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Tower Group Inc.(NASDAQ:TWGP)

Q3 2007 Earnings Call

November 7, 2007 10:00 am ET


Thomas Song - Managing Vice President

Michael Lee - President and CEO

Frank Colalucci - Senior Vice President and CFO


Beth Malone - KeyBanc

Bijan Moazami - FBR

Peter Seuss - Sunova Capital


Good morning ladies and gentlemen, my name is Cynthia, and I will be your conference facilitator today. At this time, I would like to welcome everyone to Tower Group's Third Quarter Earnings Call. (Operator Instructions)

It is now my pleasure to turn the floor over to your host, Managing Vice President, Mr. Thomas Song. Sir, you may begin your conference.

Thomas Song

Thank you operator. Good morning. Before I turn the call over to Tower Group's President and CEO, Michael Lee, and the Company's Senior Vice President and CFO, Frank Colalucci, I want to remind you that some of the statements that will be made during the 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 period 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 Relation section of Tower's website.

Now, I would like to turn the call over to Michael.

Michael Lee

Thank you, Tom, and good morning everyone. I would like to thank all of you for joining us on this conference call to discuss our third quarter operating results. As described in this morning's press release, I am pleased to report that Tower Group has once again produced strong operating results for the third quarter of 2007.

Our net income increased by 70% to $14.4 million for the third quarter from $8.5 million for the same period last year. In addition, our diluted earnings per share increased by 47.6% to $0.62 for the third quarter, as compared to $0.42 for the same period last year.

You may recall that during the second quarter, we had not yet fully deployed the additional capital that we raised in January of this year. In addition, prior to July 1, we only utilized quota share reinsurance from CastlePoint Re, and did not have the ability to place business into CastlePoint Insurance Company. As a result of these factors, as well as Preserver's high expense ratio, which we subsequently lowered, our second quarter return on equity was 17.2% which was lower than our target of 20%.

During the third quarter however, we were able to fully deploy our own capital, as well as utilized both the insurance from CastlePoint Re and risk sharing capability from CastlePoint Insurance Company.

During the quarter, we raised $23.4 million in CastlePoint Insurance Company to generate $7.5 million of fee income. In addition, as I will describe in further detail later, we were able to generate greater profits from Preserver. As a result, I'm pleased to report that we were able to increase our return on equity to 19.6% during the third quarter.

We expect our utilization of CastlePoint Insurance Company to significantly increase in the fourth quarter, and combine with our other hybrid model element; ROE in the fourth quarter is expected to exceed 20%.

Despite the soft market condition, we have been able to grow our business profitably due to our ability to segment the market and position our products in profitable market segments.

During the quarter, our growth premiums written and managed increased by 51% to $151 million from approximately $100 million during the same period last year. Despite this strong growth, we maintained our underlying discipline as reflected by our 83.4% net combined ratio, comprised of 54.7% net loss ratio, and 28.7% net expense ratio.

In addition, we were able to achieve premium increases on renewal polices of approximately 9.3% in personal lines and 2.7% in commercial lines during the quarter. Furthermore, our retention rate on renewal policies continued to be favorable; 88% for personal lines and 77% for commercial lines.

In addition to our success on our renewal policy, we had success inviting new business through our retail, as well as whole sale agent. We are seeing continued growth from approximately 900 retail agents throughout the Northeast, including approximately 300 retail agents that we added this year from our Preserver acquisition. As a result of the Preserver acquisition and territorial expansion throughout the Northeast, we were able to generate $35 million of new business during the quarter from Northeast states other than New York.

Our products are uniquely positioned in each of our agent's offices and our ability to distribute these products through the web certainly provides us with the ability to promote ease of doing business at a low cost.

We're in the final stages of launching our last and largest product line, commercial package policies on the web during the fourth quarter. In addition to improving service and lowering our expenses, the build out of all lines of business on the web will accelerate our ability to expand territorially, as well as enable us to exercise greater control over the underwriting process.

In addition to the production from our existing retail and wholesale agents in the Northeast, we generated an additional $13 million of new business during the quarter from our wholesale expansion initiative throughout the country.

We also generated $5.7 million through our participation in program and risk sharing business with CastlePoint management.

During the quarter, we also obtained the license in California, in our main operating company, Tower Insurance Company of New York. As a result, we anticipate strong growth in that state from retail and wholesale agents through Tower and program underwriting agents through CastlePoint in the fourth quarter and into 2008.

Finally, our strong operating results during the quarter reflect the continuous success in integrating Preserver. During the quarter we generated $21.5 million through Preserver agents. We also continue to lower Preserver's expense ratio and expect Preserver's expense ratio to be close to Tower's expense ratio by the end of the first quarter of next year. Therefore, we're on track to create significant value for our shareholders by quickly transforming this company that has less than a 5% return on a equity when we brought the company to a company that is now projected to achieve our target return on equity in excess of 20%.

Before, I turn over the call to Frank, I would like to emphasis that despite our strong premium growth and expansion plans, we continue to maintain underwriting and pricing discipline by focusing on small low hazard policy as well as carefully selecting and allocating capital to profitable line to business and market segment.

As I have mentioned previously, business reflected in the 54.7% loss ratio which is well below where we need to be to achieve our target return on equity of 20%. In addition, our new factor are low expense ratio of 28.7% achieved during the quarter with the opportunity to lower this even further by generating additional fees from managing CastlePoint Insurance Company you can see why we're confident in maintaining our favorable outlook despite the softening market conditions.

With that all review, I will turn it over to Frank to review our financial results and further details. Frank?

Frank Colalucci

Yes, thank you, Michael and good morning everyone. I will cover some of our financial highlights, and then provide an update on our outlook for the fourth quarter. Our net income growth in both the quarter and for the nine months period whereas the result of strong contributions from all sources of revenue. Net premiums earned commission and fee income and investment income.

For the quarter, our net premiums earned represented 65% of total revenues. Net investment income excluding realized capital losses represented 9% of total revenues and commission and fee income represented 46% of total revenues. Net premiums are increased by 40%, just $73 million for the quarter.

Our allocation of business between that which is retained on a net basis in our insurance companies and that which is either reinsured or placed directly with other companies through the insurance services segments, thereby generating commission and fee income, reached our target of approximately 50-50 for the quarter.

We utilized 40% to 80% for quota share reinsurance for CastlePoint Re from our traditional brokers pool and as Michael noted, you placed over $23 million of premiums through TRM in our insurance services segment with CastlePoint Insurance Company in the U.S.

The commission out of ceding quota share premiums and fees received on our premium space with CastlePoint Insurance Company, combined, generated substantial revenue growth this quarter.

Total commission and fee income increased by 100% to $29.3 million in the third quarter, as compared to the third quarter last year. More significant contributor to this growth was provided to the premium capacity of CastlePoint Insurance Company which resulted in a seven-fold increase in our insurance services revenue in the third quarter of last year.

We continue to experience a very favorable loss ratio which is a significant contributor to our bottom line and also means that our ceding commission and management fee range increased 2% last quarter and this rate continued into the third quarter. This represents a 36% commission or fee rate so long as the ceded loss ratio remains 58.7% or lower.

The growth loss ratio for the insurance and reinsurance segments combined for the three month ending September 30, was 50.4% and then net loss ratio was 54.7%. There was approximately $500,000 of favorable developments from prior year reserves.

The growth expense ratio for the quarter was 29.2%, and the net expense ratio was 28.7%. The acquisition of Preserver with its higher expense ratio added about 1% to the growth expense ratio.

Our investments in cash combined grew to $695 million, compared to $486 million a year ago. The growth of investments was driven by operating cash flows and the acquisition of Preserver, which resulted in a financial leverage ratio of average investment assets to average shareholders equity, up 2.4 to 1 for the quarter.

On a tax equivalent basis, the book yield on our portfolio was 5.9% as of September 30th. And we maintained a portfolio duration of approximately 4.1 years during the quarter. We had a minimum amount of net realized capital losses of $62,000 for the quarter, and currently our new money rate for the majority of our portfolio is 5.4%.

I will spend a few moments going over our investments, including subprime mortgages. As reported in other comprehensive in the third quarter, gross unrealized losses increased $9.1 million, which was about $6 million after taxes, primarily in our mortgage-backed investments, including subprime and equity REITs.

Our REITs invest primarily in commercial mortgages and HSE-backed residential mortgages. We believe the overall downward pressure on the values of these investments results from a lack of liquidity occurring in most fixed income markets, due to the unwinding of leverage funds, which has resulted in wider yield spread.

We actively monitor and analyze conditions relating to all of our investments to determine if any or other temporarily impaired, with a particular focus on subprime mortgages and reinvestments.

We have $29.1 million of subprime exposure at fair value of 97% is investment grade. This consists of about $12 million of subprime mortgages held directly, and about $17 million in a [frozen fund].

There have been no defaults or changes in ratings. As of September 30, the unrealized loss of this portion of our portfolio was estimated to be $6.1 million or about $4 million after taxes. [Weeks] totaled $13.7 million at cost, on these the fair value was less than cost by $3.8 million or about $2.5 million net of cash at the end of September.

In consideration of our relevant factors including the sheer length time, the investments have had an unrealized loss. We concluded that no investment was other than temporarily impaired. Through October, these investments continue to perform as we expect making interest and dividend payments, and there have been no ratings exchanges. Although prices declined further from the third quarter levels, due primarily to the continuing lack of liquidity.

We will continue to monitor these investments for other than temporary impairment. Just a quick word on our overall portfolio. Over half of our total fixed income portfolio averages a AAA rating or are in treasuries. And the overall average quality of our portfolio is AA.

In summary, our net income in annualized return on average equity was $14.4 million and 19.6% respectively for the quarter. Michael mentioned our ROE has come back to our target range after the effects of the first quarter common stock offering. Net income in annualized return on average equity for the nine months ending September 30, 2007 was $38 million and 20.4% respectively.

I would like to now highlight the outlook for the fourth quarter and the year.

For the fourth quarter 2007, we project net income and diluted earnings per share to increase to a range between $17 million and $19 million and between $0.75 and $0.85 per share respectively.

For the full year, we anticipate net income to be in a range of between $55 million and $57 million, and diluted earnings per share to be between $2.40 and $2.50 per share. These projections do not include any amounts for realized capital gains or losses.

We will now open the call for questions. Operator?

Question-and-Answer Session


Thank you, sir. (Operator Instructions) We will take our first question from Beth Malone with KeyBanc. Please go ahead.

Beth Malone - KeyBanc

HI, thank you. Good morning and congratulations on the quarter. I wanted to ask about the California expansion and licensing. Should we anticipate that the kind of business you are seeking in California is similar to the urban market business that you initially started riding in the New York market, that was the core of Tower Group a couple of years ago? Or is the product mix a lot broader?

Michael Lee

Good morning, Beth. We think California provides a great opportunity for Tower, we've been researching this market for sometime, the only delay has been due to lack of licensing, and we just stopped the license a few months ago. So, we’re now in a position to really extend into that stage.

We think California has similar characteristics as Tower; you alluded to urban markets, certainly that’s something that we’re targeting. We’re pretty much looking to start with the wholesale agents. We have a [storage expend] territorially with our wholesale agents first, and then we plan to build our retail distribution system in California as well as access some business that we're getting from CastlePoint. But to answer your question, we don't plan to do anything differently than what we had done in New York. If you look at our expansion plans, we have done it very judiciously, very carefully. We expanded about two to three years ago from New York into the rest of the Northeastern states and we are very pleased with the successive expansion. And we think that type of careful expansion is what you could look forward to in California as well as Western states.

Beth Malone - KeyBanc

Okay, thank you.

Michael Lee

You're welcome.


Anything further Miss Malone?

Beth Malone - KeyBanc

No, that's it. Thank you.


Thank you. (Operator Instructions) We will take our next question from Bijan Moazami with FBR. Please go ahead.

Bijan Moazami - FBR

Good morning everyone, a number of questions. Surprisingly, you guys are still getting rate increases both in the personal lines and commercial lines. And I am just wondering, if you could explain how you are still able to maintain pretty rate adequate results and on top of that, get 2.4% rate increase in the commercial lines?

Michael Lee

Good morning Bijan, lot of investors ask us that question and I guess, lot of which still out in the marketplace. We seem to be an exception for us getting any type of premium increases. First of all, I just want to point out that we are not getting rate increases, either premium increases over renewal policies, we look at the exposure base, and we adjust our premium on renewals based on the increase in exposure base. We have lots of our policies as inflation guards, endorsements that allow us to increase our premium based on, increase in market value as well as increase in exposure base.

So, when you're dealing with small policies as we are, our underwriters look at each policy carefully and make sure that we have proper exposure. And if we apply our underwriting guidelines, you typically will get exposure increases, I think, pricing increases due to our underwriters adjusting their exposure base, as they should, to reflect inflations and other changes in exposure. So that's what you are seeing, and I think the market that we are in, allows us to pass on these premium increases because when you talk about 2% to 3% increases, it doesn't translate into much when you are dealing with $2000 to $3000 policy. So, I think, we definitely are in market segments, where we are less vulnerable to pricing competition.

In addition to that, we are in market segments, where we do see competition, except we don't grow in those market segments, what we do is, we allocate capitals to market segments where we believe we can get adequate pricing, and we have done that repeatedly each year, and what we do is we research the markets, understand what's going on, and if we feel that there is price erosion in certain market segments that we are in, we withdraw from that marketplace, we don't cancel any policies, what we do is, we continue to renew, but we don't seek to expand our premium writings in those market segments. And we also look for new products, new opportunities and by doing that we believe we can continue to maintain underwriting and pricing discipline, as we had done throughout the hard market as well as into the soft market that we have been experiencing, I guess, for about a year or two years now.

Bijan Moazami - FBR

Great. Also excluding Preserver, you managed to increase the policy enforce account, in a very significant way. If you could explain a little bit how are you doing that and in particular what product line do you think that is the best increase in terms of this?

Michael Lee

Well, I think, we're seeing a growth in workers comp line of business. We're also continuing to see some growth in personal lines. I think in the package area we're seeing a lesser growth as well as in commercial auto, but you have to remember that we have a very, we're in the early stage of our expansion and we're expanding territorially. We're expanding in the Northeast and we just started doing that about two weeks ago, I mean two years ago. So, we have a lot of opportunities, we have 900 retail agents and we haven't really fully worked that distribution system. So, what you're seeing is, us getting to these brokers, signing these brokers on and putting them on the web. And as we experienced into each state, we're expanding the number of agents that accepts our system, and what you're seeing is that gradual increase in the number of agents that are accepting our system. And it's been gradual, so our premium growth has been gradual as we expand throughout the Northeast and also, we’re expanding internationally through our wholesale agents.

So, we have a lot of expansion initiatives that is countering any type softness that we’re seeing in the existing markets, in fact our growth in the existing market is probably about less than 10%, but remember we have the Preserver acquisition. We’re extending territorially, we’re introducing new products and that enables us to increase our policy count as we had done throughout this year, despite the softening market condition.

Bijan Moazami - FBR

Thank you.

Michael Lee

You’re welcome.


We’ll take our next question from Peter Seuss with Sunova Capital. Please go ahead.

Peter Seuss - Sunova Capital

Hey guys, congrats on a good quarter.

Michael Lee

Thank you.

Peter Seuss - Sunova Capital

I just had a quick question on the expense ratio, wondering if, are we currently at a full run rate for that, is Preserver fully integrated or is there still some room to bring that down?

Michael Lee

Two points there in answering the question. We can still expect further decline in Preserver's expense ratio. We think that we can continue to lower the expense ratio and get the expense ratio equal to Tower’s, and we expect that to happen in the first quarter of 2008.

Secondly, we are generating a significant amount of fee income by accessing CastlePoint Insurance Company, as I mentioned during the call, we did not have the opportunity to establish our relationship with CastlePoint Insurance Company. So, we primarily relied on quota share reinsurance arrangement with CastlePoint Re. Now that we have access to CastlePoint Insurance Company, I think you’ll see a significant increase in fee income with should offset our growth expense ratio to lower our net expense ratio even further in the fourth quarter. So, I think those things that I mentioned, the lowering of the Preserver expense ratio, as well as generating additional fee income from managing CastlePoint Insurance Company will continue to lower our net expense ratio in the fourth quarter and into 2008.

Peter Seuss - Sunova Capital

Got you. And then also obviously, kind of in the stock market, and it's getting softer, I'm just wondering you guys have been pretty active in your use of reinsurance. Are you contemplating reducing your net retention further or, any color you could give us with that dynamic?

Michael Lee

We are looking at that, and certainly we are in the market place, and we are searching for additional reinsurance capacity even beyond CastlePoint, because CastlePoint has a certain amount of capacity to provide us, and we are finding great reception and in the stock market, we've historically ceded more business, and I think you can look forward to that happening in the future. And if we do that, obviously, we are able to generate more commission income, which in turn would allow us to lower our net expense ratio, and in turn increase our return on equity.

So, I think you can anticipate we will do that as the softening market condition, while it has some adverse, in fact on the primary market, it has really a beneficial impact on us to the extent that the terms and conditions that we can get from reinsurance will significantly improve in the stock market. So, that's the advantage of our business model than we could manage the cycle better and exploit the opportunities that the stock market provides us.

Peter Seuss - Sunova Capital

Sounds good. And then, in that event, I mean, if you were to buy more reinsurance, would you then have access capital or was the growth in your business still require you to keep all the capital it has?

Michael Lee

I think, certainly if we do utilize more insurance, we'll have no need to utilize our own capitals, but I think we are pretty happy with our capital position. We're certainly not looking to increase our capital, or retain our earnings or significant that in itself. We'll provide the capital that we need to support our growth to the extent that we exceed our production exceed the growth in our capital. Then, we would place the premium with other reinsurers in addition to capital funds to the extent that they don't have the capacity that we are seeking. So, the answer to your question, we are happy with our capital position and we are not looking to raise any money, any additional capital, but in order to support our premium growth, we are looking at additional capacity that we can gain from other reinsurers.

Peter Seuss - Sunova Capital

Great, thank you.

Michael Lee

You're welcome.


(Operator Instructions) And it appears, we have no further questions. Mr. Lee; I'll turn the conference back over to you for closing comments.

Michael Lee

Thank you operator. As I mentioned earlier during this call, we have continued to successfully execute our business plans and despite the overall softness in the insurance market, we've been able to generate profitable growth to differentiate us from other insurance companies in our industry. Due to the success of the growth initiatives that we have outlined during this call, we believe, we are well positioned to continue to properly grow our business for the rest of the year and into 2008.

I would like to thank all of you for participating in our call and look forward to speaking with you next quarter.


Ladies and gentlemen, this will conclude today's presentation. We do thank you for your participation. And you may disconnect at this time.

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