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TWGP > SEC Filings for TWGP > Form 10-Q on 9-Nov-2012All Recent SEC Filings

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Form 10-Q for TOWER GROUP, INC.


9-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

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-Q 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.

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:

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

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

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

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;

the effects of acts of terrorism or war;

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

changes in regulations or laws applicable to us, our subsidiaries, brokers or customers;

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

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

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

decreased demand for our insurance or reinsurance products;

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

the effects of mergers, acquisitions or divestitures;

changes in rating agency policies or practices;

changes in legal theories of liability under our insurance policies;

changes in accounting policies or practices;

changes in general economic conditions, including inflation, interest rates and other factors;

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

currently pending or future litigation or governmental proceedings.

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-Q. 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-Q reflect our views as of the date of this Form 10-Q 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-Q that could cause actual results to differ.


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Overview

Tower, through its subsidiaries, offers a broad range of commercial, specialty and personal property and casualty insurance products and services to businesses in various industries and to individuals throughout the United States. We provide coverage for many different market sectors, including non-standard risks that do not fit the underwriting criteria of standard risk carriers due to factors such as type of business, location and premium per policy. We provide these products on both an admitted and excess and surplus ("E&S") basis.

The Company operates three business segments: Commercial Insurance, Personal Insurance and Insurance Services. Each of these segments is described below.

Our Commercial Insurance segment offers property and casualty insurance products through several business units that serve customers in general commercial and specialty markets. Our commercial lines products include commercial multiple-peril (provides both property and liability insurance), monoline general liability (insures bodily injury or property damage liability), commercial umbrella, monoline property (insures buildings, contents or business income), workers' compensation, fire and allied lines, inland marine, commercial automobile policies and assumed reinsurance.

Our Personal Insurance segment offers a broad range of products designed to fit the insurance needs of most personal lines customers. This segment includes the business written in the Reciprocal Exchanges. Our personal lines products consist of homeowners, personal automobile, package and umbrella policies. In the first quarter of 2012, Tower sold one of its insurance subsidiaries to the Reciprocal Exchanges. As a result, the Reciprocal Exchanges have expanded their licensing and increased their capacity to write business.

In our Insurance Services segment, we generate management fees primarily from the services provided to the Reciprocal Exchanges and other fees generated by our managing general agencies.

Investment in Canopius Group Limited and Exercise of Merger Option

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

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

The "Adjusted Canopius Bermuda Price Per Share" will be equal to the quotient obtained by dividing (i) the sum of (a) the Target TNAV Amount, which is the amount that Tower specifies in a written notice delivered to Canopius Group prior to the signing date of the purchase and sale agreements for the Canopius Secondary Offering, as the target amount of the tangible net asset value of Canopius Bermuda as of the closing date of the Canopius Secondary Offering, (b) the value of the retained business of Canopius Bermuda following its restructuring, (c) the aggregate amount of the placement fees received by the placement agents in connection with the Canopius Secondary Offering and (d) the aggregate amount, expressed in dollars, equal to the absolute value of the discount from the closing price of Tower's common stock on the pricing date of the Canopius Secondary Offering, or on another reasonably current date (as agreed by Tower, Canopius Bermuda and the Third Party Investors), that Tower, Canopius Bermuda and the Third Party Investors have agreed is necessary in order to effect the Canopius Secondary Offering, by (ii) the aggregate number of Canopius Bermuda common shares sold in the Canopius Secondary Offering.


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Because neither the restructuring of Canopius Bermuda nor the Canopius Secondary Offering is likely to occur until the fourth quarter of this year at the earliest, no assurances can be given as to the Target TNAV Amount or the Adjusted Canopius Bermuda Price Per Share. In determining the Target TNAV Amount, Tower will principally consider the amount of capital that it believes will be required to maintain its ratings and to operate the combined business. Tower believes this capital amount to be between $150 million and $180 million.

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

Tower has the explicit right in the Merger Agreement to terminate that agreement and not complete the merger at any time and for any or no reason prior to the effective time of the merger. In the event that Tower exercises its right to terminate the Merger Agreement, it will nonetheless be obligated to reimburse affiliates of Canopius Bermuda for costs actually incurred in connection with negotiating, documenting and implementing the Merger Agreement and the transactions contemplated thereby to the extent that such costs exceed the $1,000,000 Merger Option exercise fee paid by Tower.

Operating Income

Operating income 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 to net income on a GAAP basis. The operating income is used to calculate operating earnings per share and operating return on average equity:

                                                  Three Months  Ended                Nine Months  Ended
                                                     September 30,                     September 30,
($ in thousands)                                 2012             2011             2012             2011
Operating income (loss)                       $    23,772      $   (15,307 )    $    30,242      $    31,013
Net realized gains (losses) on investments,
excluding gains (losses) attributable to
Reciprocal Exchanges                                   80           (1,135 )          1,108            4,245
Acquisition-related transaction costs              (2,679 )           (425 )         (4,661 )           (437 )
Income tax                                            456              428              461           (1,454 )
Net income (loss) attributable to Tower
Group, Inc.                                   $    21,629      $   (16,439 )    $    27,150      $    33,367

Critical Accounting Estimates

As of September 30, 2012, there were no material changes to our critical accounting estimates; refer to the Company's 2011 Annual Report on Form 10-K for a complete discussion of critical accounting estimates.

Critical Accounting Policies

See "Note 2-Accounting Policies and Basis of Presentation" for information related to updated accounting policies.


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Consolidating Supplemental Information

The following tables present the consolidating financial statements as of
September 30, 2012 and December 31, 2011 and for the three and nine months ended
September 30, 2012 and 2011:




                                                                    September 30, 2012
                                                               Reciprocal          Elimin-
($ in thousands)                             Tower             Exchanges            ations              Total
Assets
Investments
Available-for-sale investments, at
fair value:
Fixed-maturity securities                $    2,133,676      $      303,172     $            -      $    2,436,848
Equity securities                               123,614               5,654                  -             129,268
Short-term investments                            4,748                   -                  -               4,748
Other invested assets                           131,565                   -            (77,200 )            54,365
Total investments                             2,393,603             308,826            (77,200 )         2,625,229
Cash and cash equivalents                       168,031              11,383                  -             179,414
Investment income receivable                     41,786               3,443            (15,041 )            30,188
Investment in unconsolidated affiliate           71,512                   -                  -              71,512
Premiums receivable                             327,089              42,800             (2,400 )           367,489
Reinsurance recoverable on paid losses           20,753               2,248             (3,128 )            19,873
Reinsurance recoverable on unpaid
losses                                          294,488              23,524             (4,386 )           313,626
Prepaid reinsurance premiums                     44,876              19,910             (1,966 )            62,820
Deferred acquisition costs, net                 177,086              12,503                  -             189,589
Intangible assets                               101,806               7,000                  -             108,806
Goodwill                                        250,103                   -                  -             250,103
Funds held by reinsured companies               124,353                   -                  -             124,353
Other assets                                    336,138               4,086            (19,057 )           321,167
Total assets                             $    4,351,624      $      435,772     $     (123,178 )    $    4,664,169
Liabilities
Loss and loss adjustment expenses        $    1,571,593      $      127,459     $       (4,386 )    $    1,694,666
Unearned premium                                823,155             106,106             (1,966 )           927,295
Reinsurance balances payable                     17,165               9,213             (5,528 )            20,850
Funds held under reinsurance
agreements                                       88,810                   -                  -              88,810
Other liabilities                               303,054              46,889            (34,298 )           315,645
Deferred income taxes                            41,451               7,445                  -              48,896
Debt                                            449,005              77,000            (77,000 )           449,005
Total liabilities                             3,294,661             374,111           (123,178 )         3,545,595
Stockholders' equity
Common stock                                        468                   -                  -                 468
Treasury stock                                 (181,432 )                 -                  -            (181,432 )
Paid-in-capital                                 777,864              27,647            (27,647 )           777,864
Accumulated other comprehensive income           96,125              17,090            (17,090 )            96,125
Retained earnings                               361,956              16,874            (16,874 )           361,956
Noncontrolling interests                          1,982                   -             61,611              63,593
Total stockholders' equity                    1,056,963              61,611                  -           1,118,574
Total liabilities and stockholders'
equity                                   $    4,351,624      $      435,722     $     (123,178 )    $    4,664,169


Table of Contents

                                                                     December 31, 2011
                                                               Reciprocal          Elimin-
($ in thousands)                             Tower             Exchanges            ations              Total
Assets
Investments
Available-for-sale investments, at
fair value:
Fixed-maturity securities                $    2,153,620      $      300,054     $            -      $    2,453,674
Equity securities                                87,479               1,866                  -              89,345
Short-term investments                                -                   -                  -                   -
Other invested assets                           121,547                   -            (77,200 )            44,347
Total investments                             2,362,646             301,920            (77,200 )         2,587,366
Cash and cash equivalents                       113,432                 666                  -             114,098
Investment income receivable                     33,842               2,978            (10,038 )            26,782
Premiums receivable                             367,336              41,290                  -             408,626
Reinsurance recoverable on paid losses           18,233               6,326               (656 )            23,903
Reinsurance recoverable on unpaid
losses                                          308,411              20,134             (8,881 )           319,664
Prepaid reinsurance premiums                     39,352              14,685                  -              54,037
Deferred acquisition costs, net                 156,992              11,866                  -             168,858
Intangible assets                               110,081               4,839                  -             114,920
Goodwill                                        250,103                   -                  -             250,103
Funds held by reinsured companies                69,755                   -                  -              69,755
Other assets                                    317,173               2,485            (15,575 )           304,083
Total assets                             $    4,147,356      $      407,189     $     (112,350 )    $    4,442,195
Liabilities
Loss and loss adjustment expenses        $    1,495,839      $      145,155     $       (8,881 )    $    1,632,113
Unearned premium                                790,185             102,991                  -             893,176
Reinsurance balances payable                     17,328               4,122               (656 )            20,794
Funds held under reinsurance
agreements                                       96,726                   -                  -              96,726
Other liabilities                               259,408              32,560            (25,813 )           266,155
Deferred income taxes                            24,826               4,511                  -              29,337
Debt                                            426,901              77,000            (77,000 )           426,901
Total liabilities                             3,111,213             366,339           (112,350 )         3,365,202
Stockholders' equity

Common stock                                        465                   -                  -                 465
Treasury stock                                 (158,185 )                 -                  -            (158,185 )
Paid-in-capital                                 772,938              25,851            (25,851 )           772,938
Accumulated other comprehensive income           62,244               7,771             (7,771 )            62,244
Retained earnings                               356,680               7,228             (7,228 )           356,680
Noncontrolling interests                          2,001                   -             40,850              42,851
Total stockholders' equity                    1,036,143              40,850                  -           1,076,993
Total liabilities and stockholders'
equity                                   $    4,147,356      $      407,189     $     (112,350 )    $    4,442,195


Table of Contents
                                                                                       Three Months Ended September 30,
                                                                     2012                                                           2011
                                                           Reciprocal       Elimina-                                      Reciprocal       Elimina-
($ in thousands)                             Tower         Exchanges          tions          Total          Tower         Exchanges          tions          Total
Revenues
Net premiums earned                        $ 388,090      $     42,623      $       -      $ 430,713      $ 366,874      $     46,573      $       -      $ 413,447
Ceding commission revenue                      4,990             3,190           (477 )        7,703          4,956             2,011              -          6,967
Insurance services revenue                     8,678                 -         (7,870 )          808          8,057                 -         (7,644 )          413
Policy billing fees                            2,980               153              -          3,133          2,688               142              -          2,830
Net investment income                         29,924             3,141         (1,676 )       31,389         29,817             3,268         (1,674 )       31,411
Total net realized investment gains
(losses)                                          80             1,065              -          1,145         (1,135 )           1,362              -            227
Total revenues                               434,742            50,172        (10,023 )      474,891        411,257            53,356         (9,318 )      455,295
Expenses
Loss and loss adjustment expenses            235,782            20,314              -        256,096        284,661            25,376              -        310,037
Direct and ceding commission expense          79,637             8,367           (477 )       87,527         73,066             7,188              -         80,254
Other operating expenses                      78,760            14,514         (7,870 )       85,404         68,498            13,029         (7,644 )       73,883
Acquisition-related transaction costs          2,679                 -              -          2,679            425                 -              -            425
Interest expense                               8,224             1,676         (1,676 )        8,224          8,633             1,674         (1,674 )        8,633
Total expenses                               405,082            44,871        (10,023 )      439,930        435,283            47,267         (9,318 )      473,232
Income (loss) before income taxes             29,660             5,301              -         34,961        (24,026 )           6,089              -        (17,937 )
Income tax expense (benefit)                   8,031             1,469              -          9,500         (7,587 )           1,606              -         (5,981 )
Net income (loss)                          $  21,629      $      3,832      $       -      $  25,461      $ (16,439 )    $      4,483      $       -      $ (11,956 )

Ratios
Net calendar year loss and LAE                  60.8 %            47.7 %                        59.5 %         77.6 %            54.5 %                        75.0 %
Net underwriting expenses                       35.5 %            45.8 %                        36.5 %         34.4 %            38.8 %                        34.9 %
Net Combined                                    96.3 %            93.5 %                        96.0 %        112.0 %            93.3 %                       109.9 %

Return on Average Equity                         8.4 %                                                         -6.3 %


Table of Contents
                                                                                          Nine Months Ended September 30,
. . .
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