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TWGP > SEC Filings for TWGP > Form 10-Q/A on 26-Nov-2013All Recent SEC Filings

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Form 10-Q/A for TOWER GROUP INTERNATIONAL, LTD.


26-Nov-2013

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 "Management's Discussion and Analysis of Financial Condition and Results of Operations," elsewhere in this Form 10-Q/A 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 "outlook," "expect," "intend," "plan," "believe," "project," "estimate," "may," "should," "could," "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, 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, including regulatory limitations and restrictions on the declaration and payment of dividends and capital adequacy standards;

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 our financial strength or credit ratings could impact the cost of, and our ability to obtain, capital or our ability to attract and retain customers;

changes in legal theories of liability under our insurance policies;

changes in accounting policies or practices;

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;

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

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

currently pending or future litigation or governmental proceedings;

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 availability, cost or quality of reinsurance or retrocessional coverage;


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

the Bermudian regulatory system, and potential changes thereto.

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

Overview

The following Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to assist readers in understanding the interim consolidated results of operations and financial condition of Tower Group International, Ltd. and its subsidiaries (the "Company" or "Tower") and should be read in conjunction with the interim consolidated financial statements and notes thereto included under Part I, Item 1 of this Form 10-Q/A, as well as the MD&A contained in Tower Group, Inc.'s ("TGI's") Amendment No. 2 to its Annual Report on Form 10-K for the year ended December 31, 2012. References to "we," "our," "us" or similar terms refer to the business of Tower.

Tower is a global, diversified insurance company that offers a broad range of commercial, specialty and personal property and casualty insurance products and services through its subsidiaries to businesses in various industries and to individuals. On March 13, 2013, the Company and TGI completed a merger transaction under which the Company, formerly known as Canopius Holdings Bermuda Limited, was re-named Tower Group International, Ltd. and became the ultimate parent company of TGI ("Merger Transaction"). The 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 unaudited 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 forward. In connection with the Merger Transaction, we now have an international platform with access to the U.S., Bermuda and the Lloyd's of London ("Lloyd's") markets. See further discussion under "Merger Transaction" below and in "Note 4 -Merger Transaction" to the consolidated financial statements included under

Part I, Item 1 of this Form 10-Q/A.

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 both an admitted and excess and surplus ("E&S") basis. Effective with the Merger Transaction, we have retained a net economic interest in the 2010, 2011 and 2012 underwriting years of account of Lloyd's Syndicate 4444 in the form of participation via quota share reinsurance arrangements for each year. Syndicate 4444 underwrites a number of risks globally including those pertaining to certain open market commercial, marine and energy and other specialty property and casualty exposures.

We are currently re-evaluating our internal reporting structure due to the recently completed Merger Transaction, the results of which may require a change to our segment reporting. Until this re-evaluation is completed, our operations, including those acquired in connection with the Merger Transaction, continue to be reported within our 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.


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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.

Highlights

2013 First Quarter Consolidated Results of Operations

Net income attributable to Tower Group International, Ltd. of $12.9 million, or $0.28 per share basic and diluted

Net earned premium of $421.9 million

Net investment income of $30.3 million

Operating cash outflows of ($55.1) million

Significant Business Developments and Risks and Uncertainties Resulting From Events Occurring in 2013

In the preparation of Tower's June 30 2013 consolidated financial statements, subsequent to March 31, 2013, the company reported an increase in its loss and loss adjustment expense reserves charge of approximately $365 million relating to reserve strengthening associated with losses from prior accident years. This adverse loss development arose primarily from accident years 2008-2011 within the workers' compensation, commercial multi-peril liability ("CMP"), other liability and commercial auto liability lines of business. In the second quarter of 2013, the Company performed a comprehensive update to its internal reserve study in response to continued observance in the second quarter of 2013 of higher than expected reported loss development. In conjunction with its comprehensive internal review, the Company also retained its consulting actuary to perform an independent reserve study covering lines of business comprising over 90% 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 reserve strengthening was viewed by the Company as an event or circumstance that required the Company to perform in the second quarter of 2013, a detailed quantitative analysis of whether its recorded goodwill was impaired. After performing the quantitative analysis, it was determined that $214.0 million of goodwill, which represents all of the goodwill allocated to the Commercial Insurance reporting unit, was impaired. Accordingly, the consolidated statement of operations in the second quarter of 2013, subsequent to March 31, 2013, includes a non-cash charge of $214.0 million associated with the write-down of goodwill.

As a result of the reserve strengthening, the Company is expecting its U.S. based operations to have a pre-tax loss for 2013, which would result in a three-year cumulative 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 provided a full valuation allowance against its deferred tax asset at June 30, 2013.

Reinsurance Agreements

On October 1, 2013, Tower announced that it 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 consist 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 will cede 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 at June 30, 2013 and policies written or renewed from July 1, 2013 to December 31, 2013. The agreement has a special termination clause whereby either party may terminate the agreement upon the occurrence of certain circumstances, including an A.M. Best financial strength rating downgrade to below A-. As noted below, A.M. Best downgraded Tower's financial strength rating to B++. Neither party has provided notice to terminate the agreement.

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 will cede 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 at June 30, 2013 and policies written or renewed from July 1, 2013 to December 31, 2013. The agreement has a special termination clause whereby either party may terminate the agreement upon the occurrence of certain circumstances, including an A.M. Best financial strength rating downgrade to below A-. As noted below, A.M. Best downgraded Tower's financial strength rating to B++. Neither party has provided notice to terminate the agreement.

The third reinsurance 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 agreement 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. 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. 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 agreement has a special termination clause whereby either party may terminate the agreement upon the occurrence of certain circumstances, including an A.M. Best financial strength rating downgrade to below A-. As noted below, A.M. Best downgraded Tower's financial strength rating to B++. Neither party has provided notice to terminate the agreement.

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

On October 7, 2013, Fitch Ratings ("Fitch"), downgraded Tower's Issuer Default Rating from "BBB" to "B" and Tower's insurance subsidiaries' Insurer Financial Strength ratings from "A-" to "BB". The ratings will continue to remain on negative watch until, at the earliest, the completion of Tower's exploration of strategic alternatives.

On October 8, 2013, A.M. Best Company ("A.M. Best"), lowered Tower's issuer credit, as well as its financial strength ratings, from "A-" (Excellent) to "B++" (Good). The ratings remain under review with negative implications pending further discussions between A.M. Best and Tower's management.

On October 7, 2013, Demotech, Inc. ("Demotech") 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 the second quarter of 2013, to result in a decrease in the amount of premiums the insurance subsidiaries are able to write. The net written premiums in the Commercial Insurance segment was $343.6 million for the six months ended June 30, 2013. The net written premiums in the Specialty Insurance and Reinsurance segment was $306.6 million for the six months ended June 30, 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.

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").

As of June 30, 2013, Tower Reinsurance, Ltd. ("TRL"), one the Company's two Bermuda-based reinsurers had capital and surplus that did not meet the minimum capital and surplus requirements of the BMA.

The Company has discussed with the BMA its intention to combine a substantial portion of the business and the capital of CastlePoint Reinsurance Company ("CastlePoint Re"), the Company's other Bermuda based reinsurer, with TRL. Through this combination, management believes that the combined entity's capital would meet the minimum capital and surplus thresholds determined by the BMA. The Company is currently developing this plan and expects to deliver this plan to its Bermuda regulators in the next several weeks. The Company cannot provide assurance that it will be successful in pursuing this alternative. Should the business combination not be approved, TRL would be operating at a capital level that is below the regulatory minimums as designated by the BMA. As such, TRL could be subject to significant additional regulatory oversight or, in the event that such oversight did not satisfy the BMA, placed into liquidation.

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 Re, the Company's other Bermuda based reinsurer. The 2013 obligations that CastlePoint Re assumes from the U.S. based insurance subsidiaries are then retroceded to TRL. 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. Therefore, TRL recorded $175 million of reserve strengthening on its balance sheet as of June 30, 2013 and, consequently, the financial result of such development was a reduction in the capital of TRL to $8.3 million at June 30, 2013. In addition TRL is required to collateralize the additional $175 million of assumed reserves in a trust for the benefit of TICNY, the lead pool company of the U.S. insurance companies. TRL had unencumbered liquid assets of $96 million at June 30, 2013, and during October of 2013, TRL commuted two reinsurance treaties which provided an additional $79 million in unencumbered assets.

The funding of the trust to support TICNY's reinsurance recoverable has not yet occurred and requires approval by the Bermuda regulator (the "BMA"). The Company can provide no assurance that it will be successful in finalizing the business combination or in funding the trust. If the trust funding is not approved, 1) the statutory capital of TICNY would be at a level that could result in the New York Department of Financial Services could placing TICNY under regulatory control; and 2) Tower Group, Inc. could violate the revised debt covenants of the bank credit facility at December 31, 2013, which violation, if not waived, would result in a cross default of our convertible notes. Statutory capital and surplus would be further reduced by whatever amounts are due from CastlePoint Re or from TRL that are not supported by assets held in trust. At June 30, 2013, all other U.S. based insurance subsidiaries maintained capital and surplus above company action level.

Two insurance subsidiaries that do not constitute "significant subsidiaries" of the Company under Regulation S-X are in discussions with the insurance regulatory authority in their state of domicile with respect to the imposition of restrictions on the operation of their businesses. These discussions may result in such subsidiaries' agreeing to provide the regulatory authority 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.

Liquidity

TGI is the obligor under the bank credit facility ($70 million outstanding as of June 30, 2013) and the Convertible Senior Notes ("Notes") due September 2014 ($150 million par amount outstanding as of June 30, 2013). The indebtedness of TGI is guaranteed by Tower Group International, Ltd. ("TGIL")

TGI amended its credit facility on October 11, 2013, and agreed to several restrictions under the credit facility, including:

To not enter into any new borrowings under the credit facility;

To pledge to the lending banks any proceeds of new capital raises by TGI or TGIL until such time as the credit facility is paid in full;

To pledge to the lending banks proceeds from any sales of assets occurring at TGI; and

To submit to regulatory authorities, as appropriate, a request for approval to pledge the capital stock of the U.S. based and Bermuda based insurance subsidiaries.

In addition, the following financial covenants are included in the credit facility:

Minimum Consolidated Net Worth is the greater of $553,400,000 or 90 % of Consolidated Net Worth as of June 30, 2013; this covenant increases by 90% of any new capital plus 50% of Net Income above $20,000,000;

Debt to capitalization ratio limit of 46%;

Minimum risk based capital ratio of 175% at December 31, 2013 for Tower Insurance Company of New York and any other insurance subsidiary that exceeds 10% of the consolidated statutory surplus of all insurances subsidiaries;

Bermuda enhanced minimum capital requirement of 150% for CastlePoint Re at December 31, 2013 and 110% for TRL;

Minimum statutory surplus for all insurance companies of the greater of $419,000,000 or 85% of Combined Surplus at June 30, 2013. The Company was in compliance with this covenant as of June 30, 2013; and

Independent accountant's annual report shall not be subject to any "going concern" or like qualification or exception. This financial covenant will remain in effect for the year ending December 31, 2013. Although the independent accountant's report on the consolidated financial statements for the years ended December 31, 2010, 2011 and 2012 contains a "going concern" explanatory paragraph, on November 14, 2013, the Company received a waiver from the lenders under the credit facility in respect of such "going concern" paragraph.

Tower currently is in compliance with all covenants contained in the credit facility.

The credit facility matures on May 30, 2014, at which point any unpaid balance becomes due.

The Company is evaluating potential opportunities to raise additional capital in private sales transactions as well as through other strategic alternatives currently being considered by TGIL's Board of Directors, and intends to liquidate certain investments at TGI to repay the credit facility. Should the Company default on the credit facility and should such default not be waived by the credit banks, it would cause an acceleration of the maturity of the Notes, and such notes would become due concurrently with the unpaid balance on the credit facility.

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