Thomas Song – Managing Vice President
Michael Lee – President, Chief Executive Officer
Frank Colalucci – Senior Vice President, Chief Financial Officer
Bijan Moazami - Friedman, Billings, Ramsey & Co.
Elizabeth Malone - Keybanc Capital Markets
Tower Group, Inc. (TWGP) Q1 2008 Earnings Call May 6, 2008 10:00 AM ET
Good morning, ladies and gentlemen, my name is [Kim] and I will be your conference facilitator today. At this time I would like to welcome everyone to Tower Group's first quarter 2008 earnings conference call. (Operator Instructions)
It is now my pleasure to turn the floor over to your host, Managing Vice President, Thomas Song. Sir, please go ahead.
Thank you, Operator. Good morning. Before I turn the call over to Tower Group 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 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.
Also, I want to remind everyone that a replay of this call will be available in the Investor Relations section of Tower Group's website.
Now I'd like to turn the call over to Michael.
Thank you, Tom, and good morning, everyone. I'd like to thank all of you for joining us on this conference call to discuss our first quarter operating results.
As described in this morning's press release, I'm pleased to report that Tower Group has once again produced strong operating results for the first quarter of 2008.
Our net income increased by 27.7% to $14.9 million for the first quarter as compared to $11.6 million for the same period last year.
We also reported diluted earnings per share of $0.64 during this quarter as compared to $0.49 per share during the same period last year.
Excluding a net realized investment gain of $0.9 million net of tax this quarter, our net income was $14 million or $0.60 per diluted share.
Our top line growth continues to be outstanding, as reflected in our 42% growth this past quarter and total premiums written and managed as compared to the same period last year.
Along with this strong growth, we were able to achieve favorable underwriting results as reflected by our 84.9% net combined ratio comprised of 54.5% net cost ratio and 30.4% net expense ratio.
Our return on equity was 18.1% for the quarter compared to 23.8% for the same period last year when excluding net realized investment gains and losses. Our return on equity for the first quarter tends to be lower than the return on equity for the full year. Our return on equity during the first quarter of last year was higher than normal because we utilized a fourth quarter trailing average to calculate the return on equity after the secondary offering in January. In addition, our net income was higher in the first quarter last year due to the gains from our investment in CastlePoint. We expect our ROE for the full year to be closer to 20% after adjusting for the seasonality of our business from quarter to quarter.
During the fourth quarter we took affirmative steps to maintain the quality of our investment portfolio by selling investments to reduce our exposure to subprime mortgages and writing down certain investments that had unrealized losses. We continued this effort in the first quarter and sold our REIT investments and began to change the investment profile by selling certain investments to improve the overall quality, achieve better diversification and minimize risks.
Through the actions taken in the fourth quarter of last year and the first quarter of this year, we now have substantially reduced the volatility in our investment portfolio and plan to hold substantially all of the remaining invested assets in our portfolio to maturity. Frank will review our investments in further detail later during today's presentation.
We are very pleased with our operating results, especially given that many companies have been reporting increasing levels of competition and price softening. During our meetings with our shareholders, prospective investors and analysts, we're often asked how we're able to achieve these operating results given the current challenging market conditions and, more importantly, whether we can continue to achieve these strong operating results. We have consistently responded by stating that we believe we can continue to grow our business profitably through different market cycles.
Given the keen level of interest that everyone has expressed regarding this question, I would like to now take this opportunity to provide further clarity and transparency regarding this issue. We have been in business since 1990 and have experience in successfully navigating through various market cycles. Our ability to successfully navigate through various market cycles is grounded in sound business planning that starts with a careful review of the market conditions and competition and responding to those external factors by developing and implementing business strategies that enable us to exploit opportunities even in soft market conditions.
We seek to create a favorable operating environment by constantly expanding our premium volume opportunity relative to our premium growth plan. We're able to do this by expanding our broad product line platform, identifying producers with growth potential using multiple or a multiple distribution channel, entering into new territories with favorable opportunities, and acquiring renewal books of business from small insurance companies or managing general agencies.
By expanding our growth opportunities while maintaining a reasonable growth rate, which we believe is between 15% to 20%, we're able to maintain our pricing and underwriting discipline. As a result, if we face extensive competition in any particular market segment, we have the ability to withdraw from that market and allocate our capital to different or new market segments with more favorable pricing levels while meeting our premium volume objectives.
While soft market conditions generally negatively impact our industry, there are certain aspects of the soft market that create opportunities for us due to our business model and competitive position. In addition to the acquisition opportunities that I will discuss later, we are seeing opportunities for book rollover from agents due to the adverse effect of the soft market conditions on our competitors with weaker business fundamentals.
Due to our strong business fundamentals, we have the ability to write this business profitably at a much lower combined ratio. We also have the ability to cross sell other lines of business using our broad product line platform to increase our profit margin on that book of business.
As industry fundamentals deteriorate, stronger, more diversified companies such as Tower are in a better position to be able to take advantage of these opportunities. I can't speak for the industry as a whole, but in the market segments that we choose to compete in, we are seeing these trends and our strong business fundamentals enable us to opportunistically and profitability grow our business.
In the current market, we're also seeing greater support from reinsurers that want to participate in our business due to our profitability and the competitive pressure that they face to grow their business. In addition to the reinsurance support provided by our strategic partner, CastlePoint, we have established relationships with additional reinsurers to provide us with additional underwriting capacity to support our growth. As CastlePoint successfully diversifies its business from Tower gradually, we will need to also find additional underwriting capacity to support our growth.
So we're seeing positive signs to be able to continue to grow our business and have strong support from CastlePoint as well as other reinsurers.
We are continuing to see growth in the small policy market segment, where we use our web-based platform to write this business cost effectively as well as promote ease of doing business with our agents. In addition, we are also seeing stable growth and positive market reception for the products that we position in our non-standard pricing tier, where we write business that may not fit into the typical underwriting guidelines of standard carriers on an admitted basis.
We believe we have a competitive advantage in the small, under $10,000 per policy market segment and the nonstandard market segment due to the unique combination of low-costs processing capability and underwriting expertise. Conversely, we are avoiding growth in market segments with increased levels of competition, such as in the medium or $25,000 to $100,000 per policy market segment and large policy market segment that we define as over $100,000 per policy.
We also seek to optimize our line of business mix each year by continuously adjusting to market conditions. This year we're seeing growth opportunities in the workers compensation and homeowner's lines of business, especially in the new states where we have recently entered. We're also expanding into new industry classes of business in the commercial general liability and package lines of business and adjusting to the slowing growth in real estate related classes of business in the Northeast, such as apartment and commercial building.
In addition to segmenting the market and positioning our products to minimize competition, we are utilizing our multiple distribution system to grow our business. We're seeing stable growth from approximately 850 retail agents in the Northeast, most of who have not maximized their growth potential with us and have the capacity to grow further. We're also starting to provide a web-based submission and rating capability for our commercial package and business owners policies which should have a favorable impact on production this year.
We are, however, seeing some slowing in growth from our wholesale distribution in the New York metropolitan area. We are successfully countering this slowing growth from our wholesale distribution in the New York metropolitan area with our national wholesale expansion initiative.
Due to the migration of business from the E&S market to the admitted market, we are seeing continued growth from our wholesalers outside the Northeast who desire to access our admitted paper and broad product line platform. We are seeing strong growth from our wholesalers in California, Texas and Florida, which easily replaces the lower growth rate we are seeing from our Northeast-based wholesalers while maintaining our profitability trends.
We're also seeing meaningful production through participation in the program business underwritten by CastlePoint. Through this relationship we're able to access established seasoned books of business from managing general agencies who bring underwriting expertise in classes of business that we have not traditionally focused upon.
Finally, we're continuing to see steady flow of acquisition opportunities. We have conduced due diligence on a number of managing general agencies and insurance companies during the past year, but for various reasons decided to pass on those opportunities. We're committed, however, to actively seek acquisitions of small insurance companies and managing general agencies or other types of acquisitions that will enhance shareholders' value.
While we are discussing acquisitions, I want to provide you with a quick update on the progress that we're making in integrating Preserver Group. I am pleased to report that we were able to reduce Preserver's gross expense ratios to be in line with Tower's gross expense ratio of 30.7%, which represents a decrease of over 11 points in less than one year. This reduction does not take into account the fee income that we earn on this business by ceding this business to CastlePoint and other reinsurers. Our favorable experience with the Preserver acquisition demonstrates our ability to increase shareholder value by utilizing our business model to significantly improve acquisition targets' underlying profitability.
I would like to end my portion of the presentation by emphasizing that despite our robust growth, we have been able to maintain our underwriting discipline as evidenced by our 54.5% loss ratio and 84.9% combined ratio this quarter. Overall, our policies in force increased by 17% this quarter, excluding the effect of Preserver, compared to the same period last year. In addition, our retention was approximately 80% across all lines of business that we underwrite and manage during the quarter.
We also saw a nominal increase in premium change in our renewed business. We have also addressed the risk factors associated with the entry into new products or territories by performing thorough research and due diligence and believe we are well positioned to replicate our success in the Northeast.
In the new states, we use extremely conservative property capacity guidelines to limit our capacity exposures, utilize rates provided by an established rating service or peer companies, and implement underwriting guidelines that we have developed over our 18-year history. Furthermore, our loss ratio was 57.6% in 2006, 55.5% in 2007, and 54.5% in the first quarter of 2008, well below our target of 60% when we went public in 2004. Given the size and profitability of our existing book of business, we do not believe premium that we are generating from these new territories will have a meaningful impact on our overall loss ratio and our ability to continue to produce favorable underwriting results through the market cycle.
I hope my presentation addressed some of the questions our investors and analysts may have about our ability to continue to grow profitability. I will turn the call over to Frank at this point to review our financial results in more detail. Frank?
Yes, thank you, Michael, and good morning, everyone. I'll cover the highlights and provide some additional details for the quarter, and then I'll provide our outlook for the second quarter and for the full year 2008.
First quarter growth of premiums written and managed of 42% remains quite strong, as Michael mentioned. This growth was the result of continued strength in personal lines plus contributions from Preserver of $18.5 million, our participation in traditional specialty programs of CastlePoint that increased $13 million from the first quarter 2007, and new business resulting from our wholesale producer initiative, adding $14.4 million.
Geographically, we have expanded our territorial exposures as $50.7 million of our premiums or 37% in the first quarter was written in territories other than New York State.
Total consolidated revenues increased by 31% to $110.5 million this quarter over the first quarter of last year. Net premiums earned increased by 13.3% to $68.4 million for the quarter over the same quarter in 2007. Although gross premiums earned increased 24.4%, ceded premiums earned increased 38.3% resulting from the higher ceding percentage on premiums written in the first quarter 2007 and that are being earned in the first quarter of 2008.
Net premiums earned represented 62% of total revenues. Less of a contribution to total revenues than in the past as commissions and fee income has ramped up significantly with a 93.1% increase of $31 million in the first quarter compared to $16 million last year and represented 28% of total revenues this quarter as compared to about 19% in 2007's first quarter. This was due to the increase in ceding commission revenue earned from our quota share reinsurance program with CastlePoint and the increased contribution from insurance services revenue by TRM from producing premiums on behalf of CastlePoint's U.S. insurance company, CPIC. This arrangement was not in place during the first quarter of last year.
Net investment income excluding realized capital gains represented 9% of total revenues in both periods.
Total investments of $700 million, increasing cash and cash equivalents and a receivable for securities sold late in the quarter and reinvested in the second quarter increased from about $650 million a year ago. Our portfolio activity during this quarter was directed around maintaining overall credit quality and included reducing our allocation to mortgages and other asset-backed securities, rotating some corporate holdings from the financial sector, and increasing tax-exempt securities.
This quarter we recorded $2.4 million of other than temporary impairments on the seven public equity REITs we had held that Michael referred to. Then subsequent to the end of the quarter we sold all of those REIT holdings for a small realized gain of $70,000. To reduce our exposure to the volatility in that segment of the market, we have now completely eliminated the leveraged equity securities that represented externally managed assets wherein we did not maintain direct control over the investment choices.
As a result of our portfolio activity, we realized gains of $3.8 million that, netted against the other than temporary impairment loss on the REITs of $2.4 million resulted in a net realized gain of $1.4 million pre-tax.
Realized investment losses generally do not pose problems for us in that our fixed income investments average a double A rating and generally we intend and have the ability to hold them in order to match up with the maturity of our insurance liabilities.
Net unrealized losses were $26 million at March 31, representing 3.7% of the $700 million in total investments, including the cash and cash equivalents and the receivable for securities sold.
We monitor all of our investments and, given the current market conditions, pay particular attention to mortgage-backed investments with unrealized losses with respect to considering such actions as a sale, a write down or to hold to maturity. The asset classes that have the majority of total unrealized losses at the end of the quarter are the commercial and non-agency residential mortgage-backed securities and a modest amount of subprime mortgage investments.
The commercial mortgage-backed securities have a fair value of $39 million which is 5.5% of total investments and an unrealized loss of $10 million. These are [buy] quality with an average credit quality of double A plus, and we are comfortable with this allocation.
The non-agency residential mortgage-backed securities have a fair value of $34 million, which is about 5% of total investments and an unrealized loss of $10.3 million. These have an average credit quality of double A. A portion of these securities was subject to cash flow testing as required under GAAP rules and overall the cash flows were deemed to be satisfactory. These securities continue to perform as expected, with a significant portion of the principal expected to be paid in less than three years.
The subprime mortgages are $9.9 million at fair value, which is 1.4% of total investments and consists of older vintage subprime investments primarily with a fixed interest rate that is not subject to reset risk. These have an average rating of double A minus and continue to perform as expected.
The total fair value of the forgoing asset classes is $83 million, which is approximately 12% of total investments.
A substantial portion of the unrealized loss is a result of less than normal liquidity in the market that appears to be temporary, but nonetheless results in prices that may not in all cases reflect transparency and an orderly market. Since all of our investments continue to perform as expected, we believe these investments retain economic value, which view is consistent with our intent and our ability to hold until a recovery in value to amortize costs or until maturity, therefore we also view the effect on our book value as temporary. As our held bonds approach maturity, the unrealized losses will diminish, restoring lost value.
Our triple A quality investments, which include Treasuries, cash and cash equivalents and the $68 million receivable total approximately $66 million of the fixed income portfolio - 66% of the fixed income portfolio. The target duration of our fixed income portfolio is about four years. We were [inaudible] lower at 3.6 years during this quarter from the sales - resulting from the sales in the latter part of the quarter, also resulting in a larger than usual amount of cash.
On a cash equivalent basis, the investment yield was 5.3% during the quarter compared to 5.7% in the first quarter of 2007. Again, this was due to a larger than usual position in cash and cash equivalents with a lower interest rates. Our new money rate, however, currently is about 5.5%.
For the quarter, net investment income increased by 23% to $9.8 million. That's compared to $8 million last year.
Operating cash flow was $23 million.
Turning back to our underwriting results, the gross loss ratio for the insurance segment for the three months ending March 31 was 49.7% and the net loss ratio was 54.5%, which compares to a net loss ratio of 56.2% in the first quarter of 2007. This improvement resulted from a lower level of loss emergence than was expected, particularly for our property and workers compensation lines for the current accident year and also from the effect of recent pricing increases. The net loss ratio was also favorably impacted by a reduced level of ceded cat premiums. Ceded cat premiums represented 4.4% of net premiums earned.
Prior year's net loss reserves [inaudible] favorably to the extent of about $15,000.
For the quarter, the gross expense ratio was 30.7% and the net expense ratio was 30.4%. We expect these ratios to move below 30% during the remainder of the year. Our growth and net combined ratios were 80.4% and 84.9%, respectively. As Michael mentioned, we have successfully reduced Preserver's expense ratio to be in line with the rest of our operations.
Our CastlePoint investment ownership percentage, which is carried under the equity method of accounting, is presently 6.7%. In the first quarter we recorded about $760,000 of pre-tax income as our share of CastlePoint's net income. Our book value per share at March 31, 2008 was $13.46 per share as compared to $12.33 per share at the end of the first quarter last year.
I would like to now discuss the outlook for the balance of the year. For the second quarter of 2008 we project net income to be in the range between $14.9 million and $15.8 million. We project diluted earnings per share in the second quarter to be in the range between $0.64 and $0.68 per diluted share. For the full year, we anticipate net income to be in the range between $67.5 million and $70 million, and diluted earnings per share to be between $2.90 and $3.00 per share. These projections do not include any amounts for realized investment gains or losses.
As you recall, in 2007 quarter operating earnings per share was affected by the amount of premiums placed by TRM with CastlePoint Insurance Company. That increased significantly in the third and fourth quarters, thereby increasing operating earnings per share. As this business renews in CPIC in 2008 and with the expectation of meeting our growth target with respect to business placed by TRM with CPIC, operating earnings per share is expected to trend upward in the third and fourth quarters this year as in 2007.
We'll now turn the floor over to the operator for questions.
Thank you. (Operator Instructions) Your first question comes from Bijan Moazami - Friedman, Billings, Ramsey & Co.
Bijan Moazami - Friedman, Billings, Ramsey & Co.
First of all, if you can provide a little bit more detail about your growth characteristics, is it more property lines versus casualty lines, which states that premium volume growth is coming from, and then if you can make some comments about acquisitions, what are you seeing out there, when should we be expecting you guys to either make an acquisition or do a renewal right transaction?
As far as growth is concerned, we are pretty much replicating sort of our product mix that we had in the Northeast with our wholesalers particularly in Florida, Texas and California. We're emphasizing workers comp line of business, small workers comp business. We also are looking at our small package policies, and we have a little bit homeowner's - we're writing a little bit of homeowner's policies in California.
We are seeing very good growth in those three states, but in particular we expect strong growth in California. We've recently opened up an office in Southern California, and based on our market research, we think that we'll realize strong growth from that particular state.
As far as acquisitions are concerned, as I mentioned during the earnings call, we have looked at a number of insurance companies and managing general agents to acquire. We were very close, but for various reasons we decided not to proceed with the acquisitions.
We're seeing a strong pipeline of acquisitions, and we routinely do due diligence on these types of targets, acquisition targets. So we can't really project whether we will do an acquisition in the near future, but I do believe there's a strong likelihood that we will act upon the various opportunities that we're seeing in the marketplace.
Bijan Moazami - Friedman, Billings, Ramsey & Co.
Obviously, you've been a Northeastern company. California, Texas and Florida, they are in the four different corners of the country. Would that create any kind of strategic challenges in order to manage the business?
Bijan, I mean, we've had a history of successfully diversifying from New York City, where we had written historically. So, if you recall, we branched out successfully into other parts of New York State, into New England states, into New Jersey, so we're very, very experienced as far as developing the process and implementing various strategies that we developed to minimize the risk factor associated with territorial expansion.
What we do is we go into each state and we do our market research. We have a focus group, and we try to understand the market, the competition, what the agents want, and typically what we're finding out in these various states that we're entering is that our products that we have developed in the Northeast appeals to them, specifically our nonstandard product. We position it in such a way that we write type of classes of business that E&S insurance companies write, but we offer our admitted paper and that's resonating very strongly with these producers.
So we are seeing that a lot of the techniques that we have developed in the Northeast are working very well - in fact, very well - in many of the states that we're entering. As a result, we do not see the process being any different than when we expanded out of New York City to various other parts of the Northeast. So we think the fact that we are using the same process that we have utilized and focusing on the same type of business and doing the kind of research that we're doing, including actuarial research, looking at our peer companies' loss ratio, and by doing that I think we're minimizing the risk factors associated with territorial expansion.
Not to mention that our book of business, as I mentioned during my prepared portion of the presentation, is running extremely well. When we started - when we went public in 2004, our target loss ratio was 60%, and we have faced softening market conditions probably some time in, I would say, 2006 or even maybe in 2005, but our loss ratio has declined, and we were still getting pricing increases. So I think that speaks to the strength of our strategy in terms of identifying profitable market segments, allocating our capital opportunistically to areas where we're seeing good growth opportunities, and pulling back from areas where we see an intense level of price competition.
And using that strategy we've been able to maintain our underwriting profitability, and I think we will continue to do that as we expand into these new states.
Bijan Moazami - Friedman, Billings, Ramsey & Co.
Very quickly, I assume that all that premium is from urban areas, right?
Not really. I mean, I think we're seeing the same type of market reaction in urban areas, but what we try to do is try to find pockets within various markets that we go into where we believe that we can make an underwriting profit, so I wouldn't say that it's solely focused on urban areas.
(Operator Instructions) Your next question comes from Elizabeth Malone - Keybanc Capital Markets.
Elizabeth Malone - Keybanc Capital Markets
Were there any favorable reserve developments or adverse developments in the quarter?
I'll let Frank speak to that issue. You know, we had a slight favorable development, but Frank, do you want to continue?
Yes, Beth, it was very tiny. I mentioned it was only about $15,000. For all intents and purposes, the reserves did not develop either favorably or adversely.
Elizabeth Malone - Keybanc Capital Markets
And then could you just, Michael, maybe talk a little bit more, I've been visiting with a lot of agents across the United States in different markets, and in general the pricing softness that they're describing is pretty significant in a lot of different markets. Now, it's spotty. There are some markets and products where it's not occurring, but I think the softening of the market is definitely getting worse. I'm just curious to know how are you navigating through that soft pricing market as you're developing and growing your business. Your experience is somewhat unique in the industry, actually.
Well, the best way to answer that is to explain our process. And we're not saying that we're not seeing price softness. We are seeing that in our mid-size to large accounts. We've always seen that, and we've seen it through the soft market cycles, in the prior soft market cycles. So we do have pockets or we do have market segments where we're seeing pricing erosion, but what we do is to not to seek growth in those areas and to emphasize growth in areas that we believe have a reduced level of competition for a number of reasons.
For example, we're expanding with our wholesale distribution system, and we're seeing that the wholesalers in this marketplace prefer admitted paper as opposed to E&S paper. So we're getting growth in the various states that we're expanding by not cutting price but by offering a solution that they desire, and that's based on the survey that we did. So as the market softened, we're seeing that they prefer admitted paper so we've been providing that type of solution, and we're seeing growth from that, utilizing that approach.
In addition to that we have a very broad product line platform. Some of the companies that you mentioned, that are facing problems, may face those problems because they don't have a diversified product platform. If you're writing workers comp, only workers comp, in a certainly jurisdiction, you may face increasing level of competition and that particular company may not have any other alternative except to compete.
Well, you know, we have a different platform. We have a very diversified, broad product line platform that allows us to de-emphasize in any one of line business and to emphasize other lines of business. So when we go to an agent in a new territory, that type of approach really is resonating with those producers because sometimes they may do business with a particular company that may offer just one product. But by virtue of the fact that we're able to offer many different product lines across different industries, we're able to find an opportunity within their agency for the type of business that they need. And what we do is we're able to modify our product offering to fit that particular agent.
So we don't have sort of what I refer to as a supply driven approach where we have a fixed product offering and try to distribute those products to our agents. What we have is more of a demand driven approach, where we interview our producers, find out what their needs are, look at the competition, and see where there is an opening, and then we utilize our broad product platform to find the fit between our agent and our company. And in that way, we're able to maintain the pricing and coverage integrity that we need to maintain profitability. And that is something that we have developed over our 18year history and, as a result, we are finding success in the soft market conditions.
In addition to that, we also have a business model where we cede business to reinsurers. And we're seeing that in the soft market conditions, reinsurers pricing is decreasing and the terms are getting more favorable. So that aspect of the soft market also works to our advantage.
And that does conclude our question-and-answer session today. Mr. Lee, I'll turn the conference back to you for additional or closing remarks.
Thank you, Operator. We had yet another quarter with strong operating results. We have also seen evidence that our growth strategies for 2008 have begun to bear fruit during the first quarter, and we expect to continue to execute on the key initiatives that I outlined for the remainder of 2008.
We appreciate your participation on our call and look forward to speaking with you again. Thank you.
That does conclude our conference call today. Thank you all for your participation.