Tower Group CEO Discusses Q3 2010 Results - Earnings Call Transcript

Nov. 9.10 | About: Tower Group, (TWGP)

Tower Group, Inc. (NASDAQ:TWGP)

Q3 2010 Earnings Call

November 09, 2010 09:30 a.m. ET

Executives

Bill Hitselberger - SVP & CFO

Michael Lee - President & CEO

Analysts

Bijan Moazami - FBR Capital Markets

Beth Malone - Wunderlich

Mike Grasher - Piper Jaffray

Adam Klauber - Macquarie

Operator

Good morning ladies and gentlemen, my name is Mary and I will be your conference facilitator today. At this time I would like to welcome everyone to Tower Groups Third Quarters Earnings Conference Call. All lines have been put on mute to prevent any back ground noise. After the speakers remarks there will be a questions and answering period.

It is now my pleasure to turn the floor over to your host Mr. Bill Hitselberger, Senior Vice President and Chief Financial Officer. Please go ahead sir.

Bill Hitselberger

Thank you Mary, good morning everyone. This is Bill Hitselberger, Senior Vice President and Chief Financial Officer of Tower Group, before I turn the call over to Tower group president and CEO, Michael Lee. I would remind you that some of the statements that will be making 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'd like to remind everyone that a replay of this call will be available in the Investor Relations section at Tower's website.

With that, I'd like to turn the call over to Michael.

Michael 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 third quarter operating results. On this mornings call I will provide you with updates in several areas of our business including our views on the current market conditions, our business strategies, revised segmental reporting and the acquisition of OneBeacon Personal Lines Division, which we closed on July 1.

Bill will then provide a detailed overview of our financial performance and turnings guidance; we will conclude this call with a question and answer session.

Through the several quarters we've indicated that our operating performance as measured by earnings per share and return on equity would improve beginning in the third quarter as we successfully deploy the capsule that we acquired from CastlePoint, especially after the closing of the OneBeacon acquisition.

Consisting with this guidance we're pleased that we were able to achieve a significant improvement through our overall operating results in the third quarter. Our operating incomes which excludes realized capital gains on investments, transactions related expenses and operating results of the reciprocal businesses was $33 million or $0.70 per diluted share compared with $30.2 million or $0.74 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 $33.7 million and $0.78 per diluted share respectively during the third quarter. Our annualized operating return on shareholders equity improved to 12.75% in the third quarter as compared to 8.7% for the first six months of 2010.

Our September 30, 2010 book value per share of $26.34 has increased 6.2% during the quarter, 12.8% since year-end and 15.9% compared to September 30, 2009.

During the quarter, our total premiums increased by 58.3% to 447.6 million from 282.8 million during the same period last year with a combined ratio of 93.8%, consisting of a loss ratio of 61.1% and an expense ratio of 32.7%, excluding the results of the reciprocal insurance exchanges that we now manage and are consolidated with our overall financial results. Our combined ratio was 92.9%.

Beginning in the third quarter, we reorganized our business segments as a result of the changes that we had made to our commercial business and the addition of the OneBeacon Personal Lines Division to our Personal Lines business.

We now operate in commercial, personal and insurance services segment. As a result of the addition of OneBeacon, we have created a personal lines segment to consolidate OneBeacon's Personal Lines business with our personal lines business comprises, primarily, of homeowners business.

In addition, our commercial business segment was created to combine the commercial and specialty business, which allows us to implement our overall commercial underwrite strategy to focus on small commercial business and specialty business utilizing the same underwriting infrastructure.

Finally, due to the acquisition of the managing companies in connection with the OneBeacon transaction, we would be able to significantly increase our key income in out insurance services segment, from managing their two reciprocal insurance changes.

Later, in this call, Bill will further explain the changes to our financial results as a result of the new business segment reporting and the financial impact, including the results of the reciprocals in our overall financial result.

As we've been mentioning in prior quarters, we continue to see soft insurance market conditions across the industry. I think the challenging market conditions in our industry, weak economic conditions and low interest rates that continued this quarter have reinforced our commitment to exercise underwriting and cost discipline and moderate our organic growth, while focusing on consolidating profitable business through acquisitions.

In addition, we have attempted to generate a higher return on equity by leveraging our capital effectively by wholly utilizing our capital and then generating additional reinsurance commission and fee income by transferring business to reinsurers and managing the reciprocal insurance exchanges.

Our third quarter operating results clearly show the positive trend that we're seeing as a result of our successful implementation of this business strategy. Our operating results in the third quarter were obviously impacted positively by the acquisition of the OneBeacon's Personal Lines Division. So let's review the impact of that acquisition during the recorder. After we close on the OneBeacon's acquisition on July 1, we began to immediately realize the economic benefits of this transaction in the third quarter personal lines close written premiums through by 116.2 million in the third quarter as a result of the acquisition and our investment as a portfolio grew by about 375 million from the addition of the acquired business.

We also generate 10.9 million in fee income from managing the reciprocal companies that provide additional underwriting capacity or homeowners and personal auto business. From the commercial underwriting standpoint, we've continued to successfully implement our strategy in the third quarter to focus on growing our small premium size, commercial policies while reducing our volume of middle market commercial lines policies.

In addition to focusing underwriting small premium size policies, we focus on expanding our specialty commercial business by developing and marketing specialty in each products through selected retail and wholesale agents and continuing to write select program business and meet our underwriting standards.

Consistent with our overall business strategy at this point in the market cycle, we plan to grow our commercial business through acquisitions of insurance companies as well as managing general agencies to expand our product offering and geographical footprint. In furtherance of this strategy on November 2 of this year, we acquired the renewal lights to the commercial auto liability and physical damage business from one of our existing program underwriting agents, AequiCap Program Administrators and its affiliate, TransPro Solutions, based in Fort Lauderdale, Florida.

The business subject to the agreement covers both trucking and taxi risks that Tower adds underwritten possibly for the past three years. The trucking component consists primarily of owner, operator and small fleet business written in four states with Florida constituting in excess of 90% of the premium volume.

The taxi components covers both owner operator and fleet risks written in 17 states. The two units together are expected to produce in excess of 50 million in premiums on an annual basis of which approximately 20 million will be new to Tower.

This transaction will allow us to expand our product offering in the transportation industry throughout the country to our regional offices. We plan to continue to have discussion with our existing and new managing general agencies to acquire or to make strategic investments to help us expand into new specialty classes of business as well as work closely together to allow us to exercise greater underwriting and pricing discipline.

Due to our overall underwriting strategy to limit organic growth and exercise underwriting discipline, we continue to see positive overall pricing trends that we have witnessed consistent with prior quarters. We see continued favorable pricing in personal lines and competitive but manageable pricing environment in the commercial segments in which we choose to do business.

During the quarter our premium rates on our renewed commercial and insurance business excluding programs increase 0.2% and premium rates increased 3.7%, on renewed Personal Insurance business, resulting in an overall premium rate increase on renewal business of 2.5%. Our Personal Lines retention rate was 85% and our commercial lines renewal rate was 80% for a combined retention of 84% which demonstrates continuing stability in our chosen markets.

With the acquisition of OneBeacon we have successful saw the excess capital resulting from the CastlePoint and SUA acquisitions to build a larger and more diversified insurance business. We are continuing to see opportunities to make acquisitions at reasonable valuation levels.

As a result we believe we are, we will be able to continue to effectively leverage our capital and generate the type of profitable growth that we have enjoyed throughout our history despite the current challenging market environment.

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

Bill Hitselberger

I will cover some of the financial highlights for the third quarter followed by Tower's earnings outlook for the fourth quarter. Our combined ratio was 93.8 and our operating earnings per share was $0.77 per share for the quarter.

While it substantially increased our total premiums by 58.3% over last years quarter to $447.6 million. All the increase in total premiums was a result of our acquisition of OneBeacon in July and a 2009 SUA acquisition which together added approximately $200 million in premium volumes in the quarter.

Excluding these transactions we would have experienced modest negative organic growth in third quarter 2010. Net premiums increased to $389.7 million which represents a 50.7% increase as compared to the same period last year.

Fourth quarter consolidated revenues increased by 60.3% to $423.7 million. 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 of 2009.

But in the third quarter we saw an up tick in fee revenues, from services that we provided to the reciprocal business. The premium writings of the reciprocal are included in our Personal Lines segment starting in the third quarter of 2010 as accounting rules mandate consolidation even though we do not own the reciprocal businesses.

We have recorded $7.9 million in management fees associated with the business production in our insurance services segment. With the Personal Lines segment recording the fee at an underwriting expense.

The consolidation, these fees are eliminated and the only actual expenses reported but the margin on these fees will provide our wholly company with an additional source of cash level.

For Commercial segment during the quarter we saw 19.9% increase in gross premiums written and a 15.9% increase in net premiums written compared to the same period in 2009. As we continue to maintain pricing and underwriting discipline, that resulted in declining premium volume and competitive market conditions including some of our program business that do not meet our underwriting standards. Most of the growth in the commercial segment was due to the SUA acquisition.

Our underwriting discipline is reflected in our premium on renewals as well as the high retention rate on renewed policies. During the quarter, our premium change on renewals excluding programs increased by 20 basis points. The strength of our core business is also reflected in the renewal retention rate which was very strong third quarter at 80%.

The strong renewal retention, particularly for small policies continues to offset the challenging market environment for new business. The net combined ratio in our commercial segment was 98.2. Fee and commission revenue increased for three months ended September 30th 2010 by $3.3 million, compared to the same period in 2009. The increase was a result of our decision to see commercial liability premiums on an [in for] -- and new and renewable basis effective October 1st 2009.

For our personal segment, gross written premiums more than tripled to $168.5 million in the third quarter compared to$50 million in the same period of 2009. The acquisition of OneBeacon Personal Lines accounted for $116.2 million of this increase. The remaining increase was attributable to general growth in our personal lines business.

Net premiums written also more than tripled in the third quarter to $140.3 million, compared to $43.5 million for the same period in the prior year. Fee and commission revenue as a percentage of fee and premiums written and earned declined in the third quarter. This decline is primarily attributed to the acquisition of OneBeacon Personal Lines.

And recording the fair value adjustments and acquisition, the company's VOBA was established as the value of business acquired offset by embedded ceding commissions as of July 1st 2010. According the deferred ceding commissions associated with the ceded unearned premiums were reported as zero. They being amortized into commission expense in proportion to the earnings of the business acquired.

Fee and commission revenue as a percentage of ceded premiums written and earned should increase in the fourth quarter 2010 as we begin to earn ceded commission revenues from business written in the third quarter of 2010.

Pricing on renewed business in our personal lines was positive 3.7% and retention rate was 85%. The net combined ratio in the third quarter for the Personal Lines segment was 86.8% compared to a 98.6% in the third quarter of 2009.

The lower combined ratio in this segment is a function of lower expense and loss ratios. Net expense ratio improved to 29.5% in the quarter compared to 32.2% in the third quarter of 2009. The net expense ratio in the stock companies was 31.4% and the expense ratio in the reciprocal changes was 25.3%.

The reciprocal expense ratio is the result of the business earned in the quarter reflecting amortization of VOBA and we expect the reciprocal expense ratio to increase going forward. In addition Personal Lines net loss ratio declined to 57.3% compared to 66.4% during the same period last year. Loss ratios in third quarter 2010 includes better-than-expected prior year development on the Personal Lines business including the Personal Automobile business.

In developing cost allocations between the Commercial and Personal Lines segment, we have made significant assumptions regarding cost of the insurance and internal services provided on behalf of such segments.

As we continue to review additional facts which enhance our ability to a portions sub coast, we may modify these allocation and if we do, we will have any adjustments for our reporting periods disclosed.

Overall we are very pleased with the performance of our Personal Lines segment; the OneBeacon Personal Lines acquisition significantly enhanced our product capability in scale, while at the same time providing us with a more diversified product mix.

With the contribution of the Personal Lines business of OneBeacon our product lines are well balanced between commercial package, workers count, home owners, Commercial Auto and Personal Auto and a broad product offering is helping us offset some of these facts in the soft market.

And now I could take a few moments to discuss our investment results. In the third quarter 2010, our invested asset base, including cash and cash equivalents grew by 30.6% to $2.7 billion compared which includes $328 million of reciprocal invested assets, compared to $2.1 billion at year end.

Net of the cash paid by tower, one beacon increased our investment portfolio by about $375 million. We had a $131.6 million of operating cash flows through September 30th 2010 and we had realized appreciation applicable to Tower share holders form our fifth income portfolio increased by $81.5 million from year end.

In the third quarter, net investment income increased by 34.80% to $29.3 million as compared to $21.7 million for the same period same year. The tax equivalent investment deal that amortized cost decreased to 5.1% in September 30th 2010, compared to 5.6% at September 30th 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 third quarter.

We are continuing to evaluate alternative investment classes in order to enhance our investment income. Net realized investment gains were $1.7 million for the quarter end in September 30th 2010, compared to gains of $2.6 million in the same period last year.

The third quarter gains include other then temporarily impaired losses of $5 million, as compared to $19.5 million of such losses in the third quarter of 2009.

The duration of the fixed income portfolio was approximately 4.8 years. Our net money rate is now 3.5% which is tax equivalent yield and includes immunity bond investments. Net cash flows provided by operations were $72.4 million during the third quarter and a $131.6 million on a year-to-date basis.

Last quarter we announced our stock repurchase program and during the third quarter, we repurchased $36.7 million or a hot 1.7 million shares for an average price per share of $21.63. Since inception, 3.9 million shares of common stock were purchased and aggregate consideration of $83.9 million. This leaves a $16.1 million outstanding under our program.

In the third quarter, we also issued $150 million in par value of convertible senior notes. These notes have a coupon rate of 5% and mature in 2014. And currently with a note issuance, we also entered into a hedging transaction which had the effect of increasing the strike price of the common stock to $33.42 before our shareholders experience any dilution. The after-tax cost for this capital was 5.3%. And during the third quarter, we increased our quarterly stock dividend to $0.125 a share from $0.07 a share.

We remain very active on our capital management strategy in order to ensure that we are investing in the best opportunities for returns to our shareholders, that we believe this is the best approach to capital management. As a result of share repurchases, we now have 41.5 million shares outstanding in September 30, 2010, down from 45 million shares outstanding at March 31st 2010.

Now, I'd like to turn to our earnings outlook for the fourth quarter and the full-year 2010.

We continued to implement our business plan and anticipate our earnings and return on equity to gradually increase in the fourth quarter of 2010 and into 2011. However, we continue to evaluate the low interest rate requirement and potential impact on our future operating performance.

Tower expects fourth quarter 2010 operating earnings per share to be in a range of $0.84 to $0.89 which reflects the deployment of the $375 million in net cash from OneBeacon to longer term investment at the beginning of the third quarter.

With that I'd like to turn the floor over to the operator for questions. And, Mary, if you could please open the lines for questions?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And our first question comes from the line of Bijan Moazami from FBR Capital Markets.

Bijan Moazami - FBR Capital Markets

Good morning, everyone. It's Bijan.

Michael Lee

Hi, Good morning, Bijan.

Bill Hitselberger

Morning.

Bijan Moazami - FBR Capital Markets

Good morning. You guys have owned the OneBeacon Company for about four months now. Could you talk about the problems that you've been facing in those four months and what you've done to really turn it around that entity?

Michael Lee

We evaluated this acquisition very carefully and before we closed on this transaction, we developed the business plan. So, going into -- when we closed, we're very prepared with a detail business plan and we executed on that business plan. And after we closed, we didn't see too many surprises. Some of the things that we did was consistent with our business plan. The first thing we did was to non-renew some of the business that we felt would give providers with some challenges from CAT manage -- catastrophe management standpoint so non-renew some business in Rhode Island and some parts of Massachusetts. So we could that we also downsize somewhat not much but we reduced the expense ratio and we maintained a very strong and capable staffing lot well but we also felt that we need to right size that operation which we did. And we also strong up the personal auto business and some of the business earned profitable so what we did was we changed in this next time when we favored homeowners' business but want to have to the personal auto business.

So by virtue of changing the business mix, we improved the results and in addition to that, we are getting off to main frame system that OneBeacon operated with and we begun to develop our own system and we think that by July 1 of next year we'll probably complete that development and may be I'll take a little longer to get off that system but we think that we could operate much more efficiently with these new systems.

So in summary, what we did was what we generally do with acquisition; we reduce the expense ratio, we underwrite the book of business and we try to – we position it in a way that would achieve the results where we're seeking. Going forward, what we want to do is use the reciprocal structure more, we're doing a lot of things to expand a licensing of the reciprocals throughout the Northeast to enable us to write more business through the reciprocal, exchanges that will increase our fee income and we think that that's going to be critical to be able to generate the type of returns that we're seeking from this business.

So we had all these in mind when we signed the agreement with OneBeacon and we successfully executed based on that plan. So no surprises during the third quarter.

Bijan Moazami - FBR Capital Markets

Thanks. You guys also got about 3%, 3.7% rate increase in personal lines, it appears it is somewhat less and some of your competitors. Would that mean that you're start growing organically in that line as well?

Michael Lee

I think what we want to do is to get the business mix and again that way that would reduce the overall combined ratio but we're undertaking some rate action on the auto business. So I'm not sure – I think the overall weight is indicative of the total rate increase, our overall book of business but in certain segments of our business we did increase the premium significantly but given the reciprocal structure, we're not operating with the same profitability standards as we operate on them with the stock company. So I think we're pretty satisfied with the results that we're seeing in the reciprocal insurance exchanges. So our results reflect our consolidated basis what we are experiencing under the reciprocal exchanges as well as stock company. So, that may probably have the result of us not taking decisive action that we would if we were operating within the stock insurance company setting. So, I think we are happy with what we are seeing in the reciprocal insurance exchanges but we will also taken decisive action in the business that we writ through the stock insurance companies.

Bijan Moazami - FBR Capital Markets

Great, last question for Bill how much cash you guys had at the parent company and if you could refresh my memory in terms of how much unutilized line of credit do you have right now after payments of the convertible.

Bill Hitselberger

Sure Bijan, we have roughly between 70 to $80 million liquidity of holding company right now and that excludes any assets that bank facility. The bank facility now is completely untouched in the $125 million in capacity there. So, in terms of aggregate assets to liquidity to homing companies are looking at probably access to close to $200 million of liquid capital.

Bijan Moazami - FBR Capital Markets

Thank you.

Operator

Thank you. Our next question comes from the line of Beth Malone from Wunderlich.

Beth Malone - Wunderlich

Hey thank you, good morning. Congratulations on the quarter. On the reciprocals and maybe I missed this but they do generate a higher combined ratio and you are consolidating them. Are we supposed to assume that combined ratios for the consolidated business or just the personal lines remain at an elevated level going forward?

Bill Hitselberger

What happened and you will see we are following our 10Q later today. We tried this by gap the results of the reciprocals in our segment disclosures even in the press release if we do more wholesome job of it.

But the reciprocals, given their size increased the consolidated combined ratio by a status point in the third quarter and so as we go forward with that we are going to have to address that in terms of disclosure around. If the reciprocals as Michael mentioned it's a business that the concentration of it in auto and the fact that we are generating fee income from it. We expect to run that at a higher combined ratio in our stock compensation.

Beth Malone - Wunderlich

Okay and then just in general from Michael as we look back five years the combined ratio is the growth rates, the return on equity for Tower Group are meaningfully different then what you all are generating today and during that time, has the strategy or the expectations for Tower changed during that time?

Bill Hitselberger

I could only talk about Tower and I will limit my discuss and talk about Tower's results. I think you have to understand, when we went public we operated with a different business model. Mainly our capitalization was much slower. When we are in public I believe our shareholders equity is only about 150 million or so and when we did the transaction with CastlePoint our shareholders equity was 330 million. Currently our shareholders equity is about 1.1 billion. So you're talking about significantly different capital sizes during those three periods that I have mentioned and in order for us to generate the type of return on equity that we saw earlier in our history, when we went public, we would obviously have to -- we would have to leverage that capital much more as we did before.

So I think return on equity is a reflection of the total premiums written and produced relative to our capital and given our significantly higher level of capital, you would expect a lower return on equity. That's fine because we were generating a return on equity well in excess of 20% and obviously our valuation reflected that type of leverage and return on equity and we generated a return on equity well in excess of 20%. I think we are capable of generating those types of returns but in order to do so we would have to reduce our capital and our total premiums written and managed relative to our capital has to look like what it did before and quite frankly, we don't want to go back to where we were. We were happy with how we conducted our business then and we're happy with how we're conducting our business now with a large amount of capital, larger amount of capital base that we have.

So I think its just a maturation process that we're going through and we're more focused on now returning about 13% to 15% return on equity and we're quite comfortable with that and with that I think we'll have the market determine the valuation multiples that should be according to our company generating those types of returns but just to reiterate, I think that strategy that we had in place when we went public worked for us and the strategy going forward with the lower return on equity will work for us and I think there is plenty of upside, given where we're trading, if we do achieve this type of return on equity that we're expecting to achieve. So under both situations I think we're capable of creating significant shareholders value for our shareholders and of course we're doing so with a much larger capital base than we did before.

Beth Malone - Wunderlich

Okay, and then when you talk about -- for additional acquisitions of MGAs and otherwise, is the intent to focus on building up more on the Personal lines side or on the Commercial side going forward or what is the -- or is that even the strategy? Are you just looking where the best deal might be in terms of pricing?

Bill Hitselberger

I think obviously we are -- our decision is going to be shaped by the opportunities that are presented to us but I think we're very focused on building our business model to achieve diversification and to expand into classes of business that we think are going to provide us the best return for our shareholders depending on the market conditions that we're seeing, so as far as our move to acquire OneBeacon Personal Lines Division, the rational behind that was to expand our personal lines capability and to expand into personal auto and to give us a platform that would enable us to build a more robust personal lines division.

So I think we're happy with the move that we made, we may continue to grow in the personal line segment, we think that, that's a growth area for us how ever, we're still looking at – to expand geotropically in various other part of the country, so we could focus on – we'll continue to be focused on acquiring small insurance companies that would enable us to expand territorially.

In addition to that, we're looking at acquiring MGAs or Managing General Agents or Program Underwriting Agent in order to get into more specialized classes of business. We feel that this strategy makes lot of sense and as indicated by our most recent acquisition of AequiCap, we're focused on making these acquisitions in order to improve our ability to get into certain segment of the business and to get into area that we feel are less venerable to pricing competition.

So just to summarize - I think, yes we are going to respond to the opportunity that we're seeing in the market place, but overall we're very much focused on building a diversified business model that will enable us to allocate our capital to profitable market segments, to be able to navigate successfully, through the different phases of the market cycle that's inherent in our industry.

Beth Malone - Wunderlich

Okay, last two questions. One is the pricing environment, you - obviously through more robust in the personal lines, but in the commercial, you were able to get some positive prices, not very significant and so what do you think the outlook is for 2011 that you're saying or what are expectations on pricing?

Michael Lee

I think that you have to understand that we didn't grow organically and that pretty much reflects our view of the market conditions, I think we are focusing on reacting to what is other wise a challenging market environment.

So despite what we have recorded in terms of maintaining pricing integrity, the market is pretty – is very soft and its very challenging, so in order to maintain our pricing integrity we have to avoid doing business in market segments where its competitive.

So I don't think our results have reflected of what's going on in the market place as much as our own effort to avoid the price competition that we're seeing in various parts of the industry where the pricing is fairly challenging.

So I think what we expect with 2011 is that the pricing environment will continue to be challenging yet we think that we can successfully navigate and respond to – successfully navigate through those challenges by limiting our organic growth, maintaining our pricing integrity and then looking to consolidate profitable renewal books of business that allows us to achieve the level of growth that we're seeking without sacrificing the pricing integrity that's currently inherited in our book of business. So, my expectation is that the pricing environment will continue to be challenging. But we think that we have a formula and a strategy that is working well, that is to consolidate the renewal business and to avoid competing in very end-markets where the pricing is challenging.

Beth Malone - Wunderlich

And then, one last question on the opportunities for acquisition. What's going to be -- what do you think will be the motivation for these MGAs or smaller companies, to consolidate? Is it the pricing pressure they anticipate or the low returns on capital?

Michael Lee

I think what they're facing is generally what everyone is facing except to have the resources and the business model, diversified business model to counteract those challenges. I think, most small companies, have limited product offering and they have assistance of challenges and what we're seeing is that because of these challenges, they have come to the conclusion that they really can't overcome these challenges in this current market place. So, they're continuing to be motivated by just recognition that the environment's not going to include and these limitations will continue to exist there.

And as a result of that, I think it makes a lot of strategic sense for them to exit and get premium above where they're currently trading at their public company or premium above what their current valuation level seem to indicate, based on the fundamentals that they're producing, the operating results that they're producing.

So, I think, given the recognition of those limitations, there is a lot of motivation on the part of small insurance companies and managing general agents, agencies to want to exit and to do so, gracefully, by selling to other companies like us. So, I think, we're going to continue to see fairly robust pipeline of acquisitions, let me contrast that with all the companies that are focusing not in this space, but in acquiring much larger companies. I don't think you're seeing that kind of activity amongst larger companies.

I think the opportunities are in our sweet spot which is the market occupied by small insurance companies and MGAs and as long as that continue and as long as the market continues to behave in the way that it has been behaving, we think that we have a very good strategy to counteract the challenging market conditions by continuing to consolidate this particular space and as long as we can do that, I think, we will continue to produce very good results.

Beth Malone - Wunderlich

Okay, thank you.

Michael Lee

Welcome.

Operator

Thank you. Our next question comes from the line of Mike Grasher from Piper Jaffray.

Mike Grasher - Piper Jaffray

Hi, good morning everyone. A couple of follow-ups here. Just in terms of the pricing environment. On the commercial side, where's the competition or what type of competition are you seeing that the standard players that are coming into your programs?

Michael Lee

I think we divide although we operate in three segments, the Commercial, Personal and Insurance Services. We generally look at the market in three areas. The general commercial, the specialty commercial and personal. I think there are some barriers to answering the personal lines area. So we're seeing a different dynamics here in terms of competition especially in the homeowner's area, so I think we're somewhat insulated especially in the Northeast in that segment. So we're seeing pricing integrity. If you go general commercial, that's where – of the problem reside.

The barrier change is quite low. We're seeing lot of drive – mutual insurance companies, regional companies, major stock companies really focusing on that segment. Because obviously the product knowledge is there and most companies are able to penetrate in this so the main street, low-hazard type of commercial lines area. And then you're seeing specialty space where specialize underwriting expertise let's say continuing that space somewhat insulates other carriers from entering that particular space.

So our strategy is to use our scale, use our automation to focus on small, writing small policy in the general, commercial area while developing capabilities in specialize class of the business and we're doing that by acquiring MGA as well as working with other MGA to penetrate that particular space. In addition, we're working with retail and wholesale agents and customizing products for them and that's working out very well. It's more a (inaudible) and strategy areas opposed to playing our products into the marketplace and hoping that there's some attraction. What we're doing is talking to our producers, larger producers and developing products that we feel that they need in order to minimize producing products that may not have the attraction in the marketplace.

So we feel very comfortable with the strategies that we are utilizing to respond to challenging market conditions but to answer your question, we're seeing most competition in the general commercial area.

Mike Grasher - Piper Jaffray

Okay. And on the – I guess the utilization of the receptacle like when you speak to the change or potential leverage there in driving the income higher perhaps driving or at least hire along with it?

Michael Lee

That's a very good question and I think we cover this during the earnings call but our total premiums written and managed relative to a capital increase from 1.2 last quarter to about 1.6. So we're going to write about 1.2 to 1.3 using our own capital or within our own insurance companies and then generally that additional volume using the balance sheet of re-insurers as well as other insurance companies specifically the reciprocals that we manage and our target is between 1.6 to 2 and as we do that we are going to generate additional fee income. That has before commented on the fact that we changed our business model, in the past we have written it as our premiums, total premiums written to written and managed relative to our capital that is as high as 2.5 or even higher that.

I don't think we will see us go to that extend lever the increase or lever to that extend but I think we are comfortable generating fee income and increasing our total premium, and our total premiums written and slow into our capital between 1.6 to 2. So, we have little more room to go and our plan is to write down our business especially the Personal Lines business and reciprocals to generate additional fee income and as I commented before we were doing by expanding the licensing and putting placing more of our Personal Lines business utilizing the reciprocals structure and as we do that we will see a gradual increase in our fee income and that should have a positive effect on our return on equity.

Mike Grasher - Piper Jaffray

Okay that's very helpful. Thanks very much. Congratulations on the quarter.

Bill Hitselberger

Thank you.

Operator

Our next question comes from the line of Adam Klauber from Macquarie.

Adam Klauber - Macquarie

Good morning. Thank you. Can you grab in and get OneBeacon under the belt, it looks like the Personal Lines combined ratio is very profitable, it came in at 87%. The expense ratio is down to 29.5%. In the past, you have mentioned the potential to get OneBeacon's expense ratio down even further.

Could you talk about that and what type of time frame are you thinking about?

Bill Hitselberger

I think the challenge for us on that Adam is you are right we want to get expense ratio in the Personal Line down and keep it down below 30. The biggest issue we have now is integrating and moving our systems over and getting off the main frame. Right now we have a service agreement that we have with OneBeacon where they provide us access to their mainframe system. So, our objective, our one of our core objective in the organization is to transfer reliant on that system which is obviously the mainframe is an expensive system to transfer that knowledge base into a server environment.

We expect that to occur in 2011 and we expect that this one set occurs we will see significant savings in the amount of resources that we are spending on technology. We think that's the biggest driver in reducing our expense ratio in the personal lines business.

Michael Lee

I also want to just add to Bill said and point out that the allocation of expenses between commercial and personal was somewhat I guess not a accurate or not as refined as we would have liked to add back. In the third quarter I think we need to take a look at the allocation and take a look at how we can specifically allocate the expenses directly to the two segments in a more precise manner and when we do that I think you will see the commercial line segment expense ratio go down and the Personal Line segment going up slightly.

So what you saw this quarter was a attempt for us to allocate the expenses, overall expenses relative to using our premium volume as the metric. As we allocate specific expenses in the fourth quarter and in the future I think the expense ratio will be adjusted in the manned that reflects the more precise allocation of expenses.

So having said that, I think because of some of the initiatives that we currently have to reduce the systems costs associated with operating the new OneBeacon business that in the near future you could anticipate us being able to produce the overall expense ratio in the future, even further than you have seen in the third quarter.

Adam Klauber - Macquarie

Great, that's something good to look forward to. On the -- I think you mentioned there is roughly four points of stable reserve development in the Personal Lines for the quarter. Where did that come from and can we see that in the future you think?

Bill Hitselberger

Well I think what we saw was both home owners and personal auto shared favorable development. Obviously it's a stacked developing line of business, both of those lines of business. How do you set that? I think the -- what we saw at least in home owners was a pretty benign quarter. We traditionally expect to see that. Again our book is not a wind exposed book. We primarily are in the North East. So we expect the third quarter to be pretty good. We actually expect the fourth quarter to be pretty good as well. I think we traditionally see exposures occurring for us on the home owners side in the first quarter. So we continue to believe our reserves are very good. We continue -- we took a conservative stance when we booked the reserves on from the OneBeacon acquisition. So we continue to believe that the reserves will develop and traditionally they have. I think when we look at our reserve development; there is two elements to it. We have -- we book a risk premium that's associated with the acquisitions and that risk premium amortizes -- it's an accounting requirement. That was about 20% to 25% and the favorable development was just simple amortization of that risk premium. So that is one thing that we also see and I guess clearly we would expect the risk premium to continue the trend in this favorable development in the future from the acquisitions.

Adam Klauber - Macquarie

So will that run off? Is that a 12 - 18 months or is that --that risk premium would take a bit longer?

Bill Hitselberger

It's a good question Adam. I say that 90% of it will run off in 12 to 18 months and then the remaining 10 runs in. It technically matches up against the payout side of the reserves, given the acquisitions that we've made so far in relatively short tail lines of business; you would expect to run off back to being a relatively short tail line for -- short tail as well.

Michael Lee

Just to add to what Bill said, I don't see us generating favorable development. I think the fact that we put up reserves for Personal Line and this is a short tail business. We have to add to it when we have favorable results in the third quarter. But overall I think our position is that we need to increase our loss ratio uptake, going forward we did that in the forth quarter, we're happy with that decision.

So given the kind of challenging environment that we're facing, I think we have biased towards maintaining fairly conservative reserved position, so I think we're more focused on making sure that we have the right resources going forward it just happens – this quarter based on how we quoted the reserves for OneBeacon and how the quarter turned out that we had this reserve release.

But I think going forward, you can anticipate us maintaining a fairly conservative view of a reserve position and anything, we'll be looking to maintain that conservative rhythmic and we feel that, that's a more prudent approach to take with reserving for that region.

I wouldn't anticipate any favorable reserve development in the future.

Adam Klauber - Macquarie

Great, that's all. Thank you, quiet a great quarter, thanks a lot.

Operator

Thank you our next question is a follow up from Beth Malone of Wunderlich Securities.

Beth Malone - Wunderlich Securities

Okay, thank you. On the expenses or the – on the conversion of the computer systems from one beacon are there other systems through all these acquisitions? Are there other areas where you can see an improvements or a streamlining of the technology to improve the bottom line expense results?

Michael Lee

Yes we picked up on something that we're trying to work internally, we have a – we're spending on an awful lot of money to consolidate all the systems and that's truly causing us to spend a lot of money and – which is impacting our expense ratio.

As we get off these systems I think we will have more efficient company, we should have an expense structure that is probably much better given our greater scale. Unfortunately, we have not recognized that immediate savings and that's because we're committed to build a state of the art system and to get off these various systems that we have inherited, that's going very well.

I think the technology today allow us to do that, we spend the last two years building out a platform and we've settled in on selecting a vendor that we feel very comfortable with and as a result of that I think, the patience which we would get off these legacy systems and then to convert that into our new system will be accelerated and the first focus now is to get off the mainframe environment that we operate in and in that which we have inherited from the OneBeacon transactions.

And there after I think we'll see us making progress and getting off other systems as well and when that occurs, we will see the kind of expense savings that we anticipated.

But for now we're committed to spend the money and to make sure that we have their system in place that would give us a competitive advantage and that would help us to generate greater efficiency.

Beth Malone - Wunderlich Securities

Okay. Well, thank you.

Michael Lee

You're welcome.

Operator

Thank you. I see no further questions in the queue. I would like to turn the conference back to Michael Lee for closing comments.

Michael Lee

Thank you, operator. We were very pleased with our strong operating results this quarter and the positive trends that we're seeing in our business. I would like to thank all of you for participating on this call and look forward to speaking with you again next quarter. Thank you.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may now disconnect at this time.

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 www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

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

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 www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

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