Tower Group, Inc. (NASDAQ:TWGP)
Q4 2008 Earnings Call Transcript
March 2, 2009 10:00 am ET
Thomas Song – Managing VP, Corporate Development
Michael Lee – Chairman, President and CEO
Frank Colalucci – SVP, CFO, Treasurer and Director
Beth Malone – Wunderlich
Bijan Moazami – FBR Capital
Good day, everyone, and welcome to the Tower Group's fourth quarter 2008 earnings conference call. (Operator instructions)
It is now my pleasure to turn the floor over to your host, Managing Vice President, Mr. Thomas Song. Please go ahead, sir.
Thank you, operator. Good morning. Before I turn the call over to Tower Group President and CEO, Michael Lee and the company's Senior Vice President and CFO, Frank Colalucci, I want to remind you that some of the statements that will be made 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 periodic reports that are filed by the company with SEC from time to time. Also I want to remind everyone that a replay of this call will be available in the Investor Relations section at Tower's web site. Now I'd like to turn the call over to Michael.
Thank you, Tom, and good morning, everyone. Thank you for joining us on this conference call to discuss our fourth quarter and full-year 2008 operating results. During the fourth quarter and the full year 2008, many companies in our industry experienced significant investment losses that eroded their capital base, as well as deteriorating underwriting results due to competitive market conditions and losses from hurricanes Gustav and Ike. In the face of these extremely difficult market and economic conditions, we were able to once again achieve strong operating results during the fourth quarter and for the full year 2008.
Our success under these difficult conditions once again demonstrates the strength of our business model and uniquely positions us to take advantage of the market opportunities. During this morning's call, I will highlight our operating results, update you on our acquisitions, and provide an overview of our business plan going forward. Frank will then follow up with a detailed review of our financial results.
During the quarter, Tower's diluted earnings per share, excluding realized investment gains or losses increased to $0.82, as it compared to $0.78 for the same period in 2007. For the full year, Tower's diluted earnings per share excluding realized investment gains or losses, increased 18% to $2.87 as compared to $2.43 for 2007.
Return on equity for the quarter was 23.3%, and for the full year, our ROE was 20.7%. We were able to achieve favorable underwriting results, as reflected by our 82.4% net combined ratio for the full year comprised of a 51.7% net loss ratio and a 30.7% net expense ratio. Many companies reporting their fourth-quarter results indicated there were – that they were seeing improved pricing and suggested a possible shift in the underwriting cycle. While we have not yet experienced a significant improvement in pricing during the fourth quarter, we agree with the assessment that capital pressures from mounting investment losses, deteriorating underwriting results, and a weakened financial condition of numerous, large insurance companies may pave the way for improved pricing in our industry.
Irrespective of the general economic and market conditions, we believe we can continue to realize success by utilizing our – utilizing our diversified business platform and strategies. Our strategy to achieve profitable organic growth is to continuously broaden our business platform, by expanding our product line, industry classes of business, territories, and market segments using our multiple distribution channels.
We support this organic growth by seeking opportunistic acquisitions of small insurance companies and program underwriting agents. Finally, we're able to achieve the level of profitability that we seek by allocating our capital to profitable segments of our business in response to changing market conditions. In short, through a strategy of aggressive diversification and efficient allocation of capital, we're able to successfully navigate through difficult economic and market conditions to consistently achieve our financial objectives.
During the fourth quarter, we successfully implemented this strategy by continuing to expand outside the northeast, to offset a lower growth rate in the northeast. We also exercised underwriting discipline by reducing our exposure to competitive market segments, especially the large and middle market premium size segments, and emphasizing and growing our profitable small, commercial, and personal lines business outside the northeast.
As a result, for the quarter, we achieved a record level of gross premiums written and produced, which increased by 24% to $244 million. Our territorial expansion in California, Texas, and Florida through our wholesale distribution system contributed nearly $34 million of premiums written, which represents more than double the production of last year's fourth quarter.
The program business managed by CastlePoint tripled to nearly $32 million. For the year, we also achieved a record level of gross premiums written and produced, which increased by 32% to $805 million for the year. This can be attributed to continued focus in growing our business in the northeast, but also strong contributions from our territorial expansion. We write excess and surplus lines business in Florida and Texas, and began writing on an admitted basis in California in 2008.
New business written from wholesale agents with binding authority for 2008 was approximately $86.5 million, as compared to $29 million for 2007. Our brokerage business written outside the state of New York, including premiums produced by Tower Risk Management, on behalf of CastlePoint increased by over 50% from last year, and represented 30% of our total premiums in 2008. This territory expansion will be further accelerated with our acquisition of Hermitage.
Overall, our policies in force, which includes business produced by TRM on behalf of CastlePoint Insurance Company, increased by approximately 24% this year compared to the same period last year. This very positive trend demonstrates our success in using our broad product line platform to identify profitable market segments in response to changing market conditions, and our ability to quickly deploy capital in support of those opportunities. For the quarter, price changes were relatively stable with personal lines up 2.6%, and commercial lines down 1.1%. In addition, our retention for the quarter was 89% in personal lines, and 81% in commercial lines.
I would now like to spend some time to update you on the status of CastlePoint and Hermitage transactions, which closed in February of this year. The CastlePoint acquisition, which closed on February 5th of this year, provides significant financial and operational benefits. From a financial standpoint, the CastlePoint acquisition further strengthens our financial position, to provide us with the capital to support our growth as well as to make acquisitions. As a result of the CastlePoint acquisition, we were able to increase our year-end pro forma stockholders' equity by 141% to approximately $744 million from our reported stockholders' equity of $309 million at year end 2007.
In addition, book value per share increased approximately 30% from a reported book value per share of $14.36, to a pro forma $18.54 per share at year end. Our investment portfolio increased from $677 million on a stand-alone basis, to $1.4 billion on a pro forma basis, while our average credit rating improved to AA from AA-minus. Furthermore, because CastlePoint's investment portfolio was recorded at the time of closing at fair value reflecting lower market values, we have the benefit of eliminating the unrealized losses on CastlePoint's investment portfolio. Frank will review our investments in further detail later during today's presentation.
From an operational standpoint, CastlePoint's – CastlePoint acquisition provides us with access to program underwriting agents to expand into specialty classes of business as well as to small insurance companies to offer reinsurance solutions. In 2009, we plan to position CastlePoint to focus on specialty classes of business that Tower has not historically written. We believe these specialty classes of business will be less vulnerable to underwriting cycles, due to the specialized underwriting expertise, expertise required to enter these market segments. We will continue to appoint program underwriting agents that focus on specialty program business with an established book of business and strong underwriting track record.
We are also pleased to announce that we have closed on Hermitage Insurance Group transaction. Based on our purchase price mechanism and updated diligence, the transaction closed with a value of approximately $130 million. Hermitage will provide over $100 million of premium volume on an annualized basis. This transaction will further expand our wholesale distribution system nationally, and establish a network of retail agents in the southeast. With Hermitage, we have two branches serving wholesale producers in Connecticut and Atlanta, Georgia; a retail branch in Mobile, Alabama; and operations in White Plains, New York. As a result of these acquisitions, we have successfully transformed Tower from a regional insurance company into a national insurance company.
We now operate several insurance companies that deliver a broad range of products across the country, using multiple distribution systems. We will continue to use the Tower brand to market to both retail and wholesale agents throughout the country. We plan to help differentiate the products that we offer to these two groups, by delivering more of our products to wholesale agents on a non-admitted basis using the excess and surplus licensing capability that we acquired from Hermitage. We will continue to use the CastlePoint brand to market to program underwriting agents and small insurance companies.
Finally, I would like to discuss the acquisition opportunities that we are currently seeing. In addition to continuing to seek to acquire small insurance companies, to expand into different regions, we are now also focused on broadening our product platform into specialty classes of business, by acquiring our making investments in program underwriting agents. Due to the current financial turmoil, we are seeing much greater number of acquisition opportunities at a much more reasonable price. As a result of the CastlePoint transaction, we have access to capital and, therefore, are well positioned to take advantage of these opportunities. With that overview, I will now turn the call over to Frank to review our financial results in more detail. Frank?
Thank you, Michael. Good morning, everyone. I'll cover some of the financial highlights for the quarter and the year, discuss a little bit about some positive developments regarding CastlePoint and Hermitage integration, and then I'll discuss earnings outlook for 2009.
As Michael mentioned, our diluted earnings per share, excluding realized investment gains and losses for the quarter increased to $0.82 as compared to $0.78 in the same period last year. However, including realized investment gains and losses, diluted EPS was $0.68 in the fourth quarter as compared to $0.29 in the same quarter last year. Year to date, diluted earnings per share including the realized investment gains and losses was $2.47 as compared to $1.93 in 2007.
These results also include the effects of our equity income in CastlePoint's realized investment losses and merger-related costs. The losses attributable to these items were $387,000 for the quarter, and $1.8 million on a year-to-date basis. This is – for the year, this is $0.05 per diluted share after tax. The CPS [ph] effect differs slightly from the estimated effect of CastlePoint's losses on our net income, and EPS of $0.07, which we provided during our call in November regarding the third quarter. So let me just recap and reconcile. Excluding the affects of both realized investment losses, which was $0.40 per diluted share and the losses from our share of CastlePoint's realized investment losses and merger related costs, which was about $0.05 per diluted share, diluted EPS for Tower was $2.92 for 2008.
We continue to see strong growth in net premiums earned, as well as commission of fee income. For the quarter, gross premiums written increased by 29.2%. Net premiums written increased only by 5%, since we increased our ceding percentage on quota share reinsurance contracts to 45.5%, as compared to 40% in last year's quarter.
For the quarter, total consolidated revenues increased by 21.2% to $136.4 million, as compared to the fourth quarter of 2007. For the year, total consolidated revenues increased by 18% to $484 million. Commission and fee income contributed significantly to this growth during the year, with a 40.7% increase to $149.7 million for 2008, as compared to $106.3 million in 2007.
I'd like to take a few minutes to discuss in more detail our investment results, and our combined investment assets from our acquisition of CastlePoint and Hermitage. As Michael mentioned, unprecedented market conditions in 2008 have resulted in a challenging investment environment across the majority of asset classes, most notably in the corporate bond and mortgage-backed securities sectors.
With the acquisition closing of CastlePoint Holdings, and most recently Hermitage Insurance Group, we have now improved our investment profile. Acquired investment assets have a lower cost basis and have the potential to recover in value, thereby providing capital gains to offset potential capital losses. Or alternatively, to the extent that these assets continue to be held, the lower cost basis will provide additional investment income through the accretion of what is essentially an additional discount to face value. Going forward, our combined asset base of $1.4 billion will have a positive effect on net investment income.
Total invested assets, including cash and cash equivalents for Tower were about the same between year-end 2008 at $677 million, as compared to $697 million at the end of 2007. We had $136 million in cash and cash equivalents, which is almost double the balance at year-end 2007. So while we have been directing our portfolio managers to put money to work in higher quality classes of bonds, we have also been very careful with our investment process during this volatile time in the markets.
For 2008, net investment income decreased by 6% to $34.6 million, as compared to $36.7 million last year. The investment yield for the year was lower due to the increased cash balance, and lower yields at the shorter end of the curve. Most of this decrease was seen in the fourth quarter, which we had $8.2 million in investment income, which was down $1.5 million from the fourth quarter of 2007.
On the other hand, realized losses were $5.1 million, pretax during the fourth quarter of '08, as compared to realized losses of $17.5 million pretax in the same period of 2007. The losses in the fourth quarter were primarily the result of impairments of $3.8 million on our residential mortgage-backed securities, and a $2.4 million in a debt fund. Both of these are pretax. This is less than 1% of the fair value of Tower's investments alone.
The target duration of our fixed income portfolio was about four years, and we achieved that at year-end 2008. On a tax equivalent basis the book yield was $4.6 million at December 31, 2008, as compared to – 4.6% at December 31, 2008, as compared to 5.6% in 2007. Our new money rate is now at 5.9%, which is a tax equivalent rate and includes muni bond investments. Our net cash flow provided by operations was $19.7 million during the fourth quarter.
For the quarter the gross loss ratio was 52.7%, and the net loss ratio was 50.8%. This compares to a gross loss ratio of 49.1%, and a net loss ratio of 55.2% for the same period of 2007. We had favorable development on our loss reserves of a $4.4 million during the quarter.
For the quarter, the gross expense ratio was 30.2%, and the net expense ratio was 31.8%. This compares to a gross expense ratio of 28%, and a net expense ratio of 25.7% in the same period last year. I'd like to point out that our gross – gross commission rate increased slightly during the quarter as a result of increased program business, which accounted for 17% of the gross premiums earned on the quarter. Our gross and net combined ratios were 82.9%, and 82.6% respectively during the quarter.
Now I'll turn to our earnings outlook for the full quarter and – for the quarter – first quarter and full year of 2009. Tower expects first-quarter 2009 diluted earnings per share, excluding realized investment gains and losses and nonrecurring transaction expenses related to the adoption as of January 1, 2009, of – of FAS No. 141R business combinations, to be in the range of $0.80 to $0.85 per diluted share.
For the year 2009, Tower projects diluted earnings per share, excluding realized investment gains and losses and nonrecurring transaction expenses, to be in the range between $3.10 and $3.30 per diluted share. These projections include a gain on Tower's investment in CastlePoint, resulting from the fair value of the acquired outstanding shares, which is expected to add approximately $0.20 per diluted share in the first quarter of 2009, and approximately $0.17 cents per diluted share for the full year of 2009. The difference between these two per-share numbers is due to the difference in projected weighted averaged diluted shares outstanding during those periods. These projections also reflect lower expected investment income in 2009, due to higher levels of cash held and the actual timing of the CastlePoint and Hermitage transaction closings, which occurred in February in 2009. Our projected ROE is expected to be in the range of between 16% and 18%. We will now turn the floor over to the operator for questions. Operator?
(Operator instructions) We'll have our first question from Beth Malone with Wunderlich.
Beth Malone – Wunderlich
Thank you, good morning. Congratulations on the quarter.
Beth Malone – Wunderlich
Just talking about the guidance and the outlook, how much of the adjustment from your previous guidance to the guidance you provided in this release, is due to the Hermitage and CastlePoint delay of closing? How much were they expected to contribute to the 2009 estimate?
This is Michael. Good morning, Beth. We don't have the exact breakdown, but obviously our previously – previous guidance anticipates closing as of January 1. So the revised guidance reflects the – the later closing. We don't have the exact breakdown. But I – I think if you go four quarters ahead, I think our – our projections are probably going to be similar to the projections that we have provided previously. The first quarter is somewhat complex because of the two acquisitions, and also due to the fact that we held so much cash in anticipation of these two transactions. So I would say that we probably are – our guidance is – that we previously provided is going to be right on point, if we include the first quarter of 2009, along with the three quarters in 2008.
Beth Malone – Wunderlich
Okay. And then if we look out on – when you talk about the weakness you saw in the Northeast, which was early on in your development that was a core market for you. Are you not seeing that same kind of weakness in these other markets that you're entering now?
Well, for – first of all, I think we're – first of all, we're still growing in the Northeast. But we have decided that our capital is better – better allocated to other small, premium-sized segments in other parts of the country. So our strategy was really to rotate our capital out of middle market and large accounts, where we're seeing some significant competition in the north – Northeast, and then allocate our capital to small, premium-sized segments. And in other territories, we're finding the same type of pricing integrity for that segment of the market, as we're seeing in the Northeast. So, I think as we enter into different states, especially Florida, Texas, and California, we're focusing on small premium-sized segments. And we're either writing that on an excess and surplus basis, or on an admitted basis, but competing in that E&S market segment where there is price, still pricing integrity.
Beth Malone – Wunderlich
Okay. And one last question. And then I'll get back in queue. With the stock trading close to your book, your pro forma book value, is there any thought to share repurchase?
We're considering that. And we think that if the stock does decline, it's – at a certain point, it's going to make more sense to allocate our capital to repurchasing those shares. Obviously, our return on equity in connection with the – with such a stock repurchase, would pretty much be the same or equal to if you were to deploy our capital to write new business. So certainly Beth that is something that we're thinking about.
Beth Malone – Wunderlich
Okay. All right. Thank you.
(Operator instructions) We'll go next to Bijan Moazami with FBR Capital.
Bijan Moazami – FBR Capital
Good morning, everyone. Couple of questions. First of all, have you guys reviewed your reinsurance contract with Swiss Re – and if you could remind me whether or not that was on fund withheld basis?
Yes, it was done on a fund withheld basis. We used –
Yes, collateralized. That contract was collateralized. We used Swiss Re in 2007, but now that we have enough capital, we haven't entered into any new quota share reinsurance contract. I think we have sufficient level of capital this year. If we do an acquisition, possibly we will revisit our capital situation, and potentially look to place our business with – with other reinsurers.
Bijan Moazami – FBR Capital
Okay. And I have a couple of maintenance questions for Frank. First of all, Frank, what was your organic growth rate during the quarter for the gross written premium?
I think I mentioned that –
Bijan Moazami – FBR Capital
And the second question relates to tangible book value pro forma, as of fourth quarter, including the acquisition of CastlePoint.
Well, yes, the tangible book value was about $13.00 a share on the pro forma basis at the end of 2008. And based on our projections, would move to about $16.00 a share at the end of 2009.
Bijan Moazami – FBR Capital
And of course the ROE would be fairly high using tangible book value, but given the fact that we have done a significant number of transactions, I think we're – for business planning purposes as well as for – just in terms of – in terms of planning our capital, we're looking at book value and, more importantly, we're looking at the statutory surplus, which has increased significantly this year as a result of those two transactions.
I am just getting out the –
Okay. Well, the growth – all of the growth this year was –
32%, for all the growth.
And all of that was organic.
Bijan Moazami – FBR Capital
Perfect. Thank you very much.
(Operator instructions) We have no further questions in the queue at this time. I'll turn the conference over to Mr. Michael Lee for additional or closing remarks.
Thank you, operator. 2000 was a year in which we began our transformation from a successful regional to a national insurance company. With the acquisition of CastlePoint and Hermitage, we have successfully expanded our business platform nationally, delivering broad lines of business across various industries, utilizing our multiple distribution system. Due to the CastlePoint transaction, we have significantly increased our capital to support our organic growth, as well as external growth through acquisitions. As a result, we are extremely well positioned to take advantage of the market opportunities. We thank everyone for participating in this call this morning.
That concludes today's conference. You may disconnect at this time. We do appreciate your participation.
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