Tower Group's CEO Discusses Q4 2010 Results - Earnings Call Transcript

Mar. 1.11 | About: Tower Group, (TWGP)

Tower Group (NASDAQ:TWGP)

Q4 2010 Earnings Call

March 01, 2011 8:30 am ET


William Hitselberger - Chief Financial Officer and Senior Vice President

Michael Lee - Chairman, Chief Executive Officer, President and Chairman of Executive Committee


Michael Grasher - Piper Jaffray Companies

Elizabeth Malone - Wunderlich Securities Inc.

Bijan Moazami - FBR Capital Markets & Co.


Good day, ladies and gentlemen, and welcome to the Tower Group Fourth Quarter and Year End 2010 Earnings Call. [Operator Instructions] I would now like to turn the conference over to Bill Hitselberger, Senior Vice President and CFO.

William Hitselberger

Thank you very much, and 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's President and CEO, Michael Lee, I would remind you that some of the statements that will be made during this call will be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those projected in these forward-looking statements.

For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with 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 of Tower's website.

Now 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 fourth quarter operating results. 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 and our business strategies. 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.

During the last several quarters, we 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 deployed the capital that we acquired from CastlePoint, especially after the closing of the OneBeacon acquisition. Consistent with this expectation, we're pleased that we were able to expand on our business in the third quarter and achieve a significant improvement to our overall operating results in the fourth quarter.

Our net income and diluted earnings per share were $38.5 million and $0.92 per diluted share, respectively, during the fourth quarter of 2010, compared to $30.7 million or $0.72 per diluted share in the fourth quarter of 2009. Our operating income, which excludes realized capital gains on investments, transaction-related expenses and the operating results of the reciprocal insurance companies that we manage, was $35.2 million or $0.84 per diluted share, compared with $31.9 million or $0.74 per diluted share during the same period last year.

Our annualized operating return on shareholders' equity improved to 13.1% in the fourth quarter as compared to 12.9% in the fourth quarter of 2009. Our year end 2010 book value per share of $26.22 represents an increase of 12.3% from year end 2009.

The strong fourth quarter results were primarily driven by the significant increase in our Personal Lines business, resulting from the acquisition at the beginning of the third quarter of the OneBeacon Personal Lines division and our continued expansion into Specialty Commercial business.

Our total premiums increased by 32.6% to $433.9 million in the fourth quarter from $327.3 million during the same period last year. We also continue to maintain underwriting and cost discipline as demonstrated by the 91.7% combined ratio for the fourth quarter, consisting of a loss ratio of 59.9% and an expense ratio of 31.8%, excluding the results of the reciprocal insurance exchanges that we now manage and are consolidated with our overall financial results. Our combined ratio for the quarter was 91.9%.

For the full year, our gross premiums written and managed by our insurance company subsidiaries rose 38% to $1.5 billion in 2010, up from $1.1 billion in 2009, with a 2010 combined ratio of 93.7%. Our operating income for the year was $111.2 million or $2.55 per diluted share based on 43.6 million outstanding shares in 2010, compared with $119.8 million or $3.03 per diluted share based on 39.6 million outstanding shares in 2009. Our operating income for the fourth quarter and full year 2009 included a bargain purchase gain of $13.2 million or $0.31 per diluted share from our acquisition of Specialty Underwriters' Alliance, and our 2010 operating income included after-tax catastrophe storm losses of $12.0 million or $0.27 per diluted share.

During 2010, we increased stockholders' equity from $1.05 billion at year end 2009 to $1.09 billion at year end 2010 after stock repurchases that totaled $88 million, and we drove book value per share from $23.35 to $26.60 over the same period.

Finally, our operating return on equity decreased from 15.2% in 2009 to 10.3% in 2010, primarily due to the significant increase in equity that resulted from our acquisitions of CastlePoint and SUA in 2009.

Consistent with what we have been seeing for the last few years and throughout 2010, the market conditions in our industry continue to remain soft. However, we're responding well to these challenges by continuing to consolidate business through acquisitions. During the fourth quarter, we generate an additional $95.4 million in direct premiums written from the OneBeacon Personal Lines division and $9.9 million in additional fee income from managing OneBeacon Personal Lines division’s reciprocal insurance companies. We have been able to achieve the desired mix of homeowners, personal auto and personal package policies that we had targeted prior to the acquisition of this business.

Consistent with our plan, we have also reduced our policies in Massachusetts, Rhode Island to properly manage our catastrophe exposure. We are also making very good progress in replacing the OneBeacon Personal Lines system that we're currently using to process this business, but we anticipate that the conversion will take us a little more time than originally projected.

In addition to the OneBeacon Personal Lines acquisition, we also acquired, in November 2010, the renewal rights to the commercial auto liability and physical damage business of AequiCap Program Administrators and its affiliate, TransPro Solutions, based in Florida. The business subject to the agreement covers both trucking and taxi risks that are consistent with our strategy to expand into specialty classes of business.

The trucking component consists primarily of owner-operator and smaller fleet business written in four states with Florida constituting in excess of 90% of the premium volume. The taxi component covers both owner-operator and fleet risks written in seventeen 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 business to Tower. In addition, a majority of the AequiCap employees involved in producing and servicing this commercial auto business have become employees of Tower. With this acquisition, we established another business unit that will focus on expanding our capabilities in the transportation industry.

In January 2011, we also acquired the renewal rights to the middle market commercial package and commercial auto business underwritten through NAV PAC division of Navigators Group. This transaction, which does not include NAV PAC Global or Life Sciences products, is expected to contribute $25 million in gross premiums written on an annualized basis. More importantly, this acquisition will allow us to continue to expand into certain niche classes of business, and the underwriting team that we have acquired in connection with this transaction will become part of our recently formed Customized Solutions business unit, which I will discuss later.

We will continue to seek acquisitions but now also expect to include strategic investments and joint ventures as added business tools to achieve growth. We're currently working on making strategic investments in distribution sources, both to accelerate our expansion into specialty classes of business that are less vulnerable to pricing competition and to better align our interest with the agents that we acquire by requiring them to retain risks in the business that they distribute through agents captives.

In addition to growing through acquisitions and strategic investments, we're also responding to competitive market pressures by improving our ability to generate organic growth by expanding into specialized classes of business and customizing our products for our key producers. In the fourth quarter, we began to shift our focus beyond the main street general classes of business, such as apartment buildings, contractors and restaurants, to concentrate instead on more specialized business classes that are less vulnerable to pricing competition.

In 2010, we expanded into professional employers, organizations, public entities, transportation, commercial construction and auto dealerships. We also started to differentiate Tower from competitors by customizing products for some of our largest producers. During the year, we formed a Customized Solutions business unit dedicated to working with some of the largest retail and wholesale agents throughout the country to customize product offerings for the precise needs of their customers.

Rather than pushing our existing products to these producers, we are setting ourselves apart from our competitors by gaining a thorough understanding of producers’ business needs and jointly developing products that will enhance their competitive position in the marketplace. In the coming months, we also plan to grow our business organically by establishing joint ventures with managing general agents and other underwriting organizations to expand our product offerings into specialty niche markets.

In order to respond quickly to the changes in the marketplace and improve our ability to generate organic growth, we also took decisive steps in 2010 to begin reorganizing our business into smaller, more nimble and more entrepreneurial business units. These business units will be headed by business leaders who will be accountable for all aspects of product delivery to the customers in their respective target markets.

In 2011, for the reasons that I mentioned on this call, we expect our core business from growth and underwriting profitability standpoint to remain very strong. However, we believe our earnings will be affected by several factors, most of which will result in one-time adjustments in 2011. We expect our earnings in 2011 to be negatively impacted as a result of a continuing decline in the yield on our investment portfolio. In addition, to mitigate the risks to our balance sheet resulting from potentially inadequate pricing of our risks, we will continue to use a slightly more conservative loss pick for 2011.

We also expect the earnings to be reduced as a result of the changes in the accounting for deferred acquisition costs. Finally, we plan to make significant investment in 2011 to upgrade and expand our information technology platform. While these actions will have the long-term benefit of improving our capability to generate organic growth, we expect to see slight increase in our expense ratio as we implement these changes in 2011. As we adjust to these changes, we anticipate that our earnings and our ROE will gradually increase close to our target ROE of 13% to 15% in 2012. Later on this call, Bill will provide more details on the 2011 earnings guidance, which reflects these developments.

Despite the various external factors that affect our business, we will continue to navigate through these market challenges by implementing the business strategies that we have successfully developed and utilized over the last few years. In summary, we continue to make acquisitions and strategic investments in distribution sources to broaden our product offerings and expand our geographical footprint. We will seek to achieve organic growth by continuing to diversify and expand our business platform and allocate capital to profitable market segments by specializing in select niche markets and by customizing our product offerings to meet the needs of our agents, who right-size our capital through share repurchases and increased dividend payments and increase our ROE by utilizing our hybrid business model to generate commission and fee income.

Finally, we will make significant investments in our systems and technology to improve our ability to deliver new products and efficiently develop our products and services.

I will now turn the call over to Bill to review our financial highlights for the fourth quarter and the full year results, as well as provide our guidance for 2011.

William Hitselberger

Thank you, Michael, and good morning, again, everyone. I will cover some of the financial highlights for the fourth quarter, followed by Tower's earnings outlook for 2011.

In the fourth quarter, our combined ratio was 91.7%, and our operating earnings per share was $0.84 for the quarter. While we increased our total premiums by 32.6% over last year's fourth quarter to $433.9 million, most of the premium increase was the result of our acquisition of OneBeacon in July, which accounted for $95 million of fourth quarter premiums, and to a lesser extent, the 2009 SUA acquisition, which closed in November 2009. Excluding these transactions, we would have experienced modest organic growth in fourth quarter 2010. For the quarter, consolidated revenues increased by 54.6% to $419.8 million. I'd now like to provide additional details on the operating results of our segments.

For the Commercial segment, we saw a 2.8% increase in gross premiums written and a 69.8% increase in net premiums written compared to the same period in 2009 as we continue to maintain the pricing and underwriting discipline that resulted in declining premium volume in competitive market segments. Most of the growth in the Commercial segment was due to the SUA acquisition. Our underwriting discipline is reflected in our premium change on renewals, as well as the heightened [ph] rate on renewal policies.

During the quarter, our premium change on renewals, excluding program business, increased by 1%. The strength of our core business continues to be reflected in the renewal retention rate, which ran at traditional levels and, for the quarter, was 78%. The strong renewal retention, particularly for small policies, continued to offset the challenging market environment for new business. The net combined ratio in our Commercial segment was 94.7%, up 2.4 points from the year-ago quarter. Our loss ratio increased by 5.2 points, driven mainly by a decision to strengthen our Commercial segment reserves.

Our consolidated prior year development, excluding the reciprocal businesses, was favorable by $2.4 million for the year. Ceding commission revenue decreased for the fourth quarter by $11.3 million, compared to the same period in 2009. The decrease was a result of our decision to cede commercial liability premiums on an in-force and renewal basis, effective October 1, 2009, which increased the fourth quarter 2009 ceding commissions.

For Personal segment, gross written premiums were $156.5 million in the fourth quarter 2010, an increase of $98.9 million compared to the same period in 2009. The acquisition of OneBeacon accounted for $95.4 million of this increase, and the remaining increase was attributable to modest general growth in our Personal Lines business. Net premiums written in the fourth quarter increased to $114.9 million compared to $46.6 million for the same period in the prior year.

Ceding commission revenue increased to $4.3 million in the fourth quarter 2010, up from $0.7 million in the prior year as a result of the homeowners' quota share treaty that we put in place concurrent with the OneBeacon Personal Lines acquisition. Policy billing fees were $1.9 million in the fourth quarter 2010, an increase of $1.7 million in the same period a year ago. This increase was a result of the OneBeacon Personal Lines acquisition.

The pricing on renewal business in our Personal Lines was up 5.2% over the year-ago quarter, and the retention rate was 83%. The net combined ratio in the fourth quarter for the Personal Lines segment was 86.4%, compared to a 107.4% in the fourth quarter of 2009. The lower combined ratio in this segment is a function of lower expense and loss ratios.

The net expense ratio improved to 38.3% in this quarter, compared to 41.8% in fourth quarter 2009. The net expense ratio, excluding the reciprocals, which we manage, was 41.4%, and the expense ratio on the reciprocals exchanges was 32.9%. The lower reciprocal expense ratio is the result of business earned in the quarter reflecting amortization of VOBA, and we expect a reciprocal expense ratio to increase going forward.

In addition, our Personal Lines net loss ratio declined to 48.1%, compared to 65.6% during the same period last year. The loss ratio in fourth quarter 2010 reflects better-than-anticipated homeowners results in the quarter, as well as better-than-expected prior year development on the Personal Lines business, including the Personal Automobile business acquired from OneBeacon. Aggregate favorable development recorded in the quarter for the segment, excluding the reciprocal business, was $15.2 million.

Overall, we are very pleased with the performance of our Personal Lines segment. The OneBeacon Personal Lines acquisition significantly enhanced our product capability and 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' comp, homeowners, commercial auto and personal auto. And our broad product offering is helping us offset some of the effects of the soft market.

I'd now like to take a few moments to discuss our investment results. In fourth quarter 2010, our invested asset base, including cash and cash equivalents, was $2.6 billion, compared to $2.1 billion at year end. We had $170 million of operating cash flows in 2010 and the unrealized depreciation, applicable to Tower shareholders from our fixed income portfolio, increased by $12.2 million from year end.

In the fourth quarter, net investment income increased by 40.2% to $29.7 million as compared to $21.2 million for the same period last year. The tax equivalent investment yield in amortized cost decreased to 4.7% as of December 31, 2010, compared to 5.5% at year end 2009.

We continue to see a very low yield environment with non-treasury asset classes returning to overall spread tightening in the fourth quarter. In response to this environment, we have implemented a strategy to purchase dividend paying common stocks during the fourth quarter to enhance investment income. At year end, we held $52 million in common stocks. We also continued to purchase corporate floating rate securities during the fourth quarter as a hedge against rising interest rates.

We are continuing to evaluate alternative investment classes to further enhance our investment income. Net realized investment gains were $5.9 million in the fourth quarter 2010, compared to a loss of $824,000 in the same period last year. Gains were generated in the fourth quarter as we rotated a portion of our bond holdings to common stock. The fourth quarter gains included other-than-temporary impairment losses of $376,000, as compared to $4.4 million of such losses in the fourth quarter of 2009. Duration of our fixed income portfolio was approximately five years. We believe our new money rate is now 4%, which is a tax equivalent yield and includes a tax benefit from municipal bond investments.

I previously mentioned our net-net cash flow provided by operations was $38.4 million during the fourth quarter and $170 million year-to-date. During the fourth quarter, we repurchased $4.2 million or 161,000 shares of our common stock at an average price per share of $25.84. Since the inception of the buyback program in the first quarter of this year, 4 million shares of Tower common stock were purchased in an aggregate consideration of $88 million for average costs of $21.78 per share. This leaves $12 million outstanding in availability under the 2010 program.

We continue to be very active on our capital managing strategy in order to ensure that we are investing in the best opportunities for returns to our shareholders, as we believe this is the best approach to capital management. As a result of share repurchases, we now have 41.5 million shares outstanding at December 31, 2010, down from 45 million shares outstanding at year end 2009. As we have disclosed since our first quarter release, the FASB has been discussing new guidance concerning the accounting for costs associated with acquiring or renewing insurance contracts.

They issued final guidance in October 2010 that generally follows the model used for loan origination costs. Under the new guidance, only direct incremental costs associated with successful insurance contract acquisitions or renewals would be deferrable. The guidance also states that advertising costs and indirect costs should be expensed as incurred. This guidance will be effective for fiscal years beginning after December 15, 2011, with earlier adoption permitted as of the first day of the company's fiscal year.

We expect to early adopt this guidance on January 1, 2011, to believe that the reduction to deferred acquisition costs will range from $71 million to $75 million, and reduction to stockholders' equity will range from $46.2 million to $48.8 million or $1.12 to $1.18 per share.

Now I’ll turn to our earnings outlook for 2011. We continue to be very confident about the performance of our core business and expect that we will continue to generate profitable growth in 2011 as a result of additional premium volume from OneBeacon Personal Lines business and expansion into specialty classes of business. As Michael mentioned during his portion of the call, we expect our 2011 operating results will be affected by the lower yield on our investment portfolio, by a slightly higher loss ratio pick reflecting the competitive pricing environment and a higher expense ratio due to the delay in replacing OneBeacon's Personal Lines system, as well as other systems-related initiatives. We believe our expense ratio will be lower in 2012, as we complete these system-related initiatives. We also expect that in 2011, our expenses will be increased by a change in accounting for deferred acquisition costs as we do expect to see growth in our unearned premium balances for year end 2011.

Taking these factors into account, we expect our 2011 operating earnings per share to be in a range of $2.70 to $2.90. As we adjust to the changes, which we believe to be temporary in nature, we expect to see our ROE return to our long-term goal of 13% to 15% in 2012. Consistent with our earnings patterns in 2010, we expect our earnings will be lower in the first quarter and then gradually increase, reflecting the seasonality of the business that we have experienced during the last few years.

That concludes our prepared remarks. I'll now turn the floor over to the operator for questions.

Question-and-Answer Session


[Operator Instructions] Our first question is from Beth Malone of Wunderlich Securities.

Elizabeth Malone - Wunderlich Securities Inc.

I have a couple of questions. First, related to the fourth quarter results, the expense -- this is just kind of an accounting issue I guess, but the expense ratios and the loss ratios by division were different slightly from third quarter to fourth quarter, and I was wondering is that because of a change of how you're recording this or is just -- was there weather-related in the fourth quarter that we didn't see in the third?

William Hitselberger

There's a couple of issues, Beth. Number one, you correctly point out, and one of the things that everybody will see is that when you look at the quarterly results for 2009 and 2010, you'll note that there's been some reallocation of costs, particularly for reinsurance between the segments. I think as we mentioned in our third quarter call, we were going to fine-tune the segment allocation, and we were able to accomplish that in the fourth quarter. I think what you also see in the fourth quarter is that on a net basis, we had year-to-date favorable loss experience of $2.4 million associated with prior years. That was actually tail of two different segments though, because we saw -- we did see very favorable and benign weather patterns for our company in the fourth quarter in our Personal Lines division. And we also saw favorable prior year development in the Personal Lines business, and we took an opportunity that we saw in the fourth quarter to strengthen some of the prior year Commercial Lines division. So what we did see was an uptick on the segment basis, an uptick in the loss ratio in the Commercial Lines segment and a down drift in the loss ratio in the Personal Lines business. And then some of the expense adjustments again were associated with us going through and fine-tuning the allocation of expenses between the two segments.

Elizabeth Malone - Wunderlich Securities Inc.

So are we to assume going forward in 2011 that the fluctuations diminish and then it's more quarterly stable?

William Hitselberger

Yes, exactly , Beth. The expense ratio should stabilize, as Michael mentioned and I think I affirmed as well, we expect to see a slight uptick in the expense ratios in 2011, resulting from really two things. Number one, the integration of the OneBeacon Personal Lines system moving from a mainframe to a server environment probably taking us a little bit longer than we expected. And number two and probably more importantly, the accounting change from DAC. We traditionally had benefited because we're a growing company. So on our balance sheet, we've taken some of the operating expenses associated with producing on our premiums, and they haven't run through our income statement when the premiums were produced. Now with the accounting change and with the exception of commissions and taxes, all of the traditional operating expenses that had a relationship with business production are now regarded as period expenses. So for us the growth that we're generating doesn't generate an offset to expenses, we'll continue to run those through the income statement. So those two factors should probably cause a slight uptick in the expense ratio in 2011.

Michael Lee

This is Michael, Beth. Just to add to what Bill said, we went to different segment reporting in July of this year. So just to answer your question, I think what you saw in the third and fourth quarter was our attempt to make sure that we allocate proper costs to those two segments. And now that we're done making those refinements, I think you'll see the segment reporting to be more consistent in 2011.

Elizabeth Malone - Wunderlich Securities Inc.

And then two questions on the guidance or on 2011 there, are we to assume that the DAC costs are evenly distributed throughout the four quarters or is it a one-time charge that we adjust in the first quarter?

William Hitselberger

What's going to happen is, you'll note that as the unearned premiums grow, what you would expect in the old model, the difference, the growth in our unearned premiums resulted in an expense benefit in our income statement. So I would suggest that the change is going to be pretty much ratable because we do see pretty much ratable growth in our unearned premiums. So I think that you'll expect to see that occurring pretty much evenly over the four quarters of 2011.

Michael Lee

Just to add to what Bill said, what it does is it doesn't allow us to defer expenses. So immediately starting on January 1, we're not going to be able to defer as much of the acquisition costs as we've been doing in prior years before this accounting change. But since the DAC is written down, we won't have the deferred acquisition from the prior period coming through. But as a company that has experienced significant growth, it does take time for us to catch up to this new accounting rule because, as a growth company, we're going to have more deferred acquisition costs than other companies because we're growing, and as a result, new business is going to be much higher than the renewal business that we're inheriting that were written in the prior periods. So therefore, as a growth company, we're not going to be able to defer a lot of that cost and what you're going to see in 2011 is the effect of that change coming through. Now it will take us a year to adjust to that, and 2012, we should be able to normalize that situation.

Elizabeth Malone - Wunderlich Securities Inc.

The cost of consolidating OneBeacon because of the mainframe adjustment, does that indicate that your assumptions about the profitability of that book are lower than what you originally anticipated because the cost of conversion is greater?

William Hitselberger

We’re very happy, Beth, with the transaction. I think, we haven't completed our analysis yet, but I think we pretty much recovered our purchase price within the first year. So by any metric, I think it's been a very successful transaction. We knew that it would be a challenge to get off their system and to replace it with our own system. And what we did this year is that we decided to slow things down and to look at our total information technology infrastructure, and we decided to rearrange the schedules for releasing some of these new developments, and what we did was to focus on other things that need immediate attention. And as a result we change the order of how we're going to release these developments, and what you're seeing is us delaying that project for about six months or so. The cost of the OneBeacon system is quite a bit. It's about -- between the stock companies, our companies and the reciprocal is about $23 million or so annually. So we're absorbing that cost. So once we get off that system, we should have much lower cost. So the transaction in the long term is going to be a lot more profitable as a result of our ability to get off this mainframe environment. So in retrospect, yes, I mean, we are going to take a little more time to get off the OneBeacon system. But in the long run, I think, we are lowering the cost of doing business, and as a result of that, we see much greater profitability of this business over the long term. But when we did our analysis, we only considered how long it would take for us to get our purchase price back, and it is probably going to take about a year. So from that standpoint, we're right on schedule as far as getting the returns that we were seeking.


Our next question is from Mike Grasher of Piper Jaffray.

Michael Grasher - Piper Jaffray Companies

Bill, just to clarify one more time here, let's follow up on this change in accounting on the deferred acquisition cost. First of all, it will not be one time, but it'll be throughout the year. And it sounds like it's running through the income statement more so than just sort of a charge to the balance sheet item of DAC and equity. Is that fair to say?

William Hitselberger

Yes, and actually, let me expand on it, Mike. Because it's somewhat -- there's two different aspects of it, okay? Number one, on our balance sheet today, we have about $71 million of deferred acquisition costs that relate to Tower internal costs to produce the unearned premium reserves that are on our balance sheet now. And as a reminder, we have about $870 million of unearned premium reserve on our balance sheet. So what will happen is those costs, which were originally deferred, those costs will be written off to shareholders' equity, okay? And then what happens is you get a tax benefit for that write-off, but the book value charge is about $42 million. So that's kind of phase one of it, and then phase two, and I think this is what we were trying to get across in our discussion, is that going forward, we will continue to be a growth company, again, we think that the underlying business current of our -- the underwriting results of our business are very good. So we expect to see unearned premiums grow. In the old accounting model, with that growth in unearned premiums, you would have lowered the amount of expenses that you would have on your income statement because a portion of those expenses would have been put on the balance sheet. And now what's going to happen in the new accounting model is those charges, instead of going on the balance sheet, will stay on our income statement. What's going to happen is that's going to create that charge this year in the 2011 plan that's different than I think people had anticipated.

Michael Grasher - Piper Jaffray Companies

So in phase one, we will see in 1Q's results a charge to book value somewhere around $42 million?

William Hitselberger

Right. And actually what will happen, Mike, is that gets changed effective on 1/1/2011. So basically what will happen is that will be reflected, when we issue our first quarter numbers, that will go through as an adjustment to book value, okay?

Michael Grasher - Piper Jaffray Companies

And then I guess in terms of the guidance that you've set, can you give us a little bit more detail in terms of your assumption for investment yield, your loss pick and then finally your share count?

William Hitselberger

Yes, let me handle the investments and the share count, and then I'll let Michael talk a little bit about the loss pick. With respect to investments, we believe the new money rate is 4%, and that would be if we stayed in a traditional fixed income environment. We're continuing to look at options. We entered into the common stock market in the fourth quarter to enhance investment yields because what we've been doing is buying dividend, paying common stocks. So on the margin, while that may not improve the net investment income yield, the after-tax yield will improve because we're getting the dividends received deduction on a lot of those stocks. So I mean, we expect, overall, to see a book yield in our portfolio somewhere between that 4.7% and 5% yield, that's kind of what we're locking in. And the way we're going to continue to get there, even in this challenging interest rate environment, is to be more aggressive in terms of looking at other asset classes. I think the company has historically been a fixed income investor, and that was a very good strategy for the company when it was smaller because our portfolio is growing from $600 million the end of 2008 to $2.6 billion at the end of 2010. So I think that we need to start looking at alternative asset classes as a way, number one, of diversifying our risk. And again, we've been very fortunate. Book value's growing as a result of the fixed-income strategy. But given where we see current interest rates, and I think given where we see the risks are with respect to changes in interest rates, we don't think there's a lot of upside left on the fixed-income side of the investment strategy. So we're looking at alternatives, and we think those alternatives will help us to fight the trend that we've seen in interest rates. With respect to share count, we are at 41.5 million shares outstanding at the end of 2009. We currently only have 12 million in availability under the 2010 stock buyback program, but I can tell you that we continue to look at share buybacks, certainly, opportunistically. We believe that if our stock trades below its book value, we regard that as a very significant buying opportunity. We're kind of capped right now at the 12 million, but I think if we saw any weakness in the stock, we would look to work with our board of directors to look at that as an investment opportunity. With that, I'll turn it over to Michael to talk a little bit about the loss ratio.

Michael Lee

Thanks, Bill. I think we're at a pivotal point in the market cycle, I think you saw this quarter -- I mean, this entire year, most companies have stopped releasing reserves from prior period. And I think for the most part, many companies are exercising caution and increasing their loss ratio pick for the current year. We started this in the fourth quarter of last year. Prior to the fourth quarter of last year, I believe our loss ratio was probably in the mid-50s to high 50s in terms of loss ratio. And we started to move the loss ratio pick above 60%, and we're probably looking at about 61% to 63%. And then, not that we're seeing anything that we're concerned about, we're just trying to be more prudent and by reserving -- I mean by selecting a more conservative loss pick, we think that we're being prudent, especially given the pricing environment. So just like most companies, I think what we're doing is making sure that we don't have any adverse development. So we're transitioning from, I guess, being more optimistic prior to the fourth quarter of 2009 to becoming more conservative in our approach to reserving. We have not had any adverse development, and we want to continue that streak. So what we're doing is we are proactively managing our book of business from an underwriting standpoint, as well as from a pricing standpoint, and that's why we're going to see probably about 1% or so higher loss pick for 2011. But let me tell you that we are still in the range of 88% to 92% combined ratio, which is what we try to write our business -- we try to write our business within that range. We're slightly above that range but still within that range, and as a result, we believe we're prudently managing our business, and we think that we will probably level off at about 92%, 93% combined ratio, and built into that number is a lot of conservatism, and I think we will be able to avoid any kind of risk to our the balance sheet. But let me just also point out, that we're running about 8% to 10% better on the combined ratio than the industry. So we continue to see very good results despite the fact that we're growing significantly. So in 2011, and we think that we will continue to grow profitably and maintain the underwriting and the pricing discipline that we've always were able to achieve in the past.

Michael Grasher - Piper Jaffray Companies

And just final question on your commentary around the strategic investments, the joint ventures, what has changed to sort of, I guess, change your angle or your strategy in going about it in this way as opposed to just doing the straight balance sheet acquisition?

Michael Lee

We think that -- well, first of all, there are less insurance -- I mean, a reduced number of insurance company that are available for sale. When we started to make acquisitions two and a half years ago, we drew up a list and about 80%, 85% of the companies on that list have been acquired. So we don't have many of these small companies available anymore, although we continue to see a strong pipeline, not publicly traded companies, but small insurance companies, and we will continue to look at those opportunities. But we think it makes a lot of sense to make strategic investments in our distribution sources, and we're looking at a couple of opportunities. And the reason that we like this type of opportunity rather than making straight acquisition is because we're able to get these distribution sources to shift their premium volume to us, and we could enhance our investments by providing a preferred instrument with a decent coupon. So it not only helps us to generate organic growth, but it also helps us to increase our investment yield. So we think that it makes a lot of sense given that we're in a low interest rate environment, and that we're also trying to not to write new business in a competitive market. So any strategy that we can develop that would help us to acquire existing books of business, either through acquisitions or strategic investments, we believe will help us to continue to generate profitable growth even in this competitive market environment.


[Operator Instructions] Our next question is from Bijan Moazami of FBR Capital Markets.

Bijan Moazami - FBR Capital Markets & Co.

I guess the first question is for Bill. I'm a little bit confused in terms of the way reciprocals are accounted. I know that the premium volume generated there is consolidated to Tower, but I'm not quite certain how the retention will play out going forward and what the ceding commission, if any is going to be back from the reciprocal? So could you just spend a little bit of time helping us understand that?

William Hitselberger

Sure, Bijan. The reciprocals, as you know, are units of -- or companies where the policyholders in essence own the equity rights of that business. Then Tower shareholders actually own first equity rights to that business through the surplus notes that fund the equity of that reciprocal business. What Tower shareholders get from that business is that we write premiums on behalf of the reciprocals, and the reciprocals pay us a commission, and that commission is recorded in our Insurance Services segment. And the reciprocals pay us 14% of written premiums as a service fee. In addition, Tower also manages claims for the reciprocals, and that's charged separately as part of the reciprocals LAE. But the profit to Tower shareholders really comes from the spread of us charging them 14% to source and originate the business for them and the cost to us to provide such business. So the way we account for it, Bijan, is on a segment basis. We show the revenues separately in our Insurance Services business. In consolidation, those revenues are eliminated and the way the revenues are eliminated is our expenses are reduced. So the benefit to Tower shareholders is showing up in lower overall expenses, which is really the result of the reciprocals covering a portion for more than -- we charge them more than a dollar because we have a profit element, so that profit in essence is recorded as a reduction of shareholder expenses.

Bijan Moazami - FBR Capital Markets & Co.

But let's say that you write $100 of premium, obviously, you have to buy cap green [ph] (57:19) insurance cover and then a portion of the gross written premium is reinsured back to the reciprocal. So when we are thinking about retention, what kind of retention should we be thinking going forward?

William Hitselberger

Well, what happens is we buy catastrophe reinsurance. We regard the two businesses as separate units. So we have a separate treaty. We want to make sure that we protect the reciprocal balance sheet as well. Those costs of reinsurance are borne by the reciprocal. So that's a charge that is incurred by the reciprocal, separate and distinct from the expense load that Tower charges them. So our objective for the reciprocals is to manage that business over time to grow the business, and by growing the business, increase the amount of fee income that we’ll generate from managing the business on behalf of the reciprocals.

Bijan Moazami - FBR Capital Markets & Co.

And on that topic, in terms of reinsurance protection or I guess, a portion of your reinsurance is not going to be renewed until a little bit later, could you talk about in terms of what you think about retaining in terms of risk for catastrophe and how you anticipate your reinsurance to be changing going forward?

William Hitselberger

Sure. I mean, we traditionally have used a model where what we try and do is have our capital, our shareholders' capital, at risk for catastrophic events to the tune of about anywhere from a quarter to a little more than a quarter's worth of expected operating earnings. So what we do is in our environment today, we retain net risk associated -- and for us Bijan, I'm pretty sure you're aware of it, our risk of cat [catastrophe] loss is really not a Florida storm or a California earthquake. It's really a northeast windstorm. So what we do is we retain, on a pretax basis, probably a little bit less than $100 million worth of retention, and what we do is we then buy from reinsurers to cover us up to 125-year loss from any windstorm. And so we feel in that way we're being prudent. Certainly the costs to further reduce, so in terms of going on that working layer and buying down, really could become prohibitive. I mean we’ve had the benefit over the last 20 years of having the worst cat in our history, not via windstorm, but in essence via snowstorm. And I would expect, given our retentions, that those winter storms, the gross for us is really our net because it's hard to imagine a winter storm creating a loss event that would pierce into the reinsurance layer. So for us, our strategy is to really protect against that cat event of being a hurricane that would hit the northeast coast. Now we've been fortunate and not had that experience, but we think it's prudent to continue to protect the balance sheet from that event.

Bijan Moazami - FBR Capital Markets & Co.

Bill, how much cash do you have at the parent company, and did you use any of your credit line, number one? And if Michael can talk a little bit about the Navigator transaction?

William Hitselberger

Sure, in terms of the credit facility at the end of the year, that was completely untouched, so we had $125 million of available credit capacity. And I believe we had about $30 million to $35 million of cash at the holding company at year end. So I think we maintained, and we continue to maintain, a pretty fair portion of liquidity. We keep our eyes out for opportunities to use that liquidity. With that, I'll turn it over to Michael to give a couple of comments on the NAV PAC.

Michael Lee

Thanks, Bill, and good morning, Bijan. We did the Navigators transaction in January, and the reason that we did that is mainly because of our strategy really shifting our middle market business from sort of commodity classes of business into specialty classes of business. So we've been having success in customizing products for some of our larger producers. We started this initiative in the latter half of 2010. So we wanted added staff to that business unit to allow them to do what they effectively have been doing at Navigators. But to do so, with some of our larger producers who really like the approach that we have in terms of customizing products to meet their needs. So we saw this as an opportunity not only to pick up about $25 million of the book of business that we liked from a class of business standpoint, but also wanted access to some of the people at Navigators who came along with the transaction.


I'm showing no further questions on the phone. I'll turn the call back over to Michael Lee.

Michael Lee

Thank you, operator. We were very pleased with the strong operating results for 2010 fourth quarter and the full year. In 2011, despite the various external factors that affect our business, we remain highly confident in the operating performance of our core business and believe that we're well positioned to continue to profitably grow our business. We thank all of you for participating on this call and look forward to speaking with you again next quarter. Thank you.


Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may now disconnect. Good day.

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