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       -       (77,200     96,155  

Total investments

     1,673,505       255,072       (77,200     1,851,377  

Cash and cash equivalents

     288,214       5,684       -       293,898  

Investment income receivable

     38,564       2,325       (23,396     17,493  

Premiums receivable

     267,151       44,878       (2,530     309,499  

Reinsurance recoverable on paid losses

     66,974       3,028       (1,039     68,963  

Reinsurance recoverable on unpaid losses

     555,468       25,208       (9,816     570,860  

Prepaid reinsurance premiums

     164,250       26,514       (4,288     186,476  

Deferred acquisition costs, net

     85,485       9,611       -       95,096  

Intangible assets

     73,599       6,337       -       79,936  

Goodwill

     -       -       -       -  

Funds held by reinsured companies

     98,816       -       -       98,816  

Other assets

     391,258       1,395       (9,522     383,131  

Total assets

   $ 3,703,284     $ 380,052     $ (127,791   $ 3,955,545  

Liabilities

        

Loss and loss adjustment expenses

   $ 1,973,970     $ 117,131     $ (9,816   $ 2,081,285  

Unearned premium

     657,045       110,355       (4,288     763,112  

Reinsurance balances payable

     84,948       8,441       (3,569     89,820  

Funds held under reinsurance agreements

     222,137       22       -       222,159  

Other liabilities

     268,937       50,352       (33,118     286,171  

Deferred income taxes

     10,327       19,181       -       29,508  

Debt

     382,770       77,000       (77,000     382,770  

Total liabilities

     3,600,134       382,482       (127,791     3,854,825  

Shareholders’ equity

        

Common stock

     574       -       -       574  

Treasury stock

     (39     -       -       (39

Paid-in-capital

     815,119       9,400       (9,400     815,119  

Accumulated other comprehensive income

     (19,507     1,338       (1,338     (19,507

Retained earnings (accumulated deficit)

     (700,596     (13,168     13,168       (700,596

Noncontrolling interests

     7,599       -       (2,430     5,169  

Total shareholders’ equity

     103,150       (2,430     -       100,720  

Total liabilities and shareholders’ equity

   $ 3,703,284     $ 380,052     $ (127,791   $ 3,955,545  

 

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

Assets

         

Investments

         

Available-for-sale investments, at fair value:

         

Fixed-maturity securities

   $ 2,064,148     $ 280,563      $ -     $ 2,344,711  

Equity securities

     140,695       5,563        -       146,258  

Short-term investments

     4,750       -        -       4,750  

Other invested assets

     134,986       -        (77,200     57,786  

Total investments

     2,344,579       286,126        (77,200     2,553,505  

Cash and cash equivalents

     74,018       9,782        -       83,800  

Investment income receivable

     39,439       2,610        (16,717     25,332  

Investment in unconsolidated affiliate

     71,894       -        -       71,894  

Premiums receivable

     367,760       47,031        (2,746     412,045  

Reinsurance recoverable on paid losses

     16,927       2,503        (1,821     17,609  

Reinsurance recoverable on unpaid losses

     407,068       55,839        (3,450     459,457  

Prepaid reinsurance premiums

     46,120       21,143        (3,340     63,923  

Deferred acquisition costs, net

     169,834       11,364        -       181,198  

Intangible assets

     99,914       6,854        -       106,768  

Goodwill

     241,458       -        -       241,458  

Funds held by reinsured companies

     137,545       -        -       137,545  

Other assets

     376,274       1,559        (19,852     357,981  

Total assets

   $ 4,392,830     $ 444,811      $ (125,126   $ 4,712,515  

Liabilities

         

Loss and loss adjustment expenses

   $ 1,759,888     $ 139,241      $ (3,450   $ 1,895,679  

Unearned premium

     818,055       106,556        (3,340     921,271  

Reinsurance balances payable

     34,333        11,546        (4,567     41,312  

Funds held under reinsurance agreements

     98,081       500        -       98,581  

Other liabilities

     275,614       58,115        (36,769     296,960  

Deferred income taxes

     5,069       19,694        -       24,763  

Debt

     449,731       77,000        (77,000     449,731  

Total liabilities

     3,440,771       412,652        (125,126     3,728,297  

Shareholders’ equity

         

Common stock

     530       -        -       530  

Treasury stock

     (181,435     -        -       (181,435

Paid-in-capital

     780,036       9,400        (9,400     780,036  

Accumulated other comprehensive income

     82,756       15,525        (15,525     82,756  

Retained earnings

     268,171       7,234        (7,234     268,171  

Noncontrolling interests

     2,001       -        32,159       34,160  

Total shareholders’ equity

     952,059       32,159        -       984,218  

Total liabilities and shareholders’ equity

   $ 4,392,830     $ 444,811      $ (125,126   $ 4,712,515  

 

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

Revenues

        

Net premiums earned

   $ 1,351,515     $ 161,400     $ -     $ 1,512,915  

Ceding commission revenue

     65,623       16,607       (848     81,382  

Insurance services revenue

     32,797       -       (31,647     1,150  

Policy billing fees

     11,856       443       -       12,299  

Net investment income

     106,309       9,578       (6,679     109,208  

Total net realized investment gains (losses)

     22,894       2,154       -       25,048  

Total revenues

     1,590,994       190,182       (39,174     1,742,002  

Expenses

        

Loss and loss adjustment expenses

     1,404,805       115,029       -       1,519,834  

Commission Expense

     331,551       34,328       (848     365,031  

Other operating expenses

     346,585       54,955       (31,647     369,893  

Acquisition-related transaction costs

     21,322       -       -       21,322  

Interest expense

     33,594       6,679       (6,679     33,594  

Total expenses

     2,137,857       210,991       (39,174     2,309,674  

Other income (expense)

        

Equity in income (loss) of unconsolidated affiliate

     6,962       -       -       6,962  

Goodwill and fixed asset impairment

     (397,211     -       -       (397,211

Other

     5,000       -       -       5,000  

Income (loss) before income taxes

     (932,112     (20,809     -       (952,921

Income tax expense (benefit)

     8,838       (407     -       8,431  

Net income (loss)

   $ (940,950   $ (20,402   $ -     $ (961,352

Less: Net income (loss) attributable to Noncontrolling interests

     1,666       (20,402     -       (18,736

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

     (942,616     -       -       (942,616

Ratios

                                

Net calendar year loss and LAE

     103.9     71.3       100.5

Net underwriting expenses

     40.6     44.8       41.0

Net Combined

     144.5     116.1       141.5

Return on Average Equity

     (157.2 )%                         

 

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

Revenues

       

Net premiums earned

  $ 1,558,204     $ 163,660     $ -     $ 1,721,864  

Ceding commission revenue

    18,737       14,564       (966     32,335  

Insurance services revenue

    33,570       -       (30,150     3,420  

Policy billing fees

    11,901       714       -       12,615  

Net investment income

    121,908       12,574       (7,317     127,165  

Total net realized investment gains (losses)

    12,245       13,231       -       25,476  

Total revenues

    1,756,565       204,743       (38,433     1,922,875  

Expenses

       

Loss and loss adjustment expenses

    1,154,540       109,218       -       1,263,758  

Commission Expense

    325,906       34,367       (966     359,307  

Other operating expenses

    293,458       54,189       (30,150     317,497  

Acquisition-related transaction costs

    9,229       -       -       9,229  

Interest expense

    33,268       6,679       (7,317     32,630  

Total expenses

    1,816,401       204,453       (38,433     1,982,421  

Other income (expense)

       

Equity in income (loss) of unconsolidated affiliate

    (1,470     -       -       (1,470

Income (loss) before income taxes

    (61,306     290       -       (61,016

Income tax expense (benefit)

    (27,072     (2,027     -       (29,099

Net income (loss)

  $ (34,234   $ 2,317     $ -     $ (31,917

Less: Net income (loss) attributable to Noncontrolling interests

    -       2,317       -       2,317  

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

    (34,234     -       -       (34,234

Ratios

                               

Net calendar year loss and LAE

    74.1     66.7       73.4

Net underwriting expenses

    35.5     44.6       36.4

Net Combined

    109.6     111.3       109.8

Return on Average Equity

    -3.4                        

 

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

Revenues

       

Net premiums earned

  $ 1,406,689     $ 187,161     $ -     $ 1,593,850  

Ceding commission revenue

    27,194       6,774       -       33,968  

Insurance services revenue

    30,873       -       (29,303     1,570  

Policy billing fees

    9,961       573       -       10,534  

Net investment income

    120,083       12,846       (6,455     126,474  

Total net realized investment gains (losses)

    6,980       2,414       -       9,394  

Total revenues

    1,601,780       209,768       (35,758     1,775,790  

Expenses

       

Loss and loss adjustment expenses

    972,567       104,419       -       1,076,986  

Direct and ceding commission expense

    277,285       32,541       -       309,826  

Other operating expenses

    261,974       52,176       (29,303     284,847  

Acquisition-related transaction costs

    360       -       -       360  

Interest expense

    34,290       6,455       (6,455     34,290  

Total expenses

    1,546,476       195,591       (35,758     1,706,309  

Income (loss) before income taxes

    55,304       14,177       -       69,481  

Income tax expense (benefit)

    10,869       3,182       -       14,051  

Net income (loss)

  $ 44,435     $ 10,995     $ -     $ 55,430  

Less: Net income (loss) attributable to Noncontrolling interests

    -       -       -       -  

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

    44,435       10,995       -       55,430  

Ratios

                               

Net calendar year loss and LAE

    69.1     55.8       67.6

Net underwriting expenses

    33.5     41.3       34.4

Net Combined

    102.6     97.1       102.0

Return on Average Equity

    4.3                        

Consolidated Results of Operations 2013 Compared to 2012

Total revenues. Total revenues decreased by 9.4% for the year ended December 31, 2013 as compared to 2012. This decrease is attributable to lower net premiums earned and net investment income offset by increases in ceding commission.

Premiums earned. Net premiums earned for the years ended December 31, 2013 and 2012 were $1.5 billion and $1.7 billion respectively. The decrease of 12.1% for the year ended December 31, 2013 is primarily due to decreased direct written premiums in the fourth quarter of 2013 as a result of the rating downgrades and increased ceded premiums due to new multi-line quota share reinsurance agreements. The Company entered into (i) a new homeowners quota share reinsurance treaty effective January 1, 2013, (ii) the previously disclosed reinsurance treaties with Arch and Hannover in the third quarter of 2013, and (iii) a further homeowners treaty in the fourth quarter of 2013. In 2013, the Company increased its homeowner’s reinsurance to reduce property exposure concentrated in the Northeast region of the U.S, and entered into the Arch and Hannover treaties to provide for surplus enhancement and improve certain financial leverage ratios, while increasing the Company’s financial flexibility.

Commission and fee income. Commission and fee income, comprised of ceding commission revenue, insurance services revenue and policy billing fees, increased by $46.5 million for the year ended December 31, 2013 compared to the prior year. The increase is due primarily to ceding commission revenue earned on the new 2013 reinsurance quota share treaties.

Net investment income and net realized gains (losses). For the year ended December 31, 2013, net investment income decreased $18.0 million or 14.1% compared to 2012. Net investment income in 2013 decreased primarily due to a declining invested asset base and lower reinvestment rates from the prior year. Invested assets declined by approximately $702 million in 2013 due mostly to increased cash needs that arose from funding several large reinsurance contracts and increased collateral requirements that were triggered when the Company was downgraded by A.M. Best. The pre-tax yield at amortized cost was 3.46% at December 31, 2013 as compared to 3.98% at December 31, 2012.

 

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For the year ended December 31, 2013 and 2012, OTTI losses of $13.4 million and $9.6 million, respectively, were recorded in net income. The OTTI for the year ended December 31, 2013 is related mostly to securities in the Company’s equity security portfolio.

Net realized investment gains (losses) for the year ended December 31, 2013 and 2012 were $25.0 million and $25.5 million, respectively. These gains and losses are a function of individual securities selected for sale when cash needs arise in the ordinary course of business or when market dictates disposals pursuant to our investment policy.

Income earned on the equity method investment in Canopius Group is included as separate component in the income statement rather than as a component of investment income. For the years ended December 31, 2013 and 2012, earnings on this equity investment represented a gain of $7.0 million, and a loss of $1.5 million, respectively. The Company acquired its investment in Canopius Group in the third quarter of 2012, and, accordingly, recorded no earnings or loss for the three and nine months ended September 30, 2012. On December 13, 2013, Tower sold its 10.7% investment in Canopius Group.

Loss and loss adjustment expenses. The consolidated net loss ratio, which includes the Reciprocal Exchanges, was 100.5% and 73.4% for the years ended December 31, 2013 and 2012, respectively. Excluding the Reciprocal Exchanges, the net loss ratio was 103.9% and 74.1% for the years ended December 31, 2013 and 2012, respectively. The Reciprocal Exchanges’ net loss ratio was 71.3% and 66.7% for the years ended December 31, 2013 and 2012, respectively.

Incurred losses and LAE for the year ended December 31, 2013 attributable to insured events of prior years were $538.1 million. Excluding the Reciprocal Exchanges, the incurred losses and LAE from prior accident years were $533.0 million. These prior accident year losses include unfavorable development of $539.8 million in the Commercial Insurance segment, favorable loss development of $5.4 million in the Assumed Reinsurance segment and unfavorable loss development of $3.7 million in the Personal Insurance segment for the year ended December 31, 2013. The favorable development of $5.4 million in the Assumed Reinsurance segment includes $19.1 million of favorable development resulting from the release of reserve risk premium. The Reciprocal Exchanges reported $5.1 million of unfavorable loss development for the year ended December 31, 2013.

Incurred losses and LAE for the year ended December 31, 2012 attributable to insured events of prior years were $79.2 million. Excluding the Reciprocal Exchanges, the incurred losses and LAE from prior accident years were $88.1 million. These prior accident year losses included unfavorable loss development of $86.6 million in the Commercial Insurance segment, favorable development of $2.5 million in the Assumed Reinsurance segment and unfavorable loss development of $4.0 million in the Personal Insurance segment for the year ended December 31, 2012. The Reciprocal Exchanges reported $8.9 million of favorable loss development for the year ended December 31, 2012.

Commission and Operating expenses. Operating expenses, which include commission expenses and other operating expenses, were $734.9 million for the year ended December 31, 2013, an increase of 8.6% compared to the prior year. This increase is primarily due to: (i) greater commission expense related primarily to a change in business mix. A larger proportion of earned premiums was from assumed reinsurance which have a higher commission rate compared to direct business, (ii) federal excise tax incurred by the Company on intercompany reinsurance transactions between CastlePoint Re and TRL, (iii) an impairment charge recorded on intangible assets and (iv) an increase in operating expenses related to improving information technology systems and infrastructure. The consolidated gross underwriting expense ratio increased to 34.6% for the year ended December 31, 2013 from 33.4% in the same period in 2012. This increase is due to the decline in gross earned premiums from 2012 to 2013, while commission and operating expenses increased from 2012 to 2013. The Company announced an expense control initiative whereby the Company is completing a workforce reduction affecting approximately 10% of the total employee population.

Acquisition-related transaction costs. Acquisition-related transaction costs for the years ended December 31, 2013 and 2012 were $21.3 million and $9.2 million, respectively. Acquisition–related transaction costs for the year ended December 31, 2013 relate primarily to costs associated with the Canopius Merger Transaction completed on March 13, 2013, and include $11.6 million in compensation expense (of which accelerated vesting of restricted stock was $10.3 million) and $8.7 million in legal and accounting fees. The 2012 expenses related to Tower’s acquisition of its equity interest in Canopius Group and expenses associated with the Canopius Merger Transactions.

Interest expense. Interest expense increased by $1.0 million for the year ended December 31, 2013 compared to 2012. The increase is mainly due to a combination of higher interest rates on our floating rate debt instruments and the accelerated recognition of accrued debt issuance costs that resulted with the termination of the $220 million Bank Facility on December 13, 2013, and the Letter of Credit Facility on December 5, 2013.

Equity in income (loss) of unconsolidated affiliate. Tower recognized a gain of $7.0 million on its 10.7% interest in Canopius Group in 2013. This investment was accounted for under the equity method of accounting. On December 13, 2013, Tower closed a sale of all of the shares of the capital stock of Canopius Group owned by Tower. The initial sale price was $69.7 million (£42.5

 

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million), which has been paid in full to Tower. In addition, it was agreed that, if a legally binding contract for the sale or other transfer of shares representing a majority of the voting power of Canopius Group is entered into within six months after the date of the stock purchase agreement between the third party and Tower, a further cash payment would be made to Tower. This additional cash payment would be equivalent to the excess, if any, of (1) one-third of the difference between the amount in British pound sterling paid for the shares previously owned by Tower in such sale and £40.6 million (plus Tower’s share of expenses of such sale), minus (2) £1.95 million (the “Additional Payment”). On December 18, 2013, NKSJ Holdings announced that it had entered into an agreement, through its insurance subsidiary Sompo Japan Insurance, Inc. to purchase 100% of the shares of Canopius Group. The $7.0 million represents the excess of the $69.7 million and the fair value of the Additional Payment over the carrying value of the 10.7% investment.

In 2012, Tower recognized a loss of $1.5 million relating to its equity method investment in Canopius Group. The Company records this investment on a one quarter lag (updated for significant events in the lag period). The loss is attributable to income incurred by Canopius Group in the third quarter of 2012 offset by fourth quarter 2012 losses associated with Superstorm Sandy claims.

Goodwill and Fixed Asset Impairment. For the year ended December 31, 2013, the Company recorded $271.4 million to impair goodwill and $125.8 million to impair fixed assets. The impairment charges were the result of the significant reserve development and rating agency downgrades in 2013 and their effects on the estimated fair value of each of the reporting units and fixed asset valuations.

Other. On August 19, 2013, Tower terminated an agreement to acquire American Safety Reinsurance, Ltd. (“ASRe”). Tower previously announced entering into an agreement to acquire ASRe, the Bermuda-based reinsurance subsidiary of American Safety Insurance Holdings, Ltd. from Fairfax Financial Holdings Limited. Tower received $5 million in exchange for the termination of such agreements.

Income tax expense. Tower pays federal income tax on its U.S. taxed insurance subsidiaries.

For the year ended December 31, 2013, Tower, excluding the Reciprocal Exchanges, had pre-tax losses of $901.4 million. These losses resulted in net operating loss carryforwards of $161.9 million as of December 31, 2013. In addition, Tower had net deferred tax assets, before any valuation allowances, of $265.0 million.

Management, in its judgment, concluded that a full valuation allowance was required for the net deferred tax assets after its consideration of the cumulative three-year pre-tax loss in its U.S. taxed subsidiaries resulting from certain 2013 events and the 2012 pre-tax loss of $61.3 million. In 2013, Tower had $325.6 million of prior year adverse reserve development, of which $149.7 million was recorded in Tower’s U.S. taxed subsidiaries. Management believes that the negative evidence associated with the realizability of its net deferred tax asset (including the cumulative three-year pre-tax loss, the prior year adverse reserve development, and the effects of Hurricane Irene in 2011 and Superstorm Sandy in 2012) outweighed the positive evidence that the deferred tax assets, including the net operating carryforward would be realized, and subsequently recorded the full valuation allowance.

For the year ended December 31, 2013, Tower recorded a full valuation allowance of which $240.6 million was recorded through income tax expense in the statement of operations and $32.5 million was recorded as a direct reduction to shareholders’ equity ($33.7 million in accumulated other comprehensive income and $(1.2) million in additional paid in capital). Tower’s effective tax rate of (1.0)% and 47.7% for the years ended December 31, 2013 and 2012, respectively, reflect the impact of recording the valuation allowance.

The Reciprocal Exchanges had pre-tax income (loss) for the years ended December 31, 2013 and 2012 of $(20.8) million and $0.3 million, respectively. A full valuation had previously been recorded on the Reciprocal Exchanges. The Reciprocal Exchanges’ valuation allowance as of December 31, 2013 was $17.6 million.

Net income (loss) and return on average equity. Net income (loss) and annualized return on average equity attributable to Tower Group International, Ltd. were ($942.6) million and (157.2%) for the year ended December 31, 2013 compared to ($34.2) million and (3.4%) for the year ended December 31, 2012. The return on average equity is calculated by dividing net income (loss) by average shareholders’ equity. Average shareholders’ equity was $599.5 million and $1,001.7 million at December 31, 2013 and 2012, respectively. The increase in net loss and decrease in annualized return on equity for the years ended December 31, 2013 compared to the prior year is primarily due to the prior year loss reserve development and a $397.2 million goodwill and fixed asset impairment change, as discussed above.

Consolidated Results of Operations 2012 Compared to 2011

Total revenues. Total revenues increased by 8.3% for the year ended December 31, 2012 as compared to 2011, primarily due to increased net premiums earned.

 

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Premiums earned. Net premiums earned for the years ended December 31, 2012 and 2011 were $1.7 billion and $1.6 billion respectively. The increase of 8.0% for the year ended December 31, 2012 is primarily a result of increased premiums from Tower’s assumed reinsurance business, offset by an increase in ceded premiums in 2012. Ceded premiums increased in 2012 due primarily to the reinstatement premium on the Company’s catastrophe reinsurance program as a result of Superstorm Sandy

Commission and fee income. Commission and fee income, comprised of ceding commission revenue, insurance services revenue and policy billing fees, increased by $2.3 million for the year ended December 31, 2012, compared to the prior year. The increase is due to additional policy billing fees and an increase in fees earned by our managing general agencies.

Net investment income and net realized gains (losses). Net investment income increased 0.5% for the year ended December 31, 2012 compared to 2011. Net investment income was comparable to the prior year period as average cash and invested assets were relatively constant for the year ended December 31, 2012 as compared to 2011. Operating cash invested in fixed income securities in 2012 and in 2011 has been affected by an extended low interest rate environment. Investments in high-yield securities, dividend paying equity securities and in alternative investments continue to be made to help maintain overall portfolio yield and to partially mitigate the impact of the lower interest rate environment.

The Company had net realized investment gains of $25.5 million for the year ended December 31, 2012 compared to gains of $9.4 million in 2011. OTTI losses recorded in earnings for the year ended December 31, 2012 were $9.6 million, an increase from $3.2 million of OTTI losses recorded for 2011. $8.3 million of the 2012 OTTI losses were in the equity portfolio and $1.3 million were in the bond portfolio. These gains and losses were a function of individual securities selected for sale when cash needs arose in the ordinary course of business or general duration management and portfolio rebalancing activity as dictated in our investment policy statement. The increase in gains in 2012 is primarily due to sales of fixed income and equity securities in the fourth quarter of 2012 to provide liquidity for claims payments associated with Superstorm Sandy.

Loss and loss adjustment expenses. The consolidated net loss ratio, which includes the Reciprocal Exchanges, was 73.4% and 67.6% for the years ended December 31, 2012 and 2011, respectively. Excluding the Reciprocal Exchanges, the net loss ratio was 74.1% and 69.1% for the years ended December 31, 2012 and 2011, respectively. Severe weather losses, primarily from Superstorm Sandy, added 7.3 points and 5.3 points, respectively, to the loss ratio excluding the Reciprocal Exchanges in 2012 and 2011.

Excluding the Reciprocal Exchanges, there was a reserve increase of $88.1 million for the year ended December 31, 2012 comprised of a reserve increase in Personal Insurance of $4.0 million and a reserve increase in Commercial Insurance of $86.6 million and a reserve decrease in Assumed Reinsurance of $2.5 million.

Operating expenses. Operating expenses, which include direct and ceding commission expenses and other operating expenses, were $676.8 million for year ended December 31, 2012, compared to $594.7 million for the year ended December 31, 2011 representing an increase of 13.8%. This increase is primarily due to: (i) increased business production, including more assumed premiums written which have a higher commission rate compared to direct premiums written, (ii) the Company’s ongoing efforts to build-out our information technology infrastructure to support our policy administration and claims processing needs, and (iii) a $2.9 million after-tax charge attributable to a legal settlement with Munich Reinsurance America, Inc. (“Munich Re”).

The consolidated gross underwriting expense ratio increased to 33.9% for the year ended December 31, 2012 from 32.6% in the same period in 2011. The commission portion of the gross underwriting expense ratio increased to 18.5% for the year ended December 31, 2012 compared to 17.3% in 2011. This increase is attributed to the increase in assumed reinsurance business written, as noted above, as assumed reinsurance has a significantly higher commission rate than direct written policies. The gross OUE ratio was 15.4% for the year ended December 31, 2012 compared to 15.2% for the prior year.

Acquisition-related transaction costs. Acquisition-related transaction costs for the year ended 2012 were $9.2 million and relate primarily to the acquisition of our equity interest in Canopius Group and expenses associated with the Canopius Merger Transactions. These costs were negligible for 2011.

Interest expense. Interest expense decreased by $1.7 million for the year ended December 31, 2012 compared to 2011. Interest expense declined as payments on certain of our subordinated debentures moved from higher fixed rates to floating rates per the terms of the contracts.

Equity in income (loss) of unconsolidated affiliate. Tower recognized a loss of $1.5 million in 2012 relating to its equity method investment in Canopius Group. The Company records this investment on a one quarter lag (updated for significant events in the lag period). The loss is attributable to income incurred by Canopius Group in the third quarter of 2012 offset by fourth quarter 2012 losses associated with Superstorm Sandy claims.

 

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Income tax expense. Income tax expense was a benefit of $29.1 million in 2012 compared to an expense of $14.1 million in 2011. The change of $43.2 million in income tax expense is directly attributable to the change of pre-tax income from $69.5 million in 2011 to a pre-tax loss of $61.0 million in 2012. The effective income tax rate (including state and local taxes) was 47.7% for the year ended December 31, 2012, compared to 20.2% for 2011. The increase in the effective tax rate in 2012 is related to the permanent income tax adjustments and the movement of a valuation allowance on the Reciprocal Exchanges in 2012, offset by acquisition-related transaction costs which increased the 2012 income tax benefit.

Net income (loss) and return on average equity. Net income (loss) and annualized return on average equity attributable to Tower Group, International, Ltd., were ($34.2) million and (3.4%) for the year ended December 31, 2012 compared to $44.4 million and 4.3% for the year ended December 31, 2011. The return on average equity is calculated by dividing net income (loss) by average shareholders’ equity. Average shareholders’ equity was $1,001.7 million and $1,029.9 million at December 31, 2012 and 2011, respectively.

The net loss in 2012 is primarily due to the reserve increase from Superstorm Sandy discussed above. 2012 net loss included losses of $80.1 million after-tax from Superstorm Sandy, as well as an after-tax reserve increase of $60.7 million recorded in 2012 for accident years 2011 and prior.

 

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Commercial Insurance Segment Results of Operations

 

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

Net premiums written

   $ 751,698     $ (325,527     -30.2   $ 1,077,225     $ (2,451     -0.2   $ 1,079,676  

Revenues

              

Net premiums earned

   $ 931,693     $ 172,858        -15.6   $ 1,104,551     $ 52,501       5.0   $ 1,052,050  

Ceding commission revenue

     30,115       22,413       291.0     7,702       (7,084     -47.9     14,786  

Policy billing fees

     5,637       170       3.1     5,467       1,122       25.8     4,345  

Total revenue

     968,362       (149,358     -13.4     1,117,720       46,539       4.3     1,071,181  

Expenses

              

Net loss and loss adjustment expenses

     1,185,627       325,920       37.9     859,707       118,953       16.1     740,754  

Underwriting expenses

              

Direct commission expenses

     202,777       2,843        1.4     205,620       8,364       4.2     197,256  

Other underwriting expenses

     204,131       21,240       11.6     182,891       27,315       17.6     155,576  

Total underwriting expenses

     406,908       18,397       4.7     388,511       35,679       10.1     352,832  

Underwriting profit (loss)

   $ (625,090   $ (494,592     379.0   $ (130,498   $ (108,093     -482.5   $ (22,405
                             Year Ended December 31,  
Ratios                                      2013       2012       2011  

Net calendar year loss and LAE

             127.3     77.8     70.4

Net underwriting expenses

             39.8     34.0     31.7

Net combined

                                     167.1     111.8     102.1

Commercial Insurance Segment Results of Operations 2013 Compared to 2012

Premiums. Net premiums written for the year ended December 31, 2013 decreased 325.5 million and net premiums earned for the year ended December 31, 2013 decreased $172.9 million compared to 2012. These declines are attributed to a decline in direct written premiums in the fourth quarter of 2013 as a result of the A.M. Best rating downgrades. In addition, ceded premiums increased as a direct result of the Arch and Hannover treaties entered into July 1, 2013 for in force, new and renewal business which accounted for $143.1 million of ceded written premium and $76.8 million of ceded earned premium.

Our renewal retention rate was 56.1% for the year ended December 31, 2013 compared to 64.0% during 2012. The policies-in-force for our commercial business, which is predominantly small business, increased 1.7% as of December 31, 2013 compared to the prior year.

Ceding commission revenue. Ceding commission revenue increased for the year ended December 31, 2013 by $22.4 million compared to 2012 as a result of the aforementioned quota share reinsurance treaties. This increase was offset by a decline in ceding commission revenue attributable to the increase of prior year loss reserves for the year ended December 31, 2013, which resulted in $9.8 million of return commissions to reinsurers on prior year quota share treaties. The Company recognized a $4.2 million return commission for the year ended December 31, 2012

Net loss and loss adjustment expenses. The net calendar year loss ratios were 127.3% and 77.8% for the years ended December 31, 2013 and 2012, respectively. The accident year loss ratios for the years ended December 31, 2013 and 2012 were 69.3% and 70.0%, respectively.

Incurred losses and LAE attributable to insured events of prior years were $539.8 million for the year ended December 31, 2013, which was attributed to increases in ultimate loss estimates from the company’s reserve studies completed during the year which primarily impacted the workers’ compensation, commercial package liability, other liability and commercial auto liability lines of business. Incurred losses and LAE for the year ended December 31, 2012 attributable to insured events of prior years had unfavorable loss development of $86.6 million.

Reserve increases arose primarily from accident years 2008 through 2012 within the workers’ compensation, CMP liability, and other liability lines of business partially offset by a modest amount of favorable loss development from more recent years within the short tail property lines of business. During the second, third and fourth quarters of 2013, the Company recognized that the higher than expected reported loss development it had been experiencing had become a trend. In response to this recognition, the Company continued to update its internal reserve study to respond to higher than expected reported losses and to update the actuarial assumptions within the study. In conjunction with its comprehensive internal reviews, the Company also retained its consulting actuary to perform independent reserve studies.

 

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Underwriting expenses. Underwriting expenses, which include direct commissions and other underwriting expenses, increased by $18.4 million, or 4.7%, for the year ended December 31, 2013 compared to the prior year. The net underwriting expense ratio increased 5.8 percentage points for year ended December 31, 2013 compared to 2012.

The gross underwriting expense ratio was 36.1% for the year ended December 31, 2013 compared to 31.9% for 2012. The commission portion of the gross underwriting expense ratio, which is expressed as a percentage of gross premiums earned, was 18.2% for the year ended December 31, 2013 compared to 17.1% for the prior year. The OUE ratio, including boards, bureaus and taxes (“BB&T”), was 17.8% for the year ended December 31, 2013 compared to 14.8% for 2012. The increases in the OUE and OUE ratios are due to (i) impairment charges recorded on the customer relationship intangible assets and (ii) increased costs associated with improving information technology systems and infrastructure.

Underwriting profit (loss) and combined ratio. The net combined ratio for the year ended December 31, 2013 was 167.1% compared to 111.8% for 2012. The increase in the combined ratio is driven primarily by the increase in loss reserves, as discussed above, and increase in the OUE expenses, and decline in net earned premiums.

Commercial Insurance Segment Results of Operations 2012 Compared to 2011

Premiums. Net premiums written for the year ended December 31, 2012 decreased $2.5 million and net premiums earned for the year ended December 31, 2012 increased $52.5 million compared to 2011.

Gross premiums written for the year ended December 31, 2012 were $1,179.4 million as compared to $1,152.4 million during the same period in 2011. The increase of $27.0 million is primarily attributed to our growth in programs. Gross premiums earned were $1,201.9 million as compared to $1,142.5 million during 2011.

Ceded premiums written for the year ended December 31, 2012 were $102.2 million compared to $72.7 million for the prior year. Ceded premiums earned were $97.3 million compared to $90.4 million for the year ended December 31, 2012 compared to the same period in 2011. The increase in ceded premiums written in 2012 is attributable primarily (i) to increased written premiums on certain program business which is then reinsured through the quota share treaties and (ii) to the reinstatement premiums on our catastrophe reinsurance program as a result of Superstorm Sandy. In addition, the Company’s catastrophe reinsurance premiums increased in 2012 compared to 2011.

The Company’s renewal retention rate was 64.0% for the year ended December 31, 2012 compared to 65.2% during the prior year. Premiums on renewed commercial business, other than programs, increased 4.5% in 2012. Excluding programs, policies in-force for our commercial business increased 1.0% as of December 31, 2012 from December 31, 2011.

Ceding commission revenue. Ceding commission revenue decreased for the year ended December 31, 2012 by $7.1 million compared 2011. This was primarily due to a change in loss ratio on a prior year’s quota share treaty which reduced ceding commission revenue by $4.2 million during the year ended December 31, 2012 compared to the prior year and also as a result of the non-renewal of our liability quota share contract.

Net loss and loss adjustment expenses. The net calendar year loss ratios were 77.8% and 70.4% for the years ended December 31, 2012 and 2011, respectively. The accident year loss ratios for the years ended December 31, 2012 and 2011 were 70% and 63.9%, respectively.

For the year ended December 31, 2012, the Company incurred net losses of $45.7 million relating to the Superstorm Sandy. Excluding the effects of Superstorm Sandy, the net loss ratio would have been 73.7% for the year ended December 31, 2012. For the year ended December 31, 2011, the Company incurred net losses of $31.5 million relating to Hurricane Irene and other severe weather events. Excluding the effects of these storms, the net loss ratio was 67.4% for the year ended December 31, 2011.

Management’s estimates of prior years’ loss and loss expenses increased $86.6 million for the year ended December 31, 2012. This increase in prior accident year loss and loss expense was the result of a comprehensive review of its loss reserves completed in the second quarter of 2012 and an updated analysis during the third quarter as well as recent loss emergence that occurred during the fourth quarter.

Underwriting expenses. Underwriting expenses, which include direct commissions and other underwriting expenses, increased by $35.7 million, or 10.1%, for the year ended December 31, 2012, respectively, compared to 2011. The net underwriting expense ratio increased 2.3 percentage points for year ended December 31, 2012 compared to 2011.

The gross underwriting expense ratio for the year ended December 31, 2012 was 31.9% compared to 30.5% in 2011. The commission portion of the gross underwriting expense ratio, which is expressed as a percentage of gross premiums earned, was

 

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17.1% for the year ended December 31, 2012 compared to 17.3% in 2011. The decrease is primarily due to the assumed reinsurance business which has a higher commission ratio. The OUE ratio, including BB&T, was 14.8% for the year ended December 31, 2012 compared to 13.2% for 2011. The increase in the OUE ratio is primarily a result of ongoing efforts by us to build-out our information technology infrastructure to support our policy administration and claims processing needs.

Underwriting profit (loss) and combined ratio. Underwriting loss increased $108.1 million and the combined ratio increased 9.7 percentage points for the year ended December 31, 2012 compared to the year ended December 31, 2011. The increase in the combined ratio for the twelve months ended December 31, 2012 resulted primarily from the reserve increases the Company recorded in the first and second quarters of 2012 and losses from Superstorm Sandy in the fourth quarter of 2012. Such losses aggregated $34.7 million and increased the calendar year loss ratio by 4.1 percentage points. In 2011, the Company recorded catastrophe and other severe storm losses but to a much lower extent. Such losses aggregated $31.5 million and increased the loss ratio by points in 2011. In addition, as discussed above, the expense ratio increased by 3.0 percentage points from 2011 to 2012.

 

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Assumed Reinsurance Segment Results of Operations

 

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

Net premiums written

   $ 82,530      $ (65,869     -44.4   $ 148,399      $ 75,776       104.3   $ 72,623  

Revenues

                

Net premiums earned

   $ 116,417      $ (3,598     -3.0   $ 120,015      $ 84,154       234.7   $ 35,861  

Total revenue

     116,417        (3,598     -3.0     120,015        84,154       234.7     35,861  

Expenses

                

Net loss and loss adjustment expenses

     41,474        (11,501     -21.7     52,975        35,519       203.5     17,456  

Underwriting expenses

                

Direct commission expenses

     49,627        7,045       16.5     42,582        31,162       272.9     11,420  

Other underwriting expenses

     7,879        6,337       411.0     1,542        1,103       251.3     439  

Total underwriting expenses

     57,506        13,382       30.3     44,124        32,265       272.1     11,859  

Underwriting profit (loss)

   $ 17,437      $ (5,479     -23.9   $ 22,916      $ 16,370       250.1   $ 6,456   
                               Year Ended December 31,  
Ratios                                        2013       2012       2011  

Net calendar year loss and LAE

               35.6     44.1     48.7

Net underwriting expenses

               49.4     36.8     33.1

Net combined

                                       85.0     80.9     81.8

Assumed Reinsurance Segment Results of Operations 2013 Compared to 2012

Premiums. Net premiums written for the year ended December 31, 2013 decreased $65.9 million and net premiums earned for the year ended December 31, 2013 decreased $3.6 million compared to the same period in 2012. In the fourth quarter of 2013, the Company commuted certain of its assumed reinsurance programs, which resulted in a decline in assumed premiums written and assumed premiums earned, compared to 2012.

Net loss and loss adjustment expenses. The net calendar year loss ratios were 35.6% and 44.1% for the year ended December 31, 2013 and 2012, respectively. The accident year loss ratios for the year ended December 31, 2013 and 2012 were 40.2% and 46.2%, respectively. Incurred losses and LAE attributable to insured events of prior years had a favorable loss development of $5.4 million for the year ended December 31, 2013, which were primarily attributed to the reduction in the reserve risk premium associated with the commuted Canopius reserves. Incurred losses and LAE for the year ended December 31, 2012 attributable to insured events of prior years were $2.5 million favorable.

Underwriting expenses. Underwriting expenses, which include assumed commissions and other underwriting expenses, increased by $13.4 million, or 30.3%, for the year ended December 31, 2013, compared to 2012. The net underwriting expense ratio increased 12.6 percentage points for the year ended December 31, 2013 from the prior year.

OUE increased in 2013 compared to 2012 due to the additional operating expenses incurred because of the Canopius Merger Transaction, including the addition of another insurance subsidiary (TRL) and related costs. The gross underwriting expense ratio was 20.8% for the year ended December 31, 2013 compared to 36.7% in 2012. The assumed commission portion of the gross underwriting expense ratio, which is expressed as a percentage of assumed premiums earned, was 18.0% for the year ended December 31, 2013 compared to 35.5% for 2012. The commission expense in 2013 included federal excise tax of $9.8 million on business retroceded from CastlePoint Re to TRL and no such federal excise tax was recorded in 2012. Gross premiums earned increased by 130.0% in 2013 compared to 2012. Ceded written premium increased by $159.7 million as a result of the reinsurance agreements entered into during the third quarter of 2013. The increase in gross written premium is the main cause of the decrease in the gross underwriting expense ratio in 2013 compared to the prior year

Underwriting gain (loss) and combined ratio. Underwriting profit declined $5.5 million and the combined ratio moved unfavorably by 4.1 percentage points for the year ended December 31, 2013 compared to the year ended December 31, 2012. These changes are primarily related to the Company’s decline in net premiums earned offset by the increase in federal excise tax and OUE in 2013 compared to 2012.

Assumed Reinsurance Segment Results of Operations 2012 Compared to 2011

Premiums. Net premiums written for the year ended December 31, 2012 increased $75.8 million and net premiums earned for the year ended December 31, 2011 increased $84.2 million compared to 2011. The increase in the net premiums written and earned in the year ended December 31, 2012 is attributable to Tower management actively increasing its participation in the assumed reinsurance market in 2012.

 

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Net loss and loss adjustment expenses. The net calendar year loss ratios were 44.1% and 48.7% for the years ended December 31, 2012 and 2011, respectively. The accident year loss ratios for the years ended December 31, 2012 and 2011 were 46.2% and 49.1%, respectively. Incurred losses and LAE attributable to insured events of prior years had a favorable loss development of $2.5 million for the year ended December 31, 2012. Incurred losses and LAE for the year ended December 31, 2011 attributable to insured events of prior years were $0.1 million favorable.

Underwriting expenses. Underwriting expenses, which include assumed commissions and other underwriting expenses, increased by $32.3 million and 272.1%, for the year ended December 31, 2012, respectively, compared to 2011. The net underwriting expense ratio increased 3.7 percentage points for the year ended December 31, 2012 from the prior year. The increases in the underwriting expenses are directly attributable to the Tower management’s efforts to actively increase its participation in the assumed reinsurance market in 2012.

The gross underwriting expense ratio was 36.8% the year ended December 31, 2012 compared to 32.8% in the prior year. The assumed commission portion of the gross underwriting expense ratio, which is expressed as a percentage of assumed premiums earned, was 35.5% for the year ended December 31, 2012 compared to 31.6% for 2011.

Underwriting gain (loss) and combined ratio. Underwriting profit increased $16.4 million and the combined ratio improved by 0.9 percentage points for the year ended December 31, 2012 compared to the year ended December 31, 2011. The improvements in underwriting gain and combined ratio are due to the increase in business written in 2012 compared to 2011, and the management actively increasing its participation in the assumed reinsurance market in 2012.

 

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Personal Insurance Segment Results of Operations

 

     Year Ended December 31,  
     2013           2012  
($ in thousands)    Tower     Reciprocal
Exchanges
    Total     Change     Percent     Tower     Reciprocal
Exchanges
    Total  

Net premiums written

   $ 238,560     $     159,828     $     398,388     $     (115,428     -22.5   $     356,830     $     156,986     $     513,816  

Revenues

                

Net premiums earned

   $ 303,405     $ 161,400     $ 464,805     $ (32,493     -6.5   $ 333,638     $ 163,660     $ 497,298  

Ceding commission revenue

     35,508       15,759       51,267       26,634       108.1     10,069       14,564       24,633  

Policy billing fees

     6,219       443       6,662       (486     -6.8     6,434       714       7,148  

Total revenue

     345,132       177,602       522,734       (6,345     -1.2     350,141       178,938       529,079  

Expenses

                

Net loss and loss adjustment expenses

     177,704       115,029       292,733       (58,343     -16.6     241,858       109,218       351,076  

Underwriting expenses

                

Direct commission expenses

     79,147       33,480       112,627       1,522       1.4     76,738       34,367       111,105  

Other underwriting expenses

     82,198       54,954       137,152       19,968       17.0     62,995       54,189       117,184  

Total underwriting expenses

         161,345       88,434       249,779       21,490       9.4     139,733       88,556       228,289  

Underwriting profit (loss)

   $ 6,083     $ (25,861   $ (19,778   $ 30,508       -60.7   $ (31,450   $ (18,836   $ (50,286

Ratios

                

Net calendar year loss and LAE

     58.6     71.3     63.0         72.5     66.7     70.6

Net underwriting expenses

     39.4     44.8     41.3         36.9     44.8     39.5

Net combined

     98.0     116.1     104.3                     109.4     111.5     110.1

Personal Insurance Segment Results of Operations 2013 Compared to 2012

Premiums. Net premiums written for the year ended December 31, 2013 decreased $115.4 million and net premiums earned for the year ended December 31, 2013 decreased $32.5 million, compared to the year ended December 31, 2012. The decrease in net premiums written is attributed to an increase in reinsurance purchased in 2013. The Company entered into two new homeowners quota share reinsurance treaties effective January 1, 2013 and November 1, 2013 both of which included an unearned premium portfolio. The effects of the new homeowners quota share treaty will reduce the net earned premiums over time as the ceded written premiums are earned over the life of the policies.

Personal lines renewal retention rate was 86.9% and 89.3% for the years ended December 31, 2013 and 2012, respectively. Written premiums on renewed business increased by 4.5% and 0.1% for the years ended December 31, 2013 and 2012, respectively. Policies-in-force increased 2.4% as of December 31, 2013 compared to December 31, 2012.

Ceding commission revenue. Ceding commission revenue increased for the year ended December 31, 2013 by $26.6 million compared to the year ended December 31, 2012. The increase was the result of the new homeowners quota share reinsurance treaties.

Net loss and loss adjustment expenses. For Personal Insurance, including the Reciprocal Exchanges, the net calendar year loss ratios were 63.0% and 70.6% for the years ended December 31, 2013 and 2012, respectively. The accident year loss ratios for the years ended December 31, 2013 and 2012 were 62.2% and 71.6%, respectively. Estimates of prior accident year loss and loss expenses increased by $3.7 million for the year ended December 31, 2013, and decreased by $4.9 million for the year ended December 31, 2012.

For Tower personal lines, excluding the Reciprocal Exchanges, the net calendar year loss ratios were 58.6% and 72.5% for the years ended December 31, 2013 and 2012, respectively. The accident year loss ratios for the years ended December 31, 2013 and 2012 were 59.0% and 71.3%, respectively. Estimates of prior accident year loss and loss expenses decreased by $1.4 million for the year ended December 31, 2013, compared to an increase of $4.0 million for the year ended December 31, 2012.

The Reciprocal Exchanges’ net calendar year loss ratios were 71.3% and 66.7% for the years ended December 31, 2013 and 2012, respectively. The accident year loss ratios for the years ended December 31, 2013 and 2012 were 68.1% and 72.2%, respectively. Estimates of prior accident year loss and loss adjustment expenses increased by $5.1 million for the year ended December 31, 2013, and decreased by $8.9 million for the year ended December 31, 2012.

Underwriting expenses. Underwriting expenses, which include direct commissions and other underwriting expenses, increased by $21.5 million, or 9.4% for the year ended December 31, 2013 compared to the year ended December 31, 2012. The net underwriting expense ratio increased 1.8 percentage points from 2013 to 2012. The increase in underwriting expenses is related to impairment charges recorded on customer relationship intangible assets and an increase in operating expense relating to improving information technology systems and infrastructure.

 

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The gross underwriting expense ratio was 38.2% and 35.6% for the years ended December 31, 2013 and 2012, respectively. The commission portion of the gross underwriting expense ratio, which is expressed as a percentage of gross premiums earned, was 17.7% for the year ended December 31, 2013 compared to 17.9% for 2012. The gross OUE ratio, which includes BB&T, was 20.5% for the year ended December 31, 2013 compared 17.7% for the prior year.

Underwriting profit (loss) and combined ratio. Underwriting loss decreased $30.5 million and the combined ratio improved 5.8 percentage points for the year ended December 31, 2013 compared to the year ended December 31, 2012. The improvements in underwriting loss and combined ratio are due to the 2012 results being impacted by Superstorm Sandy, which occurred in the fourth quarter of 2012. There was no significant hurricane or tropical storm in 2013.

 

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

Net premiums written

   $     356,830     $     156,986     $     513,816       27,525     $ 5.7   $     316,854     $     169,437     $     486,291  

Revenues

                

Net premiums earned

   $ 333,638     $ 163,660     $ 497,298       (8,641   $ -1.7   $ 318,777     $ 187,162     $ 505,939  

Ceding commission revenue

     10,069       14,564       24,633       5,451       28.4     12,408       6,774       19,182  

Policy billing fees

     6,434       714       7,148       959       15.5     5,616       573       6,189  

Total revenue

     350,141       178,938       529,079       (2,231     -0.4     336,801       194,509       531,310  

Expenses

                

Net loss and loss adjustment expenses

     241,858       109,218       351,076       32,301       10.1     214,355       104,420       318,775  

Underwriting expenses

                

Direct commission expenses

     76,738       34,367       111,105       9,955       9.8     68,609       32,541       101,150  

Other underwriting expenses

     62,995       54,189       117,184       (129     -0.1     65,145       52,168       117,313  

Total underwriting expenses

     139,733       88,556       228,289       9,826       4.5     133,754       84,709       218,463  

Underwriting profit (loss)

   $ (31,450   $ (18,836   $ (50,286     (44,358   $     748.3   $ (11,308   $ 5,380     $ (5,928

Ratios

                

Net calendar year loss and LAE

     72.5     66.7     70.6         67.2     55.8     63.0

Net underwriting expenses

     36.9     44.8     39.5         36.3     41.3     38.2

Net combined

     109.4     111.5     110.1                     103.5     97.1     101.2

Personal Insurance Segment Results of Operations 2012 Compared to 2011

Premiums. Net premiums written for the year ended December 31, 2012 increased $27.5 million and net premiums earned for the year ended December 31, 2012 decreased $8.6 million, compared to the year ended December 31, 2012.

Gross premiums written for the year ended December 31, 2012 were $643.2 million as compared to $585.6 million in 2011 for an increase of $57.6 million. This increase is attributed to the acquisition of personal lines renewal rights resulting in $28.8 million of written premium and an increase in homeowners business offset by a decline in mono line automobile policies. Gross premiums earned increased to $621.7 million for the year ended December 31, 2012 from $611.2 million for the year ended December 31, 2011. This increase is due primarily to the renewal rights premiums and increase in homeowners business discussed above offset by a decline in mono line automobile policies.

Ceded premiums written for the year ended December 31, 2012 were $129.4 million, an increase of $30.1 million as compared to $99.3 million in 2011. Ceded premiums earned were $124.4 million for the year ended December 31, 2012 compared to $105.2 million in 2011. The Company reinsures the homeowners and umbrella business obtained from OBPL through a quota share program. The Company also purchased catastrophe reinsurance for certain property business. The increase in ceded premiums written is due to the increase in gross premiums written and to reinstatement premiums on our catastrophe reinsurance program as a result of Superstorm Sandy.

The Company’s personal lines renewal retention was 89.3% and 83.4% for the years ended December 31, 2012 and 2011, respectively. Premiums on renewed personal business increased by 0.1% in 2012 compared to a 5.4% decline in 2011. Policies-in-force decreased by 5.2% at December 31, 2012 as compared to December 31, 2011.

 

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Ceding commission revenue. Ceding commission revenue for the year ended December 31, 2012 increased by $5.5 million compared to 2011. The increase is attributable to the commission revenue earned on the previously mentioned homeowners and umbrella quota share treaties on the OBPL acquired business.

Net loss and loss adjustment expenses. For Personal Insurance, the net calendar year loss ratios were 70.6% and 63.0% for the years ended December 31, 2012 and 2011, respectively. The accident year loss ratios for the years ended December 31, 2012 and 2011 were 71.6% and 76.2%, respectively. Estimates of prior accident year loss and loss expenses decreased by $4.9 million for the year ended December 31, 2012.

For Tower personal lines, excluding the Reciprocal Exchanges, the net calendar year loss ratios were 72.5% and 67.2% for the years ended December 31, 2012 and 2011, respectively. The accident year loss ratios for the years ended December 31, 2012 and 2011 were 71.3% and 76.4%, respectively. There was a reserve increase of $4.0 million for the year ended December 31, 2012, and net favorable loss development of $29.1 million for the year ended December 31, 2011. For the year ended December 31, 2012, the Company recorded $237.8 million of incurred losses, with $42.8 million relating to Superstorm Sandy.

The Reciprocal Exchanges’ net calendar year loss ratios were 66.7% and 55.8% for the years ended December 31, 2012 and 2011, respectively. The accident year loss ratios for the years ended December 31, 2012 and 2011 were 72.2% and 76.0%, respectively. Estimates of prior accident year loss and loss adjustment expenses decreased by $8.9 million for the year ended December 31, 2012. For the year ended December 31, 2012, the Reciprocal Exchanges recorded $9.0 million of losses relating to Superstorm Sandy.

Underwriting expenses. Underwriting expenses, which include direct commissions and other underwriting expenses, increased by $9.8 million, or 4.5% for the year ended December 31, 2012 as compared to the prior year. The net underwriting expense ratio increased 1.3 percentage points from 2011 to 2012.

The gross underwriting expense ratio for the year ended December 31, 2012 was 35.6% compared to 33.6% in 2011. The commission portion of the gross underwriting expense ratio, which is expressed as a percentage of gross premiums earned, was 17.9% for the year ended December 31, 2012 compared to 16.6% for the prior year. The increase in the commission ratio was due to the growth in OBPL business which carries a slightly higher commission rate than the traditional Tower business.

The OUE ratio, including BB&T, was 17.7% for the year ended December 31, 2012 compared 15.6% for 2011.

Underwriting profit and combined ratio. Underwriting profit decreased $44.4 million and the net combined ratio increased 8.9 percentage points for the year ended December 31, 2012 compared to the year ended December 31, 2011. The increase in the combined ratio for the twelve months ended December 31, 2012 resulted primarily from Superstorm Sandy losses in the fourth quarter of 2012. Such losses aggregated $42.8 million and increased the calendar year loss ratio by 12.8 points. These losses were partially offset by favorable prior year loss development of $4.9 million in 2012. For the year ended December 31, 2011, the Company also recorded catastrophe and other severe storm losses. In 2011, such losses aggregated $42.8 million and increased the calendar year loss ratio by 13.4 points. In addition, as discussed above, the expense ratio increased by 1.3 percentage points from 2011 to 2012.

 

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Investments

Portfolio Summary

The following table presents a breakdown of the amortized cost, aggregate fair value and unrealized gains and losses by investment type as of December 31, 2013 and 2012:

 

     Cost or      Gross      Gross Unrealized Losses            % of  
($ in thousands)    Amortized
Cost
     Unrealized
Gains
     Less than 12
Months
    More than 12
Months
   

Fair

Value

     Fair
Value
 

December 31, 2013

               

U.S. Treasury securities

   $ 370,959      $ 729      $ (7,726   $ -     $ 363,962        20.7

U.S. Agency securities

     110,362        1,420        (561     -       111,221        6.3

Municipal bonds

     277,382        7,981        (5,056     (1,201     279,106        15.9

Corporate and other bonds

     512,444        19,424        (4,360     (1,566     525,942        30.0

Commercial, residential and asset-backed securities

     342,487        23,083        (1,644     (1,462     362,464        20.7

Total fixed-maturity securities

     1,613,634        52,637        (19,347     (4,229     1,642,695        93.6

Equity securities

     97,708        11,486        (2,313     (251     106,630        6.1

Short-term investments

     5,925        -        (28     -       5,897        0.3

Total, December 31, 2013

   $ 1,717,267      $ 64,123      $ (21,688   $ (4,480   $ 1,755,222        100.0

Tower

   $ 1,465,039      $ 56,480      $ (19,335   $ (2,034   $ 1,500,150     

Reciprocal Exchanges

     252,228        7,643        (2,353     (2,446     255,072     

Total, December 31, 2013

   $ 1,717,267      $ 64,123      $ (21,688   $ (4,480   $ 1,755,222     

December 31, 2012

               

U.S. Treasury securities

   $ 183,462      $ 1,500      $ (13   $ -     $ 184,949        7.4

U.S. Agency securities

     98,502        4,351        (76     -       102,777        4.1

Municipal bonds

     633,373        52,914        (235     (9     686,043        27.5

Corporate and other bonds

     698,012        50,807        (1,954     (200     746,665        29.9

Commercial, residential and asset-backed securities

     576,837        47,891        (409     (42     624,277        25.0

Total fixed-maturity securities

     2,190,186        157,463        (2,687     (251     2,344,711        93.9

Equity securities

     149,348        1,683        (4,447     (326     146,258        5.9

Short-term investments

     4,749        1        -       -       4,750        0.2

Total, December 31, 2012

   $ 2,344,283      $ 159,147      $ (7,134   $ (577   $ 2,495,719        100.0

Tower

   $ 2,075,189      $ 141,614      $ (6,732   $ (478   $ 2,209,593     

Reciprocal Exchanges

     269,094        17,533        (402     (99     286,126     

Total, December 31, 2012

   $ 2,344,283      $ 159,147      $ (7,134   $ (577   $ 2,495,719     

Other Invested Assets

The following table shows the composition of the other invested assets as of December 31, 2013 and 2012:

 

($ in thousands)    2013      2012  

Limited partnerships, equity method

   $ 46,521      $ 23,864  

Real estate, amortized cost

     6,054        7,422  

Securities reported under the fair value option

     43,580        25,000  

Other

     -        1,500  

Total

   $ 96,155      $ 57,786  

 

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Credit Rating of Fixed-Maturity Securities

The average credit rating of our fixed-maturity securities, using ratings assigned to securities by Standard & Poor’s, was A+ at December 31, 2013 and 2012. The following table shows the ratings distribution of our fixed-maturity portfolio:

 

     Tower     Reciprocal Exchanges  
($ in thousands)    Fair Value      Percentage
of Fair
Value
    Fair Value      Percentage
of Fair
Value
 

December 31, 2013

          

Rating

          

U.S. Treasury securities

   $ 347,897        25.0   $ 16,065        6.4

AAA

     100,429        7.2     44,157        17.5

AA

     429,975        31.0     32,617        12.8

A

     229,774        16.5     75,911        30.1

BBB

     131,596        9.5     51,028        20.2

Below BBB

     150,475        10.8     32,771        13.0

Total

   $ 1,390,146        100.0   $ 252,549        100.0

December 31, 2012

          

Rating

          

U.S. Treasury securities

   $ 159,457        7.7   $ 25,494        9.1

AAA

     166,982        8.1     43,114        15.4

AA

     897,692        43.5     58,425        20.8

A

     383,957        18.6     85,116        30.3

BBB

     214,024        10.4     35,364        12.6

Below BBB

     242,036        11.7     33,050        11.8

Total

   $ 2,064,148        100.0   $ 280,563        100.0

Fixed Maturity Investments—Time to Maturity

The following table shows the composition of our fixed maturity portfolio by remaining time to maturity at December 31, 2013 and 2012. For securities that are redeemable at the option of the issuer and have a market price that is greater than redemption value, the maturity used for the table below is the earliest redemption date. For securities that are redeemable at the option of the issuer and have a market price that is less than redemption value, the maturity used for the table below is the final maturity date:

 

     Tower      Reciprocal Exchanges      Total  
($ in thousands)    Amortized
Cost
     Fair Value      Amortized
Cost
     Fair Value      Amortized
Cost
     Fair Value  

December 31, 2013

                 

Remaining Time to Maturity

                 

Less than one year

   $ 33,305      $ 33,727      $ 7,866      $ 8,021      $ 41,171      $ 41,748  

One to five years

     507,388        513,841        39,469        41,381        546,857        555,222  

Five to ten years

     459,070        459,251        82,003        81,515        541,073        540,766  

More than 10 years

     100,977        102,801        41,069        39,693        142,046        142,494  

Mortgage and asset-backed securities

     263,417        280,526        79,070        81,939        342,487        362,465  

Total

   $ 1,364,157      $ 1,390,146      $ 249,477      $ 252,549      $ 1,613,634      $ 1,642,695  

December 31, 2012

                 

Remaining Time to Maturity

                 

Less than one year

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

One to five years

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

Five to ten years

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

More than 10 years

     346,410        379,045        57,628        62,542        404,038        441,587  

Mortgage and asset-backed securities

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

Total

   $ 1,926,236      $ 2,064,148      $ 263,950      $ 280,563      $ 2,190,186      $ 2,344,711  

 

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Municipal Bonds

As of December 31, 2013, our municipal bonds consisted of state general obligations, municipal general obligations and special revenue bonds. Municipal bonds by state at December 31, 2013 are as follows:

 

     State General      Municipal General      Special         
     Obligations      Obligations      Revenue Bonds      Total  
     Amortized      Fair      Amortized      Fair      Amortized      Fair      Amortized      Fair  
($ in thousands)    Cost      Value      Cost      Value      Cost      Value      Cost      Value  

Texas

   $ 4,364      $ 4,606      $ 499      $ 542      $ 30,744      $ 31,726      $ 35,607      $ 36,874  

New York

     4,551        4,551        9,248        9,256        17,271        17,343        31,070        31,150  

California

     12,583        13,256        14,310        13,294        2,772        2,806        29,665        29,356  

New Jersey

     -        -        6,938        6,663        7,645        8,136        14,583        14,799  

Arizona

     4,155        4,400        286        319        8,772        9,184        13,213        13,903  

Wisconsin

     10,182        10,063        1,427        1,488        250        252        11,859        11,803  

Florida

     -        -        -        -        10,961        11,594        10,961        11,594  

Washington

     7,992        7,658        780        850        1,756        1,748        10,528        10,256  

Colorado

     2,901        3,029        1,810        1,885        4,517        4,445        9,228        9,359  

Indiana

     -        -        -        -        8,251        8,726        8,251        8,726  

Massachusetts

     -        -        -        -        8,842        8,656        8,842        8,656  

Other

     29,040        29,396        33,053        31,245        31,482        31,989        93,575        92,630  

Total

   $ 75,768      $ 76,959      $ 68,351      $ 65,542      $ 133,263      $ 136,605      $ 277,382      $ 279,106  

No one jurisdiction within “Other” in the table above exceeded 3% of the total fair value of municipal bonds. As of December 31, 2013, the special revenue bonds are supported primarily by water and sewer utilities, electric utilities, college revenues and highway tolls.

Fair Value Consideration

Under GAAP, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an “exit price”). GAAP establishes a fair value hierarchy that distinguishes between inputs based on market data from independent sources (“observable inputs”) and a reporting entity’s internal assumptions based upon the best information available when external market data are limited or unavailable (“unobservable inputs”). The fair value hierarchy in GAAP prioritizes fair value measurements into three levels based on the nature of the inputs. Quoted prices in active markets for identical assets have the highest priority (“Level 1”), followed by observable inputs other than quoted prices including prices for similar but not identical assets or liabilities (“Level 2”), and unobservable inputs, including the reporting entity’s estimates of the assumption that market participants would use, having the lowest priority (“Level 3”).

As of December 31, 2013, substantially all of the investment portfolio recorded at fair value was priced based upon quoted market prices or other observable inputs. For investments in active markets, we used the quoted market prices provided by the outside pricing services to determine fair value. In circumstances where quoted market prices were unavailable, we used fair value estimates based upon other observable inputs including matrix pricing, benchmark interest rates, market comparables and other relevant inputs. When observable inputs were adjusted to reflect management’s best estimate of fair value, such fair value measurements are considered a lower level measurement in the GAAP fair value hierarchy.

Our process to validate the market prices obtained from the outside pricing sources includes, but is not limited to, periodic evaluation of model pricing methodologies and analytical reviews of certain prices. We also periodically perform testing of the market to determine trading activity, or lack of trading activity, as well as market prices. Several securities sold during the year were “back-tested” (i.e., the sales price is compared to the previous month end reported market price to determine reasonableness of the reported market price).

In certain instances, we deemed it necessary to utilize Level 3 pricing over prices available through pricing services used throughout 2013 and 2012. The ability to observe stable prices and inputs may be reduced for highly-customized an illiquid instruments as currently is the case for certain non-agency residential and commercial mortgage-backed securities and asset-backed securities.

At December 31, 2013, securities with a fair value of $43.6 million included in other invested assets and 1 private convertible bond with a fair value of $3.4 million included in fixed maturity investments were priced in Level 3.

 

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As more fully described in Note 5 to our consolidated financial statements, “Investments—Impairment Review,” we completed a detailed review of all our securities in a continuous loss position, including but not limited to residential and commercial mortgage-backed securities, and concluded that the unrealized losses in these asset classes are the result of a decrease in value due to technical spread widening and broader market sentiment.

“Note 6 – Fair Value Measurements” to the consolidated financial statements provides a description of the valuation methodology utilized to value Level 3 assets, how the valuation methodology is validated and an analysis of the change in fair value of Level 3 assets. As of December 31, 2013, the fair value of Tower Level 3 assets as a percentage of Tower’s total assets carried at fair value was as follows (the Reciprocal Exchanges had no Level 3 assets):

 

($ in thousands)    Assets Carried at
Fair Value at
December 31, 2013
     Fair Value of
Level 3 Assets
     Level 3 Assets
as a Percentage of
Total  Assets Carried
at Fair Value
 

Fixed-maturity investments

   $ 1,642,695      $ 3,426        0.2

Equity investments

     106,630        -        0

Short-term investments

     5,897        -        0

Total investments available for sale

   $ 1,755,222      $ 3,426        0.2

Other invested assets

     43,580        43,580        100

Cash and cash equivalents

     293,898        -        0

Other Assets

     9,343        9,343        100

Total

   $ 2,102,043      $ 56,349        2.7

(1) $43.6 million of the $95.8 million Other invested assets reported on the consolidated balance sheet at December 31, 2013 is reported at fair value. The remaining $52.2 million of Other invested assets is reported under the equity method of accounting or at amortized cost.

Unrealized Losses

The fair value of our fixed maturity portfolio is directly affected by changes in interest rates and credit spreads. We regularly review both our fixed-maturity and equity portfolios to evaluate the necessity of recording impairment losses for other-than temporary declines in the fair value of investments.

For those fixed-maturity investments deemed not to be in an OTTI position, we believe that the gross unrealized investment loss was primarily caused by a spread widening in the capital markets. We expect cash flows from operations and investment maturities to be sufficient to meet our liquidity requirements and, therefore, we do not intend to sell these fixed maturity securities and we do not believe that we will be required to sell these securities before recovering their cost basis. For equity securities not considered OTTI, we believe we have the ability to hold these investments until a recovery of fair value to our cost basis. A substantial portion of the unrealized loss relating to the mortgage-backed securities is the result of a spread widening in the market that we believe to be temporary.

 

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The following table presents information regarding our invested assets that were in an unrealized loss position at December 31, 2013 and 2012 by amount of time in a continuous unrealized loss position:

 

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

December 31, 2013

               

U.S. Treasury securities

   $ 273,217      $ (7,726   $ -      $ -     $ 273,217      $ (7,726

U.S. Agency securities

     51,808        (561     -        -       51,808        (561

Municipal bonds

     109,345        (5,056     4,268        (1,201     113,613        (6,257

Corporate and other bonds

               

Finance

     37,811        (1,005     335        (23     38,146        (1,028

Industrial

     124,869        (2,550     10,023        (458     134,892        (3,008

Utilities

     27,698        (805     7,292        (1,085     34,990        (1,890

Commercial mortgage-backed securities

     26,469        (597     20,397        (1,157     46,866        (1,754

Residential mortgage-backed securities

               

Agency backed

     37,660        (925     5,166        (293     42,826        (1,218

Non-agency backed

     1,027        (19     182        (12     1,209        (31

Asset-backed securities

     32,461        (103     -        -       32,461        (103

Total fixed-maturity securities

     722,365        (19,347     47,663        (4,229     770,028        (23,576

Preferred stocks

     10,538        (2,285     6,154        (251     16,692        (2,536

Common stocks

     7,125        (28     -        -       7,125        (28

Short-term investments

     3,897        (28     -        -       3,897        (28

Total, December 31, 2013

   $ 743,925      $ (21,688   $ 53,817      $ (4,480   $ 797,742      $ (26,168

Tower

   $ 663,127      $ (19,335   $ 23,096      $ (2,034   $ 686,223      $ (21,369

Reciprocal Exchanges

     80,798        (2,353     30,721        (2,446     111,519        (4,799

Total, December 31, 2013

   $ 743,925      $ (21,688   $ 53,817      $ (4,480   $ 797,742      $ (26,168

December 31, 2012

               

U.S. Treasury securities

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

U.S. Agency securities

     22,345        (76     -        -       22,345        (76

Municipal bonds

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

Corporate and other bonds

               

Finance

     16,853        (1,095        -       16,853        (1,095

Industrial

     53,576        (667     4,188        (201     57,764        (868

Utilities

     20,143        (191     7        -       20,150        (191

Commercial mortgage-backed securities

     23,223        (141     95        -       23,318        (141

Residential mortgage-backed securities

               

Agency backed

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

Non-agency backed

     815        (6     588        (28     1,403        (34

Asset-backed securities

     1,499        (2     4,232        (12     5,731        (14

Total fixed-maturity securities

     263,342        (2,687     9,386        (251     272,728        (2,938

Preferred stocks

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

Common stocks

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

Total, December 31, 2012

   $ 328,618      $ (7,134   $ 15,110      $ (577   $ 343,728      $ (7,711

Tower

   $ 270,609      $ (6,732   $ 13,338      $ (478   $ 283,947      $ (7,210

Reciprocal Exchanges

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

Total, December 31, 2012

   $ 328,618      $ (7,134   $ 15,110      $ (577   $ 343,728      $ (7,711

At December 31, 2013, the investments in an unrealized loss position for twelve months or greater were primarily in our corporate industrial bonds and preferred stocks.

 

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The following table stratifies the gross unrealized losses in the portfolio at December 31, 2013, by duration in a loss position and magnitude of the loss as a percentage of the cost or amortized cost of the security:

 

            Total Gross     Decline of Investment Value  
     Fair      Unrealized     >15%     >25%     >50%  
($ in thousands)    Value      Losses     Amount     Amount     Amount  

Unrealized loss for less than 6 months

   $ 369,429      $ (2,699   $ -     $ -     $ -  

Unrealized loss for over 6 months

     382,740        (19,498     (2,308     -       -  

Unrealized loss for over 12 months

     38,566        (3,703     -       (891     -  

Unrealized loss for over 18 months

     1,472        (32     -       -       -  

Unrealized loss for over 2 years

     5,535        (236     -       -       -  

Total unrealized loss

   $ 797,742      $ (26,168   $ (2,308   $ (891   $ -  

Tower

   $ 686,223      $ (21,369   $ (2,079   $ (567   $ -  

Reciprocal Exchanges

     111,519        (4,799     (229     (324     -  

Total unrealized loss

   $ 797,742      $ (26,168   $ (2,308   $ (891   $ -  

The following table shows the number of securities, fair value, unrealized loss amount and percentage below amortized cost and the ratio of fair value by security rating as of December 31, 2013:

 

            Unrealized Loss                                
                  Percent of     Fair Value by Security Rating  
     Fair            Amortized                             BB or  
($ in thousands)    Value          Amount     Cost     AAA     AA     A     BBB     Lower  

U.S. Treasury securities

   $  273,217      $ (7,726     -3     0     100     0     0     0

U.S. Agency securities

     51,808        (561     -1     0     100     0     0     0

Municipal bonds

     113,613        (6,257     -5     7     68     24     1     0

Corporate and other bonds

     208,028        (5,926     -3     0     9     42     30     19

Commercial mortgage-backed securities

     46,866        (1,754     -4     55     6     32     7     0

Residential mortgage-backed securities

     44,035        (1,249     -3     0     97     1     0     2

Asset-backed securities

     32,461        (103     0     88     12     0     0     0

Equities

     23,817        (2,564     -14     0     0     21     76     3

Short-term investments

     3,897        (28     0     0     0     0     0     100

See “Note 5—Investments” in our consolidated financial statements for further information about impairment testing and other-than-temporary impairments.

 

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Corporate and other bonds

The following tables show the fair value and unrealized loss by sector and credit quality rating of our corporate and other bonds in an unrealized loss position at December 31, 2013:

 

Fair Value    Rating        
($ in thousands)    AAA     AA     A     BBB     BB or
lower
    Fair value  

Sector

            

Industrial

   $ -     $ 12,758     $ 44,565     $ 48,786     $ 28,783     $ 134,892  

Finance

     -       1,451       21,778       8,974       5,943       38,146  

Utilities

     -       5,095       20,677       4,650       4,568       34,990  

Total fair value

   $ -     $ 19,304     $ 87,020     $ 62,410     $ 39,294     $ 208,028  

% of fair value

     0     9     42     30     19     100
Unrealized Loss    Rating        
($ in thousands)    AAA     AA     A     BBB     BB or
lower
    Unrealized
Loss
 

Sector

            

Industrial

   $ -     $ (193   $ (947   $ (1,020   $ (848   $ (3,008

Finance

     -       (91     (700     (194     (43     (1,028

Utilities

     -       (109     (908     (714     (159     (1,890

Total unrealized loss

   $ -     $ (393   $ (2,555   $ (1,928   $ (1,050   $ (5,926

% of book value

     0     (20 %)      (120 %)      (90 %)      (50 %)      (280 %) 

The majority of our corporate bonds that are in an unrealized loss position are rated below AA. Based on our analysis of these securities and current market conditions, we expect price recovery on these over time, and we have determined that these securities are not other than temporarily impaired as of December 31, 2013.

Total securitized assets

The following tables show the fair value and unrealized loss by credit quality rating and deal origination year of our commercial mortgage-backed, non-agency residential mortgage-backed and asset-backed securities in an unrealized loss position at December 31, 2013:

 

Fair Value                                     
     Rating  
($ in thousands)                            BB or     Fair  
Deal Origination Year    AAA     AA     A     BBB     Lower     Value  

2002 - 2005

   $ -     $ -     $ 409     $ -     $ 182     $ 591  

2006 - 2008

     9,871       -       5,657       -       618       16,146  

2009 - 2010

     4,057       -       -       -       -       4,057  

2011

     5,898       -       978       -       -       6,876  

2012

     4,869       3,993       6,466       3,172       -       18,500  

2013

     29,628       2,915       1,823       -       -       34,366  

Total fair value

   $ 54,323     $ 6,908     $ 15,333     $ 3,172     $ 800     $ 80,536  

% of fair value

     67     9     19     4     1     100
Unrealized losses                                     
     Rating        
($ in thousands)                            BB or     Unrealized  
Deal Origination Year    AAA     AA     A     BBB     Lower     Loss  

2002 - 2005

   $ -     $ -     $ (5   $ -     $ (12   $ (17

2006 - 2008

     (78     -       (98     -       (13     (189

2009 - 2010

     (12     -       -       -       -       (12

2011

     (435     -       (7     -       -       (442

2012

     (73     (7     (426     (287     -       (793

2013

     (170     (78     (187     -       -       (435

Total unrealized loss

   $ (768   $ (85   $ (723   $ (287   $ (25   $ (1,888

% of book value

     (1 %)      (0 %)      (1 %)      (0 %)      (0 %)      (2 %) 

 

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Liquidity and Capital Resources

Cash Flows

The primary sources of consolidated cash flows are from the insurance subsidiaries’ gross premiums collected, ceding commissions from quota share reinsurers, loss payments by reinsurers, investment income and proceeds from the sale or maturity of investments. Funds are used by the insurance subsidiaries for loss payments and loss adjustment expenses. The insurance subsidiaries also use funds for ceded premium payments to reinsurers, which are paid on a net basis after subtracting losses paid on reinsured claims and reinsurance commissions on our net business, commissions to producers, salaries and other underwriting expenses as well as to purchase investments, fixed assets and to pay dividends to the Holding Company. The management companies’ primary sources of cash are management fees for acting as the attorneys-in-fact for the Reciprocal Exchanges.

The reconciliation of net income to cash provided from operations is generally influenced by the collection of premiums in advance of paid losses, the timing of reinsurance, issuing company settlements and loss payments.

Cash flow and liquidity are categorized into three sources: (1) operating activities; (2) investing activities; and (3) financing activities, which are shown in the following table:

 

     Year Ended December 31,  

($ in thousands)

   2013     2012     2011  

Cash provided by (used in):

      

Operating activities

   $ (350,043   $ 109,333     $ 82,754  

Investing activities

     701,306        (100,654     (111,947

Financing activities

     (141,165     (31,980     (3,927

Net increase (decrease) in cash and cash equivalents

     210,098       (23,301     (33,120

Cash and cash equivalents, beginning of year

     83,800       107,101       140,221  

Cash and cash equivalents, end of period

   $ 293,898     $ 83,800     $ 107,101  

Comparison of Years Ended December 31, 2013 and 2012

For the year ended December 31, 2013, net cash used in operating activities was $350.0 million compared to cash provided by operations of $109.3 million in 2012. This decrease in operating cash flow is largely due to higher ceded premiums in 2013 as compared to 2012. The Company had the following new treaties in 2013 as compared to 2012: (i) $283 million of cash payments made to Southport Re pursuant to the Southport Re Quota Share and Southport Re ADC reinsurance agreements (these treaties were terminated in February 2014, at which time this cash was returned to Tower); (ii) $28 million of cash payments made to other reinsurers pursuant to reinsurance agreements executed in the third and fourth quarters of 2013; and (iii) an increase in loss payments in 2013 associated with Superstorm Sandy, a fourth quarter 2012 event.

Net cash flows provided by investing activities were $701.3 million for the year ended December 31, 2013 compared to net cash flows used in investing activities of $100.7 million for the year ended December 31, 2012. The change in investing cash flows is attributed to the following items: (i) cash from investing activities increased $133.3 million on March 13, 2013 relating to the Canopius Merger Transaction; (ii) in 2013 the Company increased its sale of investment securities to fund the settlement of loss and LAE claims attributable to Superstorm Sandy; (iii) the Company sold securities in the third and fourth quarter of 2013 to generate cash which was paid to reinsurers pursuant to the third and fourth quarter reinsurance agreements; (iv) a $70 million cash inflow for the sale of Tower’s 10.7% investment in Canopius Group in 2013 (Tower had a cash outflow of $75 million in 2012 relating to its acquisition of the Canopius Group investment); and (v) an increase of $97.6 million for the Company’s restricted cash balances relating primarily to “Funds at Lloyd’s” collateral balances for its assumed reinsurance programs.

The net cash flows used in financing activities for the year ended December 31, 2013 are primarily the result of the settlement of the Company’s credit facility for $70 million. In addition, the Company paid dividends of $26 million in 2013. In 2012, the Company had uses of cash for the repurchase of common stock and dividend payments of $21.0 million and $29.1 million, respectively, offset by net cash inflows of $20 million from a drawdown on our credit facility.

Comparison of Years Ended December 31, 2012 and 2011

For the year ended December 31, 2012, net cash provided by operating activities was $109.3 million as compared to $82.8 million for 2011. The increase in operating cash flow in 2012 primarily resulted from the increase in written premiums in 2012. In addition, in the fourth quarter of 2011, Tower’s paid claims increased as a result of Hurricane Irene. In 2012, while Superstorm Sandy increased incurred losses in the fourth quarter of 2012, the majority of claims were paid in 2013.

 

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Net cash flows used in investing activities were $100.7 million for the year ended December 31, 2012 compared to $111.9 million used for the year ended December 31, 2011. The year ended December 31, 2012 and 2011 included an increase to fixed assets of $19.5 million and $53.6 million, respectively, primarily related to the build out of new systems. The remaining cash flows in 2011 relates to the Company’s purchases and sales of fixed-maturity and equity investments. The remaining net cash outflows in 2012 relate primarily to the Company’s $71.5 million investment in Canopius Group and a $35.0 million increase in restricted cash collateral posted for assumed reinsurance business with Lloyd’s of London offset by securities sales to generate cash to pay Superstorm Sandy claims.

The net cash flows used in financing activities for the year ended December 31, 2012 are primarily the result of uses of cash for the repurchase of common stock for $21.0 million and dividends of $29.1 million partially offset by cash inflows from a $20.0 million drawdown of our line of credit. In 2011, the Company had uses of cash for the repurchase of common stock and dividend payments of $64.6 million and $27.9 million, respectively, offset by net cash inflows of $50.0 million from a drawdown on our line of credit and $39.8 million from capital lease financings.

Cash flow needs at the holding company level are primarily for dividends to our shareholders, interest and principal payments on our outstanding debt and payments under the credit facility.

Insurance Subsidiaries

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.

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,

 

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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.

Other significant events

On November 14, 2013, Tower announced that the Company’s Board of Directors determined it would not declare and pay a dividend to holders of Tower’s common shares in the fourth quarter of 2013.

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 $146.9 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

 

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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.

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.

TGI was the obligor under the bank credit facility and is the obligor under the $150 million Convertible Senior Notes (“Notes”) due September 15, 2014. The indebtedness of TGI was (and the Notes are) guaranteed by Tower Group International, Ltd. (“TGIL”) and for purposes of the credit facility was also guaranteed by several of TGIL’s non-insurance subsidiaries.

On December 13, 2013, TGI closed a sale to an investment fund managed by Bregal Capital LLP (Bregal) of all of the shares of the capital stock of Canopius Group owned by TGI. The initial purchase price for the Canopius shares was $69.7 million (£42.5 million), which has been paid in full to TGI. In addition, it was agreed that if a legally binding contract for the sale or other transfer of shares representing a majority of the voting power of Canopius Group is entered into within six months after the date of TGI’s stock purchase agreement with Bregal, a further cash payment would be made by Bregal to TGI. This additional cash payment would be equivalent to the excess, if any, of (1) one-third of the difference between the amount in British pound sterling paid for the shares previously owned by TGI in such sale and £40.6 million (plus TGI’s share of expenses of such sale), minus (2) £1.95 million. TGI purchased its 10.7% equity stake in Canopius Group in August 2012 for $71.5 million. On December 18, 2013, NKSJ Holdings announced that it had entered into an agreement, through its insurance subsidiary Sompo Japan Insurance Inc. to purchase 100% of the shares of Canopius Group.

Using primarily proceeds from the sale, Tower’s wholly-owned subsidiary, Tower Group, Inc., has paid in full the $70.0 million outstanding on its credit facility led by Bank of America, N.A., and the credit facility has been terminated as of December 13, 2013.

The Company’s plan to repay the Notes is related to the closing of the ACP Re Merger Agreement with ACP Re. 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, with a stated maturity 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.

 

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See the Liquidity section in “Note 1 – Nature of Business” to the consolidated financial statements for further discussion on Liquidity and Capital Resources.

Book Value per Common Share

Book value per common share represents Tower Group International, Ltd. shareholders’ equity divided by the number of common shares outstanding. Book value per common share is impacted by, among other factors, our underwriting results, investment returns and share repurchase activity, which has an accretive or dilutive impact on book value per common share depending on the purchase price. (Historical share counts prior to March 13, 2013 have been adjusted for 1.1330 share conversion ratio, as discussed more fully in “Note 3 – Canopius Merger Transaction”.) The decline in book value per common share from December 31, 2012 to December 31, 2013 is primarily a result of the significant loss reserve development, the goodwill and fixed assets impairment charges recorded in the second and third quarters of 2013, and, to a lesser extent, to an immediate reduction from the sale of common stock to third-party investors in connection with the Canopius Merger Transaction. In addition, the decline in the fair value of the Company’s investment portfolio due to changes in interest rates had an unfavorable impact on book value per common share.

 

     December 31,      December 31,  
(in thousands, except per share data)    2013      2012  

Calculation of book value per common share:

     

Tower Group International, Ltd. shareholders’ equity

   $ 95,551      $ 950,058  

Common shares outstanding

     57,382        43,514  

Book value per common share

   $ 1.67      $ 21.83  

Commitments

The following table summarizes information about contractual obligations and commercial commitments. The minimum payments under these agreements as of December 31, 2013 were as follows:

 

     Payments due by period  
($ in millions)    Total      Less than 1
Year
     1-3 Years      4-5 Years      After 5
Years
 

Subordinated Debentures

   $ 235.1      $ -      $ -      $ -      $ 235.1  

Interest on subordinated debentures and interest rate swaps

     198.0        8.9        17.7        17.7        153.7  

Convertible senior notes

     150.0        150.0        -        -        -  

Interest on convertible senior notes

     7.5        7.5        -        -        -  

Operating lease obligations

     76.1        10.5        20.8        18.0        26.8  

Capital lease obligation

     33.2        12.6        18.2        2.4        -  

Gross loss reserves

     2,081.3        761.4        1,064.7        202.3        52.9  

Limited partnership funding commitments

     45.3        35.0        10.3        -        -  

Total contractual obligations

   $ 2,826.5      $ 985.9      $ 1,131.7      $ 240.4      $ 468.5  

At various times we have issued trust preferred securities through wholly-owned Delaware statutory business trusts. The trusts used the proceeds of the sale of the trust preferred securities to third-party investors and common trust securities to Tower to purchase junior subordinated debentures from the Company. The terms of the junior subordinated debentures match the terms of the trust preferred securities. Interest on the junior subordinated debentures and the trust preferred securities is payable quarterly. In some cases, the interest rate is fixed for an initial period of five years after issuance and then floats with changes in the London Interbank Offered Rate (“LIBOR”). In other cases the interest rate floats with LIBOR without any initial fixed-rate period. See “Note 13 – Debt” for the principal terms of the subordinated debentures.

We do not consolidate the statutory business trusts for which we hold 100% of the common trust securities because we are not the primary beneficiary of the trusts. Our $7.1 million investment in the common trust securities of the statutory business trusts is reported in Other Assets. We report as a liability the outstanding subordinated debentures issued to the statutory business trusts.

 

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Under the terms for all of the subordinated debentures, an event of default may occur upon:

 

 

non-payment of interest on the subordinated debentures, unless such non-payment is due to a valid extension of an interest payment period;

 

 

non-payment of all or any part of the principal of the subordinated debentures;

 

 

our failure to comply with the covenants or other provisions of the indentures or the subordinated debentures; or

 

 

bankruptcy or liquidation of us or the trusts.

If an event of default occurs and is continuing, the entire principal and the interest accrued on the affected subordinated debentures and junior subordinated debentures may be declared to be due and payable immediately.

Pursuant to the terms of our subordinated debentures, we and our subsidiaries cannot declare or pay any dividends if we are in default or have elected to defer payments of interest on the subordinated debentures.

In October 2010, TGI effected interest rate swap contracts with $190 million notional on the subordinated debentures. Certain of these subordinated debentures are currently paying a variable interest rate and other subordinated debentures will convert to variable rates over the next year. The interest rate swaps will fix the variable interest payments on the subordinated debentures to rates from 5.1% to 5.9%. The interest rate swaps mature in 2015.

In September 2010, TGI issued $150 million principal amount of 5.0% convertible senior notes (the “Notes”) due September 15, 2014. Interest is being paid semi-annually commencing March 2011. Holders may convert their Notes into cash or common shares, at TGI’s option, at any time on or after March 15, 2014 or earlier under certain circumstances determined by: (i) the market price of the Company’s stock, (ii) the trading price of the Notes, or (iii) the occurrence of specified corporate transactions. Upon conversion, TGI intends to settle its obligation either entirely or partially in cash. The conversion rate was adjusted quarterly while the Company was paying its quarterly dividends. At December 31, 2013 the conversion rate is 41.4269 shares of common stock per $1,000 principal amount of the Notes (equivalent to a conversion price of $24.14 per share), subject to further adjustment upon the occurrence of certain events, including future dividend payments. Additionally, in the event of a fundamental change, the holders may require TGI to repurchase the Notes for a cash price equal to 100% of the principal plus any accrued and unpaid interest.

In May 2010, the Company entered into a $125.0 million credit facility agreement. The credit facility was a revolving credit facility with a letter of credit sublimit of $25.0 million. The credit facility was being used for general corporate purposes. The Company had the option to request that the facility be increased by an amount not to exceed $50.0 million. On February 15, 2012, the Company amended its $125.0 million credit facility by increasing borrowing capacity up to $150 million, extending the maturity out to February 2016, and resetting borrowing fees to more favorable current market terms. The Company had $70.0 million outstanding under the credit facility as of December 31, 2012. On November 26, 2012, the Company further amended its credit facility whereby the lenders provided consent to the proposed merger of TGI with a subsidiary of Canopius Holdings Bermuda Limited. The second amendment also increased the Company’s maximum revolving commitment by $70 million to $220 million upon the effectiveness of the Merger and the satisfaction of certain other conditions set forth in the Second Amendment. On October 11, 2013, the Company amended its credit facility to reduce its capacity from $220 million to $70 million and change its maturity date to May 30, 2014.

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 on December 13, 2013.

The gross loss reserve payments due by period in the table above are based upon the loss and loss expense reserves estimates as of December 31, 2013 and actuarial estimates of expected payout patterns by line of business. As a result, our calculation of loss reserve payments due by period is subject to the same uncertainties associated with determining the level of reserves and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. The projected gross loss payments presented do not include the estimated amounts recoverable from reinsurers that amounted to $570.9 million, which are estimated to be recovered as follows: less than one year, $237.7 million; one to three years, $300 million; four to five years, $26.4 million; and after five years, $6.9 million. The interest on the subordinated debentures is calculated using interest rates in effect at December 31, 2013 for variable rate debentures.

For a discussion of our loss and LAE reserving process, see “Critical Accounting Policies—Loss and LAE Reserves.” Actual payments of losses and loss adjustment expenses by period will vary, perhaps materially, from the above table to the extent that current estimates of loss reserves vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns. See “Risk Factors-Risks Related to Our Business - If our actual loss and loss adjustment expense reserves

 

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exceed our loss and loss adjustment expense reserves, our financial condition and results of operations could be significantly adversely affected,” for a discussion of the uncertainties associated with estimating loss and LAE expense reserves. The estimated ceded reserves recoverable referred to above also assumes timely reimbursement from our reinsurers. If our reinsurers do not meet their contractual obligations on a timely basis, the payment assumptions presented above could vary materially.

Capital

Our capital resources consist of funds deployed or available to be deployed to support our business operations. At December 31, 2013 and 2012, our capital resources were as follows:

 

     December 31,  
($ in thousands)    2013     2012  

Outstanding under credit facility

   $ -     $ 70,000  

Subordinated debentures

     235,058       235,058  

Convertible Senior Notes

     147,712       144,673  

Tower Group International, Ltd. shareholders’ equity

     95,551       950,058  

Total capitalization

   $ 478,321     $ 1,399,789  

Ratio of debt to total capitalization

     80.0     32.1

The Company’s total capitalization declined $921.5 million, or 65.8%, from December 31, 2012 to December 31, 2013. This decline is primarily a result of the significant loss reserve development and the goodwill and fixed asset impairment charges recorded in the second and third quarters of 2013 offset by the sale of common stock to third-party investors in connection with the Canopius Merger Transaction. As a consequence, the Company’s ratings have been downgraded by the rating agencies, Tower has seen a significant decline in its production of new and renewal business and various state insurance departments have placed limitations on the activities of the subsidiary insurance companies. See Loss Reserve Increase, Goodwill impairment and deferred tax valuation allowance discussion in the Overview Section of “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further detail.

The Company has entered into the ACP Re Merger Agreement to address the reduction in capital. In the event that the ACP Re Merger Agreement does not close, Tower’s production of new and renewal business will continue to be unfavorably impacted. See “Proposed Merger with ACP Re” discussion in the Overview section of “Item 1. Business” for further detail.

The Company had $70 million outstanding as of December 31, 2012 under the credit facility. The Company was in compliance with all covenants contained in the credit facility as of December 31, 2012. On December 13, 2013, TGI paid in full the $70.0 million outstanding on the bank credit facility and the bank credit facility was terminated.

The Company’s plan to repay TGI’s $150 million Convertible Senior Notes (due September 2014) is also related to the closing of the ACP Re Merger Agreement with ACP Re. 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 line 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 discussed above in “Liquidity and Capital Resources, Insurance Subsidiaries,” the insurance subsidiaries capital and surplus levels are below Company Action Level at December 31, 2013. There are no guarantees the Company will be able to remedy the capital and surplus deficiencies in certain of these insurance subsidiaries or maintain adequate levels of capital in the future.

Inflation

Property and casualty loss and loss adjustment expense reserves are established before we know the amount of losses and loss adjustment expenses or the extent to which inflation may affect such amounts. We attempt to anticipate the potential impact of inflation in establishing our loss and LAE reserves. Inflation in excess of the levels we have assumed could cause loss and LAE expenses to be higher than we anticipated.

Substantial future increases in inflation could also result in future increases in interest rates, which in turn are likely to result in a decline in the market value of the investment portfolio and cause unrealized losses or reductions in shareholders’ equity.

Adoption of New Accounting Pronouncements

For a discussion of accounting standards, see “Note 2 – Accounting Policies and Basis of Presentation” of Notes to Consolidated Financial Statements.

 

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Item 7A. Quantitative and Qualitative Disclosures about Market Risk

Market risk is the risk that we will incur losses in our investments due to adverse changes in market rates and prices. Market risk is directly influenced by the volatility and liquidity in the market in which the related underlying assets are invested. We believe that we are principally exposed to three types of market risk: changes in interest rates, changes in credit quality of issuers of investment securities, and changes in equity prices.

Interest Rate Risk

Interest rate risk is the risk that we may incur economic losses due to adverse changes in interest rates. The primary market risk to the investment portfolio is interest rate risk associated with investments in fixed-maturity securities, although conditions affecting particular asset classes (such as conditions in the commercial and housing markets that affect commercial and residential mortgage-backed securities) can also be significant sources of market risk. Fluctuations in interest rates have a direct impact on the market valuation of these securities. The fair value of our fixed-maturity securities as of December 31, 2013 was $1.6 billion.

For fixed-maturity securities, short-term liquidity needs and potential liquidity needs for our business are key factors in managing our portfolio. We use modified duration analysis to measure the sensitivity of the fixed income portfolio to changes in interest rates as discussed more fully below under sensitivity analysis.

As of December 31, 2013, we had a total of $235.1 million of outstanding floating rate subordinated debentures underlying our trust preferred securities issued by the statutory business trusts and carrying an interest rate that is determined by reference to market interest rates. In order to reduce the interest rate risk on the subordinated debentures, the Company entered into interest rate swap contracts with Keybank National Association that are designed to convert $190 million of these outstanding borrowings from their respective floating rates to fixed rates ranging from 5.1% to 5.9%. These swaps mature in 2015.

Sensitivity Analysis

Sensitivity analysis is a measurement of potential loss in future earnings, fair values or cash flows of market sensitive instruments resulting from one or more selected hypothetical changes in interest rates and other market rates or prices over a selected time. In our sensitivity analysis model, we select a hypothetical change in market rates that reflects what we believe are reasonably possible near-term changes in those rates. The term “near-term” means a period of time going forward up to one year from the date of the consolidated financial statements. Actual results may differ from the hypothetical change in market rates assumed in this disclosure, especially since this sensitivity analysis does not reflect the results of any action that we may take to mitigate such hypothetical losses in fair value.

In this sensitivity analysis model, we use fair values to measure our potential loss. The sensitivity analysis model includes fixed-maturities, preferred stocks and short-term investments.

For invested assets, we use modified duration modeling to calculate changes in fair values. Durations on invested assets are adjusted for call, put and interest rate reset features. Durations on tax-exempt securities are adjusted for the fact that the yield on such securities is generally less sensitive to changes in interest rates compared to Treasury securities. Invested asset portfolio durations are calculated on a market value weighted basis, including accrued investment income, using holdings as of December 31, 2013.

The following table summarizes the estimated change in fair value on our fixed-maturity portfolio including preferred stocks and short-term investments based on specific changes in interest rates as of December 31, 2013:

 

Change in interest rate    Estimated
Increase
(Decrease)
in Fair Value
(in  thousands)
    Estimated
Percentage
Increase
(Decrease)
in Fair  Value
 

300 basis point rise

   $ (198,554     -12.0

200 basis point rise

     (136,745     -8.2

100 basis point rise

     (70,449     -4.2

As of 12/31/13

     -       0.0

100 basis point decline

     74,437       4.5

 

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The sensitivity analysis model used by us produces a predicted pre-tax loss in fair value of market-sensitive instruments of $74.4 million or 4.5% based on a 100 basis point increase in interest rates as of December 31, 2013. This loss amount only reflects the impact of an interest rate increase on the fair value of our fixed-maturity investments.

Interest expense would also be affected by a hypothetical change in interest rates. As of December 31, 2013, the Company had $235.1 million of floating rate debt obligations, of which $190.0 million are hedged through our interest rate swaps. A 100 basis point increase in interest rates would increase annual interest expense by $0.5 million, a 200 basis point increase would increase interest expense by $0.9 million, and a 300 basis point increase would increase interest expense by $1.4 million on the $45.1 million of non-hedged floating rate debt obligations.

With respect to investment income, the most significant assessment of the effects of hypothetical changes in interest rates on investment income would be an adjustment to amortization for mortgage-backed securities. The rates at which the mortgages underlying mortgage-backed securities are prepaid, and therefore the average life of mortgage-backed securities, can vary depending on changes in interest rates (for example, mortgages are prepaid faster and the average life of mortgage-backed securities falls when interest rates decline). The adjustments for changes in amortization, which are based on revised average life assumptions, would have an impact on investment income if a significant portion of our mortgage-backed securities holdings had been purchased at significant discounts or premiums to par value. As of December 31, 2013, the par value of our residential mortgage-backed securities holdings was $105.4 million and the amortized cost of our residential mortgage-backed securities holdings was $93.9 million. This equates to an average price of 89.08% of par, thus an adjustment in accordance with this GAAP guidance would not have a significant effect on investment income.

Credit Risk

Our credit risk is the potential loss in principal resulting from an adverse change in the counter-party’s ability to repay its obligations. We seek to manage credit risk through regular review and analysis of the creditworthiness of all investments and potential investments. However, no assurance can be given that we will achieve our investment goals.

We bear credit risk on our reinsurance recoverables and premiums ceded to reinsurers. To mitigate the credit risk associated with reinsurance recoverables, we secure certain of our reinsurance recoverables by withholding ceded premium and requiring funds to be placed in trust as well as monitoring our reinsurers’ financial condition and rating agency ratings and outlook.

 

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The following table presents the top ten reinsurer groups by reinsurance recoverable and prepaid reinsurance balances at December 31, 2013 and 2012:

 

          Recoverable on                
($ in millions)    A.M. Best
Rating
   Unpaid
Losses
     Paid
Losses
     Prepaid
Reinsurance
     Total (1)  

December 31, 2013

              

Southport Re (Cayman) Ltd.

   NR    $ 299,600      $ 48,369      $ -      $ 347,969  

Swiss Reinsurance America Corp.

   A+      56,726        5,949        717        63,392  

Ace Property & Casualty Ins Co

   A++      8,958        2,028        45,449        56,435  

Hannover Reins (Ireland) Ltd.

   A+      20,408        1,381        32,884        54,673  

Arch Reins Ltd.

   A+      18,739        1,318        33,504        53,561  

Endurance Reinsurance Corp of America

   A      18,122        2,103        12,183        32,408  

OneBeacon Insurance Co.

   A      32,150        -        -        32,150  

NationsBuilders Insurance Co.

   NR      20,876        3,222        4,355        28,453  

Lloyd’s Syndicates

   A      7,373        2,082        10,627        20,082  

Allianz Risk Transfer (Bermuda) Ltd.

   A      16,123        1,676        1        17,800  

Hannover Rueck SE (fka Hannover Ruck AG)

   A+      13,612        97         3,726        17,435  

Others

        58,173        6,021         43,030        107,274  

Total

        $ 570,860      $ 74,296      $ 186,476      $ 831,632  

December 31, 2012

              

Swiss Reinsurance America Corp.

   A+    $ 79,021      $ 5,324      $ 103      $ 84,448  

Lloyd’s Syndicates

   A      47,335        1,100        8,785        57,220  

Allianz Risk Transfer (Bermuda) Ltd.

   A      38,837        1,037        1        39,875  

OneBeacon Insurance Co.

   A      37,803        -        -        37,803  

Hannover Ruckversicherungs, AG

   A+      21,920        473        3,662        26,055  

Endurance Reinsurance Corp of America

   A      15,269        1,235        9,121        25,625  

Alterra Bermuda Ltd.

   A      24,788        15        152        24,955  

NationsBuilders Insurance Co.

   NR      8,028        1,713        9,241        18,982  

Tokio Millennium Re (UK) Ltd.

   NR      9,407        1,379        8,156        18,942  

Munich Reinsurance America Inc.

   A+      15,002        594        -        15,596  

Others

        162,047        4,739        24,702        191,488  

Total

        $ 459,457      $ 17,609      $ 63,923      $ 540,989  

(1) For the purposes of evaluating the recoverables in this table, the Company does not include the effect of Tower’s gross premium payable to each of the reinsurers. As of December 31, 2013, the gross premiums payable was $5.3 million.

The following collateral is available to the Company for amounts recoverable from reinsurers as of December 31, 2013 and 2012:

 

($ in thousands)    A.M. Best
Rating
   Regulation
114 Trust
     Letters of
Credit
     Funds
Held
     Total  

December 31, 2013

              

Southport Re (Cayman) Ltd.

   NR    $ 214,024      $ -      $ 118,657      $ 332,681  

Hannover Reins (Ireland) Ltd.

   A+      -        13,481        31,316        44,797  

Swiss Reinsurance America Corp.

   A+      -        -        33,834        33,834  

NationsBuilders Insurance Co.

   NR      3,937        -        22,679        26,616  

Tokio Marine Global Ltd. (fka Tokio Millennium Re (UK) Ltd.)

   NR      -        18,690        -        18,690  

Markel Bermuda Ltd. (fka Alterra Ins. Ltd.)

   A      12,766        3,358        22        16,146  

Allianz Risk Transfer (Bermuda) Ltd.

   A      -        4,311        11,278        15,589  

Amlin AG

   A      -        8,885        -        8,885  

Arch Reins Ltd.

   A+      -        7,660        -        7,660  

Lion Insurance Company

   A-      7,076        -        -        7,076  

Others

        11,192        13,138        4,373        28,703  

Total

        $ 248,995      $ 69,523      $ 222,159      $ 540,677  

December 31, 2012

              

Swiss Reinsurance America Corp.

   A+    $ -      $ -      $ 49,466      $ 49,466  

Allianz Risk Transfer (Bermuda) Ltd.

   A      -        3,257        26,489        29,746  

Tokio Millennium Re (UK) Ltd.

   -      -        18,690        -        18,690  

Alterra Insurance Ltd.

   A      12,853        3,608        -        16,461  

NationsBuilders Insurance Co.

   -      -        -        15,296        15,296  

Amlin AG

   A      -        10,462        -        10,462  

Lion Insurance Company

   -      7,644        -        -        7,644  

Others

        13,617        20,916        7,330        41,863  

Total

        $ 34,114      $ 56,933      $ 98,581      $ 189,628  

 

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We also bear credit risk on the premium deposits paid by our policyholders to our producers. Producers collect such premiums and remit them to us within prescribed periods. After receiving a deposit, the insurance subsidiaries’ premiums are directly billed to insureds. In New York State and other jurisdictions, premiums paid to producers by an insured may be 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 premium payment from the producer. Consequently, we assume a degree of credit risk associated with producers. Due to the unsettled and fact specific nature of the law, we are unable to quantify our exposure to this risk.

Our interest rate swap contracts contain credit support annex provisions which require Keybank National Association to post collateral if the swap fair values exceed $5 million (asset position). As of December 31, 2013 and 2012, the swaps had a fair value of $6.1 million (liability position) and $9.0 million (liability position), respectively. As of December 31, 2013, $6.3 million collateral had been posted by Tower. As of December 31, 2012, $9.1 million collateral had been posted by Tower.

Equity Risk

Equity risk is the risk that we may incur economic losses due to adverse changes in equity prices. Our equity investment securities are classified as available for sale in accordance with GAAP and carried on the balance sheet at fair value. Our outside investment managers are constantly reviewing the financial health of these issuers. In addition, we perform periodic reviews of these issuers.

 

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Item 8. Financial Statements and Supplementary Data

Index to Consolidated Financial Statements

 

     Page  

Reports of Independent Registered Public Accounting Firm

     F-2   

Consolidated Balance Sheets as of December 31, 2013 and 2012

     F-4   

Consolidated Statements of Operations for the years ended December 31, 2013, 2012, and 2011

     F-5   

Consolidated Statements of Comprehensive Income for the years ended December 31, 2013, 2012, and 2011

     F-6   

Consolidated Statements of Changes in Shareholders’ Equity for the years ended December  31, 2013, 2012, and 2011

     F-7   

Consolidated Statements of Cash Flows for the years ended December 31, 2013, 2012, and 2011

     F-8   

Notes to Consolidated Financial Statements

     F-9   

 

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Table of Contents

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders of Tower Group International, Ltd.

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, comprehensive income, changes in shareholders’ equity and cash flows present fairly, in all material respects, the financial position of Tower Group International, Ltd. and its subsidiaries at December 31, 2013 and 2012, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2013 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company did not maintain, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) because the following material weaknesses in internal control over financial reporting existed at that date. The Company did not maintain effective controls over (i) the monitoring of other control activities, (ii) the loss reserve estimation process, (iii) the premiums receivable account reconciliation, (iv) the impairment process of the long-lived tangible and intangible assets, (v) information technology general controls with respect to segregation of duties, restricted access to programs and data, and change management activities, (vi) the income tax valuation allowance estimation process and (vii) the period-end financial reporting process. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. The material weaknesses referred to above are described in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. We considered these material weaknesses in determining the nature, timing, and extent of audit tests applied in our audit of the 2013 consolidated financial statements and our opinion regarding the effectiveness of the Company’s internal control over financial reporting does not affect our opinion on those consolidated financial statements. The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in management’s report referred to above. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company experienced significant losses in 2013 that have resulted in regulatory capital deficiencies in several of its insurance subsidiaries and have negatively impacted the Company’s ability to repay its debt obligations due in September 2014. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties.

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

 

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Table of Contents

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. We do not express an opinion or any other form of assurance on management’s statement referring to (i) remediation steps to address material weaknesses and (ii) changes in internal control over financial reporting.

/s/ PricewaterhouseCoopers LLP

New York, New York

May 2, 2014

 

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Table of Contents

Part I – FINANCIAL INFORMATION

Item 1. Financial Statements

Tower Group International, Ltd.

Consolidated Balance Sheets

 

     December 31,  
($ in thousands, except par value and share amounts)    2013     2012  

Assets

    

Investments - Tower

    

Available-for-sale investments, at fair value:

    

Fixed-maturity securities (amortized cost of $1,364,157 and $1,926,236)

   $ 1,390,146     $ 2,064,148  

Equity securities (cost of $94,957 and $144,204)

     104,107       140,695  

Short-term investments (cost of $5,925 and $4,749)

     5,897       4,750  

Other invested assets

     96,155       57,786  

Investments - Reciprocal Exchanges

    

Available-for-sale investments, at fair value:

    

Fixed-maturity securities (amortized cost of $249,477 and $263,950)

     252,549       280,563  

Equity securities (cost of $2,751 and $5,144)

     2,523       5,563  

Total investments

     1,851,377       2,553,505  

Cash and cash equivalents (includes $5,684 and $9,782 relating to Reciprocal Exchanges)

     293,898       83,800  

Investment income receivable (includes $2,325 and $2,610 relating to Reciprocal Exchanges)

     17,493       25,332  

Investment in unconsolidated affiliate

     -        71,894  

Premiums receivable (includes $42,348 and $44,285 relating to Reciprocal Exchanges)

     309,499       412,045  

Reinsurance recoverable on paid losses (includes $1,989 and $682 relating to Reciprocal Exchanges)

     68,963       17,609  

Reinsurance recoverable on unpaid losses (includes $15,392 and $52,389 relating to Reciprocal Exchanges)

     570,860       459,457  

Prepaid reinsurance premiums (includes $22,226 and $17,803 relating to Reciprocal Exchanges)

     186,476       63,923  

Deferred acquisition costs, net (includes $9,611 and $11,364 relating to Reciprocal Exchanges)

     95,096       181,198  

Intangible assets (includes $6,337 and $6,854 relating to Reciprocal Exchanges)

     79,936       106,768  

Goodwill

     -        241,458  

Funds held by reinsured companies

     98,816       137,545  

Other assets (includes $1,395 and $1,559 relating to Reciprocal Exchanges)

     383,131       357,981  

Total assets

   $ 3,955,545     $ 4,712,515  

Liabilities

    

Loss and loss adjustment expenses (includes $107,315 and $135,791 relating to Reciprocal Exchanges)

   $ 2,081,285     $ 1,895,679  

Unearned premium (includes $106,067 and $103,216 relating to Reciprocal Exchanges)

     763,112       921,271  

Reinsurance balances payable (includes $4,872 and $6,979 relating to Reciprocal Exchanges)

     89,820       41,312  

Funds held under reinsurance agreements (includes $22 and $500 relating to Reciprocal Exchanges)

     222,159       98,581  

Other liabilities (includes $17,234 and $21,346 relating to Reciprocal Exchanges)

     286,171       296,960  

Deferred income taxes (includes $19,181 and $19,719 relating to Reciprocal Exchanges)

     29,508       24,763  

Debt

     382,770       449,731  

Total liabilities

     3,854,825       3,728,297  

Contingencies (Note 17)

     -        -   

Shareholders’ equity

    

Common stock ($0.01 par value; 150,000,000 shares authorized, 57,437,157 and 53,048,011 shares issued, and 57,381,686 and 43,513,678 shares outstanding)

     574       530  

Treasury stock (55,471 and 9,534,333 shares)

     (39     (181,435

Paid-in-capital

     815,119       780,036  

Accumulated other comprehensive income

     (19,507     82,756  

Retained earnings (accumulated deficit)

     (700,596     268,171  

Tower Group International, Ltd. shareholders’ equity

     95,551       950,058  

Noncontrolling interests

     5,169       34,160  

Total shareholders’ equity

     100,720       984,218  

Total liabilities and shareholders’ equity

   $ 3,955,545     $ 4,712,515  

See accompanying notes to the consolidated financial statements.

 

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Tower Group International, Ltd.

Consolidated Statements of Operations

 

     Year Ended December 31,  
(in thousands, except per share amounts)    2013     2012     2011  

Revenues

      

Net premiums earned

   $ 1,512,915     $ 1,721,864     $ 1,593,850  

Ceding commission revenue

     81,382       32,335       33,968  

Insurance services revenue

     1,150       3,420       1,570  

Policy billing fees

     12,299       12,615       10,534  

Net investment income

     109,208       127,165       126,474  

Net realized investment gains (losses):

      

Other-than-temporary impairments

     (14,396     (9,919     (3,509

Portion of loss recognized in other comprehensive income

     981       286       264  

Other net realized investment gains

     38,463       35,109       12,639  

Total net realized investment gains (losses)

     25,048       25,476       9,394  

Total revenues

     1,742,002       1,922,875       1,775,790  

Expenses

      

Loss and loss adjustment expenses

     1,519,834       1,263,758       1,076,986  

Commission expense

     365,031       359,307       309,826  

Other operating expenses

     369,893       317,497       284,847  

Acquisition-related transaction costs

     21,322       9,229       360  

Interest expense

     33,594       32,630       34,290  

Total expenses

     2,309,674       1,982,421       1,706,309  

Other income (expense)

      

Equity in income (loss) of unconsolidated affiliate

     6,962       (1,470     -   

Goodwill and fixed asset impairment

     (397,211     -        -   

Other

     5,000       -        -   

Income (loss) before income taxes

     (952,921     (61,016     69,481  

Income tax expense (benefit)

     8,431       (29,099     14,051  

Net income (loss)

   $ (961,352   $ (31,917   $ 55,430  

Less: Net income (loss) attributable to Noncontrolling interests

     (18,736     2,317       10,995  

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

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

Earnings (loss) per share attributable to Tower Group International, Ltd. shareholders:

      

Basic

   $ (17.37   $ (0.81   $ 0.96  

Diluted

   $ (17.37   $ (0.81   $ 0.96  

Weighted average common shares outstanding:

      

Basic

     54,297       42,902       45,226  

Diluted

     54,297       42,902       45,337  

Dividends declared and paid per common share

   $ 0.50     $ 0.66     $ 0.61  

See accompanying notes to the consolidated financial statements.

 

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Table of Contents

Tower Group International, Ltd.

Consolidated Statements of Comprehensive Income

 

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

Net income (loss)

   $ (961,352   $ (31,917   $ 55,430  

Other comprehensive income (loss) before tax

      

Gross unrealized investment holding gains (losses) arising during periods

     (89,416     62,326       50,851  

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

     (25,048     (25,476     (9,394

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

     (981     (286     (264

Cumulative translation adjustment

     (1,204     1,852       -   

Deferred gain (loss) on cash flow hedge

     1,881       (2,422     (10,541

Other comprehensive income (loss) before tax

     (114,768     35,994       30,652  

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

      

Unrealized investment holding gains (losses) arising during periods

     -        (22,546     (9,430

Reclassification adjustment for (gains) losses included in net income

     -        8,917       1,742  

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

     -        100       49  

Cumulative translation adjustment

     -        (648     -   

Deferred gain (loss) on cash flow hedge

     -        571       1,955  

Other comprehensive income (loss), net of income tax

     (114,768     22,388       24,968  

Comprehensive income (loss)

   $ (1,076,120   $ (9,529   $ 80,398  

Less: Comprehensive income (loss) attributable to Noncontrolling interests

     (31,241     5,001       21,189  

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

   $ (1,044,879   $ (14,530   $ 59,209  

See accompanying notes to the consolidated financial statements.

 

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Table of Contents

Tower Group International, Ltd.

Consolidated Statements of Changes in Shareholders’ Equity

 

     Common Stock     Treasury     Paid-in    

Accumulated
Other

Comprehensive

    Retained     Noncontrolling    

Total

Shareholders’

 
(in thousands)    Shares     Amount     Stock     Capital     Income (loss)     Earnings     Interests     Equity  

Balance at December 31, 2010

     51,826     $ 518     $ (91,779   $ 763,003     $ 48,279     $ 314,939     $ 4,190     $ 1,039,150  

Dividends declared

     -        -        -        -        -        (27,894     -        (27,894

Stock based compensation

     800       8       (1,834     10,657       -        -        -        8,831  

Deferred taxes on stock option activity

     -        -        -        (783     -        -        -        (783

Repurchase of common stock

     -        -        (64,572     -        -        -        -        (64,572

Net income

     -        -        -        -        -        44,435       10,995       55,430  

Other comprehensive income

     -        -        -        -        14,774       -        10,194       24,968  

Noncontrolling interest in acquired consolidated partnership

     -        -        -        -        -        -        2,001       2,001  

Balance at December 31, 2011

     52,626     $ 526     $ (158,185   $ 772,877     $ 63,053     $ 331,480     $ 27,380     $ 1,037,131  

Dividends declared

     -        -        -        -        -        (29,075     -        (29,075

Stock based compensation

     422       4       (2,263     8,937       -        -        -        6,678  

Repurchase of common stock

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

Net income

     -        -        -        -        -        (34,234     2,317       (31,917

Transfer of assets to Reciprocal Exchange

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

Other comprehensive income

     -        -        -        -        19,703        -        2,685       22,388  

Balance at December 31, 2012

     53,048     $ 530     $ (181,435   $ 780,036     $ 82,756     $ 268,171     $ 34,160     $ 984,218  

Dividends declared

     -        -        -        -        -        (26,151     -        (26,151

Stock based compensation

     245       3       (5,892     14,524       -        -        -        8,635  

Merger Transaction with Canopius Bermuda

     14,026       140       -        207,207       -        -        -        207,347  

Extinguishment of treasury stock in connection with Canopius Merger Transaction

     (9,882     (99     187,288       (187,189     -        -        -        -   

Termination of convertible senior notes hedge and warrants

     -        -        -        541       -        -        -        541  

Net income (loss)

     -        -        -        -        -        (942,616     (18,736     (961,352

Other comprehensive income (loss)

     -        -        -        -        (102,263     -        (12,505     (114,768

Increase in noncontrolling interest in consolidated partnership

                                                     2,250       2,250  

Balance at December 31, 2013

     57,437     $ 574     $ (39   $ 815,119     $ (19,507   $ (700,596   $ 5,169     $ 100,720  

See accompanying notes to the consolidated financial statements.

 

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Tower Group International, Ltd.

Consolidated Statements of Cash Flows

 

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

Cash flows provided by (used in) operating activities:

      

Net income (loss)

   $ (961,352   $ (31,917   $ 55,430  

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

      

Gain on investment in acquired unconsolidated affiliate

     (6,962     (1,064     -   

Net realized investment (gains) losses

     (25,048     (25,476     (9,394

Depreciation and amortization

     29,704       33,609       30,940  

Goodwill and fixed asset impairment

     397,211       -        -   

Intangible asset impairment

     21,917       -        -   

Amortization of bond premium or discount

     10,136       11,447       9,239  

Amortization of debt issuance costs

     (4,290     (1,667     (1,712

Amortization of restricted stock

     13,195       8,247       10,292  

Deferred income taxes

     4,745       (14,935     5,847  

Changes in operating assets and liabilities:

      

Investment income receivable

     7,839       1,450       (2,912

Premiums receivable

     111,527       4,387       (15,832

Reinsurance recoverable

     305,970       (161,382     (20,934

Prepaid reinsurance premiums

     29,878       (9,886     23,590  

Deferred acquisition costs, net

     91,920       (12,340     (4,735

Funds held by reinsured companies

     737,548       (67,790     (66,176

Other assets

     94,528       (43,048     15,371  

Increase (decrease) in liabilities:

      

Loss and loss adjustment expenses

     (445,007     263,566       21,692  

Unearned premium

     (337,103     28,095       21,150  

Reinsurance balances payable

     41,910       27,116       (14,243

Funds held under reinsurance agreements

     (437,136     1,855       3,573  

Other liabilities

     (31,173     99,066       21,568  

Net cash flows provided by (used in) operations

     (350,043     109,333       82,754  

Cash flows provided by (used in) investing activities:

      

Net cash (used in) acquired from acquisitions

     133,294       -        2,274  

Purchase of fixed assets

     (30,880     (44,951     (53,568

Sale of (investment in) unconsolidated affiliate

     69,743       (71,512     -   

Purchase - fixed-maturity securities

     (1,273,710     (1,855,590     (2,019,603

Purchase - equity securities

     (1,258,780     (1,525,206     (819,180

Short-term investments, net

     25,844       (4,750     1,560  

Purchase of other invested assets

     (39,039     (13,440     (42,346

Sale of fixed-maturity securities

     1,730,078       1,813,628       2,032,027  

Maturity of fixed-maturity securities

     150,975       205,534       -   

Sale - equity securities

     1,291,343       1,442,225       793,886  

Change in restricted cash

     (97,562     (46,592     (6,997

Net cash flows provided by (used in) investing activities

     701,306       (100,654     (111,947

Cash flows provided by (used in) financing activities:

      

(Payments under) proceeds from capital lease financing

     (7,603     -        39,839  

Increase in deposit assets

     (35,151     -        -   

Proceeds from credit facility borrowings

     -        20,000       67,000  

Repayment of credit facility borrowings

     (70,000     -        (17,000

Noncontrolling interests investment in consolidated partnership

     2,250       -        -   

Proceeds from convertible senior notes hedge termination

     2,380       -        -   

Payments for warrants termination

     (1,000     -        -   

Issuance of common stock under stock-based compensation programs

     2       -        -   

Proceeds from share-based payment arrangements

     -        345       534  

Treasury stock acquired-net employee share-based compensation

     (5,892     (2,263     (1,834

Repurchase of Common Stock

     -        (20,987     (64,572

Dividends paid

     (26,151     (29,075     (27,894

Net cash flows provided by (used in) financing activities

     (141,165     (31,980     (3,927

Increase (decrease) in cash and cash equivalents

     210,098       (23,301     (33,120

Cash and cash equivalents, beginning of period

     83,800       107,101       140,221  

Cash and cash equivalents, end of period

   $ 293,898     $ 83,800     $ 107,101  

Supplemental disclosures of cash flow information:

      

Cash paid for income taxes

   $ -      $ -      $ 3,000  

Cash paid for interest

     18,494       20,917       25,880  

See accompanying notes to the consolidated financial statements.

 

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Table of Contents

Tower Group International, Ltd.

Notes to Consolidated Financial Statements

Note 1—Nature of Business

Tower Group International, Ltd. (the “TGIL”, the Company” or “Tower”) offers a range of commercial, assumed reinsurance and personal property and casualty insurance products and services through its subsidiaries to businesses and to individuals. On March 13, 2013, the Company and Tower Group, Inc. (“TGI”) completed a merger transaction under which the Company, formerly known as Canopius Holdings Bermuda Limited (“Canopius Bermuda”), was re-named Tower Group International, Ltd. and became the ultimate parent company (the “Canopius Merger Transaction”). The Company’s Common Shares (as defined below) are publicly traded on the NASDAQ Global Select Market under the symbol “TWGP”, which was also the symbol of TGI common shares on that exchange prior to the Canopius Merger Transaction. See “Note 3 – Canopius Merger Transaction” for further discussion of the Canopius Merger Transaction and the Company’s succession to TGI as registrant. As stated above, the registrant is deemed to be the successor to Tower Group, Inc. pursuant to Rule 12g-3(a) under the Exchange Act and, following the consummation of the merger described above by the registrant and Tower Group, Inc., the consolidated financial statements of Tower Group, Inc. for the periods through March 13, 2013, closing date of the merger, became the registrant’s consolidated statements for the same periods. Accordingly, as used herein, 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.

Significant Business Developments and Risks and Uncertainties

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 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.

 

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Table of Contents

Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

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.

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 quarters and fourth 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 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.

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 consisted 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

 

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Table of Contents

Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

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 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 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 reinsurance agreements with Arch and Hannover Re 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 “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

 

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Table of Contents

Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

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 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, 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”).

 

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Table of Contents

Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

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 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.

 

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Table of Contents

Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

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.

Going Concern

There can be no guarantee that the Company will be able to remedy current statutory capital deficiencies in certain of its insurance subsidiaries, maintain adequate levels of statutory capital in the future, or generate sufficient liquidity to repay the Notes due in 2014. Consequently, there is substantial doubt about the Company’s ability to continue as a going concern. Should the Company be unable to successfully execute the merger with ACP Re or generate sufficient funds to repay the Notes and remedy the capital deficiencies, these conditions 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.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

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.

Note 2—Accounting Policies and Basis of Presentation

Basis of Presentation

The accompanying consolidated financial statements included in this report have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All intercompany transactions have been eliminated in consolidation.

The Canopius Merger Transaction was accounted for as a reverse acquisition, under which TGI was identified and treated as the accounting acquirer. As such, the Company’s consolidated financial statements include the accounts and operations of TGI and its insurance subsidiaries, managing general agencies and management companies as its historical financial statements, with the results of Tower Group International, Ltd., as accounting acquiree, being included from March 13, 2013, the effective date of the Canopius Merger Transaction. The consolidated financial statements also include the accounts of Adirondack Insurance Exchange, a New York reciprocal insurer, and New Jersey Skylands Insurance Association, a New Jersey reciprocal insurer (together, the “Reciprocal Exchanges”). The Company does not own the Reciprocal Exchanges but manages their business operations through its wholly-owned management companies.

In 2013, the Company changed the presentation of its business results by allocating its assumed reinsurance previously reported in the Commercial Insurance segment to a new Assumed Reinsurance segment. In addition, the Company redefined the Personal Insurance segment to include its management companies, which provide certain services to the Reciprocal Exchanges for a management fee. The Reciprocal Exchanges continue to be included in the Personal Insurance segment and transactions between the management companies and the Reciprocal Exchanges have been eliminated. The management companies were previously reported in the Insurance Services segment. The Company will no longer present an Insurance Services segment. These changes in presentation reflected the way management organized the Company for operating decisions and assessing profitability in the second quarter of 2013, subsequent to the Canopius Merger Transaction and the significant business developments and risks and uncertainties that occurred in 2013.

Following the changes in presentation the Company now operates in three business segments: Commercial Insurance, Assumed Reinsurance and Personal Insurance:

 

 

Commercial Insurance (“Commercial”) segment offers a range of standard commercial lines property and casualty insurance products to businesses distributed through a network of retail and wholesale agents and through program underwriting agents, on both an admitted and non-admitted basis;

 

 

Assumed Reinsurance (“Assumed Reinsurance”) segment offers international assumed reinsurance and certain U.S. based assumed reinsurance; and

 

 

Personal Insurance (“Personal”) segment offers a broad range of personal lines property and casualty insurance products to individuals distributed through a network of retail and wholesale agents. Also included in the Personal Insurance segment are the results of the Reciprocal Exchanges.

See “Note 21 – Segment Information” for further information on the composition of the Company’s operating and reportable segments.

Use of Estimates

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

Intercompany transactions

In the first quarter 2012, Tower transferred a licensed insurance subsidiary shell to the Reciprocal Exchanges and received cash for its statutory book value. At the date of the transfer, Tower’s GAAP carrying basis in this subsidiary exceeded the statutory book value and the transfer resulted in a loss to Tower of $1.8 million. Since this was a non-recurring transaction between entities

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

under common control, assets are transferred at historical book value. Any difference in the consideration paid and the book value of the assets transferred is treated as an adjustment to equity. This transaction had no effect on consolidated shareholders’ equity.

Reclassifications and Adjustments

Since the Company accounted for the Canopius Merger Transaction as a reverse acquisition and recapitalization, it has retroactively restated Common Stock, Treasury Stock and Paid-in-Capital accounts and earnings per share for periods prior to the Canopius Merger Transaction to reflect the historical capitalization of TGI, adjusted for the 1.1330 conversion ratio as discussed in “Note 3 – Canopius Merger Transaction”. Certain other reclassifications have also been made to prior years’ financial information to conform to the current year presentation, including the changes in segment presentation discussed in “Note 1 – Nature of Business.”

The table below reflects the previously reported and revised shareholders’ equity accounts resulting from the Canopius Merger Transaction:

 

($ in thousands, except share amounts)    As previously
Reported
    Revised
Amount
 

As of December 31, 2012

    

Common stock

   $ 469     $ 530  

Treasury stock

     (181,435     (181,435

Paid-in-capital

     780,097       780,036  

As of December 31, 2011

    

Common stock

     465       526  

Treasury stock

     (158,185     (158,185

Paid-in-capital

     772,938       772,877  

For the year ended December 31, 2012

    

Earnings (Loss) per Share:

    

Basic

   $ (0.73   $ (0.81

Diluted

     (0.73     (0.81

Weighted average common shares outstanding

    

Basic

     38,795       42,902  

Diluted

     38,975       42,902  

For the year ended December 31, 2011

    

Earnings (Loss) per Share:

    

Basic

   $ 1.48     $ 0.96  

Diluted

     1.48       0.96  

Weighted average common shares outstanding

    

Basic

     40,833       45,226  

Diluted

     40,931       45,337  

Revision to the 2012 Consolidated Balance Sheet and 2012 and 2011 Consolidated Statements of Cash Flows

Management is revising the Company’s 2012 consolidated balance sheet and 2012 and 2011 consolidated statements of cash flows to properly reflect the changes in restricted cash as change in cash flows from investing activities. In its Amendment No. 2 to Form 10-K for the year ended December 31, 2012, the Company previously recorded $9.1 million and $7.0 million of restricted cash within the “cash and cash equivalents” caption on the consolidated balance sheet as of December 31, 2012 and 2011, respectively. These amounts should have been recorded within “other assets,” and management has properly corrected those amounts out of the “cash and cash equivalent” balances in the 2012 and 2011 financial statements contained herein. In addition, in the 2012 consolidated balance sheet, management also corrected the classification of $9.4 million of “receivable for securities” that was originally reported within “cash and cash equivalents” to “other assets.” Also, in the 2012 consolidated balance sheet, management previously reported $0.9 million of receivables from reinsurance within “reinsurance balances payable.” The Company has properly reflected the $0.9 million as a receivable reported within “other assets.” These adjustments had no impact on shareholders’ equity or net income (loss). Management has concluded these corrections were not material to the 2012 consolidated balance sheet.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

In addition, as a result of the immaterial adjustments to the “cash and cash equivalents” balances discussed above, the Company also revised its statement of cash flows. Cash flows used in investing activities increased from $89.1 million as originally reported to $100.5 million for the year ended December 31, 2012, and cash and cash equivalents as of December 31, 2012 decreased from $102.3 million to $83.8 million. Cash flows used in investing activities increased from $104.5 million as originally reported to $111.9 million for the year ended December 31, 2011, and cash and cash equivalents as of December 31, 2011 decreased from $114.1 million to $107.1 million. Management concluded these corrections were not material to the 2012 or 2011 consolidated statements of cash flows.

Accounting Policies

Net Premiums Earned

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

Ceding Commission Revenue

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

Insurance Services Revenue

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

Policy Billing Fees

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

Loss and Loss Adjustment Expenses (“LAE”)

The liability for loss and LAE represents management’s best estimate of the ultimate cost and expense of all reported and unreported losses that are unpaid as of the balance sheet date. The liability for loss and LAE is recorded net of a tabular reserve discount for workers’ compensation and excess workers’ compensation claims in the amount of $5.5 million (net of reinsurance basis) and $8.4 million at December 31, 2013 and 2012, respectively. The 2013 discount relates to $244.7 million of total net reserves for workers’ compensation. The projection of future claims payments and reporting is based on an analysis of the Company’s historical experience, supplemented by analyses of industry loss data. Management believes that the liability for loss and LAE is an adequate reasonable provision to cover the ultimate cost of losses and claims to date; however, because of the uncertainty from various sources, including changes in reporting patterns, claims settlement patterns, judicial decisions, legislation, and economic conditions, actual loss experience may not conform to the assumptions used in determining the estimated amounts for such liability at the balance sheet date. As adjustments to these estimates become necessary, such adjustments are reflected in expense for the period in which the estimates are changed.

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

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

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 to loss and ALAE payments for last three calendar years.

Reinsurance

The Company uses reinsurance to limit its exposure to certain risks. Management has evaluated its reinsurance arrangements and determined that significant insurance risk is transferred to the reinsurers. Reinsurance agreements have been determined to be short-duration prospective and retrospective contracts. For prospective contracts, the costs of reinsurance are recognized over the life of the contracts in a manner consistent with the earning of premiums on the underlying policies subject to the reinsurance contract. For retroactive reinsurance agreements, when incurred losses and loss reserves exceed consideration paid for the retroactive reinsurance agreement, a gain results. The gain is deferred and amortized over the estimated remaining settlement period.

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

Management estimates uncollectible amounts receivable from reinsurers based on an assessment of a number of factors. The Company recorded no allowance for uncollectible reinsurance at December 31, 2013 or 2012. The Company did not write-off balances from reinsurers during the three year period ended December 31, 2013.

Deposit Assets

Deposit assets arise from ceded reinsurance contracts purchased that do not transfer significant underwriting or timing risk. Under deposit accounting, consideration received or paid, excluding non-refundable fees, is recorded as a deposit asset or liability in the balance sheet as opposed to recording premiums and losses in the statement of operations. At December 31, 2013, deposit assets of $28.7 million are included in Other Assets.

Cash and Cash Equivalents

Cash consists of cash in banks, generally in operating accounts. The Company maintains its cash balances at several financial institutions. Management monitors balances and believes they do not represent a significant credit risk to the Company. The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. Cash and cash equivalents are presented at cost, which approximates fair value. Cash restricted as to use is included in Other Assets.

Restricted Cash

Restricted cash balances relate primarily to “Funds at Lloyd’s” collateral balances for its assumed reinsurance programs. The Company also has restricted cash collateralizing its interest rate swap contracts. Restricted cash balances are reported in “Other Assets” on the accompanying consolidated balance sheets. As of December 31, 2013 and 2012, these assets were approximately $134.1 million and $44.2 million, respectively. Certain amounts in prior years have been reclassified to conform to the current year presentation. These reclassifications had no effect on net income or equity.

Investments

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

Fair value for fixed-maturity securities and equity securities is primarily based on quoted market prices or a matrix pricing using observable inputs, with limited exceptions as discussed in “Note 6 – Fair Value Measurements”. Changes in unrealized gains and losses, net of tax effects, are reported as a separate component of other comprehensive income while cumulative unrealized gains and losses are reported net of tax effects within accumulated other comprehensive income in shareholders’ equity. Realized gains and losses are determined on the specific identification method. Investment income is recorded when earned and includes the amortization of premium and discount on investments.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

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

The Company’s other invested assets consist of investments in limited partnerships accounted for using the equity method of accounting, real estate and certain securities for which the Company has elected the fair value option. In accounting for the partnerships, management uses the financial information provided by the general partners, which is on a three-month lag. As of December 31, 2013, the Company had future funding commitments of $45.3 million to these limited partnerships. For securities in which the Company has elected the fair value option, interest and dividends are reported in net investment income with the remaining change in overall fair value reported in other net realized investment gains (losses).

Fair Value

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

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

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

Premiums Receivable

Premiums receivable represent amounts due from insureds and reinsureds for insurance coverage and are presented net of an allowance for doubtful accounts of $17.6 million and $16.5 million at December 31, 2013 and 2012, respectively. The allowance for uncollectible amounts is based on an analysis of amounts receivable giving consideration to historical loss experience and current economic conditions and reflects an amount that, in management’s judgment, is adequate. Uncollectible premiums receivable of $12.1 million, $4.8 million and $3.0 million were written off in 2013, 2012 and 2011, respectively.

Deferred Acquisition Costs

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

The value of business acquired (“VOBA”) is an intangible asset relating to the estimated fair value of the unexpired insurance policies acquired in a business combination. VOBA is determined at the time of a business combination and is reported on the consolidated balance sheet with DAC and is amortized in proportion to the timing of the estimated underwriting profit associated with the in force policies acquired. The Company fully amortized the VOBA in the year ended December 31, 2011 and,

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

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. See “Note 8 – Deferred Acquisition Costs” for additional information regarding deferred acquisition costs.

Goodwill

In business combinations, including the acquisition of a group of assets, the Company allocates the purchase price to the net tangible and intangible assets acquired based on their relative fair values. Any portion of the purchase price in excess of this amount results in goodwill. Identifiable intangible assets with a finite useful life are amortized over the period that the asset is expected to contribute directly or indirectly to the future cash flows of the Company and are tested for impairment when impairment indicators are present. Intangible assets with an indefinite life and goodwill are not amortized and are subject to annual impairment testing at the reporting unit level or more frequently if circumstances indicate that the value of goodwill may be impaired.

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

The second and third quarter reserve increases were viewed by the Company as events or circumstances 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 impaired the remaining $55.5 million of goodwill, all of which was allocated to the Personal Insurance reporting unit. See “Note 7 – Goodwill, Intangible and Fixed Asset Impairments” for additional detail on the Goodwill impairment.

Intangible Assets

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 performed its impairment analysis on its intangible assets with a finite useful life in 2013 and concluded impairment charges of $21.9 million were required to reduce its customer relationship intangible assets. 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.

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.

Other Assets

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

Fixed Assets

Furniture, leasehold improvements, computer equipment, and software, including internally developed software, are reported at cost less accumulated depreciation and amortization. We periodically evaluate our long-lived assets to be held and used. Our judgments regarding the existence of impairment indicators are based on factors such as operational performance, market conditions and legal factors. Any adverse changes in these factors could cause an impairment in our assets. For long-lived assets to be held and used, if an impairment indicator exists, we compare the expected future undiscounted cash flows against the carrying amount of that asset. If the sum of the estimated undiscounted cash flows is less than the carrying amount of the asset, we record an impairment loss for the carrying amount in excess of the estimated fair value, if any, of the asset. Gross fixed assets and accumulated depreciation were $194.0 million and $54.7 million, as of December 31, 2013, and 2012, respectively. As a

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

result of the reserve increases, rating downgrades 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 in 2013 and recorded a non-cash charge to earnings of $125.8 million in 2013. Gross fixed assets and accumulated depreciation (after the effects of the impairment) were $20.7 million and $1.0 million as of December 31, 2013.

Other liabilities

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

Variable Interest Entities

The Company consolidates the Reciprocal Exchanges as it has determined that these are variable interest entities and that the Company is the primary beneficiary. See “Note 4 – Variable Interest Entities” for more details.

Investment in unconsolidated affiliate

Although the Company owned less than 20% of the outstanding common stock of Canopius Group at December 31, 2012, it recorded its investment in Canopius Group under the equity method of accounting as it was able to significantly influence the operating and financial policies and decisions of Canopius Group. In the twelve months ended December 31, 2013 and December 31, 2012, the change in the value of the Company’s investment in Canopius was a gain of $6.9 million and a loss of $1.5 million, respectively. Changes in the value were recognized in Equity in income (loss) of unconsolidated affiliate in the consolidated statement of operations. On December 13, 2013, Tower sold its 10.7% ownership in Canopius Group.

Income Taxes

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

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

Management in its judgment concluded that a full valuation allowance was required for the net deferred tax assets after its consideration of the cumulative three-year pre-tax loss in its U.S. taxed subsidiaries resulting from certain 2013 events and the 2012 pre-tax loss of $61.0 million. In 2013, Tower had $325.6 million of prior year adverse reserve development, of which $149.7 million was recorded in Tower’s U.S. taxed subsidiaries. Management believes that the negative evidence associated with the realizability of its net deferred tax asset (including the cumulative three-year pre-tax loss, the prior year adverse reserve development, and the effects of Hurricane Irene in 2011 and Superstorm Sandy in 2012) outweighed the positive evidence that the deferred tax assets, including the net operating loss carryforward would be realized, and subsequently recorded the full valuation allowance.

Treasury Stock

The Company accounts for the treasury stock at the repurchase price as a reduction to shareholders’ equity as it does not currently intend to retire the treasury stock held at December 31, 2013.

Stock-based Compensation

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

Assessments

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

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

Earnings (loss) per Share

The Company measures earnings (loss) per share at two levels: basic earnings (loss) per share and diluted earnings (loss) per share. Basic earnings per share is calculated by dividing net income (loss) attributable to Tower common shareholders by the weighted average number of common shares outstanding during the year. Undistributed net earnings (loss) (net income less dividends declared during the period) are allocated to both common stock and unvested share-based payment awards (“unvested restricted stock”). Because the common shareholders and unvested restricted stock holders share in dividends on a 1:1 basis, the earnings per share on undistributed earnings is equivalent; however, undistributed losses are allocated only to common shareholders. Undistributed earnings are allocated to all outstanding share-based payment awards, including those for which the requisite service period is not expected to be rendered. The computation of diluted earnings (loss) per share excludes outstanding options and other common stock equivalents in periods where inclusion of such potential common stock instruments would be anti-dilutive.

Foreign currency

The Company’s functional currency is the U.S. dollar.

Statutory Accounting Principles

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

Concentration and Credit Risk

Financial instruments that potentially subject the Company to concentration and credit risk are primarily cash and cash equivalents, investments, interest rate swaps, premiums receivable and reinsurance recoverables. Investments are diversified through many industries and geographic regions through the use of money managers who employ different investment strategies. The Company limits the amount of credit exposure with any one financial institution and believes that no significant concentration of credit risk exists with respect to cash and investments. The interest rate swap contracts contain credit support annex agreements with collateral posting provisions which reduces counterparty non-performance risk. The premiums receivable balances are generally diversified due to the number of entities comprising the Company’s distribution network and its customer base, which is largely concentrated in the Northeast, Florida, Texas and California. To reduce credit risk, the Company performs ongoing evaluations of its distribution network’s and customers’ financial condition. The Company also has receivables from its reinsurers. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company periodically evaluates the financial condition of its reinsurers and, in certain cases, requires collateral from its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. As of December 31, 2013, the largest uncollateralized reinsurance recoverable balance from any one reinsurer was $56.4 million representing 6.8% of the Company’s total reinsurance recoverable balance. Management’s policy is to review all outstanding receivables at period end as well as the bad debt write-offs experienced in the past and establish an allowance for doubtful accounts, if deemed necessary.

Our largest agent accounted for 9.7%, 7.5% and 10%, respectively, of the insurance subsidiaries’ premiums receivable balances at December 31, 2013, 2012 and 2011. Our largest agent accounted for 9%, 7% and 7% of the insurance subsidiaries’ direct premiums written in 2013, 2012 and 2011, respectively.

Accounting Pronouncements

Accounting guidance adopted in 2013

In July 2012, the Financial Accounting Standards Board (FASB) issued an accounting standard that allows a company, as a first step in an impairment review, to assess qualitatively whether it is more likely than not that an indefinite-lived intangible asset is impaired. We are not required to calculate the fair value of an indefinite-lived intangible asset and perform a quantitative impairment test unless we determine, based on the results of the qualitative assessment, that it is more likely than not the asset is impaired. The standard became effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. We adopted the standard on its required effective date of January 1, 2013. (See Note 7 for a discussion of Goodwill, Intangible and Fixed Asset Impairments in 2013).

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

In February 2013, the FASB issued amended guidance on the presentation of amounts reclassified out of accumulated other comprehensive income in one place, either on the face of the income statement or in the footnotes to the financial statements. The Company adopted this guidance effective January 1, 2013 on a prospective basis as prescribed by the amended guidance. As all of the information that this guidance requires to be disclosed is already presented elsewhere in the Company’s financial statements under existing GAAP, and it does not affect the classification, recognition or measurement of items within other comprehensive income, the adoption will not affect the Company’s financial position, results of operations or cash flows.

Accounting guidance not yet effective

In March 2013, the FASB issued an accounting standard addressing whether consolidation guidance or foreign currency guidance applies to the release of the cumulative translation adjustment into net income when a parent sells all or a part of its investment in a foreign entity or no longer holds a controlling financial interest in a subsidiary or net assets that are a business (other than a sale of in-substance real estate) within a foreign entity. The guidance also resolves the diversity in practice for the cumulative translation adjustment treatment in business combinations achieved in stages involving foreign entities.

Under this standard, the entire amount of the cumulative translation adjustment associated with the foreign entity should be released into earnings when there has been: (i) a sale of a subsidiary or group of net assets within a foreign entity and the sale represents a complete or substantially complete liquidation of the foreign entity in which the subsidiary or the net assets had resided; (ii) a loss of a controlling financial interest in an investment in a foreign entity; or (iii) a change in accounting method from applying the equity method to an investment in a foreign entity to consolidating the foreign entity. The standard is effective for fiscal years and interim periods beginning after December 15, 2013, and will be applied prospectively. We plan to adopt the standard on its required effective date of January 1, 2014 and do not expect the adoption of the standard to have a material effect on our consolidated financial condition, results of operations or cash flows.

In July 2013, the FASB clarified the applicable guidance for the presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. An unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward as long as it is available, at the reporting date under the tax law of the applicable jurisdiction, to settle any additional income taxes that would result from the disallowance of a tax position (with certain exceptions). The assessment of whether a deferred tax asset is available is based on the unrecognized tax benefit and deferred tax asset that exist at the reporting date and should be made presuming disallowance of the tax position at the reporting date. This ASC update is effective for annual and interim periods beginning after December 15, 2013, with early adoption permitted, and is to be applied prospectively to all unrecognized tax benefits that exist at the effective date. Retrospective application is permitted. The Company does not expect the adoption of this standard to have a material impact on its financial position or results of operations.

In July 2013, the FASB issued an accounting standard that permits the Federal Funds Effective Swap Rate (or Overnight Index Swap Rate) to be used as a U.S. benchmark interest rate for hedge accounting purposes in addition to U.S. Treasury rates and LIBOR. The standard also removes the prohibition on the use of differing benchmark rates when entering into similar hedging relationships. The standard became effective on a prospective basis for qualifying new or redesignated hedging relationships entered into on or after July 17, 2013 to the extent the Federal Funds Effective Swap Rate is used as a U.S. benchmark interest rate for hedge accounting purposes. The Company will consider this guidance if and when it enters into any new hedging relationships.

Note 3—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 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.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

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 were 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. TGIL, succeeding to the attributes of TGI as registrant, including TGI’s SEC file number, TGIL’s 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 closed a sale to an investment fund managed by Bregal Capital LLP (“Bregal”) of all of the shares of the capital stock of Canopius Group owned by Tower. The initial purchase price for the Canopius shares is $69.7 million (£42.5 million), which has been paid in full to Tower. In addition, if a legally binding contract for the sale or other transfer of shares representing a majority of the voting power of Canopius Group is entered into within six months after the date of Tower’s stock purchase agreement with Bregal, a further cash payment would be made by Bregal to Tower. This additional cash payment would be equivalent to the excess, if any, of (1) one-third of the difference between the amount in British pound sterling paid for the shares previously owned by Tower in such sale and £40.6 million (plus Tower’s share of expenses of such sale), minus (2) £1.95 million (the “Additional Payment”). On December 18, 2013, NKSJ Holdings announced that it had entered into an agreement, through its insurance subsidiary Sompo Japan Insurance, Inc. to purchase 100% of the shares of Canopius Group. This Additional Payment meets the definition of a derivative as of December 31, 2013. Management in its judgment concluded that the initial fair value of this derivative is $7.2 million and has included it in other assets on the balance sheet. In addition, $2.1 million has been recorded in realized gains on the income statement, reflecting the increase in fair value of the derivative from its inception date of December 13, 2013 to the reporting date of December 31, 2013.

With proceeds from the sale, Tower has paid in full the $70.0 million outstanding on its credit facility led by Bank of America, N.A., and the credit facility has been terminated.

Accounting for the Canopius Merger Transaction

The Company has accounted for the Canopius Merger Transaction as a reverse acquisition in which TGI, the legal acquiree, was identified and treated as the accounting acquirer and Tower Group International, Ltd., the legal acquirer, was identified and treated as the accounting acquiree. The identification of the accounting acquirer and acquiree in the Canopius Merger Transaction was primarily based on the fact that immediately following the close of the Canopius Merger Transaction there was a change in control of the Company with TGI designees to the Company’s Board of Directors comprising all of its directors and TGI’s former senior management comprising the Company’s entire senior management team. In accordance with accounting guidance for reverse acquisitions, the unaudited consolidated financial statements of the Company following the Canopius Merger Transaction have been issued under the name of the Company, as the legal parent, but reflect a continuation of the financial statements of TGI, as the accounting acquirer, with one exception, which was the retroactive adjustment of TGI’s historical legal capital to reflect the transaction as a recapitalization of TGI’s historical capital accounts. On the effective date of the Canopius Merger Transaction, the assets and liabilities of Tower Group International, Ltd. were accounted for under the acquisition method, under which they have been reflected at their respective acquisition date fair values.

Prior to the Canopius Merger Transaction, Canopius Bermuda restructured its insurance operations as contemplated in the Master Transaction Agreement. This restructuring occurred primarily through the execution of retrocession agreements with Canopius Reinsurance Limited (“CRL”), an indirectly wholly-owned subsidiary of Canopius Group, to retrocede a percentage of Lloyd’s of

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

London Syndicate 4444 (“Syndicate 4444”) business for the Year of Account (“YOA”) 2012, YOA 2011 and prior years, which Canopius Bermuda assumed from Canopius Group. Syndicate 4444 is an insurance syndicate managed by Canopius Group. The Company accounts for these retrocession agreements in accordance with prospective accounting treatment, and reports the assumed and ceded assets and liabilities on a gross basis on the consolidated balance sheet. On September 30, 2013, Tower commuted the Syndicate 4444 YOA 2012 and YOA 2011 and prior years’ retrocession agreements with CRL and novated the assumed reinsurance with Canopius Group on these same contracts.

In addition, effective January 1, 2013, pursuant to the terms of the Master Transaction Agreement, prior to the Canopius Merger Transaction, TGI entered into a commutation agreement whereby TGI commuted Syndicate 4444 YOA 2012 and YOA 2011 business TGI previously reinsured from Canopius Group in prior years. There was no gain or loss recognized on this commutation.

The following provides details of the purchase consideration, the fair values of the respective assets acquired and liabilities assumed and the resulting amount of goodwill recorded in connection with the Canopius Merger Transaction on March 13, 2013.

The purchase consideration was determined based on the total consideration received by Canopius Group for its sale of 100% of its equity ownership of Canopius Bermuda, and the proceeds received for the issuance and exercise of the Merger Option from TGI.

 

(in thousands)        

Consideration received by Canopius Group from the third party sale

   $ 205,863  

Fair value of Merger Option received in connection with TGI’s investment in Canopius Group

     484  

Exercise price of Merger Right received from TGI upon exercise

     1,000  

Total preliminary purchase consideration

   $         207,347  

 

($ in thousands)        

Assets

  

Cash and cash equivalents

   $ 134,741  

Investments

     26,485  

Reinsurance recoverables

     463,745  

Prepaid reinsurance

     152,431  

Funds held by reinsured companies

     698,819  

Other assets

     80,201  

Liabilities

  

Loss and loss adjustment expenses

     630,613  

Unearned premiums

     169,963  

Funds held under reinsurance agreements

     560,714  

Other liabilities

     15,916  

Net assets acquired

   $         179,216  

Purchase Consideration

     207,347  

Goodwill

   $ 28,131  

Direct costs of the acquisition were expensed as incurred. During the year ended December 31, 2013, the Company recognized approximately $20.3 million of such costs, all of which have been classified within “acquisition-related transaction costs” on the consolidated statement of operations. Such costs included $11.6 million in compensation expense (of which accelerated vesting of restricted stock was $10.3 million) and $8.7 million in legal and accounting fees.

The resulting goodwill recognized in connection with the Canopius Merger Transaction was mainly derived from the synergies and economies of scale expected to result from the combined operations of the Company. This goodwill was fully impaired in the second quarter of 2013. See “Note 7 – Goodwill, Intangible and Fixed Asset Impairments” for the allocation of the Canopius Merger Transaction goodwill by segment and discussion on the non-cash impairment charge.

The fair value of loss and loss adjustment expenses includes $19.1 million of reserves for risk premiums (“risk premiums”). The risk premium was determined using a cash flow model. This model used an estimate of net nominal future cash flows related to liabilities for losses and loss adjustment expenses that a market participant would expect as of the date of the transaction. These future cash flows were adjusted for the time value of money at a risk free rate and a risk margin to compensate an acquirer for bearing the risk associated with the liabilities. The risk premium was fully amortized in the third quarter of 2013 in connection with the September 30, 2013 commutation and novation of the Syndicate 4444 YOA 2012 and YOA 2011 and prior years assumed reinsurance and retrocession agreements.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

The September 30, 2013 commutation of the Syndicate 4444 YOA 2012 and YOA 2011 and prior years retrocession agreements with CRL and the novation of the assumed reinsurance with Canopius Group on these same contracts provided the Company access to $30.3 million of assets that were previously restricted as “Funds at Lloyd’s” assets. No commutation gain or loss was recognized on these transactions.

Since the effective date of the Canopius Merger Transaction on March 13, 2013 through December 31, 2013, the operations of the acquired business accounted for approximately $53.5 million and $(11.8) million of the Company’s consolidated revenues and net income (loss), respectively.

The following unaudited pro forma financial information presents the consolidated revenues and net income (loss) of the Company for years ended December 31, 2013 and 2012, as if the Canopius Merger Transaction had been completed as of January 1, 2012.

These pro forma amounts exclude any pro forma impacts to the Company’s effective federal income tax rates.

 

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

Revenues

   $ 1,745,146     $ 1,933,942  

Net Income (Loss)

     (922,959     (19,567

Note 4—Variable Interest Entities (“VIEs”)

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

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

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

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

For the year ended December 31, 2013, the Reciprocal Exchanges recognized total revenues, total expenses and net loss of $190.2 million, $211.0 million and $(20.4) million, respectively. For the year ended December 31, 2012, the Reciprocal Exchanges recognized total revenues, total expenses and net income of $204.7 million, $202.4 million and $2.3 million, respectively.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

Note 5—Investments

The cost or amortized cost and fair value of the Company’s investments in fixed maturity and equity securities, gross unrealized gains and losses, and other-than-temporary impairment losses as of December 31, 2013 and December 31, 2012 are summarized as follows:

 

($ in thousands)   

Cost or

Amortized

Cost

    

Gross
Unrealized

Gains

    

Gross
Unrealized

Losses

    Fair Value     

Unrealized

OTTI
Losses (1)

 

December 31, 2013

             

U.S. Treasury securities

   $       370,959      $ 729      $ (7,726   $         363,962      $ -  

U.S. Agency securities

     110,362        1,420        (561     111,221        -  

Municipal bonds

     277,382        7,981        (6,257     279,106        -  

Corporate and other bonds

             

Finance

     148,132        9,797        (1,028     156,901        -  

Industrial

     316,474        8,286        (3,008     321,752        -  

Utilities

     47,838        1,341        (1,890     47,289        (17

Commercial mortgage-backed securities

     189,808        16,852        (1,754     204,906        (634

Residential mortgage-backed securities

             

Agency backed securities

     63,668        891        (1,218     63,341        -  

Non-agency backed securities

     30,228        4,659        (31     34,856        (13

Asset-backed securities

     58,783        681        (103     59,361        -  

Total fixed-maturity securities

     1,613,634        52,637        (23,576     1,642,695        (664

Preferred stocks, principally financial sector

     21,330        54        (2,536     18,848        -  

Common stocks, principally financial and industrial sectors

     76,378        11,432        (28     87,782        -  

Short-term investments

     5,925        -        (28     5,897        -  

Total, December 31, 2013

   $ 1,717,267      $ 64,123      $ (26,168   $ 1,755,222      $ (664

Tower

   $ 1,465,039      $ 56,480      $ (21,369   $ 1,500,150      $ (664

Reciprocal Exchanges

     252,228        7,643        (4,799     255,072        -  

Total, December 31, 2013

   $ 1,717,267      $ 64,123      $ (26,168   $ 1,755,222      $ (664

December 31, 2012

             

U.S. Treasury securities

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

U.S. Agency securities

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

Municipal bonds

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

Corporate and other bonds

             

Finance

     233,849        21,293        (1,095     254,047        -  

Industrial

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

Utilities

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

Commercial mortgage-backed securities

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

Residential mortgage-backed securities

             

Agency backed securities

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

Non-agency backed securities

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

Asset-backed securities

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

Total fixed-maturity securities

     2,190,186        157,463        (2,938     2,344,711        (6

Preferred stocks, principally financial sector

     31,272        730        (481     31,521        -  

Common stocks, principally industrial and financial sectors

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

Short-term investments

     4,749        1        -       4,750        -  

Total, December 31, 2012

   $ 2,344,283      $ 159,147      $ (7,711   $ 2,495,719      $ (6

Tower

   $ 2,075,189      $ 141,614      $ (7,210   $ 2,209,593      $ (6

Reciprocal Exchanges

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

Total, December 31, 2012

   $ 2,344,283      $ 159,147      $ (7,711   $ 2,495,719      $ (6

 

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

As of December 31, 2013 and 2012, U.S. Treasury Notes and other securities with carrying values of $398.4 million and $351.1 million, respectively, were on deposit with various states to comply with the insurance laws in which the Company is licensed.

In addition, the Company had $248.9 million and $481.5 million of investments as of December 31, 2013 and 2012, respectively, held by counterparties as collateral or in trusts to support letters of credit issued on Tower’s behalf, reinsurance liabilities on certain assumed reinsurance treaties and obligations under certain leases.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

Major categories of net investment income are summarized as follows:

 

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

Income

      

Fixed-maturity securities

   $ 75,731     $ 96,056     $ 105,533  

Equity securities

     22,912       28,989       24,576  

Cash and cash equivalents

     244       1,112       695  

Other invested assets

     16,138       6,680       274  

Other

     736       387       643  

Total

     115,761       133,224       131,721  

Expenses

      

Investment expenses

     (6,553     (6,059     (5,247

Net investment income

   $ 109,208     $ 127,165     $ 126,474  

Tower

     106,309       121,907       120,083  

Reciprocal Exchanges

     9,578       12,575       12,846  

Elimination of interest on Reciprocal Exchange surplus notes

     (6,679     (7,317     (6,455

Net investment income

   $ 109,208     $ 127,165     $ 126,474  

Proceeds from the sale of fixed-maturity securities were $1.7 billion, $1.8 billion and $2.0 billion for the years ended December 31, 2013, 2012 and 2011, respectively. Proceeds from the sale of equity securities were $1.3 billion, $1.4 billion and $793.9 million for the years ended December 31, 2013, 2012 and 2011, respectively.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

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

 

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

Fixed-maturity securities

      

Gross realized gains

   $ 51,598     $ 59,319     $ 44,550  

Gross realized losses

     (9,760     (2,780     (11,101
     41,838       56,539       33,449  

Equity securities

      

Gross realized gains

     18,004       13,090       8,328  

Gross realized losses

     (28,649     (31,404     (29,138
     (10,645     (18,314     (20,810

Other (1)

      

Gross realized gains

     12,946       3,432       -   

Gross realized losses

     (5,676     (6,548     -   
       7,270       (3,116     -   

Net realized gains on investments

     38,463       35,109       12,639  

Other-than-temporary impairment losses:

      

Fixed-maturity securities

     (6,682     (1,320     (580

Equity securities

     (6,733     (8,313     (2,665

Total other-than-temporary impairment losses recognized in earnings

     (13,415     (9,633     (3,245

Total net realized investment gains (losses)

   $ 25,048     $ 25,476     $ 9,394  

Tower

   $ 22,894     $ 12,245     $ 6,980  

Reciprocal Exchanges

     2,154       13,231       2,414  

Total net realized investment gains (losses)

   $ 25,048     $ 25,476     $ 9,394  

 

(1) 

Other gross realized gains and losses consists primarily of foreign exchange and “debt and equity securities sold, not yet purchased,” which are reported in Other liabilities. The Company recorded a $4.3 million gain from translation of foreign currency transactions to the functional currency.

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

Impairment Review

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

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

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

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

 

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Notes to Consolidated Financial Statements

 

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

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

The following table shows the amount of fixed-maturity and equity securities that were OTTI for the years ended December 31, 2013, 2012 and 2011. This resulted in recording impairment write-downs included in net realized investment gains (losses), and reduced the unrealized loss in other comprehensive net income:

 

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

U.S. Treasury securities

   $ (801   $ -      $ -   

U.S. Agency securities

     (572     -        -   

Municipal bonds

     (367     (113     -   

Corporate and other bonds

     (4,271     (1,029     -   

Commercial mortgage-backed securities

     (1,176     (430     (219

Residential mortgage-backed securities

     (423     (34     (235

Asset-backed securities

     (53     -        (391

Equities

     (6,733     (8,313     (2,664

Other-than-temporary-impairments

     (14,396     (9,919     (3,509

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

     981       286       264  

Impairment losses recognized in earnings

   $ (13,415   $ (9,633   $ (3,245

Tower

   $ (13,414   $ (9,919   $ (3,245

Reciprocal Exchanges

     (1     286       -   

Impairment losses recognized in earnings

   $ (13,415   $ (9,633   $ (3,245

The following table provides a rollforward of the cumulative amount of credit related OTTI for securities still held showing the amounts that have been included in earnings on a pretax basis for the years ended 2013 and 2012 (none of such OTTI was included within the Reciprocal Exchanges):

 

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

Balance, January 1,

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

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

      

No OTTI has been previously recognized

     6,252       1,259       44  

OTTI has been previously recognized

     430       61       537  

Reductions due to:

      

Securities sold during the period (realized)

     (3,357     (9,494     (5,990

Balance, December 31,

   $ 7,817     $ 4,492     $ 12,666  

Unrealized Losses

There are 511 securities at December 31, 2013, including fixed maturities and equity securities, which account for the gross unrealized loss, none of which is deemed by management to be OTTI. Temporary losses on corporate and other bonds result from purchases made in a lower interest rate environment or lower yield spread environment. In addition, there have been some ratings

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

downgrades on certain of these securities. After analyzing the credit quality, balance sheet strength and company outlook, management believes these securities will recover in value. The structured securities that had significant unrealized losses resulted primarily from declines in both residential and commercial real estate prices. To the extent projected cash flows on structured securities change adversely, they would be considered OTTI, and an impairment loss would be recognized in the current period. Management considered all relevant factors, including expected recoverability of cash flows, in assessing whether a loss was other-than-temporary. The Company does not intend to sell these fixed maturity securities, and it is not more likely than not that these securities will be sold before recovering their cost basis.

For all fixed-maturity securities in an unrealized loss position at December 31, 2013, the Company has received all contractual interest payments (and principal if applicable). Based on the continuing receipt of cash flow and the foregoing analyses, management expects continued timely payments of principal and interest and considers the losses to be temporary.

The unrealized loss position associated with the fixed-maturity portfolio was $23.6 million as of December 31, 2013, consisting primarily of municipal bonds, corporate and other bonds and U.S. Treasury securities of $19.9 million. The total fixed-maturity portfolio of gross unrealized losses included 490 securities which were, in aggregate, approximately 3.0% below amortized cost. Of the 490 fixed maturity investments identified, 68 have been in an unrealized loss position for more than 12 months. The total unrealized loss on these investments at December 31, 2013 was $4.2 million. Management does not consider these investments to be other-than-temporarily impaired.

For common stocks, there were 20 securities in a loss position at December 31, 2013 totaling $2.6 million. Management evaluated the financial condition of the common stock issuers, the severity and duration of the impairment, and our ability and intent to hold to recovery and determined these securities are not OTTI. The evaluation consisted of a detailed review, including but not limited to some or all of the following factors for each security: the current S&P rating, analysts’ reports, past earnings trends and analysts’ earnings expectations for the next 12 months, liquidity, near-term financing risk, and whether the company was currently paying dividends on its equity securities. Management does not consider these investments to be other-than-temporarily impaired.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

The following table presents information regarding invested assets that were in an unrealized loss position at December 31, 2013 and December 31, 2012 by amount of time in a continuous unrealized loss position:

 

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

December 31, 2013

               

U.S. Treasury securities

   $ 273,217      $ (7,726   $ -       $ -      $ 273,217      $ (7,726

U.S. Agency securities

     51,808        (561     -         -        51,808        (561

Municipal bonds

     109,345        (5,056     4,268        (1,201     113,613        (6,257

Corporate and other bonds

               

Finance

     37,811        (1,005     335        (23     38,146        (1,028

Industrial

     124,869        (2,550     10,023        (458     134,892        (3,008

Utilities

     27,698        (805     7,292        (1,085     34,990        (1,890

Commercial mortgage-backed securities

     26,469        (597     20,397        (1,157     46,866        (1,754

Residential mortgage-backed securities

               

Agency backed

     37,660        (925     5,166        (293     42,826        (1,218

Non-agency backed

     1,027        (19     182        (12     1,209        (31

Asset-backed securities

     32,461        (103     -         -        32,461        (103

Total fixed-maturity securities

     722,365        (19,347     47,663        (4,229     770,028        (23,576

Preferred stocks

     10,538        (2,285     6,154        (251     16,692        (2,536

Common stocks

     7,125        (28     -         -        7,125        (28

Short-term investments

     3,897        (28     -         -        3,897        (28

Total, December 31, 2013

   $ 743,925      $ (21,688   $ 53,817      $ (4,480   $ 797,742      $ (26,168

Tower

   $ 663,127      $ (19,335   $ 23,096      $ (2,034   $ 686,223      $ (21,369

Reciprocal Exchanges

     80,798        (2,353     30,721        (2,446     111,519        (4,799

Total, December 31, 2013

   $ 743,925      $ (21,688   $ 53,817      $ (4,480   $ 797,742      $ (26,168

December 31, 2012

               

U.S. Treasury securities

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

U.S. Agency securities

     22,345        (76     -         -        22,345        (76

Municipal bonds

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

Corporate and other bonds

               

Finance

     16,853        (1,095     -         -        16,853        (1,095

Industrial

     53,576        (667     4,188        (201     57,764        (868

Utilities

     20,143        (191     7        -        20,150        (191

Commercial mortgage-backed securities

     23,223        (141     95        -        23,318        (141

Residential mortgage-backed securities

               

Agency backed

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

Non-agency backed

     815        (6     588        (28     1,403        (34

Asset-backed securities

     1,499        (2     4,232        (12     5,731        (14

Total fixed-maturity securities

     263,342        (2,687     9,386        (251     272,728        (2,938

Preferred stocks

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

Common stocks

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

Total, December 31, 2012

   $ 328,618      $ (7,134   $ 15,110      $ (577   $ 343,728      $ (7,711

Tower

   $ 270,609      $ (6,732   $ 13,338      $ (478   $ 283,947      $ (7,210

Reciprocal Exchanges

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

Total, December 31, 2012

   $ 328,618      $ (7,134   $ 15,110      $ (577   $ 343,728      $ (7,711

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

 

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Notes to Consolidated Financial Statements

 

Fixed-Maturity Investment—Time to Maturity

The following table shows the composition of the fixed-maturity portfolio by remaining time to maturity at December 31, 2013 and 2012. For securities that are redeemable at the option of the issuer and have a market price that is greater than par value, the maturity used for the table below is the earliest redemption date. For securities that are redeemable at the option of the issuer and have a market price that is less than par value, the maturity used for the table below is the final maturity date.

 

     Tower      Reciprocal Exchanges      Total  
($ in thousands)    Amortized
Cost
     Fair Value      Amortized
Cost
     Fair
Value
     Amortized
Cost
     Fair Value  

December 31, 2013

                 

Remaining Time to Maturity

                 

Less than one year

   $ 33,305      $ 33,727      $ 7,866      $ 8,021      $ 41,171      $ 41,748  

One to five years

     507,388        513,841        39,469        41,381        546,857        555,222  

Five to ten years

     459,070        459,251        82,003        81,515        541,073        540,766  

More than 10 years

     100,977        102,801        41,069        39,693        142,046        142,494  

Mortgage and asset-backed securities

     263,417        280,526        79,070        81,939        342,487        362,465  

Total

   $ 1,364,157      $ 1,390,146      $ 249,477      $ 252,549      $ 1,613,634      $ 1,642,695  

December 31, 2012

                 

Remaining Time to Maturity

                 

Less than one year

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

One to five years

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

Five to ten years

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

More than 10 years

     346,410        379,045        57,628        62,542        404,038        441,587  

Mortgage and asset-backed securities

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

Total

   $   1,926,236      $   2,064,148      $   263,950      $   280,563      $   2,190,186      $   2,344,711  

Other Invested Assets

The following table shows the composition of the other invested assets as of December 31, 2013 and 2012:

 

($ in thousands)    2013      2012  

Limited partnerships, equity method

   $ 46,521      $ 23,864  

Real estate, amortized cost

     6,054        7,422  

Securities reported under the fair value option:

     43,580        25,000  

Other

     -         1,500  

Total

   $   96,155      $   57,786  

Securities reported under the fair value option include eight securities for which the Company has elected the fair value option. This election was made to simplify the accounting for these instruments which contain embedded derivatives and other features.

The significant inputs used to determine fair value of these limited partnerships are considered Level 3 pursuant to the fair value hierarchy. See “Note 6 – Fair Value Measurements” below. As of December 31, 2013, the Company and its insurance companies had future funding commitments of $45.3 million including but not limited to the limited partnerships.

Note 6—Fair Value Measurements

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

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

 

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Notes to Consolidated Financial Statements

 

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

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

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

The Additional Payment derivative’s fair value was calculated as discussed in “Note 3 – Canopius Merger Transaction.” The significant unobservable inputs included the estimated sales price Bregal could sell Canopius Group to a third party and the probability of such a sale closing. In December 2013, Bregal executed a stock purchase agreement with a third party.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

As of December 31, 2013 and 2012, the Company’s financial instruments carried at fair value are allocated among levels as follows:

 

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

December 31, 2013

          

Fixed-maturity securities

          

U.S. Treasury securities

   $ -       $ 363,962     $ -       $ 363,962  

U.S. Agency securities

     -         111,221       -         111,221  

Municipal bonds

     -         279,106       -         279,106  

Corporate and other bonds

     -         522,516       3,426        525,942  

Commercial mortgage-backed securities

     -         204,906       -         204,906  

Residential mortgage-backed securities

          

Agency

     -         63,341       -         63,341  

Non-agency

     -         34,856       -         34,856  

Asset-backed securities

     -         59,361       -         59,361  

Total fixed-maturities

     -         1,639,269       3,426        1,642,695  

Equity securities

     106,630        -        -         106,630  

Short-term investments

     -         5,897       -         5,897  

Total investments at fair value

     106,630        1,645,166       3,426        1,755,222  

Other invested assets (1)

     -         -        43,580        43,580  

Other Assets

          

Additional Payment derivative

     -         -        9,343        9,343  

Other liabilities

          

Interest rate swap contracts

     -         (6,066     -         (6,066

Debt and equity securities sold, not yet purchased

     -         (11,099     -         (11,099

Total, December 31, 2013

   $ 106,630      $ 1,628,001     $ 56,349      $ 1,790,980  

Tower

   $ 104,107      $ 1,375,452     $ 56,349      $ 1,535,908  

Reciprocal Exchanges

     2,523        252,549       -         255,072  

Total, December 31, 2013

   $ 106,630      $ 1,628,001     $ 56,349      $ 1,790,980  

December 31, 2012

          

Fixed-maturity securities

          

U.S. Treasury securities

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

U.S. Agency securities

     -         102,777       -         102,777  

Municipal bonds

     -         686,043       -         686,043  

Corporate and other bonds

     -         746,665       -         746,665  

Commercial mortgage-backed securities

     -         242,053       -         242,053  

Residential mortgage-backed securities

          

Agency

     -         295,716       -         295,716  

Non-agency

     -         42,156       -         42,156  

Asset-backed securities

     -         44,352       -         44,352  

Total fixed-maturities

     -         2,344,711       -         2,344,711  

Equity securities

     146,258        -        -         146,258  

Short-term investments

     -         4,750       -         4,750  

Total investments

     146,258        2,349,461       -         2,495,719  

Other invested assets (2)

     -         -        25,000        25,000  

Other liabilities

          

Interest rate swap contracts

     -         (9,016     -         (9,016

Debt and equity securities sold, not yet purchased

     -         (17,101     -         (17,101

Total, December 31, 2012

   $ 146,258      $ 2,323,344     $ 25,000      $ 2,494,602  

Tower

   $ 140,695      $ 2,042,780     $ 25,000      $ 2,208,475  

Reciprocal Exchanges

     5,563        280,564       -         286,127  

Total, December 31, 2012

   $     146,258      $     2,323,344     $     25,000      $     2,494,602  

(1) $43.6 million of the $96.2 million Other invested assets reported on the consolidated balance sheet at December 31, 2013 is reported at fair value. The remaining $52.6 million of Other invested assets is reported under the equity method of accounting.

(2) $25.0 million of the $57.8 million Other invested assets reported on the consolidated balance sheet at December 31, 2012 is reported at fair value. The remaining $32.8 million of Other invested assets is reported under the equity method of accounting or at amortized cost.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

As of December 31, 2013, substantially all of the investment portfolio recorded at fair value was priced based upon quoted market prices or other observable inputs. For investments in active markets, we used the quoted market prices provided by the outside pricing services to determine fair value. In circumstances where quoted market prices were unavailable, we used fair value estimates based upon other observable inputs including matrix pricing, benchmark interest rates, market comparables and other relevant inputs. When observable inputs were adjusted to reflect management’s best estimate of fair value, such fair value measurements are considered a lower level measurement in the GAAP fair value hierarchy.

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

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

Substantially all of the portfolio valuations at December 31, 2013 classified as Level 1 or Level 2 in the above table is priced by utilizing the services of several independent pricing services that provide the Company with a price quote for each security. There were no adjustments made to the prices obtained from the independent pricing sources and dealers on securities classified as Level 1 or Level 2.

In 2013, there were no transfers of investments between Level 1 and Level 2 and one investment transfer between Level 2 and Level 3. In 2012, there were no transfers of investments between Level 1 and Level 2 or between Level 2 and Level 3.

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

The fair values of the debt and equity securities sold, not yet purchased were derived by using quoted prices for similar securities in active markets. These instruments resulted in net realized gains of $.6 million for the year ended December 31, 2013.

The Company holds seven securities which are reported in other invested assets and have been classified as Level 3 of the fair value hierarchy. Management utilizes a discounted cash flow analysis to derive the fair values. Two of the seven securities, START VII CLO and HONDIUS CRAFT CLO, are credit linked notes which will mature in 2015 and 2017, respectively, and whose cash flows are supported by underlying short-term loans, the significant unobservable inputs include the underlying short-term loans’ probability of default and loss severity, and a discount for the security’s lack of marketability. Increases in the probability of default and loss severity assumptions (which generally move directionally with each other) would have the effect of decreasing the fair value of this security. The Company obtains credit ratings on the underlying short-term loans quarterly and considers these ratings when updating its assumptions. A third security, Aeolus CHIAT SAC, is an equity instrument which entitles the Company to residual interests of a finite life special purpose vehicle. The significant unobservable inputs include the estimated losses to be incurred by the vehicle and the equity instrument’s lack of marketability. The Company obtains quarterly financial data from the vehicle and evaluates the estimated incurred loss figure. An increase in the vehicle’s estimated incurred losses would have the effect of decreasing the instrument’s fair value. The remaining four securities are preferred equity interests in limited partnerships that invest in leisure hotels. The preferred interests pay a stated quarterly dividend with residual equity incentives payable after the General Partner’s minimum return thresholds are met. The significant unobservable inputs include the market discount rate and the instruments’ lack of marketability. The three of the four preferred equity interest investments closed in the latter part of June 2013 (and the fourth investment closed on July 1, 2013). These four preferred equity interest investments are carried at fair value with changes recorded in the statement of operations.

At December 31, 2013, management transferred a private convertible bond with a fair value of $3.4 million from Level 2 to Level 3. During the fourth quarter, management used a liquidation pricing methodology to determine the convertible bond’s fair value as of December 31, 2013 and the change in pricing methodology for this security resulted in the Company recording an OTTI loss of $3.6 million, which was reported through realized losses.

Management is responsible for the determination of the value of the investments carried at fair value and the supporting methodologies and assumptions. Management has reviewed the pricing techniques and methodologies of the independent pricing sources and believes that their policies adequately consider market activity, either based on specific transactions for the issue valued or based on modeling of securities with similar credit quality, duration, yield and structure that were recently traded. Management monitors security-specific valuation trends and discusses material changes or the absence of expected changes with

 

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Table of Contents

Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

the portfolio managers to understand the underlying factors and inputs and to validate the reasonableness of pricing. Management also back-tests the prices on numerous sales of securities during the year to validate the previous pricing provided as well as utilizes other pricing sources to validate the pricing provided by our primary provider of the majority of the non-U.S. Treasury securities and non-agency securities included in Level 2.

The following table summarizes changes in Level 3 assets measured at fair value for the years ended December 31, 2013, 2012 and 2011 for Tower (the Reciprocal Exchanges do not have any Level 3 assets):

 

     Year Ended December 31,  
     2013     2012 (1)      2011(1)  
($ in thousands)    Other
Invested
Assets
    Fixed
Maturity
Securities (2)
     Additional
Payment
Derivative
     Total                 

Beginning balance, January 1

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

Total gains (losses)-realized / unrealized

               

Included in net income

     (670     -         2,081         (670     -         (1,067

Included in other comprehensive income (loss)

     -        -         -         -        -         -   

Purchases

     19,250       -         7,262        28,593       -         25,000  

Issuances

     -        -         -         -        -         -   

Settlements

     -        -         -         -        -         -   

Net transfers into (out of) Level 3

     -        3,426        -         3,426       -         (991

Ending balance, December 31,

   $ 43,580       3,426        9,343        56,349     $ 25,000      $ 25,000  

(1) All activity for years ended December 31, 2012 and 2011 is comprised of other invested assets

(2) Comprised of corporate and other bonds

Note 7—Goodwill, Intangible and Fixed Assets Impairments

Goodwill

Goodwill is calculated as the excess of purchase price over the net fair value of assets acquired. Under GAAP, the Company is required to allocate goodwill to each of its reporting units. On March 13, 2013, the Company recorded $28.1 million of goodwill in connection with the Canopius Merger Transaction (See “Note 3 – Canopius Merger Transaction”), which was mainly derived from synergies and economies of scale expected to result from the combined operations of the Company. Management allocated the goodwill recognized in the Canopius Merger Transaction to the Commercial Insurance reporting unit.

2013 Reorganizations

In the second quarter of 2013, the Company changed the way it presented its results by segment. Following the reorganization, based on information reviewed by the Company’s chief operating decision maker, the Company concluded it had three reporting units corresponding to it each of the business segments: (i) Commercial Insurance, (ii) Specialty Insurance and Assumed Reinsurance and (iii) Personal Insurance. (Each of the reporting units corresponds with the Company’s reporting segments).

In the third quarter of 2013, the Company re-evaluated the way it presents its results by segment, as described in “Note 1 – Nature of Business”. Following the third quarter 2013 reorganization, based on the information reviewed by the Company’s chief operating decision maker, the Company concluded it had three reporting units corresponding to it each of the business segments: (i) Commercial Insurance, (ii) Assumed Reinsurance and (iii) Personal Insurance. (Each of the reporting units corresponds with the Company’s reporting segments).

Goodwill Impairment Testing and Charge

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

 

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Table of Contents

Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

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 reorganization 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.

Marine and Energy Acquisition goodwill

In the third quarter of 2013, the Company accounted for the Marine and Energy Acquisition as a business combination and recorded $1.9 million of goodwill in the Commercial Insurance reporting unit. As of September 30, 2013, in response to the significant business developments discussed in “Note 1 – Nature of Business,” management in its judgment concluded this goodwill was fully impaired.

 

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Table of Contents

Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

The following table reflects the changes to goodwill during the years ended December 31, 2013 and 2012 and is presented using the reporting units prior to the reorganizations.

 

($ in thousands)    Commercial
Insurance
    Personal
Insurance
    Total  

Balance, January 1, 2012

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

Adjustments

     -        -        -   

Balance, December 31, 2012

     185,918       55,540       241,458  

Goodwill from Canopius Merger Transaction

     28,131       -        28,131  

Goodwill from Marine and Energy acquisition

     1,853       -        1,853  

Goodwill impairment

     (215,902     (55,540     (271,442

Total, December 31, 2013

   $ -      $ -      $ -   

Intangible Assets

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

The components of intangible assets and their useful lives, accumulated amortization, and net carrying value as of December 31, 2013 and 2012 are as follows:

 

            December 31, 2013      December 31, 2012  
($ in thousands)    Useful
Life
(in-yrs)
     Gross
Carrying
Amount
     Accumulated
Amortization/
Impairment
    Net
Carrying
Amount
     Gross
Carrying
Amount
     Accumulated
Amortization/
Impairment
    Net
Carrying
Amount
 

Insurance licenses

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

Management contracts

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

Customer relationships

     10-25         57,890        (53,030     4,860        57,890        (26,754     31,136  

Trademarks

     5         5,290        (3,817     1,473        5,290        (3,261     2,029  

Total

            $ 136,783      $ (56,847   $ 79,936      $ 136,783      $ (30,015   $ 106,768  

Tower

      $ 128,283      $ (54,684   $ 73,599      $ 128,283      $ (28,369   $ 99,914  

Reciprocal Exchanges

              8,500        (2,163     6,337        8,500        (1,646     6,854  

Total

            $ 136,783      $ (56,847   $ 79,936      $ 136,783      $ (30,015   $ 106,768  

The activity in the components of intangible assets for the years ended December 31, 2013 and 2012 consisted of intangible assets acquired from business combinations and amortization expense as shown in the table below:

 

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

Balance, January 1, 2012

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

Additions

     -         -         -        -        -   

Amortization

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

Balance, December 31, 2012

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

Tower

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

Reciprocal Exchanges (a)

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

Total, December 31, 2012

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

Additions

     -         -         -        -        -   

Amortization

     -         -         (4,359     (556     (4,915

Impairment

     -         -         (21,917     -        (21,917

Balance, December 31, 2013

   $ 19,003      $ 54,600      $ 4,860     $ 1,473     $ 79,936  

Tower

   $ 16,003      $ 54,600      $ 2,608     $ 388     $ 73,599  

Reciprocal Exchanges

     3,000        -         2,252       1,085       6,337  

Total, December 31, 2013

   $ 19,003      $ 54,600      $ 4,860     $ 1,473     $ 79,936  

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

 

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Table of Contents

Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

Intangible asset impairment testing and amortization

The Company performs an analysis at least annually to identify potential impairment of intangible assets with both definite and indefinite lives and measures the amount of any impairment loss that may need to be recognized. Intangible asset impairment testing requires an evaluation of the estimated fair value of each identified intangible asset to its carrying value. An impairment charge could be recorded if the estimated fair value is less than the carrying amount of the intangible asset. Management assessed the carrying value of its intangible assets in the second quarter of 2013, and concluded an impairment charge of $3.8 million was required to reduce its customer relationship intangible assets. These charges are reported in Other Operating Expenses in the consolidated statements of operations. In addition, after further reserve increases and A.M. Best rating downgrades in the third quarter of 2013, management in its judgment concluded an impairment charge of another $18.1 million was required to further reduce the customer relationship intangible asset.

As of December 31, 2013, the Company has $4.9 million of customer relationships and $54.6 million of management contracts recorded as intangible assets. Subsequent intangible asset assessments could result in impairment due to future unfavorable developments, including rating agency downgrades, significant declines in renewal retention rates or increases in expected loss ratios.

No impairments were identified during the years ended December 31, 2012 and 2011, respectively.

The Company recorded amortization expense related to intangible assets with definite lives of $4.9 million, $8.2 million and $8.9 million in the years ended December 31, 2013, 2012 and 2011, respectively. The estimated amortization expense associated with these intangible assets for each of the next five years is:

 

($ in thousands)    Tower      Reciprocal
Exchanges
     Total  

2014

   $ 544      $ 466      $ 1,010  

2015

     303        405        708  

2016

     191        354        545  

2017

     171        311        482  

2018

     155        276        431  

Fixed Assets

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 ratings downgrades and the expected significant declines in net written premiums and other items more fully discussed in Significant Business Developments and Risks and Uncertainties in “Note 1 – Nature of Business”, management tested fixed assets for recoverability in 2013.

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 in 2013. This charge is recorded within Goodwill and fixed-assets impairment in the statement of operations. As of December 31, 2013, the Company has recorded $19.7 million of fixed assets in Other Assets on the consolidated balance sheet.

 

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Table of Contents

Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

Note 8—Deferred Acquisition Costs (“DAC”)

Acquisition costs incurred and policy-related ceding commission revenue are deferred and amortized to income on property and casualty business for the year ended December 31, 2013, 2012 and 2011 as follows:

 

     Year Ended December 31,  
     2013     2012     2011  
($ in thousands)    Tower     Reciprocal
Exchanges
    Total     Tower     Reciprocal
Exchanges
    Total     Tower     Reciprocal
Exchanges
    Total  

Deferred acquisition costs, net, January 1

   $ 169,834     $ 11,364     $ 181,198     $ 156,992     $ 11,866     $ 168,858     $ 145,917     $ 18,206     $ 164,123  

Cost incurred and deferred:

                  

Commissions and brokerage

     266,987       32,425       299,412       298,701       31,266       329,967       279,699       31,837       311,536  

Other underwriting and acquisition costs

     58,846       7,627       66,473       68,238       7,467       75,705       64,416       5,896       70,312  

Ceding commission revenue

     (101,640     (18,987     (120,627     (25,052     (15,878     (40,930     (20,082     (11,446     (31,528

Net costs incurred and deferred

     224,193       21,065       245,258       341,887       22,855       364,742       324,033       26,287       350,320  

Amortization

     (308,542     (22,818     (331,360     (329,045     (23,357     (352,402     (312,958     (32,627     (345,585

Deferred acquisition costs, net, December 31,

   $ 85,485     $ 9,611     $ 95,096     $ 169,834     $ 11,364     $ 181,198     $ 156,992     $ 11,866     $ 168,858  

Note 9—Reinsurance

The Company utilizes various excess of loss, quota share and catastrophe reinsurance programs to limit its exposure to a maximum loss on any one risk. In addition, as disclosed in “Note 1 – Nature of the Business,” as a result of the 2013 significant business developments, Tower entered into reinsurance agreements with Arch, Hannover and Southport Re.

Under the terms of the excess of loss programs in 2013, Tower was at risk for $5.0 million on property, $3.5 million on workers’ compensation and $2.5 million on umbrella. The Company then had reinsurance coverage up to $30 million for property, $60 million for workers’ compensation, and $5 million for umbrella. In addition the Company also had “clash coverage” in effect for 2013 for a limit of $5 million in excess of $5 million which applies to the aggregate liability for liability losses from multiple insureds involved in the same occurrence.

Tower’s 2013 quota share reinsurance program ceded 40.0% of the homeowners business written by the companies obtained in the OBPL transaction in the north east. This coverage had a $250 million per occurrence cap. Tower also ceded 30% of the homeowners business written by the other Tower companies in the north east. This coverage had a $230 million occurrence cap. On November 1, 2013, Tower placed a 35% quota share on the same homeowners subject business. This coverage has an occurrence limit of 135% of the ceded earned premium and will expire on May 31, 2014.

On July 1, 2013, Tower ceded 17.5% of its auto liability, other liability and commercial package brokerage business to Arch. This coverage has an occurrence limit of $25 million and a loss ratio cap of 120% of the ceded reinsurance premium. This coverage expired on December 31, 2013, on a run-off basis. On July 1, 2013, Tower also ceded 14.0% of its auto liability, other liability, workers’ compensation and commercial package brokerage business to Hannover. This coverage had occurrence limits of $10 million for PCS events, $5 million for auto liability, other liability and commercial package liability, $2 million for workers’ compensation and a per risk limit of $5 million for commercial package property, and a loss ratio cap of 110%. This coverage expired on December 31, 2013, on a run-off basis.

Effective July 1, 2013, Tower ceded 30% quota share of its workers’ compensation and employer’s liability business to Southport Re. The agreement covered losses occurring on or after July 1, 2013 for policies in force as of June 30, 2013 and policies written or renewed during the term of the agreement, subject to a maximum liability of $1.5 million per loss occurrence and has been accounted for using deposit accounting treatment. Deposit assets of $28.7 million as of December 31, 2013 are reflected in Other assets in the consolidated balance sheet. Effective July 1, 2013, Tower also purchased from Southport Re an Aggregate Excess of Loss Agreement covering a portion of the losses incurred by Tower on its workers’ compensation and employer’s liability business between January 1, 2011 and May 31, 2013, but paid by on or after June 1, 2013. The coverage was provided in three layers. Each layer provided coverage for varying percentages of losses per underwriting period, not to exceed a specified percentage of the earned premium on the subject business through May 31, 2013, up to caps applicable to each of the layers. The Southport Quota Share and Southport Re ADCs were terminated on February 14, 2014, after determining that such reinsurance agreements were no longer necessary as of result of Tower’s recent rating agency downgrades. In 2014, the company will record a gain of approximately $6.4 million resulting from the terminations.

The Company also purchases property catastrophe reinsurance on an excess of loss basis above a specified retention to protect itself from an accumulation of losses resulting from a catastrophic event. At the July 1, 2013 renewal of its property catastrophe program, the Company maintained a retention of $75 million per catastrophe, had 100% catastrophe protection for the next $925 million of loss above the $75 million.

In 2013 Tower purchased an Original Insured Market Loss Warranty basis, whereby the Company can recover up to the limit of the contract for its ultimate net loss arising from the windstorm peril in the Northeast in an event where the insured market loss exceeds a specified threshold.

 

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Table of Contents

Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

On January 3, 2014, concurrently with the execution of the ACP Re Merger Agreement, Tower had entered into two Cut-Through Reinsurance Agreements, pursuant to which a subsidiary of AmTrust and a subsidiary of NGHC agreed to 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 AmTrust, a significant majority 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 received a 20% ceding commission from AmTrust or NGHC on all Tower premiums that are subject to the Cut-Through Reinsurance Agreements.

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

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

At the July 1, 2012 renewal of its property catastrophe program, the Company maintained a retention of $75 million per catastrophe, had 100% catastrophe protection for the next $75 million of loss above the $75 million, 70% catastrophe protection for the next $75 million of loss over $150 million and 100% catastrophe protection for the next $700 million of loss in excess of $225 million.

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

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

The Company maintains funds held liabilities under the liability quota share reinsurance agreements written in 2010 and prior years and is required to credit interest to the reinsurers with annual effective yields ranging from 2.5% to 4.0% on the monthly balance in the funds held liability accounts. The amounts credited for 2012, 2011 and 2010 were $3.9 million, $3.6 million and $2.7 million, respectively, and have been recorded as interest expense. The funds held under reinsurance agreements liability increased from $98.1 million as of December 31, 2012 to $222.1 million as of December 31, 2013 as a result of reinsurance treaties executed in the third and fourth quarters of 2013.

The Reciprocal Exchanges are not party to the reinsurance agreements discussed above, except for the homeowners quota share treaty whereby in 2013 they ceded 40.0% of homeowners business written. The Reciprocal Exchanges were covered under this treaty in 2012, 2011 and 2010. The Reciprocal Exchanges are also protected under a property catastrophe reinsurance cover placed on an excess of loss basis. In 2012, 2011 and 2010, this coverage was for 100% of $150 million in excess of a $10 million retention and in 2013 it was for $170 million in excess of $10 million.

Impact of Reinsurance on Premiums

The table below shows direct, assumed and ceded premiums for the years ended December 31, 2013, 2012 and 2011:

 

($ in thousands)    Direct     Assumed     Ceded     Net  

2013

        

Premiums written

   $ 1,606,249     $ 121,411     $ 495,045     $ 1,232,615  

Change in unearned premiums

     111,252       187,520       18,472       280,300  

Premiums earned

   $ 1,717,501     $ 308,931     $ 513,517     $ 1,512,915  

2012

        

Premiums written

   $ 1,755,157     $ 215,915     $ 231,691     $ 1,739,381  

Change in unearned premiums

     3,969       (31,370     (9,884     (17,517

Premiums earned

   $ 1,759,126     $ 184,545     $ 221,807     $ 1,721,864  

2011

        

Premiums written

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

Change in unearned premiums

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

Premiums earned

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

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

Reinsurance Balances

As of December 31, 2013 and 2012, the Company had $440.4 million and $495.9 million, respectively, of reinsurance recoverables and ceded unearned premiums with reinsurers rated A- or higher by A.M. Best. These represented 53.0% and 91.7%, respectively, of the Company’s total reinsurance recoverables as of those dates. As of December 31, 2013 and 2012, the largest reinsurance recoverable balance with any one reinsurer was approximately 364.2% and 8.6% of the Company’s shareholders’ equity. The largest reinsurance recoverable balance as of December 31, 2013 was due from Southport Re, of which 96.1% was collateralized or in a funds withheld account.

The Company did not record any modifications of its reinsurance recoverables on paid or unpaid losses in the years ended December 31, 2013, 2012 or 2011. The Company recorded no allowance for credit losses on its reinsurance recoverables on paid or unpaid losses as of December 31, 2013 or 2012. The Company did not consider that any of its undisputed reinsurance recoverables on paid or unpaid losses as of years ended December 31, 2013 and 2012 to be past due. As discussed in “Note 17 – Contingencies”, certain reinsurance agreements are subject to legal proceedings.

Under certain reinsurance agreements, collateral and letters of credit (“collateral”) are held to secure performance of reinsurers in meeting their obligations. The amount of such collateral was $540.7 million and $189.6 million at December 31, 2013 and 2012, respectively. The collateral we hold does not apply to our entire outstanding reinsurance recoverable. Rather, collateral is provided on an individual basis. For each individual reinsurer, the collateral held may exceed or fall below the total outstanding recoverable from that individual reinsurer.

Ceding Commission Revenue

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

The estimated ultimate loss ratios are the Company’s best estimate based on facts and circumstances known at the end of each period that losses are estimated. The estimation process is complex and involves the use of informed estimates, judgments and actuarial methodologies relative to future claims severity and frequency, the length of time for losses to develop to their ultimate level, possible changes in law and other external factors. The same uncertainties associated with estimating loss and loss adjustment expense reserves affect the estimates of ceding commissions earned. The Company monitors and adjusts the ultimate loss ratio on a quarterly basis to determine the effect on the commission rate and ceding commissions earned. The decrease in estimated ceding commission income relating to prior years recorded in 2013, 2012 and 2011 was $9.8 million, $4.2 million and $0.1 million, respectively.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

Note 10—Loss and Loss Adjustment Expense

The components of the liability for loss and LAE expenses and related reinsurance recoverables for the years ended December 31, 2013 and 2012 are as follows:

 

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

December 31, 2013

                 

Case-basis reserves

   $ 936,751      $ 290,080      $ 63,198      $ 5,945      $ 999,949      $ 296,025  

IBNR reserves

     1,037,220        267,377        44,116        7,458        1,081,336        274,835  

Recoverable on paid losses

     -         66,974        -         1,989        -         68,963  

Total, December 31, 2013

   $ 1,973,971      $ 624,431      $ 107,314      $ 15,392      $ 2,081,285      $ 639,823  

December 31, 2012

                 

Case-basis reserves

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

IBNR reserves

     846,477        327,157        72,326        42,229        918,803        369,386  

Recoverable on paid losses

     -         16,927        -         682        -         17,609  

Total, December 31, 2012

   $ 1,759,888      $ 423,995      $ 135,791      $ 53,071      $ 1,895,679      $ 477,066  

The following tables provide a reconciliation of the beginning and ending consolidated balances for unpaid losses and LAE for the years ended December 31, 2013, 2012 and 2011:

 

     Year Ended December 31,  
     2013     2012  
($ in thousands)    Tower     Reciprocal
Exchanges
    Total     Tower     Reciprocal
Exchanges
    Total  

Balance at January 1,

   $ 1,759,888     $ 135,791     $ 1,895,679     $ 1,495,839     $ 136,274     $ 1,632,113  

Less reinsurance recoverables on unpaid losses

     (407,068     (52,389     (459,457     (280,968     (11,253     (292,221
     1,352,820       83,402       1,436,222       1,214,871       125,021       1,339,892  

Net reserves, at fair value, of acquired entities

     166,868       -        166,868       -        -        -   

Reduction in net reserves for the Southport Re agreements (i)

     (306,833     -        (306,833     -        -        -   

Incurred related to:

            

Current year

     871,767       109,946       981,713       1,066,411       118,099       1,184,510  

Prior years unfavorable/(favorable) development

     533,038       5,083       538,121       88,129       (8,881     79,248  

Total incurred

     1,404,805       115,029       1,519,834       1,154,540       109,218       1,263,758  

Paid related to:

            

Current year

     502,791       73,771       576,562       431,437       98,682       530,119  

Prior years

     696,365       32,739       729,104       585,154       52,155       637,309  

Total paid

     1,199,156       106,510       1,305,666       1,016,591       150,837       1,167,428  

Net balance at end of period

     1,418,504       91,921       1,510,425       1,352,820       83,402       1,436,222  

Add reinsurance recoverables on unpaid losses

     555,468       15,392       570,860       407,068       52,389       459,457  

Balance at December 31,

   $     1,973,972     $     107,313     $     2,081,285     $     1,759,888     $     135,791     $     1,895,679  

(i) In the third quarter of 2013, Tower executed the Southport Re ADCs (see “Note 1 - Nature of the Business” for further description). The Southport Re ADCs resulted in a direct reduction to net loss reserves. A deferred gain of $12.5 million was recorded on the Southport Re ADCs and is reported in Other Liabilities. In addition, Tower executed the Southport Re Quota Share in the third quarter of 2013. This treaty is accounted for using deposit accounting and reduced the net reserves by $7.2 million.

 

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

Balance at January 1,

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

Less reinsurance recoverables on unpaid losses

     (265,592     (11,384     (276,976
     1,173,514       159,931       1,333,445  

Net reserves, at fair value, of acquired entities

     -        -        -   

Incurred related to:

      

Current year

     933,791       142,254       1,076,045  

Prior years unfavorable/(favorable) development

     38,776       (37,835     941  

Total incurred

     972,567       104,419       1,076,986  

Paid related to:

      

Current year

     337,268       59,078       396,346  

Prior years

     593,942       80,251       674,193  

Total paid

     931,210       139,329       1,070,539  

Net balance at end of period

     1,214,871       125,021       1,339,892  

Add reinsurance recoverables on unpaid losses

     280,968       11,253       292,221  

Balance at December 31,

   $ 1,495,839     $ 136,274     $ 1,632,113  

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

Incurred losses and LAE for the year ended December 31, 2013 attributable to insured events of prior years increased by $538.1 million. Excluding the Reciprocal Exchanges the incurred losses and LAE increased by $533.0 million.

The consolidated net loss ratio, which includes the Reciprocal Exchanges, was 100.5% and 73.4% for the years ended December 31, 2013 and 2012, respectively. Excluding the Reciprocal Exchanges, the net loss ratio was 103.9% and 74.1% for the years ended December 31, 2013 and 2012, respectively. The Reciprocal Exchanges’ net loss ratio was 71.3% and 66.7% for the years ended December 31, 2013 and 2012, respectively.

Excluding the Reciprocal Exchanges, there was a reserve increase of $533.0 million for the year ended December 31, 2013 comprised of favorable development of $1.4 million in Personal Insurance, favorable development of $5.4 million in Assumed Reinsurance segment and adverse development of $539.8 million in Commercial Insurance.

Prior year development is based upon numerous estimates by line of business and accident year. No additional premiums or return premiums have been accrued as a result of the prior year effects, although we recorded changes in ceding commissions on reinsurance treaties of $9.8 million for which the ceding commissions depend in part on loss experience. The Company’s management continually monitors claims activity to assess the appropriateness of carried case and incurred but not reported (“IBNR”) reserves, giving consideration to Company and industry trends.

Incurred losses and LAE for the years ended December 31, 2013 and 2012 included reductions in loss and loss expense reserves pertaining to the amortization of the reserve risk premium on loss reserves recorded in connection with the Company’s acquisitions in prior years. Excluding the Reciprocal Exchanges these reductions in loss reserves were $19.1 million and $7.2 million, respectively, for 2013 and 2012. The Reciprocal Exchanges had reductions in loss reserves of nil for 2013 and $2.5 million for 2012.

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

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 and Automobile Physical Damage. The casualty lines include Homeowners-liability, Commercial Multi-peril Liability, Other Liability, Workers’ Compensation, Commercial Automobile Liability, and Personal

 

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Table of Contents

Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

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.

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

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

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

For claims that are defended by in-house attorneys, we 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 the ratio of ULAE payments to 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.

Note 11—Shareholders’ Equity

Shares of Common Stock Issued

As previously discussed in “Note 3 – Canopius Merger Transaction”, the Canopius Merger Transaction was accounted for as a reverse acquisition with TGI treated as the accounting acquirer. Accordingly, Tower’s historical common stock balance immediately prior to the Merger is the historical common stock of TGI adjusted for the number of shares issued in the Canopius Merger Transaction by the Company to TGI shareholders (i.e., TGI’s outstanding shares immediately prior to the Canopius Merger Transaction multiplied by the conversion ratio of 1.1330).

Canopius Bermuda had 14,025,737 outstanding common shares outstanding on March 13, 2013 which were sold by Canopius Group to third-party investors in connection with the Canopius Merger Transaction.

For the years ended December 31, 2013 and 2012, 2,674 and no new common shares, respectively, were issued as the result of employee stock option exercises and 242,626 and 422,176 new common shares, for the same periods, respectively, were issued as the result of restricted stock grants.

For the years ended December 31, 2013 and 2012, 345,946 and 117,377 shares, respectively, of common stock were purchased from employees in connection with the vesting of restricted stock issued under the 2008 Long Term Equity Compensation Plan (the “Plan”). The shares were withheld at the direction of employees as permitted under the Plan in order to pay the expected

 

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Table of Contents

Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

amount of tax liability owed by the employees from the vesting of those shares. In addition, for the years ended December 31, 2013 and 2012, 57,080 and 28,513 shares, respectively, of common stock were surrendered as a result of restricted stock forfeitures.

In connection with the Canopius Merger Transaction, all Treasury shares held by TGI as of the effective date of the Canopius Merger Transaction were cancelled. There were 55,471 Treasury shares of the Company held at December 31, 2013.

Share 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 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.

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 2013 no shares of common stock were purchased under this program.

Dividends Declared

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.

The Company will not resume paying dividends in the near future even if the necessary financial conditions are met and if sufficient cash is available for distribution.

Note 12—Accumulated Other Comprehensive Income

The following table provides a summary of changes in accumulated other comprehensive income, by component, for year ended December 31, 2013, with all amounts reflected net of income taxes and noncontrolling interest:

 

($ in thousands)    Unrealized
gains (losses)
on available for
sale securities
    Gains
(losses) on
cash flow
hedges
    Cumulative
translation
adjustments
    Total  

Balance at December 31, 2012

   $ 87,412     $ (5,860   $ 1,204     $ 82,756  

Other comprehensive income before reclassifications, net of tax

     (80,046     (1,496     (1,204     (82,746

Amounts reclassified from accumulated other comprehensive income, net of tax

     (22,894     3,377        -       (19,517

Net current period other comprehensive income

     (102,940     1,881        (1,204     (102,263

Balance at December 31, 2013

   $ (15,528   $ (3,979   $ -     $ (19,507

The following provides a summary of the items that have been reclassified from accumulated other comprehensive income to net income in their entirety during the year ended December 31, 2013, including the line item on the consolidated statement of operations on which the impact is reflected. Unrealized gains (losses) on available for sale securities are reclassified from accumulated other comprehensive income when a security is sold or when a non-credit impairment is recorded. Gains (losses) on cash flow hedges are reclassified from accumulated other comprehensive income when the related hedged item (subordinated debentures floating rate interest payments) are recorded in the statement of operations.

 

($ in thousands)
Accumulated other comprehensive income components    Amounts reclassified
from accumulated other
comprehensive income
    Affected line item in the consolidated statement of operations

Unrealized gains (losses) on available for sale securities

   $ (22,894   Other net realized investment gains
     -      Income tax expense
  

 

 

   
   $ (22,894   Total net of income taxes
  

 

 

   

Gains (losses) on cash flow hedges interest rate swaps

   $ 3,377     Interest expense
     -      Income tax expense
  

 

 

   
   $ 3,377     Total net of income taxes
  

 

 

   

 

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Table of Contents

Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

Note 13—Debt

The Company’s borrowings consisted of the following at December 31, 2013 and 2012:

 

     December 31, 2013      December 31, 2012  
($ in thousands)    Carrying
Value
    

Fair

Value

     Carrying
Value
    

Fair

Value

 

Credit facility

   $ -      $ -      $ 70,000      $ 70,000  

Convertible senior notes

     147,712        129,525        144,673        152,063  

Subordinated debentures

     235,058        114,900        235,058        232,678  

Total

   $         382,770      $         244,425      $         449,731      $         454,741  

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

Aggregate Scheduled Maturities and Interest Expense

Aggregate scheduled maturities of the Company’s borrowings at December 31, 2013 are:

 

($ in thousands)        

2014

   $ 150,000 (a) 

2033

     20,620  

2034

     25,775  

2035

     13,403  

2036

     123,713  

2037

     51,547  
     $ 385,058  

(a) Amount reflected in balance sheet for convertible senior notes is net of unamortized original issue discount of $2.3 million

Total interest expense incurred, including interest expense on the funds held liabilities disclosed in “Note 9 – Reinsurance”, was $33.6 million, $32.6 million and $34.3 million for the years ended December 31, 2013, 2012 and 2011, respectively.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

Subordinated Debentures

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

 

($ in millions)

Issue Date

   Issuer    Maturity Date   

Early

Redemption

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

May 2003

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

September 2003

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

May 2004

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

December 2004

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

December 2004

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

March 2006

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

January 2007

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

September 2007

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

December 2006

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

December 2006

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

Total

                       $ 7.1       $ 235.1   

Under the terms for all of the subordinated debentures, an event of default may occur upon:

 

   

non-payment of interest on the subordinated debentures, unless such non-payment is due to a valid extension of an interest payment period;

 

   

non-payment of all or any part of the principal of the subordinated debentures;

 

   

our failure to comply with the covenants or other provisions of the indentures or the subordinated debentures;

 

   

bankruptcy or liquidation of us or the trusts; or

 

   

If an event of default occurs and is continuing, the entire principal and the interest accrued on the affected subordinated debentures and junior subordinated debentures may be declared to be due and payable immediately.

Interest Rate Swaps

In October 2010, the Company entered into interest rate swap contracts (the “Swaps”) with $190 million notional value to manage interest costs and cash flows associated with the floating rate subordinated debentures. The Swaps have terms of five years. The majority of the Swaps is forward starting and become effective when the respective subordinated debentures change from fixed to floating rates and convert the subordinated debentures to fixed rates ranging from 5.1% to 5.9%. As of December 31, 2013 and 2012, the Swaps had a fair value of $6.1 million and $9.0 million, respectively, in a liability position and are reported in Other Liabilities.

The Company has designated and accounts for the Swaps as cash flow hedges. The Swaps are considered to have no ineffectiveness and changes in their fair values will be recorded in Accumulated Other Comprehensive Income (“AOCI”), net of tax. For the years ended December 31, 2013, 2012 and 2011, $3.4 million, $1.6 million and $0.4 million, respectively, was reclassified from AOCI to interest expense for the effects of the hedges. As of December 31, 2013 and 2012, the Company had collateral on deposit with the counterparty amounting to $6.3 million and $9.1 million, respectively, pursuant to its Credit Support Annex.

Credit Facility

On April 3, 2013, an increase in borrowing capacity up to $220 million became effective pursuant to the second amendment to the credit agreement and consent by and between TGI and Bank of America, N.A., as administrative agent for the lenders party to the credit agreement, dated as of November 26, 2012, and the limited waiver and amendment agreement, dated as of March 3, 2013. The increase in the Credit Facility was negotiated in the event that holders of the convertible senior notes put their bonds to Tower as a result of the Canopius Merger Transaction. This put option expired on April 26, 2013. This second amendment and consent also included (i) TGIL as a guarantor of TGI’s obligations under the credit facility and (ii) consent by the lenders to the change in control triggered by the completion of the Canopius Merger Transaction. The maturity date and borrowing fees were not changed in this amendment.

The credit facility contained customary covenants for facilities of this type, including restrictions on indebtedness and liens, limitations on mergers, dividends and the sale of assets, and requirements to maintain certain consolidated net worth, debt to capitalization ratios, minimum risk-based capital and minimum statutory surplus. The credit facility also provided for customary events of default, including failure to pay principal when due, failure to pay interest or fees within three days after becoming due, failure to comply with covenants, any representation or warranty made by TGI or the Company as a guarantor being false in any material respect, default under certain other indebtedness, certain insolvency or receivership events affecting the TGI or the Company as guarantor and its material subsidiaries, the occurrence of certain material judgments, or a change in control of the Company, and upon an event of default, the administrative agent (subject to the consent of the requisite percentage of the lenders) was able to immediately terminate the obligations to make loans and to issue letters of credit, declare the Company’s obligations

 

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Table of Contents

Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

under the credit facility to become immediately due and payable, and require the Company to deposit in a collateral account cash collateral with a value equal to the then outstanding amount of the aggregate face amount of any outstanding letters of credit.

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.

Convertible Senior Notes

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

The adjusted conversion rate at December 31, 2013 is 41.4269 shares of common stock per $1,000 principal amount of the Notes (equivalent to a conversion price of $24.14 per share), subject to further adjustment upon the occurrence of certain events, including the following: if Tower issues shares of common stock as a dividend or distribution on shares of the common stock, or if Tower effects a share split or share combination; if Tower issues to all or substantially all holders of common stock any rights, options or warrants entitling them, for a period of not more than 45 calendar days after the announcement date of such issuance, to subscribe for or purchase shares of the common stock at a price per share that is less than the average of the last reported sales price of the common stock for the ten consecutive trading day period ending on the date of announcement of such issuance; if Tower distributes shares of its capital stock, other indebtedness, other assets or property of Tower or rights, options or warrants to acquire capital stock or other securities of Tower, to all or substantially all holders of capital stock; if any cash dividend or distribution is made to all or substantially all holders of the common stock, other than a regular quarterly cash dividend that does not exceed $0.110 per share; if Tower makes a payment in respect of a tender offer or exchange offer for common stock, and the cash and value of any other consideration included in the payment per share of common stock exceeds the last reported sale price of the common stock on the trading day next succeeding the last day on which the tenders or exchange may be made.

The proceeds from the issuance of the Notes were allocated to the liability component and the embedded conversion option, or equity component. The equity component was reported as an adjustment to paid-in-capital, net of tax, and is reflected as an original issue discount (“OID”). The OID of $11.5 million and $5.0 million of deferred origination costs relating to the liability component are being amortized into interest expense over the term of the Notes. After considering the contractual interest payments and amortization of the original issue discount, the Notes’ effective interest rate is 7.2%. Transaction costs of $0.4 million associated with the equity component were netted with the equity component in paid-in-capital. Interest expense, including amortization of deferred origination costs, recognized on the Notes was $11.9 million for the year ended December 31, 2013.

The following table shows the amounts recorded for the Notes as of December 31, 2013 and 2012:

 

     December 31,  
($ in thousands)    2013     2012  

Liability component

    

Outstanding principal

   $ 150,000     $ 150,000  

Unamortized OID

     (2,288     (5,327

Liability component

     147,712       144,673  

Equity component, net of tax

   $ 7,469     $ 7,469  

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

Convertible Senior Notes Hedge and Warrant Transactions

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

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

In March 2013, as a result of the Canopius Merger Transaction, the Company terminated the Note Hedges and Warrants. The Company received $2.4 million and paid $1.0 million to terminate the Note Hedges and Warrants, respectively. The effects of the terminations and an associated tax adjustment of $0.8 million were recorded directly to paid-in-capital in shareholders’ equity.

Note 14—Stock Based Compensation

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

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

The 2008 LTEP provides for the granting of non-qualified stock options, incentive stock options (within the meaning of Section 422 of the Internal Revenue Code), stock appreciation rights (“SARs”), restricted stock and restricted stock unit awards, performance shares and other cash or share-based awards. The maximum amount of share-based awards authorized is 2,325,446 of which 73,441 are available for future grants as of December 31, 2013.

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

The Compensation Committee of the Board of Directors has established, beginning in 2013 a new Long Term Incentive Plan (the “2013 LTIP”), to replace the Company’s existing 2008 Long Term Equity Compensation Plan. The 2013 LTIP was approved by the shareholders in May 2013. The maximum amount of share-based awards authorized is 2,150,000 of which 2,147,531 are available for future grants as of December 31, 2013.

Restricted Stock

The following table provides an analysis of restricted stock activity for the years ended December 31, 2013, 2012 and 2011 (historical share counts and fair values have been adjusted for the 1.1330 share conversion ratio, as discussed more fully in “Note 3 – Canopius Merger Transaction”):

 

     Year Ended December 31,  
     2013      2012      2011  
      Number of
Shares
    Weighted
Average
Grant Date
Fair Value
     Number of
Shares
    Weighted
Average
Grant Date
Fair Value
     Number of
Shares
    Weighted
Average
Grant Date
Fair Value
 

Outstanding, January 1

     1,015,902     $ 20.38        1,120,090     $ 20.69        670,366     $ 20.39  

Granted

     242,626       18.09        422,176       19.77        741,185       21.01  

Vested

     (965,862     20.38        (497,851     20.94        (270,115     20.79  

Forfeitures

     (57,080     17.22        (28,513     20.69        (21,346     20.84  

Outstanding, December 31,

     235,586     $ 17.98        1,015,902     $ 20.38        1,120,090     $ 20.69  

On March 13, 2013, 525,548 shares vested as a result of the Canopius Merger Transaction.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

Stock Options

The following table provides an analysis of stock option activity for the years ended December 31, 2013, 2012 and 2011 (historical share counts and fair values have been adjusted for the 1.1330 share conversion ratio, as discussed more fully in “Note 3 – Canopius Merger Transaction”). As of December 31, 2013, the exercise price for all stock options exceeds the December 31, 2013 common share price.

 

     Year Ended December 31,  
     2013      2012      2011  
      Number of
Shares
    Average
Exercise
Price
     Number of
Shares
     Average
Exercise
Price
     Number of
Shares
    Average
Exercise
Price
 

Outstanding, January 1

     969,307     $ 17.78        969,307      $ 17.78        1,039,127     $ 17.66  

Exercised

     (2,674     16.48        -         -         (39,215     9.48  

Forfeitures and expirations

     (10,829     20.19        -         -         (30,605     24.35  

Outstanding, December 31

     955,804     $ 17.75        969,307      $ 17.78        969,307     $ 17.78  

Exercisable, December 31

     955,804     $ 17.75        969,307      $ 17.78        969,307     $ 17.78  

All options outstanding as of December 31, 2013 are fully exercisable as shown on the following table:

 

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

$10.01 - $20.00

     769,833        2.6      $ 16.32        769,833      $ 16.32  

$20.01 - $30.00

     183,857        4.1        23.60        183,857        23.60  

$30.01 - $40.00

     2,114        1.1        30.35        2,114        30.35  

Total Options

     955,804        2.9      $ 17.75        955,804      $ 17.75  

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

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

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

Stock Based Compensation Expense

The following table provides an analysis of stock based compensation expense for the years ended December 31, 2013, 2012 and 2011:

 

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

Restricted stock

        

Expense, net of tax

   $ 8,577      $ 6,043      $ 6,126  

Value of shares vested

     21,278        9,485        5,622  

Value of unvested shares

     796        15,967        19,940  

Stock options

        

Expense, net of tax

     -         -         105  

Intrinsic value of outstanding options

     -         1,149        1,150  

Intrinsic value of vested outstanding options

     -         1,149        1,150  

Unrecognized compensation expense

        

Unvested restricted stock, net of tax

     851         8,262        9,617  

Weighted average years expense will be recognized

     3.2        2.1        2.3  

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

Note 15—Income Taxes

Under current Bermuda Law the Company is not required to pay any taxes on Bermuda based income or capital gains. The Company has received an undertaking from the Minister of Finance in Bermuda that in the event of such taxes being imposed, the Company will be exempted from taxation until the year 2035 pursuant to the Bermuda Exempted Undertakings Tax Protection Act of 1966. The Company’s United States-based subsidiaries are subject to federal, state and local taxes, as applicable, on income and capital gains earned by those subsidiaries.

The Company and TRL, its Bermuda reinsurance subsidiary, are deemed to have permanent establishments in Bermuda. The Bermuda companies have not and do not expect to be engaged in the conduct of a trade or business in the U.S. All transactions between Tower’s U.S.-based subsidiaries and the Bermuda companies are subject to transfer pricing rules. The Company has executed certain reinsurance treaties and service agreements between its U.S.-based subsidiaries and TRL and management believes these arrangements to be conducted at current market rates and in accordance with transfer pricing rules.

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

The provision for Federal, state and local income taxes consist of the following components for the years ended December 31, 2013, 2012 and 2011:

 

     Year ended December 31,  
     2013      2012     2011  
($ in thousands)    Tower      Reciprocal
Exchanges
    Total      Tower     Reciprocal
Exchanges
    Total     Tower     Reciprocal
Exchanges
     Total  

Current Federal income tax expense (benefit)

   $ 3,000      $ 132     $ 3,132      $ (17,400   $ 593     $ (16,807   $ 6,951     $ 1,510      $ 8,461  

Current state income tax expense (benefit)

     553        -        553        200       -        200       (257     -         (257

Deferred Federal and state income tax (benefit)

     5,285        (539     4,747        (9,872     (2,620     (12,492     4,175       1,672        5,847  

Provision for income taxes

   $ 8,838      $ (407   $ 8,431      $ (27,072   $ (2,027   $ (29,099   $ 10,869     $ 3,182      $ 14,051  

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

 

     December 31,  
     2013     2012  
($ in thousands)    Tower     Reciprocal
Exchanges
    Total     Tower     Reciprocal
Exchanges
    Total  

Deferred tax assets:

            

Claims reserve discount

   $ 26,994     $ 1,554     $ 28,548     $ 44,528     $ 1,747     $ 46,275  

Unearned premium

     22,614       5,819       28,433        55,134       5,928       61,062  

Equity compensation plans

     3,627        -        3,627        6,072       -        6,072  

Net operating loss carryforwards

     161,884        11,175       173,059        32,584       4,830       37,414  

Convertible senior note and note hedge OID

     -        -        -        618       -        618  

AMT credits

     2,008       611       2,619       1,846       508       2,354  

Fair value of interest rate swap

     2,123       -        2,123       3,155       -        3,155  

Bad debt reserves

     5,793        265       6,058        5,793       22       5,815  

Deferred rent

     1,977       -        1,977       1,905       -        1,905  

Accrued interest from foreign affiliate

     2,199       -        2,199       3,710       -        3,710  

Adjustment on Retroactive Reinsurance

     42,882       -        42,882       -        -        -   

Depreciation and amortization

     18,574        -        18,574        -        -        -   

Other

     2,052        1,754       3,806        -        1,008       1,008  

Total gross deferred tax assets

     292,727       21,178       313,905       155,345       14,043       169,388  

Less: valuation allowance

     275,332       17,593       292,925       2,258       4,726       6,984  

Total deferred tax assets

     17,395       3,585       20,980        153,087       9,317       162,404  

Deferred tax liabilities:

            

Deferred acquisition costs net of deferred ceding commission revenue

     11,010        3,319       14,329       59,387       3,864       63,251  

Convertible senior note and note hedge OID

     2,163       -        2,163       -        -        -   

Depreciation and amortization

     -        2,155       2,155       46,025       2,357       48,382  

Net unrealized appreciation of securities

     12,030       967       12,997       46,953       5,791       52,744  

Surplus notes

     2,519       16,325       18,844       1,800       17,024       18,824  

Unconsolidated affiliate

     -        -        -        3,843       -        3,843  

Other

     -       -        -       123       -        123  

Total deferred tax liabilities

     27,722       22,766       50,488        158,131       29,036       187,167  

Net deferred income tax asset (liability)

   $ (10,327   $ (19,181   $ (29,508   $ (5,044   $ (19,719   $ (24,763

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

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

During the year ended December 31, 2013, Tower’s U.S. taxed subsidiaries (excluding the Reciprocal Exchanges) recognized pre-tax losses of approximately $901.4 million. This resulted in $161.9 million of net operating loss carryforwards in ($161.2 million federal NOL and $0.7 million state NOL) the deferred tax inventory and a net deferred tax asset, before any valuation allowance, of $265.0 million (excluding the Reciprocal Exchanges) as of December 31, 2013. Including the Reciprocal Exchanges, the net deferred tax asset, before any valuation allowance, was $263.4 million.

At December 31, 2013, a full valuation allowance was recorded against the deferred tax assets. For the year ended December 31, 2013, $240.6 million of the valuation allowance was recorded in income tax expense (benefit) in the statement of operations and $32.5 million was recorded in other comprehensive income as a direct charge to shareholder’s equity ($33.7 million as a component of accumulated other comprehensive income and $(1.2) million as a component of additional paid in capital).

Management in its judgment concluded that a full valuation allowance was required for Tower’s U.S. taxed subsidiaries after its consideration of the cumulative three-year pre-tax loss in its U.S. taxed subsidiaries resulting from certain second quarter 2013 events and the 2012 pre-tax loss of $61.3 million. In the second quarter of 2013, the following items contributed significantly to pre-tax losses in Tower’s U.S. taxed subsidiaries: (i) $325.6 million of prior year reserve increases were recorded, of which $149.7 million related to Tower’s U.S. taxed subsidiaries, and (ii) a $214.0 million goodwill impairment charge, of which $185.9 million related to Tower’s U.S. taxed subsidiaries. Management believes that the negative evidence associated with the realizability of its net deferred tax asset, including the cumulative three-year pre-tax loss, the prior year adverse reserve development recorded in 2012 and 2013, and the effects of Hurricane Irene in 2011 and Superstorm Sandy in 2012 outweighed the positive evidence that the deferred tax assets, including the net operating loss carryforward, would be realized, and recorded the full valuation allowance. As of December 31, 2013, management continues to believe the negative evidence outweighs the positive evidence.

The United States also imposes an excise tax on insurance and reinsurance premiums paid to non-U.S. insurers or reinsurers with respect to risks located in the United States. The rates of tax, unless reduced by an applicable U.S. tax treaty, are four percent for non-life insurance premiums and one percent for life insurance and all reinsurance premiums. The Company incurs federal excise taxes on certain of its reinsurance transactions, including amounts ceded through intercompany transactions. Tower incurred $8.3 million of federal excise tax in 2013.

Section 382 of the Internal Revenue Code (“Section 382”) imposes annual limitations on the ability of a corporation to utilize its net operating tax loss carryforwards (“NOLs”) if the corporation experiences an “ownership change” as defined in Section 382. We will perform a Section 382 limitation calculation to determine whether any changes in ownership during 2013, including changes in ownership resulting from the merger with Canopius, caused an “ownership change” that would result in an annual limitation under Section 382. As of December 31, 2013, the Tower NOL totaled $460.6 million, and the NOLs will expire in years 2019 through 2032.

Preserver Group, Inc. (“PGI”), acquired by the Company in 2007, and CastlePoint, acquired by the Company in 2009, had NOLs at the time of the acquisitions of $43.7 million and $17.4 million, respectively. As a result of the acquisitions, those NOLs of PGI and CastlePoint are subject to annual limitations of $2.8 million and $11.1 million, respectively. Any unused annual limitation may be carried over to later years. The PGI and CastlePoint NOLs will expire in years 2025 through 2029.

Additionally, Tower and the Reciprocal Exchanges have an AMT credit of $2.6 million that can be carried over indefinitely.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

As of December 31, 2013 and 2012, the Company had no material uncertain tax positions and no adjustments to liabilities or operations were required.

The Internal Revenue Service performed an audit of The Company’s 2006 and 2007 tax years and closed these audits in 2011 with no changes. Additionally, in 2011 the IRS performed an audit of CastlePoint and subsidiary’s federal income tax return for the period ended February 2009 and closed this audit with no changes. CastlePoint’s federal excise tax for the 2009 and 2010 tax years were examined by the IRS in 2012. This audit was closed in 2012 with no changes. One of the Reciprocal Exchanges was under an IRS excise tax examination for the 2011 tax year. This audit closed in 2013 with no changes. The 2008 and 2009 years closed by statute. At the end of March 2014, the IRS notified the Company that its 2010, 2011 and 2012 tax returns were selected for examination.

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

 

     Year Ended December 31,  
     2013     2012     2011  
($ in thousands)    Tower     Reciprocal
Exchanges
    Total     Tower     Reciprocal
Exchanges
    Total     Tower     Reciprocal
Exchanges
    Total  

Federal income tax expense at

                  

U.S. statutory rate

   $ (326,239   $ (7,075   $ (333,314   $ (21,458   $ 99     $ (21,359   $ 19,161     $ 4,820     $ 23,981  

Rate differential on Non U.S. Operations

     10,746       -        10,746       -        -        -        -        -        -   

Tax exempt interest

     (4,476     (397     (4,873     (7,374     (901     (8,275     (6,823     (418     (7,241

State income taxes net of

         -               

Federal benefit

     359       -        359       130       -        130       488       -        488  

Goodwill Impairment

     78,465       -        78,465       -        -        -        -        -        -   

Acquisition related transaction costs

     1,801       -        1,801       2,261       -        2,261       100       -        100  

Prior period adjustment

     1,408       (784     624       (619     (162     (781     207       -        207  

Valuation Allowance

     242,189       7,944       250,133       -        (1,072     (1,072     -        (1,757     (1,757

Other

     4,585       (95     4,490       (12     9       (3     (2,264     537       (1,727

Provision for income taxes

   $ 8,838     $ (407   $ 8,431     $ (27,072   $ (2,027   $ (29,099   $ 10,869     $ 3,182     $ 14,051  

Note 16—Employee Benefit Plans

The Company maintains a defined contribution Employee Pretax Savings Plan (401(k) Plan) for its employees. The Company matches 50% of each participant’s contribution up to 8% of the participant’s eligible contribution. The Company incurred $3.9 million, $3.6 million, and $3.2 million of expense in 2013, 2012 and 2011, respectively, related to the 401(k) Plan.

Supplemental Executive Retirement Plan (“SERP”)

The SERP is a non-qualified defined contribution plan that was established effective as of January 1, 2009 and is intended to enhance retirement benefits for the Company’s most senior executives and certain other key employees. Eligibility to participate in the SERP generally requires three years of prior employment with the Company for Executive Vice Presidents and Senior Vice Presidents and between five and 10 years of prior employment with the Company for other key employees. In 2013, all of the Named Executive Officers (“NEOs”), as well as certain other key executives selected at the discretion of the Compensation Committee, participated in the SERP. Subject to the approval of the Compensation Committee, the Company may make annual contributions to the SERP on behalf of each participant. The SERP is a defined contribution plan and a target benefit level cannot be guaranteed. For all participants, the amount of the annual contribution is presently equal to 5.0% of their annual cash compensation. In general, Company contributions for each participant remain unvested until such participant has completed 10 years of service with the Company, and vest in full upon completion of 10 years of service. However, as a result of the change in control provision as part of the Canopius Merger Transaction in Q1 2013, all previous Company contributions vested at that time. The Compensation Committee has discretion to terminate the SERP at any time or to adjust upward or downward the level of the Company’s contribution each year.

Note 17—Contingencies

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

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

asserted on behalf of a class of persons who purchased Tower stock between May 9, 2011 and August 7, 2013. On October 4, 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

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

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 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.

Leases

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

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

 

($ in thousands)    Operating
Leases
     Capital
Leases
     Total  

2014

   $ 10,463      $ 12,557      $ 23,020  

2015

     10,397        14,823        25,220  

2016

     10,398        3,371        13,769  

2017

     9,142        1,787        10,929  

2018

     8,850        640        9,490  

Thereafter

     26,761        -         26,761  
     $ 76,011      $ 33,178      $ 109,189  

Total rental expense was $10.4 million, $9.7 million and $11.1 million in 2013, 2012 and 2011, respectively.

Assessments

Tower’s insurance subsidiaries are also required to participate in various mandatory insurance facilities or in funding mandatory pools, which are generally designed to provide insurance coverage for consumers who are unable to obtain insurance in the voluntary insurance market. The insurance subsidiaries are subject to assessments in New York, Florida, New Jersey, Georgia, California and other states for various purposes, including the provision of funds necessary to fund the operations of the New York Insurance Department and the New York Property/Casualty Insurance Security Fund, which pays covered claims under certain policies provided by impaired, insolvent or failed insurance companies and various funds administered by the New York Workers’ Compensation Board, which pays covered claims under certain policies provided by impaired, insolvent or failed insurance companies.

The Company paid $4.9 million, $4.8 million and $5.1 million in 2013, 2012 and 2011, respectively, for its proportional share of the operating expenses of the New York Insurance Department. Property casualty insurance company insolvencies or failures may result in additional security fund assessments to the Company at some future date. At this time the Company is unable to estimate the possible amounts, if any, of such assessments. Accordingly, the Company is unable to determine the impact, if any; such assessments may have on financial position or results of operations of the Company. The Company is permitted to assess premium surcharges on workers’ compensation policies that are based on statutorily enacted rates. Actual assessments have resulted in differences to the original estimates based on permitted surcharges of $1.1 million in 2011. The Company estimates its liability for future assessments based on actual written premiums and historical rates and available information. As of December 31, 2013, the liability for the various workers’ compensation funds, which includes amounts assessed on workers’ compensation policies, was $10.3 million. This amount is expected to be paid over an eighteen month period ending June 30, 2015. As of December 31, 2012 the liability for the various workers’ compensation funds was $7.5 million.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

Note 18—Statutory Financial Information and Accounting Policies

United States

For regulatory purposes, the Company’s U.S.-based insurance subsidiaries, excluding the Reciprocal Exchanges, prepare their statutory basis financial statements in accordance with practices prescribed or permitted by the state they are domiciled in (“statutory basis” or “SAP”). The more significant SAP variances from GAAP are as follows:

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

Investments in stocks of subsidiaries are carried as assets on the statutory basis balance sheet. Under GAAP, investments in stocks of subsidiaries are generally consolidated if the investor owns greater than fifty percent or otherwise demonstrates control of the subsidiary.

In preparing its statutory basis financial statements, the Company does not use any prescribed or permitted statutory accounting practices.

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

For the years ended December 31, 2013, 2012 and 2011, the Company’s insurance subsidiaries had SAP net (loss) income of $(402.4) million, $ (42.3) million and $ 52.0 million, respectively. At December 31, 2013 and 2012 the Company’s insurance subsidiaries had reported SAP capital and surplus of $172.9 million and $594.2 million, respectively, as filed with the insurance regulators.

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”).

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

The Company’s U.S.-based insurance subsidiaries paid zero, $10.2 million and $15.0 million in dividends and or return of capital to TGI in 2013, 2012 and 2011, respectively. As of December 31, 2013, none of the Company’s net statutory assets held at the U.S. insurance subsidiaries were available for distribution or advances to Tower (without prior consent from the insurance regulators).

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 three 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.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

Dividends

U.S. state insurance regulations restrict the ability of our insurance subsidiaries to pay dividends to Tower Group International, Ltd. as their ultimate parent (the “Holding Company”). Generally dividends may only be paid out of earned surplus, and the amount of an insurer’s surplus following payment of any dividends must be reasonable in relation to the insurer’s outstanding liabilities and adequate to meet its financial needs. As of December 31, 2013, no dividends may be paid to the Holding Company without the approval of the state regulators or BMA, as appropriate.

Bermuda

CastlePoint Re and TRL are registered as a Class 3 reinsurer under The Insurance Act 1978 (Bermuda), amendments thereto and related regulations (the “Insurance Act”). Under the Insurance Act, CastlePoint Re and TRL are required to prepare Statutory Financial Statements and to file a Statutory Financial Return. The Insurance Act also requires CastlePoint Re and TRL to maintain minimum share capital and surplus, and it has met these requirements as of December 31, 2013.

For Bermuda registered companies, there are some differences between financial statements prepared in accordance with GAAP and those prepared on a Bermuda statutory basis. The more significant Bermuda SAP variances from GAAP are as follows:

 

 

Deferred policy acquisition costs have been fully expensed to income.

 

 

Prepaid expenses and fixed assets have been removed from the statutory balance sheet.

 

 

Investments in fixed-maturity securities are carried at amortized cost. GAAP requires investments in fixed-maturity securities classified as available for sale to be reported at fair value.

 

 

Deferred income taxes, intangible assets and goodwill are not included in the Bermuda statutory capital and surplus balances.

 

 

Investments in stocks of subsidiaries are carried as assets on the statutory basis balance sheet. Under GAAP, investments in stocks of subsidiaries are generally consolidated if the investor owns greater than fifty percent or otherwise demonstrates control of the subsidiary.

CastlePoint Re and TRL are also subject to dividend limitations imposed by Bermuda under the Companies Act 1981 of Bermuda, as amended (the “Companies Act”). As of December 31, 2013, CastlePoint Re and TRL were unable to pay dividends to Tower, without BMA approval.

Bermuda based insurance entities minimum capital and surplus requirements are calculated from a solvency formula prescribed by the BMA. As of December 31, 2013, TRL and CastlePoint Re had capital and surplus that did not meet the minimum capital and surplus requirements of the BMA. Management has discussed the ACP Re Merger Agreement and provided 2014 solvency forecasts to the BMA.

The TRL and CastlePoint Re capital and surplus amounts were $14.4 million and $(37.2) million, respectively. The CastlePoint Re negative surplus includes ($109.7) million of a deferred gain associated with retroactive accounting treatment on an intercompany retroactive reinsurance agreement between CastlePoint Re and TRL. This gain will be recognized as the underlying claims are paid on the losses reinsured by TRL. This deferred gain is eliminated in the preparation of the TGIL consolidated financial statements.

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.

For the year ended December 31, 2013, the Bermuda based insurers had statutory net income (loss) of $ (198.6) million and at December 31, 2013, had statutory surplus of $60.3 million. The statutory capital surplus amounts as of December 31, 2013 include $26.5 million from U.S.-based insurance subsidiaries that are owned by CastlePoint Re.

CastlePoint Re paid $22.0 million, $2.5 million and $20.0 million in dividends and/or return of capital to TGI in 2013, 2012 and 2011, respectively. As of December 31, 2013, none of the Company’s net statutory assets held at its Bermuda based insurance subsidiaries were available for distributions or advances to Tower.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

Reciprocal Exchanges

The Reciprocal Exchanges prepare their statutory basis financial statements in accordance with SAP. The more significant SAP variances from GAAP are consistent with those discussed above for the U.S.-based insurance subsidiaries.

For the years ended December 31, 2013, 2012 and 2011, the Reciprocal Exchanges had combined SAP net income (loss) of $(8.8) million, $7.4 million and $16.5 million, respectively. At December 31, 2013 and 2012 the Reciprocal Exchanges had combined capital and surplus of $81.2 million and $91.4 million, respectively.

The Reciprocal Exchanges are required to maintain minimum capital and surplus. The minimum capital and surplus requirements were determined to be above Company Action Level. As of December 31, 2013 and 2012, the combined Company Action Level capital and surplus requirement for Adirondack was $34.5 million and $38.1 million, respectively. As of December 31, 2013 and 2012, the combined Company Action Level capital and surplus requirement for New Jersey Skylands was $11.2 million and $10.2 million, respectively.

The Reciprocal Exchanges are not owned by the Company, but managed through management agreements. Accordingly, the Reciprocal Exchanges’ net assets are not available to the Company. In addition, no dividends can be paid from the Reciprocal Exchanges to Tower.

Note 19—Fair Value of Financial Instruments

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

Fixed maturity and equity securities: Fair value disclosures for investments are included in “Note 6—Fair Value Measurements.”

Other invested assets: The fair value of securities which are reported under the fair value option are included in “Note 6—Fair Value Measurements.

Premiums receivable and reinsurance recoverable: The carrying values reported in the accompanying balance sheets for these financial instruments approximate their fair values. Premiums receivable and reinsurance recoverable are considered Level 3 pursuant to the fair value hierarchy due to the lack of available observable inputs for their valuation in the market.

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

Reinsurance balances payable and funds held under reinsurance contracts: The carrying value reported in the balance sheet for these financial instruments approximates fair value. Reinsurance balances payable and funds held under reinsurance contracts are considered Level 3 pursuant to the fair value hierarchy due to the lack of available observable inputs for their valuation in the market.

Note 20—Earnings (loss) per Share

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

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

The following table shows the computation of the earnings per share (historical earnings per share amounts have been adjusted for the 1.1330 share conversion ratio in connection with the Canopius Merger Transaction):

 

     Year Ended December 31,  
(in thousands, except per share amounts)    2013     2012     2011  

Numerator

      

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

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

Less: Allocation of income for unvested participating restricted stock

     -        -        (370

Less: Dividends on unvested participating restricted stock

     (262     (686     (679

Net income available to common shareholders - Basic

     (942,878     (34,920     43,386  

Reallocation of income for unvested participating restricted stock

     -        -        (1

Net income (loss) available to common shareholders - Diluted

     (942,878     (34,920     43,385  

Denominator

      

Basic earnings per share denominator

     54,297       42,902       45,226  

Effect of dilutive securities:

     -        -        111  

Diluted earnings per share denominator

     54,297       42,902       45,337  

Earnings (loss) per share attributable to Tower shareholders - Basic

      

Common stock:

      

Distributed earnings

   $ 0.50     $ 0.66     $ 0.61  

Undistributed earnings

     (17.86     (1.47     0.35  

Total - Basic

     (17.37     (0.81     0.96  

Earnings (loss) per share attributable to Tower shareholders - Diluted

   $ (17.37   $ (0.81   $ 0.96  

The computation of diluted earnings (loss) per share excludes outstanding options and other common stock equivalents in periods where inclusion of such potential common stock instruments would be anti-dilutive. For the years ended December 31, 2013, 2012 and 2011, 955,800, zero and 166,700, respectively, options and other common stock equivalents to purchase Tower shares were excluded from the computation of diluted earnings (loss) per share because the exercise price of the options was greater than the average market price.

Note 21—Segment Information

The Personal Insurance segment, which includes the Reciprocal Exchanges and the management companies, reports the management fees earned by Tower from the Reciprocal Exchanges for underwriting, investment management and other services as a reduction to other underwriting expenses. The effects of these management fees between Tower and the Reciprocal Exchanges are eliminated in consolidation to derive consolidated net income. However, the management fee income is reported in net income attributable to Tower Group International, Ltd. and included in basic and diluted earnings (loss) per share.

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

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

Business segments results are as follows:

 

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

Commercial Insurance Segment

      

Revenues

      

Premiums earned

   $ 931,693     $ 1,104,551     $ 1,052,050  

Ceding commission revenue

     30,115       7,702       14,786  

Policy billing fees

     5,637       5,467       4,345  

Total revenues

     967,445       1,117,720       1,071,181  

Expenses

      

Loss and loss adjustment expenses

     1,185,627       859,707       740,754  

Underwriting expenses

     406,908       388,511       352,832  

Total expenses

     1,592,535       1,248,218       1,093,586  

Underwriting profit (loss)

   $ (625,090   $ (130,498   $ (22,405

Assumed Reinsurance Segment

      

Revenues

      

Premiums earned

   $ 116,417     $ 120,015     $ 35,861  

Ceding commission revenue

     -        -        -   

Total revenues

     116,417       120,015       35,861  

Expenses

      

Loss and loss adjustment expenses

     41,474       52,975       17,456  

Underwriting expenses

     57,506       44,124       11,859  

Total expenses

     98,980       97,099       29,315  

Underwriting profit (loss)

   $ 17,437     $ 22,916     $ 6,546   

Personal Insurance Segment

      

Revenues

      

Premiums earned

   $ 464,805     $ 497,298     $ 505,939  

Ceding commission revenue

     51,267       24,633       19,182  

Policy billing fees

     6,662       7,148       6,189  

Total revenues

     522,734       529,079       531,310  

Expenses

      

Loss and loss adjustment expenses

     292,733       351,076       318,775  

Underwriting expenses

     249,779       228,289       218,463  

Total expenses

     542,512       579,365       537,238  

Underwriting profit (loss)

   $ (19,778   $ (50,286   $ (5,928

Tower

   $ 6,083     $ (31,450   $ (11,308

Reciprocal Exchanges

     (25,861     (18,836     5,380  

Total underwriting profit (loss)

   $ (19,778   $ (50,286   $ (5,928

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

The following table reconciles revenue by segment to consolidated revenues:

 

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

Commercial insurance segment

   $ 967,445      $ 1,117,720      $ 1,071,181  

Assumed reinsurance segment

     116,417        120,015        35,861  

Personal insurance segment

     522,734        529,079        531,310  

Total segment revenues

     1,606,596        1,766,814        1,638,352  

Net investment income

     109,208        127,165        126,474  

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

     25,048        25,476        9,394  

Insurance services revenue

     1,150        3,420        1,570  

Consolidated revenues

   $ 1,742,002      $ 1,922,875      $ 1,775,790  

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

 

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

Commercial insurance segment underwriting profit (loss)

   $ (625,090   $ (130,498   $ (22,405

Assumed reinsurance segment underwriting profit (loss)

     17,437       22,916       (6,546

Personal insurance segment underwriting profit (loss)

     (19,778     (50,286     (5,928

Net investment income

     109,208       127,165       126,474  

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

     25,048       25,476       9,394  

Corporate expenses, and other income

     (14,581     (12,460     (9,950

Acquisition-related transaction costs

     (21,322     (9,229     (360

Interest expense

     (33,594     (32,630     (34,290

Goodwill and fixed asset impairment

     (397,211     -        -   

Equity income in unconsolidated affiliate

     6,962       (1,470     -   

Income (loss) before income taxes

   $ (952,921   $ (61,016   $ 69,481  

Note 22—Unaudited Quarterly Financial Information

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

 

     2013  
($ in thousands, except per share amounts)    First     

Second (2)

   

Third (2) (3)

    Fourth     Total  
        (as revised)        (as revised)       

Revenues

   $ 476,483      $ 460,518     $ 478,881     $ 326,120     $ 1,742,002  

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

     12,917        (515,847     (348,053     (91,633     (942,616

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

           

Basic (1)

   $ 0.28      $ (9.03   $ (6.09   $ (1.60   $ (17.37

Diluted (1)

   $ 0.28      $ (9.03   $ (6.09   $ (1.60   $ (17.37
      2012  
   First      Second     Third     Fourth     Total  

Revenues

   $ 466,223      $ 506,392     $ 474,891     $ 475,369     $ 1,922,875  

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

     19,166        (16,809     21,629       (58,220     (34,234

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

           

Basic (1)

   $ 0.43      $ (0.39   $ 0.50     $ (1.38   $ (0.81

Diluted (1)

   $ 0.43      $ (0.39   $ 0.50     $ (1.38   $ (0.81

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

(1) Since the weighted-average shares for the quarters are calculated independently of the weighted-average shares for the year, quarterly earnings (loss) per share may not total to annual earnings per share. Earnings (loss) per share has been calculated using weighted-average shares that have been adjusted for the 1.1330 share conversion ratio resulting from the Canopius Merger Transaction.
(2) Net Income (loss) attributable to Tower Group International, Ltd. and per share amounts have been revised from amounts previously reported to adjust for a correction in income tax expenses by $8.5 million in the second quarter of 2013 and $0.4 million in the third quarter of 2013. The Company adjusted the valuation allowance recorded on its deferred taxes. This correction included an adjustment to increase total liabilities by $8.5 million in second quarter of 2013. This correction resulted in a total increase to liabilities of $8.9 million and cumulative decrease in equity of $8.5 million by the third quarter of 2013. This correction had no impact to cash flows. Management concluded these revisions were not material to the previously reported financial statements.
(3) Revenues have been revised from amounts previously reported to adjust for a correction in accounting for the Southport Quota Share. In the third quarter of 2013, management should have used deposit accounting. This correction resulted in greater net earned premiums of $46.1 million and less ceded commission revenue of $10.1 million, and additional loss and loss adjustment expense of $36.0 million. This correction had no impact to net income (loss). This correction also resulted in an adjustment to decrease total assets and total liabilities by $23.9 million. Cash flows provided by (used in) operating activities increased and Cash flows provided by (used in) financing activities decreased by $35.1 million in the third quarter of 2013. Management concluded these revisions were not material to the previously reported financial statements.

Note 23—Subsequent Events

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, 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 agreed to 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 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 received 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

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

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 owned 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.

Fitch Downgrades the Company’s Financial Strength and Issuer Credit Ratings

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.”

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.”

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 year ended December 31, 2013, respectively. Business written through certain program underwriting agents requires an A.M. Best rating of A- or greater.

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).

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.

 

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Tower Group International, Ltd.

Notes to Consolidated Financial Statements

 

Other

On April 7, 2014, the Company and a lessor mutually agreed to enter into a final settlement agreement to terminate a lease agreement for IT systems supporting certain personal lines business. Under the terms of the settlement agreement, the Company paid the lessor $10.4 million from a pledged collateral account funded by the Company for the benefit of the lessor. The final settlement agreement and payment were approved by the NYDFS.

 

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Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure 

None.

Item 9A. Controls and Procedures

(a) Disclosure Controls and Procedures

The Company’s management is responsible for establishing and maintaining disclosure controls and procedures designed to ensure that information required to be disclosed by the Company in the reports it files or submits under the Securities Exchange Act of 1934, as amended (Exchange Act), is recorded, processed, summarized, and reported within time periods specified in the rules and forms of the SEC. The Company’s disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is accumulated and communicated to management, including the principal executive officer and principal financial officer, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure.

The Company’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”) evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)), as of December 31, 2013, the end of the period covered by this report. Based on their evaluation, the Company’s CEO and CFO concluded that, as of December 31, 2013, the Company’s disclosure controls and procedures were not effective because of the material weaknesses in our internal control over financial reporting described below.

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

Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934. Our internal control over financial reporting is a process designed by or under the supervision of our principal executive and principal financial officers, or persons performing similar functions, and effected by the Company’s board of directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of management and the directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on our financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management of the Company has assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2013. In making its assessment of internal control over financial reporting, management used the criteria described in Internal Control—Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

Based on their evaluation, the Company’s management, including CEO and CFO concluded that, as of December 31, 2013, the Company did not maintain effective internal control over financial reporting based on the criteria in Internal Control – Integrated Framework (1992) issued by COSO because of the material weaknesses in our internal control over financial reporting described below.

A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.

The Company did not maintain effective monitoring controls. Specifically, the Company did not maintain effective ongoing and separate evaluation controls to monitor performance of certain other control activities. Ongoing and separate evaluation monitoring controls were not effective to achieve appropriate remediation of identified control deficiencies. This material weakness also 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.

 

 

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(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.

These deficiencies resulted in audit adjustments to the consolidated financial statements line items described above. Additionally, these deficiencies could have resulted in a material misstatement to the annual or interim consolidated financial statements that would not have been prevented or detected, and accordingly the Company’s CEO and CFO, in consultation with the Audit Committee, concluded that these control deficiencies constituted material weaknesses as of December 31, 2013.

The effectiveness of the Company’s internal control over financial reporting as of December 31, 2013 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears herein.

(c) Remediation Steps to Address the Material Weaknesses

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 to assist the Company in estimating its loss reserves, and reviewing and critiquing the loss reserve 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

 

(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.

 

(iv) 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, it is expected that Merger Sub will merge with and into Tower, with Tower as the

 

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  surviving corporation in the merger and a wholly owned subsidiary of ACP Re. The transaction is expected to 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. Upon the consummation of the merger agreement, the Company believes it will have an enhanced ability to attract financial and operations personnel.

(d) Changes in internal control over financial reporting

During the fourth quarter of 2013, the Company continued to experience departures of personnel and identified additional material weaknesses, as discussed above.

Other than the material weakness discussed above, there have been no changes in internal control over financial reporting during the year ended December 31, 2013 that have materially affected, or are reasonably likely to affect, the Company’s internal control over financial reporting, except for the following:

 

(i) Changes management has begun to implement to address the material weaknesses, as discussed in “(c) Remediation Steps to Address the Material Weaknesses” above. The implementation of the loss reserving, evaluation of long-lived tangible and intangible assets, and premiums receivable reconciliation process remediation activities began with minimal changes to the control activities during the fourth quarter of 2013.

 

(ii) 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, it is expected that Merger Sub will merge with and into Tower, with Tower as the surviving corporation in the merger and a wholly owned subsidiary of ACP Re. The transaction is expected to 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. Since the merger announcement, the Company has experienced more significant turnover in its accounting and operations units than in recent history, and it has found replacing such personnel to be difficult because the merger agreement is still pending completion.

Item 9B. Other Information

Not applicable.

PART III

Item 10. Directors and Executive Officers and Corporate Governance of Tower

Corporate Governance

Stock Ownership Guidelines

Stock Ownership Guidelines for Directors. In March 2013, the Board of Directors of the Company (the “Board of Directors” or the “Board”) approved director stock ownership guidelines requiring each of the Company’s independent Directors to own, within five years from the later of April 1, 2009 or the date on which such Director joins the Board and at all times thereafter, common stock of the Company having a minimum market value equal to three times the base annual cash retainer paid to the Directors. These guidelines were initially adopted by the board of directors of Tower Group, Inc., the holding company at the time of the closing of the Canopius Merger Transaction and currently a wholly-owned subsidiary of the Company (the “Predecessor Company”), in February 2009 and were in effect at the time of the Canopius Merger Transaction. In November 2013, upon the recommendation of the Corporate Governance and Nominating Committee and in view of the significant decline in the Company’s stock price in 2013, the Board of Directors agreed to extend, from April 1, 2014 to April 1, 2016, the date by which each current independent Director is required to comply with such stock ownership guidelines.

Stock Ownership Guidelines for Chief Executive Officer and Other Named Executive Officers. In March 2013, the Board of Directors approved stock ownership guidelines for the Company’s Chief Executive Officer and other Named Executive Officers requiring each such officer to own, within five years from the later of March 1, 2011 or the date such officer becomes a Named Executive Officer and at all times thereafter, common stock of the Company having a minimum market value equal to (1) with respect to the Chief Executive Officer, five times his or her annual base salary, and (2) with respect to each of the other Named Executive Officers, two times his or her annual base salary. These guidelines were initially adopted by the board of directors of the Predecessor Company in February 2011 and were in effect at the time of the Canopius Merger Transaction.

Anti-Pledging Policy. In March 2013, the Corporate Governance and Nominating Committee adopted a policy prohibiting the Directors and designated executive officers of the Company from pledging any shares of stock, stock options, stock appreciation rights, restricted stock units or performance shares of the Company arising out of any agreement entered into by a Director or officer following the date of adoption of this policy. This policy was initially adopted by the corporate governance and nominating committee of the Predecessor Company in November 2012 and was in effect at the time of the Canopius Merger Transaction.

Anti-Hedging Policy. In March 2013, the Corporate Governance and Nominating Committee adopted a policy prohibiting the Directors and designated executive officers of the Company from engaging in hedging, derivative or other speculative transactions in the Company’s securities including, among others, short sales, swaps or collars with respect to the Company’s securities, purchases or sales of put or call options, transactions intended to capitalize on short-term movements in the price of the Company’s securities, and transactions intended to allow an investor to own the Company’s securities without the full risks and rewards of ownership. This policy was initially adopted by the corporate governance and nominating committee of the Predecessor Company in February 2013 and was in effect at the time of the Canopius Merger Transaction.

 

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Audit Committee

The Company’s Board of Directors has determined that all members of the Audit Committee meet the standards of independence required of Audit Committee members by applicable NASDAQ Stock Market (“NASDAQ”) and United States Securities and Exchange Commission (the “SEC”) rules and regulations. See “Director Independence” below.

The Board of Directors has determined that: (i) none of the members of the Audit Committee has participated in the preparation of the financial statements of the Company or any current subsidiary of the Company at any time during the past three years; (ii) all of the members of the Audit Committee are able to read and understand fundamental financial statements, including a company’s balance sheet, income statement and cash flow statement; and (iii) Austin P. Young, III, who previously served as an audit partner in the Houston and New York offices of KPMG Peat Marwick until 1986, is an Audit Committee financial expert. In making this last determination, the Board of Directors made a qualitative assessment of Mr. Young’s level of knowledge and experience based on a number of factors, including his formal education, past employment experience in accounting and professional certification in accounting.

The Audit Committee operates under a formal written charter adopted by the Board of Directors that governs its duties and conduct. The charter is reviewed annually. Copies of the charter can be obtained free of charge on the Company’s web site, www.twrgrpintl.com, or by contacting the Company’s Secretary at Bermuda Commercial Bank Building, 19 Par-la-Ville Rd., Hamilton HM 11, Bermuda.

The Company’s independent registered public accounting firm reports directly to the Audit Committee. The Audit Committee meets with management and the Company’s independent registered public accounting firm before the filing of officers’ certifications with the SEC to receive information concerning, among other things, any significant deficiencies in the design or operation of internal control over financial reporting. The Audit Committee has also established procedures to enable confidential and anonymous reporting to the Audit Committee of concerns regarding accounting or auditing matters. The Company conducts an appropriate review of all related party transactions for potential conflict of interest situations on an ongoing basis, and all such transactions must be approved by the Audit Committee.

Compensation Committee

The Company’s Board of Directors has determined that all members of the Compensation Committee meet the standards of independence required of Compensation Committee members by applicable NASDAQ and SEC rules and regulations. See “Director Independence” below. Further, each member is a “non-employee Director,” as defined under Rule 16b-3(b)(3) of the Securities Exchange Act of 1934, as amended, and an “outside Director” as defined in Treasury Regulations Section 1.162-27, promulgated under the Internal Revenue Code of 1986, as amended (the “Code”). The Compensation Committee operates under a formal written charter adopted by the Board of Directors that governs its duties and conduct. The charter is reviewed annually. Copies of the charter can be obtained free of charge on the Company’s web site, www.twrgrpintl.com, or by contacting the Company’s Secretary at Bermuda Commercial Bank Building, 19 Par-la-Ville Rd., Hamilton HM 11, Bermuda.

Corporate Governance and Nominating Committee

All members of the Corporate Governance and Nominating Committee have been determined to meet NASDAQ’s standards of independence. See “Director Independence” below. The Corporate Governance and Nominating Committee operates under a formal written charter that governs its duties and conduct. The charter is reviewed annually. Copies of the charter can be obtained free of charge on the Company’s web site, www.twrgrpintl.com, or by contacting the Company’s Secretary at Bermuda Commercial Bank Building, 19 Par-la-Ville Rd., Hamilton HM 11, Bermuda.

As part of its duties, the Corporate Governance and Nominating Committee develops and recommends to the Board of Directors corporate governance principles. The Corporate Governance and Nominating Committee also identifies and recommends individuals for Board of Directors membership. To be considered for membership on the Board of Directors, a candidate should meet the following criteria, at a minimum: a solid education, extensive business, professional or academic experience, and the requisite reputation, character, skills and judgment, which, in the Corporate Governance and Nominating Committee’s view, have prepared him or her for dealing with the multifaceted financial, business and other issues that confront a Board of Directors of a corporation with the size, complexity, reputation and success of the Company.

The Corporate Governance and Nominating Committee does not have a formal diversity policy with respect to the identification and recommendation of individuals for Board of Directors membership. However, in carrying out this

 

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responsibility, the Corporate Governance and Nominating Committee values differences in professional experience, educational background, viewpoint and other individual qualities and attributes that facilitate and enhance the oversight by the Board of Directors of the business and affairs of the Company.

Investment Committee

All members of the Investment Committee have been determined to meet NASDAQ’s standards of independence. See “Director Independence” below. The Investment Committee assists the Board in its general oversight of the investments of the Company and the periodic evaluation of the Company’s investment portfolio managers. The Investment Committee operates under a formal written charter adopted by the Board of Directors that governs its duties and conduct. The charter is reviewed annually. Copies of the charter can be obtained free of charge on the Company’s web site, www.twrgrpintl.com, or by contacting the Company’s Secretary at Bermuda Commercial Bank Building, 19 Par-la-Ville Rd., Hamilton HM 11, Bermuda.

Code of Business Conduct and Ethics

The Company has adopted a Code of Business Conduct and Ethics that includes provisions ranging from restrictions on gifts to conflicts of interest, portions of which Code are intended to meet the definition of a “code of ethics” under applicable SEC rules. The Code of Business Conduct and Ethics is applicable to all Directors, officers and employees, including the principal executive officer, principal financial officer and persons performing similar functions. Copies of the Code of Business Conduct and Ethics can be obtained free of charge from the Company’s web site, www.twrgrpintl.com, or by contacting the Company’s Secretary at Bermuda Commercial Bank Building, 19 Par-la-Ville Rd., Hamilton HM 11, Bermuda.

Communications with the Board of Directors

A shareholder who wishes to communicate with the Board of Directors, or specific individual Directors, may do so by directing a written request addressed to such Directors to the attention of the Company’s Secretary at the address appearing on the first page of this Form 10-K, or by e-mail at boardofdirectors@twrgrp.com. All communications directed to members of the Board of Directors will be forwarded to the intended Director(s).

Additional Information Regarding the Board

Board Leadership Structure. The Board of Directors has separated the positions of Chairman of the Board and Chief Executive Officer of the Company. Following the resignation of Michael H. Lee as Chairman, President and Chief Executive Officer of the Company on February 6, 2014, the Board elected Jan R. Van Gorder, who had previously served as lead independent Director, as Chairman of the Board, and William W. Fox, Jr., who had served on the Board until his resignation on December 31, 2013, as President and Chief Executive Officer of the Company. The Board believes that this structure serves the Company well, by delineating the respective responsibilities of the Chairman of the Board and the Chief Executive Officer of the Company, facilitating communication between the Board and senior management of the Company, and enhancing Board oversight of the Company’s business and affairs.

Prior to the Board’s decision to separate the positions of Chairman and Chief Executive Officer and in view of evolving best practices with respect to Board leadership structure and to enhance the Company’s corporate governance, the Corporate Governance and Nominating Committee had established the position of lead independent Director in March 2013. The corporate governance and nominating committee of the Predecessor Company initially established the position of lead independent Director in November 2012. As a result of Mr. Lee’s resignation and the Board’s decision to separate the positions of Chairman of the Board and Chief Executive Officer of the Company in February 2014, the Board believes that a lead independent Director is not currently needed.

Board Role in Risk Oversight. The Board of Directors plays a significant role in providing oversight of the Company’s management of risk. Senior management has responsibility for the management of risk and reports to the Board with respect to its ongoing enterprise risk management efforts. Because responsibility for the oversight of elements of the Company’s risk management extends to various committees of the Board, the Board has determined that it, rather than any one of its committees, should retain the primary oversight role for risk management. In exercising its oversight of risk management, the Board has delegated to the Audit Committee primary responsibility for the oversight of risk related to the Company’s financial statements and processes, and has determined that the Company’s internal audit function should report directly to the Audit Committee and on a dotted line basis to the Company’s Senior Vice President, General Counsel and Secretary. The Board has delegated to the Compensation Committee primary responsibility for the oversight of risk related to the Company’s compensation policies and practices. The Board has delegated to the Corporate Governance and Nominating Committee primary responsibility for the oversight of risk related to the Company’s corporate governance practices. The Board has delegated to the Investment Committee primary responsibility for the oversight of risk related to the Company’s investments. Each committee advises the Board with respect to such committee’s particular risk oversight responsibilities.

 

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Meetings. During 2013, the Board of Directors of the Company met 34 times. The standing independent committees of the Board of Directors of the Company consisted of the Audit, Compensation, Corporate Governance and Nominating, and Investment Committees. In 2013, each Director of the Company attended at least 75% of the total number of meetings of the Company’s Board of Directors and any committees on which such Director served. All Directors were present at the Company’s annual general meeting of shareholders in 2013.

Board Committees. The Audit Committee of the Company met 20 times in 2013. During 2013, the Audit Committee consisted of Messrs. Young (Chair), Robbie and, prior to their respective dates of resignation from the Board on October 9, 2013 and December 31, 2013, Charles A. Bryan and William W. Fox, Jr. In January 2014, Mr. Van Gorder was appointed to the Audit Committee. Among other duties, the Audit Committee selects the Company’s independent registered public accounting firm; reviews and recommends action by the Board of Directors regarding the Company’s quarterly and annual reports filed with the SEC; discusses the Company’s audited financial statements with management and the Company’s independent registered public accounting firm; and reviews the scope and results of the independent audit and any internal audit.

The Compensation Committee of the Company met nine times in 2013. During 2013, the Compensation Committee consisted of Messrs. Schuster, Smith, Van Gorder and, prior to his resignation from the Board on October 9, 2013, Mr. Bryan, who served as Chairman of the Compensation Committee until such resignation. In November 2013, Mr. Smith was appointed Chairman of the Compensation Committee. Among other duties, the Compensation Committee evaluates the performance of the Company’s principal officers, reviews and approves the compensation of principal officers, and administers the Company’s various compensation plans.

The Corporate Governance and Nominating Committee of the Company met six times in 2013. During 2013, the Corporate Governance and Nominating Committee consisted of Messrs. Schuster (Chair), Van Gorder and, prior to their respective date of resignation from the Board on October 9, 2013 and December 31, 2013, Messrs. Bryan and Fox. Among other duties, the Corporate Governance and Nominating Committee is responsible for recommending to the Board of Directors candidates for nomination to the Board as well as corporate governance principles applicable to the Company.

The Investment Committee of the Company met five times in 2013. During 2013, the Investment Committee consisted of Messrs. Robbie, Schuster, Smith and Young. Mr. Smith served as Chairman of the Investment Committee prior to November 2013, at which time the Board appointed Mr. Robbie as Chairman of the Investment Committee in view of Mr. Smith’s appointment as Chairman of the Compensation Committee. Mr. Smith remains a member of the Investment Committee. Among other duties, the Investment Committee monitors the performance of the Company’s investment portfolio and evaluates the Company’s investment portfolio managers.

While the Company has not adopted a formal policy with regard to attendance by members of the Board of Directors at annual meetings, it encourages all Directors to attend the Annual General Meeting of Shareholders.

Compensation Committee Interlocks and Insider Participation

No member of the Compensation Committee is or has ever been an officer or employee of the Company or of any of its subsidiaries or affiliates. None of the Company’s executive officers served as a director or member of the compensation committee (or other board committee performing similar functions) of any entity of which a member of the Company’s Compensation Committee was an executive officer, nor did any of the Company’s executive officers serve as a member of the compensation committee (or other board committee performing similar functions or, in the absence of such a committee, the entire board of directors) of any entity for which any of the Company’s Directors served as an executive officer.

 

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The Board and Board Committees

The following table shows each of the four current standing committees established by the Board and the current members and chairman of each committee:

 

Name    Audit
Committee
   Compensation
Committee
   Corporate
Governance and
Nominating
Committee
   Investment
Committee

William A. Robbie *

   X          Chair

Steven W. Schuster *

      X    Chair    X

Robert S. Smith *

      Chair       X

Jan R. Van Gorder *

   X    X    X   

Austin P. Young, III *

   Chair          X

Number of Meetings in 2013

   20    9    6    5

 

* Independent Director

Management -Directors and Executive Officers

The table below sets forth the names, ages and positions of the Company’s Directors and executive officers.

 

Name    Age    Position

Jan R. Van Gorder (2)

   66    Chairman of the Board

William W. Fox, Jr.

   72    President and Chief Executive Officer

William A. Robbie (3)

   62    Director

Steven W. Schuster (3)

   59    Director

Robert S. Smith (1)

   55    Director

Austin P. Young, III (2)

   73    Director

William E. Hitselberger

   56    Executive Vice President and Chief Financial Officer

William F. Dove

   47    Senior Vice President, Chief Risk Officer and Chief Actuary

Scott T. Melnik

   42    Senior Vice President, Claims

Elliot S. Orol

   58    Senior Vice President, General Counsel and Secretary

Christian K. Pechmann

   64    Senior Vice President, Marketing

Laurie A. Ranegar

   52    Senior Vice President, Operations

James E. Roberts

   69    Senior Vice President, Reinsurance

Catherine M. Wragg

   43    Senior Vice President, Human Resources and Administration

 

(1) Denotes Class I Director with term to expire in 2016.
(2) Denotes Class II Director with term to expire in 2015.
(3) Denotes Class III Director with term to expire in 2014.

Set forth below is certain biographical information for each of the Company’s Directors and executive officers:

Jan R. Van Gorder

Chairman of the Board

Mr. Van Gorder has been the Chairman of the Board of Directors of the Company since February 2014 and was previously the lead independent Director of the Board. From February 2009 until the closing of the Canopius Merger Transaction in March 2013, he served as a member of the board of directors of the Predecessor Company. He is a member of the Company’s Compensation Committee and Corporate Governance and Nominating Committee, positions he also held while serving as a member of the board of directors of the Predecessor Company, and in January 2014 was appointed as a member of the Company’s Audit Committee. Prior to serving as a member of the board of directors of the Predecessor Company, Mr. Van Gorder served as a member of the board of directors of CastlePoint Holdings, Ltd., a company that merged with the Predecessor Company in February 2009. He held that position from March 2007 to February 2009. Mr. Van Gorder was employed by Erie Insurance Group from November 1981 through December 2006. He held a variety of positions at that company, including Acting Chief Executive Officer from January 2002 to May 2002 and his most recent position as Senior Executive Vice-President, Secretary and General Counsel from December 1990 through December 2006. He served as a consultant and acting Secretary and General Counsel at Erie Insurance Group during the period January 1, 2007 through May 12, 2007. Mr. Van Gorder served as a member of the board of directors of Erie Indemnity Company, Erie, Pennsylvania, from 1990 to 2004. Mr. Van Gorder has also served as a Director and Chairman of the Insurance Federation of Pennsylvania. Mr. Van Gorder received a B.A. in International Relations from the University of Pennsylvania in 1970 and a J.D. from Temple University School of Law in 1975.

 

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The Board of Directors believes that Mr. Van Gorder possesses the experience, qualifications, attributes, and skills necessary to serve on the Board because of his more than 30 years of relevant insurance industry-related legal and business experience, including serving as General Counsel of a public insurance company, and his years of service on various insurance-related boards of directors.

William W. Fox, Jr.

President and Chief Executive Officer

Mr. Fox currently serves as the President and Chief Executive Officer of the Company. The Board elected Mr. Fox as President and Chief Executive Officer of the Company effective as of February 14, 2014. Before joining the Company as an Executive Officer, Mr. Fox served as a director of the Company, and prior to the closing of the Canopius Merger Transaction of the Predecessor Company, from April 2006 to December 2013. He also served as a member of the Audit Committee and the Corporate Governance and Nominating Committee of the Company and the Predecessor Company. He has over 40 years experience in the insurance and reinsurance industry. Mr. Fox was employed by Balis & Co., Inc. and its successor, the Guy Carpenter reinsurance brokerage division of Marsh & McLennan Companies, from 1962 through 1988, and again from 1992 through 1999. Mr. Fox had a number of positions at Balis & Co., Inc., and Guy Carpenter, including President of Balis from 1985 through 1988 and again from 1992 through 1999. Mr. Fox also served as a member of Guy Carpenter’s Executive Committee and Board of Directors, and as a Managing Director of J&H, Marsh & McLennan. Between 1992 and 1999, Mr. Fox was also the Chief Executive Officer of Excess Reinsurance Company. In 1988, Mr. Fox founded PW Reinsurance Management Company, as a joint venture with Providence Washington Insurance Company (“PW Group”) to underwrite reinsurance on behalf of PW Group. Mr. Fox was a Senior Vice President of PW Group from 1988 to 1989 and was responsible for selecting and overseeing reinsurance intermediaries. In 1989, the Baloise Insurance Group acquired Providence and appointed Mr. Fox President of the PW Group. Mr. Fox has served on several insurance-related boards of directors. Mr. Fox is a member of the CPCU Society and holds a Pennsylvania Property and Casualty License.

William A. Robbie, C.P.A.

Director

Mr. Robbie currently serves as a Director of the Company. From February 2009 until the closing of the Canopius Merger Transaction in March 2013, he served as a member of the board of directors of the Predecessor Company. He is a member of the Audit Committee and was appointed Chairman of the Investment Committee in November 2013. He previously served as a member of the Audit Committee and the Investment Committee of the board of directors of the Predecessor Company. Prior to serving as a member of the board of directors of the Predecessor Company, Mr. Robbie served as a member of the board of directors of CastlePoint Holdings, Ltd., a company that merged with the Predecessor Company in February 2009. He held that position from January 2006 until February 2009. From 2004 through 2009, he provided financial and corporate governance advisory services to the insurance industry through his own consulting firm. Mr. Robbie was Chief Financial Officer of Platinum Underwriters Reinsurance Ltd., a property and casualty reinsurance company in Bermuda, from 2002 to 2004 with responsibility for that company’s finance, claims and IT functions. He was the lead financial team member in the initial public offering of Platinum Underwriters Reinsurance Ltd., which became a separate public company from St. Paul Reinsurance, Inc. where he held the same position from August 2002 to November 2002. From 1997 to 2002, Mr. Robbie held various positions at XL Capital Ltd., a Bermuda-based insurance, reinsurance and financial risk company, and its subsidiaries, including Executive Vice President of Global Services, Senior Vice President and Corporate Treasurer, and Chief Financial and Administrative Officer of XL Re, Ltd., with responsibility for that company’s finance, claims, IT, human resources, business processing and administration functions. Prior to that, he held a variety of senior positions in the insurance industry, including roles as Chief Financial Officer of Prudential AARP Operations, Chief Accounting Officer at Continental Insurance Companies, Treasurer of Monarch Life Insurance Company and various positions at Aetna Life and Casualty Company. From 2005 to 2008, Mr. Robbie was a director and chairman of the Audit Committee of American Safety Insurance Company, Ltd. Mr. Robbie is a Certified Public Accountant. Mr. Robbie received his B.A. from St. Michael’s College and his Master of Accounting and M.B.A. from Northeastern University.

The Board of Directors believes that Mr. Robbie possesses the experience, qualifications, attributes, and skills necessary to serve on the Board because of his more than 40 years of relevant industry-related experience in finance, including serving as Chief Financial Officer of insurance and reinsurance companies, and his extensive background in accounting and business administration.

Steven W. Schuster

Director

Mr. Schuster currently serves as a Director of the Company. From 1997 until the closing of the Canopius Merger Transaction in March 2013, he served as a member of the board of directors of the Predecessor Company. He is Chairman of the Corporate Governance and Nominating Committee and a member of both the Compensation Committee and the Investment Committee of the Board of Directors, positions he also held while serving as a member of the board of directors of the Predecessor Company. Mr. Schuster has been engaged in the practice of corporate law for over 30 years and is co-chair of McLaughlin & Stern LLP’s corporate and securities department, where he has been a partner since 1995. Mr. Schuster received his B.A. from Harvard University in 1976 and his J.D. from New York University in 1980.

 

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The Board of Directors believes that Mr. Schuster possesses the experience, qualifications, attributes, and skills necessary to serve on the Board because of his more than 30 years of relevant corporate and securities legal and transactional experience and his extensive knowledge of the Company and its business.

Robert S. Smith

Director

Mr. Smith currently serves as a Director of the Company. From February 2009 until the closing of the Canopius Merger Transaction in March 2013, he served as a member of the board of directors of the Predecessor Company. Mr. Smith is a member of the Investment Committee and was appointed Chairman of the Compensation Committee in November 2013. Prior thereto, he served as Chairman of the Investment Company and was a member of the Compensation Committee, positions he also held while serving as a member of the board of directors of the Predecessor Company. Prior to serving as a member of the board of directors of the Predecessor Company, Mr. Smith served as a member of the board of directors of CastlePoint Holdings, Ltd., a company that merged with the Predecessor Company in February 2009. He held that position from January 2006 until February 2009. Mr. Smith is currently a principal of Sherier Capital LLC, a business advisory firm that he founded in 2005, a Managing Director of National Capital Merchant Banking, LLC (“NCMB”), an investment firm that he joined in April 2008, and serves as the President and CEO of Welbeck Secure Solutions, LLC, a portfolio company of NCMB. He was previously Chief Operating Officer (from December 1999 to April 2004) and Executive Vice-President (from April 2004 to August 2004) of Friedman, Billings, Ramsey Group, Inc., where he was instrumental in, among other things, growing Friedman, Billings, Ramsey Group, Inc. from a privately-held securities boutique to a nationally recognized investment bank, helping accomplish its 1997 initial public offering, the creation of an affiliated public company, FBR Asset Investment Corporation, and the merger of the two companies in 2003. Before joining Friedman, Billings, Ramsey Group, Inc. as its General Counsel in 1997, Mr. Smith was an attorney with the law firm of McGuireWoods LLP from 1986 to 1996. Mr. Smith currently serves on the Steering Committee of the Washington Performing Arts Society Legacy Society (“WPAS”) and as a member of the WPAS Pension Committee. He is also a director of Precise Systems, Inc., an employee-owned company serving federal Department of Defense customers. Mr. Smith received his LL.B. and Dip L.P. (graduate Diploma in Legal Practice) from Edinburgh University, and his LL.M. from the University of Virginia.

The Board of Directors believes that Mr. Smith possesses the experience, qualifications, attributes, and skills necessary to serve on the Board because of his more than 30 years of relevant experience including investment experience, service as a senior executive of a public company, experience in the public securities markets, and his corporate legal background.

Austin P. Young, III, C.P.A.

Director

Mr. Young currently serves as a Director of the Company. From 2004 until the closing of the Canopius Merger Transaction in March 2013, he served as a member of the board of directors of the Predecessor Company. He is Chairman of the Audit Committee and a member of the Investment Committee of the Board of Directors, positions he also held while serving as a member of the board of directors of the Predecessor Company. He also serves as a Director and the Chairman of the Audit Committee of Insperity, Inc. and Amerisafe, Inc. Previously, he served as Senior Vice President, Chief Financial Officer and Treasurer of CellStar Corporation from 1999 to December 2001, when he retired. Before joining CellStar Corporation, he served as Executive Vice President — Finance and Administration of Metamor Worldwide, Inc. from 1996 to 1999. Mr. Young also held the position of Senior Vice President and Chief Financial Officer of American General Corporation for over eight years. He was a partner in the Houston and New York offices of KPMG Peat Marwick where his career spanned 22 years before joining American General Corporation. He holds an accounting degree from The University of Texas. He is a member of the Houston and State Chapters of the Texas Society of Certified Public Accountants, the American Institute of Certified Public Accountants and Financial Executives International.

The Board of Directors believes that Mr. Young possesses the experience, qualifications, attributes, and skills necessary to serve on its Board of Directors because of his more than 50 years of relevant experience in the financial and accounting fields, his years of service on various boards of directors and audit committees, and his extensive knowledge of the Company and its business.

William E. Hitselberger

Executive Vice President and Chief Financial Officer

Mr. Hitselberger currently serves as Executive Vice President and the Chief Financial Officer of the Company. Prior to the closing of the Canopius Merger Transaction in March 2013, Mr. Hitselberger served as Executive Vice President and Chief Financial Officer of the Predecessor Company. Initially, he joined the Predecessor Company in December 2009 as Senior Vice President and became Chief Financial Officer in March 2010 and Executive Vice President in May 2012. Before joining the Predecessor Company, Mr. Hitselberger served as Executive Vice President and Chief Financial Officer of PMA Capital Corporation from April 2004 to November 2009 and as Senior Vice President, Chief Financial Officer and Treasurer from June 2002 to March 2004. Prior to this, he served as Vice President of The PMA Insurance Group from 1996 to 2002. Mr. Hitselberger is a Certified Public Accountant and a Chartered Financial Analyst. Mr. Hitselberger graduated from the University of Pennsylvania, where he received a B.S. in Economics in 1980.

 

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William F. Dove

Senior Vice President, Chief Risk Officer and Chief Actuary

Mr. Dove currently serves as Senior Vice President, Chief Risk Officer and Chief Actuary of the Company. Prior to the closing of the Canopius Merger Transaction in March 2013, Mr. Dove served as Senior Vice President, Chief Risk Officer and Chief Actuary of the Predecessor Company. He joined the Predecessor Company in October 2011 as Senior Vice President and Chief Risk Officer and became Chief Actuary in January 2012. Before joining the Predecessor Company, Mr. Dove served in a series of roles with various subsidiaries of ACE Limited since 2003, including as Chief Operating Officer and Chief Actuary of Brandywine Group Holdings from 2007 to 2011, Chief Technical Officer of ACE Risk Management from 2006 to 2007, and as President of ACE Financial Solutions from 2004 to 2006. From 1995 to 2003, he served in a series of roles including Senior Vice President and Chief Pricing Actuary of Centre Insurance Company. From 1991 to 1995 he served as Assistant Vice President for Continental Insurance Company. He currently serves on the Audit & Compliance Committee of the Princeton Family YMCA and the Citizens’ Finance Advisory Committee for Princeton, NJ. He is a Fellow of the Casualty Actuarial Society, an Associate of the Society of Actuaries, a member of the American Academy of Actuaries and a Chartered Enterprise Risk Analyst. He holds a B.A. in Mathematics from Haverford College in Haverford, PA.

Scott T. Melnik

Senior Vice President, Claims

Mr. Melnik currently serves as Senior Vice President of Claims of Tower Group, Inc., a subsidiary of the Company and the holding company for its U.S. operations. From June 2008 until the closing of the Canopius Merger Transaction in March 2013, Mr. Melnik served as Senior Vice President, Claims of the Predecessor Company. Initially, he joined the Predecessor Company in March 1999 as a Claims Manager and throughout his more than fourteen years with the Predecessor Company served in a number of other management positions within the Claims Division. Over the last 22 years in the insurance industry, Mr. Melnik has been involved in the technical claim handling and management of various types of property and casualty insurance claims, both personal and commercial lines. Before joining the Predecessor Company, Mr. Melnik held management positions in the Risk Management division of CNA Insurance Companies. From 1991 to 1994, he held positions at the self-insured and reciprocal management firm Wright Risk Management.

Elliot S. Orol

Senior Vice President, General Counsel and Secretary

Mr. Orol currently serves as Senior Vice President, General Counsel and Secretary of the Company. Prior to the closing of the Canopius Merger Transaction in March 2013, Mr. Orol had served as Senior Vice President, General Counsel and Secretary of the Predecessor Company since December 2008. Before joining the Predecessor Company, Mr. Orol served until November 2008 at The Navigators Group, Inc. as Chief Compliance Officer from November 2004, Senior Vice President and General Counsel from May 2005, and Secretary from May 2006. Prior to joining Navigators, Mr. Orol was in private legal practice and, from 2002 to 2003, served as Managing Director and General Counsel of Gerling Global Financial Products, Inc. From 1999 through 2001, he was a partner with the law firm of Cozen O’Connor. He served from 1996-1999 as Vice President, General Counsel and Secretary of the GRE Insurance Group, and from 1987-1996 as Vice President of The Continental Insurance Company. Mr. Orol was previously a member of the Board of Trustees of The Dalton School. Mr. Orol received a B.S. in Mathematics from the State University of New York at Binghamton, a J.D. from the University of Chicago Law School and an M.B.A. from the University of Chicago Graduate School of Business.

Christian K. Pechmann

Senior Vice President, Marketing

Mr. Pechmann currently serves as Senior Vice President, Marketing of Tower Group, Inc., a subsidiary of the Company and the holding company for its U.S. operations. Prior to the closing of the Canopius Merger Transaction in March 2013, Mr. Pechmann had served as Senior Vice President, Marketing of the Predecessor Company since September 2003. Before joining the Predecessor Company, Mr. Pechmann was employed in various profit center and field management roles at Kemper Insurance Companies. His last positions with that company were as Midwest Region President and Northeast Region President, responsible for the commercial lines branch offices within those respective regions. A graduate of Hartwick College, Mr. Pechmann received a B.A. in English, and participated in the Executive Development Program at Columbia University. He holds the Associate of Risk Management (ARM) and the Associate of Insurance Management (AIM) from the Insurance Institute of America.

Laurie A. Ranegar

Senior Vice President, Operations

Ms. Ranegar currently serves as Senior Vice President of Operations of Tower Group, Inc., a subsidiary of the Company and the holding company for its U.S. operations. She is responsible for service delivery, billing and collections, premium audit, statistical reporting and technology user acceptance testing. Prior to the closing of the Canopius Merger Transaction in March 2013, Ms. Ranegar had served as Senior Vice President of Operations of the Predecessor Company since October 2003. She has 30 years of insurance industry experience with extensive experience in off-shoring back office processes. Before joining the Predecessor Company, she was Regional Operations Director of the Northeast for Kemper Insurance. Before joining Kemper, Ms. Ranegar held management positions at Highlands Insurance Group, Inc. from 1996 until 2002, where she held the positions

 

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of Vice President, Claim Field Operations, and Vice President, Underwriting and Operations, responsible for a commercial small business service center. She began her insurance career with Aetna Life and Casualty and is a graduate of the University of Pittsburgh with a B.A. in Economics.

James E. Roberts

Senior Vice President, Reinsurance

Mr. Roberts currently serves as Senior Vice President, Reinsurance of the Company. From May 2011 to the closing of the Canopius Merger Transaction in March 2013, Mr. Roberts served as Senior Vice President – Corporate Underwriting and from October 2009 to May 2011, he served as Managing Vice President – Corporate Underwriting of the Predecessor Company. Before joining the Predecessor Company, Mr. Roberts was employed by AequiCap Group where he served as President of AequiCap Insurance Company from January 2006 to October 2009 and President of AequiCap Program Administrators from September 2007 to October 2009. From November 2002 to October 2005, Mr. Roberts was Executive Vice President and Chief Underwriting Officer of the Reinsurance Division of Alea North America Company and Senior Vice President of Alea North America Insurance Company. From May 1995 to November 2002, Mr. Roberts was employed by Trenwick Group, Ltd. and its predecessor company, Trenwick Group, Inc. At Trenwick, he served from October 1999 to November 2002 as Chairman and Chief Executive Officer of the Insurance Corporation of New York, Dakota Specialty Insurance Company and Recor Insurance Company Inc. From March 2000 to November 2002, he served as Chairman and Chief Executive Officer and from October 1999 to March 2000, he served as Vice Chairman of Chartwell Reinsurance Company. From May 1995 to March 2000, he was Vice Chairman of Trenwick America Reinsurance Corporation, where he was co-head of the Company’s Underwriting Department. During the nine years prior to joining Trenwick, Mr. Roberts held the following positions at Re Capital Corporation, where he was one of the Company’s three founding officers: President and Chief Executive Officer from 1992 to 1995; President and Chief Operating Officer from 1991 to 1992; Senior Vice President from 1986 to 1991; Director from 1989 to 1995; and President and Chief Executive Officer of the Company’s principal operating subsidiary, Re Capital Reinsurance Corporation from 1991 to 1995. From June 1995 to May 2013, Mr. Roberts was a Director of Harris & Harris Group, Inc., a venture capital firm specializing in active, early stage investments in transformative nanotechnology companies. He served as Lead Independent Director of the Board of Harris & Harris from May 2011 until stepping down at the end of his term in May 2013. Mr. Roberts graduated from Cornell University (A.B.).

Catherine M. Wragg

Senior Vice President, Human Resources and Administration

Ms. Wragg currently serves as Senior Vice President, Human Resources and Administration of Tower Group, Inc., a subsidiary of the Company and the holding company for its U.S. operations. Prior to the closing of the Canopius Merger Transaction in March 2013, Ms. Wragg had served as Senior Vice President, Human Resources and Administration of the Predecessor Company since May 2011. Initially, she joined the Predecessor Company in December 1995 and was promoted to Managing Vice President in January 2008. Ms. Wragg is currently responsible for all aspects of employee relations, recruiting, benefits, compensation, real estate, general office administration and related expenses. Before joining Predecessor Company, Ms. Wragg was responsible for the oversight of the payroll and benefits function with the firm Bachner, Tally, Polevoy and Misher LLP from 1993 through 1995. Ms. Wragg studied English at Northern Arizona University.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the Securities Exchange Act of 1934, as amended, requires the Company’s officers and Directors and persons who own more than 10% of a registered class of the Company’s equity securities to file initial reports of ownership and reports of changes in ownership with the SEC. Such persons are required by SEC regulation to furnish the Company with copies of all Section 16(a) forms they file. Based solely on the Company’s review of the copies of such forms received by the Company with respect to fiscal year 2013 or written representations from certain reporting persons during the year ended December 31, 2013, all Section 16(a) filing requirements applicable to the Directors, officers and greater than 10% shareholders were complied with by such persons, except that one report covering one transaction was filed late by Mr. Lee, the former Chief Executive Officer of the Company.

 

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Item 11. Executive Compensation

COMPENSATION DISCUSSION AND ANALYSIS

The Company’s Performance in 2013

The Company’s performance in 2013 did not meet the financial performance metrics set by the Compensation Committee at the beginning of the year. Accordingly, the Compensation Committee (the “Compensation Committee” or the “Committee”) determined:

 

(i) not to increase the annual base salaries for the Company’s Named Executive Officers included in the Summary Compensation Table below (the “Named Executive Officers” or “NEOs”) or other employees in 2014;

 

(ii) not to make any annual cash bonus awards for 2013 performance under the Tower Group International, Ltd. Short Term Performance Incentive Plan (the “Short Term Incentive Plan” or “STIP”);

 

(iii) following the Committee’s previous determination not to make any equity awards to the NEOs for 2012 performance for at least six months following the closing of the Canopius Merger Transaction in March 2013, not to make any equity awards to the NEOs for 2012 performance under the Tower Group, Inc. 2004 Long Term Equity Compensation Plan (as amended and restated, effective May 15, 2008, the “2008 Long Term Equity Plan” or “2008 LTEP”); and

 

(iv) not to make any long-term equity awards for the 2013-2015 performance period under the new Tower Group International, Ltd. 2013 Long Term Incentive Plan (the “2013 Long Term Incentive Plan” or “2013 LTIP”).

In addition, the Compensation Committee does not expect to make annual cash awards for performance in 2014 under the STIP or long term equity awards for the 2014-2016 performance period under the LTIP.

Merger Agreement with ACP Re

On January 3, 2014, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with ACP Re Ltd. (“ACP Re”), and a wholly-owned subsidiary of ACP Re (“Merger Sub”), pursuant to which Merger Sub would merge with and into Tower (the “ACP Re Merger”), with Tower as the surviving corporation in the ACP Re Merger and a wholly owned subsidiary of ACP Re. ACP Re is a Bermuda-based reinsurance company. The obligations of the parties to complete the ACP Re Merger are subject to the satisfaction or waiver of the closing conditions in the Merger Agreement. 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.

Pursuant to the terms of the Merger Agreement, the Company has agreed, among other matters, not to increase the base salary or to make cash or equity bonus awards to any of its employees, including the Named Executive Officers listed below, without the prior written consent of ACP Re. The Company’s executive compensation program and plans described below in this Compensation Discussion and Analysis are all subject to the restrictions imposed upon the Company pursuant to the Merger Agreement, as well as to applicable insurance department regulatory restrictions.

2013 Say-on-Pay Results

At the 2013 annual general meeting of shareholders of the Company, more than 95% of the shares present in person or by proxy were cast in a nonbinding advisory say-on-pay vote in support of the Company’s executive compensation program and policies.

 

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Executive Compensation and Corporate Governance Policy Highlights

The Company is committed to maintaining best practices with respect to executive compensation practices and corporate governance standards, and has adopted the policies and practices, among others, set forth in the chart below.

 

Compensation or Governance Practice    Company’s Policy
Performance-based long term incentive equity awards   

Equity awards made to the NEOs under the Company’s 2013 Long Term Incentive Plan are based 75% upon two financial performance metrics, relative total shareholder return (50%) and return on tangible equity (25%), each measured over a three-year performance period and vesting at the end of such three-year period.

 

Total shareholder return is measured relative to a selected peer group. Return on tangible equity is measured against pre-established levels determined with reference to operating return on tangible equity for the selected peer group for the prior three-year period.

 

Performance-based award payouts will range from no award if threshold performance is not met, to above-target awards for superior performance.

 

The making of any new equity awards is currently subject to restrictions under the Merger Agreement.

Dividends on unvested stock    We have eliminated the payment of dividends on unvested stock and restricted stock units (“RSUs”) issued under the 2013 Long Term Incentive Plan. Dividends are instead credited to holders of unvested stock and RSUs and are paid only if and when the restricted stock or RSUs vest; otherwise, dividends will be forfeited.
Election of Directors    Majority voting standard for the election of Directors in uncontested elections and required offer of resignation from any Director who is not reelected (as described under “Corporate Governance – Director Independence” below).
Stock ownership guidelines for Directors    Stock ownership guidelines for Directors (as described under “Corporate Governance – Stock Ownership Guidelines” above).
Stock ownership guidelines for CEO and other NEOs    Stock ownership guidelines for the CEO and other NEOs (as described under “Corporate Governance – Stock Ownership Guidelines” above).
Stock pledging    Anti-pledging policy for the CEO, the other NEOs and other designated executive officers and Directors (as described under “Corporate Governance – Stock Ownership Guidelines” above).
Stock hedging    Anti-hedging policy for the CEO, the other NEOs and other designated executive officers and Directors (as described under “Corporate Governance – Stock Ownership Guidelines” above).
Lead Director    A lead independent Director is provided for as part of the leadership structure of the Company’s Board of Directors (as described under “Additional Information Regarding the Board – Board Leadership Structure” above). Since the positions of Chairman and Chief Executive Officer are now held by different individuals, there is at present no lead independent Director.

 

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Payments to Directors    Prohibition on payment of any consulting, legal, advisory or other fees to independent Directors by the Company other than fees paid strictly for service on the Board of Directors or Board committees (as described under “Corporate Governance – Payment of Fees to Independent Directors” below).
Change in a Director’s principal employment    Required offer of resignation from any Director who changes his principal employment (as described under “Corporate Governance – Offer of Resignation Upon Change of Employment” below).
Tax gross-ups    Tax gross-ups have been eliminated from the employment agreements of all NEOs, and will not be included in any new employment agreements.
Change in control provision    The 2013 Long Term Incentive Plan requires a double trigger – both a change in control and termination of employment within two years of the change in control – for the acceleration of unvested equity awards in the event of a change in control.
Internal pay equity    Under the 2013 Long Term Incentive Plan, the CEO’s maximum bonus opportunity was reduced to 200% of target from 300% of target under the prior plan, to reflect current market practice and enhance internal pay equity. The newly elected CEO, William W. Fox, Jr., is not eligible for a bonus award under his employment agreement.
Prospective clawback provision    Under the terms of the 2013 Long Term Incentive Plan, the Committee reserves the right to recoup certain payments made under the plan to the extent necessary to comply with the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Company will implement a clawback policy as soon as the SEC issues applicable final rules.
Independence of Board committees    All committees of the Board, including the Compensation Committee, are composed entirely of independent Directors.
Compensation consultant    The Compensation Committee’s executive compensation consulting firm, Pearl Meyer & Partners, is retained directly by the Committee and performs no other services for the Committee or the Company. All such services were authorized by the Committee.
Compensation policies and risk    The Compensation Committee reviews annually the Company’s risk management with respect to its executive compensation policies and practices to assure that these policies and practices do not create risks that are reasonably likely to have a material adverse effect on the Company.
Peer group    Our Compensation Committee, assisted by our outside compensation consultant, extensively reviewed during 2013 potential peers and selected only those that have a close business model alignment.

Compensation Philosophy and Objectives

The Company’s approach to executive compensation is based upon its pay-for-performance philosophy, which is intended to align the compensation of the Company’s executive officers with the performance of the Company as measured by various performance metrics set by the Compensation Committee. The Company’s executive compensation program is also designed to attract and retain the services of highly qualified executives and to reward and provide incentives for individual performance as well as for overall Company performance. The Company seeks to establish and maintain a performance-driven, entrepreneurial culture that delivers impressive performance relative to its peers and exceptional value to its shareholders, and to attract and reward individuals who fit that culture and reflect the core values of the Company: leadership, passion, hard work, teamwork, innovation, customer service, trust, flexibility, social responsibility and excellence. To attract and retain highly skilled individuals, the Company’s compensation program is intended to be competitive with that offered by other employers within the industry that compete with the Company for talent. The Company uses all of the elements of its compensation program together to achieve these objectives.

 

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The compensation for each NEO reflects his level of responsibility, the Company’s performance, the achievement of individually established goals, his personal contribution to the Company’s success, experience, expertise, knowledge of the Company’s operations and the insurance industry, and marketplace considerations. Other than the CEO, no NEO or other officer plays a role in determining compensation for the NEOs.

Elements of Compensation

The Company’s executive compensation program for its NEOs for 2013 consisted of the following four key elements:

 

(i) annual base salary;

 

(ii) an annual bonus, payable under the Short Term Incentive Plan;

 

(iii) a long term equity award for the 2013-2015 performance period, granted under the 2013 Long Term Incentive Plan; and

 

(iv) retirement income plans.

The Company does not generally target any specific allocation among these various elements of compensation for NEOs or other employees. While the elements of compensation described above are considered separately, the Compensation Committee takes into account the full compensation package offered by the Company to each NEO, including healthcare and other benefits. The Compensation Committee believes that the compensation mix for the NEOs strikes a balance between salary and variable compensation arrangements and is consistent with the Company’s compensation policies for employees in general.

As a result of the Company’s 2013 performance, the Compensation Committee determined not to make any annual cash bonus awards for 2013 or any long-term equity awards for the 2013-2015 performance period. The Committee approved, on October 6, 2013, cash retention awards to James E. Roberts, but not to any other NEOs, and to certain other employees recommended by management, in varying amounts ranging from 20%-100% of their annual base salary and payable to such employees (i) on September 30, 2014 if they remain at such date employees of the Company or (ii) if terminated other than for Cause (as defined in the 2013 LTIP) prior to September 30, 2014, on the date of such termination. Mr. Roberts would be eligible to receive a cash retention award in the amount of 100% of his annual base salary, or $350,018.

Base Salaries. The annual base salary is the fixed element of compensation and is intended to attract and retain high performing executives. The level of base salary for each of the NEOs reflects his position and tenure with the Company, the Company’s needs, the NEO’s individual performance, achievements and contributions to the Company, and the overall financial results of the Company. The Compensation Committee determined the base salary for each NEO for 2013 in the first quarter of 2013.

Annual Bonuses. The NEOs are eligible for annual bonuses under the Short Term Incentive Plan, which are generally paid in cash in the first quarter of each year. The Short Term Incentive Plan supports the Company’s recruitment objectives by enabling the Company to attract qualified new employees. The STIP supports the Company’s retention and incentive objectives by providing eligible NEOs with competitive compensation and appropriate incentives to enhance the profitability and growth of the Company, and by rewarding them for their service and personal contribution to the Company’s success.

The STIP bonus awards are intended primarily to reflect the degree to which the Company meets its annual financial plan. For 2013, such awards would have been determined based primarily upon the degree to which the Company achieved selected corporate performance targets (the “STIP Bonus Targets”) with respect to four equally weighted components:

 

(1) operating return on equity (excluding gains and losses realized on investments and non-recurring transaction costs) (the “Adjusted Operating Return on Equity”),

 

(2) gross premiums written and produced,

 

(3) combined ratio, and

 

(4) growth in diluted book value per share (the “Adjusted Growth in Diluted Book Value Per Share”).

The Adjusted Operating Return on Equity performance target and the Adjusted Growth in Diluted Book Value Per Share performance target are intended to measure the increase in shareholder value over various periods of time. The gross premiums written and produced performance target is intended to measure premium growth. The combined ratio performance target is a standard property and casualty insurance industry measure of profitability, and also serves as a risk management tool by discouraging the Company from writing unprofitable business. The Compensation Committee believes that the STIP Bonus Targets for annual bonus awards under the Short Term Incentive Plan were set at levels that could be achieved only with significant effort on the part of the NEOs.

 

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Based upon the degree of the Company’s achievement of the STIP Bonus Targets under the Short Term Incentive Plan and pursuant to the terms of the Merger Agreement, the Compensation Committee determined not to award annual cash bonuses to the NEOs for 2013.

Stock-Based Incentives. As a result of the approval by the shareholders of the 2013 Long Term Incentive Plan at the 2013 annual general meeting of shareholders, the NEOs are eligible for equity awards under the 2013 Long Term Incentive Plan. Awards granted under the 2013 LTIP for each of the NEOs and certain other senior officers of the Company designated by the CEO and approved by the Compensation Committee are:

 

   

75% performance-based, and

 

   

25% time-based.

An equity award for each of the NEOs and other designated senior officers under the 2013 LTIP would be calculated as follows:

 

(1) 50% of such equity award will be based on total shareholder return for the Company relative to that of its peers over the immediately preceding three-year period and will vest at the end of such three-year period,

 

(2) 25% of such equity award will be based on return on tangible equity over such three-year period and will vest at the end of such three-year period, and

 

(3) 25% of such equity award will be based on such plan participant’s target bonus opportunity and will vest concurrently with the performance component of such award.

With respect to (1) and (2) above (the “LTIP Performance-Based Bonus Targets”), the total shareholder return performance metric is intended to measure the return on investment to the Company’s shareholders based upon share price appreciation and dividends paid relative to that of the Company’s peers. The return on tangible equity performance metric is intended to measure the increase in shareholder value over various periods of time. The Compensation Committee believes that the LTIP Performance-Based Bonus Targets were set at levels that could be achieved only with significant effort on the part of the CEO and other NEOs. The Committee believes that (3) above (“the LTIP Time-Based Bonus Target” and, together with the LTIP Performance-Based Bonus Targets, the “LTIP Targets”) supports the recruitment and retention objectives of the Company’s executive compensation program as described above. The performance components and measurement period to be used to determine equity awards under the 2013 LTIP for NEOs and other designated senior officers differ from those to be used to determine annual bonus awards under the STIP. The Compensation Committee has discretion to adjust downward, but not upward, the annual equity bonus award payable to each NEO under the 2013 Long Term Incentive Plan.

Based upon the Company’s financial performance in 2013, the Compensation Committee determined not to make any equity awards under the 2013 LTIP for the three-year performance period from 2013-2015.

The Company encourages ownership by officers of the Company’s stock through its equity-based awards, and has adopted stock ownership requirements for NEOs as described under “Corporate Governance – Stock Ownership Guidelines” above. The 2013 LTIP requires that both a change in control and the termination of employment within two years of the change in control are required for accelerated vesting.

Retirement Income Plans. The Company’s retirement income plans include the Tower Group, Inc. Deferred Compensation Plan (the “Deferred Compensation Plan”), the Tower Group, Inc. Supplemental Executive Retirement Plan (the “SERP”) in which the NEOs and certain other officers of the Company are eligible to participate, and the Company’s 401(k) Plan with matching Company contribution, in which all employees are eligible to participate.

The Deferred Compensation Plan is a voluntary, non-qualified plan offered to all officers of the Company at the level of Vice President and above and to all of the Company’s Directors. Participants in the Deferred Compensation Plan are able to defer a portion of their current base salary and annual cash bonus, resulting in lower current taxable income and tax-deferred earnings growth on their deferred amounts. Each participant is able to self-direct the investment of his or her account balance from a choice of 17 valuation funds. Currently, 23 of the eligible officers and Directors of the Company are enrolled in the Deferred Compensation Plan. Of the NEOs, only Mr. Hitselberger participated in the Deferred Compensation Plan in 2013.

The SERP is a non-qualified defined contribution plan effective as of January 1, 2009 that is intended to enhance retirement benefits for the Company’s most senior executives and certain other key employees. Eligibility to participate in the SERP generally requires three years of prior employment with the Company for Executive Vice Presidents and Senior Vice Presidents and between five and 10 years of prior employment with the Company for other key employees. While Mr. Dove has been employed with the Company for less than three years, the Compensation Committee determined, based upon his senior management position and his importance to the Company, to permit him to participate in the SERP beginning in 2012. Messrs. Hitselberger, Orol, Dove and Roberts, as well as certain non-NEO key executives selected at the discretion of the Compensation Committee, are eligible to participate in the SERP. Subject to the approval of the Compensation Committee, the Company may make annual contributions to the SERP on behalf of each participant. The SERP is not a defined benefit plan.

 

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For all SERP participants, the current amount of the Company’s annual contribution is equal to 5% of their annual cash compensation for the prior year. Company contributions for each participant remain unvested until such participant has completed 10 years of service with the Company, and vest in full upon completion of 10 years of service. However, as required by the terms of the SERP, unvested Company contributions for each participant became fully vested as a result of the closing of the Canopius Merger Transaction on March 13, 2013. Since the former CEO had more than 10 years of service with the Company, the Company’s SERP contributions for him were fully vested prior to the closing of the Merger in March 2013. The Compensation Committee has discretion to terminate the SERP at any time or to adjust upward or downward the level of the Company’s contribution each year.

In addition to the Deferred Compensation Plan and the SERP, each currently employed NEO is eligible to participate in the Company’s 401(k) Plan. The 401(k) Plan provides for the Company to match each participating employee’s annual contributions to the Plan in an amount up to 4% of such employee’s base salary and cash bonus at the matching rate of $.50 per $1.00 contributed, subject to certain matching contribution limits under applicable law. The Company’s matching contributions vest ratably over a five-year period.

Supplemental Benefits. Except as noted below, currently employed NEOs participate in the Company’s health and welfare benefits on the same terms and conditions as other employees. Executive compensation also includes a limited number of supplemental benefits and perquisites for the Company’s key executives. These benefits include a supplemental medical reimbursement plan for executive officers (other than Mr. Roberts) in an annual amount of up to $5,000. In addition to the foregoing, the perquisites for the former CEO included a country club membership and an automobile allowance. The Company believes that its supplemental benefits and perquisites are customary and enhance the Company’s ability to retain talented executives.

The Compensation Committee’s Process

The Compensation Committee, working with the Company’s senior management, develops and implements the Company’s executive compensation policies. The Compensation Committee is responsible for the Company’s compensation program for its NEOs and for recommending to the Board of Directors the compensation of the Company’s Directors. The Compensation Committee is also responsible for the administration, including designating in its discretion the recipients, amounts and terms of equity grants, of the 2013 Long Term Incentive Plan, as well as of the 2008 Long Term Equity Plan, with respect to which the Committee determined to make no further awards following the approval of the 2013 LTIP by the shareholders at the 2013 annual general meeting.

The Compensation Committee conducts its review of executive performance and compensation on an annual basis and generally adjusts base salaries and makes cash bonus and equity-based awards annually in the first calendar quarter of the year following the performance year. This process includes an assessment of the performance of the Company and of each NEO for the year, and a comparison of each NEO’s compensation to market data for executives in similar positions at peer companies of the Company. The Committee engages an independent compensation consultant to compile this market data. Compensation adjustments can be made during the year if circumstances are appropriate, such as when an individual is promoted or takes on additional responsibilities. Cash bonuses and equity-based awards may also be made to individuals during the year in which they join the Company.

Assessment of Company Performance in 2013. As noted under “Compensation Discussion and Analysis — The Company’s Performance in 2013” above, the Compensation Committee did not make annual cash bonus awards for 2013 performance under the STIP or long term equity awards for the 2013-2015 performance period under the 2013 LTIP. Based upon the Committee’s assessment of the Company’s performance in 2013, the Committee has determined to reduce the Company’s expenses and, as described under “Compensation Philosophy and Objectives – Elements of Compensation” above, to focus on the retention of key employees.

Assessment of Individual Performance. Each year, the Compensation Committee considers the individual performance of each NEO. Factors that are evaluated to determine each NEO’s individual contribution include his strategic vision, leadership and management skills, technical skills and judgment in performing his responsibilities.

Benchmarking against Peer Group. In setting compensation, the Compensation Committee compares the elements of compensation for the Company’s executives against the compensation of executives at a peer group of publicly traded insurance

 

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companies of comparable size, based on gross written premium, and complexity of business structure, based on the Committee’s understanding of such companies’ lines of business written. The Committee retains an executive compensation consulting firm, Pearl Meyer & Partners, to assist it in selecting appropriate peer companies and to obtain and organize the information. The Committee compares the compensation of individual executives to their counterparts at the peer group if the positions are sufficiently similar to make the comparison meaningful. The Committee uses the peer group data as one factor in the decision on what compensation levels to set and as a guide in determining the competitiveness of each element of the compensation program. The peer group used for 2013 consisted of the following companies:

 

Allied World Assurance Company    Aspen Insurance Holdings, Ltd.    Markel Corp.
American Financial Group, Inc.    Axis Capital Holdings Limited    The Navigators Group, Inc.
AmTrust Financial Services, Inc.    Endurance Specialty Holdings, Ltd.    Selective Insurance Group, Inc.
Arch Capital Group, Ltd.    The Hanover Insurance Group, Inc.    Validus Holdings, Ltd.
Argo Group International Holdings, Ltd.    HCC Insurance Holdings, Inc.   

The executive compensation consultant provided a report to the Compensation Committee in November 2013. This report compared the Company’s compensation program to those of its peer companies and to available compensation surveys, and included salary ranges and commonly used equity-based incentives, structure and mix of compensation, design, and content of annual and long term incentive plans. The executive compensation consultant also provided consultative advice to the Compensation Committee with respect to executive compensation during 2013. While the Compensation Committee believes that using an executive compensation consultant is an effective way to keep current regarding competitive compensation practices, the Committee does not believe that it should accord undue weight to the advice of such consultant. Accordingly, while the Committee generally considers the 50th percentile of comparable market data in executive compensation studies as a guideline in setting the annual compensation of the NEOs, this is only one of several factors used by the Committee to set such compensation.

Under its charter, the Compensation Committee is authorized to retain a compensation consultant and outside advisors at the Company’s expense. In 2013, as noted above, the Compensation Committee retained Pearl Meyer & Partners to advise it on matters related to executive compensation and the Company’s compensation plans. Other than providing the November 2013 report described in the paragraph above to and discussing it with the Compensation Committee and providing such consultative advice, Pearl Meyer & Partners played no role in advising the CEO or the Compensation Committee on compensation decisions in 2013. Pearl Meyer & Partners provides no other services to the Company.

The Compensation Committee has reviewed the independence of Pearl Meyer & Partners in light of SEC rules and NASDAQ listing standards regarding compensation consultants and has concluded that Pearl Meyer & Partners’ work for the Compensation Committee is independent and does not raise any conflict of interest.

2013 Awards to the Chief Executive Officer and Other Named Executive Officers. As noted under “Summary of Key Agreements – Former Chief Executive Officer Separation and Release Agreement” below, the Company’s former CEO, Mr. Lee, resigned on February 6, 2014. Mr. Lee’s compensation for 2013 included cash compensation of $900,000, consisting solely of his annual base salary. In addition, as required under the terms of Mr. Lee’s Separation and Release Agreement with the Company described under “Summary of Key Agreements – Former Chief Executive Officer Separation and Release Agreement” below, which reduced the amount that the Company would have been required to pay to Mr. Lee pursuant to his employment agreement in effect as of the date of such resignation, the Company paid to Mr. Lee in March 2014 a separation payment in the amount of $3,280,614.

With respect to the NEOs, as noted under “Compensation Discussion and Analysis – The Company’s Performance in 2013” above, the Compensation Committee determined not to make annual cash bonus awards under the STIP with respect to 2013 performance and not to make long term equity awards under the 2013 LTEP for the 2013-2015 performance period.

The Compensation Committee believes that the compensation mix for these NEOs strikes an appropriate balance between salary and variable compensation arrangements and is consistent with the Company’s compensation policies for employees in general.

 

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Employment Agreements. The Company enters into employment agreements to attract and retain talented executives. The Company has entered into employment agreements with certain of its executive officers, including Messrs. Hitselberger, Orol and Dove. The Company has not entered into an employment agreement with Mr. Roberts. Each of these employment agreements was reviewed by the Compensation Committee prior to the Company’s entering into such agreement. Based on this review, the Company believes the terms of these agreements are competitive with those entered into by its peer companies. For a description of the employment agreements with NEOs, see “Summary of Key Agreements” below.

There are no change-in-control agreements or severance agreements between the Company and its NEOs other than provisions set forth in (i) the employment agreements between the Company and certain of its NEOs and (ii) the 2013 Long Term Incentive Plan. For a description of these provisions with respect to the NEOs, see “Summary of Key Agreements” below. The accelerated vesting of unvested restricted shares of stock awarded under the 2013 LTIP, unlike the accelerated vesting of unvested restricted shares of stock awarded under the 2008 LTEP, requires both a change in control and the termination of employment within two years of the change in control.

Tax Considerations. Under Section 162(m) of the Code, annual compensation in excess of $1,000,000 paid to certain executive officers of a publicly held corporation will not be deductible unless such compensation is based upon performance objectives meeting certain regulatory criteria or is otherwise excluded from the limitation. The Company considers this limitation on deductions when structuring executive compensation. Incentive compensation paid to the Company’s executive officers pursuant to the Short Term Incentive Plan, the 2008 Long Term Equity Plan, and the 2013 Long Term Incentive Plan is intended to qualify for deductibility by the Company under Section 162(m), but there can be no assurance that this compensation will meet the required criteria. The Compensation Committee recognizes that in certain instances, it may be in the best interests of the Company’s shareholders to provide compensation that is not fully deductible and may do so as it determines appropriate.

COMPENSATION COMMITTEE REPORT

The Compensation Committee of the Company has reviewed and discussed with management the Compensation Discussion and Analysis required by Item 402(b) of Regulation S-K and, based on such review and discussions, the Compensation Committee has recommended to the Board of Directors that the Compensation Discussion and Analysis be included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

 

The Compensation Committee
Robert S. Smith, Chairman
Steven W. Schuster
Jan R. Van Gorder

 

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SUMMARY COMPENSATION TABLE

The following table sets forth a summary of the compensation paid by the Company to the Chief Executive Officer, the Principal Financial Officer and each of the five other most highly paid executive officers (including the former Chief Executive Officer and the former Chief Underwriting Officer) of the Company or its subsidiaries (the “Named Executive Officers” or “NEOs”).

 

Name and Principal Position   Year   Salary   Bonus (1)   Stock
Awards  (2)
  Option
Awards
  Non-
Equity
Incentive
Compensation
  Change in
Pension
Value and
Nonqualified
Deferred
Compensation
Earnings
  All
Other
Compensation  (3)
  Total

William E. Hitselberger
Executive Vice President, Chief Financial Officer

      2013       $ 539,069       $ -       $ -       $       -       $       -       $       -       $ 58,144       $ 597,213  
      2012         506,253         84,094         248,625         -         -         -         91,254         930,226  
      2011         450,000         194,513         786,094         -         -         -         48,786         1,479,393  

Elliot S. Orol
Senior Vice President, General Counsel and Secretary

      2013         383,355         -         -         -         -         -         46,013         429,368  
      2012         368,336         112,200         173,400         -         -         -         59,690         713,629  
      2011         340,000         135,660         365,500         -         -         -         59,592         900,752  

William F. Dove
Senior Vice President, Chief Risk Officer

      2013         410,000         -         -         -         -         -         49,264         459,264  
      2012         410,000         123,000         246,000         -         -         -         36,332         815,332  
      2011         84,102         386,000         725,000         -         -         -         6,387         1,201,489  

James E. Roberts
Senior Vice President, Reinsurance

      2013         343,403         -         -         -         -         -         36,475         379,878  
      2012         306,919         186,180         198,250         -         -         -         21,945         713,294  
      2011         276,667         146,425         215,000         -         -         -         17,371         655,463  

Michael H. Lee (4)
Chairman of the Board, President and Chief Executive Officer

      2013         900,000         -         -         -         -         -         152,311         1,052,311  
      2012         900,000         225,000         1,525,590         -         -         -         325,720         2,976,310  
      2011         900,000         622,170         3,321,676         -         -         -         688,942         5,532,788  

Gary S. Maier (5)
Executive Vice President, Chief Underwriting Officer

      2013         315,305         -         -         -         -         -         724,225         1,039,530  
      2012         407,461         66,942         212,713         -         -         -         65,441         752,557  
      2011         385,000         166,416         496,650         -         -         -         63,316         1,111,382  

 

(1) Based upon the degree of the Company’s achievement of the STIP Bonus Targets under the Short Term Incentive Plan and pursuant to the terms of the Merger Agreement, the Compensation Committee determined not to award annual cash bonuses to the NEOs under the STIP in 2013.
(2) This amount reflects the grant date fair value in accordance with FASB ASC Topic 718. Following the Compensation Committee’s previous determination not to make any equity awards to the NEOs for 2012 performance for at least six months following the closing of the Canopius Merger Transaction in March 2013 to provide the Committee with an opportunity to assess the results of the Canopius Merger Transaction, including the organizational structure and the role of each NEO in the Company following the Canopius Merger Transaction, the Committee determined not to make any equity awards to the NEOs for 2012 performance. See Note 14, “Stock Based Compensation,” in the Notes to the Company’s Consolidated Financial Statements included in Item 8 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 for the assumptions used to determine the compensation costs associated with stock and option awards that the Company expensed in 2013, 2012 and 2011.

 

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(3) All Other Compensation includes (1) for Mr. Hitselberger, (a) officer medical reimbursement -2013: $5,000; 2012: $5,000; 2011: $5,000; (b) 401(k) match - 2013: $8,750; 2012: $10,000; 2011: $9,800; (c) term life insurance premium – 2013: $1,050; 2012: $798; 2011: $798; (d) dividends on restricted stock – 2013: $7,743; 2012: $31,933; 2011 - $33,188; and (e) SERP contribution – 2013: $35,601; 2012: $43,523; 2011: $0. (2) for Mr. Orol: (a) officer medical reimbursement – 2013: $5,000; 2012: $5,000; 2011: $5,000; (b) 401(k) match– 2013: $10,200; 2012: $10,000; 2011: $9,800; (c) term life insurance premium – 2013: $1,050; 2012: $798; 2011: $775; (d) dividends on restricted stock – 2013: $4,279; 2012: $17,117; 2011: $20,642; and (e) SERP contribution – 2013: $25,484; 2012: $26,775; 2011: $23,375; (3) for Mr. Dove: (a) officer medical reimbursement - 2013: $0; 2012: $0; 2011: $0; (b) 401(k) match - 2013: $8,750; 2012: $0; 2011: $0; (c) term life insurance premium – 2013: $1,050; 2012: $798; 2011: $166; (d) dividends on restricted stock – 2013: $6,664; 2012: $31,322; 2011 - $6,221; and (e) SERP contribution – 2013: $32,800; 2012: $4,212; 2011: $0; (4) for Mr. Roberts: (a) officer medical reimbursement -2013: $0; 2012: $0; 2011: $0; (b) 401(k) match - 2013: $10,200; 2012: $10,000; 2011: $9,800; (c) term life insurance premium – 2013: $683; 2012: $920; 2011: $798; (d) dividends on restricted stock – 2013: $2,756; 2012: $11,025; 2011 - $6,773; and (e) SERP contribution – 2013: $22,836; 2012: $0; 2011: $0; (5) for Mr. Lee: (a) officer medical reimbursement - 2013: $5,000; 2012: $5,000; 2011: $5,000; (b) 401(k) match - 2013: $10,200; 2012: $10,000; 2011: $9,800; (c) term life insurance premium – 2013: $1,050; 2012: $798; 2011: $798; (d) dividends on restricted stock – 2013: $37,952; 2012: $159,880; 2011: $168,066; (e) SERP contribution – 2013: $76,109; 2012: $128,042; 2011: $483,278; (f) country club dues – 2013: $10,000; 2012: $10,000; 2011: $10,000; and (g) car allowance – 2013: $12,000; 2012: $12,000; 2011: $12,000; and (6) for Mr. Maier: (a) officer medical reimbursement -2013: $0; 2012: $0; 2011: $0; (b) 401(k) match - 2013: $8,750; 2012: $8,500; 2011: $8,250; (c) term life insurance premium – 2013: $1,050; 2012: $798; 2011: $798; (d) dividends on restricted stock – 2013: $5,788; 2012: $23,611; 2011 - $25,946; (e) SERP contribution – 2013: $28,919; 2012: $32,532; 2011: $28,322; and (f) for 2013, a separation payment in the amount of $679,718 pursuant to the separation agreement, dated September 24, 2013, between the Company and Mr. Maier.
(4) On February 6, 2014, Mr. Lee resigned as Chairman, President and Chief Executive Officer of the Company.
(5) On October 4, 2013, Mr. Maier resigned as Executive Vice President, Chief Underwriting Officer of Tower Group, Inc., a wholly owned subsidiary of the Company.

Summary of Key Agreements

Named Executive Officers’ Employment Agreements. Under their respective employment agreements, each of Messrs. Hitselberger, Orol and Dove has agreed to serve in his current position and/or in such other positions as the Company (or, with respect to Mr. Dove, the Predecessor Company) may assign. The initial term of service under the agreements is two years for Messrs. Hitselberger, Orol and Dove, followed in each case by automatic additional one-year terms unless a notice not to extend the term is provided by the Company or the employee prior to the end of the term. The amount of notice required is one year for Messrs. Hitselberger, Orol and Dove. Mr. Roberts does not have an employment agreement with the Company.

Each of Messrs. Hitselberger, Orol and Dove receives a minimum annual base salary and an annual incentive bonus, to be determined by the Board of Directors, with the current target bonus of 65% of annual base salary for Mr. Hitselberger and 60% of annual base salary for Messrs. Orol and Dove. Each such Named Executive Officer’s salary and target annual bonus are subject to review for increase at the discretion of the Board of Directors or a committee of the Board of Directors; however, they cannot be decreased below the salaries and target bonus percentages stated above. Each named executive may also participate in the Company’s long-term incentive plans. The 2013 annual base salaries for Messrs. Hitselberger, Orol and Dove were $543,375, $385,220, and $410,000, respectively, and were not increased in 2014.

If a Named Executive Officer’s employment terminates as a result of disability or death, his employment agreement automatically terminates, and he or his designated beneficiary or administrator, as applicable, is entitled to accrued salary through the termination date and a prorated target bonus. Additionally, all stock-based awards will vest and his stock options will remain exercisable for one year after the date his employment terminates (or until the last day of the stock option term, whichever occurs first).

If the Company (or, with respect to Mr. Dove, the Predecessor Company) terminates the employment of the Named Executive Officer without cause, or if the Named Executive Officer terminates his employment with good reason, then the terminated employee is entitled to (i) his accrued base salary and a prorated target bonus, (ii) a cash severance payment equal to 100% of the sum of his annual base salary and his target annual bonus, (iii) the continuation of health and welfare benefits for one year, except that those benefits will be reduced to the extent comparable benefits are received by or made available to the Named Executive Officer by a subsequent employer, and (iv) three months (or until the last day of the stock option term, whichever occurs first) to exercise any vested stock options. “Cause” includes gross negligence or gross misconduct or the conviction of, or such Named Executive Officer’s pleading nolo contendere to, a felony involving moral turpitude. “Good reason” under the employment agreement for each of Messrs. Hitselberger, Orol and Dove means any of the following events that has remained uncured, if curable, for 30 days after notice from such Named Executive Officer: the assignment to such NEO of duties materially inconsistent with his position or a substantial diminution in his authority and duties; any reduction in such

 

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NEO’s annual base salary or annual target bonus or annual target equity award opportunity; requiring such NEO to be based more than 50 miles away from the Predecessor Company’s headquarters in New York, New York; the material breach by the Company (or, with respect to Mr. Dove, the Predecessor Company) of any of its other obligations under the employment agreement; or the failure of the Company (or, with respect to Mr. Dove, the Predecessor Company) to obtain the assumption of the employment agreement by any successor of the Company (or, with respect to Mr. Dove, the Predecessor Company).

If the Company (or, with respect to Mr. Dove, the Predecessor Company) terminates a Named Executive Officer’s employment agreement without cause, or if the Named Executive Officer terminates his employment with good reason, in anticipation of, or within the 24-month period following, a change in control, which has substantially the same definition as set forth for such term under the 2013 LTIP and the 2008 LTEP, the Named Executive Officer is entitled to receive the foregoing benefits and is also entitled to immediate vesting of his previously unvested stock awards. The employment agreements for Messrs. Hitselberger, Orol and Dove do not provide for an excise tax gross-up payment, and each provides instead that if payments received under the agreement and other payments received under other agreements or employee benefit plans result in the imposition of an excise tax under Section 4999 of the Code, then the payments would be reduced (but not below zero) by the amount necessary to prevent the excise tax but only if, by reason of the deduction, the net after-tax economic benefit to Mr. Hitselberger, Mr. Orol or Mr. Dove, as applicable, would exceed the net after-tax economic benefit to such Named Executive Officer if no such reduction were made.

If Mr. Hitselberger, Mr. Orol or Mr. Dove retires after attaining age 55 but before attaining age 62, he receives his accrued base salary through the retirement date and applicable retiree benefits, if any, and will have three months (or until the last day of the stock option term, whichever occurs first) to exercise any vested stock options. If Mr. Hitselberger, Mr. Orol or Mr. Dove retires after attaining age 62, he receives his accrued salary through the retirement date, applicable retiree benefits, if any, and vesting of previously unvested stock awards, and his stock options will remain exercisable for the full option term.

The Named Executive Officers are subject under the terms of their respective employment agreements to non-solicitation provisions for a period of one year after the termination of their employment, along with ongoing confidentiality and non-disclosure requirements. Mr. Dove is also subject to a non-competition provision for a period of one year after termination under the terms of his employment agreement with the Predecessor Company.

In the “Potential Payments Upon Termination of Employment or Change of Control” table below, amounts are not provided for the financial effect of a termination for cause, as defined in each Named Executive Officer’s employment agreement, because the Named Executive Officers are not entitled to further benefits or compensation following such a termination.

Former Chief Executive Officer Separation and Release Agreement. On February 6, 2014, the Company entered into a Separation and Release Agreement with Mr. Lee (the “Separation Agreement”), which provided that Mr. Lee’s employment with the Company would terminate on such date. Pursuant to the Separation Agreement, which reduced the amount that the Company would have been required to pay to Mr. Lee pursuant to his employment agreement in effect as of the date of such resignation, the Company agreed to pay to Mr. Lee in cash, within 30 business days of the date of the Separation Agreement, any earned but unpaid annual base salary and a lump sum payment in the amount of $3,280,614. Mr. Lee agreed to a general release and waiver of claims against, among other parties, the Company and its officers and directors, and agreed and acknowledged that his obligations under the non-competition, confidential information, non-solicitation and non-interference provisions of his employment agreement, dated as of February 27, 2012 and amended as of March 13, 2013, continued to apply in accordance with their terms.

Chief Executive Officer Employment Agreement. On February 14, 2014, the Company entered into an employment agreement with Mr. Fox. Pursuant to Mr. Fox’s employment agreement, Mr. Fox will serve as the Company’s President and Chief Executive Officer for a term of nine months from the date of such agreement. Pursuant to his employment agreement, Mr. Fox receives a base salary of $585,000 during such nine-month term. The employment agreement does not provide for the payment of either an annual incentive bonus award under the Short Term Incentive Plan or a long-term equity award under the 2013 Long Term Incentive Plan. The employment agreement also provides for a one-time cash payment of $7,500, payable within 30 days of the date of the agreement, which is intended to defray Mr. Fox’s tax planning costs and attorneys’ fees in connection with his entry into the agreement, and for a monthly benefit allowance of $3,000 in lieu of Mr. Fox’s participation in any of the health and welfare benefit, retirement, supplemental retirement, and deferred compensation plans, policies and arrangements that are provided generally to other senior officers of the Company.

2008 Long Term Equity Plan and 2013 Long Term Incentive Plan. As a result of the Canopius Merger Transaction on March 13, 2013, a change in control, as defined under the 2008 LTEP, occurred. Accordingly, as required by the terms of the 2008 LTEP, the vesting of all unvested restricted stock and restricted stock units issued under the 2008 LTEP was accelerated, and such unvested restricted stock and restricted stock units were immediately vested.

 

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With respect to the 2013 Long Term Incentive Plan, on the other hand, options issued under the 2013 LTIP become immediately exercisable only upon, and the period of restriction for any restricted stock and restricted stock units issued under the 2013 LTIP lapses only upon, both (1) the occurrence of a change in control and (2) the termination of employment other than for cause within two years of such change in control. A change in control is defined under the 2013 LTIP to mean any of the following events: (a) any “person” (within the meaning of Section 3(a)(9) of the Securities Exchange Act of 1934, including a “group” as defined in Section 13(d) of the Securities Exchange Act of 1934 (a “Person”)) (other than the Company, any trustee or other fiduciary holding securities under an employee benefit plan of the Company, or any corporation owned directly or indirectly by the shareholders of the Company in substantially the same proportion as the ownership of stock of the Company) that is not on the Effective Date (as defined in the 2013 LTIP) the “beneficial owner” (as defined in Rule 13d-3 under the Securities Exchange Act of 1934), directly or indirectly, of securities of the Company representing more than 20% of the combined voting power of the Company’s then outstanding securities becomes after the Effective Date the beneficial owner, directly or indirectly, of securities of the Company representing more than 20% of the combined voting power of the Company’s then outstanding securities; (b) individuals who, as of the Effective Date, constitute the Board (the “Incumbent Board”) cease for any reason to constitute at least a majority of the Board of the Company, provided that any person becoming a director subsequent to the date hereof whose election, or nomination for election by the Company’s shareholders, was approved by a vote of at least a majority of the directors then comprising the Incumbent Board (other than an election or nomination of an individual whose initial assumption of office is in connection with an actual or threatened election contest relating to the election of the directors of the Company) shall be, for purposes of this definition, considered as though such person were a member of the Incumbent Board; (c) consummation of a merger, consolidation, reorganization, share exchange or similar transaction (a “Transaction”) of the Company with any other entity, other than (i) a Transaction that would result in the voting securities of the Company outstanding immediately prior thereto directly or indirectly continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity or a parent company) more than 70% of the combined voting power of the voting securities of the Company or such surviving entity or parent company outstanding immediately after such Transaction or (ii) a Transaction effected to implement a recapitalization of the Company (or similar transaction) in which no Person acquires more than 20% of the combined voting power of the Company’s then outstanding securities; (d) the sale, transfer or other disposition (in one transaction or a series of related transactions) of more than 50% of the operating assets of the Company; or (e) the approval by the shareholders of a plan or proposal for the liquidation or dissolution of the Company.

Outstanding Equity Awards at December 31, 2013

The following table sets forth information for each Named Executive Officer with respect to his outstanding equity awards as of December 31, 2013.

 

     Option Awards     Stock Awards  
Name    Option
Grant Date
     Number of
Securities
Underlying
Unexercised
Options
Exercisable
     Number of
Securities
Underlying
Unexercised
Options
Unexercisable
     Option
Exercise
Price
     Option
Exercise
Date
    Stock Award
Grant Date
     Number of
Shares of
Stock That
Have Not
Vested
     Market
Value of
Shares of
Stock That
Have Not
Vested
 

 

William E. Hitselberger (1)

     -         -         -         -         -        -         -         -   

Elliot S. Orol (1)

     -         -         -         -         -        -         -         -   

William F. Dove (1)

     -         -         -         -         -        -         -         -   

James E. Roberts (1)

     -         -         -         -         -        -         -         -   

Michael H. Lee

     04/01/06         515,927        -       $ 16.28        04/01/16        -         -         -   

Michael H. Lee

     03/22/07         64,403        -       $ 23.61        03/22/17        -         -         -   

Michael H. Lee

     03/10/08         109,105        -       $ 16.48        03/10/18        -         -         -   

Michael H. Lee (1)

     -         -         -         -         -        -         -         -   

Gary S. Maier (1)

     -         -         -         -         -        -         -         -   

 

(1) 

As a result of the closing of the Canopius Merger Transaction on March 13, 2013, and in accordance with the terms of the 2008 LTEP, all unvested shares of restricted stock held by Messrs. Hitselberger, Orol, Dove, and Roberts, as well as by Mr. Lee, the former CEO, and Mr. Maier, the former Executive Vice President, Chief Underwriting Officer, prior to the effective time of the Canopius Merger Transaction became vested. The Compensation Committee has not made any equity awards to NEOs subsequent to the closing of the Canopius Merger Transaction on March 13, 2013.

 

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Option Exercises and Stock Vested in 2013

The following table sets forth information for each Named Executive Officer with respect to stock options that were exercised and restricted shares that vested, and the value realized on such exercise or vesting, during 2013.

 

     Option Awards    Stock Awards  
Name    Number of Shares
Acquired on
Exercise
   Value Realized on
Exercise
   Number of Shares
Acquired on
Vesting
     Value Realized on
Vesting
 

William E. Hitselberger (1)

           2,693      $ 49,955  

William E. Hitselberger (2)

           12,615        239,748  

William E. Hitselberger (3)

           25,987        514,282  

Elliot S. Orol (4)

           1,878        34,837  

Elliot S. Orol (5)

           2,234        41,843  

Elliot S. Orol (6)

           5,865        111,464  

Elliot S. Orol (7)

           1,423        27,734  

Elliot S. Orol (8)

           11,423        226,061  

William F. Dove (9)

           2,664        49,417  

William F. Dove (10)

           32,877        650,636  

James E. Roberts (11)

           2,147        39,827  

James E. Roberts (12)

           287        5,376  

James E. Roberts (13)

           3,450        65,567  

James E. Roberts (14)

           8,817        174,488  

Michael H. Lee (15)

           14,573        270,329  

Michael H. Lee (16)

           24,748        463,530  

Michael H. Lee (17)

           52,097        990,103  

Michael H. Lee (18)

           110,990        2,196,492  

Gary S. Maier (19)

           2,304        42,739  

Gary S. Maier (20)

           3253        60,929  

Gary S. Maier (21)

           7,970        151,470  

Gary S. Maier (22)

           2,349        45,782  

Gary S. Maier (23)

           14,994        296,731  

 

(1)

Mr. Hitselberger acquired 2,693 shares with a market price of $18.55 on March 1, 2013 upon the vesting of Restricted Stock Shares.

(2)

Mr. Hitselberger acquired 12,615 shares with a market price of $19.01 on March 7, 2013 upon the vesting of Restricted Stock Shares.

(3)

Mr. Hitselberger acquired 25,987 shares with a market price of $19.79 on March 13, 2013 upon the vesting of Restricted Stock Shares as a result of the closing of the Canopius Merger Transaction.

(4)

Mr. Orol acquired 1,878 shares with a market price of $18.55 on March 1, 2013 upon the vesting of Restricted Stock Shares.

(5)

Mr. Orol acquired 2,234 shares with a market price of $18.73 on March 5, 2013 upon the vesting of Restricted Stock Shares.

(6)

Mr. Orol acquired 5,865 shares with a market price of $19.01 on March 7, 2013 upon the vesting of Restricted Stock Shares.

(7)

Mr. Orol acquired 1,423 shares with a market price of $19.49 on March 12, 2013 upon the vesting of Restricted Stock Shares.

(8)

Mr. Orol acquired 11,423 shares with a market price of $19.79 on March 13, 2013 upon the vesting of Restricted Stock Shares as a result of the closing of the Canopius Merger Transaction.

(9)

Mr. Dove acquired 2,664 shares with a market price of $18.55 on March 1, 2013 upon the vesting of Restricted Stock Shares.

(10)

Mr. Dove acquired 32,877 shares with a market price of $19.79 on March 13, 2013 upon the vesting of Restricted Stock Shares as a result of the closing of the Canopius Merger Transaction.

(11)

Mr. Roberts acquired 2,147 shares with a market price of $18.55 on March 1, 2013 upon the vesting of Restricted Stock Shares.

(12)

Mr. Roberts acquired 287 shares with a market price of $18.73 on March 5, 2013 upon the vesting of Restricted Stock Shares.

(13)

Mr. Roberts acquired 3,450 shares with a market price of $19.01 on March 7, 2013 upon the vesting of Restricted Stock Shares.

 

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(14)

Mr. Roberts acquired 8,817 shares with a market price of $19.79 on March 13, 2013 upon the vesting of Restricted Stock Shares as a result of the closing of the Canopius Merger Transaction.

(15)

Mr. Lee acquired 14,573 shares with a market price of $18.55 on March 1, 2013 upon the vesting of Restricted Stock Shares.

(16)

Mr. Lee acquired 24,748 shares with a market price of $18.73 on March 5, 2013 upon the vesting of Restricted Stock Shares.

(17)

Mr. Lee acquired 52,097 shares with a market price of $19.01 on March 7, 2013 upon the vesting of Restricted Stock Shares.

(18)

Mr. Lee acquired 110,990 shares with a market price of $19.79 on March 13, 2013 upon the vesting of Restricted Stock Shares as a result of the closing of the Canopius Merger Transaction.

(19)

Mr. Maier acquired 2,304 shares with a market price of $18.55 on March 1, 2013 upon the vesting of Restricted Stock Shares.

(20)

Mr. Maier acquired 3,253 shares with a market price of $18.73 on March 5, 2013 upon the vesting of Restricted Stock Shares.

(21)

Mr. Maier acquired 7,970 shares with a market price of $19.01 on March 7, 2013 upon the vesting of Restricted Stock Shares.

(22)

Mr. Maier acquired 2,349 shares with a market price of $19.49 on March 12, 2013 upon the vesting of Restricted Stock Shares.

(23)

Mr. Maier acquired 14,994 shares with a market price of $19.79 on March 13, 2013 upon the vesting of Restricted Stock Shares as a result of the closing of the Canopius Merger Transaction.

Nonqualified Deferred Compensation for 2013

The following table sets forth information for the Named Executive Officers with respect to the Company’s Deferred Compensation Plan and SERP.

 

Name    Executive
Contributions in
2013
     Registrant
Contributions in
2013 (1)
     Aggregate
Earnings in 2013
    Aggregate
Withdrawals/
Distributions
     Aggregate Balance
December 31,2013
 

William E. Hitselberger (2)

   $ 69,000      $ 35,601      $ 48,527     $ -       $ 379,726  

Elliot S. Orol (3)

     -         25,484        4,211       -         153,830  

William F. Dove (4)

     -         32,800        (1,043     -         36,782  

James E. Roberts (5)

     -         22,836        -        -         22,836  

Michael H. Lee (6)

     -         76,109        -        -         1,614,402  

Gary S. Maier (7)

     -         28,919        -        -         130,122  

 

(1) 

Company contributions to the SERP for each participant remain unvested until such participant has completed 10 years of service with the Company, and vest in full upon completion of 10 years of service. Company contributions to the SERP are also reported in the Summary Compensation Table for 2013 in the All Other Compensation column. As required by the terms of the SERP, all unvested Company contributions for each participant became fully vested as a result of the closing of the Canopius Merger Transaction on March 13, 2013.

(2) 

Mr. Hitselberger participated in the Voluntary Deferred Compensation Plan and SERP in 2013. Of the aggregate balance at December 31, 2013, $35,601 and $43,523 were reported as compensation in the years ended December 31, 2013 and 2012, respectively, and $0 was reported as compensation in the year ended December 31, 2011, since he was not a member of the plan in 2011. Contributions were invested in the Nationwide NVIT Money Market V, Fidelity VIP Freedom 2015, MFS VIT Value and Nationwide NVIT Mid Cap Index I funds.

(3) 

Mr. Orol participated in the SERP in 2013. Of the aggregate balance at December 31, 2013, $25,484, $26,775 and $23,375 were reported as compensation in the years ended December 31, 2013, 2012 and 2011, respectively. Contributions were invested in the Nationwide NVIT Money Market V, Dreyfus Stock Index Initial and PIMCO VIT Real Return Admin funds.

(4) 

Mr. Dove participated in the SERP in 2013. Of the aggregate balance at December 31, 2013, $32,800 and $4,212 were reported as compensation in the years ended December 31, 2013 and 2012, respectively, and $0 was reported as compensation in the year ended December 31, 2011, since he was not a member of the plan in 2011. Contributions were invested in the Lazard Ret Emerging Mkt Eq fund.

(5) 

Mr. Roberts participated in the SERP in 2013. Of the aggregate balance at December 31, 2013, $22,836 was reported as compensation in the years ended December 31, 2013 and $0 was reported as compensation in the years ended December 31, 2012 and 2011, since he was not a member of the plan in 2012 or 2011. Contributions were invested in the Nationwide NVIT Money Market V fund.

(6) 

Mr. Lee participated in the SERP in 2013. Of the aggregate balance at December 31, 2013, $76,109, $128,042 and $483,278 were reported as compensation in the years ended December 31, 2013, 2012 and 2011, respectively. Contributions were invested in the Nationwide NVIT Money Market V fund.

 

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(7) 

Mr. Maier participated in the SERP in 2013. Of the aggregate balance at December 31, 2013, $28,919, $32,532 and $28,322 were reported as compensation in the years ended December 31, 2013, 2012 and 2011, respectively. Contributions were invested in the Nationwide NVIT Money Market V fund.

Potential Payments Upon Termination of Employment or Change in Control

The following tables provide information with respect to potential payments to the Named Executive Officers upon termination of their employment without cause by the Company or for good reason by the Named Executive Officers as these terms are defined in their respective employment agreements described under “Summary of Key Agreements” above (other than Mr. Roberts, who does not have an employment agreement with the Company). The tables assume a date of termination of December 31, 2013. We have not included a table below for Mr. Maier, who resigned on October 4, 2013 as Executive Vice President and Chief Underwriting Officer of Tower Group, Inc., a wholly-owned subsidiary of the Company. In connection with his resignation, Mr. Maier received a separation payment from the Company in the amount of $679,718 pursuant to the separation agreement, dated September 24, 2013, between the Company and Mr. Maier.

 

William E. Hitselberger  
Executive Benefits and Payments Upon Termination   Voluntary
Termination
without Good
Reason
   

Voluntary
Termination

for Good

Reason or
Involuntary
Termination
Without Cause (a)

    Retirement  (b)     Death or
Disability
    Change in
Control
(“CIC”) (c)
    Involuntary or
Good Reason
Termination upon
or within 24
months after CIC (d)
 

Cash Severance Payment

           

Base Salary

  $ -      $ 543,375     $ -      $ -      $ -      $ 543,375  

Bonus

    -        353,194       -        -        -        353,194  

Pro-Rata Bonus (e)

    -        353,194       -        353,194       -        353,194  

Value of Unvested and Accelerated Equity Awards

           

Options

    -        -        -        -        -        -   

Restricted Stock

    -        -        -        -        -        -   

Gross Value of Continuing Benefits (f)

    -        23,528       -        -        -        23,528  

Excise Tax Gross-Up

    -        -        -        -        -        -   

Total

  $ -      $ 1,273,291     $ -      $ 353,194     $ -      $ 1,273,291 (g) 

 

(a)

Severance payments equal to base salary plus target bonus in the fiscal year in which termination occurs.

(b)

Mr. Hitselberger was age 55 as of December 31, 2013. Upon retirement between 55 and 62, Mr. Hitselberger is eligible for: (i) retiree benefits, if any; and (ii) stock options will remain exercisable until the earlier of the third anniversary of the date of termination or the last day of the option term. Outstanding/unvested equity awards would be forfeited.

(c)

Change in Control column excludes involuntary/good reason termination.

(d)

Severance payments equal to base salary plus target bonus in the fiscal year of the change in control; requires both a change in control and termination of employment within two years of such change in control.

(e)

Represents pro-rata bonus equal to the target bonus opportunity in the fiscal year in which the termination event occurs.

(f)

Represents one additional year of coverage for medical and life insurance.

(g)

Payments will be reduced (but not below zero) by the amount necessary to prevent triggering excise tax under Sections 280G and 4999 of the Code.

 

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Elliot S. Orol  
Executive Benefits and Payments Upon Termination   Voluntary
Termination
without Good
Reason
    Voluntary
Termination
for Good
Reason or
Involuntary
Termination
Without  Cause (a)
    Retirement  (b)     Death or
Disability
    Change in
Control
(“CIC”) (c)
    Involuntary or
Good Reason
Termination upon
or within 24
months after CIC (d)
 

Cash Severance Payment

     

Base Salary

  $ -      $ 385,220     $ -      $ -      $ -      $ 385,220  

Bonus

    -        231,132       -        -        -        231,132  

Pro-Rata Bonus (e)

    -        231,132       -        231,132       -        231,132  

Value of Unvested and Accelerated Equity Awards

           

Options

    -        -        -        -        -        -   

Restricted Stock

    -        -        -        -        -        -   

Gross Value of Continuing Benefits (f)

    -        23,818       -        -        -        23,818  

Excise Tax Gross-Up

    -        -        -        -        -        -   

Total

  $ -      $ 871,302     $ -      $ 231,132     $ -      $ 871,302 (g) 

 

(a)

Severance payments equal to base salary plus target bonus in the fiscal year preceding termination.

(b)

Mr. Orol was age 57 as of December 31, 2013. Upon retirement between 55 and 62, Mr. Orol is eligible for: (i) retiree benefits, if any; and (ii) stock options will remain exercisable until the earlier of the third anniversary of the date of termination or the last day of the option term. Outstanding/unvested equity awards would be forfeited.

(c)

Change in Control column excludes involuntary/good reason termination.

(d)

Severance payments equal to base salary plus target bonus in the fiscal year of the change in control; requires both a change in control and termination of employment within two years of such change in control.

(e)

Represents pro-rata bonus equal to the target bonus opportunity in the fiscal year of the termination event.

(f)

Represents one additional year of coverage for medical and life insurance.

(g)

Payments will be reduced (but not below zero) by the amount necessary to prevent triggering excise tax under Sections 280G and 4999 of the Code.

 

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William F. Dove  
Executive Benefits and Payments Upon Termination   Voluntary
Termination
without Good
Reason
    Voluntary
Termination
for Good
Reason or
Involuntary
Termination
Without  Cause (a)
    Retirement  (b)     Death or
Disability
    Change in
Control
(“CIC”) (c)
    Involuntary or
Good Reason
Termination upon
or within 24
months after CIC (d)
 

Cash Severance Payment

     

Base Salary

  $ -      $ 410,000     $ -      $ -      $ -      $ 410,000  

Bonus

    -        246,000       -        -        -        246,000  

Pro-Rata Bonus (e)

    -        -        -        246,000       -        -   

Value of Unvested and Accelerated Equity Awards

           

Options

    -        -        -        -        -        -   

Restricted Stock

    -        -        -        -        -        -   

Gross Value of Continuing Benefits (f)

    -        22,561       -        -        -        22,561  

Excise Tax Gross-Up

    -        -        -        -        -        -   

Total

  $ -      $ 678,561     $ -      $ 246,000     $ -      $ 678,561 (g) 

 

(a)

Severance payments equal to base salary plus target bonus in the fiscal year preceding termination.

(b)

Mr. Dove was not retirement eligible as of December 31, 2013. Upon retirement, Mr. Dove is eligible for: (i) retiree benefits, if any; (ii) all unvested equity will continue to vest in accordance with their terms; and (iii) stock options will remain exercisable until the earlier of the third anniversary of the date of termination or the last day of the option term.

(c)

Change in Control column excludes involuntary/good reason termination.

(d)

Severance payments equal to base salary plus target bonus in fiscal year of the change in control; requires both a change in control and termination of employment within two years of such change in control.

(e)

Represents pro-rata bonus equal to the target bonus opportunity in the fiscal year preceding the termination event.

(f)

Represents one additional year of coverage for medical and life insurance.

(g)

Payments will be reduced (but not below zero) by the amount necessary to prevent triggering excise tax under Sections 280G and 4999 of the Code.

 

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James Roberts  
Executive Benefits and Payments Upon Termination   Voluntary
Termination
without Good
Reason
    Voluntary
Termination
for Good
Reason or
Involuntary
Termination
Without  Cause (a)
    Retirement  (b)     Death or
Disability
    Change in
Control
(“CIC”) (c)
    Involuntary or
Good Reason
Termination upon
or within 24
months after CIC (a)
 

Cash Severance Payment

     

Base Salary

  $ -      $ 175,009     $ -      $ -      $ -      $ 175,009  

Bonus

    -        -        -        -        -        -   

Pro-Rata Bonus

    -        -        -        -        -        -   

Value of Unvested and Accelerated Equity Awards

           

Options

    -        -        -        -        -        -   

Restricted Stock

    -        -        -        -        -        -   

Gross Value of Continuing Benefits

    -        -        -        -        -        -   

Excise Tax Gross-Up

    -        -        -        -        -        -   

Total

  $ -      $ 175,009     $ -      $ -      $ -      $ 175,009  

 

(a)

Mr. Roberts does not have an employment or severance agreement with the Company. Under the Company’s general guidelines, upon involuntary termination, he is eligible to receive severance between 50% and 100% of his salary. The value shown assumes that he receives severance of 50% of salary.

(b)

Mr. Roberts is retirement eligible as of December 31, 2013. Upon retirement, Mr. Roberts is eligible for retiree benefits, if any.

(c)

Change in Control column excludes involuntary/good reason termination.

 

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Michael H. Lee *  
Executive Benefits and Payments Upon Termination    Voluntary
Termination
without Good
Reason
     Voluntary
Termination
for Good
Reason or
Involuntary
Termination
Without  Cause (a)
     Retirement  (b)      Death or
Disability
     Change in
Control
(“CIC”) (c)
    

Involuntary or

Good Reason
Termination upon
or within 24
months after CIC (d)

 

Cash Severance Payment

        

Base Salary

   $ -       $ 2,700,000      $ -       $ -       $ -       $ 2,700,000  

Bonus

     -         847,170        -         -         -         847,170  

Pro-Rata Bonus (e)

     -         -         -         -         -         -   

Value of Unvested and Accelerated Equity Awards

                 

Options

     -         -         -         -         -         -   

Restricted Stock

     -         -         -         -         -         -   

Gross Value of Continuing Benefits (f)

     -         71,256        -         -         -         71,256  

Excise Tax Gross-Up

     -         -         -         -         -         -   

Total

   $ -       $ 3,618,426      $ -       $ -       $ -       $ 3,618,426 (g) 

 

* On February 6, 2014, Mr. Lee resigned as Chairman, President and Chief Executive Officer of the Company. Pursuant to the terms of Mr. Lee’s Separation Agreement as described under “Summary of Key Agreements – Former Chief Executive Officer Separation and Release Agreement” above, the Company paid to Mr. Lee in March 2014, any earned but unpaid annual base salary as of the date of his resignation and a separation payment of $3,280,614.
(a)

Severance payments equal to three times base salary plus three times average annual bonus paid in the three fiscal years preceding termination.

(b)

Mr. Lee was not retirement eligible as of December 31, 2013. Upon retirement, Mr. Lee is eligible for: (i) pro rata bonus based on actual company performance; (ii) retiree benefits, if any; (iii) all unvested equity will continue to vest; and (iv) stock options will remain exercisable until the earlier of the third year anniversary of termination and the last day of the option term.

(c) 

Change in Control column excludes involuntary/good reason termination.

(d) 

Severance payments equal to three times base salary plus three times average annual bonus paid in the three fiscal years preceding a change in control.

(e) 

Represents pro-rata bonus based on actual bonus the executive would have earned in the year that the termination occurs. Mr. Lee’s bonus for fiscal year 2013 was $0.

(f) 

Represents three additional years of coverage for medical and life insurance.

(g) 

Payments will be reduced (but not below zero) by the amount necessary to prevent triggering excise tax under Sections 280G and 4999 of the Code.

 

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DIRECTOR COMPENSATION FOR 2013

The following table sets forth the total number of meetings of the Board and each Board standing committee in 2013. The table does not include the special committee established by the Board in October 2013 and described under “Independent Director Compensation” below, which met 24 times in 2013.

 

      Board    Audit
Committee
   Compensation
Committee
   Corporate Governance and
Nominating Committee
   Investment Committee

Number of Meetings in 2013

   34    20    9    6    5

The following table sets forth the total compensation earned or paid to each independent Board member for 2013:

 

Name    Fees Earned
or Paid
in Cash
     Stock
Awards  (3)
     Total  

Charles A. Bryan (1)

   $ 132,000      $ -       $ 132,000  

William W. Fox, Jr. (2)

     203,000        -         203,000  

William A. Robbie

     182,500        -         182,500  

Steven W. Schuster

     190,000        -         190,000  

Robert S. Smith

     210,000        -         210,000  

Jan R. Van Gorder

     225,000        -         225,000  

Austin P. Young, III

     215,500        -         215,500  

 

(1) 

Mr. Bryan resigned from his position as a Director of the Company on October 9, 2013. At the time of his resignation, Mr. Bryan was Chairman of the Compensation Committee and a member of the Audit Committee of the Board of Directors.

(2) 

Mr. Fox resigned from his position as a Director of the Company on December 31, 2013. At the time of his resignation, he was a member of the Audit Committee and the Corporate Governance and Nominating Committee of the Board of Directors. On February 14, 2014, Mr. Fox joined the Company as President and Chief Executive Officer.

(3) 

For 2013, the Compensation Committee determined not to grant the restricted stock portion of the annual retainer to the Directors.

Independent Director Compensation

Directors’ compensation is intended to attract and retain well-qualified and dedicated independent directors. Fees paid to independent directors are designed to compensate Directors for time spent on Company matters. Stock-based awards are designed to align the Directors’ interests with those of the Company’s shareholders and to allow the Company to remain competitive with other companies in attracting and retaining well-qualified directors. The compensation structure for independent Directors that was in effect through the end of 2013 provided for the payment of an annual retainer of $110,000, consisting of $55,000 in cash, payable quarterly, and $55,000 in restricted stock, which vested on the first anniversary of the date of grant. For 2013, the Compensation Committee determined not to award to the independent Directors the restricted stock portion of the annual retainer. Each independent Director was also paid $8,000 for attendance at each two-day set of quarterly Board and committee meetings and $11,000 for attendance at each three-day set of quarterly Board and committee meetings. Directors were not compensated for attendance at Board or committee meetings other than the regularly scheduled quarterly meetings unless the meeting chairman determined, based upon such factors as the need to travel and the length of the meeting, that attendance at a particular meeting was compensable, in which event the fee payable to each Director for attendance at such a Board meeting would be $2,000, the fee payable to each Audit Committee member for attendance at such an Audit Committee meeting would be $1,500, and the fee payable to each Compensation Committee member, Corporate Governance and Nominating Committee member and Investment Committee member for attendance at such a meeting of their respective committees would be $1,000. In addition, the Audit Committee chairman received an annual fee of $20,000, the Compensation Committee chairman received an annual fee of $15,000, and the Corporate Governance and Nominating Committee and Investment Committee chairmen each received an annual fee of $10,000. Also, the lead independent Director of the Board, a position created in November 2012 as described under “Additional Information Regarding the Board – Board Leadership Structure,” received an annual fee of $15,000. Directors were reimbursed for expenses incurred in traveling to and from Board and committee meetings. In addition, in October 2013, the chairman of the Audit Committee received a one-time cash payment of $15,000 in recognition of his extraordinary effort and time commitment with respect to various Audit Committee matters.

 

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The compensation structure for independent Directors described above was revised, effective as of January 1, 2014, to provide for (1) a quarterly cash retainer for each director of $35,000 (2) additional quarterly cash retainers of $30,000 for the Chairman of the Board, $10,000 for the chairman of the Audit Committee, and $5,000 for the chairman of each of the Compensation, Corporate Governance and Nominating, and Investment Committees, (3) the continuation of the Board and committee meeting fees in effect in 2013 as described in the preceding paragraph, and (4) an additional fee of $5,000 per day for additional tasks, including, for example, days spent in New York on Company business, assigned to the directors by the Chairman of the Board.

In addition to the standing committees described above, the Board may also from time to time create special or temporary committees to address certain unique issues or transactions as the Board deems appropriate. The fees for special committees can vary depending on the effort and time commitment required of the committee members.

In October 2013, the Board unanimously approved a fee structure for a special committee composed of Messrs. Van Gorder (Chair), Fox and Smith, which was established to explore a range of alternatives with respect to the Company that ultimately led to the entry by the Company into the Merger Agreement on January 3, 2014, that provided as follows: (i) a lump sum payment of $15,000 to the chair of the special committee, (ii) a lump sum payment of $10,000 to each other member of the special committee, (iii) $2,000 per meeting to each special committee member for in-person meetings, (iv) $1,000 per meeting to each special committee member for telephonic meetings or for participation by telephone in in-person meetings, and (v) payment of a meeting fee to directors not on the special committee only if such directors were invited to attend the meeting by the special committee chair. The special committee completed its work upon the execution by the Company of the Merger Agreement on January 3, 2014.

Compensation Policies and Practices As They Relate to the Company’s Risk Management

The Compensation Committee believes that the Company’s compensation policies and practices for all employees, including its executive officers, do not create risks that are reasonably likely to have a material adverse effect on the Company. The process undertaken by the Compensation Committee to reach this conclusion consisted of a review and discussion by the Committee of the various elements of the Company’s compensation program. In its review and discussion, the Compensation Committee noted that these elements include a balance of fixed and variable compensation, that the variable compensation consists of both short-term and long-term incentive plans, and that the incentive plans provide for the vesting of certain benefits over several years and, for Named Executive Officers and certain other designated senior officers participating in the 2013 LTIP, for equity awards primarily based on performance measured over a three-year period and payable following such period.

The Compensation Committee further noted that four distinct financial performance metrics are used generally as a guide in determining compensation levels under the STIP for Named Executive Officers and other employees and that these metrics are based on, among other things, profitability measures such as operating return on equity and combined ratio as well as on premium growth. The Committee believes that in addition to being a standard property and casualty insurance industry measure of profitability, combined ratio also serves as an important risk management tool by discouraging the Company from writing unprofitable business.

In 2013, as described under “Compensation Discussion and Analysis — Compensation Philosophy and Objectives” above, the Compensation Committee established the 2013 LTIP to more directly align the interests of the Named Executive Officers and other designated senior officers of the Company with those of the Company’s shareholders. Under the 2013 LTIP, two distinct performance metrics, relative total shareholder return and relative operating return on tangible equity, each measured over a three-year period, will be the primary determinants of maximum, and actual, compensation levels for the Named Executive Officers. Individual employees do not have particular incentives that differ from those of other employees or of the Company.

Item 12. Security Ownership Of Certain Beneficial Owners And Management And Related Shareholder Matters

The following table sets forth certain information regarding the ownership of the Company’s common shares as of March 3, 2014 by: (i) each person known to the Company to own beneficially more than 5% of the outstanding common shares;

 

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(ii) each of the Company’s directors and named executive officers; and (iii) all of the directors and executive officers as a group. As used in this table, “beneficially owned” means the sole or shared power to vote or dispose of, or to direct the voting or disposition of, the shares, or the right to acquire such power within 60 days after March 3, 2014 with respect to any shares.

 

Name (1)    Shares
Beneficially
Owned (2)
    Percent
Beneficially
Owned
 

BlackRock Inc. (3)

     3,741,982       6.5

Michael H. Lee (4)

     2,987,361  (4)      5.2

Dimensional Fund Advisors, L.P. (5)

     2,965,726       5.2

William F. Dove

     31,369           

William W. Fox, Jr.

     15,660           

William E. Hitselberger

     46,227           

Elliot S. Orol

     39,421           

James E. Roberts

     13,467           

William A. Robbie

     35,662           

Steven W. Schuster

     13,259           

Robert S. Smith

     31,821           

Jan R. Van Gorder

     18,978           

Austin P. Young, III

     21,073           

Total Directors and Executive Officers

     306,186       0.5

* Less than 1%

(1) Each named shareholder’s business address is 120 Broadway, New York, New York 10271, with the exceptions of BlackRock Inc. the business address of which is 40 East 52nd Street, New York, NY 10022, and Dimensional Fund Advisors, L.P. the business address of which is Palisades West, Building One, 6300 Bee Cave Road, Austin, Texas 78746.

(2) To the Company’s knowledge, the persons named in the table have sole voting and investment power with respect to all shares of common stock shown as beneficially owned by them, unless otherwise noted in the footnotes to this table.

(3) Based solely on the Schedule 13G/A filing made by BlackRock Inc. on February 3, 2014.

(4) Based on the Form 4 filing made by Michael H. Lee on September 20, 2013. Includes 689,435 shares issuable upon the exercise of stock options held by Mr. Lee, which stock options, to the Company’s knowledge, Mr. Lee still owns. The exercise price for Mr. Lee’s options ranges from $16.28-$23.61. Mr. Lee resigned from his positions as Chairman, President and Chief Executive Officer of the Company on February 6, 2014.

(5) Based solely on the Schedule 13G filing made by Dimensional Fund Advisors, L.P. on February 10, 2014.

Equity Compensation Plan Information

The following table provides information with respect to the Company’s equity compensation plan as of December 31, 2013.

 

     (A)      (B)      (C)  
  

 

 

 
Plan Category    Number of securities to be
issued upon exercise of
outstanding options and
vesting of unvested stock
grants
     Weighted average
exercise price of
outstanding
options
     Number of securities
remaining available for future
issuance under equity
compensation plans (excluding
securities reflected in column
A)
 

Equity compensation plans approved by security holders

     1,191,390      $ 17.75        2,220,972  

Equity compensation plans not approved by security holders

     -        -         -  

Total

     1,191,390      $ 17.75        2,220,972  

Item 13. Certain Relationships And Related Transactions, And Director Independence

Director Independence

The Board of Directors of the Company applies the NASDAQ standards in determining whether a Director is “independent.” The NASDAQ rules generally provide that no Director or nominee for Director qualifies as “independent” unless the Board of Directors affirmatively determines that such person has no relationship with the Company that, in the opinion of the

 

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Board, would interfere with the exercise of independent judgment in carrying out the responsibilities of a Director. Specifically, the following persons may not be considered independent: (i) a Director or nominee for Director who is, or at any time during the past three years was, employed by the Company or by any subsidiary of the Company; (ii) a Director or nominee for Director who accepts, or has a family member who accepts, any payments from the Company or any subsidiary of the Company in excess of $120,000 during any period of twelve consecutive months within any of the past three fiscal years preceding the determination of independence other than (1) compensation for Board or Board committee service, (2) compensation paid to a family member who is a non-executive employee of the Company or a subsidiary of the Company or (3) benefits under a tax-qualified retirement plan, or non-discretionary compensation; (iii) a Director or nominee for Director who has a family member who is, or at any time during the past three years was, employed by the Company or any subsidiary of the Company as an executive officer; (iv) a Director or nominee for Director who is, or has a family member who is, a partner in, or a controlling shareholder or an executive officer of, any organization to which the Company made, or from which the Company received, payments for property or services in the current or any of the past three fiscal years that exceeded 5% of the recipient’s consolidated gross revenues for that year or $200,000, whichever is more, other than (1) payments arising solely from investments in the Company’s securities or (2) payments under non-discretionary charitable contribution matching programs; (v) a Director or nominee for Director who is, or has a family member who is, employed as an executive officer of another entity at any time during the past three years where any of the executive officers of the Company serves on the compensation committee of such other entity; and (vi) a Director or nominee for Director who is, or has a family member who is, a current partner of the Company’s independent registered public accounting firm or was a partner or employee of the Company’s independent registered public accounting firm, who worked on the Company’s audit at any time during the past three years.

The Board of Directors, in applying the above-referenced standards, has affirmatively determined that each of the following individuals is an “independent” Director of the Company: William A. Robbie, Steven W. Schuster, Robert S. Smith, Jan R. Van Gorder and Austin P. Young, III. As part of the Board’s process in making such determination, each such Director provided confirmation that (a) all of the above-cited objective criteria for independence are satisfied and (b) each such Director has no other relationship with the Company that would interfere with the exercise of independent judgment in carrying out the responsibilities of a Director.

Payment of Fees to Independent Directors. In March 2013, the Board of Directors approved a policy providing that independent Directors shall not accept directly or indirectly any consulting, legal, advisory, or other compensatory fee from the Company or any of its subsidiaries, other than fees paid to any such Director in his or her capacity as a member of the Board and its Committees. The policy was initially adopted by the board of directors of the Predecessor Company in July 2006 and was in effect at the time of the Canopius Merger Transaction.

Offer of Resignation Upon Change of Employment. In March 2013, the Board of Directors approved a policy providing that any Director who changes his or her principal employment submit a letter of resignation to the Board, which shall determine in its discretion whether or not to accept such resignation. The policy was initially adopted by the board of directors of the Predecessor Company in October 2008 and was in effect at the time of the Canopius Merger Transaction.

Majority Vote Standard in Uncontested Director Elections. In March 2013, the Board of Directors approved a policy providing for a majority voting standard for the election of Directors in uncontested elections. In accordance with the policy, a nominee for Director must receive more votes cast “for” than “against” by shareholders at the annual general meeting of shareholders to be elected or re-elected to the Board in an uncontested election of Directors. A Director who does not receive a majority of the votes cast in such an election must submit his or her resignation to the Board of Directors. Within 90 days after such annual general meeting, the Board shall determine, acting upon the recommendation of its Corporate Governance and Nominating Committee, whether or not to accept such resignation and shall disclose in a required filing with the SEC its determination and the rationale and process for such determination. The policy was initially adopted by the board of directors of the Predecessor Company in November 2011 and was in effect at the time of the Canopius Merger Transaction.

Lead Director. In March 2013, the Corporate Governance and Nominating Committee adopted a policy establishing the position of lead independent Director, with responsibilities that include, among others, presiding at executive sessions of the independent Directors, collaborating with the Chairman and Chief Executive Officer with respect to setting of Board agendas, and communicating with the Chairman and Chief Executive Officer on behalf of the independent Directors, when appropriate, with respect to the views and concerns of the independent Directors and other Board matters. The policy, which contemplates that there will be a lead independent director of the Board when the positions of Chairman of the Board and Chief Executive Officer are filled by the same person, was initially adopted by the corporate governance and nominating committee of the board of directors of the Predecessor Company in November 2012 and was in effect at the time of the Canopius Merger Transaction.

 

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Independent Directors

The Company’s Board of Directors has determined that all five of its members meet NASDAQ’s standards for independence. See “Director Independence” above. The independent Directors of the Board of Directors of the Company met in executive session at least twice during 2013.

Transactions with Related Persons

Board of Directors Related Party Policies

In March 2013, the Board of Directors approved a policy providing that independent Directors shall not accept directly or indirectly any consulting, legal, advisory, or other compensatory fee from the Company or any of its subsidiaries, other than fees paid to any such Director in his or her capacity as a member of the Board of Directors and its committees. This policy was initially adopted by the board of directors of the Predecessor Company in July 2006 and was in effect at the time of the Canopius Merger Transaction.

In March 2013, the Board of Directors adopted a policy that calls for the prior review and approval by the Audit Committee of any proposed transaction (or series of transactions) between the Company and any related party. Under the policy, full disclosure of all facts and circumstances relating to the proposed transaction must be made to the Audit Committee, which may only approve transactions that are in, or are not inconsistent with, the best interests of the Company and its shareholders. Related parties are defined as executive officers, 5% shareholders, Directors, director nominees and any of their immediate family members (as those terms are defined under Item 404 of Regulation S-K). This policy was initially adopted by the board of directors of the Predecessor Company in February 2007 and was in effect at the time of the Canopius Merger Transaction.

Item 14. Principal Accountant Fees And Services

Audit Committee Report

The Audit Committee has been appointed by the Board of Directors to assist the Board of Directors in fulfilling its responsibility to oversee the financial affairs, risk management with respect to financial, audit, accounting and internal control matters, accounting and financial reporting processes and audits of the financial statements of the Company. The Committee operates under a written charter adopted by the Board of Directors and reviewed annually by the Committee. The charter is available on the Company’s website at www.twrgrpintl.com. The Committee has furnished the following report for 2013.

Management has the primary responsibility for establishing and maintaining adequate internal financial controls for the preparation of the financial statements and for the public reporting process. PricewaterhouseCoopers LLP, the Company’s 2013 independent registered public accounting firm, is responsible for expressing its opinions on the conformity of the Company’s audited financial statements with generally accepted accounting principles and on the effectiveness of the Company’s internal control over financial reporting.

The Committee has reviewed and discussed with management and with the independent registered public accounting firm the audited financial statements for the year ended December 31, 2013 and PricewaterhouseCoopers LLP’s evaluation of the Company’s internal control over financial reporting. The Committee has discussed with the independent registered public accounting firm the matters required to be discussed by the standards adopted or referenced by the Public Company Accounting Oversight Board (“PCAOB”) and SEC Rule 2-07, Communications with Audit Committees, as currently in effect.

The Committee has received the written disclosures and letter from the independent registered public accounting firm required by applicable requirements of the PCAOB regarding the independent registered public accounting firm’s communications with the Committee concerning independence, and has discussed with the independent registered public accounting firm that firm’s independence. The Committee has also considered the compatibility of the provision for non-audit services with the independent registered public accounting firm’s independence.

Based on the Committee’s reviews and discussions referred to above, the Committee recommended that the Board of Directors include the audited consolidated financial statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 for filing with the Securities and Exchange Commission.

This report is provided by the following independent directors, who constitute the Committee:

Austin P. Young, III, Chairman
William A. Robbie
Jan R. Van Gorder

 

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Pre-Approval Policy for Services of Independent

Registered Public Accountant

The Audit Committee is required to pre-approve all audit and non-audit services provided by the independent registered public accounting firm, both as to the permissibility of the auditors performing such services and the amount of fees to be paid in connection therewith, subject to certain de minimis exceptions for which the Audit Committee’s approval is required before completion of the audit. The Audit Committee may delegate pre-approval authority to one or more of its members when appropriate, provided that the decisions of such members to grant pre-approvals shall be presented to the full Audit Committee at its next scheduled meeting. Policies and procedures for the pre-approval of audit and permissible non-audit services must be detailed as to the particular service. The Audit Committee must be informed of each service rendered pursuant to any such policies or procedures.

Independent Registered Public Accountant’s Fees

The aggregate fees billed for professional services by PricewaterhouseCoopers in 2013 and 2012 for these various services were:

 

Type of Fees    2013 (1)      2012  

Audit fees

   $ 17,350,000       $ 6,551,200  

Audit-related fees

     -        898,811  

Tax fees

     -        43,401  

All other fees

     6,000        1,800  

Total

   $ 17,356,000       $ 7,495,212  

(1) Estimate

In the above table, in accordance with the SEC’s definitions and rules, “Audit fees” are fees and out-of-pocket expenses that are billed or expected to be billed by PricewaterhouseCoopers LLP for the audit of annual financial statements included in the Form 10-K, the review of financial statements included in the Forms 10-Q, the audit of internal control in compliance with Section 404 of the Sarbanes-Oxley Act of 2002, the review of comfort letters, the preparation of consents and the completion of statutory audits.

“Audit-related fees” are fees billed by PricewaterhouseCoopers, LLP relating to the performance of audits and attest services including work related to the Canopius Merger Transaction, review of pro forma filings for acquisitions and miscellaneous statutory filings for acquired businesses. “Tax fees” are fees billed for tax compliance, tax advice and tax planning. “All other fees” are for any services not included in the first three categories.

The Audit Committee retained PricewaterhouseCoopers LLP to audit the consolidated financial statements and internal controls over financial reporting for 2013. In addition, the Audit Committee retained PricewaterhouseCoopers LLP as well as other accounting firms to provide other auditing and advisory services in 2013. When PricewaterhouseCoopers LLP’s proposed services are consistent with the SEC’s rules on auditor independence and other applicable laws, the Audit Committee will consider whether PricewaterhouseCoopers LLP is best positioned to provide these services efficiently. The Audit Committee has also adopted procedures to pre-approve all non-audit related work performed by PricewaterhouseCoopers LLP.

PART IV

Item 15. Exhibits, Financial Statement Schedules

 

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

The following entire exhibits are included:

 

Exhibit 21.1

   Subsidiaries of Tower Group International, Ltd.

Exhibit 23.1

   Consent of PricewaterhouseCoopers LLP

 

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Exhibit 31.1

  Certification of CEO to Section 302(a)

Exhibit 31.2

  Certification of CFO to Section 302(a)

Exhibit 32

  Certification of CEO and CFO to Section 906

The following exhibits are filed electronically herewith:

 

EX-101

  INSTANCE DOCUMENT

EX-101

  SCHEMA DOCUMENT

EX-101

  CALCULATION LINKBASE DOCUMENT

EX-101

  LABELS LINKBASE DOCUMENT

EX-101

  PRESENTATION LINKBASE DOCUMENT

EX-101

  DEFINITION LINKBASE DOCUMENT

 

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SIGNATURES

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

 

    Tower Group International, Ltd.
    Registrant
Date: May 2, 2014     /s/ William W. Fox, Jr.
   

William W. Fox, Jr.

President and Chief Executive Officer

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

 

Signature      Title   Date

/s/    JAN R. VAN GORDER

     Chairman of the Board   May 2, 2014
Jan R. Van Gorder       

/s/    WILLIAM E. HITSELBERGER

     Executive Vice President, Chief Financial Officer (Principal Financial Officer, Principal Accounting Officer)   May 2, 2014
William E. Hitselberger       
      

/s/    WILLIAM A. ROBBIE

     Director   May 2, 2014
William A. Robbie       

/s/    STEVEN W. SCHUSTER

     Director   May 2, 2014
Steven W. Schuster       

/s/    ROBERT S. SMITH

     Director   May 2, 2014
Robert S. Smith       

/s/    AUSTIN P. YOUNG, III

     Director   May 2, 2014
Austin P. Young, III       

 

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Tower Group International, Ltd.

Index to Financial Statement Schedules

 

Schedules  

           Pages      
I  

Summary of Investments—other than investments in related parties

     S-2   
II  

Condensed Financial Information of the Registrant as of and for the years ended December  31, 2013 and 2012

     S-3   
III  

Supplementary Insurance Information for the years ended December 31, 2013, 2012, and 2011

     S-7   
IV  

Reinsurance for the years ended December 31, 2013, 2012, and 2011

     S-8   
V  

Valuation and Qualifying Accounts for the years ended December 31, 2013, 2012, and 2011

     S-9   
VI  

Supplemental Information Concerning Insurance Operations for the years ended December  31, 2013, 2012, and 2011

     S-10   

 

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Tower Group International, Ltd.

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

 

     December 31, 2013  
($ in thousands)    Cost      Fair
Value
     Amount
Reflected on
Balance Sheet
 

Fixed maturities:

        

Available for sale:

        

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

   $ 481,321      $ 475,183      $ 475,183  

Corporate securities

     512,444        525,942        525,942  

Mortgage-backed securities

     342,487        362,464        362,464  

Municipal securities

     277,382        279,106        279,106  

Total fixed maturities

     1,613,634        1,642,695        1,642,695  

Preferred stocks

     21,330        18,848        18,848  

Common stock:

        

Public utilities, industrial and other

     76,378        87,782        87,782  

Total equities

     97,708        106,630        106,630  

Short-term investments

     5,925        5,897        5,897  

Other invested assets

     96,155        96,155        96,155  

Total investments

   $ 1,813,422      $ 1,851,377      $ 1,851,377  

 

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

Fixed maturities:

        

Available for sale:

        

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

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

Corporate securities

     698,012        746,665        746,665  

Mortgage-backed securities

     576,837        624,277        624,277  

Municipal securities

     633,373        686,043        686,043  

Total fixed maturities

     2,190,186        2,344,711        2,344,711  

Preferred stocks

     31,272        31,521        31,521  

Common stock:

        

Public utilities, industrial and other

     118,076        114,737        114,737  

Total equities

     149,348        146,258        146,258  

Short-term investments

     4,749        4,750        4,750  

Other invested assets

     57,786        57,786        57,786  

Total investments

   $ 2,402,069      $ 2,553,505      $ 2,553,505  

 

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Tower Group International, Ltd.

Schedule II – Condensed Financial Information of the Registrant

Condensed Balance Sheets

 

     December 31,  
($ in thousands)    2013      2012  

Assets

     

Fixed-maturity securities, available-for-sale, at fair value (amortized cost of $0 and $7,656)

   $ -      $ 8,121  

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

     -        -  

Other invested assets

     -        2,045  

Cash and cash equivalents

     438        17,130  

Investment in subsidiaries

     108,961        1,250,436  

Investment in unconsolidated affiliate

     -        71,894  

Federal and state taxes recoverable

     -        -  

Deferred income taxes

     -        15,879  

Investment in statutory business trusts, equity method

     -        2,664  

Due from affiliate

     -        -  

Other assets

     3,317        69,172  

Total assets

   $ 112,716      $ 1,437,341  

Liabilities

     

Accounts payable and accrued expenses

   $ 1,826      $ 25,622  

Due to affiliates

     15,339        75,823  

Deferred rent liability

     -        4,537  

Federal and state income taxes payable

     -        -  

Debt

     -        381,301  

Total liabilities

     17,165        487,283  

Shareholders’ equity

     95,551        950,058  

Total liabilities and shareholders’ equity

   $ 112,716      $ 1,437,341  

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

 

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Tower Group International, Ltd.

Schedule II – Condensed Financial Information of the Registrant

Condensed Statements of Operations and Comprehensive Income

 

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

Revenues

      

Net realized gains (losses) on investments

   $ 221     $ (1,570   $ (264

Investment income

     8,667       815       1,394  

Equity in net earnings of subsidiaries

     (923,809     (6,254     61,681  

Total revenues

     (914,921     (7,009     62,811  

Expenses

      

Other operating expenses

     7,786       11,754       10,067  

Interest expense

     4,887       18,782       17,843  

Total expenses

     12,673       30,536       27,910  

Other Income

      

Equity income in unconsolidated affiliate

     954       (1,470     -  

Gain on investment in acquired unconsolidated affiliate

     -       -       -  

Acquisition related transaction costs

     (17,261     (9,229     (360

Income before income taxes

     (943,901     (48,244     34,541  

Provision/(benefit) for income taxes

     (1,285     (14,010     (9,894

Net income

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

Other comprehensive income (loss) net of tax

     (102,262     19,704        14,774   

Comprehensive income (loss)

     (1,044,878     (14,530     59,209   

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

 

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Tower Group International, Ltd.

Schedule II – Condensed Financial Information of the Registrant

Condensed Statements of Cash Flows

 

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

Cash flows provided by (used in) operating activities:

      

Net income

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

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

      

(Gain) loss on sale of investments

     -       1,570       264  

Dividends received from consolidated subsidiaries

     -       22,954       55,400  

Equity in undistributed net income of subsidiaries

     923,809        2,088       (62,189

Depreciation and amortization

     -       4,388       3,362  

Amortization of debt issuance costs

     -       2,830       2,635  

Amortization of restricted stock

     -       9,283       10,292  

Deferred income tax

     -       (13,165     (3,836

Excess tax benefits from share-based payment arrangements

     -       (345     (162

Change in operating assets and liabilities

      

Investment income receivable

     (5,855 )     -       173  

Federal and state income tax recoverable

     -       (18,409     15,998  

Equity loss (income) in unconsolidated affiliate

     -       1,746       -  

Other assets

     (3,317 )     (20,639     (16,763

Accounts payable and accrued expenses

     17,166        57,610       6,089  

Deferred rent

     -       (534     (581

Net cash flows provided by operations

     (10,813 )     15,143       55,117  

Cash flows provided by (used in) investing activities:

      

Net change in cash from reverse acquisition

     (1,899     -       -  

Investment in unconsolidated affiliate

     -       (71,512     -  

Principal pay-down received on promissory note

     14,500        -        -   

Sale or maturity - fixed-maturity securities

     -       3,947       58,367  

Purchase - fixed-maturity securities

     -       (6,117     (46,848

Purchase - equity securities

     -       -       (4,224

Purchase of other invested assets

     -       8,413       (10,458

Sale - equity securities

     -       8,390       1,304  

Net cash flows used in investing activities

     12,601        (56,879     (1,859

Cash flows provided by (used in) financing activities:

      

Proceeds from credit facility borrowings

     -       20,000       67,000  

Repayment of credit facility borrowings

     -       -       (17,000

Proceeds from intercompany borrowings

     -       77,968       -  

Proceeds from convertible senior notes hedge termination

     -       -       -  

Payments for warrants termination

     -       -       -  

Exercise of stock options and warrants

     -       (2,263     373  

Excess tax benefits from share-based payment arrangements

     -       345       161  

Treasury stock acquired-net employee share-based compensation

     -       (4     (1,834

Repurchase of common stock

     -       (20,987     (64,572

Dividends paid

     (18,480     (29,075     (27,894

Net cash flows provided by (used in) financing activities

     (18,480     45,984       (43,766

Increase (decrease) in cash and cash equivalents

     (16,692     4,248       9,492  

Cash and cash equivalents, beginning of year

     17,130       12,882       3,390  

Cash and cash equivalents, end of year

   $ 438     $ 17,130     $ 12,882  

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

 

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Tower Group International, Ltd.

Schedule II – Condensed Financial Information of the Registrant

Notes to Condensed Financial Information

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

Note 1—Organization and Description of Business

On March 13, 2013, Tower Group, Inc. (“TGI”) completed a merger transaction whereby TGI merged into a subsidiary of Tower Group International, Ltd. (“TGIL”). TGIL was formerly known as Canopius Holdings Bermuda Limited (“Canopius Bermuda”). This merger (referred to as the “Canopius Merger”) was accounted for as a reverse acquisition under the acquisition method of accounting for business combinations, with TGI treated as the acquiring company for accounting purposes. TGIL is deemed to be the successor to TGI, the predecessor, pursuant to Rule 12g-3(a) under the Exchange Act.

The parent company financial statements presented herein include the historical financial information from TGI for the period from January 1, 2013 through March 13, 2013 and for the years ended December 31, 2012 and 2011. The parent company financial statements presented herein also include the financial information from TGIL for the period from March 14, 2013 through December 31, 2013 and as of December 31, 2013.

Note 2—Investment in Subsidiaries

This amount is inclusive of a promissory note issued by TGI to TGIL in 2013. The $335.5 million loan (and the $5.9 million accrued interest income receivable thereon) is included in Investment in Subsidiaries as the ultimate parent would be required to cover any losses generated by its subsidiaries.

Note 3—Debt

The information relating to debt is incorporated by reference from “Note 13 – Debt” in the consolidated financial statements. The debt disclosed in the balance sheet continued to be held by the predecessor company after the date of the Canopius Merger and was not transferred to the successor company.

Note 4—Income Taxes

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

 

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Tower Group International, Ltd.

Schedule III – Supplementary Insurance Information

 

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

Gross

Future

Policy
Benefits,
Losses and
Loss
Expenses

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

2013

                      

Commercial Insurance

   $ 60,879      $ 1,102,533      $ 417,475      $ 931,693      $ 1,185,627      $ (197,980   $ 204,131      $ 751,698  

Assumed Reinsurance

     10,140        603,380        22,837        116,417        41,474        (40,576     7,879        82,530  

Personal Insurance

     24,077        375,372        322,800        464,805        292,733        (92,805     137,152        398,388  

Total

   $ 95,096      $ 2,081,285      $ 763,112      $ 1,512,915      $ 1,519,834      $ (331,361 )    $ 349,162      $ 1,232,616  

2012

                      

Commercial Insurance

   $ 112,334      $ 838,656      $ 529,414      $ 1,104,551      $ 859,707      $ (207,208   $ 182,891      $ 1,077,225  

Assumed Reinsurance

     16,831        619,309        65,146        120,015        52,975        (42,582     1,542        148,399  

Personal Insurance

     52,033        437,714        326,711        497,298        351,076        (102,612     117,184        513,816  

Total

   $ 181,198      $ 1,895,679      $ 921,271      $ 1,721,864      $ 1,263,758      $ (352,402 )    $ 301,617      $ 1,739,440  

2011

                      

Commercial Insurance

   $ 111,649      $ 1,177,582      $ 551,674      $ 1,052,050      $ 740,755      $ (232,922   $ 155,576      $ 1,079,676  

Assumed Reinsurance

     9,006        40,141        36,762        35,861        17,456        (9,490     439        72,623  

Personal Insurance

     48,203        414,390        304,740        505,939        318,775        (103,173     117,313        486,291  

Total

   $ 168,858      $ 1,632,113      $ 893,176      $ 1,593,850      $ 1,076,986      $ (345,585 )    $ 273,328      $ 1,638,590  

 

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Tower Group International, Ltd.

Schedule IV – Reinsurance

 

($ in thousands)    Gross
Amount
     Ceded to
Other
Companies
     Assumed from
Other
Companies
     Net
Amount
     Percentage of
Amount
Assumed to
Net
 

Year ended December 31, 2013

              

Premiums

              

Property and casualty insurance

   $ 1,717,501      $ 513,517      $ 308,931      $ 1,512,915        20.4

Accident and health insurance

     -         -         -         -         -   

Total Premiums

   $ 1,717,501      $ 513,517      $ 308,931      $ 1,512,915        20.4

Year ended December 31, 2012

              

Premiums

              

Property and casualty insurance

   $ 1,759,126      $ 221,807      $ 184,545      $ 1,721,864        10.7

Accident and health insurance

     -         -         -         -         -   

Total Premiums

   $ 1,759,126      $ 221,807      $ 184,545      $ 1,721,864        10.7

Year ended December 31, 2011

              

Premiums

              

Property and casualty insurance

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

Accident and health insurance

     -         -         -         -         -   

Total Premiums

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

 

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Tower Group International, Ltd.

Schedule V – Valuation and Qualifying Accounts

 

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

Year ended December 31, 2013

          

Premiums receivable

   $ 16,509        13,144        (12,060     17,593  

Deferred income taxes, net

     6,984        285,941        -       292,925  

Year ended December 31, 2012

          

Premiums receivable

     14,383        6,916        (4,790     16,509  

Deferred income taxes, net

     6,961        23        -       6,984  

Year ended December 31, 2011

          

Premiums receivable

     7,719        9,669        (3,005     14,383  

Deferred income taxes, net

     11,824        -        (4,863     6,961  

 

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Tower Group International, Ltd.

Schedule VI – Supplemental Information Concerning Insurance Operations

 

          Reserves
For Unpaid
                            Claims and Claims
Adjustment Expenses
Incurred and Related to
                   
$ in thousands)   Deferred
Acquisition
Cost
    Claims and
Claim
Adjustment
Expenses
    Discounted
Reserves
    Unearned
Premium
    Earned
Premium
    Net
Investment
Income
    Current
Year
    Prior Year*
Includes
PXRE
Commutation
   

Amortization
of

DAC

    Paid Claims
and Claim
Adjustment
Expenses
    Net
Premiums
Written
 

2013

                     

Consolidated Insurance Subsidiaries

  $ 95,096     $ 2,081,285     $ 7,192     $ 763,112     $ 1,512,915     $ 109,208     $ 981,713     $ 538,121     $ (331,360   $ 1,305,666     $ 1,232,615  

2012

                     

Consolidated Insurance Subsidiaries

    181,198       1,895,679       8,354       921,271       1,721,864       127,165       1,184,510       79,248       (352,402     1,167,428       1,739,382  

2011

                     

Consolidated Insurance Subsidiaries

    168,858       1,632,113       3,674       893,176       1,593,850       126,474       1,076,045       941       (345,585     1,070,539       1,638,591  

 

S-10


Table of Contents

The exhibits listed below and designated with an asterisk are filed with this report. The exhibits listed below and designated with two asterisks are submitted electronically herewith. The exhibits listed below and not so designated are incorporated by reference to the documents following the descriptions of the exhibits.

 

Exhibit
Number

  

Description of Exhibits

    2.1    Agreement and Plan of Merger, dated as of August 4, 2008, by and among Tower Group, Inc., Ocean I Corporation and CastlePoint Holdings, Ltd., incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K/A filed on August 6, 2008
    2.2    Agreement and Plan of Merger, dated as of June 21, 2009, by and among Tower Group, Inc., Tower S.F. Merger Corporation and Specialty Underwriters’ Alliance, Inc., incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8 filed on June 22, 2009
    2.3    Amended and Restated Agreement and Plan of Merger, dated as of June 21, 2009, by and among Tower Group, Inc., Tower S.F. Merger Corporation and Specialty Underwriters’ Alliance, Inc., incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K/A filed on July 23, 2009
    2.4    Purchase Agreement, dated as of February 2, 2010, by and among Tower Group, Inc., OneBeacon Insurance Group, Ltd., OneBeacon Insurance Group LLC, OneBeacon America Insurance Company, The Employers’ Fire Insurance Company, The Camden Fire Insurance Association, Homeland Insurance Company of New York, OneBeacon Insurance Company, OneBeacon Midwest Insurance Company, Pennsylvania General Insurance Company and The Northern Assurance Company of America, incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on February 3, 2010
    2.5    Agreement and Plan of Merger, dated as of July 30, 2012, by and among Tower Group, Inc., Canopius Holdings Bermuda Limited, Canopius Mergerco, Inc. and Condor 1 Corporation, incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on July 31, 2012 incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on July 31, 2012
    2.6    Letter Agreement, dated as of July 30, 2012, by and among Tower Group, Inc., Canopius Holdings Bermuda Limited, Canopius Mergerco, Inc. and Canopius Group Limited incorporated by reference to Exhibit 2.2 to the Company’s Current Report on Form 8-K filed on July 31, 2012
    2.7    Amendment No. 1 to Agreement and Plan of Merger, dated as of November 8, 2012, by and among Tower Group, Inc., Canopius Holdings Bermuda Limited, Canopius Mergerco, Inc. and Condor 1 Corporation, with respect to the Agreement and Plan of Merger, dated as of July 30, 2012, incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on November 13, 2012
    2.8   

Share Purchase Agreement, dated as of June 2, 2013, by and between Tower Group International, Ltd.

and Fairfax Financial Holdings Limited incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on June 3, 2013

    2.9    Stock Purchase Agreement, dated as of December 13, 2013, by and between Tower Group, Inc. and Bregal Fund III L.P. incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on December 18, 2013
    2.10    Agreement and Plan of Merger, dated as of January 3, 2014, by and among Tower Group International, Ltd., ACP Re Ltd. and London Acquisition Company Limited incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on January 6, 2014
    3.1    Amended and Restated Certificate of Incorporation of Tower Group, Inc., incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-1 (Amendment No. 2) (No. 333-115310) filed on July 23, 2004
    3.2    Certificate of Amendment to Amended and Restated Certificate of Incorporation of Tower Group, Inc., incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-8 (No. 333-115310) filed on February 5, 2009
    3.3    Certificate of Designations of Preferred Stock, incorporated by reference to the Company’s Current Report on Form 8-K filed on December 8, 2006
    3.4    Certificate of Designations of Series A-1 Preferred Stock of Tower Group, Inc. incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on January 12, 2007
    3.5    Amended and Restated By-laws of Tower Group, Inc. as amended November 3, 2011, incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on November 9, 2011
    3.6    Memorandum of Association of Tower Group International, Ltd. incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on March 13, 2013
    3.7    Amended and Restated Bye-laws of Tower Group International, Ltd. incorporated by reference to Exhibit 3.2 to the Company’s Current Report on Form 8-K filed on March 13, 2013
    4.1    Specimen Common Stock Certificate, incorporated by reference to Exhibit 4.1 to the Company’s Registration Statement on Form S-1 (Amendment No. 6) (No. 333-115310) filed on September 30, 2004
    4.2    Warrant issued to Friedman, Billings, Ramsey & Co., Inc., incorporated by reference to Exhibit 4.3 to the Company’s Registration Statement on Form S-1 (Amendment No. 3) (No. 333-115310) filed on August 25, 2004
    4.3    Indenture, dated as of September 20, 2010, between Tower Group, Inc. and U.S. Bank National Association relating to the 5.00% Convertible Senior Notes due 2014, incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed on September 20, 2010

 

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Exhibit
Number

  

Description of Exhibits

    4.4    Base Call Option Confirmation, dated as of September 14, 2010, between Bank of America, N.A. and Tower Group, Inc. relating to the 5.00% Convertible Senior Notes due 2014, incorporated by reference to Exhibit 4.2 to the Company’s Current Report on Form 8-K filed on September 20, 2010
    4.5    Base Call Option Confirmation, dated as of September 14, 2010, between JPMorgan Chase Bank, National Association, London Branch and Tower Group, Inc. relating to the 5.00% Convertible Senior Notes due 2014, incorporated by reference to Exhibit 4.3 to the Company’s Current Report on Form 8-K filed on September 20, 2010
    4.6    Additional Call Option Confirmation, dated as of September 15, 2010, between Bank of America, N.A. and Tower Group, Inc relating to the 5.00% Convertible Senior Notes due 2014, incorporated by reference to Exhibit 4.4 to the Company’s Current Report on Form 8-K filed on September 20, 2010
    4.7    Additional Call Option Confirmation, dated as of September 15, 2010, between JPMorgan Chase Bank, National Association, London Branch and Tower Group, Inc. relating to the 5.00% Convertible Senior Notes due 2014, incorporated by reference to Exhibit 4.5 to the Company’s Current Report on Form 8-K filed on September 20, 2010
    4.8    Base Warrant Confirmation, dated as of September 14, 2010, between Bank of America, N.A. and Tower Group, Inc. relating to the 5.00% Convertible Senior Notes due 2014, incorporated by reference to Exhibit 4.6 to the Company’s Current Report on Form 8-K filed on September 20, 2010
    4.9    Base Warrant Confirmation, dated as of September 14, 2010, between JPMorgan Chase Bank, National Association, London Branch and Tower Group, Inc. relating to the 5.00% Convertible Senior Notes due 2014, incorporated by reference to Exhibit 4.7 to the Company’s Current Report on Form 8-K filed on September 20, 2010
    4.10    Additional Warrant Confirmation, dated as of September 15, 2010, between Bank of America, N.A. and Tower Group, Inc relating to the 5.00% Convertible Senior Notes due 2014, incorporated by reference to Exhibit 4.8 to the Company’s Current Report on Form 8-K filed on September 20, 2010
    4.11    Additional Warrant Confirmation, dated as of September 15, 2010, between JPMorgan Chase Bank, National Association, London Branch and Tower Group, Inc. relating to the 5.00% Convertible Senior Notes due 2014, incorporated by reference to Exhibit 4.9 to the Company’s Current Report on Form 8-K filed on September 20, 2010
    9.1    Voting Agreement, dated August 4, 2008, between Tower Group, Inc. and Michael H. Lee, incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on August 5, 2008
  10.1    Employment Agreement, dated as of February 27, 2012, by and between Tower Group, Inc. and Michael H. Lee, incorporated by reference to Exhibit 10.1 to the Company’s Annual Report on Form 10-K filed on February 29, 2012
  10 .2    Employment agreement, dated as of October 18, 2011, by and between Tower Group, Inc, and William F. Dove, incorporated by reference to Exhibit 99.1 to the Company’s Current Report on Form 8-K filed on October 18, 2011
  10.3    Employment Agreement, dated as of November 19, 2009, by and between Tower Group, Inc. and William E. Hitselberger, incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on November 19, 2009
  10.4    Employment Agreement, dated as of July 23, 2007, by and between Tower Group Inc. and Gary S. Maier, incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q filed on November 9, 2007
  10.5    2004 Long-Term Equity Compensation Plan, as amended and restated effective May 15, 2008, incorporated by reference to Exhibit 99.1 to the Company’s Registration Statement on Form S-8 (No. 333-115310) filed on June 20, 2008
  10.6    2001 Stock Award Plan, incorporated by reference to Exhibit 10.8 to the Company’s Registration Statement on Form S-1 (No. 333-115310) filed on May 7, 2004
  10.7    2000 Deferred Compensation Plan, incorporated by reference to Exhibit 10.9 to the Company’s Registration Statement on Form S-1 (Amendment No. 6) (No. 333-115310) filed on September 30, 2004
  10.8    Amended & Restated Declaration of Trust, dated as of May 15, 2003, by and between Tower Group, Inc., Tower Statutory Trust I and U.S. Bank National Association, incorporated by reference to Exhibit 10.10 to the Company’s Registration Statement on Form S-1 (No. 333-115310) filed on May 7, 2004
  10.9    Indenture, dated as of May 15, 2003, by and between Tower Group, Inc. and U.S. Bank National Association, incorporated by reference to Exhibit 10.11 to the Company’s Registration Statement on Form S-1 (No. 333-115310) filed on May 7, 2004
  10.10    Guarantee Agreement, dated as of May 15, 2003, by and between Tower Group, Inc. and U.S. Bank National Association, incorporated by reference to Exhibit 10.12 to the Company’s Registration Statement on Form S-1 (No. 333-115310) filed on May 7, 2004
  10.11    Amended and Restated Trust Agreement, dated as of September 30, 2003, by and between Tower Group, Inc., JPMorgan Chase Bank, Chase Manhattan Bank USA, National Association and Michael H. Lee, Steven G. Fauth and Francis M. Colalucci as Administrative Trustees of Tower Group Statutory Trust II, incorporated by reference to Exhibit 10.13 to the Company’s Registration Statement on Form S-1 (No. 333-115310) filed on May 7, 2004

 

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Exhibit
Number

  

Description of Exhibits

  10.12    Junior Subordinated Indenture, dated as of September 30, 2003, by and between Tower Group, Inc. and JPMorgan Chase Bank, incorporated by reference to Exhibit 10.14 to the Company’s Registration Statement on Form S-1 (No. 333-115310) filed on May 7, 2004
  10.13    Guarantee Agreement, dated as of September 30, 2003, by and between Tower Group, Inc. and JPMorgan Chase Bank, incorporated by reference to Exhibit 10.15 to the Company’s Registration Statement on Form S-1 (No. 333-115310) filed on May 7, 2004
  10.14    Service and Expense Sharing Agreement, dated as of December 28, 1995, by and between Tower Insurance Company of New York and Tower Risk Management Corp., incorporated by reference to Exhibit 10.16 to the Company’s Registration Statement on Form S-1 (No. 333-115310) filed on May 7, 2004
  10.15    Real Estate Lease and amendments thereto, by and between Broadpine Realty Holding Company, Inc. and Tower Insurance Company of New York, incorporated by reference to Exhibit 10.17 to the Company’s Registration Statement on Form S-1 (Amendment No. 1) (No. 333-115310) filed on June 24, 2004
  10.16    Third Amendment to Lease between Tower Insurance Company of New York and 120 Broadway Holdings, LLC executed September 1, 2005, incorporated by reference to Exhibit 10.01 to the Company’s Current Report on Form 8-K filed on August 26, 2005
  10.17    License and Services Agreement, dated as of June 11, 2002, by and between AgencyPort Insurance Services, Inc. and Tower Insurance Company of New York, incorporated by reference to Exhibit 10.18 to the Company’s Registration Statement on Form S-1 (Amendment No. 3) (No. 333-115310) filed on August 25, 2004
  10.18    Agreement, dated as of April 17, 1996, between Morstan General Agency, Inc. and Tower Risk Management Corp., incorporated by reference to Exhibit 10.19 to the Company’s Registration Statement on Form S-1 (No. 333-115310) filed on May 7, 2004
  10.19    Amended and Restated Declaration of Trust, dated December 15, 2004, by and among Wilmington Trust Company, as Institutional Trustee; Wilmington Trust Company, as Delaware Trustee; Tower Group, Inc., as Sponsor; and the Trust Administrators Michael H. Lee, Francis M. Colalucci and Steve G. Fauth, incorporated by reference to Exhibit 10.04 to the Company’s Current Report on Form 8-K filed on December 20, 2004
  10.20    Indenture between Tower Group, Inc. and Wilmington Trust Company, as Trustee, dated December 15, 2004, incorporated by reference to Exhibit 10.03 to the Company’s Current Report on Form 8-K filed on December 20, 2004
  10.21    Guarantee Agreement dated December 15, 2004, by and between Tower Group, Inc. and Wilmington Trust Company, incorporated by reference to Exhibit 10.02 to the Company’s Current Report on Form 8-K filed on December 20, 2004
  10.22    Amended and Restated Declaration of Trust, dated December 21, 2004, by and among JPMorgan Chase Bank, National Association, as Institutional Trustee, Chase Manhattan Bank USA, National Association, as Delaware Trustee; Tower Group, Inc., as Sponsor; and the Trust Administrators Michael H. Lee, Francis M. Colalucci and Steve G. Fauth, incorporated by reference to Exhibit 10.04 to the Company’s Current Report on Form 8-K filed on December 23, 2004
  10.23    Indenture between Tower Group, Inc. and JPMorgan Chase Bank, National Association, as Trustee, dated December 21, 2004, incorporated by reference to Exhibit 10.03 to the Company’s Current Report on Form 8-K filed on December 23, 2004
  10.24    Guarantee Agreement dated December 21, 2004, by and between Tower Group, Inc. and JPMorgan Chase Bank, National Association, incorporated by reference to Exhibit 10.02 to the Company’s Current Report on Form 8-K filed on December 23, 2004
  10.25    Amended and Restated Declaration of Trust, dated March 31, 2006, by and among Wells Fargo Bank, National Association, as Institutional Trustee; Wells Fargo Delaware Trust Company, as Delaware Trustee; Tower Group, Inc., as Sponsor; and the Trust Administrators Francis M. Colalucci and Steve G. Fauth, incorporated by reference to Exhibit 10.04 to the Company’s Current Report on Form 8-K filed on April 6, 2006
  10.26    Indenture between Tower Group, Inc. and Wells Fargo Bank, National Association, as Trustee, dated March 31, 2006, incorporated by reference to Exhibit 10.03 to the Company’s Current Report on Form 8-K filed on April 6, 2006
  10.27    Guarantee Agreement dated March 31, 2006, by and between Tower Group, Inc. and Wells Fargo Delaware Trust Company, incorporated by reference to Exhibit 10.02 to the Company’s Current Report on Form 8-K filed on April 6, 2006
  10.28    Stock Purchase Agreement by and among Tower Group, Inc. and Preserver Group, Inc. dated November 13, 2006, incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on November 17, 2006
  10.29    Exchange Agreement by and among Tower Group, Inc. and CastlePoint Management Corp. dated January 11, 2007 incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on January 12, 2007
  10.30    Master Agreement dated April 4, 2006 by and among Tower Group, Inc., Tower Insurance Company of New York, Tower National Insurance Company, CastlePoint Holdings, Ltd. and CastlePoint Management Corp. incorporated by reference to Exhibit 10.1to the Company’s Current Report on Form 8-K filed on January 22, 2007

 

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Exhibit
Number

  

Description of Exhibits

  10.31    Addendum No. 1 to the Master Agreement by and among Tower Group, Inc. and CastlePoint Holdings, Ltd. incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on January 22, 2007
  10.32    Amended and Restated Declaration of Trust, dated January 25, 2007, by and among Wilmington Trust, as Institutional Trustee and as Delaware Trustee; Tower Group, Inc., as Sponsor; and the Trust Administrators Michael H. Lee, Francis M. Colalucci and Stephen L. Kibblehouse, incorporated by reference to Exhibit 10.02 to the Company’s Current Report on Form 8-K filed on January 26, 2007
  10.33    Indenture between Tower Group, Inc. and Wilmington Trust Company, as Trustee, dated January 25, 2007, incorporated by reference to Exhibit 4.01 to the Company’s Current Report on Form 8-K filed on January 26, 2007
  10.34    Guarantee Agreement dated January 25, 2007, by and between Tower Group, Inc. and Wilmington Trust Company, incorporated by reference to Exhibit 10.01 to the Company’s Current Report on Form 8-K filed on January 26, 2007
  10.35    Management Agreement, dated July 1, 2007, by and between CastlePoint Insurance Company and Tower Risk Management Corp., incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q filed on November 9, 2007
  10.36    Fourth Amendment to Lease between Tower Insurance Company of New York and 120 Broadway Holdings, LLC dated July 25, 2006, incorporated by reference to Exhibit 10.49 to the Company’s Annual Report on Form 10-K filed on March 14, 2008
  10.37    Fifth Amendment to Lease between Tower Insurance Company of New York and 120 Broadway Holdings, LLC dated December 20, 2006, incorporated by reference to Exhibit 10.50 to the Company’s Annual Report on Form 10-K filed on March 14, 2008
  10.38    Service Agreement dated May 1, 2007 by and among Tower Risk Management Corp. and CastlePoint Management Corp., incorporated by reference to Exhibit 10.59 to the Company’s Annual Report on Form 10-K filed on March 14, 2008
  10.39    Form of Tower Group, Inc. 2004 Long Term Equity Compensation Plan Restricted Stock Award Agreement, incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on March 18, 2008
  10.40    Form of Tower Group, Inc. 2004 Long Term Equity Compensation Plan Performance Shares Award Agreement, incorporated by reference to Exhibit 10.50 to the Company’s Annual Report on Form 10-K filed on March 16, 2009
  10.41    Form of Tower Group, Inc. 2004 Long Term Equity Compensation Plan, as amended and restated effective May 15, 2008, Restricted Stock Units Award Agreement, incorporated by reference to Exhibit 10.63 to the Company’s Annual Report on Form 10-K filed on March 14, 2008
  10.42    Stock Purchase Agreement dated August 27, 2008 between CastlePoint Reinsurance Company, Ltd., HIG, Inc. and Brookfield US Corporation, incorporated by reference to Exhibit 2.1 to CastlePoint Holdings, Ltd.’s Current Report on Form 8-K filed on September 2, 2008
  10.43    Asset Purchase Agreement, dated as of August 26, 2008, by and among CastlePoint Reinsurance Company, Ltd., Tower Insurance Company of New York, Tower National Insurance Company, Preserver Insurance Company, Mountain Valley Insurance Company, North East Insurance Company and Tower Risk Management Corp., incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed August 27, 2008
  10.44    Limited Waiver Agreement, dated as of August 26, 2008, by and among Tower Group, Inc., Ocean I Corporation and CastlePoint Holdings, Ltd., incorporated by reference to Exhibit 2.2 to the Company’s Current Report on Form 8-K filed August 27, 2008
  10.45    Parent Guarantee Agreement, dated as of December 1, 2006, between CastlePoint Holdings, Ltd. and Wilmington Trust Company, incorporated by reference to Exhibit 10.32 to CastlePoint Holdings Ltd.’s Registration Statement on Form S-1 (No. 333-139939) filed on January 11, 2007
  10.46    Guarantee Agreement, dated as of December 1, 2006, between CastlePoint Management Corp. and Wilmington Trust Company, incorporated by reference to Exhibit 10.33 to CastlePoint Holdings Ltd.’s Registration Statement on Form S-1 (No. 333-139939) filed on January 11, 2007
  10.47    Indenture, dated as of December 1, 2006, between CastlePoint Management Corp. and Wilmington Trust Company, incorporated by reference to Exhibit 10.34 to CastlePoint Holdings Ltd.’s Registration Statement on Form S-1 (No. 333-139939) filed on January 11, 2007
  10.48    Amended and Restated Declaration of Trust, dated as of December 1, 2006, among Wilmington Trust Company as Institutional Trustee, Wilmington Trust Company, as Delaware Trustee, CastlePoint Management Corp., as Sponsor, and Joel Weiner, James Dulligan and Roger Brown, as Administrators, incorporated by reference to Exhibit 10.35 to CastlePoint Holdings Ltd.’s Registration Statement on Form S-1 (No. 333-139939) filed on January 11, 2007
  10.49    Parent Guarantee Agreement, dated as of December 14, 2006, between CastlePoint Holdings, Ltd. and Wilmington Trust Company, incorporated by reference to Exhibit 10.36 to CastlePoint Holdings Ltd.’s Registration Statement on Form S-1 (No. 333-139939) filed on January 11, 2007
  10.50    Guarantee Agreement of CastlePoint Management Corp., dated as of December 14, 2006, between CastlePoint Management Corp. and Wilmington Trust Company, incorporated by reference to Exhibit 10.37 to CastlePoint Holdings Ltd.’s Registration Statement on Form S-1 (No. 333-139939) filed on January 11, 2007

 

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Exhibit
Number

  

Description of Exhibits

  10.51    Indenture, dated as of December 14, 2006, between CastlePoint Management Corp. and Wilmington Trust Company, incorporated by reference to Exhibit 10.38 to CastlePoint Holdings Ltd.’s Registration Statement on Form S-1 (No. 333-139939) filed on January 11, 2007
  10.52    Amended and Restated Declaration of Trust, dated as of December 14, 2006, among Wilmington Trust Company as Institutional Trustee, Wilmington Trust Company, as Delaware Trustee, CastlePoint Management Corp., as Sponsor, and Joel Weiner, James Dulligan and Roger Brown, as Administrators, incorporated by reference to Exhibit 10.39 to CastlePoint Holdings Ltd.’s Registration Statement on Form S-1 (No. 333-139939) filed on January 11, 2007
  10.53    CastlePoint Holdings, Ltd. 2006 Long-Term Equity Compensation Plan, incorporated by reference to Exhibit 10.4 to CastlePoint Holdings Ltd.’s Registration Statement on Form S-1 (File No. 333-134628) filed on June 1, 2006
  10.54    Amendment No. 1 to CastlePoint Holdings, Ltd. 2006 Long-Term Equity Compensation Plan, incorporated by reference to Exhibit 4.5 to CastlePoint Holdings Ltd.’s Registration Statement on Form S-8 (File No. 333-134628) filed on December 5, 2007
  10.55    Form of Stock Option Agreement for Executive Employee Recipients of Options under 2006 Long-Term Equity Compensation Plan, incorporated by reference to Exhibit 10.5 to CastlePoint Holdings Ltd.’s Registration Statement on Form S-1 (File No. 333-134628) filed on June 1, 2006
  10.56    Form of Stock Option Agreement for Non-Employee Director Recipients of Options under 2006 Long-Term Equity Compensation Plan, incorporated by reference to Exhibit 10.6 to CastlePoint Holdings Ltd.’s Registration Statement on Form S-1 (File No. 333-134628) filed on June 1, 2006
  10.57    Indenture between CastlePoint Bermuda Holdings, Ltd. and Wilmington Trust Company, as Trustee, dated September 27, 2007, incorporated by reference to Exhibit 4.1 to CastlePoint Holdings Ltd.’s Current Report on Form 8-K filed on October 1, 2007
  10.58    Guarantee Agreement dated September 27, 2007 by and between CastlePoint Bermuda Holdings, Ltd. and Wilmington Trust Company, incorporated by reference to Exhibit 4.2 to CastlePoint Holdings Ltd.’s Current Report on Form 8-K filed on October 1, 2007
  10.59    Amended and Restated Declaration of Trust, dated September 27, 2007, by Wilmington Trust, as Institutional Trustee and as Delaware Trustee; CastlePoint Bermuda Holdings, Ltd. as Sponsor, and Trust Administrators Roger A. Brown, Joel S. Weiner and James Dulligan, incorporated by reference to Exhibit 4.3 to CastlePoint Holdings Ltd.’s Current Report on Form 8-K filed on October 1, 2007
  10.60    Fixed/Floating Rate Junior Subordinated Deferrable Interest Debenture, dated September 27, 2007 by CastlePoint Bermuda Holdings, Ltd. in favor of Wilmington Trust Company as institutional trustee, incorporated by reference to Exhibit 4.4 to CastlePoint Holdings Ltd.’s Current Report on Form 8-K filed on October 1, 2007
  10.61    Supplemental Guarantee, dated as of February 5, 2009, by and among Ocean I Corporation, CastlePoint Holdings, Ltd. and Wilmington Trust Company (related to that certain Parent Guarantee Agreement, dated as of December 1, 2006, between CastlePoint Holdings, Ltd. and Wilmington Trust Company), incorporated by reference to Exhibit 10.71 to the Company’s Annual Report on Form 10-K filed on March 16, 2009
  10.62    Supplemental Guarantee, dated as of February 5, 2009, by and among Ocean I Corporation, CastlePoint Holdings, Ltd. and Wilmington Trust Company (related to that certain Parent Guarantee Agreement, dated as of December 14, 2006, between CastlePoint Holdings, Ltd. and Wilmington Trust Company), incorporated by reference to Exhibit 10.72 to the Company’s Annual Report on Form 10-K filed on March 16, 2009
  10.63    Supplemental Guarantee, dated as of February 5, 2009, by and among Ocean I Corporation, CastlePoint Holdings, Ltd. and Wilmington Trust Company (related to that certain Parent Guarantee Agreement, dated as of November 8, 2007, between CastlePoint Holdings, Ltd. and Wilmington Trust Company), incorporated by reference to Exhibit 10.73 to the Company’s Annual Report on Form 10-K filed on March 16, 2009
  10.64    Separation Agreement, dated as of February 27, 2009, by and between Tower Group, Inc. and Patrick J. Haveron, incorporated by reference to Exhibit 10.75 to the Company’s Annual Report on Form 10-K filed on March 16, 2009
  10.65    Consulting Agreement, dated as of February 27, 2009, by and between Tower Group, Inc. and Patrick J. Haveron, incorporated by reference to Exhibit 10.76 to the Company’s Annual Report on Form 10-K filed on March 16, 2009
  10.66    Letter of Amendment dated February 23, 2009 to Stock Purchase Agreement dated August 27, 2008 between CastlePoint Reinsurance Company, Ltd., HIG, Inc. and Brookfield US Corporation, incorporated by reference to Exhibit 10.77 to the Company’s Annual Report on Form 10-K filed on March 16, 2009
  10.67    Credit Agreement dated as of May 14, 2010 by and among Tower Group, Inc., Bank of America, N.A., JPMorgan Chase Bank, N.A., KeyBank National Association, PNC Bank, National Association, J.P. Morgan Securities Inc. and Banc of America Securities LLC, incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on May 17, 2010
  10.68    Investment and Shareholders’ Agreement dated as of April 25, 2012 by and among Tower Group, Inc. and the principal shareholders of Canopius Group, Ltd., incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on April 25, 2012
  10.69    Master Transaction Agreement, dated as of April 25, 2012, by and among Tower Group, Inc., Canopius Holdings Bermuda Limited, Canopius Mergerco, Inc. and Canopius Group Limited incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on April 25, 2012

 

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Number

  

Description of Exhibits

  10.70    Employment agreement, dated as of December 1, 2008, by and between Tower Group, Inc, and Elliot S. Orol, incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q filed on November 9, 2012
  10.71    Amendment to Employment agreement, dated as of November 16, 2012, by and between Tower Group, Inc, and Elliot S. Orol, incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q filed on November 9, 2012
  10.72    Amendment to Employment agreement, dated as of November 16, 2012, by and between Tower Group, Inc, and Gary S. Maier, incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q filed on November 9, 2012
  10.73    Second Amendment to Credit Agreement and Consent, dated as of November 26, 2012, by and among Tower Group, Inc., Bank of America, N.A., JPMorgan Chase Bank, N.A., KeyBank National Association, PNC Bank, National Association, J.P. Morgan Securities Inc. and Banc of America Securities LLC, incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on November 28, 2012
  10.74    Form of Indemnification Agreement to be entered into by and between Tower Group International, Ltd. and certain of its directors, officers and employees incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on March 13, 2013
  10.75    Registration Rights Agreement, dated as of March 13, 2013, by and among Canopius Holdings Bermuda Limited (now known as Tower Group International, Ltd.) and certain shareholders of Canopius Holdings Bermuda Limited incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on March 13, 2013
  10.76    Guarantee of Tower Group International, Ltd, dated as of March 13, 2013 incorporated by reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K filed on March 13, 2013
  10.77    Assignment and Assumption and Amendment Agreement, effective as of March 13, 2013, by and among the Company, TGI and Michael H. Lee incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on March 15, 2013
  10.78    Assignment and Assumption and Amendment Agreement, effective as of March 13, 2013, by and among the Company, TGI and William E. Hitselberger incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on March 15, 2013
  10.79    Assignment and Assumption and Amendment Agreement, effective as of March 13, 2013, by and among the Company, TGI and Elliot S. Orol incorporated by reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K filed on March 15, 2013
  10.80    Guaranty Agreement, dated as of April 3, 2013, by Tower Group International, Ltd. in favor of Bank of America, N.A., as administrative agent for the lenders party to the Credit Agreement incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on April 5, 2013
  10.81    First Amendment to Credit Agreement and Consent, dated as of June 22, 2012, between Tower Group, Inc. and Bank of America, N.A., as administrative agent, fronting agent and L/C administrator incorporated by reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K filed on April 5, 2013
  10.82    Limited Waiver and Amendment Agreement, dated as of March 3, 2013, between Tower Group, Inc. and Bank of America, N.A., as administrative agent, fronting agent and L/C administrator incorporated by reference to Exhibit 10.5 to the Company’s Current Report on Form 8-K filed on April 5, 2013
  10.83    Fourth Amendment Agreement and Waiver, dated as of April 3, 2013, between Tower Group, Inc. and Bank of America, N.A., as administrative agent, fronting agent and L/C administrator incorporated by reference to Exhibit 10.6 to the Company’s Current Report on Form 8-K filed on April 5, 2013
  10.84   

Assignment and Assumption Agreement, dated as of August 18, 2013, by and between

Tower Group International, Ltd., Fairfax Financial Holdings Limited and Catalina Holdings (Bermuda) Ltd. incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on August 19, 2013

  10.85    Arch Reinsurance Ltd. Brokerage Multi-Line Quota Share Agreement, dated as of September 27, 2013 incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on October 1, 2013
  10.86    Hannover Re (Ireland) Plc Brokerage Multi-Line Quota Share Agreement, dated as of September 26, 2013 incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on October 1, 2013
  10.87    Tower New York – Southport Re (Cayman), Ltd. Workers’ Compensation Quota Share Agreement, dated as of September 25, 2013 incorporated by reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K filed on October 1, 2013
  10.88    Tower New York – Southport Re (Cayman), Ltd. Workers’ Compensation Adverse Development Aggregate Excess of Loss Agreement, dated as of September 25, 2013 incorporated by reference to Exhibit 10.4 to the Company’s Current Report on Form 8-K filed on October 1, 2013
  10.89    Tower Re – Southport Re (Cayman), Ltd. Workers’ Compensation Adverse Development Aggregate Excess of Loss Agreement, dated as of September 26, 2013 incorporated by reference to Exhibit 10.5 to the Company’s Current Report on Form 8-K filed on October 1, 2013

 

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Exhibit
Number

  

Description of Exhibits

  10.90    Fifth Amendment Agreement to the Amended and Restated Credit Facility Agreement, by and among the Company, TGI, Bank of America, N.A. as Administrative Agent, Fronting Bank and L/C Administrator, and the Lender parties thereto incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on October 15, 2013
  10.91    Letter of Credit Facility Agreement, dated as of November 11, 2011, by and among Tower Insurance Company of New York, CastlePoint Insurance Company, CastlePoint National Insurance Company, Hermitage Insurance Company and Barclays Bank PLC incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on October 24, 2013
  10.92    Amendment Agreement to the Letter of Credit Facility Agreement, dated as of March 12, 2012, by and among Tower Insurance Company of New York, CastlePoint Insurance Company, CastlePoint National Insurance Company, Hermitage Insurance Company and Barclays Bank PLC incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on October 24, 2013
  10.93    Amendment Agreement to the Letter of Credit Facility Agreement, dated as of July 16, 2012, by and among Tower Insurance Company of New York, CastlePoint Insurance Company, CastlePoint National Insurance Company, Hermitage Insurance Company and Barclays Bank PLC incorporated by reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K filed on October 24, 2013
  10.94    Amendment Agreement to the Letter of Credit Facility Agreement, dated as of November 21, 2012, by and among Tower Insurance Company of New York, CastlePoint Insurance Company, CastlePoint National Insurance Company, Hermitage Insurance Company and Barclays Bank PLC incorporated by reference to Exhibit 10.4 to the Company’s Current Report on Form 8-K filed on October 24, 2013
  10.95    Amendment and Restatement Agreement to the Letter of Credit Facility Agreement, dated as of March 7, 2013, by and among Tower Insurance Company of New York, CastlePoint Insurance Company, CastlePoint National Insurance Company, Hermitage Insurance Company, Barclays Bank PLC and Bank of Montreal incorporated by reference to Exhibit 10.5 to the Company’s Current Report on Form 8-K filed on October 24, 2013
  10.96    Amendment Agreement to the Letter of Credit Facility Agreement, dated as of May 2, 2013, by and among Tower Insurance Company of New York, CastlePoint Insurance Company, CastlePoint National Insurance Company, Hermitage Insurance Company, Barclays Bank PLC and Bank of Montreal incorporated by reference to Exhibit 10.6 to the Company’s Current Report on Form 8-K filed on October 24, 2013
  10.97    Waiver Letter to Letter of Credit Facility Agreement, dated as of October 18, 2013, by and among Tower Insurance Company of New York, CastlePoint Insurance Company, CastlePoint National Insurance Company, Hermitage Insurance Company, Barclays Bank PLC and Bank of Montreal incorporated by reference to Exhibit 10.7 to the Company’s Current Report on Form 8-K filed on October 24, 2013
  10.98    Amendment Agreement to Letter of Credit Facility Agreement, dated as of October 22, 2013, by and among Tower Insurance Company of New York, CastlePoint Insurance Company, CastlePoint National Insurance Company, Hermitage Insurance Company, Barclays Bank PLC and Bank of Montreal incorporated by reference to Exhibit 10.8 to the Company’s Current Report on Form 8-K filed on October 24, 2013
  10.99    Waiver Letter to Letter of Credit Facility Agreement, dated as of November 4, 2013, by and among Tower Insurance Company of New York, CastlePoint Insurance Company, CastlePoint National Insurance Company, Hermitage Insurance Company, Barclays Bank PLC and Bank of Montreal incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on November 6, 2013
  10.100    Form of Amendment to the indemnification agreements, dated as of March 13, 2013, between the Company and each of the Company’s directors and certain of the Company’s executive officers incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on November 8, 2013
  10.101    Waiver Letter to the Credit Agreement, dated as of November 14, 2013, by and among TGI, Bank of America, N.A. as Administrative Agent, Fronting Bank and L/C Administrator, and the Lender parties thereto incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on November 20, 2013
  10.102    Waiver Letter to Letter of Credit Facility Agreement, dated as of November 26, 2013, by and among Tower Insurance Company of New York, CastlePoint Insurance Company, CastlePoint National Insurance Company, Hermitage Insurance Company, Barclays Bank PLC and Bank of Montreal incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on December 2, 2013
  10.103    Cancellation Letter, dated as of December 5, 2013, by and among Tower Insurance Company of New York, CastlePoint Insurance Company, CastlePoint National Insurance Company, Hermitage Insurance Company, Barclays Bank PLC and Bank of Montreal incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on December 9, 2013
  10.104    Termination Letter, dated as of December 13, 2013, by and between Tower Group, Inc. and Bank of America, N.A. incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on December 18, 2013
  10.105    Commercial Lines Cut-Through Reinsurance Agreement, dated as of January 3, 2014, by and among Tower Insurance Company of New York, Castle Point National Insurance Company, Tower National Insurance Company, Hermitage Insurance Company, Castle Point Florida Insurance Company, Kodiak Insurance Company, North East Insurance Company, York Insurance Company of Maine, Massachusetts Homeland Insurance Company, Preserver Insurance Company, Castle Point Insurance Company, and Technology Insurance Company, Inc. incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on January 6, 2014

 

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Exhibit
Number

  

Description of Exhibits

  10.106    Personal Lines Cut-Through Reinsurance Agreement, dated as of January 3, 2014, by and among Tower Insurance Company of New York, Castle Point National Insurance Company, Tower National Insurance Company, Hermitage Insurance Company, Castle Point Florida Insurance Company, Kodiak Insurance Company, North East Insurance Company, York Insurance Company of Maine, Massachusetts Homeland Insurance Company, Preserver Insurance Company, Castle Point Insurance Company, and Integon National Insurance Company incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on January 6, 2014
  10.107    Voting Agreement, dated as of January 3, 2014, by and between Michael H. Lee and ACP Re Ltd. incorporated by reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K filed on January 6, 2014
  10.108    Separation and Release Agreement between Tower Group International, Ltd. and Michael H. Lee, effective as of February 6, 2014 incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on February 10, 2014
  10.109    Employment Agreement between Tower Group International, Ltd. and William W. Fox, Jr., effective as of February 14, 2014 incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K/A filed on February 18, 2014
  10.110    Reinsurance Commutation Agreement, dated as of February 14, 2014 and effective as of February 19, 2014, by and among Southport Re (Cayman) Ltd., Tower Reinsurance, Ltd. and Tower Insurance Company of New York incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on February 24, 2014
  16    Letter from Johnson, Lambert & Co. LLP regarding change in certifying accountant, incorporated by reference to Exhibit 16.1 to the Company’s Current Report on Form 8-K filed on March 5, 2010
  21.1    Subsidiaries of the registrant*
  23.1    Consent of PricewaterhouseCoopers LLP*
  31.1    Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by William W. Fox, Jr.*
  31.2    Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by William E. Hitselberger*
  32    Certification of Chief Executive Officer and Chief Financial Officer, Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*
EX-101    INSTANCE DOCUMENT**
EX-101    SCHEMA DOCUMENT**
EX-101    CALCULATION LINKBASE DOCUMENT**
EX-101    LABELS LINKBASE DOCUMENT**
EX-101    PRESENTATION LINKBASE DOCUMENT**
EX-101    DEFINITION LINKBASE DOCUMENT**

 

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