Tower Group Management Discusses Q4 2012 Results - Earnings Call Transcript

Feb.26.13 | About: Tower Group, (TWGP)

Tower Group (NASDAQ:TWGP)

Q4 2012 Earnings Call

February 26, 2013 9:00 am ET


William E. Hitselberger - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Michael H. Lee - Chairman, Chief Executive Officer and President


Adam Klauber - William Blair & Company L.L.C., Research Division


Good morning, ladies and gentlemen. My name is Kevin, and I will be your conference facilitator today. At this time, I would like to welcome everyone to Tower Group's Fourth Quarter 2012 Earnings Conference Call. [Operator Instructions] It is now my pleasure to turn the floor over to your host, Bill Hitselberger, Executive Vice President and Chief Financial Officer. Please go ahead, sir.

William E. Hitselberger

Thank you, Kevin, and good morning, everyone. As a reminder, Michael and I will be speaking today and referencing a slideshow that is available on our website at, under the Investors section. Also, a replay of this call will be on the Tower website immediately following the call.

Before I turn the call over to Michael, I want to mention that with us today on the call is Bernie Kilkelly, who joined Tower in January as the Head of Investor Relations. Many of you may already know Bernie, who has been an investor relations officer in the insurance industry for many years. We encourage analysts and our investors to reach out to Bernie and look forward to having him here as a key part of our team.

I'd also like to remind you that some of the statements that will be presented during this call will be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Actual results could differ materially from those projected in these forward-looking statements. For more information on the risks and other factors that may affect future performance, investors should review the periodic reports that are filed by the company with the SEC from time to time.

With that, let me turn the call over to Michael.

Michael H. Lee

Thank you, Bill, and good morning, everyone. I'd like to thank all of you for joining us on this conference call to discuss our fourth quarter and 2012 operating results.

Let me start on Page 2 by giving everyone a brief snapshot of our results. From a financial perspective, 2012 was disappointing, as the impact of Superstorm Sandy and the reserve charge combined to yield our first annual operating loss since we went public in 2004. While our financial results in 2012 were disappointing, we made substantial progress on various important strategic initiatives, including our agreement to merge with Canopius Bermuda reinsurance company.

In the fourth quarter, we had an operating loss of $54.9 million due to the $80.1 million after-tax loss from Superstorm Sandy. For the full year, our operating loss was $27.9 million due to the losses from Sandy and after-tax reserve charge totaling $50.9 million.

Excluding the losses from Sandy and the reserve charge, our core business, excluding reciprocals, generated a combined ratio of 96% and return on equity of 10.1%, in line with our near-term target of 10% to 12%.

From a strategic standpoint, we continued to implement our organic growth initiative to drive premium growth by expanding our product offerings, improving existing business units and creating new ones. Our new business units, assumed reinsurance and Customized Solutions, contributed $195 million in gross written premiums written and managed in 2012. This helped gross written -- premiums written and managed increase by 8.8%, just shy of $2 billion.

In addition to our organic growth initiative, we took an important strategic step towards accomplishing our long-term goal by entering into an agreement to merge with Bermuda reinsurance business of Canopius. We believe this is a final key step in executing our long-term plan to create a global, diversified specialty insurance company with access to U.S., Bermuda and Lloyd's markets, as well as achieving 13% to 15% return on equity within 18 months of closing.

We're progressing well with this transaction and anticipate that we will be able to complete this transaction by the end of the first quarter of 2013. I will provide further details on this merger later in this presentation.

In the charts on Page 3, we break out the impact of the catastrophes and reserve developments on operating earnings and EPS to better highlight the underlying profitability of our business. Excluding these items, we had fourth quarter operating income of $25.2 million or $0.66 per share compared to $29 -- $27.9 million or $0.70 per share in the fourth quarter of 2011.

In 2012, excluding these items, we had operating income of $106.4 million or $2.74 per share compared to $115.7 million or $2.83 per share in 2011.

Turning to Slide 4. Our stockholders' equity at the end of 2012 decreased to 5% -- decreased by 5% to $981 million from $1.03 billion at the end of 2011. This was due to the impact of claims paid for Superstorm Sandy, as well as $50 million return to shareholders during 2012 in stock repurchases and dividends.

Book value per share declined by 3% to $25.54. We expect that our earnings in the first quarter of 2013 will put us back on track of sequentially improving book value per share.

We achieved strong growth in premium volume in the fourth quarter and full year 2012. Gross premiums written and managed rose 11% in the fourth quarter to $481 million, and in 2012, we're just shy of $2 billion. As I mentioned before, our growth is being driven by our organic growth initiatives.

Now on Page 5, I would like to provide some additional detail on Superstorm Sandy and its financial impact on Tower. As you know, Sandy made landfall in New Jersey on October 29 and caused an estimated $25 billion in total industry losses. Tower had exposure through our direct insurance operations, our assumed reinsurance businesses and certain alternative investments, including our investment in Canopius.

Our pre-tax net loss from Sandy was $123 million, resulting in an after-tax loss of $80.1 million. This included $18 million in reinstatement premiums and $2.7 million after-tax losses from our investment in Canopius.

Although Superstorm Sandy was a devastating event, it created an opportunity for our team to demonstrate their commitment to customer service. Despite the fact that hundreds of Tower employees were personally affected and our headquarters building and 2 of our other offices were inaccessible for 1 week, our disaster response and claims professionals immediately manned the phones, ultimately handling more than 30,000 customer claims.

Through February 24, 2013, we are pleased to report that Tower has closed 93.7% of the claims received by our stock companies and their reciprocal exchanges for a total of 30,551 (sic) [30,511] claims and paid more than $164 million in gross claims between these 2 companies. 99% of these claims were received by February 1, 2013. These statistics clearly demonstrate the success and the quality of our claims handling in responding to this unprecedented catastrophic event.

While we do not believe our catastrophe exposure in the Northeast is excessive, we're committed to further limiting our exposure in the Northeast by continuing to write more personal lines business in the reciprocals and expanding geographically in our stock company to minimize our exposure in any one area.

In addition, to reduce our earnings volatility in 2013, we have secured 30% quota share reinsurance on Tower's homeowners business. As I will discuss this later, this additional reinsurance protection will modestly reduce our projected net income in 2013.

Given the magnitude and unprecedented nature of this catastrophic event in the Northeast region, we are not surprised by the regulatory scrutiny that insurance companies are receiving from various state regulators, especially over claims handling.

On February 21, 2013, the New York Department of Financial Services, or DFS, announced that it was investigating certain insurers, including one of Tower's insurance company subsidiaries, for unacceptable claims practices in New York related to Superstorm Sandy. We have responded to the DFS and provided the statistics that we have cited above regarding our claims handling. We believe that any allegations in this manner do not constitute a pattern or practice of Tower and will not have a material adverse effect on Tower's financial condition or results of operations.

In fact, given our strong financial condition and reputation as one of the largest and long-standing insurance companies in the New York State area, with access to both our stock and reciprocal insurance exchanges that we manage, we believe we're well-positioned to take advantage of the more favorable personal lines market that we anticipate will develop after Sandy. In the aftermath of Sandy, we believe affordability and availability of insurance in coastal states, including New York State, will continue to be the focus of regulatory concern as it was prior to Sandy, rather than claims handling.

Now on Page 6, let's discuss the operating results for our business segments. Before I review our business segment results for 2012, I would like to explain some of the underwriting actions that we took last year. During 2012, we completed our re-underwriting action that we began several years ago to build a more profitable business portfolio by shifting our business mix more to more profitable and shorter tail property and specialty business while discontinuing less profitable business.

We also introduced more detailed price monitoring protocols, maintained tighter controls on re-underwriting and non-renewal plans and developed a market profile grading system to evaluate the long-term profit potential of our market segments and to assess their availability to withstand competitive pressures through all phases of the market cycle.

Based on this grading system, we exited or reduced our writings in market segments that we deemed too competitive or where we had poor product positioning, and we accelerated our organic growth by developing a pipeline of new opportunities in market segments with greater profit potential.

As a result of these actions, we believe our current business, as well as the business we plan to write in new markets, will be positioned to achieve superior underwriting results. In addition to our re-underwriting and market grading initiatives, Tower achieved overall premium increases during each quarter of 2012 for the first time in many years.

The level of these increases grew and accelerated throughout the year, and by fourth quarter, we had achieved increases in every line of our business. For the year, our premium change on renewal business was between 4.5% to 5%.

In our Commercial segment, we continued to focus on growing our Specialty line business, while in the Commercial General area, we continue to focus on growing our small account business and continuing to eliminate or seek rate increases on middle-market business. Despite increasing rate environment in California workers' comp market, we continued to take action in 2012 to limit this business to about $100 million to $125 million, or 5% to 6% of our total business for 2013.

Our personal lines business unit grew premium volume by 10% in 2012 as we are continuing to roll out our personal lines system, as well as expanding our high-value homes and packaged personal lines product. We believe that market conditions for homeowners business in the Northeast should improve substantially in the aftermath of Superstorm Sandy as many companies face substantial losses from this event.

As I mentioned previously, we believe we're very well positioned given our ability to utilize both reciprocal and stock insurance companies. We plan to expand our utilization of these reciprocals in the Northeast, while our stock companies continue to diversify away from the Northeast. This should help us to expand our fee income.

Now I will turn the call over to Bill to provide further financial highlights. Bill?

William E. Hitselberger

Thank you, Michael. Turning to Slide 7. The exhibits here break out the impact of catastrophes and reserve development on our combined ratio and their impact on our return on equity.

As you can see, the fourth quarter combined ratio, excluding the reciprocal business, was impacted by 31.8 points from the effect of Superstorm Sandy, while the fourth quarter 2011 combined ratios did not feel much impact from storms other than a modest charge for the October 2011 snow event. Absent these storms, our combined ratio was up about 3 points year-over-year in the fourth quarter, largely due to an increased expense ratio driven by commission expense on assumed reinsurance business. I'll comment further on this in a few slides.

On a full year basis, excluding storms and development, our combined ratio was at 96% in 2012 compared to 94.3% in 2011. The increase for the year is also driven by the changing mix of our business towards assumed reinsurance. Our operating return on equity in 2012, excluding catastrophes and adverse development, was 10.1%, within our target range of 10% to 12%.

We're confident that the progress we've made in advancing our long-term strategy, including our impending merger, will drive meaningful growth and profit and higher returns in 2013 and beyond. We expect our ROE to improve next year to bring us inside the 10% to 12% target. If we are able to successfully complete the merger transaction, we expect our return on equity to be in the 13% to 15% range within 18 months from the date of the transaction close.

Turning to Slide 8. These charts break out the impact of catastrophes and prior year reserve development on our loss ratio in the fourth quarter and in 2012. Superstorm Sandy added 30 loss ratio points to our fourth quarter. Excluding the impact of severe weather and reserve development, the net loss ratio improved to 61.7% in the fourth quarter 2012 compared to 63.2% in the fourth quarter 2011. And the 2012 loss ratio improved to 60.9% from 61.1% in 2011. As Michael mentioned previously, this improvement in loss ratio is due to our continued shift away from middle-market lines of business and a focus on property and short-tailed assumed reinsurance lines of business. In the fourth quarter of 2012, we've had no adverse development reported.

Page 9 of the presentation details our expense ratio for the stock companies for 2012 as compared to 2011. The commission portion of the underwriting expense ratio, net of ceding commission we received, was 19.7% for 2012 compared to 17.8% for 2011. We had expected to see this increase. It is due mainly to writing more assumed reinsurance in 2012 as compared to 2011. This business reinsures -- reimburses the reinsurer for their direct expenses for the commission ratio. We just about doubled this business in 2012 as compared to 2011. This has led to an increase in our commission ratio and an improving loss ratio, as the business has better results than our traditional business.

Underwriting expenses, excluding the reciprocals, were $137.6 million, representing an increase of 8.9% over the fourth quarter of 2011. The increase in expenses was primarily due to increased business production. We also continued our spending to support our ongoing efforts to build out our information technology infrastructure to support our personal lines policy administration and claims processing technology platform. The other underwriting expense component of the ratio, net of fees, was 12% in 2012 compared to 11.7% for the same time period last year.

In the beginning of 2012, we changed the loss cost allocation methodology. And this change increased our underwriting expense ratio by about 1 point as compared to last year. The organic growth initiatives that Michael mentioned earlier have led to increased scale savings in 2012, and we've seen an -- a reduction in our other underwriting expense ratio in the 2012 from this increase in scale, as the rate of organic growth is outpacing the rate of growth in other underwriting expenses. This improvement, while offset by the change in methodology in allocating loss adjustment expenses, will continue to become more apparent in 2013 as the costs associated with the personal lines technology platform begin to decrease.

Looking at investments on Slide 10. At year end 2012, our invested asset base was $2.4 billion, excluding the reciprocal exchange investments and excluding our minority interest investment in Canopius, flat with about 1 year ago.

Operating cash flows increased to $107 million for 2012 as compared to $83 million in 2011. Tax-equivalent book yields in our portfolio have been flat at between 4.5% and 4.8% since the second quarter of 2011.

At year end 2012, our tax-equivalent book yield was 4.5%, down slightly from the 4.7% yield at year end 2011. We have seen a flattening of our reported tax-adjusted book yields since 2010, and this is the result of deploying invested assets into higher-yielding corporate securities, and also opportunistic increases in our tax exempt portfolio to combat the steady decrease in reinvestment rates. We've also been allocating funds into dividend-paying equity securities, which has improved our tax-equivalent portfolio yield.

We continued to make alternative investments in real estate and other private ventures in 2012 and have seen several of these investments start to generate positive returns, which has helped our yield in 2012.

Our consolidated balance sheet now contains the caption Other Invested Assets, which is where we are classifying most of our alternatives. We're continuing to look at real estate and private investments as alternative asset classes to enhance our investment return.

In the third quarter of 2012, we also closed on a minority equity investment in Canopius Group, Ltd. This investment is recorded on its own line in the balance sheet, Investment in Unconsolidated Affiliates. Despite the reinvestment rate challenges that we have been seeing, our net investment income remained flat compared to last year. The actions we are taking in asset classes other than fixed maturities have allowed us to mitigate the impact of the flattening yield environment.

In summary, we have been maintaining stable cash-equivalent book yield returns since year end 2010 and an upward movement in our absolute portfolio returns due to continued positive operating cash flows, as well as to our revised allocation of assets and the alternative investment strategy.

With that, I'd like to turn the call over to Michael to update us on the merger with Canopius' reinsurance subsidiary.

Michael H. Lee

Thank you, Bill. Since our last conference call, we have made significant progress on our proposed merger with Bermuda reinsurance operations of Canopius. We have received all regulatory approvals and are now working diligently to complete the merger in the first quarter of 2013. A proxy statement and prospectus were recently mailed to Tower's shareholders for a special meeting on March 12 to approve the merger. We encourage our shareholders to exercise their voting right with regard to this transaction.

In the near future, Bill and I will be meeting with investors in connection with the marketing of the shares of Canopius Bermuda that are part of the transaction. As the shares of Canopius Bermuda are not registered, this will be accomplished by way of a private placement of the shares. In addition to the proxy, we have made an 8-K filing of the presentation that we will be using to explain this transaction in further detail.

We're excited by the -- about the merger and believe that the new merged business will provide significant structural advantages to Tower. The merger will create a new holding company domiciled in Bermuda, which will continue to trade on NASDAQ under our current symbol. The new holding companies, which will be named Tower Group International, Ltd., will provide access to world's 3 key insurance markets in U.S., Bermuda and Lloyd's and will give us an efficient platform to grow our assumed reinsurance and specialty businesses.

This merger is an extremely important strategic transaction to Tower and the last key step towards completing our 5-year plan that we began in 2010 to build a larger, more profitable diversified specialty insurance company. We believe this merger will also be financially beneficial to our shareholders over the short and long term despite the issuance of additional shares to complete this transaction, resulting from the additional capital of $190 million to $200 million. We expect our EPS accretion to be over 5% in 2013 and over 15% in 2014. We also expect our ROE to increase to our target of 13% to 15% within 18 months of closing. Now I would like to provide our earnings guidance.

In 2013, we expect our operating earnings to be in the range of $2.75 to $2.95 per share, including the effect of the proposed merger transaction. This guidance is a little lower than we anticipated in the fourth quarter to reflect the change in the merger closing date from year end 2012 to late March 2013 and the additional cost of the reinsurance program that I mentioned earlier during the call. However, we expect our guidance during the 12 months of closing to be within -- to be in line with our previous guidance.

In summary, while we're disappointed with the financial results in 2012, we are pleased with the progress that we have made last year towards accomplishing our long-term goals, especially with the further advancement of our organic growth initiative and the Canopius merger. As a result of the progress that we have made along these lines and the positive signs that we are observing in the marketplace, we believe we're on track to return to profitability in 2013 and create long-term value for our shareholders.

With that, I would like to turn the call over to the operator for questions. Operator?

Question-and-Answer Session


[Operator Instructions] Our first question comes from Adam Klauber with William Blair.

Adam Klauber - William Blair & Company L.L.C., Research Division

A couple of different questions. What's your organic growth outlook for 2013 in commercial versus the personal lines segment?

Michael H. Lee

Adam, this is Michael. As I mentioned during the presentation, what we have done this year is to come up with a -- last year, I should say, come up with the market profile grading system, where we rank our various businesses in terms of the market conditions that they operate in. And based on that determination, we have decided to exit certain areas, mainly the larger middle-market business with a focus on smaller commercial business that has historically been profitable. We've also increased our international property business that's running very well and the assumed reinsurance business with our participation with various Lloyd's syndicates. And then, we've been focused on growing a pipeline of organic growth opportunities in markets where we see very good profit potential. So we have established a market intelligence department whose job is to identify market opportunities, and we've been very much focused on meeting with producers in search of those opportunities and to create products, mainly in the specialty space, to be able to identify profitable product as well as market opportunities. So in 2013, we think that we will continue to look for this type of business in the specialty area, as well as continue to expand in the Lloyd's market and then continue to focus on the core areas of our personal and commercial lines business, businesses that have been profitable throughout our history. So we have done that over the last 3 years, and we believe the trend line is very positive. We have exited areas that we felt that we're vulnerable to price competition. And as a result, you're seeing in 2012 rate increases between 4.5% to 5%, and certainly, the performance of our business being much better. Obviously, in 2012, we were hampered by the results on business that we have written in previous years. But what we have written beginning in the middle of 2011 and 2012 is running extremely well, and that's showing up in our policy-year results and we're seeing a positive trend line. And for that reason, we're pretty happy with what we have achieved in the last few years, and we expect to continue to see positive trends in the future.

Adam Klauber - William Blair & Company L.L.C., Research Division

As far as your -- the $2.75 to $2.95 guidance, what -- how many catastrophe points are you expecting? And what expense ratio does that assume?

William E. Hitselberger

Well, it assumes -- Adam, it's Bill. It assumes an expense ratio of 36%. I mean, we expect that the expense ratio will stay elevated into 2013. We expect to start seeing a drop in the expense ratio in 2014 as a result of the scale. The loss ratio has a, I guess, what I would consider to be a reasonably normal amount of cat. Certainly, we haven't anticipated nor do we -- nor we hope to see a repositioning over the last 2 years in terms of our cat activity. But what drives -- and obviously, I think you know that what drives the expense or the earnings impact next year is obviously the platform change. And I think that we're very comfortable that, that platform change is going to help us to achieve our operating results in 2013.

Michael H. Lee

Just to add to what Bill said, the deviation from the original guidance for 2013 really has to do with the additional cost of buying the reinsurance program. We secured 30% quota share to protect our net position on our Towers Homeowners business, which has been impacted by Irene and Sandy. So we didn't explicitly put additional funds into the cat reserve, but we did spend a significant amount of our earnings towards protecting our net position by securing this 30% quota share. So we believe, going into this year's hurricane season, we have done a much better job of protecting our net liability from these events. I also would like to highlight that our guidance was really affected, in addition, by the change in the closing date from year end to late first quarter. But if you look at our guidance for the full 12 months after the closing, we're pretty much in line with our previously issued guidance, which I don't recall, but it's around $3, and we feel pretty comfortable with that guidance. And of course, over the -- within the 18 months of closing, we expect our ROE to improve to 13% to 15% range. And we have done detailed projections, and we feel that the projections that we have provided is realistic based on the, as Bill mentioned, change in the business model. So we're not assuming anything heroic. We're assuming the benefit that will come from this transaction as a result of the modeled change.

Adam Klauber - William Blair & Company L.L.C., Research Division

So that's helpful. But first, catastrophes, would you say it's in the -- you're assuming in the 200 to 400 basis point range, or less than that?

William E. Hitselberger

Probably more like 100 to 200 basis points would be our best guess, Adam.

Adam Klauber - William Blair & Company L.L.C., Research Division

Okay, okay. And as far as the -- also, your thoughts around Canopius in that $2.75 to $2.95, how much of the capital or how much premium do you expect to put to work in 2013 in Canopius?

William E. Hitselberger

We expect -- if you look at the capital we raised, Michael mentioned that it's going to be somewhere between $190 million to $200 million. Based on the current stock price, it's probably a little bit closer to $200 million. It may actually be a tiny bit more than that. We will see when we market the shares. If we look at that capital and the fact that we're bringing it in, in March, the leverage against that capital will actually push our operating leverage down in 2013. So we think that the underwriting earnings associated with that new capital are actually pretty modest in 2013. Why we expect to see an increase in the earnings accretion? It's really because, in 2014, we'll see the full effects. We'll start to earn against that capital. Whereas in 2013, we're really just writing against that capital, not generating any significant earnings against that capital base.

Michael H. Lee

Yes, just -- this is Michael. Just to add to what Bill said, we did not assume that we would deploy this capital to a great extent. We are fairly conservative in terms of the assumptions that we make with respect to the deployment of this capital. But I assume that we will, after the closing, we will continue to expand in the Lloyd's markets, as well as to bring back some of the businesses that we have created while I was at CastlePoint. We've generated a significant amount of premium volume by offering various solutions, including risk-sharing solutions, that generated a substantial amount of premium volume, while CastlePoint -- when CastlePoint enjoyed the Bermuda platform from 2006 to 2009. We haven't really built that into our model. So we think we're pretty conservative when we made our assumption with respect to the assumptions regarding the deployment of capital. For that reason, we're not coming -- we're not deriving the -- we're not getting to the 13% to 15% return on equity until 18 months of closing when we fully deploy this capital. And for that reason, we think we're pretty prudent and conservative about the assumptions that we made with respect to the guidance that we've just provided.

Adam Klauber - William Blair & Company L.L.C., Research Division

Okay. And then on -- as far as the reserves, I think you said there is no development or no -- not much development during the quarter. If we look at it by segment, would either the commercial or personal lines have either favorable or adverse development for the quarter?

William E. Hitselberger

Yes, and that's a good question. No, the overall development for both segments was basically 0 for the quarter. And it was, again, it was 0 for the entire second half of the year since we took that reserve charge.


I'm not showing any further questions at this time. I'd like to turn the conference back to our host for closing remarks.

William E. Hitselberger

Thanks, Kevin. I just wanted to tell people on the call that because we're in a marketing situation, there's several of our analysts that track our stock are currently precluded from calling in, which is why we had a -- probably a smaller Q&A than we anticipated. But I just wanted to thank everybody for the call. And Kevin, if you can go ahead and give the closing instructions.


Ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to All other use is prohibited.


If you have any additional questions about our online transcripts, please contact us at: Thank you!