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TWGP > SEC Filings for TWGP > Form 10-K on 2-May-2014All Recent SEC Filings

Show all filings for TOWER GROUP INTERNATIONAL, LTD.

Form 10-K for TOWER GROUP INTERNATIONAL, LTD.


2-May-2014

Annual Report


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 . . .

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