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Tower Group, Inc. (NASDAQ:TWGP)

Q2 2010 Earnings Call Transcript

August 9, 2010 10:00 am ET

Executives

Thomas Song – Managing VP

Michael Lee – Chairman, President and CEO

Bill Hitselberger – SVP and CFO

Analysts

Beth Malone – Wunderlich Securities

Adam Klauber – Macquarie

Mike Grasher – Piper Jaffray

Bijan Moazami – FBR Capital Markets

Robert Farnam – KBW

Operator

Good morning, ladies and gentlemen. My name is Ally and I will be your conference facilitator today. At this time, I would like to welcome everyone to Tower Group's Second Quarter 2010 Earnings Conference Call. All lines have been placed in mute to prevent any background noise. After the speakers there will be question-and-answer period.

It is now my pleasure to turn the floor over to your host, Managing Vice President, Mr. Thomas Song. Please go ahead, sir.

Thomas Song

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, Bill Hitselberger, I would remind you that some of the statements that will be made during the 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 the 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 website.

Now I’d like to turn the call over to Michael.

Michael Lee

Thank you, Tom and good morning everyone. I’d like to thank all of you for joining us on this conference call to discuss our second quarter operating results. Our operating income, which excludes realized capital gains on investment and transaction related expenses was $25.3 million or $0.57 per diluted share compared with $29.5 million or $0.73 per diluted share during the same period last year. Including the realized capital gains and transaction related expenses, our net income and diluted earnings per share were $28.3 million or $0.63 per diluted share respectively.

Our June 30, 2010 book value per share of $24.81 exhibited strong growth with sequential growth of 3.9% during the quarter, 6.3% since year-end and 18.5% on a year-over-year basis. During the second quarter, our total premiums increased by 26.7% to $331 million from $261 million during the same period last year with a combined ratio of 93% comprised of a loss ratio of 58.6% and an expense ratio of 34.4%. As Bill will explain later, the expense ratio is anticipated to decline during the second half of the year.

On this morning's call, I will provide you with updates in several areas of our business, including our views on the current market conditions, our business strategies and the acquisition of OneBeacon's Personal Lines Division which we closed on July 1. Bill will then provide a detailed overview of our financial performance and earnings guidance. We will conclude this call with a question-and-answer session.

As we’ve been mentioning in prior quarters, we continue to see soft insurance market conditions across the industry. In fact, the challenging market conditions in our industry, combined with weak economic conditions that continued this quarter, validated our strategy over the past two years of building a larger, diversified company focusing on the consolidation of profitable business through acquisitions and maintaining underwriting and cost discipline.

During the last several quarters, our operating performance, as measured by earnings per share was adversely affected while we were deploying the capital that that we acquired from CastlePoint and integrating acquisitions, as well as by the need to adjust our expected loss ratio upward to reflect the competitive underwriting environment.

During our earnings call last quarter, we indicated that our operating performance in 2010 would improve in the second half of the year, especially after we closed on the OneBeacon acquisition. Based on the strong operating results this quarter and the anticipated benefits from the OneBeacon transaction on July 1, we are confident on our outlook for the remainder of the year and for 2011.

In response to challenging market conditions, we have utilized our diversified business platform and allocated capital to profitable markets while aggressively re-underwriting unprofitable segments of our renewal business. Through acquisitions we have also successfully broadened our commercial business, added to our specialty business and with the OneBeacon acquisition, we have substantially expanded our Personal Lines product offerings and capabilities.

In addition, we have successfully grown our business by consolidating renewal business rather than competing for new business in competitive market segments. During the quarter we have continued to successfully implement our underwriting strategy to focus on growing our small premium size commercial policies, while reducing our volume of middle market commercial lines policies. We have implemented this strategy as we believe the pricing and retention on the small account business is better than the middle and large account business.

As a result, we are seeing higher retention rates and relatively more favorable pricing on our commercial business. In addition to focusing on underwriting small premium size policies, we have revised our strategy for the specialty business this quarter by consolidating the specialty division with our commercial lines operations. We have made this change to allow our regional offices to develop and market specialty niche products through our selected retail and wholesale agents, which offsets the reduced premium volume from the middle and large commercial accounts.

As a result, our commercial line strategy will be to focus on underwriting small accounts while targeting our growth on niche products customized to meet the needs of selected producers. We will continue to write program business from selected program underwriting agents and will continue to focus only on programs that meet our underwriting standards.

With this reorganization and anticipated scale that the OneBeacon transaction provides in our Personal Lines Division, we anticipate reporting our results by commercial, which will be comprised of both brokerage and specialty business, personal and service business segments beginning in the third quarter.

Now I would like to provide you with an update on the acquisition of OneBeacon's Personal Lines Division which closed on July 1. This transaction was financed with existing cash provided from our operations rather than through external financing or issuance of additional shares. As a result, we will be able to immediately begin to realize the economic benefit of this transaction beginning in the third quarter without experiencing any dilutive effects from issuing additional shares.

This transaction will allow us to access over $450 million of additional Personal Lines business on an annualized basis to allow us to increase our scale and efficiency. We will also be able to increase our invested assets by approximately $380 million, which in turn will increase our investment income.

We will be able to generate the income from managing the reciprocal companies that provide additional underwriting capacities for homeowners and personal auto business. We also plan to grow our Personal Lines business by emphasizing personal package policies in order to differentiate ourselves from the direct auto writers and national carriers.

With this and other transactions, we have successfully executed our strategy that we began in early 2009 to fully deploy CastlePoint's capital by building a larger and more diversified insurance business. We are now focused on our capital management strategy, which includes increasing the dividend payout ratio that will increase the distribution of our current earnings to our stockholders.

Consistent with this strategy, we are pleased to announce that our board has authorized a 78.6% increase in our quarterly dividend from $0.07 per share to the $12.5 per share to stockholders of record as of September 10, 2010.

This increase is the result of our internal assessment of our dividend yield payout, are relative to other companies, so the yield now brings us in line with our peers. In addition to the higher dividend payment, we will continue to focus on enhancing value to our stockholders by continuing our share repurchase plan and evaluating accretive acquisition opportunities that further strengthen and diversify our business.

With that overview, I would like to now turn over the call to Bill to provide financial details on this quarter. Bill?

Bill Hitselberger

Thank you, Michael and good morning everyone. I will cover some of the financial highlights for the second quarter followed by Tower's earnings outlook for the third quarter and for the full year.

Our combined ratio was 93% and our operating earnings per share was $0.57 per share for the quarter. While we substantially increased our total premiums by 26.7% to $331 million during the quarter, much of the increase in total premiums was primarily the result of our acquisition of SUA, which added approximately $31.5 million of the premium growth during the quarter.

Net premiums written increased to $292.6 million, which represents a 24.1% increase as compared to the same period last year. For the quarter, consolidated revenues increase by 22.3% to $311.8 million. For the combined brokerage and specialty segments, our net combined ratio was 93% for the second quarter as compared to 84.6% during the same period last year.

Much of this increase was the result of higher net loss ratios, which were 58.6% as compared to 52.2% in last year's quarter. The higher losses incurred in the specialty business were the primary contributors to this increase in loss ratio. Our combined net expense ratio was 34.4% as compared to 32.4% last year.

As Michael mentioned, due to the additional premium volume from the OneBeacon Personal Lines acquisition, we should begin to see a meaningful reduction in our expense ratio beginning in the third quarter.

Our operating return on equity for the quarter was 10.2% as compared to 14.4% last year. While this is clearly not in the range that we are targeting prospectively, I would note that investment returns were somewhat constrained as we liquidated $167 million of investments in June to provide the cash necessary to finance the closing of the OneBeacon transaction.

I would now like to provide additional details on the operating results of our segments. As you may know, our Insurance Services segment has not been utilized as much since the acquisition of CastlePoint in the first quarter 2009, but we anticipate that the reciprocal management companies will provide us additional fee opportunities, which will be represented in this segment going forward.

The premium writings of the receptacles will be included in our Personal Lines segment starting in third quarter 2010, as accounting rules mandate consolidation, even though we do not own the reciprocal businesses. We will record fees and expenses associated with the business production in our Insurance Services segment with the Personal Lines segment recording the fate as an underwriting expense.

In consolidation, the fees will eliminate even though they will provide our holding company with an additional source of cash flow. For the brokerage segment, during the quarter we saw 9.5% increase in gross premiums written, a modest growth of 1.9% in net premiums written as we continue to maintain pricing and underwriting discipline that resulted in declining premium volume in the more competitive middle and larger market accounts. The small amount of growth in this segment was achieved due to small account business.

Our underwriting discipline is also reflected in our premium change on renewals, as well as the high retention rate on renewal policies. During the quarter our premium change on renewals increased by 0.1% for commercial lines, 3.4% for personal lines and 1.3% overall. The strength of our core business is also reflected in the renewal retention rate, which was very strong for the quarter with 81% retention in commercial lines and 91% retention for personal lines.

As a result, our brokerage results were exceptional, considering overall market conditions. In contrast for the first quarter, there were no catastrophe losses in the second quarter and the brokerage segment produced an 88.5% net combined ratio.

Overall, we continue to observe stronger pricing trends and higher levels of retention in personal lines, as compared to commercial lines. And we expect this to continue as we focus going forward on personal package policies, which we believe have very favorable characteristics and margins.

In our specialty business, the second quarter results were affected in two areas. First, we are in the final stages of running off CastlePoint reinsurance's third party business, which has both a higher loss ratio and much higher acquisition costs, this third party reinsurance assumed business contributed only about $15 million of earned premium during the second quarter, but added 1.5 points to the overall segment and loss ratio.

Additionally, we are in our later stages of fully integrating the SUA business and as a result, reorganization costs elevated the expense ratio in this segment. We expect this to continue for two more quarters which is in line with our expectation that it will take about one year to fully integrate this business.

With these two factors in mind, our gross premiums grew to $80.7 million during the quarter from $31.3 million last year as this business began to deliver scale from the combination of CastlePoint and SUA specialty businesses. SUA contributed approximately 44% of this growth, however during the quarter and SUA's premiums were reduced by almost 30% to $31.5 million in both specialty and brokerage segments as compared to SUA's reported 2009 second quarter, as a result of our re-underwriting in that book of business.

As Michael mentioned, we have decided that in order to more effectively manage this business and to better support our strategy of providing differentiated products to small commercial policyholders through producers in both our specialty and brokerage businesses.

This segment will be combined with our brokerage business into a combined commercial segment. We will continue to shrink programs and commoditize classes of business while we focus more on growth through customized solutions across our distribution network.

Also, in the second quarter we strengthened reserves in the specialty segment for prior periods by $2.3 million or 2.6 loss ratio points, primarily due to adverse experience on two specialty programs that we terminated and put into runoff in 2010.

Our gross underwriting expenses in the specialty segment was 31.6% for the second quarter of 2010 as compared to 26% for the same period last year. The other underwriting expense ratio, which includes income before income taxes was 9.2% in the second quarter compared to 7.3% for the same period last year.

The increase in expense ratio resulted from an increase in headcount associated with the acquisition of SUA. Our net expense ratio was 33.1% in the second quarter compared to 27.5% a year ago. As I highlighted, expense reductions associated with the consolidation of management will be realized beginning in the first quarter of 2011.

I would now like to provide an update on the product line diversification that we have achieved. Last year in the second quarter, commercial package represented 37.2% of our direct premiums, as compared to only 28.1% in 2010. General liability was 11.9% of our production last year, but has now been reduced to 8.7%.

Looking forward with the contribution of the personal lines business of OneBeacon, our product lines will be well balanced between commercial package, worker's comp, homeowners, commercial auto and personal auto and we will have a very broad product offering that we believe is important during a soft market.

I would like to take a few moments now to discuss our investment results. In the second quarter 2010, our invested asset base including cash and cash equivalents, grew by 30.9% to $2.1 billion compared to $1.6 billion in the second quarter of 2009.

Importantly, we acquired an investment portfolio of $525 million on July 1st, 2010 in the OneBeacon transaction. And net of the $167 million we paid to purchase these investments will be captured in our third quarter financial statements.

In the second quarter, net investment income increased by 37.4% to $23.9 million as compared to $17.4 million for the same period last year. The tax equivalent investment yield at amortized cost decreased to 5.2% at June 30, 2010 compared to 5.7% at June 30, 2009.

We continue to see a very low yield environment with non-treasury asset classes returning to overall spread tightening after a brief period of widening during the second quarter. We expect our investment yields to be further pressured by the OneBeacon transaction and that the $525 million that we received was transferred to us in the form of cash. While we had prepared to quickly deploy this, much of it was that lower yields in the current environment.

Net realized investment gains were $5.2 million for the three months ended June 30, 2010 compared to a gain of $400,000 in the same period last year. The second quarter gains included other than temporarily impaired losses of $300,000 as compared to $4.1 million of such losses in the second quarter of 2009.

The duration of our fixed income portfolio was approximately 4.2 years. Our blended new money rate is now 3.8%, which is a tax equivalent yield and includes the muni-bond investments. Net cash flow provided by operations was $22.5 million during the second quarter and $59.2 million year-to-date.

Last quarter we announced our stock repurchase program and during the second quarter of this year, we repurchased $39.7 million or over $1.8 million shares for an average price per share of $21.51. Since inception, $2.2 million shares of common stock were purchased at an aggregate consideration of $47.2 million this leaves $52.8 million outstanding in the program.

Additionally, we closed on a $125 million three-year credit facility led by JP Morgan and Bank of America during the second quarter. At June 30, 2010 we had drawn $56 million against this facility. We continue to analyze capital management strategies, including our dividend policy, which after the increase authorized by Tower's board brings our payout ratio to be a greater portion of our earnings.

We want to make sure that we are investing in the best opportunities for return to our shareholders and we believe this is the best approach to capital management, as a result of share repurchases, we now have $43.1 million shares outstanding as of quarter end, down from $45 million shares outstanding at March 31, 2010.

Now I’ll turn to our earnings outlook for the third quarter and full year 2010. As we continue to implement our business plans, we anticipate our earnings and return on equity to gradually increase in the second half of 2010 and into 2011.

Tower expects third quarter 2010 operating earnings per share to be in a range of $0.75 to $0.80 per share. For full year 2010, Tower projects its operating earnings per share to be in the range between $2.55 and $2.65 a share, which reflects the effects of low new money rates and the deployment of the $525 million in cash from the OneBeacon assets to longer term investments at the beginning of the third quarter.

With that, I’d like to turn the floor over to Ally [ph] for any questions. Ally, if you could open the lines.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Beth Malone of Wunderlich Securities. Please go ahead.

Beth Malone – Wunderlich Securities

Thank you. Good morning and congratulations on a good quarter. I have a couple of questions. One, on the guidance that you’re providing, the top line is slightly lower than what you had forecast after the first quarter. And I understand that yields are – that you have a lot of a cash from the OneBeacon that you have to deploy, but wasn't that already known when you guys decided your first quarter that you would have a lot of cash that wouldn’t be earning anything for a little while as you transitioned or was there something else that changed that caused you to bring that top line down a little?

Bill Hitselberger

Hi Beth, it's Bill. I think the reality is that in the second quarter – we put out our earnings announcement in the first quarter. Clearly we had an anticipated and I think even we noted that we would be getting cash and we would be investing that. We had an assumption that the cash that we got from the OneBeacon transaction would be put to use and the blended money rate would be about 5%. The invested money rate or the new rate as of today we announced was 3.8% we did a little bit better with that with the OneBeacon assets, but they are at about 4.3% to 4.5% returns. So that lowering of yield is putting a little bit of pressure on our earnings that we did not contemplate when we issued the guidance in the first quarter.

Michael Lee

Beth, this is Michael. I would add to what Bill said is yeah, we still think within the guidance that we provided, except we wanted to be somewhat more proactive in terms of guiding the analyst and the street. And we felt that based on the changes we have seen that we were looking at lower end of that guidance so we adjusted by nickel [ph], but we still think we’re within the range that we were contemplating. So we did not want to signal that there is a meaningful deviation from our guidance as much as just the refinement of what we have put out. So I would not view that as a material change as much as a refinement. As we got into the third quarter and the fourth quarter, we just want to make sure that we properly communicate what we are seeing internally.

Beth Malone – Wunderlich Securities

Okay. Thanks. And then on the SUA acquisition, you said that the premiums generated from SUA are meaningfully lower than when you are acquired it. I understand a lot of that is intentional. I just wondered is it tracking where you anticipated it would when you acquired it or has market conditions changed to make it tougher to write that program business?

Michael Lee

That’s a good question. I don't think we’re seeing any change. We like some programs and we did not like other programs. And, in fact we wanted to accelerate the kind of changes that we wanted to put into place immediately after the SUA acquisition. So I think it took a little longer than we wanted to and it's hitting the books in the second quarter. But this is based on our view that some of the programs, especially with program underwriting agents, need to be looked at very carefully and we executed on the plan that we had developed which is to reallocate that capital to better business.

And with the OneBeacon acquisition, I think we can start to accelerate some of the underwriting actions that we wanted to take across all our business segments. If you recall, we started with the commercial lines in the middle market and then large account business segments and we have done that and we have successfully brought – we have successfully improved our results on the commercial lines, as a result of downsizing that business and emphasizing small, premium size policies.

Likewise, we are expanding that approach to other parts of our book of business, in the Specialty area, we wanted to make sure that we took the proper steps to eliminate program business where we felt was somewhat underpriced. And we’re executing on that. And as a result of that, we’re going to see less program business, but we have – as we mentioned, we’re focusing on specialty business written through our retail and wholesale distribution sources using our five regional offices or regional areas. And by doing that, we think that we can get better quality specialty business rather than relying on just our Chicago office to originate that business.

So I think the changes that we’ve made signals that we are going to be focusing on specialty business, but not necessarily exclusively through program underwriting agency, but through our other distribution channels, namely the retail and wholesale agents, because we believe that we need to penetrate those niche areas and downsize the program business that we’re seeing through program underwriting agents. So just to summarize, what you have seen in terms of the reduction in premium volume is consistent with the underwriting strategy that we have communicated after we acquired SUA.

Beth Malone – Wunderlich Securities

Okay. And then one last question on that specialty business. I just want to make sure I understand what occurred in that – in the second quarter in that business, because they – I know you did point this out, Bill, I'm not sure I followed it. The specialty business segment generated a 69% loss ratio, I think and an operating loss and is that because that is where the reserve development took place or am I missing something else?

Bill Hitselberger

Yeah. There was a modest amount of reserve development that is associated with two programs that we terminated in 2010. I think the good news at least from our perspective is that the development was not really coming from the SUA business it was coming from the old program business associated with Tower and CPU rates.

When we acquired SUA, obviously we went through our purchase GAAP accounting and we went through a diligent actuarial process. And the reserving of that, we’re very confident that we are not going to see any development leading through from the SUA acquisition. This was really associated with old programs, there was actually only two of them that we terminated in 2010 and that led to a higher incurred loss ratio in the second quarter.

Beth Malone – Wunderlich Securities

I'm sorry, how much was that? It was 2.6 percentage points or?

Bill Hitselberger

It was 2.6 loss ratio points, but then also associated there was the loss ratio itself was higher because of the old CPRe business.

Beth Malone – Wunderlich Securities

So that made – that explains kind of the trend that…

Bill Hitselberger

It is really those two pieces – it is those 2 pieces and then there’s also a further association, which I would say was that the pricing on the new business was pressured, which put a little bit more on the incurred loss ratio in the second quarter this year.

Michael Lee

Just to add to what Bill said, I just want to highlight the fact that our run-rate is about 90% to 92% or around 91% combined ratio and I think you are going to see that in the third and the fourth quarter, so with all the actions that we have taken, even with the increase in loss ratio and with the conservatism that we put into our future business by increasing our expected loss ratio, we’re at a very good run-rate compared to the rest of the industry. And as you look at all the companies reporting, I think the run-rate is much higher close to 100 combined ratios.

So I think we are feeling very comfortable that we’re proactive in terms of doing what we needed to do to re-underwrite certain portions of the business. And, as a result I think we're in good shape going forward. I think the actions, that we have taken in the fourth quarter is certainly working; I mean we certainly have taken action prior to the fourth quarter with the middle market and large account business. And as a result, I think our bulk of business is performing very well as indicated by the pricing increases on renewals as well as the high retention rates that we are getting.

So our book now is comprised of very stable business that is generating very good retention rates, good pricing and then we are getting additional book of business from the acquisitions that we have made but we are not just taking on that book of business. We are re-underwriting that business and only bringing the profitable portions of that book of business.

So while we're not seeing that much organic growth, we’re still seeing growth but growth with renewal business. So our strategy of creating sort of an internal hard market by consolidating renewal book of business and then aggressively re-underwriting it to make it more profitable certainly seems to be working.

Beth Malone – Wunderlich Securities

Okay. Well, thank you.

Michael Lee

Welcome.

Operator

Our next question comes from Adam Klauber of Macquarie. Please go ahead.

Adam Klauber – Macquarie

Good morning, everyone. Thank you. Now that you had a little bit more time to look at the OneBeacon, what type of combined ratio do you think you can get that business down to? And of the $450 million, roughly how much of that do you think you will keep after 12 months?

Michael Lee

Thank you for that question Adam. You know, what, interestingly and I think it's worthwhile spending some time in terms of how this business will run through our books, about half of that business will be written into reciprocal. So the reason that we like the reciprocal structure is because we can write at a higher leverage about 2.5 to 1. And it is non-rated facility and it is suitable for the type of business that OneBeacon writes, which is the personal auto, as well as homeowners business.

Our intention is to – our goal is to push more premium volume through the reciprocal. And if we do that, we can write at a slightly higher combined ratio. We think that we can write that business at around 95 combined. But it is not going to affect our results within the stock company. We’re generating fee income from managing that business. So while – although it’s going to be consolidated, it’s going to give us the ability to price our product in a way that would work for us, mainly because we generate the fee income from managing that business and not only that the higher leverage associated with that business, 2.5 to 1 versus stock company where we can only write it to about 1.3 to 1, allows that reciprocal to generate that same level of profitability at a higher combined ratio.

So what we want to do is to write more business of that business in the reciprocals, thereby generating higher fee income and give us the pricing advantage for that type of business and satisfy our agents, while we write the package business which we think runs at about a 90 combined. And we will position our stock companies to write only the package business and provide our agents with access to mono-line auto and homeowners business to mitigate our cat exposure, as well as to provide a mono-line autos product that can be written at a higher combined ratio than we would be otherwise able to do within our stock company.

It is a very important point and we like this model and it is going to give us a pricing flexibility that we are seeking for this type of business. So, in summary we think this business for the package type of business, as well as some of the homeowners that we are writing, will allow us to generate within the stock company in the high 80s combined ratio to low 90 combined ratio within the stock company and then within the reciprocal, probably we’re looking at about a 95 combined ratio. And because of the unique structure that I just spoke about it and because of our ability to generate fee income, it works for us.

So it is a win-win for us in that we will be able to write the type of product that requires a lower combined ratio within the stock company by focusing on writing the package business within the stock companies that we manage and then while allowing for this business to be written at a slightly higher combined ratio within the reciprocal and generating the fee income. So we think we have a very unique approach to the personal lines segment and as a result, we think that we could maintain the volume and we’re looking at the Personal Lines Division as a means to grow our business organically at this point in the market cycle.

Adam Klauber – Macquarie

Thank you very much.

Michael Lee

You’re welcome.

Operator

Our next question comes from Mike Grasher of Piper Jaffray. Please go ahead.

Mike Grasher – Piper Jaffray

Hey, good morning everyone. Congratulations on the quarter. Hey, Michael, I wanted to ask about your exposure in worker's compensation in that line. Maybe if you could just update us on the trends that you’re seeing there with more specifically to your classes of risks?

Michael Lee

Okay. Well, as far as the comp is concerned, you have to remember that our results have been much better than the industry results and we’re somewhat insulated from what others are seeing, mainly because of our focus on small account business. And just like across all of our other lines of business in the worker's comp line of business area, our focus on small accounts allows us to focus on policies that generate – that are written at a much higher premium volume – I mean a much higher rate or guarantee cost rates and you don't see the kind of discounting that you see for middle market and large account type of business.

So in New York loss ratios were much higher than what we have experienced because of that focus. Now in California we apply the same strategy of focusing on this segment of the business and as a result of that, our results are fairly good. However, what we are seeing, which we are not seeing in other parts of the country, is that we're getting rate increases in California.

So I think the trend is very positive in that our loss ratio is probably in the low 60s in California and yet we are able to push through rate increases and it is sticking, because the general market is doing much worse than we are. So we are able to push through rate increases to generate the type of results that we are seeking.

So I think the comp decision to go into California was a good one. We have been very prudent, disciplined. We have expanded but held the line as far as the total amount of premium volume that we would write in that state and we have waited for the market to come back, so we are very well positioned to take advantage of what is going on in California.

But our overall approach to this business is consistent with our overall approach across the board, which is to plant the seed by getting into certain territories and wait for the market conditions to improve and then increase their volume accordingly. And we are using our diversified business platform to allocate our capital to different geographical areas based on the market conditions, as well as across different product lines depending on the market conditions and that allow us the ability to navigate through the market conditions effectively. And I think this quarter's results is indicative of the kind of discipline that we are exercising during this part of the market cycle.

Mike Grasher – Piper Jaffray

Okay. And then just to follow-up on that piece, the claim trends and I understand your performance in the low 60s and that has been quite good. But the claim trends, has there been any change in the open claim inventory the duration extending?

Michael Lee

No. I think our business is somewhat unique. We don't focus on long tailed type of business where you may get surprises, our business across different lines of businesses are comprised of low hazard types of classes of business, where reporting is quite predictable and we do a pretty good job of putting up proper reserves. So I think our claim trends rather benign, the only thing that we were concerned about as we mentioned in the fourth quarter was the expected loss ratio going forward. And we took the hit and we adjusted the loss ratio upward.

As you will recall last year, we were at mid-50s in terms of loss ratio and we said that was too low. And we said going forward we should be conservative. And we are now booking about 61% for the year, especially after OneBeacon transaction. So we already adjusted our expected loss ratio. Despite that, we are going to be able to meet our financial target and I think what the street saw was the first quarter and the second quarter on top of that I think we had the Cat losses. So I think the expectation was that we are seeing some deterioration in our business and that is not what we are seeing.

We are seeing the acquisitions providing us with the diversification. We are seeing very good growth in all different areas, we are seeing stability and we already have taken the hit, so to speak, in the fourth quarter in terms of what we had projected as far as future loss ratio and then we also have taken corrective underwriting actions in various parts of our business that we felt were vulnerable to potentially seeing unfavorable trends occurring.

And, as a result of that, I think we’re very well positioned and with the OneBeacon acquisition adding more volume we also have fully deployed the capital. And for that reason, I think our strategy that we began in 2009 of creating a more diversified company is working. So we feel we are in very good shape going into the third and fourth quarter and certainly into 2011.

Mike Grasher – Piper Jaffray

Okay. That’s helpful. I appreciate clearing that up. And then Bill, I did have a question; I guess an accounting related question, just in terms of the acquisitions that occurred. I noticed the unearned premium in the quarter, the change there; I guess it was less than what I would have anticipated given the acquisitions. Can you talk to that in terms of why maybe that did not accelerate?

Bill Hitselberger

I'm not sure, I exactly have your model, Michael but – we showed obviously year-over-year growth in terms of our written premiums. I think the earnings trends were consistent with what we had expected, what we would have seen is you would see a big burp in the unearned premium in the fourth quarter and that would have been the result of the acquisition of SUA. And then the growth rate would hopefully trend more with the change in the writings from what it was from December.

So you have to remember that when you acquire the unearned premium in the fourth quarter, that unearned premium is starting to go down. So while we had significant growth on a year-over-year basis you're really going to look at the unearned premium as emerging from when the acquisitions were put on. Now having said that, we would expect to see a pretty significant growth in unearned premium in the third quarter this year, when we booked the effects of the acquisition of OneBeacon.

Mike Grasher – Piper Jaffray

Okay. So it is a timing issue then?

Bill Hitselberger

Yes. And I think what will happen is you're going to see spikiness in the unearned premium in the quarters that the acquisitions are going to be put on. And then, even though you have increased writings, you also have the effect of the earnings of that unearned premium coming down. So it kind of mutes the year-over-year growth in written because you have the amortization of the unearned premium for the earned piece of the acquisition.

Mike Grasher – Piper Jaffray

Okay. That is helpful. Thanks very much.

Bill Hitselberger

Thank you.

Operator

Our next question comes from Bijan Moazami of FBR Capital Markets. Please go ahead.

Bijan Moazami – FBR Capital Markets

Good morning everyone. A number of questions. First of all I assume that you guys will try to transfer some of the Tower's premium to the reciprocal. How fast can you do that and what percentage of the homeowners premium can be transferred to the reciprocal? And also at what point in time does Tower has to be buying additional surplus notes, I think, in that reciprocal in order to keep it capitalized at an adequate level?

Bill Hitselberger

I think, to answer your first question, Bijan I think we anticipate the reciprocal growth coming primarily from new business opportunities in mono-line auto and homeowners business. I don't think we would be transferring a significant portion of our business from Tower into OneBeacon.

With respect to the surplus note, the surplus note we have to – our covenant with the state is to maintain the net premiums written in those two reciprocals to a factor no greater than 2.5 times their capital as of the acquisition date, the capital in those businesses is roughly about $100 million. So, as we grow if we grew above a net of $250 million in the reciprocals and reciprocals don't have organic growth in their capital, we would then start to look at increasing the reciprocal note.

Michael Lee

Just to add to what Bill said, this is Michael. I think we are not looking at transferring any of Tower's business. However, we may look at the opportunity to putting more of the business that we have acquired from OneBeacon into the reciprocal structure. We have some plans on how we can achieve that.

In addition to that, I think we are focused on increasing the fee-based income. I think you can anticipate us possibly making other plans to be able to have other companies come in and to provide us with additional capacity. Because we have a very good personal lines platform in the northeast and I think to manage our cat exposure properly, we are inclined to use other companies in addition to the reciprocals to provide the capacity that we don't have within Tower, I mean, we certainly have the capital but we feel that from a risk management standpoint it makes sense to push all of the growth that we are seeing to the reciprocals, as well as other insurance companies.

And I think you can anticipate our next move to be to bring in additional capacity from outside with third party reinsurers or insurance companies to supplement our capacity. What this means is that we will be able to generate additional fee income. And, as you know, as we begin to do that, we leverage our capital more effectively at our ROE increases. Not only that, the free cash flow that we get from the management company allows us to service our dividend payments, as well as our debt service.

So we really are reemphasizing the hybrid nature of our business model. And I think this move to push more of the premium writings to the reciprocal allows us to get a permanent third party provider that we have always been seeking to be able to reemphasize the hybrid nature of our business model and in doing so, I think our results, especially in terms of ROE, will improve accordingly.

Bijan Moazami – FBR Capital Markets

Maybe just to get that dry, so historically you guys wrote more premium that your capacity allowed you to do that and you bought third party reinsurance for Tower's business. In this new model, should we assume that Tower is just going to be riding at its capacity and the reinsurance or auto vehicle will be using it to support the reciprocal or am I getting something wrong?

Michael Lee

What, I think we are going to marginally increase the fee income. I think you have to understand and we did our planning for the next several years – we are going to throw off significant retained earnings. And maybe the investors did not see it in terms of EPS but we are throwing off a significant amount of net income and even in this year, although our EPS is slightly down, what we’re are seeing positive trends in terms of net income. So we have more capital to deploy, so I think we have had increased our dividend and we have initiated stock repurchase plans, because essentially we have more capital than we had before.

In addition to that, with the capital that we have acquired from CastlePoint, we’re operating at a lower leverage position than we have historically. So to answer your question, I think we have enough capital. So even if we bring in other partners to increase our fee income, we are generating significant amount of retained earnings, which we need to deploy. So we're going to continue to look at acquisitions but you have to understand that the equity portion of the equation, the premium being the numerator and the equity being paid the dominator – fee is going to grow.

And, as a result, we are going to have more capital. So our leverage, although we have these initiatives to put a lot of the premium into the reciprocal, we are going to have the equity portion of that equation increasing. And what that means is that despite the fact that we will continue to increase fee income, we are going to have retained earnings and we're going to have to find ways to deploy that. And we plan to do that through active capital management, as Bill discussed, as well as to look for acquisitions.

Bijan Moazami – FBR Capital Markets

Okay. So, I guess, SUA gave you a program business. OneBeacon is giving you personal lines. You got Hermitage with surplus volume what is missing in the business mix or what do you see the next transaction being?

Michael Lee

You know, we really like what we have accomplished over the last two years. We have a platform that we’re very happy with, diversified across different lines of business. What we may look to is to increase our penetration into certain geographical areas. So we would like to see an acquisition on the West Coast, maybe the Southwest but we pretty much have penetrated to different parts of the country. So we feel that from a product line standpoint and from a geographical diversification standpoint we have accomplished what we have sought out to achieve in that strategy which was communicated two years ago.

Bijan Moazami – FBR Capital Markets

Thank you.

Michael Lee

You’re very welcome.

Operator

Our next question comes from Robert Farnam of KBW. Please go ahead.

Robert Farnam – KBW

Thank you. Good morning. So with the OneBeacon book, in the second quarter, I know it was not – would you guys it was OneBeacon was any catastrophe losses in that segment that now is yours?

Bill Hitselberger

Yeah. There was, Bob, I think as we looked at it I think the Cat losses associated with the Personal Lines that we acquired were in the second quarter about $300,000. So it is pretty minimal activity.

Robert Farnam – KBW

Pretty minimal, okay. And do you think that is typical? I'm trying to figure out what we should be expecting in terms of modeling (inaudible)?

Bill Hitselberger

In terms of modeling, my suggestion is it would be it’s going to trend very consistently with our book in that it is northeast exposure. So winter storms are probably more risky than summer storms, so I think that is really what our view of the business is.

Michael Lee

Yeah. And to add to what Bill said, but obviously a lot of the exposure or the cat losses are going to be contained within the reciprocals and it is really not going to affect our results. The beauty of this acquisition is that we’re able to increase our premium writings, but we're going to be using the reciprocal structure to insulate us from any additional cat losses.

And let me just point out the cat losses that we have experienced in the first quarter. Even with the cat losses that we have experienced, our personal lines poised to do very well for the year. So we are not a company that is really – that writes cat-prone business. So I don't have the math in front of me, but this event that occurred in the second quarter was a one-time event that we have not experienced over 20 years, I'm sorry, first quarter that we have not experienced over 20 years and even with the inclusion of the losses, we are seeing our homeowners business, which is affected by this line of catastrophe perform very well.

So, as we go forward for the rest of the year we are going to be able to more than offset the higher losses that we have incurred in the first quarter by virtue of the performance of the homeowners book, which will perform very well and bring that line of business for the year consistent or close to our initial projections. I just want to make those points clear and make sure that everyone understands that we are not looking at increased CAT activity as a result of the OneBeacon acquisition.

Robert Farnam – KBW

Just to summarize, it sounds like the more higher hazard coastal risks will probably go into the reciprocal exchange and the more inland would be going to your standard book?

Michael Lee

No, I don't think so. We’re prudent either way in terms of how we manage the cat exposure whether we write it in the reciprocal or whether we write it in the stock company. But certainly having the reciprocal structure allows us more flexibility in terms of how we manage the cat exposure.

Bill Hitselberger

And certainly, Bob, I mean one of the things that we were aware of when we went into our reinsurance treaty negotiations this year, I mean is that one renewals, we were certainly aware of the business profile of OneBeacon's homeowners business and we contemplated that in our reinsurance volume.

Michael Lee

And just a final point on that that I would like to make, after we acquired OneBeacon, we took corrective action in the Cape, as well as in Rhode Island to mitigate our cat exposure. So even though – and that is how come you are seeing the premium drop off a little bit, so between the reciprocal structure and our conservative approach to cat management, I think, even with the increase in premium volume, we’re well positioned to manage the cat exposure in a prudent manner.

Robert Farnam – KBW

Very good. Thank you.

Michael Lee

Thanks, Rob. Welcome.

Operator

I'm showing no further questions at this time and would like to turn the call back over to Michael Lee.

Michael Lee

Thank you, operator. During the quarter we were pleased with our strong operating results for this quarter, the positive trends that we’re seeing for the rest of 2010 and 2011 and our ability to substantially increase our dividend payment. We thank everyone for joining this call and look forward to talking with you again next quarter.

Operator

Ladies and gentlemen, that does conclude today's conference. You may all disconnect and have a wonderful day.

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Source: Tower Group, Inc. Q2 2010 Earnings Call Transcript
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