Tower Group's CEO Discusses Q1 2012 Results - Earnings Call Transcript

May. 8.12 | About: Tower Group, (TWGP)

Tower Group (NASDAQ:TWGP)

Q1 2012 Earnings Call

May 08, 2012 9:00 am ET

Executives

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

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

Analysts

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

John Thomas

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

Operator

Good morning, ladies and gentlemen, my name is Samya and I'll be your conference facilitator today. At this time, I would like to welcome everyone to Tower Group's First Quarter 2012 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, Samya, 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 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 a reminder, Michael and I will be speaking today and referencing a slide show that is available on our website, www.twrgrp.com, under the Investor 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 first quarter 2012 operating results and our recent transaction with Canopius Group that we announced on April 25.

Let me start on Page 3 by giving everyone a brief snapshot of our first quarter results. We had operating income of $21.9 million during the first quarter, which was in line with our expectations. We achieved 20% top line growth, driven by our organic growth initiative and continue to see positive market and pricing trends.

We expect our growth rate for the year to be lower, close to the upper end of our 5% to 10% target. Finally, we were successful in initiating the rollout of our personal lines system this quarter after developing this system for more than 2 years, which should improve our efficiency and gradually lower our expense ratio.

As previously announced on April 25, we also agreed to make an investment in Canopius Group, a privately held international specialty, insurance and reinsurance company, underwriting primarily through its Lloyd's managing general agency and syndicates. We committed to make an investment of $75 million in Canopius, representing a 10.7% interest in this company.

In addition to the investment, this transaction allows us to potentially establish a presence at Lloyd's, subject to the approval of Lloyd's and the Financial Services Authority. It also provides us with the opportunity to potentially merge with Canopius' Bermuda reinsurance operation.

As shown on Page 4, our operating income for the first quarter was $21.9 million or $0.56 per diluted share, compared to operating income of $20.3 million in the same period last year or $0.49 per diluted share. The first quarter 2012 results include an after-tax charge of $8.4 million associated with prior year reserve strengthening and also reflect lower-than-expected property losses, as unseasonably warm weather on the East Coast of the United States resulted in lower property claims.

Operating income in the first quarter of 2011 was impacted by claims related to unusually severe weather. Our stockholders' equity increased by 2% to $1.058 billion, from $1.043 billion, after taking into account $77 million of share repurchases and dividend payments since the first quarter of last year.

Our book value per share increased by 6% to $26.83 per share at March 31, 2012, from $25.24 per share at March 31, 2011. As shown on Page 5, our combined ratio net of reciprocals during the quarter was 99.2%, compared to 97.6% for the same period last year. Our ROE was 8.4% for the quarter, compared to 7.8% in the first quarter of 2011. We expect our ROE to gradually improve throughout the year and for us to be close to our 10% to 12% target beginning in the second half of 2012 and into 2013.

Due to the organic growth initiative that we implemented last year, our premiums written and managed for this quarter increased by 12% to $467 million from $390 million that we achieved during the same period last year.

Page 6 provides further details on our organic growth initiative, which helped us to achieve our strong top line growth this quarter. Through our organic growth initiative, we are developing new products, creating more entrepreneurial business units and improving the various functions related to generating organic growth.

This quarter, we expanded into commercial property, inland marine and surety products. The surety product offers a unique and innovative program aimed at the small and mid-sized contractor. This program supports contractors throughout the construction process by providing bonding, working capital and other support services. We're also in the process of enhancing our personal package policies to appeal to more affluent clients.

In addition to developing new products, we're also improving our existing business units and creating new ones, while recruiting senior-level underwriting executives with national experience. During the quarter, we hired a new personal lines executive with national experience to expand our personal lines product offerings. We also created a new national commercial property business unit to focus on writing property business, especially in the construction industry.

The newly created business units, customized solutions and assumed reinsurance, continue to drive our organic growth with $54 million in gross written premiums generated in the first quarter. Through our assumed reinsurance business unit, we continue to access property-oriented business through the Lloyd's market where we are seeing favorable pricing trends.

The customized solutions business unit continued to build a pipeline of unique products from regional and national retail agents. We also established a market research department this quarter to identify and develop a pipeline of profitable business opportunities and hire senior marketing executives to support our organic growth initiative. Based on the organic growth that we have been seeing for the last few quarters, we're confident about our ability to expand into profitable new markets, while continuing to reunderwrite or terminate less profitable businesses.

Page 7 outlines our operating results for each of our segments. As I mentioned at the beginning of the presentation, we have seen positive market trends over the last 2 quarters. Our overall Commercial business grew significantly this quarter, driven primarily by the growth in assumed reinsurance. Other segments achieved moderate levels of growth.

In the Commercial General business unit, we are seeing signs of pricing stabilization with modest improvements in our middle-market Commercial business and our workers' compensation line of business. We plan to expand our small workers' compensation business in 2012 and began to see meaningful growth opportunities in this business during the first quarter, utilizing our web-based platform over wider geographical territory.

In our Commercial Specialty unit, the 2 newly created business units, customized solutions and assumed reinsurance, generated $54 million during the first quarter. We will also seek to make strategic investments in program underwriting agencies, with a profitable specialty business that are willing to assume risk on their business in an effort to better align our interests and achieve more consistently profitable results.

In addition to increasing rates, we expect to continue to lower our loss ratio by improving business mix impact through the aggressive runoff of poorly performing business in the national programs and the addition of more business in lower loss ratio property, inland marine and surety lines.

This includes our new national property department, our excess and surplus homeowners expansion and a joint venture with a surety operation. The growth of our personal lines business in the first quarter was essentially flat from the prior period, due primarily to the continued reunderwriting of monoline personal auto. We continue to see favorable trends from the emphasis on our package and homeowners product line, our personal lines business segment overall, had a 91% retention rate and positive renewal change of 3.0% with a 92.9% combined ratio.

Finally, in our Insurance Service segment, we generated approximately $7 million in fee income from managing the reciprocal exchanges, the licensing of the reciprocal insurance companies is being expanded and they plan to write additional business in these reciprocals, which will increase our fee income in 2012.

In summary, we remain confident that our -- that the improved market, our actions to cancel nonperforming programs and our shift in business mix towards more property, will continue to have a favorable impact on the achievement of our results.

Now with that, I will turn the call over to Bill to provide additional financial highlights and then I will discuss our recent transaction with Canopius. Bill?

William E. Hitselberger

Thank you, Michael. Slide 8 details our loss ratios for the first quarter of 2012. We will focus our discussion on the loss ratios excluding the reciprocal exchanges, as these ratios are those that impact our shareholder results.

In the first quarter of 2012, we experienced net after-tax adverse development of $8.4 million, compared to $5.2 million for the same period last year. For the first quarter of 2012, $7.7 million of the after-tax unfavorable development was in our Commercial segment and arose from changes in estimated ultimate losses for accident years 2010 and prior, based on reserve studies completed during the quarter. The majority of these charges from these studies were due to updated loss development factors affecting reserve estimates, primarily for discontinued program business.

We had $700,000 in after-tax unfavorable development in Personal Insurance in the first quarter of 2012, which was mostly from our 2011 accident year automobile physical damage. The $5.2 million after-tax development in the first quarter of 2011 was primarily due to severe weather losses at year end 2010, and contributed to our recognizing $9.8 million in after-tax severe weather losses in the first quarter of 2011. We had no severe weather losses in the first quarter of 2012.

Excluding the adverse development, our first quarter 2012 loss ratio was 60.7%, which is modestly higher than the 60.2% we recorded in the first quarter of 2011. Going forward, we expect to see an improving accident year loss ratio as we expect that the current positive pricing trends that we are seeing in our existing business will result in improving loss ratios as these trends fall into earnings.

Our current new business focus, monoline property, customized solutions and assumed reinsurance, should also generate improving accident year loss ratios, as these businesses start to become a higher proportion of our earned premiums.

Finally, our loss ratio should also improve as premiums earned from program business sourced from non-risk taking MGAs winds down.

Page 9 of the presentation details our expense ratio for the first quarter of 2012, as compared to the same period in 2011. Underwriting expenses excluding the reciprocals, were $137.5 million representing an increase of 15% over the same period in 2011. The increases in expenses were primarily due to increased business production, as well as a change in the methodology of allocating loss adjustment expenses, which increased the expense ratio by about 1 point as compared to 2011.

We also continued our spend to support our ongoing effort to build out our information technology infrastructure to support our personal lines policy administration and claims processing technology platform. As Michael mentioned, we began the implementation of this platform at the end of the first quarter.

The commission portion of the underwriting expense ratio, net of ceding commissions we received, was 18.4% in the first quarter of 2012, compared to 17.6% for the same period last year. We expect to see a higher commission rate in the first half of the year, reflecting a change in the proportion of our earned premiums derived from assumed reinsurance, which has a higher commission cost than our direct business.

By the fourth quarter, this increase in commission expense is expected to be less pronounced, as the proportion of earned assumed reinsurance should be more consistent at that time between 2011 and 2012. The other underwriting expense component of the expense ratio, net of fees, was 12.9% in the first quarter of 2012, compared to 11.7% for the same time period last year.

The largest component of this increase was a change in allocation methodology for loss-adjusting expenses, which increased the other underwriting expense ratio by about 1 point. We expect the increase in earned premiums anticipated in the second half of this year to reduce the impact of this change in allocation.

The organic growth initiative that Michael mentioned earlier should lead to increased scale savings in 2012 and we expect to see a reduction in our other underwriting expense ratio into 2012 from this increase in scale, as the rate of organic growth is expected to significantly outpace the rate of growth in other underwriting expenses.

This improvement should become more apparent in the second half of the year, as the cost associated with the personal lines technology platform begin to decrease.

Page 10 shows our investment highlights. As of March 31, 2012, our invested asset base was $2.4 billion, excluding the reciprocal exchange investments, up about $180 million from the year ago period. Operating cash flows were higher by $20 million in the first quarter of 2012, compared to first quarter of 2011.

Tax-equivalents book yields in our portfolio have been flat at between 4.6% and 4.8% since the first quarter of 2011. We have seen a flattening of tax-adjusted book yields since 2010, which is the result of deployment of new invested assets into higher-yielding corporate securities and also opportunistic increases in our tax exempt portfolio, to combat this steady decrease in the reinvestment rates.

We've also been allocating funds into dividend-paying equity securities, which have improved our tax-equivalent portfolio yields. We made some alternative investments in real estate and other private ventures in 2011, and have seen several of these investments start to generate positive returns, which has helped our yield in 2012.

Our consolidated balance sheet now contains the caption other invested assets, which is where we are classifying most of our alternatives. We are continuing to look at real estate and private investments as alternative asset classes to enhance our investment returns.

Despite the reinvestment rate challenges that we have been seeing, our net investment income increased by 5.1% from first quarter 2011. The actions we are taking in asset classes other than fixed maturities have allowed to continue our trend of growth in investment income.

In summary, we have been seeing stable, tax-equivalent book yields since year end 2010 and an upward movement in our total portfolio return, due to continued positive operating cash flows, as well as to our revised asset allocation and alternative investment strategy.

On Page 11, I will conclude my remarks by summarizing our first quarter 2012 results and providing some guidance as to what we expect to see in the rest of 2012 and trends that we believe will occur in our business beyond 2012.

In the first quarter of 2012, we experienced another period of significant growth in our business, aided by increased organic writings in our assumed reinsurance and customized solutions businesses. We expect growth throughout the remainder of this year, although at a lower pace than the 20% rate we saw in the first quarter, and we expect to end this year at the higher end of our projected growth rate of 5% to 10%.

We expect to see our loss ratio between 62% and 63% in 2012, as we expect to see continued improving accident year loss ratios due to positive pricing trends that we are seeing in our existing business and improvements as our new business focus on monoline property, customized solutions and assumed reinsurance, start to become a higher proportion of our earned premiums.

Our loss ratio should also improve as premiums earned and program business sourced from non-risk taking MGAs winds down, with the potential to see lower loss ratios beyond 2012 from anticipated price increases.

We anticipated a modest uptick in our expense ratio in 2012, as increased commission costs were expected to offset scale-driven expense savings. We expect to see an improvement in the expense ratio for the balance of 2012, as earned premium volume outpaces expense growth.

We believe that this trend will continue beyond 2012 and expect to see lower expense ratios being driven by scale savings in our underwriting expenses beyond 2012. Our combined ratio should be between 96% and 98% in 2012, absent significant catastrophe activity.

Beyond 2012, we believe that the scale savings, as well as lower technology costs associated with the completion of some major initiatives, should lead to a reduced combined ratio. We expect to see investment income increase in 2012, due to an increase in our investment base, as well as the increasing impact that we expect from the alternative investments and asset allocation.

We expect to be below our 10% return target in the first half of 2012, but expect that we should see an improvement in our earnings in the second half of the year and beyond 2012, and we expect to be in the 10% to 12% ROE range by the second half of this year and into next year.

With that, let me turn the call back to Mike, who will talk a little bit about the Canopius transaction.

Michael H. Lee

Thanks, Bill. Now I would like to discuss our recent transaction with Canopius that we announced on April 25. Before I do that, on Page 13, I want to briefly outline our goals for the second 5-year period, from 2010 to 2014, since we went public in October of 2004.

During this period, we have made significant progress in accomplishing our goal of transitioning from a regional to a national insurance company developing commercial, specialty and personal product offerings and improving our systems.

Our transaction with Canopius will enable us to achieve our goal of enhancing our business model by gaining access to both Bermuda reinsurance and Lloyd's platforms, while also supplementing our fee-generating capability. With the accomplishment of this goal, we'll also will be able to achieve the final goal of increasing our ROE target in excess of the 10% to 12% range.

Turning to Page 14, I just want to provide further information on our transaction with Canopius. This transaction will allow us the opportunity to invest $75 million in Canopius, subject to the completion of Canopius' acquisition of publicly-traded London-based Omega Insurance Holdings. The investment will represent 10.7% interest in Canopius and will be funded from our existing investment portfolio. We will account for it by using the equity method and therefore, our operating and results reflect our pro rata share of Canopius' earnings.

Page 15 provides a background information on Canopius. Canopius is a privately-owned international insurance and reinsurance group writing a diversified insurance and reinsurance business primarily using its Lloyd's syndicates. Canopius underwrote approximately GBP 616 million or $1 billion U.S. equivalent of gross written premiums with their own capital, as well as capital provided by third parties.

With the exception of last year, when Canopius suffered losses from various catastrophes, Canopius has had excellent operating results, as reflected by 2007 to 2010 average combined ratio of 92% and 19.2% return on equity. We have an existing relationship with Canopius and for 2012, provide a quota -- a 6% quota share on their main syndicate. Our investment is contingent on Canopius' acquisition of Omega, which is subject to the necessary regulatory consents and acceptance of offer by Omega's shareholders.

Canopius anticipates that the acquisition should deliver substantial scale benefits to it. The acquisition will also significantly increase the size of Canopius' underwriting operations at Lloyd's.

Page 16 outlines our rationale for acquiring a Lloyd's option as part of the investment in Canopius and the terms of our agreement with respect to the Lloyd's option. As part of this initiative, in July of last year, we entered into a qualifying quota share arrangement with Canopius, pursuant to which, we assumed a portion of business it underwrote in its largest syndicate. As I mentioned in my comments on last the slide, the percentage is currently 6%. The option we're acquiring is an extension of the current relationship we have with Canopius and enables us to accelerate our access to profitable, specialty and international business underwritten through the Lloyd's market. It is exercisable for a period of about 18 months after they -- after Canopius closes on the Omega transaction.

We will work with Canopius to establish a presence at Lloyd's, subject to the approval of Lloyd's and the Financial Services Authority. Working with Canopius provides us with 2 significant advantages: First, in developing this Lloyd's business, we will be able to access Canopius' experience and expertise in the Lloyd's market; second, by working with an established and well-respected existing Lloyd's company such as Canopius, we believe we will minimize the execution risks associated with attempting to acquire or develop a standalone Lloyd's business by ourselves, and maximize the likelihood that we will be able to develop a Lloyd's business of our own over time.

Under the terms of the agreement, we will increase our quota share reinsurance of Canopius Syndicate 4444 to 10% starting in 2013. In addition, we may reinsure a greater portion of a class of specialty property business of Canopius called Direct and Facultative business. Finally, over time, we will work with Canopius to establish a Lloyd's presence, subject to the approval of Lloyd's and the Financial Services Authority.

Page 17 outlines the background and rationale for us acquiring the Bermuda option as part of the Canopius investment. In 2009, we made the strategic decision to merge CastlePoint Reinsurance Company into Tower. While this merger significantly increased Tower's size and capital position, it also resulted in CastlePoint becoming subject to U.S. taxation.

Since that time, we have had 2 objectives with respect to CastlePoint. First, we desired to deploy the capital that Tower had access to because of the merger. Second, we had explored ways to increase the profitability of CastlePoint by regaining the Bermuda advantage.

Over the past few years, we have successfully deployed the excess capital that CastlePoint provided to Tower, both through a series of acquisitions and through organic growth. Now, this option may enable us to achieve our second objective with respect to CastlePoint regaining the advantages of a Bermuda platform.

The option provides us with the opportunity to work with Canopius to carefully evaluate various transaction structures, including a combination with the Canopius' Bermuda reinsurance business. We are currently -- we are able to successfully -- if we're able to successfully execute this combination, CastlePoint would cease to be a subsidiary of a U.S. company, thereby regaining the advantages of a Bermuda platform.

Furthermore, following this combination, the capital in Bermuda subsidiaries would represent about 50% of the total capital in Tower. Exercising this option is subject, among other things, to our board approval. We intend to exercise this option only if we believe that the execution of the merger would allow us to achieve a return on equity in excess of our current target range of 10% to 12%.

Now with that, I'll turn the call over to answer any questions that any of you might have.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Randy Binner of FBR.

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

A couple, first, just a clarification and a little more detail on the reserve charge. Could you -- and I think pieces of this were in the call, but I just want to kind of get an all-in answer on the reserve development in the quarter. What accident years in particular were affected and what business lines were affected? I think it's workers' comp and commercial auto, but the percentage of each of those lines represented in the charge would be helpful.

William E. Hitselberger

Yes, I don't have the exact percentage in front of me, Randy. I can tell you that the charge was primarily from accident years 2010 and 2009. And you are right, in fact, the vast majority of the reserves charge related to workers' compensation and commercial auto. I would say that the -- I think that the biggest piece of it pertains to workers' comp, but that's something I can track down for you.

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

Okay. And then it's predominantly in the runoff programs too, right?

William E. Hitselberger

Yes, Randy. We have noted that, what we'd done as part of our normal quarterly process at the end of the year, our actuaries go through and adjust their estimates. They increased their loss development factors and that's a fancy way of saying that what they do is they look at how long they expect to see claims emergence because of some of the charges, because some of the things that we took in 2011, that increased their estimate of how long they thought the reserves would continue to develop. The charges that we took in 2011 were predominantly in the discontinued program business. So I think the reserve development, the loss development factors, were really associated with that segment. I know Michael wanted to give a little bit of additional color as to what our current business plans are.

Michael H. Lee

This adverse development is in the context of our overall 2000 plan, it's really not going to have an impact because we've been fairly conservative with respect to our planning and we believe that we can absorb this adverse development, as we did in 2011 when we had the adverse development in the first quarter of last year. So a little bit more detail on our reserving, from 2007 to, I think, 2010, we're seeing that the pricing erosion that we experienced probably would cause us to have to look at those years very carefully, and that's what we're doing and that's how come we did a thorough review this quarter and adjusted our loss development factors. But we feel that what we are writing since then, beginning in 2010, '11 and this year, our pricing is much better and we feel that the reserves for those years are in a very good position. So as far as our reserving position is concerned, we feel that with the exception of the -- our reserving from those the 3 years, from 2007 to 2010, we feel that we're in a very good shape. Just to add more to that, from an underwriting standpoint, since 2010, we have terminated many parts, many programs that we felt were not meeting our pricing standards, and what you're seeing this year is the runoff effect of the business that we terminated in those years, while we're seeing some very good positive pricing trends for the business that we have underwritten in the last 2 years. So I think we're going to continue to monitor the situation, but we feel that our business plan allows us to take any type of adverse development that we may experience in those years and in the course of our business planning, we anticipated that we may have to be conservative with our calendar year loss ratio plan for 2012 to accommodate for that type of potential development.

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

And just one follow-up question there, if I can, is what -- maybe what are the 3 things -- I mean, you're growing a lot now again in programs. So how should we investors think about the difference between the program business you're running now and the program business that's generated these issues from the past?

Michael H. Lee

Well first of all, I think we started to make significant change in our underwriting strategy after the fourth quarter of 2009. We developed the organic growth initiative to target profitable areas and to aggressively change our business mix to position, to allocate our capital into specialty, as well as property lines of business and away from middle-market, as well as non-risk bearing MGA programs. Those are the areas that we identified as problem areas and we aggressively terminated business in those areas, while aggressively shifting our capital to assumed reinsurance, where we are supporting Lloyd's syndicates, as well as other insurance companies that have a very strong track record of success, as well as being responsible with their underwriting, given that they support their underwriting with their own capital. So I think the biggest change that we made is to withdraw our capital from a managing general agency who really didn't have any skin in the game and who did not have the proper alignment of insurance at this point in the market cycle. So we terminated all those programs starting in late 2009 and what you're seeing is the runoff effects of the business that we have terminated. But we feel very, very comfortable that we are now -- we have been positioning our capital in markets where there are higher profit margin and where the underwriting quality is much better and we feel that by doing that, the underwriting performance of 2011 and 2012 is significantly better. We don't carve out the results from the business that we have underwritten recently, but we believe that the combined ratio is below 90%. So what you're seeing is a very good experience from the business that we have recently expanded into, while we're still facing the runoff effects from the terminated program. So we think by the second half of the year, we'll be done with that and we will be able to allow the profitable results that we're generating from our new business to be unburdened by the runoff effects that we believe that we're going to be facing for the first 2 quarters of 2012 and our plans for 2012 contemplated that. And therefore, we're not revising our guidance because we anticipated that we would need little bit of cushion in our 2012 plan to potentially deal with any ill effects from the runoff programs that we have discontinued.

Operator

Our next question comes from John Thomas of William Blair.

John Thomas

I was wondering if you guys are seeing any opportunities in home owners as a lot of carriers are raising rates there?

Michael H. Lee

That's a very good question. We're in fact seeing some very good opportunities. We had -- we're fielding many opportunities. In fact for the first time in some states that are exposed to catastrophes, we're beginning to see some great opportunities. We're seeing for the first time the ability to use E&S, or excess and surplus company, to write this type of business. So we have our -- a wholesale division focusing on writing E&S homeowners business. And obviously, that has advantages in terms of being able to push through rates and controlling the terms and conditions. But we are seeing that, and overall, we're seeing some very positive trends, not only in homeowners, but property lines of business and that's how come we created the commercial, monoline commercial property department and we're certainly seizing the opportunity, the opportunities that we're seeing in that area, as well as internationally, through our Lloyd's, participation in Lloyd's market. We're seeing some pricing increases for the international, as well as specialty business.

William E. Hitselberger

John, just to add to what Michael said, one of the things we are doing with respect to that growth is we are looking at that from a reinsurance perspective, a little bit differently than we look at our traditional property. As you know, we have a large reinsurance cover that covers our Northeast exposure, but our reinsurance retention on these businesses and these properties that are outside of the Northeast, are at a much lower retention, generally speaking between $10 million and $20 million for a net event, as compared to our Northeast exposure.

John Thomas

Okay. And then on the reciprocal, how should we think about the insurance service revenue? Is that at all correlated to the profit of the reciprocal exchange? Or is it just separate and it's just based on the amount of premium?

William E. Hitselberger

It's really -- that's a good question, John. It's based on -- it's actually based on 2 things at this stage. It's based on volumes. So as a write business, we charge them a fixed portion, which is 14% of premiums for -- as compensation for sourcing the business and producing the business for them. We also then charge them for out-of-pocket costs related to the development of the personal lines platform because that's a platform that both companies -- stock companies, as well as the reciprocal, will be sharing.

Michael H. Lee

Just to add to what Bill said, the reciprocals really provides with a strategic advantage to take advantage of what's going on in the marketplace. We haven't fully utilized the capacity that currently exists in the reciprocal exchanges. We're also trying to expand the licensing and we have succeeded in doing that, to address the needs that we see throughout the country. As we shift -- as we write more business in our stock company in the Northeast, we'll be able to shift more of our writings into the reciprocals and that would generate more fee income while freeing up the capacity to be able to focus on our package, as well as our focus on the high valued home market. So not only are we able to generate more fee income by writing more business in the reciprocals, we're also able to free up the capacity in our stock company to focus on the package market.

Operator

Our next question comes from Bob Farnam of KBW.

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

Do you still have MGAs that are not taking part the of -- share of the risk?

Michael H. Lee

We do, and they have to be in the specialty area, where they're less vulnerable to pricing competition. When we acquired SUA in 2009, we decided to terminate all of the MGAs that we're writing what we call now, Commercial General business, where they didn't have any kind of pricing advantage or ability to differentiate themselves and therefore, were subject to pricing competition. We saw that -- we believe that, that type of business is better handled using our own underwriters and what we have done is terminated our relationships with those managing general agencies. And where it was appropriate, we have begin to use our underwriters to underwrite that type of business, specifically the trucking, as well as some of the workers' comp business. We are writing the trucking business or commercial auto business using our own underwriters based in Florida. And some of our underwriters that are located regionally throughout the country are writing workers' comp business. However, we have very good programs in the specialty area, where we believe they're positioned well, even in the soft market, through their differentiation in terms of product and knowledge, product and market knowledge in specialized areas and those programs are the programs that we're highlighting. On top of that, what we have done is starting to partner with those specialty MGAs and providing them with the strategic investment to be able to gain access to that business. So while we do have some MGAs that don't take -- that don't assume risks, we are positioning, we're allocating our capital only to those MGAs that are in the more profitable specialty areas, as well as joint venturing with them for them to assume risk through some type of captive arrangement. So by repositioning our program business in that way starting in 2010, we believe we have substantially improved our profitability in that area. And unfortunately, we're not benefiting from that. Our policy, our results are very good, but we're still, unfortunately, seeing the effects of the business that we've terminated since 2010, and that is continuing to have some effect on our results. And we believe that by the third quarter, we should be done with the runoff -- effects of the runoff from those terminated programs.

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

Okay. And so it sounds like the newer MGA relationships, that you are requiring them to take some risk. I mean, can you just give us an idea of how much risk you are looking for them to take?

Michael H. Lee

Well, I think taking risk, forcing them to take risk, is really for us to differentiate ourselves. We wouldn't do any business with anybody that are not positioned in specialty markets, where we're seeing some very good underwriting results. So first thing is that the managing and general agency has to be positioned in classes of business where we want to be in, while we allow our own underwriters focus on in areas where we believe it's better to be underwritten by controlling that underwriting authority in-house. But for those underwriters, for those MGAs that we're doing business with, they first have to be positioned in specialty markets and then as far as asking them to take risk, it's really a way for us to differentiate ourselves and allowing them to increase their revenue by participating in the underlying risk that they believe in. So as far as how we go about doing that, we make an investment at the holding company level, and allow them to set up a captive and then they would be able to assume 10% or 20% of their business. And by doing that, we're aligning ourselves or aligning our interest with the MGA, as well as helping them to increase their revenue by not only generating the commission income, but also participating in the underlying profitability of that business. So by doing that, what we're doing is not only differentiating ourselves from our competitors, but we're also allowing the MGA to increase their revenues and focus on underwriting, as opposed to generating commission income by expanding their premium writings.

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

Good. And one last question, one line on the acquisition-related transaction costs, was that -- in this quarter, was that related to Canopius or what was that?

William E. Hitselberger

Yes, substantially all of that, Bob, was related to Canopius. As you can imagine, it's an investment in a private firm. It's in the Lloyd's market and it's governed by international law. So we were working very closely with some accounting firms and some legal firms to put that investment together.

Operator

I'm not showing any further questions at this time, I would like to turn the call back to Mr. Lee for any closing remarks.

Michael H. Lee

Thank you, operator. We'd like to thank all of you for joining this call and we look forward to talking with you again next quarter. Thank you.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a great day.

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