certain of its operating assets to satisfy repayment of the Notes.

As of December 31, 2013, there were $235.1 million of subordinated debentures outstanding. The subordinated debentures do not have financial covenants that would cause an acceleration of their stated maturities. The earliest stated maturity date is on a $10 million debenture, which matures in May 2033. The Company has the ability to defer interest payments on its subordinated debentures for up to twenty quarters.

The merger with ACP Re is expected to close in the summer of 2014, and there are contractual termination rights available to each of Tower and ACP Re under various circumstances. There can be no assurance that the merger will close, or that it will close under the same terms and conditions contained in the ACP Re Merger Agreement. There can be no guarantee that the Company will be able to remedy current statutory capital deficiencies in certain of its insurance subsidiaries or maintain adequate levels of statutory capital in the future.

Consequently, there is substantial doubt about the Company’s ability to continue as a going concern. Should the Company no longer continue to support its capital or liquidity needs, or should the Company be unable to successfully execute the above mentioned initiatives, the above items would have a material adverse effect on its business, results of operations and financial position.

Resignation of Tower’s Chairman of the Board, President and Chief Executive Officer and Appointment of new Chairman of the Board and new President and Chief Executive Officer

On February 6, 2014, Tower and Michael H. Lee entered into a Separation and Release Agreement in connection with the resignation of Mr. Lee from his positions as Chairman of the Board of Directors, President and Chief Executive Officer, effective as of February 6, 2014. Mr. Lee’s employment with the Company was terminated effective as of February 6, 2014. In connection with his resignation, Mr. Lee received on March 31, 2014 a severance payment of approximately $3.3 million calculated pursuant to terms of his employment agreement.

Jan R. Van Gorder, who is the lead independent director of the Board and a member of the Board’s Audit Committee, Compensation Committee and Corporate Governance and Nominating Committee, was appointed on February 9, 2014 to succeed Mr. Lee as Chairman of the Board. William W. Fox, Jr., who had served as a member of the Board and of the Board’s Audit Committee and Corporate Governance and Nominating Committee until his resignation from the Board on December 31, 2013, succeeded Mr. Lee as President and Chief Executive Officer of Tower effective as of February 14, 2014.

Expense Control Initiative

On November 22, 2013, the Company announced the implementation of an expense control initiative to streamline its operations and focus resources on its most profitable lines of business. As part of this initiative, the Company has implemented a workforce reduction affecting approximately 10% of the total employee population of approximately 1,400. The areas that are most significantly impacted are commercial lines underwriting as well as operations. This workforce reduction is expected to result in annualized cost savings of approximately $21.0 million. The Company currently recognized pre-tax charges of $5.5 million in the fourth quarter of 2013 for severance and other one-time termination benefits and other associated costs.

Other

Tower received a document request from the U.S. Securities and Exchange Commission (the “SEC”) dated January 13, 2014, as part of an informal inquiry (the “SEC Request”). The SEC Request asks for documents related to Tower’s financial statements, accounting policies, and analysis. Tower is cooperating with the SEC’s inquiry and has provided the requested information.

The Company and certain of its current and former senior officers have been named as defendants in several class action lawsuits instituted against them by certain shareholders. In addition, the Company and certain of its current and former directors, along with certain other parties, have been named as defendants in a putative class action lawsuit instituted against them by another purported shareholder. See “Note 17 – Contingences” for additional detail on such litigation.

Canopius Merger Transaction

On August 20, 2012, TGI closed on its previously announced $74.9 million acquisition of a 10.7% stake in Canopius Group. In connection with this acquisition, TGI also entered into an agreement dated April 25, 2012 (the “Master Transaction Agreement”) under which Canopius Group committed to assist TGI with the establishment of a presence at Lloyd’s of London through a

 

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special purpose syndicate (“SPS Transaction Right and Acquisition Right”) (subject to required approvals) and granted TGI an option (the “Merger Option”) to combine with Canopius Bermuda. On July 30, 2012, TGI 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 would acquire all of TGI’s common stock. TGI 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 TGI shareholders (the Original Merger Agreement as so amended, the “Merger Agreement”).

Prior to the Canopius Merger Transaction date, Canopius Group priced on March 6, 2013, a private sale of 100% of the shares of Canopius Bermuda to third party investors for net consideration of $205,862,755. This investment resulted in 14,025,737 shares being issued in the private placement immediately preceding the merger.

On March 13, 2013, Canopius Bermuda and TGI consummated the Canopius Merger Transaction contemplated by the Merger Agreement. Canopius Bermuda was re-named Tower Group International, Ltd. and became the ultimate parent company of TGI, with TGI becoming its indirect wholly-owned subsidiary. Pursuant to the terms of the Merger Agreement, among other things, (i) 100% of the issued and outstanding shares of TGI common stock was cancelled and automatically converted into the right to receive 1.1330 common shares of the Company, par value $0.01 per share (the “ Common Shares”), (ii) each outstanding option to acquire TGI common stock, whether vested or unvested and whether granted under TGI’s 2008 Long-Term Equity Compensation Plan or otherwise, automatically vested, free of any forfeiture conditions, and constituted a fully vested option to acquire that number of Common Shares (rounded down to the nearest whole number) equal to the number of shares of TGI common stock subject to such option multiplied by 1.1330, on the same terms and conditions (other than vesting and performance conditions) as were applicable to such TGI stock option immediately prior to the Canopius Merger Transaction, with the exercise price of such option adjusted to be the original exercise price divided by 1.1330, and (iii) substantially all issued and outstanding shares of TGI restricted stock, whether granted under TGI’s 2008 Long-Term Equity Compensation Plan or otherwise, automatically vested, free of any forfeiture conditions, and were converted into the right to receive, as soon as reasonably practicable after the effective time, 1.1330 Common Shares.

Immediately after giving effect to the issuance of Common Shares to the former TGI shareholders in the Canopius Merger Transaction, approximately 57,432,150 Common Shares were outstanding, of which 76% were held by the former TGI shareholders. The remaining 24% of Common Shares outstanding immediately after giving effect to the Canopius Merger Transaction were held by third party investors. As the Company is the successor issuer to TGI, succeeding to the attributes of TGI as registrant, including TGI’s SEC filer code, its Common Shares trade on the same exchange, the NASDAQ Global Select Market, and under the same trading symbol, “TWGP,” that the shares of TGI common stock traded on and under prior to the Canopius Merger Transaction.

The Canopius Merger Transaction was expected to advance the Company’s strategy and create a more efficient global, diversified specialty insurance company consisting of commercial, specialty and personal lines, reinsurance and international specialty products. In addition, the establishment of a Bermuda domicile provided the Company with an international platform through which it accesses the U.S., Bermuda and the Lloyd’s of London (“Lloyd’s”) markets.

On December 13, 2013, Tower sold its 10.7% ownership in Canopius Group Limited.

Principal Revenue and Expense Items

We generate revenue from four primary sources:

 

 

Net premiums earned;

 

 

Ceding commission revenue;

 

 

Insurance Service revenue; and

 

 

Net investment income and realized gains and losses on investments.

We incur expenses from four primary sources:

 

 

Losses and loss adjustment expenses;

 

 

Operating expenses;

 

 

Interest expense; and

 

 

Income taxes.

Each of these is discussed below.

Net premiums earned. Premiums written include all policies produced in an accounting period. Premiums are earned over the term of the related policy. The portion of the premium that relates to the policy term that has not yet expired is included on the

 

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balance sheet as unearned premium to be earned in subsequent accounting periods. Premiums can be assumed from or ceded to reinsurers. Direct premiums combined with assumed premiums are referred to as gross premiums and subtracting premiums ceded to reinsurers results in net premiums.

Ceding commission revenue. We earn ceding commission revenue (generally a percentage of the premiums ceded) on the gross premiums written that we cede to reinsurers under quota share reinsurance agreements. We typically do not earn ceding commission revenue on property catastrophe or excess of loss reinsurance that we purchase.

Insurance service revenue. We earn fee income primarily from services provided to the Reciprocal Exchanges for underwriting, claims, investment management and other services. The fees earned from the Reciprocal Exchanges are eliminated in the Company’s consolidated financial statements because the Reciprocal Exchanges are consolidated with Tower’s balance sheets and statements of operations, changes in shareholders’ equity and cash flows Additional commission and fee income is generated on premiums produced by the managing general agencies on behalf of third-party reinsurance companies.

Net investment income and realized gains and losses on investments. We invest our available funds in cash, cash equivalents, securities and investment partnerships. Our investment income includes interest and dividends earned on our invested assets. Realized gains and losses on invested assets are reported separately from net investment income. We earn realized gains when invested assets are sold for an amount greater than their amortized cost, in the case of fixed maturity securities, and cost, in the case of equity securities, and we recognize realized losses when invested assets are written down or sold for an amount less than their amortized cost or actual cost, as applicable.

Losses and loss adjustment expenses. We establish loss and loss adjustment expense (“LAE”) reserves in an amount equal to our estimate of the ultimate liability for claims under our insurance policies and the cost of adjusting and settling those claims less the amounts already paid on these claims. Loss and LAE expense recorded in a period includes estimates for losses incurred during the period and changes in estimates for prior periods.

Operating expenses. In our Commercial Insurance, Assumed Reinsurance and Personal Insurance segments, we refer to the operating expenses that we incur to underwrite risks as underwriting expenses. These include commission expenses (payments to our producers for the premiums that they generate for us) and other underwriting expenses.

Interest expense. We pay interest on our subordinated debentures, convertible senior notes, credit facility and on segregated assets placed in trust accounts on a “funds withheld” basis in order to collateralize reinsurance recoverables. In addition, interest expense includes amortization of debt origination costs and original issue discounts over the remaining term of our debt instruments.

Income taxes. We pay federal, state and local income taxes and non income-related other taxes.

Measurement of Results

We use various measures to analyze the growth and profitability of our business segments. In our Commercial Insurance, Assumed Reinsurance and Personal Insurance segments, we measure growth in terms of gross, ceded and net premiums written, and we measure underwriting profitability by examining our loss, expense and combined ratios. We also measure our gross and net written premiums to surplus ratios to measure the adequacy of capital in relation to premiums written. We measure profitability in terms of net income attributable to Tower Group, International, Ltd. and return on average equity related to Tower Group International, Ltd.

Premiums written. We use gross premiums written to measure our sales of insurance products and, in turn, our ability to generate ceding commission revenues from premiums that we cede to reinsurers. Gross premiums written also correlates to our ability to generate net premiums earned.

Loss ratio. The loss ratio is the ratio of losses and LAE incurred to premiums earned and measures the underwriting results of a company’s insurance business. We measure our loss ratio on a gross (before reinsurance) and net (after reinsurance) basis. We also measure the loss ratio on the ceded portion (the difference between gross and net premiums) for our Commercial Insurance and Personal Insurance segments. We use the gross loss ratio as a measure of the overall underwriting profitability of the insurance business we write and to assess the adequacy of our pricing. We use the loss ratio on the ceded portion of our insurance business to measure the experience on the premiums that we cede to reinsurers, including the premiums ceded under our quota share treaties. In some cases, the loss ratio on such ceded business is considered in determining the ceding commission rate that we earn on ceded premiums. Our net loss ratio is meaningful in evaluating our financial results, which are net of ceded reinsurance, as reflected in our consolidated financial statements. In addition, we use accident year and calendar year loss ratios to measure our underwriting profitability. An accident year loss ratio measures losses and LAE for insured events occurring in a

 

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particular year, regardless of when they are reported, as a percentage of premiums earned during that particular accident year. A calendar year loss ratio measures losses and LAE for insured events occurring during a particular year and the changes in estimates in loss and LAE reserves from prior accident years as a percentage of premiums earned during that particular calendar year.

Underwriting expense ratio. The gross underwriting expense ratio is the ratio of direct commission expenses and other underwriting expenses less policy billing fees to gross premiums earned. The gross underwriting expense ratio measures a company’s operational efficiency in producing, underwriting and administering its insurance business. We also calculate our net underwriting expense ratio after the effect of ceded reinsurance. Ceding commission revenue is applied to reduce our underwriting expenses in our insurance company operation.

Combined ratio. We use the net combined ratio to measure our underwriting performance. The combined ratio is the sum of the loss ratio and the underwriting expense ratio. We analyze the combined ratio on a gross (before the effect of reinsurance) and net (after the effect of reinsurance) basis. If the combined ratio is at or above 100%, an insurance company is not underwriting profitably and may not be profitable unless investment income is sufficient to offset underwriting losses.

Management fee income earned by the management companies. Our management companies provide various underwriting, claims, investment management and other services to the Reciprocal Exchanges. We receive a percentage of the gross written premiums issued by the Reciprocal Exchanges.

Net income and return on average equity. We use net income to measure our profits and return on average equity to measure our effectiveness in utilizing our shareholders’ equity to generate net income on a consolidated basis. In determining return on average equity for a given year, net income is divided by the average of shareholders’ equity for that year.

Book value per share. Book value per share is calculated as Tower Group International, Ltd. shareholders’ equity divided by the number of shares outstanding. We use this as a measure of value per share of the Company independent from the market price per share.

Tangible book value per share. Tangible book value per share is calculated as Tower Group International, Ltd. shareholders’ equity, less intangible assets and goodwill, divided by the number of shares outstanding. We use this as a measure of value per share of the Company independent from the market price per share.

Operating income (loss). Operating income (loss) excludes realized gains and losses and acquisition-related transaction costs, net of tax. This is a common measurement for property and casualty insurance companies. We believe this presentation enhances the understanding of our results of operations by highlighting the underlying profitability of our insurance business. Additionally, these measures are a key internal management performance standard.

The following table provides a reconciliation of operating income (loss) to net income (loss) attributable to Tower Group International, Ltd. on a GAAP basis. The operating income (loss) is used to calculate operating earnings (loss) per share and operating return on average equity.

 

     Year Ended December 31,  
($ in thousands)    2013     2012     2011  

Operating income (loss)

   $ (544,204   $ (33,934   $     40,285  

Net realized gains (losses) on Tower’s investments

            22,894            12,245       6,980  

Acquisition-related transaction costs

     (21,322     (9,229     (360

Goodwill and fixed asset impairment

     (397,211     -        -   

Income tax

     (2,773     (3,316     (2,470

Net income (loss) attributable to Tower Group International, Ltd.

   $ (942,616   $ (34,234   $ 44,435  

Critical Accounting Estimates

In preparing our consolidated financial statements, management is required to make estimates and assumptions that affect reported assets, liabilities, revenues and expenses and the related disclosures as of the date of the financial statements. Management considers an accounting estimate to be critical if it requires assumptions to be made that involve uncertainty at the time the estimate is made and, had different assumptions been selected, the changes in the outcome could have a significant effect on our financial statements. We review our critical accounting estimates and assumptions quarterly. Actual results may differ, perhaps substantially, from the estimates.

 

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Our most critical accounting estimates involve the estimation of reserves for losses (including losses that have occurred but had not been reported by the financial statement date) and LAE, establishing fair value of losses and LAE for acquired businesses, net earned premiums, the reporting of ceding commissions earned, the amount and recoverability of reinsurance recoverable balances, deferred acquisition costs, investment impairments and potential impairments of intangible and long-lived assets.

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 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 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 a matter of judgment 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, by program. 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.

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

 

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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 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 adjusted periodically to reimburse our in-house legal department for all their costs.

We determine ULAE reserves by applying a paid-to-paid ratio to the case and IBNR reserves by line of business. The paid-to-paid ratio is based on ratios of ULAE payments divided by loss and ALAE payments for last three calendar years.

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. Also see “Item 9A. - Controls and Procedures” for a discussion on the companies material weakness over financial reporting as they relate to the effectiveness of the loss reserving process.

Establishing fair value of loss and LAE reserves for acquired companies. At acquisition date, accounting standards require that loss and LAE reserves must be set to fair value. As there are no readily observable markets for these liabilities, we use a valuation model that estimates net nominal future cash flows related to the loss and LAE reserve. This valuation is adjusted for the time value of money and a risk margin to compensate the Company for holding capital supporting the risk associated with the liabilities. This adjustment is referred to as the “reserve risk premium”, which is amortized over the expected payout pattern of the claims.

Net premiums earned. Insurance policies issued or reinsured by us are short-duration contracts. Accordingly, premium revenue, including direct writings and reinsurance assumed, net of premiums ceded to reinsurers, is recognized as earned in proportion to the amount of insurance protection provided, on a pro-rata basis over the terms of the underlying policies. Unearned premiums represent premiums applicable to the unexpired portions of in-force insurance contracts at the end of each year. Prepaid reinsurance premiums represent the unexpired portion of reinsurance premiums ceded.

Ceding commissions earned. We have historically relied on quota share, excess of loss and catastrophe reinsurance to manage our regulatory capital requirements and limit our exposure to loss.

Ceding commissions under a quota share reinsurance agreement are based on the agreed-upon commission rate applied to the amount of ceded premiums written. Ceding commissions are realized in income as ceded premiums written are earned. The ultimate commission rate earned on certain of our quota share reinsurance contracts is determined by the loss ratio on the ceded premiums earned. If the estimated loss ratio decreases from the level currently in effect, the commission rate increases and additional ceding commissions are earned in the period in which the decrease is recognized. If the estimated loss ratio increases, the commission rate decreases, which reduces ceding commissions earned. As a result, the same uncertainties associated with estimating loss and LAE reserves affect the estimates of ceding commissions earned. We monitor the ceded ultimate loss ratio on a quarterly basis to determine the effect on the commission rate of the ceded premiums earned that we accrued during prior accounting periods. The estimated ceding commission income relating to prior years recorded in 2013, 2012, and 2011 was a decrease of $9.8 million, $4.2 million and $2.7 million, respectively. These decreases are attributed to prior year reserve development that was not initially anticipated.

Reinsurance recoverables. Reinsurance recoverable balances are established for the portion of paid and unpaid loss and LAE that is assumed by reinsurers. Prepaid reinsurance premiums represent unearned premiums that are ceded to reinsurers. Reinsurance recoverables and prepaid reinsurance premiums are reported on our balance sheet separately as assets, instead of netted against the related liabilities, since reinsurance does not relieve us of our legal liability to policyholders and ceding companies. We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. Consequently, we bear credit risk with respect to our individual reinsurers and may be required to make judgments as to the ultimate recoverability of our reinsurance recoverables. Additionally, the same uncertainties associated with estimating loss and LAE reserves affect the estimates of the amount of ceded reinsurance recoverables. We continually monitor the financial condition and rating agency ratings of our reinsurers. Non-admitted reinsurers are required to collateralize their share of unearned premium and loss reserves either by placing funds in a trust account meeting the requirements of New York Regulation 114 or by providing a letter of credit. In addition, from October 2003 to December 31, 2005, we placed our quota share treaties on a “funds withheld” basis, under which we retained the ceded premiums written and placed that amount in segregated trust accounts from which we may withdraw amounts due to us from the reinsurers.

 

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Deferred acquisition costs, net. We defer certain expenses that vary with and are directly related to the successful acquisition of new and renewal insurance business, including commission expense on gross premiums written, premium taxes and certain other costs related to the acquisition of insurance contracts. These costs are capitalized and the resulting asset, DAC, is amortized and charged to expense or income in future periods as gross and ceded premiums written are earned. The method followed in computing deferred acquisition costs, net, limits the amount of such deferred amounts to its estimated realizable value. The ultimate recoverability of deferred acquisition costs is dependent on the continued profitability of our insurance underwriting. We also consider anticipated invested income in determining the recoverability of these costs. If our insurance underwriting becomes unprofitable, we may have to write off a portion of our deferred acquisition costs, resulting in a further charge to income in the period in which the underwriting losses are recognized. 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 cash flow or interest component of VOBA is amortized in proportion to the expected pattern of future cash flows. The Company fully amortized the VOBA in the year ended December 31, 2011 and, accordingly, does not have any VOBA recorded on its balance sheet as of December 31, 2013 or 2012. The Company considers anticipated investment income in determining the recoverability of these costs and believes they are fully recoverable.

Impairment of invested assets. Impairment of investment securities results in a charge to operations when a market decline below cost is deemed to be other-than-temporary. We regularly review our fixed-maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. In evaluating potential impairment, we consider, among other criteria:

 

 

the overall financial condition of the issuer;

 

 

the current fair value compared to amortized cost or cost, as appropriate;

 

 

the length of time the security’s fair value has been below amortized cost or cost;

 

 

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;

 

 

whether management intends to sell the security and, if not, whether it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis;

 

 

specific cash flow estimations for fixed-income securities; and

 

 

current economic conditions.

If an other-than-temporary-impairment (“OTTI”) loss is determined for a fixed-maturity security (for which we do not have the intent to sell or it is not more likely than not we would be required to sell), the credit portion is recorded in the income statement as realized investment losses and the non-credit portion is recorded in accumulated other comprehensive income. The credit portion results in a permanent reduction in the cost basis of the underlying investment. For all other fixed-maturity security and equity security impairments, the entire impairment is reflected as a realized investment loss and reduces the cost basis of the security. The determination of OTTI is a subjective process and different judgments and assumptions could affect the timing of loss realization. We recorded OTTI losses on our fixed maturity and equity securities in the amounts of $14.4 million, $9.9 million and $3.5 million in 2013, 2012, and 2011, respectively, of which $13.4 million, $9.6 million and $3.2 million were recorded in Net realized investment gains (losses) in 2013, 2012, and 2011, respectively.

Since total unrealized losses are a component of shareholders’ equity, the recognition of OTTI losses has no effect on our comprehensive income or shareholders’ equity.

See “Business-Investments” and “Note 5 – Investments” in the notes to consolidated financial statements for additional detail regarding our investment portfolio at December 31, 2013, including disclosures regarding OTTI.

Goodwill, intangible and fixed assets impairment. The costs associated with a group of assets acquired in a transaction are allocated to the individual assets, including identifiable intangible assets, based on their relative fair values. Purchase consideration in excess of the fair value of tangible and intangible assets is recorded as goodwill.

Identifiable intangible assets with a finite useful life are amortized over the period in which the asset is expected to contribute directly or indirectly to our future cash flows. Identifiable intangible assets with finite useful lives are amortized over their useful lives and tested for recoverability whenever events or changes in circumstances indicate that a carrying amount may not be recoverable. Identifiable intangible assets with indefinite useful lives are not amortized. Rather, they are tested for recoverability at least annually or whenever events or changes in circumstances indicate that a carrying amount may not be recoverable. Management assessed the carrying value of its intangible assets with a finite useful life 2013 and concluded impairment charges of $21.9 million were required to reduce its customer relationship intangible assets to fair value. These charges are reported in Other Operating Expenses in the consolidated statements of operations. No impairment losses were recognized on intangible assets with a finite useful life in 2012 or 2011.

 

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The Company completed its annual indefinite lived intangible asset assessment as of December 31, 2013. An impairment loss is recognized if the carrying value of an intangible asset is not recoverable and its carrying amount exceeds its fair value. Any amount of intangible assets determined to be impaired will be recorded as an expense in the period in which the impairment determination is made. No impairment losses were recognized on indefinite lived intangible assets in 2013, 2012 or 2011.

Goodwill is not amortized. The Company tests goodwill balances for impairment annually in the fourth quarter of each year using a September 30 measurement date, or more frequently if circumstances indicate that the value of goodwill may be impaired. Goodwill impairment is performed at the reporting unit level and the test requires a two-step process. In performing Step 1 of the impairment test, management compared the estimated fair values of the applicable reporting units to their aggregate carrying values, including goodwill. If the carrying amount of a reporting unit including goodwill were to exceed the fair value of the reporting unit, Step 2 of the goodwill impairment would be performed. Step 2 of the goodwill impairment test requires comparing the implied fair value of the affected reporting unit’s goodwill against the carrying value of that goodwill.

The process of evaluating goodwill for impairment requires judgments and assumptions to be made to determine the fair value of each reporting unit, including discounted cash flow calculations, assumptions that market participants would make in valuing each reporting unit and the level of the Company’s own share price. Fair value estimates utilize both the market approach and income approach. Management considered valuation techniques such as peer company price-to-earnings and price-to-book multiples and an in-depth analysis of projected future cash flows and relevant discount rates, which considered market participant inputs. Other significant assumptions include levels of surplus available for distribution, future business growth and earnings projections for each reporting unit. Estimates of fair value are subject to assumptions that are sensitive to change and represent the Company’s reasonable expectation regarding future developments. Management also considers the implied control premium derived from its market capitalization and the implied fair value of the enterprise.

In its 2012 annual impairment test, management determined that a greater risk of future impairment existed for the Commercial Insurance reporting unit. During the second quarter of 2013, management in its judgment concluded a quarterly impairment test was required as a result of the segment reorganization (see “Note 2 – Accounting Policies and Basis of Presentation”) and significant prior years’ loss reserves incurred (see “Note 10 – Loss and Loss Adjustment Expense”). In the third quarter of 2013, as a result of the additional significant prior years’ loss reserves incurred, management in its judgment concluded a quarterly impairment test was required again as of September 30, 2013 in the preparation of the September 30, 2013 consolidated financial statements.

In conducting the goodwill impairment analysis as of June 30, 2013, the Company tested the reporting units prior to the reorganization as required by GAAP. The Company estimated each of the reporting units’ fair values using a market multiple approach based on tangible book values. Historically, the Company also utilized market multiple approaches based on (i) book value, (ii) estimates of projected results for future periods, and (iii) a valuation technique using discounted cash flows. However, based upon the significance of the loss reserve charge recorded in the second quarter of 2013, the reduction to Tower’s insurance subsidiaries’ capital and surplus levels (see “Note 18 – Statutory Financial Information”), management in its judgment concluded a multiple of tangible book value was most indicative of a price a market participant would pay for the reporting units. In addition, the Commercial Insurance reporting unit’s estimated fair value was adjusted for the expected capital infusion a market participant would be expected to fund into the insurance businesses to maintain historical rating agency ratings.

Step 1 of the impairment test indicated the Commercial Insurance unit’s carrying value exceeded its fair value and the Personal Insurance unit’s fair value exceeded its carrying value.

Accordingly, the Company performed a Step 2 impairment test on the Commercial Insurance reporting unit. Based on the results, the Company recorded a non-cash goodwill impairment charge of $214.0 million to write-down all of the goodwill in the Commercial Insurance reporting unit as of June 30, 2013. As of June 30, 2013, the Company reported $55.5 million of goodwill, all of which related to the Personal Insurance reporting unit.

In conducting the goodwill impairment analysis for the quarter ended September 30, 2013, the Company estimated the Personal Insurance fair values using Tower’s current market capitalization, adjusted for a control premium. Historically, the Company also utilized various market multiple approaches for Personal Insurance reporting unit. However, based upon the significant 2013 events, including A.M. Best’s downgrade to “B” for the insurance subsidiaries, management in its judgment concluded the market capitalization, adjusted for a control premium, was most indicative of a price a market participant would pay for the reporting unit.

Step 1 of the impairment test as of September 30, 2013 indicated the Personal Insurance unit’s carrying value exceeded its fair value.

Accordingly, the Company performed a Step 2 impairment test on the Personal Insurance reporting unit. Based on the results, the Company recorded a non-cash goodwill impairment charge of $55.5 million to write-down all of the goodwill in the Personal Insurance reporting unit as of September 30, 2013. As of December 31, 2013, the Company had no goodwill reported on its consolidated balance sheet.

 

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Fixed assets, including furniture, leasehold improvements, computer equipment, and software, including internally developed software, are reported at cost less accumulated depreciation and amortization. As of December 31, 2012, gross fixed assets and capital leases were $194.0 million and accumulated depreciation was $54.7 million (for net fixed assets and capital leases of $139.3 million).

As a result of the significant business developments discussed above, including the A.M. Best, Fitch and Demotech rating downgrades in December of 2013 and the expected significant declines in net written premiums and the orders and restrictions placed by various insurance departments, management tested fixed assets for recoverability.

Long-lived tangible assets that an entity will continue to hold and use should be reviewed for impairment, which includes two steps. The first step in the impairment test is to determine whether the long-lived assets are recoverable as measured by comparing net carrying value of the asset or asset group to the undiscounted net cash flows to be generated from the use and eventual disposition of that asset or asset group. In performing this step, management concluded that the sum of the undiscounted cash flows was less than the carrying value of the asset group. Accordingly, the Company performed an impairment analysis in which the implied fair value of the fixed assets was determined to be lower than the carrying value.

Management determined the fair value of fixed assets by (i) calculating an estimated software charge (i.e. fee for use of software) a market participant would pay the owner of the asset in return for the ability to use the Company’s software and (ii) performing an orderly liquidation value analysis ranging from 0%-15% for furniture, leasehold improvements and computer equipment, and concluded the fixed assets were impaired as of September 30, 2013. The Company recorded a non-cash charge to earnings of $125.8 million. This charge is recorded within Goodwill and fixed-assets impairment in the statement of operations.

See “Note 7 – Goodwill, Intangible and Fixed Asset Impairments” in the notes to consolidated financial statements. Also see “Item 9A. Controls and Procedures” for a discussion on the companies material weakness over financial reporting as it relates to the impairment process of assessing long-lived tangible and intangible assets.

 

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Consolidating Supplemental Information

The following tables present the consolidating financial statements as of December 31, 2013 and 2012 and for the years ended December 31, 2013, 2012 and 2011:

 

     December 31, 2013  
($ in thousands)    Tower     Reciprocal
Exchanges
    Eliminations     Total  

Assets

        

Investments

        

Available-for-sale investments, at fair value:

        

Fixed-maturity securities

   $ 1,390,146     $ 252,549     $ -     $ 1,642,695  

Equity securities

     104,107       2,523       -       106,630  

Short-term investments

     5,897       -       -       5,897  

Other invested assets

     173,355       -