UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

 

For the transition period from              to            .

Commission File Number:  000-50990

Tower Group, Inc.

(Exact name of registrant as specified in its charter)

 

(212) 655-2000

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.0l par value per share

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of Securities Act.  Yes   x   No   o

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   o   No   x

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   x   No   o

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.   x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer: in Rule 12b-2 of the Exchange Act.  (Check one):

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes   o   No   x

The aggregate market value of the registrant’s common stock held by non-affiliates on June 30, 2005 (based on the closing price on the Nasdaq National Market) on such date was approximately $264,037,653.

As of March 10, 2006, the registrant had 19,855,841 shares of common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE:

Part III of this Form 10-K incorporates by reference certain information from the registrant’s definitive Proxy Statement with respect to the registrant’s 2006 Annual Meeting of Shareholders, to be filed not later than 120 days after the close of the registrant’s fiscal year (the “Proxy Statement”).

TABLE OF CONTENTS

 

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PART I

Item 1.                        BUSINESS

Overview

As used in this Form 10-K, references to the “Company”, “we”, “us”, or “our” refer to Tower Group, Inc. and its subsidiaries, including its insurance companies, Tower Insurance Company of New York (“TICNY”), Tower National Insurance Company (“TNIC”) and its managing general agency, Tower Risk Management Corporation (“TRM”), unless the context suggests otherwise.

Through our subsidiaries Tower Insurance Company of New York, Tower National Insurance Company and Tower Risk Management Corporation, we offer a broad range of specialized property and casualty insurance products and services to small to mid-sized businesses and to individuals in New York State and the surrounding areas. By targeting select underserved market segments and expeditiously delivering needed products and services, we position ourselves to obtain favorable policy terms, conditions and pricing, thereby creating opportunities for favorable underwriting results. Our commercial lines products provide insurance coverage to businesses such as retail and wholesale stores, grocery stores, restaurants, artisan contractors and residential and commercial buildings, while our personal lines products currently focus on modestly valued homes and dwellings.

We provide coverage for many different market segments, including nonstandard risks that do not fit the underwriting criteria of standard carriers due to factors such as type of business, location and premium per policy. As of December 31, 2005 TICNY is licensed in fifteen states and TNIC is licensed in sixteen states. TRM, through its managing general agency, produces business on behalf of other insurance companies, referred to as “issuing companies”, and primarily focuses on commercial risks with higher per policy premium, including risks that TICNY had not been able to target due to, among other things, licensing and surplus limitations. TICNY also reinsures a modest amount of the premiums written by TRM’s issuing companies. In addition, TRM earns fee revenues by providing claims administration and reinsurance intermediary services to its issuing companies and to other insurance companies.

Strategy

The business model that we have developed in the 16 years since we began our operations has allowed us to create and support a much larger premium base and insurance company infrastructure than otherwise would have been possible with the limited pre-IPO capital base. Through retained earnings generated from our operations in 2005 and the infusion of the proceeds from our IPO and the concurrent private placement in October 2004, we increased the statutory surplus in our insurance company and are pursuing continued profitable growth through the following strategies:

·       Reducing our Dependence on Reinsurance and Other Insurance Companies.  The additional capital from the IPO and the concurrent private placement has allowed us to retain a greater percentage of our premium writings and thereby reduce our use of quota share reinsurance in TICNY. It has also provided us with greater flexibility to selectively retain a larger portion of the business previously placed with other insurance companies while continuing to utilize TRM to generate commissions on premiums placed with other insurance companies and non-risk bearing, service income.

·       Improving our Rating to Attract Customers in Other Market Segments. As a result of the infusion of $98.0 million of the proceeds of the IPO and concurrent private placement into our insurance company operation, on October 26, 2004, TICNY received a rating upgrade from A.M. Best to “A-” (Excellent) from “B++” (Very Good). Our A.M. Best rating reflects A.M. Best’s opinion of TICNY’s financial strength and is not an evaluation directed to investors in neither our common stock nor a recommendation to buy, sell or hold our common stock. Ratings are an increasingly important factor in establishing the competitive position of insurance companies.

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There is no guarantee that TICNY will maintain the improved rating. An increase in rating positions us to write policies in rating-sensitive market segments that TICNY was not previously able to access, especially policies written by TRM’s issuing companies. Tower National Insurance Company is also rated “A-” (Excellent) by A.M. Best.

·       Expanding Territorially. TICNY is presently licensed in fifteen states including New York State as of December 31, 2005. We believe that the insurance products and services that we currently offer carry strong market demand. On March 25, 2005, Tower Group, Inc. closed on its purchase of the outstanding common stock of North American Lumber Insurance Company and renamed it Tower National Insurance Company. This acquisition will allow us to continue executing our plan to expand territorially first in New Jersey, followed by expansion into other states. On August 5, 2005, following our shell acquisition strategy, we announced our execution of an agreement to acquire MIIX Insurance Company of New York (MIIX), an insurance company with licenses in New York and New Jersey. Closing of the transaction is expected to occur during early 2006 and is contingent upon a variety of conditions including approval of the transaction by the New York State Insurance Department. In the event of closing, we will pay $225,000 in cash as well as an amount equal to MIIX’s statutory surplus which was approximately $7.8 million as of December 31, 2004. MIIX has no liabilities for insurance losses. MIIX’s assets consist of U.S. Treasuries and cash. We also expect to make similar shell acquisitions in the future in order to offer products in various market segments in the same territory. In addition, we formed a Program Underwriting Unit to expand on our regional distribution approach and allow us greater access to established, highly focused and narrowly defined industry classes of business with which we are familiar but which are typically distributed over a broader geographical area.

·       Acquiring Books of Business. We intend to continue to acquire books of business that fit our underwriting competencies from competitors, managing agents and other producers. In September 2004, the Company entered into a Commercial Renewal Rights Agreement with OneBeacon Insurance Group LLC and some of its insurance company subsidiaries pursuant to which we have acquired OneBeacon’s rights to seek to renew a block of commercial lines insurance policies in New York State. Through the OneBeacon renewal rights transaction, we were able to add approximately 363 retail agents throughout New York State to expand our number of appointed agents. As we enter other states, we will continue to expand our distribution capability by appointing quality wholesale and retail agents. As of December 31, 2005, on an inception to date basis, the premiums written or produced subject to the OneBeacon Renewal Rights agreement were $39.6 million and the new business written or produced through former OneBeacon producers that we appointed in connection with the renewal rights transaction were $22.1 million.

·       Expanding Non-Risk-Bearing Fee-Generating Services. We plan to continue to generate commission and fee income through our insurance services operation by offering managing general underwriting, reinsurance intermediary and claims administration services.

·       Continuing Implementation of Technological Improvements. We plan to continue our implementation of technology-based initiatives such as WebPlus, our web-based platform for quoting and capturing policy submissions from our agents, in order to improve customer service and further lower our underwriting expense ratio.

Business Segments

We operate in three business segments:

·       Insurance. In our insurance segment, TICNY and TNIC provide commercial lines policies to businesses and personal lines policies to individuals in New York State. TICNY’s commercial lines

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products include commercial multiple-peril, monoline general liability, commercial umbrella, monoline property, workers’ compensation and commercial automobile policies. Its personal lines products consist of homeowners, dwelling and other liability policies. See “Item 1.—Insurance Segment Products”.

·       Reinsurance. In our reinsurance segment, TICNY accepts or assumes reinsurance directly from TRM’s issuing companies or indirectly from reinsurers that provide reinsurance coverage directly to these issuing companies. As a reinsurer, TICNY assumes a modest amount of the risk on the premiums that TRM produces. While this reinsurance business historically has not been profitable, the commission income generated by TRM on the production of this business has exceeded any underwriting losses from the reinsurance assumed on this business. See “Item 1.—Insurance Services Segment Products and Services”.

·       Insurance Services. In our insurance services segment, TRM, as a managing general agency, generates commission income by producing premiums on behalf of its issuing companies and generates fees by providing claims administration and reinsurance intermediary services. TRM does not assume any risk on business produced by it. All of the risk is written by the issuing companies and ceded to a variety of reinsurers pursuant to reinsurance programs arranged by TRM working with outside reinsurance intermediaries. Placing risks through TRM’s issuing companies allowed us to underwrite larger policies and gain exposure to market segments unavailable to TICNY due to rating, financial size, geographical licensing limitations, or other factors. Through its issuing companies, TRM produces commercial package, monoline general liability, monoline property, commercial automobile and commercial umbrella products. See “Item 1.—Insurance Services Segment Products and Services”.

Prior to our IPO, TICNY’s limited capital, rating and licensing constrained its ability to write and retain large premium volume. Consequently, TICNY made extensive use of quota share reinsurance to manage the level of risk it retains in relation to its capital. In 1995, we formed TRM in order to produce business for other insurance companies that TICNY was precluded from writing due to TICNY’s limited capital, rating and licensing. TRM also enabled us to earn fee revenue and to lower our underwriting expense ratio by creating economies of scale and sharing some of the cost of developing and maintaining a full insurance infrastructure. In order for us to obtain reinsurance for TRM’s issuing companies, the reinsurers often require TICNY to assume reinsurance premiums directly from TRM’s issuing companies or from reinsurers that reinsure the premiums written by these companies.

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The following table summarizes the focus of our three segments:

 

Insurance Segment Products

In our insurance segment, TICNY offers a broad array of commercial and personal lines products. Our insurance segment products currently target low severity, low frequency risks with an overall average annual premium in 2005 of $4,359 policy for commercial lines and $1,043 per policy for personal lines. Typically, the liability coverage on these classes of business is not exposed to long-tailed (i.e., many years may pass before claims are reported or settled), complex or contingent risks, such as products liability, asbestos or environmental claims. These risks are located in New York City and the adjacent areas of New York State, a market that we feel, in our lines of business, level of risk and premium size, has historically been overlooked by regional and national insurance companies. With the OneBeacon Renewal Rights Agreement, TICNY has expanded its marketing territory to other areas of New York State, including Long Island, the Hudson River Valley and Western New York. However, TICNY is maintaining a targeted approach to underwriting; focusing on underserved markets that we believe will permit us to achieve favorable premium rates.

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The following table shows our gross premiums earned and loss ratio for the insurance segment’s products for the years ended December 31, 2005 and December 31, 2004.

 

Commercial Multiple-peril.   Our commercial multiple-peril products include commercial package policies, businessowners policies and landlord package policies. Our commercial package policies provide property and casualty coverages and focus on classes of business such as retail and wholesale stores, grocery stores, restaurants and residential and commercial buildings. We have written commercial package policies since TICNY commenced operations in 1990. Our businessowners policies provide property and liability coverages to small businesses. We introduced this product in 1997 to provide broader built-in coverages for businesses in the standard and preferred pricing tiers at lower rates than on commercial package policies. Our landlord package policy provides property and casualty coverage for three- and four-family dwellings with a maximum coverage limit of $700,000. As of December 31, 2005, approximately 38,656 commercial multiple-peril products were in place, including 22,741 commercial package policies and 11,179 landlord package policies and 4,736 businessowners policies.

Other Liability.   We offer other liability products in personal and commercial lines. Our commercial products are comprised of monoline commercial general liability and commercial umbrella policies. We write commercial general liability policies for risks that do not have property exposure or whose property exposure is insured elsewhere. Primarily, we target residential and commercial buildings, as well as artisan contractors for monoline general liability. Our commercial umbrella policy, introduced in 2002, provides additional liability coverage with limits of $1,000,000 to $5,000,000 to policyholders who insure their primary general liability exposure with TICNY through a business owners, commercial package policy, or commercial general liability policy. We have the ability to offer limits of up to $10,000,000 with facultative reinsurance. As of December 31, 2005, approximately 1,774 monoline commercial general liability policies and 342 commercial umbrella policies were in force. We also write monoline personal liability policies as an addition to our dwelling fire policies. As of December 31, 2005, TICNY had approximately 1,447 comprehensive personal liability policies in force. We also write personal lines excess liability or umbrella policies covering personal liability in excess of the amounts covered under our homeowners and dwelling policies. We offer this policy with a $1,000,000 limit. We do not market excess liability policies to individuals unless we also write the underlying homeowner’s policy. Further, the excess liability is usually handled as an endorsement to the homeowner’s policy. Also, due to the upgrade in TICNY’s rating from A.M. Best to “A-” (Excellent) from “B++” (Very Good), other liability premiums that were formerly produced through TRM are now being written and earned in TICNY.

Workers’ Compensation.   We introduced our workers’ compensation product in 1995. Our underwriting focus is on businesses such as restaurants, retail stores, offices, and clothing manufacturers that generally have a lower potential for severe injuries to workers from exposure to dangerous machines, elevated worksites and occupational diseases. This product is currently offered on a guaranteed cost basis

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at the rates published by the New York State Workers’ Compensation Bureau. As of December 31, 2005, we had approximately 9,517 workers’ compensation policies in force.

Commercial Automobile.   Our commercial automobile product focuses on non-fleet business such as contractor and wholesale food delivery vehicles. We underwrite primarily medium and lightweight trucks (under 30,000 lbs. gross vehicular weight). Historically unprofitable accounts for this segment of the insurance industry such as livery, trucking for hire or long-haul trucking operations are presently excluded under our underwriting guidelines. We commenced writing commercial automobile business in 1998. As of December 31, 2005, approximately 2,173 commercial automobile policies were in force.

Homeowners.   Our homeowner’s policy is a multiple-peril policy providing property and liability coverages for one- and two-family owner-occupied residences. While we are expanding our marketing territories throughout New York State, the homes we currently insure are located predominantly in the greater New York City area. We market both a standard and preferred homeowner’s product. As of December 31, 2005, approximately 51,225 homeowner’s policies were in force.

Fire and Allied Lines.   Our fire and allied lines policies consist of dwelling policies and monoline commercial property policies. Our dwelling product targets owner-occupied dwellings of no more than two families. The dwelling policy provides optional coverages for personal property and can be combined with an optional endorsement for liability insurance. This provides an alternative to the homeowner’s policy for the personal lines customer. As of December 31, 2005, we had approximately 16,457 dwelling policies in force. We also write monoline commercial property policies for insureds that do not meet our underwriting criteria for the liability portion of our commercial package policies. The classes of business are the same as those utilized for commercial package property risks. Generally, the rates charged on these policies are higher than those for the same property exposure written on a commercial package policy. As of December 31, 2005, approximately 232 monoline commercial property policies were in force.

Reinsurance Segment Products

In order for TRM to obtain reinsurance support for the business it produces for its issuing companies, Virginia Surety Company Inc. and State National Insurance Company Inc., TICNY is often required to assume a limited amount of reinsurance on this business from the issuing companies or the issuing companies’ reinsurers. By assuming risk, we align our interests with the issuing companies and their reinsurers. While this assumed business had historically been unprofitable, the direct commission income generated by TRM has historically offset assumed losses. In 2005, TICNY assumed 4.2% of the business produced by TRM, with gross written premiums assumed of $1.5 million, representing 0.5% of TICNY’s total gross premiums written and 1.0% of its net premiums earned.

With respect to Virginia Surety, TICNY also assumed 100% of the liability above the loss ratio caps under the 2004 Multiple Lines Quota Share Reinsurance Agreement. These loss ratio caps were 95% for the small business program, 115% for the middle market program and 125% for the large lines general liability real estate program. TICNY also assumed from Virginia Surety the liability for losses not covered under the original quota share reinsurance treaties between Virginia Surety and its other reinsurers. Pursuant to an aggregate excess of loss reinsurance agreement, TICNY also assumed from two Virginia Surety’s quota share reinsurers 10.25% of losses in excess of a loss ratio of 68.0% under the small market program, 15.25% of losses in excess of a loss ratio of 68.0% under the middle market program and 19.0% of losses in excess of a loss ratio of 63.0% for the large lines general liability real estate program. The Virginia Surety Multiple Lines Quota Share Reinsurance Agreement was renewed as of January 1, 2006.

In 2005, TICNY assumed from State National 100% of the liability above the loss ratio caps under the 2005 State National Combined Quota Share Reinsurance Agreement. These loss ratio caps were 95% for the small business overflow program, 115% for the middle market program and 125% for the large lines general liability real estate program. TICNY also assumed from State National the liability for losses not covered under the original quota share reinsurance treaties between State National and its other

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reinsurers. Pursuant to an aggregate excess of loss reinsurance agreement, TICNY also assumed from State National’s quota share reinsurers 10.25% of losses in excess of a loss ratio of 68.0% under the small market program, 15.25% in excess of 68.0% under the middle market program and 19.0% of losses in excess of a loss ratio of 63.0 % for the large lines general liability real estate program.

Effective August 1, 2005, TICNY agreed to be  the quota share reinsurer for a book of business covering artisan contractors and general contractors written by Accident Insurance Company (“AIC”). Under the terms of the treaty, AIC cedes to TICNY 65% of the premiums written and TICNY allows AIC a 25% ceding commission. In addition, the terms provide for TICNY to pay AIC a contingent commission equal to 30% of any profit accruing to TICNY during each accounting period, where profit is calculated as earned premiums, less commission, less 15% of ceded earned premiums for reinsurers’expenses, less incurred losses, less any loss carried forward from the previous accounting period. TICNY’s limit of liability under the treaty is capped at 150% of ceded gross earned premium, i.e. earned premium gross of ceding commission and after deduction of any return premiums and cancellations.

Insurance Services Segment Products and Services

TRM provides non-risk bearing managing general agency, reinsurance intermediary and claims administration services that generate commission and fee income for us. TRM also provides us with additional market capability to produce business in other states, product lines and pricing tiers that TICNY cannot currently access. TRM produces this business on behalf of its issuing companies, which have higher ratings, greater financial resources and more licenses than TICNY.

TRM provides underwriting, claims administration and reinsurance intermediary services to its issuing companies by utilizing TICNY’s staff, facilities and insurance knowledge and skills. All of the business produced by TRM for its issuing companies is ceded to reinsurers. TRM earns a commission, equal to a specified percentage of ceded net premiums written, which is deducted from the premiums paid to the issuing insurance companies. TRM’s commission rate varies from year to year depending on the loss experience of the business  produced by TRM. The commission rate in 2005 was 27.1%. TRM also performs claims administration services on behalf of other insurance companies, including companies for which TRM produced business in the past, but as to which it may no longer act as an underwriting agent.

While TICNY had incurred underwriting losses from its assumed premiums to support TRM’s business, those losses were based upon assumed premiums that represented only a small portion of TRM’s issuing companies. TRM, as a managing general agency, however, generated commissions on all of the premiums produced. As result, TRM has contributed to both the profitability and the growth of our organization while at the same time reducing TICNY’s underwriting expense ratio through economies of scale and the sharing of TICNY operating costs. As consideration for the use of TICNY’s staff, equipment and facilities, TRM reimburses a portion of TICNY underwriting expenses through an expense sharing agreement. These reimbursements were $2.0 million, $3.0 million and $2.2 million in 2005, 2004 and 2003, respectively, representing 5.6%, 13.2% and  13.7%, respectively, of TICNY’s total other underwriting expenses in those years. TRM also reimburses TICNY for the use of TICNY’s claims and legal defense staff based upon the hourly billing rates charged by TRM to its issuing companies. These reimbursements were $4.3 million, $4.0 million and $3.6 million in 2005, 2004 and 2003, respectively, representing 3.1%, 4.8% and 4.9%, respectively, of TICNY’s gross loss and loss adjustment expenses in those periods. In addition to lowering TICNY’s underwriting expenses through expense reimbursement, TRM also contributes the balance of its revenues after these expense reimbursements to our overall pre-tax income. Those contributions were $2.8 million, $2.0 million and $1.5 million in 2005, 2004 and 2003, respectively.

In 2005 and 2004 TRM underwrote business on behalf of Virginia Surety and State National. Virginia Surety is rated “A-” (Excellent) and State National is rated “A” (Excellent) by A.M. Best. Virginia Surety and State National are each licensed in all 50 states and the District of Columbia. Virginia Surety is expected to be TRM’s only issuing company in 2006.

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TRM’s business is primarily sourced through wholesale and retail brokers. See “Item 1.—Product Development and Marketing Strategy—Distribution” for further detail on our producers. The business TRM writes for its issuing companies is reinsured 100% to various reinsurers in addition to TICNY, including Tokio Millennium Re Ltd., Hannover Reinsurance (Ireland) Ltd. and E+S Reinsurance (Ireland) Ltd. TRM acts as a reinsurance intermediary for its issuing companies and arranges for all of the reinsurance ceded. For 2005, all of the reinsurers providing reinsurance for TRM’s issuing companies are rated “A-” (Excellent) or better by A.M. Best

Managing General Agency

TRM produces business for its issuing companies through various programs, as follows:

TRM Small Business Overflow Program.   TRM’s small business overflow program, created in 2003, provides additional capacity and the ability to write risks outside of New York for commercial lines products of the kind written by TICNY (other than workers’ compensation and landlord package policies), generating annual premiums per policy of less than $25,000. All the rates, forms and underwriting guidelines for this program are identical to those used by TICNY.

TRM Middle Market Program.   TRM’s middle market program enables us to access commercial lines business for the same classifications of risk written by TICNY, but having annual premiums per policy in excess of $25,000. The middle market program also enables us to serve accounts that require a larger insurer than TICNY or are located outside of New York. For risks that would otherwise qualify for a commercial package policy, this program can offer monoline property or general liability coverages where one of the coverage parts does not qualify due to overly competitive pricing, lack of capacity, insufficient underwriting expertise or a restricted underwriting classification. Due to the upgrade in TICNY’s A.M. Best rating to “A-” (Excellent) in late 2004, certain policies in the more rating sensitive middle market program were renewed in the insurance segment in 2005.

This program focuses on mercantile, residential and commercial building risks and offers property limits up to $30.0 million per location. Most of the business is located in New York City, with some accounts in other areas of New York State and New Jersey. Prior to 2001, the premium rates for the middle market program were significantly lower than the rates offered by TICNY. Beginning in 2001, the rates in this program were significantly increased, and in 2004 and 2005 they were not substantially different from those offered by TICNY.

TRM Large Lines General Liability Real Estate Program.   This program, which we began in 1996, provides monoline general liability policies for mercantile, residential and commercial building risks primarily in New York City, generating annual general liability premiums in excess of $100,000. From 2001 through 2003, premium rates increased significantly on a cumulative basis from 2000 levels and we re-underwrote this program. While the rate levels stabilized in 2004 and 2005, we continued to obtain modest premium changes. Due to the upgrade in TICNY’s A.M. Best rating to “A-” (Excellent) in late 2004, certain policies in the more rating sensitive large lines program were renewed in the insurance segment in 2005.

TRM Claims Service

TRM’s claims service division provides complete claims adjusting and litigation management service for all commercial and personal property and casualty lines of business to TRM’s issuing insurance companies, reinsurers and self-insureds. TRM presently bills its claims administration cost as a value added service to its issuing companies and is reimbursed by the issuing companies for the amounts billed. The fees earned by TRM help offset the total expenses incurred by TICNY’s claims staff and allow TICNY to maintain a larger claims infrastructure than it would otherwise be able to support with its own premium base. The amount of claims administration fees reimbursed by the issuing companies was $4.3 million in 2005, $4.0 million in 2004 and $3.6 million in 2003.

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In addition, TRM generates fees for a profit by providing claims administration, audit and consulting services to self-insureds and other insurance companies. While TRM has not actively marketed its claims service division, its reputation in claims administration and litigation management has brought several opportunities to act as a third-party claims administrator. We plan to expand our claims administration services for profit in the future.

Tower Risk Reinsurance Intermediary Services

TRM’s reinsurance intermediary services division provides reinsurance intermediary services to TICNY and to TRM’s issuing companies. Its revenue is derived from a fee sharing agreement with an outside reinsurance intermediary on the premium ceded to various reinsurers that reinsure TICNY and TRM’s issuing companies. Its revenue for performing these services was $0.7 million in 2005, $0.7 million in 2004 and $1.1 million in 2003

Product Development and Marketing Strategy

We believe that many insurance companies develop and market their products based on an underwriting focused approach in which they define products based upon their underwriting guidelines and subsequently market those products to producers whose needs fit within the bounds of their underwriting criteria. Conversely, while we are a disciplined underwriting organization, our product development and marketing strategy is to first identify needed products and services from our producers and then to develop profitable products in response to those needs. After positioning our products in this manner, we focus on developing underwriting guidelines that enable us to make an underwriting profit. This approach has allowed our organization to gain the reputation of being responsive to market needs with a highly service oriented approach to our producer base.

When we first began operations in 1990, our producers confirmed the need for us to underwrite small commercial risks, such as apartment buildings, restaurants and retail stores in urban areas such as New York City that other insurance companies avoided due to a perceived lack of underwriting profitability. In response to this need, we developed commercial package policies that provided limited property and liability coverage customized to meet the needs of this nonstandard market segment, as well as underwriting and claims approaches that enabled us to achieve underwriting profitability. Since then, we have continued to develop other commercial lines products such as business owners, workers’ compensation and commercial automobile policies, and introduced personal lines products such as homeowner’s and dwelling policies, to respond to the needs of our customers in other nonstandard segments as well as customers in the preferred and standard market segments where we generally offer lower rates and broader coverages for risks that we perceive to have more desirable underwriting characteristics.

With the development of our broad product line offering, we have been able to access markets with significant premium volume and opportunity for market penetration. We have increased our market share in each of these lines of business. We have been able to achieve profitable premium growth by keeping our annual premium volume objectives in the various lines of business low relative to the overall size of the market in those lines. This approach allows us to remain selective in our underwriting and to avoid sacrificing profitability for the sake of volume.

In marketing our products, we segment the market based upon industry, location, pricing tiers and premium size. For commercial lines products, we have generally focused on specific classes of business in the real estate, retail, wholesale and service industries such as retail and wholesale stores, residential and commercial buildings, restaurants and artisan contractors. We target these underserved classes of business because we believe that they are less complex, have reduced potential for loss severity and can be easily screened and verified through physical or telephonic inspection.

We also have historically targeted risks located in urban areas such as New York City that require special underwriting expertise and have generally been avoided by other insurance companies. We have

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had success targeting markets in geographical areas outside of New York City by focusing on classes of business such as residential real estate buildings that other companies have avoided. In 2006 we plan to expand territorially into New Jersey, Pennsylvania and the New England states.

We have also expanded our product offering to various lines of business within the preferred, standard and non-standard pricing segments. Within the preferred, standard or non-standard market segment, we first developed different pricing, coverages and underwriting guidelines. For example, the pricing for the preferred risk segment is generally the lowest, followed by the standard and non-standard risk segments. The underwriting guidelines are correspondingly stricter for preferred risks in order to justify the lower premium rates charged for these risks. Underwriting standards become progressively less restrictive for standard and non-standard risks.

In addition to segmenting our products by industry, location and pricing tiers, we further classify our products into the following premium size segments: under $25,000 (small), $25,000 to $150,000 (medium) and over $150,000 (large). We have historically had more success in the small premium size segment due to our focus on reducing our underwriting expenses by realizing economies of scale, utilizing technology and developing efficient business processes. We believe that due to the higher cost of underwriting small policies, other insurance companies have not been able to price competitively in this premium size segment. Our expense advantage has allowed us to maintain adequate rates through industry cycles. With improved market conditions in recent years, we have seen adequate pricing in the medium and large premium size segments as reflected by improved operating performance by TRM and in 2005 by TICNY, which has focused on these premium size segments.

Each year, we analyze various market segments and deliver products for each line of business in those segments that present the best opportunity to earn an underwriting profit based on the prevailing market conditions. As a result, the segments on which we focus will vary from year to year as market conditions change. We expand our product offerings in segments where we believe that we have established the appropriate price, coverage and commission rate to generate the desired underwriting profit. Conversely, we aim to reduce our product offerings in market segments where competition has reduced opportunities for us to earn an underwriting profit.

Distribution

We generate business through independent wholesale and retail agents and brokers, whom we refer to collectively as producers. These producers sell policies for us as well as for other insurance companies. We had approximately 808 producers appointed to generate business in 2005,  including 363 former OneBeacon producers.

Approximately 40% of the total of TICNY’s gross premiums written and premiums produced by TRM on behalf of its issuing companies in 2005 were derived from our top 10 producers. In 2005, Morstan General Agency, CRC Insurance and Davis Agency Inc., produced, 11%, 5% and 5%, respectively, of the total of TICNY’s gross premiums written and premiums produced by TRM on behalf of its issuing companies. No other producer was responsible for more than 5% of TICNY’s gross premiums written and premiums produced by TRM for its issuing companies in 2005.

We carefully select our producers by evaluating several factors such as their need for our products, premium production potential, and 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 premium volume greater than $5,000,000. We expect a new producer to be able to produce at least $250,000 in annual premiums for us during the first year and $500,000 in annual premiums after three years. The newly appointed producers that were part of the OneBeacon transaction are providing access to the expiring OneBeacon renewal policies, as well as producing new business within our established underwriting guidelines and marketing appetite.

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Commissions paid to producers in 2005 for TICNY averaged 16.4% of gross premiums earned. For TRM business, average commissions in 2005 were 14.4%. Our commission schedules are 1 to 1.5 points higher for wholesalers as compared to retailers in recognition of the additional duties that wholesalers perform. Also, TICNY has a profit sharing plan that added less than ½% to overall commission rates in 2005.

Prior to the IPO, we were able to generate as much premium volume as TICNY’s surplus would support consistent with its A.M. Best rating. With the additional capital infusion resulting from the IPO we have increased marketing and business development efforts aimed at increasing premium volume in New York City as well as other areas in New York State. This has been directed at the orientation and training of the newly appointed agents. Additionally, with the acquisition of additional state licenses, our focus has increased in developing marketing capabilities and agency relationships in other northeastern states. Currently, our activities are directed toward constructing a producer network in New Jersey. In March 2005 we completed the acquisition of North American Lumber Insurance Company, a shell company and renamed it Tower National Insurance Company that is now licensed in sixteen states as of December 31, 2005. Additionally on March 1, 2005 we announced the formation of a Programs Underwriting Unit to compliment our regional distribution approach. The Program Underwriting Unit will allow us to gain access to established highly focused and narrowly defined books of business that are distributed over a broader geographical area not accessible through our regional distribution approach. It will also enable us to add greater value to our existing agents by developing new program opportunities for classes of business that we do not currently underwrite or in which we have a limited market penetration.

To ensure that we obtain profitable business from our producers, we attempt to position ourselves as our producers’ primary provider of the products that we offer. We manage the results of our producers through a quarterly review to monitor premium volume and profitability. At the end of each quarter, we produce premium and loss history reports and develop actuarial ultimate accident year factors in order to project the profitability of the producers. We continuously monitor the producers in this manner so we can develop corrective action, if necessary, at any time throughout the year.

Underwriting

The underwriting strategy for controlling our loss ratio is to seek diversification in our products and an appropriate business mix for any given year, emphasizing profitable lines of business and de-emphasizing unprofitable lines. At the beginning of each year, we establish the target loss ratios for each line of business. We monitor the actual loss ratio throughout the year on a monthly basis. If any line of business fails to meet its target loss ratio, a cross-functional team comprised of personnel from the underwriting teams and the corporate underwriting, actuarial, claims and loss control departments meets to develop a corrective action plan that may involve revising underwriting guidelines, non-renewing unprofitable segments or entire lines of business and/or 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 lines of business or add new lines of business with better underwriting profit potential.

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. Our underwriting process involves securing an adequate level of underwriting information from our producers, identifying and evaluating risk exposures and then pricing the risks we choose to accept. For certain approved classes of commercial risks and most personal lines policies, we allow our producers to initially bind these risks utilizing rating criteria that we provide to them. Also, our web-based platform WebPlus provides our producers with the capability to submit and receive quotes over the Internet and contains our risk selection and pricing logic, thereby enabling us to streamline our initial

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submission and screening process. If the individual risk does not meet the initial submission and screening parameters contained within WebPlus, the risk is automatically referred to our assigned underwriter for specific offline review. See “Item 1.—Technology”.

Once a risk is bound by our underwriter or producers, our internal or outside loss control representatives conduct physical inspections of substantially all of the insured premises to validate the information provided by our producers and provide a loss control report to our underwriters to make a final evaluation of the risk. With the exception of a few typically low risk classes of business such as beauty parlors and offices, all of the new risks that are bound are physically inspected or subject to a telephone survey, generally within 60 days from the effective date of the policy. If the inspection reveals that the risk insured under the policy does not meet our established underwriting guidelines, the policy is generally cancelled within the first 60 days from its effective date. 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 coverages 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 carefully underwrite potential catastrophe exposures 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 40 employees in any one building. However, please see “Item 1A.—Risks Related to Our Business—we may face substantial exposure to losses from terrorism, we are currently required by law to provide coverage against such losses.”  Our property limits profile and the premium size of our policies in TICNY have risen as a result of the increase in TICNY’s statutory surplus due to the capital contribution of $98 million of the proceeds from the IPO and the rating upgrade to “A-” (Excellent) by A.M. Best.

We underwrite our products through four underwriting teams that are each headed by an underwriting manager having an average of approximately 16 years of industry experience in the property and casualty industry. We have the following five business units: small commercial, middle market, commercial auto, personal lines and programs. These business units perform underwriting functions and 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 line underwriting with technical assistance, developing underwriting guidelines, granting underwriting authority, training, developing new products and monitoring underwriting quality control through audits. The actuarial department is responsible for monitoring rate adequacy on all of our products and analyzing loss data on a monthly basis. The underwriting operations department is responsible for developing workflows, conducting operational audits and providing technical assistance to the underwriting teams. The loss control department conducts loss control inspections on nearly all new 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.

Pricing

We price our products to make an acceptable underwriting profit. In situations where rates for a particular line become insufficient to produce satisfactory results, we control growth and reduce our premium volume in that line.

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We generally use actuarial loss costs promulgated by the Insurance Services Office, a company providing statistical, actuarial and underwriting claims information and related services to insurers, as a benchmark in the development of pricing for our products. We further tailor pricing to each specific product we underwrite (other than workers’ compensation), taking into account our historical loss experience and individual risk and coverage characteristics. For workers’ compensation policies, we use statistical information provided by the New York Compensation Insurance Rating Board (“NYCRIB”) as a benchmark in developing our pricing.

If a particular business line is not performing well, we may seek rate increases, which are subject to regulatory approval (See “Item 1.—Regulation”) and market acceptance. Recently, we have been successful in increasing our rates. We increased premiums on our commercial renewals as measured against expiring premium by 5.5% in 2005 and 9.0% in 2004 and 9.0% in 2003. In personal lines we increased premiums by 7.6% in 2005, 9.5% in 2004 and 2.6% in 2003.

Beginning in the latter half of 2004 and continuing throughout 2005, the rates for property and casualty insurance products began to moderate, and for certain products, rates began to decrease due to an increased level of competition. The softening in the personal lines market for both primary and reinsurance was interrupted by effects of hurricanes Katrina, Rita and Wilma on the insurance industry. We did not have any exposure to these hurricanes. However, these changes may still signal the start of a “soft market” cycle that could restrict or diminish our ability to obtain rate increases as in the recent past. We cannot predict with any certainty the direction the market will take during 2006 or thereafter.

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 and to expand our underwriting capacity. Reinsurance coverage can be purchased on a facultative basis, where individual risks are reinsured, or on a treaty basis, where a class or type of business is reinsured. We 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 each loss and loss adjustment expenses. 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. See “Item 7.—Critical Accounting Policies—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 treaty reinsurance on an excess of loss basis to protect ourselves from an accumulation of net loss exposures from a catastrophic event or series of events such as terrorist acts, riots, windstorms, hailstorms, tornadoes, hurricanes, earthquakes, blizzards and freezing temperatures. We 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 an acceptable price. Our excess of loss reinsurance program was renewed on January 1, 2006 and Tower Group, Inc. is in discussions with a Bermuda reinsurance company in formation to enter into a multi-year quota share reinsurance agreement. Until this agreement is in place we are retaining all of the risk for 2006 that would have been ceded to quota share reinsurers. In 2005, we ceded 25% of its net premiums written to reinsurers in accordance with its quota share treaty. Our 2005 Property Catastrophe Program warrants that a minimum 25% quota share cession be in place. If a loss to the Property Catastrophe Program occurs after January 1, 2006 but before the inception of the proposed multi-year quota share agreement we would be required to retain 25% of the loss as if a 25% quota share cession was in place. Our Property Catastrophe Reinsurance Program renewed on July 1, 2005.

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In recent years, the reinsurance industry has undergone very dramatic changes. Soft market conditions created by years of inadequate pricing brought poor results, which were exacerbated by the events of September 11, 2001. As a result, market capacity was reduced significantly. Reinsurers exited lines of business, significantly raised rates and imposed much tighter terms and conditions where coverage was offered, to limit or reduce their exposure to loss.

In an effort to maintain quota share capacity for our business with favorable commission levels, we have been accepting loss ratio caps in our reinsurance treaties. Loss ratio caps cut off the reinsurer’s liability for losses above a specified loss ratio. 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 reinsurer. We believe our reinsurance arrangements qualify for reinsurance accounting in accordance with SFAS 113, Accounting for Reinsurance Contracts. The loss ratio caps for our quota share treaties are 95.0% for 2005, and were 95.0% in 2004, 92.0% in 2003, 97.5% in 2002 and 100.0% in 2001.

Recently, regulators and other governmental authorities have been investigating certain types of insurance and reinsurance arrangements that they allege are intended only to smooth an insured company or ceding insurer’s earnings rather than to transfer insurance risk. As noted above, we believe our quota share reinsurance meets all requirements pertaining to risk transfer. However, these investigations, the related legal actions and the accompanying increased scrutiny of “non-traditional” reinsurance arrangements may lead to a change in the applicable accounting standards or a reduction in the availability of some types of reinsurance. In turn, these developments could produce higher prices for reinsurance, an increase in the amount of risk we retain, reduced ceding commission revenue, or other potentially adverse developments. In that event, we may be required to restructure or reduce use of quota share reinsurance or reduce our premium writings. See “Item 1.—Regulation—Industry Investigations”.

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.

As of December 31, 2005, we had unsecured reinsurance recoverables and ceding commissions receivable totaling $33.2 million owed by PXRE Reinsurance Company. On February 16, 2006, A.M. Best downgraded to “B++”(Very Good)  its former “A-”(Excellent) financial strength rating on PXRE and issued a negative outlook. On February 24, 2006 A.M. Best downgraded PXRE to “B+”(Very Good) with a negative outlook. We believe that the unsecured reinsurance recoverables and ceding commission receivables from PXRE, none of which are past due nor in dispute, are fully collectible. Our judgment is based primarily on PXRE’s capital position as a result of its recent capital raising initiatives.

To further minimize our exposure to reinsurance recoverables, effective October 1, 2003, we have placed our quota share reinsurance treaty 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. We also used the proceeds from the IPO and the concurrent private placement to increase the capitalization of our insurance subsidiary. As a result of this increase in capital, our insurance subsidiary has been able to retain more of the risk on the business it writes, thereby reducing our need for quota share reinsurance.

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The following table summarizes our reinsurance exposures by reinsurer as of December 31, 2005.

(1)           Downgraded to “B+” (Very Good) in February 2006.

2006 Reinsurance Program

Quota Share Reinsurance.   We are in discussion with a Bermuda reinsurance company in formation to enter into a multi-year quota share reinsurance agreement. Until this agreement is in place we are  retaining all of the risk for 2006 that would have been ceded to quota share reinsurers. In 2005, we ceded 25% of its net premiums written to reinsurers in accordance with its quota share treaty. Our 2005 Property Catastrophe Program warrants that a minimum 25% quota share cession be in place. If a loss to the Property Catastrophe Program occurs after January 1, 2006 but before the inception of the proposed multi-year quota share agreement we would be required to retain 25% of the loss as if a 25% quota share cession was in place.

Umbrella Quota Share Reinsurance.   The Umbrella Quota Share Reinsurance, originally effective January 1, 2005, was renewed on January 1, 2006, at terms similar to the 2005 terms. The treaty reinsures against umbrella losses up to $5.0 million per occurrence. We cede 95% of its premiums written and retain the remaining 5%. The provisional ceding commission under this treaty is 30% of ceded premium written. Of the premium ceded, Platinum Underwriters Reinsurance, Inc., rated “A” (Excellent) by A.M. Best, reinsures 50% and Hannover Ruckversicherungs AG, rated “A” (Excellent) by A.M. Best, reinsures 50%.

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Excess of Loss Reinsurance.   Effective January 1, 2006 we entered into an Excess of Loss Reinsurance Program with similar terms as the 2005 Excess of Loss Reinsurance Program. The 2006 Excess of Loss Reinsurance Program was placed with Platinum Underwriters Reinsurance, Inc., rated “A” (Excellent) by A.M. Best, Endurance Reinsurance Corporation of America, rated “A-” (Excellent) by A.M. Best, QBE Reinsurance Corporation, rated “A” (Excellent) by A.M. Best, Syndicates from Lloyd’s of London, rated “A” (Excellent) by A.M. Best, Hannover Ruckversicherungs AG, rated “A” (Excellent) by A.M. Best, Aspen Insurance UK limited, rated “A” (Excellent) by A.M. Best and ACE European Group Ltd., rated “A” (Excellent) by A.M. Best.

Catastrophe Reinsurance.   The 2005 Property Catastrophe Program provides coverage for events occurring through June 30, 2006 and is expected to be renewed on July 1, 2006 with a similar structure to the expiring program.

Terrorism Reinsurance.   Pursuant to the Terrorism Risk Insurance Act of 2002 (“Terrorism Act”), TICNY must offer insureds the option to purchase coverage for certified acts of terrorism for an additional premium or decline such coverage. When the coverage is not purchased, we endorse the policy to exclude coverage for certified acts of terrorism, but losses from an act of terrorism that is not a certified event may be covered in any case. Also, even for certified acts of terrorism, losses from fire following the act of terrorism are covered.

The Terrorism Act reimburses up to 90% of the losses to commercial insurers due to certified acts of terrorism in excess of a deductible. Our deductible in 2004 was 10% of our 2003 direct earned premium on commercial lines. Our deductible in 2005 is 15% of our 2004 direct earned premiums on commercial lines

On December 17, 2005, Congress passed a two-year extension of the Terrorism Act though December 31, 2007 with the passage of the Terrorism Risk Insurance Extension Act of 2005 (“TRIEA”). Under the terms of the extension, TICNY’s deductible will increase to 17.5% of direct earned premium in 2006 and 20% in 2007. The minimum size of the triggering event will be increased from the current $5 million to $50 million for the last nine months of 2006 and $100 million for 2007. As a consequence of these changes, potential losses from a terrorist attack could be substantially larger than previously expected. Potential future changes to TRIEA 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.

2005 Reinsurance Program

Quota Share Reinsurance.   Effective January 1, 2005, TICNY entered into a quota share treaty to reinsure against losses up to $1.0 million per occurrence on the gross premiums written in the insurance segment. Under the terms of the treaty, TICNY cedes 25% of its net premiums written and retains the remaining 75%. The provisional ceding commission under this treaty is 39.1% of ceded net premiums written. Of the premium ceded, Tokio Millennium Re Ltd. (“Tokio Millennium”), rated “A+” (Superior) by A.M. Best, reinsures 50%, Hannover Reinsurance (Ireland) Ltd., rated “A” (Excellent) by A.M. Best, reinsures 40% and E+S Reinsurance (Ireland) Ltd. (collectively “Hannover”), rated “A” (Excellent) by A.M. Best, reinsures the remaining 10%. The 2005 quota share treaty contains various exclusions and provides coverage for 100% of extra-contractual obligations and losses in excess of policy limits. To reduce TICNY’s credit exposure to reinsurance, the quota share reinsurance has been placed on a “funds withheld” basis. Under the terms of the reinsurance treaty, TICNY guarantees to credit the reinsurers with a 3% annual effective yield on the monthly balance of this account.

Effective January 1, 2005, TICNY entered into a quota share treaty to reinsure against umbrella losses up to $5.0 million per occurrence. Under the terms of the treaty TICNY cedes 95% of its premiums written and retained the remaining 5%. The provisional ceding commission under this treaty is 30% of ceded premium written. Of the premium ceded, Platinum Underwriters Reinsurance, Inc., rated “A”

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(Excellent) by A.M. Best, reinsures 50% and Hannover Ruckversicherungs AG, rated “A” (Excellent) by A.M. Best, reinsures 50%.

Effective December 1, 2005, TICNY entered into a quota share treaty to reinsure against umbrella losses up to $5 million per occurrence on a book of commercial umbrella business produced by a third party managing general agent, W. H. Greene. Under the terms of the treaty TICNY cedes 80% of its premium written and retains the remaining 20%. The flat ceding commission under this treaty is 29% of ceded written premium. Of the premium ceded, Endurance Reinsurance Corporation of America, rated “A-” (Excellent) by A.M. Best, reinsures 50%, AXIS Reinsurance Company, rated “A” (Excellent) by A.M. Best, reinsures 20% and NGM Insurance Company, rated “A” (Excellent) by A.M. Best, reinsures 10%.

Excess of Loss Reinsurance.   Effective January 1, 2005 TICNY entered into an Excess of Loss Reinsurance Program with the same terms as the 2004 Excess of Loss Reinsurance Treaty. The 2005 Excess of Loss Reinsurance Program was placed with American Re-Insurance Company (“Am Re”), rated “A” (Excellent) by A.M. Best, Platinum Underwriters Reinsurance, Inc., rated “A” (Excellent) by A.M. Best, Endurance Specialty Insurance, Ltd., rated “A-” (Excellent) by A.M. Best, syndicates from Lloyd’s of London, rated “A” (Excellent) by A.M. Best, and Hannover Ruckversicherungs AG, rated “A” (Excellent) by A.M. Best.

Catastrophe Reinsurance.   The 2004 Property Catastrophe Program provided coverage for events occurring through June 30, 2005 and was renewed on July 1, 2005 with a similar structure to the expiring program.

2004 Reinsurance Program

Quota Share Reinsurance.   Effective January 1, 2004, TICNY entered into a quota share treaty to reinsure against losses up to $1.0 million per occurrence on the gross premiums written in the insurance segment. Under the terms of the treaty, TICNY ceded 60% of its net premiums written and retained the remaining 40%. In accordance with treaty terms, TICNY elected to reduce the quota share cession from 60% to 25% on October 1, 2004. The provisional ceding commission under this treaty was 39.1% of ceded net premiums written. Of the premium ceded, Tokio Millennium, rated “A+” (Superior), reinsured 331¤3%; Converium Reinsurance (North America) Inc. (“Converium), rated “B-” (Fair) by A.M. Best, reinsured 331¤3%; Hannover Reinsurance (Ireland) Ltd., rated “A” (Excellent) by A.M. Best, reinsured 262¤3% and E+S Reinsurance (Ireland) Ltd., rated “A” (Excellent), reinsured the remaining 62¤3%. The 2004 quota share treaty contained various exclusions and provided coverage for 100% of extra-contractual obligations and losses in excess of policy limits. To reduce TICNY’s credit exposure to reinsurance, the quota share reinsurance was placed on a “funds withheld” basis. Under the terms of the reinsurance treaty, TICNY guaranteed to credit the reinsurers with a 2.5% annual effective yield on the monthly balance of this account.

In September 2004, A.M. Best downgraded the rating of Converium to “B-” (Fair) and Converium was placed into run-off by its parent company. As a result, on September 2, 2004, we delivered notice to Converium under our quota share treaty of our intent to terminate their participation under the quota share treaty on a cut-off basis effective November 1, 2004 (subsequently extended to December 31, 2004). Subsequently we reached an agreement with Converium, Tokio Millennium and Hannover to effect a novation of Converium’s quota share treaty to those other reinsurers effective January 1, 2004, as a result of which Tokio and Hannover agreed to each take 50% of Converium’s share under the quota share treaty. In connection with the agreement, Tokio, Hannover and TICNY agreed to fully release Converium for any liabilities under the quota share treaty. In addition, we decided to retain the unearned premiums and risks as of December 31, 2004 that would have been ceded to Converium absent the novation.

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Effective October 1, 2004, TICNY entered into a quota share treaty to reinsure against equipment breakdown losses up to $35 million per occurrence. Under the terms of the treaty, TICNY cedes 100% of its premium written to The Hartford Steam Boiler Inspection and Insurance Company, rated “A++” (Superior) by A.M. Best. The flat ceding commission under this treaty is 30%. A nominal amount of premium was ceded to this treaty in 2004. The treaty is placed on a continuous basis, therefore the above terms were in effect during 2005 and will be in effect in 2006.

Excess of Loss Reinsurance.   Effective January 1, 2004 TICNY entered into an Excess of Loss Reinsurance Program whereby our reinsurers were liable for 100% of the ultimate net losses in excess of $1 million for all lines of business we write, up to $10 million of limit. The program provided coverage in several layers. The first layer, which applied to multiple lines of business, afforded coverage for property business up to $1 million in excess of $1 million for each risk, with a per occurrence limit of $3 million, and for casualty business and for workers’ compensation losses, up to $1 million in excess of $1 million per occurrence. The excess of loss program then bifurcated into separate workers’ compensation and property layers. The workers’ compensation layers afforded coverage for workers’ compensation business up to $3 million in excess of $2 million for each occurrence, and for up to $5 million in excess of $5 million for each occurrence, with a maximum of $5 million for any one life. The property layers afforded coverage for property business up to $3 million in excess of $2 million for each risk, subject to a per occurrence limit of $6 million, and for up to $5 million in excess of $5 million for each risk, with a maximum of $5 million for each occurrence. The excess of loss treaties contained various sub-limits or exclusions for specific lines of business, provided coverage for 90% of extra-contractual obligations and losses in excess of policy limits, and allowed TICNY to recover allocated loss adjustment expenses on a pro rata basis in proportion to net loss. The 2004 excess of loss reinsurance treaties were placed with Am Re, rated “A” (Excellent) by A.M. Best, Platinum Underwriters Reinsurance, Inc., rated “A” (Excellent) by A.M. Best, Endurance Specialty Insurance, Ltd., rated “A-” (Excellent) by A.M. Best, syndicates from Lloyd’s of London, rated “A” (Excellent) by A.M. Best, Hannover Ruckversicherungs AG, rated “A” (Excellent) by A.M. Best, and Aspen Insurance UK Limited, rated “A” (Excellent) by A.M. Best.

Catastrophe Reinsurance.   Effective July 1, 2004, the 2003 Property Catastrophe Program described below was extended until August 31, 2004 and provided coverage in four layers on a per occurrence basis for losses up to $55 million, less our net retention of the first $5 million of losses. Effective September 1, 2004, we entered into a property catastrophe reinsurance program that provides coverage in five layers for losses up to $75 million, less our retention of the first $15 million of losses through June 30, 2005. The program covered aggregations of net exposures on our in force, new, renewal and assumed personal and commercial property as well as auto physical damage and inland marine business, subject to certain exclusions, including mold claims, terrorists events and nuclear, chemical and biochemical attacks. In the event of a catastrophic event that results in a loss under this program, we must reinstate the amount of cover exhausted by the loss on a one-time basis by paying an additional premium to the reinsurers. Each year we select the amount of catastrophic reinsurance that we believe will be necessary to protect our Company against catastrophic events. We believe the amount of catastrophic coverage is sufficient to cover our probable maximum loss from a once in a one hundred year catastrophic event. Our catastrophic reinsurers include American Agricultural Insurance Company, rated “A” (Excellent) by A.M. Best, Folksamerica Reinsurance Company, rated “A” (Excellent) by A.M. Best, Odyssey America Reinsurance Corporation, rated “A” (Excellent) by A.M. Best, PXRE Reinsurance Company, rated “B+” (in 2006) (Very Good) by A.M. Best, and syndicates from Lloyd’s of London, rated “A” (Excellent) by A.M. Best.

Investments

We derive investment income from our invested assets. We invest TICNY’s statutory surplus and funds to support its loss and loss adjustment expense reserves and its unearned premium reserves. Due to historically limited amounts of statutory surplus and net retention by TICNY, our net investment income

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had not been significant. Our investment income, however, has increased beginning in 2002 as TICNY’s invested assets increased due to TICNY’s increased net premiums written and surplus as well as from its $98.0 million of new investments as a direct result of a capital contribution of a portion of the IPO proceeds. Our net investment income was $15.0 million in 2005, compared to $5.1 million in 2004.

Our primary investment objectives are to preserve capital and maximize after-tax investment income. Our strategy is to purchase debt securities in sectors that represent the most attractive relative value and to maintain a moderate equity exposure. As of December 31, 2005, the fixed maturity securities represented approximately 91% of the fair market value of our investment portfolio and equity securities represented approximately 9%. Historically, we have emphasized liquidity to meet our claims obligations and debt service and to support our obligation to remit ceded premium (less ceding commission and claims payments) to our quota share reinsurers on a quarterly basis. Accordingly we have traditionally maintained between 8% and 10% of our portfolio in cash and cash equivalents. As of December 31, 2005, cash and cash equivalents represented approximately 9.8% of the total of fair market value of our investment portfolio and cash and cash equivalents.

Our investments are managed by an outside asset management company, Hyperion Capital Management, Inc., a New York based investment management firm. Hyperion has authority and discretion to buy and sell securities for us, subject to guidelines established by our Board of Directors. We may terminate our agreement with Hyperion upon 30 days notice. Our investment policy is conservative, as approximately 88.4% of the fixed income portion of our investment portfolio is rated A or higher as of December 31, 2005. The current equity target is 10% of the investment portfolio. The maximum allocation to equities, which results from market appreciation, is 20% of the investment portfolio. We monitor our investment results on a monthly basis to review the performance of our investments, determine whether any investments have been impaired and monitor market conditions for investments that would warrant any revision to our investment guidelines. Hyperion also provides us with a comprehensive quarterly report providing detailed information on our investment results as well as prevailing market conditions. Our investment results are also reviewed quarterly by the Board of Directors.

See “Item 7.—Investments” for further information on the composition and results of our investment portfolio.

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The following table shows the market values of various categories of invested assets, the percentage of the total market value of our invested assets represented by each category and the book yield based on market value of each type as of the dates and for the periods indicated:

 

The principal change in allocations in 2005 was an increase in the allocation to common stocks, municipal bonds, mortgage-backed securities and corporate bonds. During 2005 we reallocated a portion of the investment portfolio to higher yielding investments in equity securities. This includes common shares of a closed-end management investment company investing predominantly in asset-backed securities and mortgage-backed securities. We also invested in publicly traded real estate investment trusts (REITs) and one private placement REIT scheduled for an early 2006 IPO. During 2005 we had net purchases of mortgage-backed securities, municipal bonds and corporate bonds of approximately $108.6 million from investing new cash flow from operations. These new fixed maturity investments offered us favorable yields and fundamental credit quality. At December 31, 2005, the average credit quality of our fixed income investments was AA+ and the duration was 3.96 years.

During 2004, the most significant portfolio activity came during the fourth quarter with the investment of the IPO proceeds of $98.0 million. In order to increase the portfolio’s overall tax-exempt allocation, approximately 60% of the proceeds were invested into tax-exempt securities. Due to the steeper yield curve in the tax-exempt market compared to the taxable market, the tax-exempt purchases were focused in longer duration securities averaging approximately six years. To offset these longer duration securities, the taxable bond purchases were concentrated in short durations averaging two to three years.

In addition, during the fourth quarter of 2004, the effective duration of the portfolio decreased to 4.17 years compared to 4.41 years as of September 30, 2004. The lower duration was primarily due to the significant cash increase from the net proceeds from the issuance of $26.8 million of subordinated debentures underlying trust preferred securities in December 2004.

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The following table shows the composition of our investment portfolio by remaining time to maturity at December 31, 2005 and December 31, 2004. 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.

 

The average credit rating of our fixed maturity portfolio, using ratings assigned to securities by Standard and Poor’s, was AA+ at December 31, 2005 and AA+ at December 31, 2004. The following table shows the ratings distribution of our fixed income portfolio as of the end of each of the past two years.

 

We regularly review our portfolio for declines in value. If a decline in value is deemed temporary, we record the decline as an unrealized loss in other comprehensive net income on our consolidated statement of income and accumulated other comprehensive net income on our consolidated balance sheet. If the decline is deemed “other than temporary,” we write down the carrying value of the investment and record a realized loss in our consolidated statements of income. As of December 31, 2005 and December 31, 2004, we had cumulative net unrealized (losses)/gains on our fixed maturity portfolio of $(4.4) million and $1.0 million, respectively. There were no other than temporary declines in the fair value of our securities at December 31, 2005 and 2004.

Loss and Loss Adjustment Expense Reserves

We maintain reserves for the payment of claims (incurred losses) and expenses related to adjusting those claims (loss adjustment expenses or LAE). Our loss reserves consist of case reserves, which are reserves for reported claims, and reserves for claims that have been incurred but have not yet been reported (sometimes referred to as IBNR). The amount of loss reserves for reported claims is based primarily upon a claim-by-claim evaluation of coverage, liability, injury severity or scope of property

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damage, and any other information considered pertinent to estimating the exposure presented by the claim. The amounts of loss reserves for unreported claims and loss adjustment expense reserves are determined using historical information by line of business as adjusted to current conditions. Reserves for LAE are intended to cover the ultimate cost of settling claims, including investigation and defense of lawsuits resulting from such claims. The amount of loss and LAE reserves is determined by us on the basis of industry information, the development to date of losses on the relevant line of business and anticipated future conditions. Because loss reserves are an estimate of the ultimate cost of settling claims, they are closely monitored by us and recomputed at least quarterly based on updated information on reported claims and a variety of statistical techniques. Furthermore, an independent actuary prepares a report each year concerning the adequacy of the loss reserves.

Reconciliation of Loss and Loss Adjustment Expense Reserves

The table below shows the reconciliation of reserves on a gross and net basis for each of the last three calendar years, reflecting changes in losses incurred and paid losses.

 

Our claims reserving practices are designed to set reserves that in the aggregate are adequate to pay all claims at their ultimate settlement value. Thus, our reserves are not discounted for inflation or other factors.

Loss Development

Shown below is the loss development for business written each year from 1995 through 2005. 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 on the basis of GAAP.

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, 2002 we estimated that $15.476 million would be a sufficient reserve to settle all claims not already settled that had occurred prior to December 31, 2002 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 $15.476 million as of December 31, 2002, by the end of 2005 (three years later) $9.090 million had actually been paid in settlement of the claims.

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The next section of the table sets forth the re-estimates 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 $15.476 million was re-estimated to be $16.461 million at December 31, 2005. The increase from the original estimate is caused by a combination of factors, including: (1) reserves 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 and (3) more or fewer claims being reported after December 31, 2002 than had occurred prior to that date.

The “cumulative redundancy/ (deficiency)” represents, as of December 31, 2005, 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, 2005 and based upon updated information, we re-estimated that the reserves which were established as of December 31, 2004 were $392,000 redundant.

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.

Analysis of Loss and Loss Adjustment Reserve Development

 

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Analysis of Reserves

The following table shows our net outstanding case loss reserves and IBNR by line of business as of December 31, 2005.

 

In 2004 and 2005 we had favorable development in our net losses from prior accident years  of $199,000 and $392,000, respectively.

We carefully 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 will indicate inadequate pricing on our products and may impact our financial condition.

Our actuaries utilize several methodologies to project losses and corresponding reserves. These methodologies generally are classified into three types:

·       Loss development projections. Loss development projection methods are characterized by determination of loss development factors utilizing patterns of loss development from incurred and paid losses for prior accident years. This is the main methodology utilized for each accident year except for the most current accident year.

·       Loss ratio projections. There also is significant weight given to the loss ratio projections. Loss ratio projections determine the loss ratio for the current year based upon applying inflation, or trend, and the effect of rate changes to the loss ratios from the prior years. This method is given weight for the current accident year when there is high volatility in the reported development patterns at early ages.

·       Frequency and severity projections. Frequency and severity projections are characterized by development of numbers of claims reported and average claims severity, and these methods are utilized as a check on the other methods.

Based upon these methods our actuaries determine a best estimate of the loss reserves. All of these methods are standard actuarial approaches and have been utilized consistently since 2003.

We are not aware of any claims trends that have emerged or that would cause future adverse development that have not already been considered in existing case reserves and in our current loss development factors.

Also, in New York State, lawsuits for negligence, subject to certain limitations, must be commenced within three years from the date of the accident or are otherwise barred. Accordingly, our exposure to IBNR for accident years 2003 and prior is limited although there remains the possibility of adverse development on reported claims. Due to the reserve strengthening in 2002 and close monitoring and analysis of reserves, we believe our loss reserves are adequate. This is reflected by the loss development as of December 31, 2005 showing developed redundancies since 2003. However, there are no assurances that future loss development and trends will be consistent with our past loss development history, and so

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adverse loss reserves development remains a risk factor to our business. See “Item 1A.—Risks Related to Our Business—If our actual loss and loss adjustment expenses exceed our loss reserves, our financial condition and results of operations could be significantly adversely affected.”

The net loss reserves for the most recent accident years on a consolidated basis as of December 31, 2005 were $76.1 million for accident year 2005 and $12.7 million for accident year 2004. A redundancy or (deficiency) in net reserves for these years would impact our income before income taxes by the following :

 

Claims

Our claims division combines the services of our staff defense, coverage and appellate attorneys with a traditional multi-line insurance claims adjusting staff. See “Item 1.—Business Segments—Insurance Services Segment Products and Services” for a description of TRM’s claim service fee-based operations.

The claims division seeks to provide expedient, fair and consistent claims handling, while controlling loss adjustment expenses. Handling the claims adjustment and defense of insureds in-house enables us to accurately evaluate coverage, promptly post accurate loss and loss adjustment expense reserves, maintain the highest policyholders service standards and aggressively defend against liability claims. In addition, through the use of a claims database that captures detailed statistics and information on every claim, our underwriting and loss control departments are able to access information to assist them in the monitoring of the various lines of business and identifying adverse loss trends, giving them the ability to make informed underwriting and pricing decisions.

The claims division is divided into eight units: auto claims, workers’ compensation claims, property claims, liability claims, coverage, in-house defense, administration and processing, and subrogation and recovery. Our in-house legal staff consists of approximately 16 attorneys who are managed by two co-managing attorneys reporting to the Senior Vice President Claims.

The continued development of in-house expertise in all areas remains a primary goal of the claims division. We have continued to build an in-house defense team in order to handle a substantial percentage of lawsuits in New York State and vigorously defend against fraudulent and frivolous lawsuits. Given the high cost of coverage counsel in those instances where coverage may be an issue, we formed an in-house coverage law firm. Our claims staff and in-house attorneys handle all of our claims and the majority of our lawsuits internally. Approximately 75% of all lawsuits arising from our insurance company operation are currently handled in-house. This approach enables us to maintain a high level of service to our policyholders and vigorously defend non-meritorious and frivolous claims while controlling loss adjustment expenses. We have also formed a full time staff of in-house liability field investigators to replace a traditionally outsourced claims function. We have also built an experienced team of field property adjusters to push down costs and to ensure high quality claims experience for our commercial and personal lines property policyholders.

Ultimately, the claims division endeavors to provide a prompt response to the needs of policyholders in all first-party losses. Rapid review of the loss, confirmation of coverage and speedy payment to the insured is the ongoing commitment of our claims division. With respect to third-party claims, our approach is the thorough investigation of all claims as soon as reported, in order to separate those that should be

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resolved through settlement from those that should be denied and/or defended. Suspicious or fraudulent first- and third-party claims are always aggressively investigated and defended.

Technology

We seek to leverage technology and make use of business process redesign in order to gain operating efficiencies and effectiveness. For example, we were able to eliminate redundant keying of policy information  by upgrading our policy data entry system. This has enabled us to control the growth of our clerical staff and improve our customer service. We have implemented a number of technology improvements and redesign of business processes, including an on-line imaging system, a data warehouse that houses both claims and underwriting data to provide management reporting and a web-based platform (WebPlus) for quoting and capturing policy submissions directly from our producers.

We utilize Hewlett Packard/Compaq servers that run the Microsoft Windows Server 2000 operating system. Backups of server data and programs are made to tape daily and are taken to an off-site facility by an outside vendor. We have begun migrating our production servers to an offsite location. This secure facility will provide fully redundant power, air conditioning, communications and 24-hour support. With this off site premise, we will have two operational data centers, one primary and one secondary, to handle disaster recovery needs.

WebPlus ®

Since April 2003, we have been using WebPlus, our web-based software platform for quoting and capturing policy submissions directly from our producers. WebPlus allows our producers to submit, rate and, where permitted by the program, bind small premium accounts. Through a rules based engine, we have implemented our underwriting guidelines within WebPlus. Through an ongoing monthly, quarterly and annual management review and analysis of the book of business, we confirm the risk quality and loss ratio profile of policies processed in WebPlus. We utilize WebPlus for all of our personal lines business and landlord package policies. We started using WebPlus in April 2003 and within twelve months approximately 94% of our personal lines policies were being processed through WebPlus. We believe that this technology reduces underwriter involvement in each policy application, as well as improves our ability to validate and capture all relevant policy information early in the submission process and at a single point. We believe that WebPlus has significantly reduced our expense associated with processing business, improved customer service and made it easier for our producers to do business with us. In  2004, we added workers’ compensation and automobile to the suite of products that can be submitted to us through WebPlus, and we are now developing commercial package and automobile policies capability.

WebPlus was developed for us by AgencyPort Insurance Services, Inc. (“AgencyPort”), a technology Company specializing in the property and casualty insurance industry, in exchange for our commitment to invest $1 million in AgencyPort.  In addition, we licensed AgencyPort’s KeyOnce software development kit (SDK), which AgencyPort utilized to develop WebPlus. We also obtained a warrant to acquire common shares in AgencyPort. On January 7, 2004 TICNY exercised this warrant in full for 1,072,525 common shares of AgencyPort, for $1 million less $663,000 paid towards the development of WebPlus resulting in a payment of $337,000. These payments have been capitalized as software and are being amortized over three years. The 1,072,525 shares represented approximately 25% of the outstanding shares of AgencyPort as of December 31, 2005. We do not exercise significant influence over AgencyPort and we do not have any representation on the Board of Directors of AgencyPort. The relationship is primarily one of AgencyPort as a licensor and developer of software for our benefit. Accordingly, we do not account for our investment in AgencyPort on the equity method. We have assigned no value to the shares acquired as AgencyPort as of December 31, 2005. As of December 31, 2003, we held another warrant to acquire an additional 30% of the outstanding shares of AgencyPort. On August 31, 2004, we entered into an agreement with AgencyPort to eliminate this warrant in consideration for certain rights granted to us including access to certain software source code. We received the source code upon execution of the agreement.

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