When I bought shares in Tower Group (Nasdaq: TWGP), a small specialty insurance company, I thought that the Street was basically overlooking a growing insurance company that had significant expansion potential and a record of savvy management. As it turns out, maybe the Street wasn't missing so much – delays in integrating a major acquisition and surprisingly large underwriting losses have definitely eroded some of the value in this name. Although it remains a respectable value idea, the story has shifted from waiting for the Street to discover it to waiting on management to re-establish its bona fides.
A Tougher Landscape
It may not even be relevant to think of Tower as a specialty insurance company like W.R. Berkley (NYSE: WRB) anymore. From a business base that was once centered around small business casualty policies in the Northeast, Tower has expanded more and more into property, individual lines, and new regions like Florida, Texas, and California. Accordingly, it's more like a small P&C insurer competing for business with the likes of Travelers (NYSE: TRV), Allstate (NYSE: ALL), Berkshire Hathaway's (NYSE: BRK.A) GEICO, and Progressive (NYSE: PGR), but with a more focused attention on business customers.
In any case, 2011 was not a great year for the P&C insurance business. Claims from natural occurrences like storms have boosted loss rates and it has been very difficult to find much premium leverage. With interest rates so low, it is not as hard to capitalize an insurance business, so there is ample capital chasing the same pool of insurable business. Likewise, low returns on investment portfolios incentivize some insurance management teams to loosen underwriting standards and/or cut prices to keep up the appearance of growth. All in all, whether an investor looks at Allstate, Progressive, Chubb (NYSE: CB), or Berkley, returns on asset and capital are below long-term trends; sometimes substantially below.
Some Wounds Are Self-Inflicted
In a market where even the likes of Allstate, Travelers, and Progressive have seen below-average returns, it may seem unfair to criticize Tower management for 2011's performance. Unfortunately, some Tower Group's problems are of their own making.
The acquisition of OneBeacon was supposed to be transformative and so far it has … but not in the good way. The company has had some challenges integrating the business and that is depriving investors of the promised margin and return benefits. More to the point, management keeps pushing back the target date for full integration and the company keeps racking up expenses like tech service fees for maintaining the two platforms.
Along similar lines, recent acquisitions have hinted that management may not have been so thorough on pre-M&A due diligence. Reserve development from acquired business has not been as favorable as hoped and that is not only increasing underwriting losses (and decreasing earnings and returns), but undermining some of the analyst/investor community faith in management.
Tower management has also talked about expanding into “alternative investments” to boost income. Given that the experiences of AIG (NYSE: AIG), Allstate, and XL Capital (NYSE: XL) with “alternative investments” are still fairly fresh memories, that decision may not go over well with all investors. Of course it's not fair to draw such direct comparisons, but Wall Street is more and more in a “show me” mood these days.
Improvements In Store?
With sound underwriting policies, insurance is still a great long-term business and Tower Group did not get this far without demonstrating some degree of skill. The question, then, is how much more pain and adjustment is in store as the company adapts to its new, larger footprint.
Fortunately, companies like Allstate, Travelers, and Progressive have been more optimistic of late. Losses from 2011 and before have chastened some of the more aggressive underwriters and it looks like premiums are firming. It also helps that Tower operates in more potentially profitable specialty markets where the larger players don't compete so aggressively (if at all). And of those that do compete there, companies like Berkley and Markel (NYSE: MKL) tend to be rational competitors.
The Bottom Line
Investors looking at the insurance industry will note that a lot of the quality companies (Progressive, ACE (NYSE: ACE), or Arch Capital (Nasdaq: ACGL) for instance) tend to be trading pretty close to fair value. The companies that look like better bargains all seem to have some spots on them.
Given the underwriting results and the challenges in integrating acquisitions, I'm bumping up the discount rate on Tower Group in my excess returns model. I still believe that the company can achieve 13% returns on equity by 2015 and that doing so can fuel a target price above $28. Realistically, Tower Group has to rebuild some goodwill with institutional investors and analysts before the stock can work, but a less eventful 2012, coupled with real internal operating efficiency progress, could be just the ticket for this stock.
Disclosure: I am long TWGP.