Tower Group (NASDAQ:TWGP)
Q1 2011 Earnings Call
May 10, 2011 9:00 am ET
Michael Lee - Chairman, Chief Executive Officer and President
William Hitselberger - Chief Financial Officer, Principal Accounting Officer and Senior Vice President
Michael Grasher - Piper Jaffray Companies
Elizabeth Malone - Wunderlich Securities Inc.
Robert Farnam - Keefe, Bruyette, & Woods, Inc.
Bijan Moazami - FBR Capital Markets & Co.
Good morning, ladies and gentlemen. My name is Tyrone. I'll be your conference facilitator today. At this time, I would like to welcome everyone to Tower Group's First Quarter 2011 Earnings Conference Call. [Operator Instructions] It is now my pleasure to turn the floor over to your host, Bill Hitselberger, Chief Financial Officer. Please begin, sir.
Thank you, Tyrone, and good morning, everyone. Michael and I will be commenting on the presentation, which is on our website at www.twrgrp.com, and which can be viewed by clicking on the Investors section and then by clicking on the icon entitled View Presentation.
Before I turn the call over to Tower Group Chairman, CEO and President, Michael Lee, I'd like to remind you that some of the statements that will be presented during this call will be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those projected in these forward-looking statements. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time.
As we noted in our earnings release, in October 2010, the Financial Accounting Standards Board issued new guidance concerning the accounting per cost associated with acquiring or renewing insurance contracts. We have adopted this guidance effective January 1, 2011, and have therefore adjusted our previously issued financial information. Adoption of this guidance reduced the carrying value of our deferred acquisition costs as of December 31, 2010, by $78.7 million, and Tower Group Inc.'s stockholders equity by $42.6 million. Diluted earnings per share for the first quarter 2010 were reduced by $0.09 as a result of this change in accounting. A replay of this call will be on the Tower website immediately following the call. With that, I'd like to turn the call over to Michael.
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 first quarter operating results. As Bill mentioned at the beginning of this call, we will refer to the presentation that is available on our website during this call. In addition to providing our quarterly results, we provided additional information and color in the presentation material that we believe might be helpful in demonstrating the positive trends that we're seeing in our core business. On this morning's call, I will provide you with updates in several areas of our business, including our views on the insurance market, our strategic response and new business initiatives that will enable us to generate organic growth. Bill will then provide a detailed overview of our financial performance. We will then conclude this call with a question-and-answer session.
As described in last night's press release, Tower Group, despite losses from an increase in winter-weather-related claims activity, produced another quarter of profitable underwriting results. As shown on Page 2, our operating income increased by 52% to $20.3 million in the first quarter from $13.4 million during the same period last year. Our diluted operating EPS increased by 69% to $0.49 per share compared to $0.29 per share during the same period last year. As we previously announced, we experienced an increase in the winter-weather-related claims activity from the record snowfall in the Northeast, Midwest and Mid-Atlantic, beginning in late December 2010 and throughout the first quarter, that totaled $9.8 million on an after-tax basis, or $0.23 per share. Excluding the storm losses, our first quarter 2011 net income and EPS would've been $30.1 million, or $0.72, respectively. As Bill mentioned at the start of the call, we adopted the new accounting rules applicable to the treatment of deferred acquisition costs beginning on January 1 of this year, which required us to adjust our last year's financials using this new accounting standard. As a result, we're seeing greater percentage increases and positive trends in 2011 as compared to 2010. Bill will provide further details on the effect of this accounting rule change later on in this presentation.
Page 3 provides additional financial highlights for the quarter. Despite the challenging industry conditions, Tower has continued to grow profitably in the first quarter. Our gross premiums, written and managed, increased by 38% in the first quarter to $390 million from $283 million for the same period last year. This growth was driven primarily by the acquisition of OneBeacon Personal Lines Division and Navigators' renewal rights transaction. However, we began seeing organic growth from our new business units, customized solutions and assumed reinsurance and risk sharing. I will provide more details on these initiatives later on this call. In addition to achieving an impressive top line growth rate, we were able to maintain our underwriting discipline, as demonstrated by a 97.7% combined ratio this quarter compared to 99.4% for the same period last year. Excluding the losses from the winter storms, our combined ratio for the quarter was 93.8%. We expect the combined ratio to decrease throughout the year, mainly due to a lower loss ratio that we experienced throughout our history for the rest of the year and a lower expense ratio as our fixed expenses become leveraged with higher premium volume.
Finally, our ROE was 7.8% this quarter compared to 5.9% during the same period last year. Excluding the winter storm losses, our ROE was 11.6%. We project our ROE will increase gradually closer to our target ROE of 13% to 15% by the fourth quarter of this year, mainly driven by the lower combined ratio and higher investment income.
Page 4 outlines our strategic response to the challenging market conditions. As you probably are aware, the P&C industry experienced significant catastrophe losses during the first quarter. Our industry suffered total insured losses from the New Zealand earthquake, Australian floods and Japanese tsunami and earthquake that some industry experts estimate to be close to $50 billion. In addition, many primary companies experienced severe weather-related losses during the first quarter. As a result, many companies shortly revised their earnings estimate downward for 2011. In addition, due to the competitive market conditions, the industry's combined ratio for 2010 is close to 103% and projected to be far worse in 2011 after the first quarter catastrophe losses.
As a result of the first quarter catastrophe losses, there is a potential for increasing reinsurance rates as well as in certain primary lines of business. We also believe that insurance and reinsurance companies will be under greater pressure to increase rates or find strategic solutions to exit from the marketplace. In contrast to the industry, our results for the quarter, while affected by the overall industry dynamics, were strong and show positive trends for the rest of 2011 and beyond. Tower has succeeded this quarter by continuing to diversify into different products and territories, expanding beyond the mainstream classes of business into specialty business and customizing products for large select producers. We're also increasing the probability -- I'm sorry, the profitability of existing business units by decentralizing and making these units more autonomous, completing automation initiatives and efficiently allocating capital and resources to these units. To drive growth, we are allocating additional capital and resources to new business units that have a greater potential for growth and profitability. Finally, at this point in the market cycle, we believe the best way to grow is to consolidate business through acquisitions and invest in distribution sources and underwriting managers. The positive trends that we're seeing in the first quarter and our positive outlook for the rest of 2011 and beyond are largely based on the success of these business strategies.
Page 5 outlines our business segment results. As you can see, our growth during the quarter was driven by the significant increase in the premiums from the Personal Line segments, with more modest growth in the commercial, general and specialty areas. The General Commercial area that focuses on mainstream classes of business such as apartment buildings, restaurants and contractors, saw growth in the larger policies underwritten in the middle market business unit, while seeing a slight decrease in the small business unit. We're beginning to see rate increases and premium growth in the middle market workers comp business. The small business is still competitive but seeing signs of stabilization and will benefit from the efficiency gains that we're making through automation initiatives.
In the Commercial Specialty area, we're completing the reunderwriting action that we have taken on the program business from the program underwriting agents. We are making up for the reduction in the business from this area by growing our Customized Solutions business from large select retail and wholesale agents. In addition, while we did not generate a significant amount of business from the assumed reinsurance and risk sharing department during the first quarter, we finalized many business relationship in the fourth quarter of last year and the first quarter of this year and expect these relationships to generate a meaningful amount of assumed reinsurance risk sharing and Specialty business for the rest of the year and into 2012. Finally, we're progressing well with the integration of OneBeacon Personal Lines business. Our underwriting results in the Personal Lines area are better than expected due to the change in the overall business mix, shifting more towards the homeowners and personal package business and less towards the less-profitable monoline auto business. We also increased our fee income to $7 million from our management fee reciprocal insurance companies. We anticipate writing a greater amount of homeowners business in the reciprocals for the remainder of the year. The reciprocal insurance companies may become critical in providing additional underwriting capacity should the demand for homeowners increase as a result of the increased catastrophe reinsurance pricing.
Page 6 provides further explanation of the Customized Solutions business unit that is driving our organic growth. As mentioned earlier, we're responding to competitive market pressures by developing products customized to meet the needs of a large, select retail and wholesale producers. In addition to working with program underwriting agents that have access to specialty program business, we formed a new business unit in the fourth quarter of last year to work with large retail and wholesale agents that want to develop products that will increase their ability to compete effectively in the marketplace. Rather than pushing existing off-the-shelf products, our customized solutions process begins with understanding the needs of these producers and then developing products to promote ease of doing business and providing more product customization and, in some cases, exclusivity in distributing these product in certain regions. Thus far, we have developed new product to serve niche specialty markets such as nonstandard lawyers, landscape contractors, auto dealers and franchise restaurants. Our evaluation process is the same as with any new business, with a focus on underwriting, pricing and market analysis. During the quarter, we generated $6 million from the customized solutions business unit and expect approximately $40 million on an annualized basis.
The next page, 7, explains the Assumed Reinsurance and Risk Sharing business unit that we formed in the fourth quarter of last year. The strategy here is to rebuild the reinsurance and risk sharing business that we operated under CastlePoint prior to our acquisition of CastlePoint in 2009. What changed since that time that would cause us to re-enter this area? Well, we're seeing growth opportunities by aligning ourselves with reinsurers, insurance companies and managing general agents with a proven track record in markets with growth potential. We believe it makes sense to participate in the various specialty areas of business by supporting these underwriting organizations in order to quickly take advantage of the growth opportunities and avoid startup costs and time that it would take to build our own underwriting platform in these areas.
During the quarter, we signed on with an insurance company writing B&O business as well as a reinsurer's writing a limited amount of catastrophe reinsurance business that is minimally correlated to our primary business. We believe this business will complement our high-frequency, low-severity business and offset our reinsurance costs. We're also currently evaluating opportunities to support other underwriting managers, writing international and specialty business. This unit will be headed by Jim Roberts, Senior Vice President with Reinsurance, who has a wealth of experience and knowledge in the reinsurance and specialty primary business having held various senior-level positions with reinsurance and specialty insurance companies over the last 20 years. We believe our entry into this area is well-timed given the market opportunities in the areas that we're focusing on and expect a meaningful amount of production from these opportunities in 2011 and beyond.
Turning to Page 8, I would like to provide more color on what we are seeing in the acquisitions and strategic investments area. From an acquisition standpoint, we have been successful in consolidating books of business through acquisitions and rightsizing the acquired business and staff to meet our profitability standards. Due to the challenging market conditions, we're seeing a growing pipeline of acquisitions that are attractively priced in the first quarter, more so than we have seen any time in the past. We have also benefited during the quarter from the Navigators renewal rights transaction that added $7 million in gross written premiums during the first quarter, and it's expected to add $20 million for the year. The integration into the customized solutions unit is proceeding in line with our expectation. We're also evaluating opportunities to meet strategic investments in distribution sources and underwriting managers to expand into specialty classes of business that are less vulnerable to pricing competition and properly align our interests with these potential partners.
Now I will turn the call over to Bill to provide additional financial highlights. Bill?
Thank you, Michael. Slide 9 shows our first quarter 2011 loss ratio compared to the same period last year. In addition, it shows the calendar and accident year loss ratio since 2007. Before I discuss the first quarter loss ratio results, I'd like to emphasize that Tower has not had adverse annual prior-year development since it went public in 2004. Given our acquisitions track record, their yield reserves appearing on our statutory scheduled fee exhibits may be misleading for the following reasons. First, it includes the reserve strengthening associated with our acquisitions prior to their close. Statutory rules require that we include the results of the business for the entire calendar year and not just from the point of our acquisition. Therefore, our statutory statements contain development which is not reflected in our consolidated operating results. In addition, the statutory statements do not reflect the additional risk premium reserves of $9.8 million that appear on our GAAP consolidated results. Finally, they do not take into account the aggressive cost reductions that we have implemented through our internal claims costs.
You will also note that we have been releasing reserves from 2007 to 2009. Our accident year loss ratio is approximately 55%, even after eliminating the prior year reserve releases. Despite this trend, we decided to increase our loss ratio pick for 2010 and 2011 above 60% to reflect the change in business mix and the current pricing environment. We do not expect our loss ratio selection to go above the current loss ratio picks as we believe we have fully reflected the current business mix and pricing environment. Even with the increased loss ratio and without the benefit of the reserve releases that other companies are using to offset deteriorating accident year loss results, we are continuing to significantly outperform our industry peers.
Now that we discussed our loss reserve position and loss selection, let me discuss the first quarter loss experience. The consolidated net loss ratio was 63.2% in the first quarter of 2011 and 2010. The 2011 net loss ratio was impacted by claims related to winter storms, which increased the loss ratio by 3.9 points. The first quarter 2010 loss ratio was impacted by weather losses related to the March 2010 winter catastrophe, which added 6.5 points to the loss ratio. Excluding the effects of the winter storms in 2011 and the catastrophe losses in 2010, the net loss ratios for the 3-month periods ended March 31, 2011 and 2010 would have been 59.3% and 56.7%, respectively. The increase in loss ratio is a result of an increase in personal automobile insurance business, which carries a higher loss ratio in Tower's other businesses, and also a result of the continued competitive pricing environment. There was a modest amount of reserve development in 2011 coming from our property lines of business, the result of late storms in 2010. The devastating tornado activity that the South and Southeast experienced in April is being compared to 1974, the most severe tornado season on record. While it's too early in the process of able to provide reliable loss figures, given the geographic profile of our book, we do not anticipate these severe tornadoes will result in significant losses for Tower.
Page 10 of the presentation details our expenses and expense ratio for the first quarter of 2011 as compared to the same period in 2010. Operating expenses were $66.3 million for the 3 months ended March 31, 2011, an increase of 30% from the same period in 2010, primarily as a result of our OneBeacon Personal Lines acquisition. In addition, the company has incurred costs in the first quarter 2011 under the transition services agreement with OneBeacon. These transition costs are for moving the Personal Lines technology platform from a mainframe environment to Tower's server environment. The commission portion of the underwriting expense ratio net of ceding commissions was 18% in the first quarter of 2011 compared to 17.8% in the first quarter of 2010. Boards, bureaus and taxes were impacted unfavorably in the first quarter of 2010 from a New York State workers compensation assessment of $2.6 million, which we believe will be nonrecurring. The other underwriting expense component of the ratio net of fees declined to 13% in the first quarter of 2011 from 13.3% in the first quarter of 2010. This decrease was the result of controlled work expense growth being outpaced by the growth in earned premiums. We believe that the organic growth initiatives that Michael mentioned earlier will continue to lead to increase growth in earned premiums and expect to see a continued reduction in our expense ratio throughout the remainder of 2011.
Page 11 shows in the first quarter of 2011, our invested asset base was $2.6 billion, comparable to year end. Average invested assets increased $570 million for the first quarter of 2011, up 25% from the first quarter of 2010, primarily from $365 million of net invested assets acquired from the OneBeacon Personal Lines acquisition and from operating cash flows of $170 million generated during 2010. The significant increase in invested assets has been deployed in a period of depressed new money rates and has reduced our tax equivalent investment yield from 5.7% at first quarter 2010 to 4.8% at first quarter 2011. The lower yield at the end of the year is the result of the significant increase in investable assets combined with the lower interest rate environment. Tower's rate of growth in invested assets over the past year has led to a decline in tax equivalent yields that we believe is beyond that of the industry. We saw a modest sequential increase in tax-adjusted book yields in the first quarter of 2011 as compared to the fourth quarter of 2010, which is the result of deployment of invested assets into dividend paying equities and into high-yield corporate floating-rate securities. We have made some alternative investments in real estate in 2011 and expect that these investments will help our yields in the coming quarters. We are continuing to look at real estate and private investments as alternative asset classes to enhance our investment returns. Despite the decrease in tax equivalent yields, our net investment income increased by about 40% from the first quarter of 2010. We expect that the actions we are taking in different asset classes will allow for our tax equivalent yields to start improving, as we saw in the first quarter 2011 as compared to the fourth quarter of 2010.
In summary, after experiencing declining yields for the last few years due to having to deploy significant amounts of new money at low rates, we are beginning to see an upward movement in our investment yields due to our buybacks and allocations and alternative investment strategy.
Page 12 of the presentation provides additional information regarding the impact of the new GAAP guidance on DAC as well as how this impacted our 2011 guidance, along with a few other items. The impact of this accounting change will be mandated for our industry by the end of 2011, and we believe that the effect of the accounting change will be more significant for companies that had been growing their books of business, such as Tower. We reduced our book value per share by $1.03 as a result of adopting this guidance, and as I mentioned earlier, reduced the first quarter 2010 operating results by $0.09 to reflect the consistent presentation with 2011. As the exhibit on Page 12 of the presentation details, our operating earnings in 2010 restated for the effect of the accounting change are $2.23 per share. We expect our growth rate in operating earnings in 2011, based on our current guidance, to be between 20% and 30%. As you can see, adjusting for the effects of the change in accounting, the growth rate in operating earnings continues to be strong. You will recall that we discussed the effect of the new GAAP guidance on accounting for deferred acquisition costs during our year-end earnings release and on our fourth quarter call. With the benefit of another quarter, we would like to make sure that we properly explain the reason that our guidance for 2011 differed from expectations. Our guidance issued at year end contemplated the change in accounting for deferred acquisition costs, which we believe will reduce our 2011 earnings by about $0.15. Our guidance also contemplated winter storms. So the $0.23 per share that we recorded related to the winter events of 2011 did not change earnings outlook for 2011, and our conservatism in accruing for the expected winter storms has benefited us by allowing us to maintain our earnings guidance. Additionally, as I noted in my expense comments, we continue to incur charges under the transition services agreement, which we contemplated in our guidance but are about $0.10 greater than we had in 2010. Finally, as I noted in the previous slide, we believe that the impact of investment rates is more pronounced for us than the industry given the significant growth in invested assets that I noted earlier and the fact that this growth occurred in the second half of 2010. While we contemplated this in our year end guidance, we believe this impacted our forecast by about $0.15 in 2011. So in summary, our guidance would've been higher, as shown above, but for these adjustments. However, the good news is that we are now in a position to build on this earnings base and continue to grow earnings consistent with our past. With that, I'd like to turn the call back to Michael for a recap.
Thanks, Bill. On Page 13, I will conclude by summarizing our first quarter results. Our business in all aspects is trending well. Our premium growth will continue to be strong supported by the anticipated organic growth from the new business initiatives. We expect our underwriting margins to increase as a result of lower loss ratio after the first quarter winter storms and declining expense ratio as we increase scale. After decline in investment yield, we project our investment yield to begin to increase as a result of the change in our invested asset allocation. As a result, we see a gradual increase in the return on equity starting in the second quarter, with the bulk of the increase coming in the second part of the year, eventually getting close to our target 13% to 15% return on equity by the fourth quarter of this year. Despite the storm losses, we are maintaining our earning guidance of $2.70 to $2.90 for the year. Based upon this positive outlook and to increase shareholders value, we are increasing our annual dividend by 50% to $0.50 to -- from $0.50 to $0.75. Even at this higher dividend rate, our dividend-to-earnings payout ratio is still conservative at 27.5% based on our projected 2011 earnings. With this latest increase in dividends, we have increased our dividend by 168% to $0.75 from $0.28 in less than one year. In addition, we have repurchased an additional 733,000 shares during the quarter, bringing our total stock repurchase to 305.6 million since we initiated the repurchase program a year ago. These actions clearly demonstrate our commitment to deliver value to our shareholders.
This concludes our prepared portion of the presentation, and now, we'll take any questions. Operator?
[Operator Instructions] Our first question is from Beth Malone of Wunderlich Securities.
Elizabeth Malone - Wunderlich Securities Inc.
A couple of questions. You speak about expanding into the reinsurance market, I guess as an insurer, through these relationships. And my question is do you feel that, that is spreading your management and infrastructure a little bit thin given all the other markets that you're already focused on? And does that suggest that there's not opportunities in the markets you're already in?
That's a great question. We did a lot of thinking over the past year or so, and what we have concluded is that it makes sense to take our existing businesses and focus on making them more efficient and to create new business units. The decision to get into -- back to reinsurance business is really to replicate what we did at CastlePoint. This is not the first time that we're getting into this business. We operated this business successfully when we operated CastlePoint. We feel that it's the right time right now to get into the reinsurance and risk-sharing business. We've always had a favorable outlook as far as this business is concerned. The reason that we decided to get into it is because we feel that the market opportunities in the reinsurance business as well as the opportunities that we see from discussions with other underwriting managers make sense for us to do that rather than, at this point in the market cycle, replicating and recreating the platform. That would cause us to increase our expense ratio. And at this point, we don't think that makes sense. As far as the magnitude of this move, it's not that significant. Our purpose in getting into this area is to offset significant reinsurance costs that we have. The exposures that we will take on is minimally correlated to our primary business. And I think it will, in the end, will help us to lower our expense ratio, because we've been seeing about close to, I would say, $60 million, $70 million to cap reinsurers without incurring any losses for the past 20 years. So we think that business is very profitable, and we're -- by getting rid of that, it's increasing our net loss ratio. So by taking on -- assume reinsurance that are non-correlated to our primary business, we'll be able to offset this cost. As far as getting into other areas, mainly specialty insurance areas, we partnered with very good underwriters, and we think they can do a better job than us in managing that particular business. So in summary, what we -- our strategic plan calls for us to make our existing businesses more efficient and to shift resources and capital to other businesses that we feel provide us with better margins. In that sense, we think that we'll be able to increase our return on equity by making that decision and efficiently managing our capital a lot more effectively. I think it's a smart play. I think it reflects the times and it reflects a strategic thinking about what's the best way to navigate through the current market cycles.
Elizabeth Malone - Wunderlich Securities Inc.
And then a question on the DAC change. Does that affect -- I assume that affects the expense ratio as well?
Yes, Beth, it would affect the expense ratio as well, because what'll happen is you now have a GAAP basis, a higher amount of expense, running through against your own premiums. Its impact on the expense ratio is reasonably modest. I can certainly send that off to you if you need it.
But to add to what Bill said, I just want to point out that the impact is -- it will gradually decrease. You saw it from the slide that Bill put up that by fourth quarter, we're seeing the impact decrease. It's the most significant in the first quarter, and it will decrease. And we think that by 2012, we'll adjust it to this new accounting change. What I also want to point out is that this rule is applicable for everyone starting next year, and that's a mandatory adoption. We decided to make the early adoption because we wanted to make sure that we got -- we addressed all the issues with respect to increasing our loss ratio pick as well as making all the other adjustments that we felt were prudent in order to position us for continued growth in 2012. As far as the impact on back for us, as Bill mentioned, it's more significant, because we're a growth company, and as such, our expenses in the current year will be higher than in the prior year So that it does affect us much more than a company who is experiencing flat growth or declining growth. In that case, in some ways, it may help some of those companies. So I think the impact of the back change is different for different companies depending on their profile, but for us, it was a significant issue. And the good news is that we'll be able to put that behind us and go into 2012 in a very good position.
Elizabeth Malone - Wunderlich Securities Inc.
Okay, and then you did a nice increase on the dividend. Did that -- and you also repurchased shares. Is there a suggestion that your capital, that there's not as many acquisition opportunities out there? That you feel the capital is better used in dividends and share repurchase?
Beth, we look at this issue very carefully. The fact of the matter is we don't need that much capital. We think that it makes sense to shift capital from our existing businesses, and we could support our business with less capital. Our retained earnings are also very strong. So each year, we're faced with the task of not only deploying CastlePoint, the capital that we picked up from CastlePoint, but also to deploy retained earnings. And with our leverage being what it is, we think we have a lot more capital than we need to support our existing business. That gives us an opportunity to increase dividends as well as to repurchase shares. But as we mentioned during the earnings call, we're seeing some positive growth opportunities organically as well as by externally looking at making strategic investments in other underwriting managers. As far as acquisition is concerned, we think that we could continue to make acquisitions, but we also realize that we need to focus on increasing our currency. And the best way that we think that we can do that is by demonstrating that we're committed to increasing shareholders returns in the short term by increasing dividend payments. And I think we're going to be very much focused on that and trying to deliver value to our shareholders in the short term. And the way that we're going to do that is to constantly look at our payout ratio and, to the extent that it's possible, to increase dividends on a regular basis going forward.
Our next question is from Mike Grasher of Piper Jaffray.
Michael Grasher - Piper Jaffray Companies
The question I had, did you mention, Bill, the percentage of alternative investments as a percent of the total portfolio?
Yes -- no, Michael, I didn't. The percentage of alternative investments today is still very, very small, it's less than 1%. We expect to see that increasing over the course of the year to be a number closer to 5%. We have a, certainly, a number of things that we're evaluating. All of those are, we believe, good opportunities for us to deploy some of our investment assets. Clearly, we'll yield higher than what we're seeing in the current bond environment.
I'll just add to what Bill said, Mike, I mean, our portfolio is very conservative and sure, and we have a very limited percentage of allocation to equities. So these alternative investments that we're making is really to shift our asset allocation from the bond portfolio, and we think that it makes sense to go into this area rather than significantly increase our allocation to equities.
Michael Grasher - Piper Jaffray Companies
Okay, Yes, that make sense. I'm just curious, the duration on these alternative investments as you analyze all of them, what that may look like.
Actually, it's funny, Mike. Some of them are real estate development projects. The duration of them, we think, is going to be relatively short. Some of them could be -- certain of them could be equity investments in other business types, and they are -- there you'd have a longer duration, but I think our view is we would be entering into those after discussions with the principals and understanding from them what their ultimate exit strategies are. So I think that, that's the way we're going to control our duration with some of these more private investments.
Michael Grasher - Piper Jaffray Companies
And then, have you discussed -- could you, if you haven't, the impact of RMS 11.0 on your capital model?
Fortunately, Mike, I mean, we ran the new model, and obviously, just like everyone else, we were very concerned at the beginning of the year. For us, the impact was not that significant as it was for other companies, mainly because of our profile. We tend to be in more coastal areas. As a result, we already -- our P&L levels are fairly high to begin with, so we weren't impacted as much as other companies that may have business more in the interior areas of the country. So I think we're in pretty good shape as far as that's concerned. We also anticipated this and put it into our budget for higher reinsurance costs. So we think we'll be able to absorb the potential rate increases very well. And as I mentioned, our entry into the assumed reinsurance market will also help us to defray or offset some of the increased reinsurance costs that may be on the horizon as a result of the increased cat [catastrophe] activity and the model change.
Michael Grasher - Piper Jaffray Companies
So bottom line is you're already at a higher starting point than what most drivers were?
And the next question is from Bijan Moazami of FBR Capital Markets.
Bijan Moazami - FBR Capital Markets & Co.
Michael, historically, your strategy was to control a larger book of business that your capital allows you to write and generate a better rate of return that a typical property casualty insurance company can produce, whether it was a use of CastlePoint or the use of reciprocals. Could you talk about what you think on the rate of return of the insurance or reinsurance businesses? And where do you guys plan to take your returns over time by leveraging some of the reciprocal or other stuff that you might have?
Okay. Well, that's a very good question, and I think, first and foremost, we're projected to write about $1.75 billion to $1.8 billion this year. Most of that is high-frequency, low-severity business. And while that's very good from predictability standpoint, it's also a very difficult environment to operate in, mainly because everybody wants to get into that particular area. So you do have a lot of players in that market, and it is competitive. And we're doing a very good job of that by consolidating books of business and not writing new business, so we feel very comfortable, especially given that we increased the loss pick to a level that we feel very comfortable with. Having said that, we think that what makes sense is to introduce a little bit of severity to offset that high-frequency business. And we're not talking about a significant amount that will materially impact the kind of earnings patterns that we have in the past. We're just talking about participation in the excess layers of capital grants as well as more long-tail, specialty products that generally have longer tail and has probably much more or higher underwriting margin associated with that. We think, in all likelihood, this business will be a lot more profitable. A little more risk but a lot more profitable. And I think it makes sense to write some of that using our capital base. And the blended business mix that we get, we think, on a risk-adjusted basis is better with the introduction of this new business as opposed to just focusing on what we have focused on. And so we feel internally that we're making a very prudent decision in introducing a little bit of volatility. But on a normalized basis, we think that this will have a beneficial effect on our loss ratio, maybe potentially 1% to 1.5% better on the loss ratio. That gives us the ability to achieve a slightly better loss ratio and be able to continue to do what we do well but at the same time have a little bit of a higher margin business that will make the overall book of business perform a lot better.
Bijan Moazami - FBR Capital Markets & Co.
Great. Also, if I remember properly, you guys are trying very hard over time to diversify away from the Northeast. Is your acquisition strategy going forward still going to be focused on geographic diversification? Or is it just going to be opportunistic?
I think we have a very thoughtful strategy in place, and I think we've executed very well based on that strategy. So what we are trying to do is take our existing businesses, the commercial business, the regional business that we have created and then to make -- and then to leverage that business throughout the country. So we think that it makes sense to increase scale and to diversify territorially with respect to Commercial and Personal Lines business. So we're going to continue with that strategy by looking at acquisitions in different parts of the country. What we are also doing is expanding into the specialty area. We think that area has a higher margin, and we're seeing some very good growth opportunities. So our strategy really involves continuing to increase scale in very low-severity, high-frequency Commercial and Personal Lines business, because we think that make sense. And the best way to do that is bolt-on acquisitions and expand geographically. That way we have a geographical diversification and we obtain efficiency in many ways, including the ability to purchase cat reinsurance cost-effectively. As far as the specialty area is concerned, as I mentioned before, expansion in this area makes a lot of sense, because that allows us to complement our low-severity, high-frequency business with a little bit of higher-severity business that will allow us to generate much better results. So we have 3 legs, and we're very happy with the Commercial strategy, the Specialty strategy and the Personal Lines strategy. And the strength of our business model is the diversification and the ability to continually grow using those 3 areas as a foundation to build upon.
Our next question is from Bob Farnam of KBW.
Robert Farnam - Keefe, Bruyette, & Woods, Inc.
With the loss trends in Commercial lines, I see premium rates are going up about 1%, I'm just curious what the frequency and severity of the Commercial lines losses are doing?
We think that we have done a lot to make sure that we're able to counter the pricing decreases. But now, we're seeing the rate flatten or increase, and I think we've shown that in our presentation. So what we were mostly concerned about, I believe in the first quarter of 2009, was how the pricing environment would impact our reserves, and we took a very proactive approach and increased our loss pick in 2010 and 2011. We don't expect us to increase our loss pick. We also did significant amount of re-underwriting, especially program business and some of the excess and surplus lines business. We've been doing that for the past 2 years. And quite frankly, we think that we were ahead of others. You see our results. Our run rate, at about 60% to 62%, really reflects the current pricing environment. And also, it's not -- it really, truly is the run rate, the accident year loss ratio. It's not held by prior-year reserve development. We stopped doing that at the end of 2009, and we started to focus on making sure that our loss pick is really reflective of the current environment. So we paid a price for it, going from 55 to 60, our earned premium, current premium, equates to about $75 million or so. So we absorbed a lot. And we -- our earnings was adversely affected by that move. But as I mentioned during the presentation, we're stabilized -- we stabilized at that loss ratio with pricing environment improving, so we think we're in very good shape. And the main thing is that our loss ratio is truly reflective of accident year results and is not improved or -- improved by prior year reserve releases, as is the case for many companies in our industry. So we think that, even at this current pricing, we're able to achieve our target returns that we're seeking, and we think we're in a great position as a result of that.
And this ends the Q&A portion of today's conference. I'd like to turn the conference over to management for any closing remarks.
Thank you, Operator. I'd like to thank all of you for participating on this earnings call, and we look forward to speaking with you again next quarter. Thank you.
Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect, and have a wonderful day.
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