Tower Group: Solid Foundations

| About: Tower Group, (TWGP)

You say synergy, I say mutually beneficial strategic relationship but let’s not call the whole thing off. Either way, when it comes to taking on insurance risk in an increasingly competitive rate market, it pays to have a friend to lean on — even if you’re a tower.

And it’s not hard to make friends when you have the charm of two years of approximately 20% return-on-equity and a 70% year-over-year rise in net income like New York-based property and casualty insurer Tower Group, Inc. (Nasdaq: TWGP) had in the third quarter of 2007.

The secret behind Tower’s market-defying profitability amid the softening North American insurance landscape is its expert specialization in serving small segments of the market that are less competitive, yet still lucrative and offer a unique strategic reinsurance relationship (more on that later).

“The company has been very successful in identifying underserved markets where pricing competition is less severe, allowing them to write new business at a faster rate than the industry average,” KeyBanc Capital Markets analyst Elizabeth Malone told Tower’s bread and butter has always been writing low- to moderate-risk small-sized “main street” policies (think restaurants, small businesses, retail stores, modestly priced homes), but it is now beginning to offer an even wider range of products.

The $633 million insurer is still a fairly small fish in the property and casualty pond, competing directly with the likes of Erie Indemnity Co. (Nasdaq: ERIE) and The Allstate Corp. (NYSE: ALL). With the purchase of a book of renewal premiums here and a debt offering there, however, Tower has moved slowly but surely from its modest beginnings in 1989 along a profitably expansionary path. The 2007 acquisition of New Jersey-based Preserver Group Inc. and its 300 retail agents in particular has enabled meaningful growth into New England markets and has opened up a new opportunity to move into the auto insurance segment.

Third-quarter results also highlight some of Tower’s other strengths that are driving its growth. For example, the company had an enviable 88% retention rate for personal lines and a 77% rate for commercial lines, 62.3% growth in investment income and a 27.9% jump in premiums written. Then there is the company’s ability to efficiently service its large volume of policies and keep its underwriting risk predictable and moderate, which allows for loss and expense ratios well below industry averages.

But it is the significant 99.6% year-over-year growth in its third-quarter commission and fee revenue that really stands out. This development is largely the result of its practice of transferring premiums to reinsurers and other partner insurance agencies. Tower management likes to call this arrangement its “hybrid” approach and claims that it allows the company to generate more than half of its premiums without using its own capital.

Tower’s main partner in this game is its Bermuda-based (and tax-advantaged) buddy, CastlePoint Holdings, Ltd. (Nasdaq: CPHL), which, incidentally, shares Tower’s chairman, president and CEO Michael Lee as its own chairman and CEO. According to Malone, their “symbiotic” relationship is fairly unique among property and casualty insurers. The approach combines CastlePoint’s access to capital and cost-effective reinsurance products with Tower’s excess infrastructure capacity, technology and expertise to provide services and competitive policies to similar small insurers.

Tower’s business plan also includes staying on the lookout for other growth and acquisition opportunities in relatively untapped market segments. Outside its Northeast and Mid-Atlantic foothold, Tower has recently begun establishing a nationwide wholesale distribution network and has also recently planted its flag in California and expects to begin writing policies there in 2008. In fact, according to Malone, making an acquisition to increase market share in California would actually make a lot of sense for Tower given its history.

The urban markets of larger cities like San Francisco and Los Angeles have similar needs for the small specialty commercial insurance products that Tower started the business with in New York. These types of policies are thornier to process, more difficult to underwrite and come with higher risk, but Tower was born in that particular insurance briar patch and could easily replicate its model to serve Santa Monica’s boutiques or cafes on Haight Street.

But all this rapid growth could lead to miscalculations, especially during a period of market softening, reasons Zack’s Investment analyst Eric Rothmann in a Jan. 30 report. His sanguine view of the company’s eagerness to deploy capital and its risk of underpricing in unfamiliar markets led him to conservatively decrease his six-month price target to $32.25 per share from $34.25 per share and reiterate his “hold” rating on Tower, which already trades at a premium to peers.

Malone, who has a $38.50 12-month price target and a “buy” rating on Tower, maintains that the niche market expansion is insulated from intense price pressures and said in Nov. 7 note that the relationship with CastlePoint should support “substantial” future growth. The five analysts surveyed by Thomson Financial seem to generally share her optimism and seem to believe the company can produce its targeted 20% return-on-equity in 2008 and have a mean price target on Tower at $39.10. The stock closed at $27.29 on Tuesday and has a 52-week trading range of between $23.60 and $37.47.

With the prospect of strong growth courtesy of its hybrid business model and its knack for finding lucrative niches, this Tower (TWGP) seems to be built on a very solid foundation.

Disclosure: none