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Tower Group (NASDAQ:TWGP)

Q3 2011 Earnings Call

November 08, 2011 9:00 am ET

Executives

William E. Hitselberger - Chief Financial Officer, Principal Accounting Officer and Senior Vice President

Michael H. Lee - Chairman, Chief Executive Officer and President

Analysts

Adam Klauber - William Blair & Company L.L.C., Research Division

Randy Binner - FBR Capital Markets & Co., Research Division

Robert Farnam - Keefe, Bruyette, & Woods, Inc., Research Division

Richard W. Mortell - Piper Jaffray Companies, Research Division

Operator

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 Third Quarter 2011 Earnings Conference Call. [Operator Instructions] It is now my pleasure to turn the floor over to your host, Bill Hitselberger, Executive Vice President and Chief Financial Officer. Please go ahead, sir.

William E. Hitselberger

Thank you, Tyrone, and good morning, everyone. Before I turn the call over to Tower Group President and CEO, Michael Lee, I would 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 presented 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 for costs associated with acquiring or renewing insurance contracts. We adopted this guidance effective January 1, 2011, and 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 third quarter 2010 and for the 9-months ended September 30, 2010, were reduced by $0.12 and $0.27 per share, respectively, as a result of this change in accounting.

As a reminder, Michael and I will be speaking today and referencing a slide show that is available on our website at www.twrgrp.com under the Investors section. Also 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.

Michael H. 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. Let me start on Page 2 by giving everyone a brief snapshot of our third quarter results. We had a $15.3 million operating loss during the third quarter due to the $60 million loss from Hurricane Irene and net after-tax loss reserve strengthening of $6.3 million, primarily from terminated business. Excluding these 2 items, we had a strong operating results with a year-to-date, 93.6% combined ratio and 10.8% return on equity.

For the first time in several years, our growth was driven almost exclusively by organic growth rather than external growth from acquisitions. We're also seeing positive pricing trends, which bode well for our business going into the fourth quarter and 2012.

As shown on Page 3, our operating loss was $15.3 million or $0.38 per diluted share compared to operating income of $27.9 million in the same quarter last year or $0.65 per diluted share. Operating income was impacted by catastrophe losses, primarily related to Hurricane Irene of $39.1 million after tax or $0.96 per diluted share. The storm losses added 16.4 points to the third quarter 2011 loss ratio for the combined segments, excluding the Reciprocal Exchanges. Tower recorded no severe weather losses in the third quarter of 2010.

In addition, we conducted a comprehensive review of our reserves during the quarter, including the reserves that we have established from various companies that we have acquired during the last few years. Based on this review, we recorded a pretax net increase to loss reserves, excluding Reciprocal Exchanges, of $9.7 million or $6.3 million after tax or $0.15 per diluted share, primarily due to prior [indiscernible] year development from various program business that the company discontinued in 2010 and early 2011. Excluding the catastrophe losses and the reserve strengthening, our third quarter operating income net operating EPS would have been $30.1 million and $0.73, respectively.

Our book value decreased by 4% to $1.01 billion from $1.053 billion due to our earnings being offset by share repurchases of $54.6 million since the third quarter of last year and making $25.6 million in dividend payments. Our book value per share increased slightly from the third quarter of last year, even after taking into account the severe weather losses and making $0.625 per share in dividend payments since third quarter of 2010.

As shown on Page 4, despite the unprecedented losses from Irene, we continue to see great strength in our core business. While our growth during the last few years has resulted primarily from acquisitions, our 16% premium growth during this quarter was driven primarily by organic growth from 2 newly created business units: Customized Solutions and Assumed Reinsurance. For the 9-month period, our premiums grew by 38% to $1.377 billion from $1.063 billion during the same period last year. Our combined ratio was 109.9% this quarter compared to 96.8% during the same period last year.

Excluding Irene, our combined ratio improved to 93.8% this quarter compared to 96.8% during the same period last year. For the 9-month period, our combined ratio was 101.1% and 93.6%, excluding the storm losses.

Finally, our ROE was negative 5.9%, and 9% excluding the storm losses for this quarter compared to 11% during the same period last year. For the 9-month, our ROE was 10.8% excluding the storm losses.

Page 5 provides further details on Hurricane Irene and the impact of catastrophe losses on Tower. Irene is the first hurricane to make landfall in the tri-state region since 1985 and the first to make landfall in New Jersey since 1903. The $60 million loss from Irene, in addition to the being the largest single loss event in our 20-year history, is also greater than the total of all catastrophe losses experienced by Tower throughout its history.

So 2011 was a highly unusual year for catastrophe losses and is not reflective of Tower's risk profile. In addition, despite our 3.9% industry market share, the business affected by Irene in the tri-state area, our share of the industry loss was limited to 1.3%. This clearly shows the strength of our underwriting and risk management capabilities. The last 2 points that I would make here are the historical profitability of our Property business as reflected by our loss ratio of approximately 51% since 2005 and the favorable market conditions for Property business that we anticipate after Irene and the record catastrophe losses that we experienced this year.

Page 6 provides an update on our new growth -- new organic growth strategy that we developed in the latter part of 2010. As we mentioned during the last call, our strategy is now to focus on generating organic growth while becoming more focused and selective in generating growth through acquisitions. The third quarter results clearly demonstrate the success of this strategy as reflected by $15.3 million in gross written premiums, generated through Customized Solutions and $61.1 million through the Assumed Reinsurance and risk-sharing business units. Given the growth in the Assumed Reinsurance and risk-sharing business this quarter, let me provide further details on this business.

For 2011, we committed to write slightly less than $20 million of mid- to upper-layer Property Catastrophe Reinsurance business that is non-correlated or minimally correlated to our Northeast business. These writings are designed to partially offset the roughly $60 million of catastrophe reinsurance protection that we purchased primarily for our Northeast business. The rest of the Assumed Reinsurance and risk-sharing business is comprised of our quarter share support of a limited number of carefully selected underwriting managers and Lloyd's syndicates with an established track record of profitability, typically with historical loss ratios between 50% and 60%.

As the Lloyd's syndicate for the shares are protected by the same comprehensive reinsurance program that protect the syndicates themselves, our net loss, even on a significant industry loss event, is generally limited to less than $10 million. In addition, we are seeing meaningful premium increases for this business and expect continued profitability on the order of what we have seen in 2011.

We spent most of 2010 evaluating these opportunities and made commitments only to those underwriting organizations that had a track record of producing consistently profitable underwriting results. The combined ratio on this business, on a year-to-date basis, is between 85% to 90%, and it's outperforming our existing business.

In summary, through our participation in this business, we expect to participate in markets with favorable pricing trends and achieve prudent risk diversification that we believe will improve our overall risk-adjusted returns.

Finally, as part of our organic growth strategy, we have officially launched a product innovation initiative in the third quarter to develop new specialty products across different product lines and new industries. As part of this initiative, we made several key senior level hires to improve our internal business development, product development and corporate marketing capabilities. We believe this initiative will continue to generate organic growth in 2012.

As mentioned on Page 7, Tower is also experiencing favorable pricing trends. We saw a 1.4% pricing increase in the third quarter but more meaningful rate increases for select areas, such as California Workers Comp business and Assumed Reinsurance and risk-sharing clients who are reporting much higher pricing increases. More importantly, we're implementing a plan to drive meaningful rate increases in the fourth quarter and next year rather than simply non-renewing, unprofitable business due to our belief that the markets are finally ready to accept pricing increases. As a result of the catastrophe losses this year, we are also seeing meaningful opportunities in Homeowners and Commercial Property lines of business.

Overall, we believe we are well-positioned for a market turn given our diversified business platform with access to business in different territories and lines of business and industries. After making significant investment in people, business processes and technology, we believe the loss ratio on our business will continue to outperform the industry.

Now I will turn the call over to Bill to provide more details on our financial results. Bill?

William E. Hitselberger

Thank you, Michael. PT [ph] outlines our segment results. As Michael mentioned previously, during the third quarter, we significantly grew our Commercial Specialty business. We focused on markets with favorable pricing trends, while slightly reducing our business in General, Commercial and Personal businesses. Our overall Commercial business grew significantly this quarter, mainly driven by the growth in the 2 newly created business units: Customized Solutions and Assumed Reinsurance. As Michael mentioned previously, we are seeing the opportunity to benefit from pricing increases in the Assumed Reinsurance business unit.

The Commercial segment also showed strength as reflected by the 76.8% retention ratio and positive renewal changes of 1.3%, with 108.9% combined ratio, or 97.7% combined ratio, excluding the losses from Irene.

Our Personal Lines business declined to $152 million in the third quarter from $169 million during the same period last year due primarily to the underwriting of Personal Auto and Homeowners business that we decided to cancel after the OneBeacon Personal Lines acquisition. Our overall Personal Lines business segment had a 90% retention ratio and positive renewal changes of 1.6%, with 112% combined ratio or an 88.1% combined ratio excluding the losses from Irene. In our Insurance segment, we generated $7.6 million in fee income from managing reciprocals.

Slide 9 details our loss ratios for the quarter and year-to-date periods ended September 30, 2011. While we have presented the loss ratios, including the reciprocal exchanges in our consolidated statement, we will analyze the loss ratios excluding the reciprocal exchanges as these ratios are more relevant for our operating results.

Our loss ratios have been significantly impacted by catastrophic events in 2011 as Michael mentioned earlier. Third quarter 2011 loss ratios, excluding the reciprocals included 16.4 points on the hurricane. Also, prior-year adverse development added 2.6 points to the quarter loss ratio and 1.6 points to the 9-month numbers, as compared to favorable development of 2.1 points and 0.5 points, respectively for the quarter and year-to-date periods ended September 30, 2010.

After the storm losses and adjusting for development in both years, our loss ratio excluding the reciprocal exchanges would've been 58.6% and 59% for the quarter and year-to-date periods ended September 30, 2011, respectively, compared to 61.1% and 58.7% for the quarter and 9 months ended September 30, 2010, respectively.

The improvement in the underlying loss ratio in the third quarter 2011 compared to 2010 is due to a shift in business mix, that Assumed Reinsurance is a higher proportion of our book in 2011 versus 2010 and private passenger auto, a lesser percentage. On a year-to-date basis, these shifts are less apparent as the 2010 increase in Personal Auto arose in the third quarter from the OneBeacon acquisition. The $9.7 million in adverse development in the third quarter excludes reciprocal development and is the development that impacts operating earnings and earnings per share.

In the third quarter, the Tower stock company saw favorable development of $14 million in our Personal segment and adverse development of $24 million in our Commercial segment, which included $10.7 million in adverse development on certain programs that we discontinued in 2010 and in early 2011.

Page 10 of the presentation details our expense ratio for the stock companies for the third quarter and year-to-date 2011 and as compared to the same periods in 2010. Consolidated operating expenses were $154.2 million and $441.6 million for the 3- and 9-months-ended September 30, 2011, increases of 4% and 22% from the same period in 2010, respectively. While operating expenses for the stock company were $134 million and $377.7 million for the quarter and year-to-date periods ended September 30, 2011, an increase of 2% and 9% from the same periods in 2010, respectively.

The main driver of the year-to-date aggregate increase were costs associated with the acquisition of OneBeacon Personal Lines. In addition, the company has incurred costs during the first 9 months of 2011 under the transition services agreement with OneBeacon. These transition costs are for moving the personal lines technology platform from the mainframe environment to Tower server environment. We are making good progress on this initiative.

The commission portion of the underwriting expense ratio, net of ceding commissions we received, was 18.5% and 18% for the quarter and 9-months-ended September 30, 2011, respectively, down slightly compared to 18% and 18.4% for the same periods in 2010 as we continue to see an increase in business flow and retail agents. Our boards, bureaus and taxes are up 40 basis points in the quarter but down 50 basis points to 3.7% for the year-to-date 2011, mainly due to higher workers compensation assessments recorded in 2010.

The other underwriting expense component of the ratio, net of fees, was 12.3% and 11.8% in the third and year-to-date 2011, respectively, improved from the same periods in 2010, largely attributable to economies in scale from earned premium growth in 2011. The organic growth initiatives that Michael mentioned earlier should lead to increased growth in earned premiums over the balance of the year and we expect to see a reduction in our underwriting expense ratio throughout the remainder of 2011 and into 2012 from the increase in scale as the rate of organic growth is significantly outpacing the rate of growth and other underwriting expenses.

Page 11 details our investment performance. In the third quarter of 2011, our invested asset base was $2.7 billion, comparable with year-end and to the year-ago period. Operating cash flows in the 9 months have been strong at $111 million, but we have used $70 million in cash flows to fund common share repurchases and pay dividends. So investment growth has been somewhat tempered.

Yields in the fixed income portfolio have been flat at between 4.6% and 4.8% since year end. We have seen a flattening of tax-adjusted book yield since year end, which is the result of deployment of invested assets into higher-yielding corporate securities. We have also been deploying funds into dividend-paying equity securities, which we believe will improve our tax equivalent portfolio yield. We have made some alternative investments in real estate in 2011 and expect that these investments will help our yield over the remainder of the year.

Our consolidated balance sheet now contains a caption” Other Invested Assets” , which is where we are classifying our alternatives. 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 7% from third quarter 2010. The actions we are taking in asset classes other than fixed maturities have allowed us to continue our trend of growth and investment income.

In summary, after declining yields for the past few years, due to the deployment of a significant amount of new money at low rates, we are beginning to see stabilizing fixed income yields and an upward movement in our total portfolio investment yield due to our revised asset allocations and alternative investment strategy.

And with that, I'll turn the call back to Michael.

Michael H. Lee

Thank you, Bill. On Page 12, I will conclude by summarizing our third quarter results. Despite the loss from Irene, our outlook remains positive due to the various factors that we discussed during this presentation.

First, we're encouraged by the success of our organic growth strategy and our expansion into higher margin specialty business. In addition, after a prolonged period of downward pricing, we're finally seeing some signs of improved pricing. We believe we will be able to successfully drive pricing increases in the fourth quarter of 2011 and through 2012. We believe our expense ratio will decrease as our rate of organic premium growth is outpacing expense growth, and this trend will accelerate as we successfully integrate the various acquisitions that we have made during the last several years and as we complete various technology projects.

Finally, through alternative investments and revised asset allocation, we have been able to successfully counter the lower investment yields. We expect full-year 2011 operating earnings to be between $1.40 and $1.50 per share, which reflects the impact of $1.30 in storm losses. Given the current investment environment and underwriting and market conditions, we expect our return on equity to be in the range of 10% to 12% in the near-term, and then gradually increase as we successfully lower our expense ratio through greater scale and efficiency and as our pricing changes that we're beginning to see manifest themselves in our earned premium base. We're confident that these returns will continue to outperform those of our industry peers.

So with that, I'll open the lines for any questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from Randy Binner of FBR Capital Markets.

Randy Binner - FBR Capital Markets & Co., Research Division

Just looking for some color on business lines and accident years that drove the adverse development on the Commercial side, and also a similar question on what drove the favorable result on the Personal Lines side?

Michael H. Lee

Okay, I'll start. This is Michael, and then I'll turn it over to Bill to add anything that he sees fit. We did a thorough review of all the acquisitions that we have done. We've done 7 over the last 3 year So what we saw going into the fourth quarter was that we had redundancy in the Property Lines of business, mainly in the Personal Lines business, so we released about, $14 million. And then we saw some issues with our Commercial business, namely the terminated program business that we acquired from the SUA acquisitions that we terminated in 2010 and '11, and we saw a need to strengthen the reserves on that business. The remaining adverse development on the ongoing business on the Commercial side really offset it, what we saw as strength in our Personal Lines business. So as far as our ongoing business is concerned, we didn't see too much or we didn't see any adverse development, but we did see the adverse development on the terminated program business. So we reacted to that during this quarter and if you’ll recall, starting in, I think, fourth quarter of 2009, we became a lot more vigilant about protecting our balance sheet, so we increased our loss pick and we significantly reduced our claims expenses and adopted a much more conservative, rigorous reserving process. So we're reacting to what we see each quarter, and that's what we did. We think our reserves are in very good shape. The nature of our business is such that we don't have the wild fluctuations that you would see for companies with long-tailed business. More than 50% of our business is comprised of Property Lines of business and the remainder of the business is comprised of short-tail Liability business. So unlike other companies, we have to react very quickly, because many of these claims are reported very quickly, and as a result, we don't have much discretion in putting up IBNR. I mean, most of the -- what's coming through our cases that develop adversely. But having said that, I don't think we are the type of company where we see a significant risk to adverse development. And in fact, since we went public in 2004, we haven't seen any adverse development. And this adverse development, on an after-tax basis, is a little over $6 million and represents about 1% of our total reserves. So after doing 7 acquisitions and after having no adverse at all since 2004, we think we have a very good track record of maintaining very conservative reserves. Having said that, we understand that there are risks and we're very vigilant, and we are reacting to it. And I think we've been ahead of the curve as far as being very, very careful about how to navigate through this market condition by adopting the kind of controls that we have adopted as well as taking the actions that we have taken, and if that results in a $6 million adverse development this quarter, so be it. But we're not at all concerned, mainly because of the nature of our business, because of our strong track record as well as the type of actions that we have taken to prevent our reserves from deteriorating. And we feel very confident about where we are, especially given the kind of the market conditions that we're seeing right now.

William E. Hitselberger

Just -- Randy, just to give you little bit more color with respect to lines of business. On our run-off book, it's the $10.7 million, and it's principally done with our Workers Compensation and Commercial Auto. And then the other remaining Commercial business we sold primarily in Commercial Auto, about $7 million, and then in other Liability. And that was really -- those, that development was offset by favorable development in the Personal lines and that was predominantly in the Personal -- the Private Passenger Automobile lines of business.

Randy Binner - FBR Capital Markets & Co., Research Division

Okay, favorable on Personal Auto, on Personal lines -- it's just, is there any accident year color you can give around all that, I think that'd just be helpful for me and other folks to understand kind of where it's coming from.

William E. Hitselberger

Yes, principally, the adverse development that we're seeing is from accident years '09 and '10, and what we're seeing with respect to favorable development is predominantly coming from accident year 2010.

Michael H. Lee

And let me just emphasize that most of the adverse development is coming from the SUA acquisition. We've canceled about 5, 6 programs, we only had about 8, we only kept 2. We thought that we put up the appropriate amount of reserves, but we've seen that business deteriorate, we had to give about 6 months cancellation. We already -- we spent 6 months after we made the acquisition, evaluating the book of business and making that decision, but it had lasting effect given that it took quite some time, about a year, for us to fully get off this business. And it's turning out to be adverse by about $10 million, but the programs had really run off in 2011. And therefore, we won't see that risk, risk of further adverse development coming from the terminated programs. So we think our track record speaks for itself. We have a good track record. We're cautious at this point in the market cycle, and we're doing everything to make sure we don't have any adverse development going forward.

Operator

Your next question is from Adam Klauber of William Blair.

Adam Klauber - William Blair & Company L.L.C., Research Division

For 2012, I think you mentioned ROE of around 10% to 12%. What sort of catastrophe losses are you factoring in there?

Michael H. Lee

We're looking to look at normalized cat activity, I would say, we haven't finalized our plan, but I think 10% to 12% ROE reflects normalized cat activity that we're now budgeting into our plan. And I don't think we're going to have, hopefully, not an Irene, because that's quite an unusual event for us. So we think that 10% to 12% range is very achievable given that we've been at -- on the upper end of that in terms of ROE but given the current market environment as well as the cat activity that we have experienced, we feel very comfortable. We think it's prudent to be at that range, and if we do experience some catastrophe losses, we think that we can consistently maintain 10% to 12% return on equity, and I think that's what you've been seeing for the last several years. So we think it's very achievable.

William E. Hitselberger

Yes. And, Adam, I guess just to provide or touch more color, I mean, I think that we would always expect to have storm losses similar to what we saw in the first quarter with respect to winter storms. But to Michael's point, I mean, clearly we're not, in that 10% to 12% forward look, we're not anticipating another hurricane.

Adam Klauber - William Blair & Company L.L.C., Research Division

Right. So is normalized maybe in the 2% to 4% range, is that a realistic assumption?

William E. Hitselberger

I’d use -- in terms of raw numbers, I'd probably say, it's more like in the $20 million range, $20 million to $30 million in aggregate cat.

Michael H. Lee

Yes. I mean, if you look at our history, we haven't had any catastrophe losses but given what has happened in the last year, we think it's prudent to start putting a meaningful amount of cat reserves, and that's what we're going to do going forward and the 10% to 12% ROE reflects that.

Adam Klauber - William Blair & Company L.L.C., Research Division

Okay. On the expense ratio, you mentioned, particularly on the Personal Lines you expect it to improve as you scale the business. In other words, as premiums grow. Is that kind of a major driver or moving towards the new system being that also significant driver of better expense ratio?

Michael H. Lee

Our internal expenses are around $200 million, and it has crept up from about $100 million in probably around 2008. So we've made significant investments, especially in technology area. We also are spending a lot of money in integrating many of the acquisitions. Now we think that we could cut expenses significantly, but we'd rather invest in technology, invest in people, improve the business processes. We think that market will eventually turn and we'll be rewarded for that, so I think we're one of the few companies that feel that they have the kind of profitability at this point to make the investment and to set up the company for the market turn, and we're seeing some signs of that. So I think our 34% expense ratio is something that we're not accustomed to seeing. I think we could make short-term decisions to reduce that quite a bit, but we choose not to do that. We think that, that will happen naturally as we scale the business, because we've move from one type of business, Commercial, and a little bit of Homeowners to really having 3 different types of business segments and there's infrastructural costs associated with maintaining 3 segments. We believe in diversification. We believe that we have the diversification across territories, across different product lines. And as a result, we are carrying more expenses than what we're accustomed to seeing. And we can probably do a lot to drive the expense ratio in the short-term lower. But our strategic direction is to build for the future and to position us for a market turn. And I think we will have planted the seeds in various places, and I think we're going to benefit significantly from the market turn, and that's our strategy and we're committed to that. And I think the byproduct of that is that while our loss ratios is below about 60 to 63, which is significantly lower than the industry, our combined ratio is going to be around mid-90s, which is below our target of around 92. But as we lever -- as we scale the business and we finish these technology projects as well as integrate the acquisitions, we should see our expense ratio coming closer to low-30s. And we're within striking distance, but at this point in the market cycle, we don't see a need to press to achieve those expense reductions in the short-term. So over long-term, we think that just by reducing our expense ratio, we'll be able to achieve a return on equity greater than the 10% to 12%, and we feel comfortable that as we finish these various technology projects and finish the integration projects that we'll be able to achieve that.

Adam Klauber - William Blair & Company L.L.C., Research Division

A couple questions on the newer business units. On the Assumed Reinsurance, is that mainly Property business? Geographically, could you give us, I guess, some picture of were that is, is that mainly domestic, is there some international? And also I think you mentioned $10 million loss, is that $10 million per client or is that -- yes, that was the question.

Michael H. Lee

Yes, okay. Well, thanks for that question. Our strategy here is really to opportunistically allocate capital to specialty markets with a strong track record of profitability and a higher profit margin to offset mainly our business, which is comprised of high-frequency, low-severity business, but that business has some pricing risk. So what we're trying to do is balance our portfolio by writing Specialty business that has a better -- that are seen with the better pricing trends. And using this strategy, we think that we can achieve a better risk of adjusted returns without meaningfully increasing our risk profile. There's 2 different types of business in the Assumed Reinsurance and Risk-Sharing business units. One is the catastrophe business, which is comprised of mid- to upper-layered catastrophe reinsurance business. That is just designed to offset our reinsurance costs and we don't -- our ceded reinsurance business has run a loss-free for 20 years. And by participating in mid- to upper-layer catastrophe reinsurance program, we're trying to just to recoup some of that cost. As far as the quota shares of Lloyd's syndicates, or other underwriting managers, we're looking at specialty business, not catastrophe reinsurance business. As far as the loss-per-event is $10 million, given the participation that we have across different underwriting managers, we think that worst case scenario, we're looking at about $20 million to $30 million. If worst case scenario does occur and all of the underwriting managers do get hit, so I think based on just our analysis of where we are and how spread out that we are geographically across the world, I just don't think that we're going to face that type of situation. And even if we do, I think it's pretty much commensurate with what we're seeing in the northeast with these winter storm activities. So diversification is critical here and making sure that we use our balance sheet that is underutilized in other parts of the U.S., as well as other parts in the world where we take a little bit of risk in non core-related areas and that allows us to, I think, prudently use our balance sheet a lot more effectively because it's underutilized right now with all our business being concentrated in the northeast and byproduct of that is that we have a better portfolio and we have a better business mix. And this was something that we thought about very carefully and we're executing on that strategy and as a result, we're seeing loss -- combined ratios in the mid-80s from participating in this business. We're also getting the most rate increases in this area, because we have positioned ourselves in markets where they were actually -- where the underwriting managers are seeing much more rate increases that we're seeing in the northeast. So overall, I think our strategy is working in allocating our capital to high margin business that's non-correlated to our business, and so we're very optimistic that we can continue to see better results overall by participating in this business.

Adam Klauber - William Blair & Company L.L.C., Research Division

And just 1 or 2 numbers questions. Can you give us a breakdown of the catastrophes between Personal Lines and Commercial? And also on the negative development in the Commercial Lines, the non-program, which accident years did that come from?

William E. Hitselberger

Okay, yes. Adam, it's Bill. The $60.1 million breaks out as follows: There’s roughly $32.5 million of the loss is in our Commercial Line segment and just about $27.5 million is in our Personal Line segment. So what we did when I was giving my comments is we described the effect on the combined ratios for both of those. And those take into account those 2 numbers. With respect to the commercial reserve adjustments that we saw, again I think, it's predominantly coming from accident year 2009 and from the accident year 2010 as well.

Operator

Our next question is from Richard Mortell of Piper Jaffray.

Richard W. Mortell - Piper Jaffray Companies, Research Division

Just a clarification. First on the near-term ROE for 2012, you guys say 10% to 12%, are you talking about the first quarter 2012 you're going to get there or gradually through the year you're going to build up to that?

Michael H. Lee

I think -- this is Michael. I think we're looking at -- we're trying to avoid giving guidance and giving sort of target. We haven't really finalized our business plans, so we're not ready to give guidance. But I think given the fact that we've performed by historically in that range, what we wanted to do was be very conservative going into next year and to provide guidance that fully reflects the risks that are currently in the marketplace. We think that we will be moving up in that range, the latter part of the year, but certainly given the weather patterns that we experience in the first 2 quarters of any year, we should us being at the lower end of that range and gradually increasing. And while I don't want to give guidance for 2010, I think a lot of it -- I mean, I’m sorry 2013, I think we will pick up momentum in the latter part of 2012. I think we have done a lot to de-risk our company, especially with respect to some of the actions that we're taken, taken with respect to our reserves as well as taking aggressive action to shift our business mix towards businesses in better markets with -- I mean, with better pricing trends. So we're doing a lot of things, that I think are prudent. Unfortunately, it may not be showing up in the numbers but what we're trying to do is remain conservative. That's the key, especially at this point in the market cycle. And I know some people have mentioned about adverse development this quarter, but quite frankly, I don’t understand it. Like I said, we never had any adverse development. We had 7 acquisitions and our bill for that thus far is about $6.5 million. So I think what we're showing is very careful and prudent management of our risk as well as to build up our company for the future. And I think compared to other companies that are showing much worse combined ratio, I mean let's put it into the right perspective. Normalized basis, we're still in the mid-90s. We're returning 10% to 12% return on equity. So I think sometimes we lose sight of the fact that we have performed well, and despite the fact that we may not be in the 18% to 20% return on equity range that we've had historically, we're still a very profitable company. We are probably going to end the year with $1.8 billion and we grew our book from $800 million in 2008 to $1.8 billion. So we created 3 different businesses and we've done a lot. So we're very proud of what we have achieved and if Irene -- I think Irene shows what could happen if a worst case type of scenario does occur and we held up pretty well. We just – it was an earnings event and overall we're quite happy with the direction of the company and the kind of conservative approach that we're taking especially given the risks that are inherent in the marketplace, and I think we started early on in the fourth quarter of 2009 and we've been working through all these challenges, and I think we're going to emerge out of this in very good shape.

Richard W. Mortell - Piper Jaffray Companies, Research Division

That's helpful. And is there an impact from on goodwill from the negative development? From...

William E. Hitselberger

[indiscernible], Richard. I mean, we obviously go through the accounting process of evaluating the goodwill on an annual basis. I think we tend to take the view with respect to catastrophe losses that while they are abnormal with respect to their timing and when they impact, when you smooth the cat impacts out we still are very comfortable that we've been -- we've done our acquisitions and we've really purchased well-performing books of business.

Richard W. Mortell - Piper Jaffray Companies, Research Division

Okay, great. And then my last question was do you guys just have a rough estimate of how much you'll be spending on tech going forward for, maybe 2012 or just a quarterly run rate for the system upgrades?

William E. Hitselberger

For tech, technology, okay. Our overall IT spend is including -- that includes people and processes, et cetera, so that's $60 million. So now that, again, includes a lot of different things and insurance companies have the habit of having different accounting methodologies for what they include in technology, but ours include all of our data, all our data lines as well as system developers and people as well as the IT infrastructure.

Michael H. Lee

And I think most importantly, we are paying about $24 million to OneBeacon for the use of their personal line system, which is split between the reciprocal companies and our stock company. So we should see that come to an end, hopefully towards the latter part of 2012 and certainly an early part of 2013. So we should see significant reduction in our technology cost. So as I mentioned before, we're operating an elevated expense ratio, mainly because of investments that we have made in the short-term.

Operator

Our next question is from Bob Farnam of KBW.

Robert Farnam - Keefe, Bruyette, & Woods, Inc., Research Division

The guidance that you've given for 2011, does that include any of the storm losses that we've had recently, just in the fourth quarter?

William E. Hitselberger

It does not, at this point, Bob. And we don't have -- actually you're right, there has been a storm that occurred the last week in October on the northeast. There was a snow storm that's caused some power outages. It's too early for us to declare anything with respect to that. We've had some claims activity, but right now, it's very early within the stage of getting reported information on that.

Robert Farnam - Keefe, Bruyette, & Woods, Inc., Research Division

Okay. And just to clarify, the $60 million of cat and the $10 million of development, that's just in the stock companies, you're not giving us any of the numbers for the reciprocals.

William E. Hitselberger

That's correct, Bob. And what I try and do in terms of the presentation here is to focus on the numbers that'll impact our operating earnings results. Then just to give you some color, the reciprocals had overall favorable -- and that'll come out, you'll see it in our Q when that gets published. Reciprocals had year-to-date favorable development, they continued the trend that they had year-to-date through 2011 -- through June, I'm sorry. The reciprocals had, in terms of storm losses, $6.5 million. And then on an aggregate basis on a year-to-date basis, they continued to display favorable development in primarily within the trends that we saw in the stock companies with respect to Personal Auto.

Operator

Thank you. This ends the Q&A portion of today's conference. I'd like to turn the call over to management for any closing remarks.

Michael H. Lee

Thank you, Tyrone. I just want to thank everyone for participating on this call and we look forward to getting together with you next quarter. Thank you very much.

Operator

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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