Tower Group Management Discusses Q3 2012 Results - Earnings Call Transcript

| About: Tower Group, (TWGP)

Tower Group (NASDAQ:TWGP)

Q3 2012 Earnings Call

November 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

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

Ron Bobman - Capital Returns Management

Robert Paun - Sidoti & Company, LLC

Samuel Hoffman

John Thomas

Operator

Good morning, ladies and gentlemen. My name is Sayeed, and I will be your conference facilitator today. At this time, I would like to welcome everyone to Tower Group's Third 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, Sayeed. Good morning, everybody. As a reminder, Michael and I will be speaking today and referencing a slideshow that is available on our website at www.twrgrp.com, under the Investors section. Also, a replay of this call will be available on the Tower website immediately following the call.

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. With that, I'd like to turn the call over to Michael Lee.

Michael H. Lee

Thank you, Bill, and good morning, everyone. Before I begin my quarterly remarks, I want to comment on Superstorm Sandy. Our fourth quarter operating results will be adversely affected by Superstorm Sandy, which will easily cause the largest catastrophic event in our history. Our sympathies go out to those who have been severely impacted by this event, including our policyholders, agents and employees situated in the affected areas. While it is premature to estimate the full extent of our insured losses, we are confident that our capital position for the year will not be materially impaired based on the current claims-reporting pattern, our underwriting profile and robust reinsurance program, which was substantially strengthened after Hurricane Irene last year. Despite the obvious challenges arising from this event, we are proud of the performance and the dedication of our staff, who have been working around-the-clock to service our customers and agents to provide relief to our customers.

Bill will provide further details regarding Hurricane Sandy's effect on our company later in the presentation.

Now turning to Page 3. I'd like to discuss our third quarter 2012 operating results and report on our year-end expectations and some strategic initiatives.

As noted in yesterday's earnings release, we had strong third quarter operating results with operating earnings at $0.62 per share, compared to the same period last year, when we recorded an operating loss of $0.38 per share.

The third quarter 2011 numbers had the effects of Hurricane Irene and some loss reserve strengthening, while this year's third quarter results had no catastrophe losses or reserve strengthening. During the quarter, we settled the previously disclosed litigation with Munich Reinsurance America for $2.9 million after tax or $0.08 per share, which is included as a charge against third quarter 2012 operating results.

This settlement pertained to business that was sourced prior to 2001 from Tower's Insurance Services segment. Excluding this litigation settlement, our operating results would've been $0.70 for the quarter. Our gross premiums written and managed decreased by 6.6% to $484.8 million. In the third quarter, we non-renewed a large program that generated $51.7 million in gross premiums written. In addition, the third quarter 2011 reported numbers included $23.3 million of assumed reinsurance business, which we canceled in the fourth quarter of 2011.

Adjusting for these 2 items, our growth rate was 8.2%, and this increase was primarily in our assumed reinsurance and customized solutions businesses.

Both our net loss ratio and our combined ratio improved in the third quarter of this year compared to the same period last year. Our net loss ratio, excluding the reciprocals, improved to 60.8%, compared to 77.6% last year with an improvement of about 2 points stripping out the catastrophe loss and prior year reserve strengthening in 2011.

The combined ratio excluding reciprocals improved to 96.3% this quarter, compared to 112% for the same period last year. Excluding the effect of reserve strengthening and storm losses, the combined ratio was 96.3% in the third quarter of this year, compared to 97.1% in the third quarter of last year. We continue to see positive market and pricing trends as exemplified by an overall premium increase on renewed business of 4.3% or 4% increase for commercial lines and 4.5% increase for personal lines.

As shown on Page 4, our operating income for the third quarter was $23.8 million or $0.62 per diluted share, compared to an operating loss of $15.3 million in the same quarter last year or a loss of $0.38 per diluted share.

Our operating income in the third quarter of 2011 was reduced by adverse development of $6.3 million after tax, over $0.15 per share and by severe weather losses of $29.2 million after tax or $0.72 per share.

Even adjusting for these events, the improvement in our quarterly operating earnings per share was just over 25%.

Our stockholders equity increased by 4% to $1.055 billion from $1.014 billion despite reductions of $64.5 million associated with share repurchases and dividend payments since the third quarter of last year.

Our book value per share increased by 8% to $27.49 per share at September 30, 2012 from $25.42 per share at September 30, 2011.

We expect to report a loss in the fourth quarter of this year associated with the effects of Superstorm Sandy, which we will speak to in more detail later in the presentation.

We share the view with many of the industry analysts that the loss will likely to be an earnings event for Tower as compared to a capital event. We expect that our earnings in the first quarter of 2013 will put us back on track of sequentially improving book value per share.

As shown on Page 5, our combined ratio, excluding the reciprocals during the quarter, was 96.3%, compared to 112% for the same period last year.

Reserve strengthening added 2.6 points to our loss ratio in the third quarter of 2011. Excluding the effect of reserve strengthening and storm losses, the combined ratio was 96.3% in the third quarter 2012 compared to 97.1% in third quarter 2011.

This improvement was driven by a lower loss ratio associated with business mix changes and underwriting actions that we have been taking, offset in part by a higher expense ratio, the result of increasing the assumed reinsurance business, which carries a higher commission ratio than our other businesses. Our operating return on equity was 9.2% for the quarter compared to negative 5.9% in the third quarter of 2011.

During the third quarter of 2011, our return on equity was reduced by 2.4 percentage points of reserve strengthening and by 11.2 percentage points of storm losses.

Absent these charges, our year-over-year improvement in operating ROE was 150 basis points. We expect our ROE to improve next year to bring us to the low-end of our 10% to 12% target. If we're able to successfully complete the merger transaction, we expect our return on equity to be in the 13% to 15% range within 18 months from the date the transaction closes.

Turning to Page 6. I'd like to talk about our organic growth initiative. During the quarter, we continued to generate growth by successfully implementing our organic growth initiative, which is focused on expanding our products, improving existing business units, creating new business units and improving the various operating processes associated with generating growth.

In the third quarter of 2012, we took underwriting actions on program accounts that we felt would not achieve our profitability targets. This underwriting action reduced our gross written premiums by $51.7 million in the third quarter of 2012.

In addition, we wrote a reinsurance treaty in the third quarter of 2011 for $23.3 million that we decided to commute in the fourth quarter of 2011. Absent these 2 items, our gross written premium growth rate was 8.2% due to the organic growth initiative.

We saw continued strength in our assumed reinsurance business with $39 million of writings during the quarter and are beginning to see significant demand for customized product solutions with key distribution sources.

To support our efforts with this initiative, we have partnered with Lloyd's syndicates, as well as reinsurance intermediaries to provide added underwriting and analytical capabilities. We are leveraging our internal as well as a strategic capabilities to customize product offerings in profitable market segments. In addition to seeing robust growth opportunities, we made significant progress in non-renewing unprofitable business, as I mentioned before, and continue to drive rate increases across all business units. As a result, we're confident about the profitability of our ongoing business, and we remain well positioned to take advantage of the improving market conditions.

In addition to expanding our products, we're continuing to implement our franchise concept by recruiting talented underwriting managers to expand our existing business units, as well as to create new business units focused on profitable market segments. Through our newly created market intelligence department, we're also identifying pipeline of organic growth opportunities. As a part of our 2013 business plan, we're currently working on several new organic growth opportunities in profitable specialty markets. As we continue to focus on organic growth, we will continue to allocate capital to higher-margin specialty business and withdraw from less attractive competitive markets. We will also continue to improve and transform our customer experience.

Page 7 outlines our operating results for each of our segments. As I mentioned during our previous earnings calls, we continue to see improving market conditions across all lines of business, but particularly in property lines of business in the U.S. and internationally through our strategic underwriting partners. Through our organic growth initiative that we implemented last year, we have shifted our capital from competitive markets and reallocated to more profitable markets. In our commercial segment, as I previously mentioned, our premium volume declined from the third quarter of last year due to the cancellation of a program that did not need our profit objectives, as well as the reversal of a third quarter 2011 reinsurance treaty.

Absent these 2 items, the growth in the commercial segment was flat overall and trending well due to our re-underwriting, change in business mix and rate increases. During the quarter in the commercial general area, we continue to focus on growing our small account business, while continuing to eliminate or seek rate increase on middle market business. Despite increasing rate environment in the California workers comp market, we continued to take action during this quarter to limit this business to about $100 million to $125 million or 5% to 6% of our total business for 2013.

In the Commercial Specialty area, we've continued to terminate non-risk-bearing-program business in competitive market segments and replace this business with assumed reinsurance business underwritten by extremely competent underwriting managers, who assume risk under business.

Our personalized business, excluding reciprocals, grew by 20% during the quarter with a 99.2% combined ratio and an 89% retention rate with a positive renewal change of 4.5%. Our expenses continue to be elevated due to the technology services fee that we're paying to OneBeacon.

We're continuing to roll out our personal line system as well and continue to expand our high-value homes and packaged personal lines product. While it's too early to estimate the full effects of Superstorm Sandy, we believe the market conditions for homeowners' business in the Northeast should improve substantially as many companies face substantial losses from this event. We believe we're very well positioned given our manageable losses from this event, as Bill will explain later, and our ability to utilize both our reciprocal and stock insurance companies.

To meet the anticipated increase in demand for homeowners business, we plan to expand our utilization of these reciprocals in the Northeast, while our stock companies continue to diversify away from the Northeast to minimize our earnings volatility from our concentration in the Northeast. This should also help us to expand our fee income. During the quarter, we recorded a fee income of $9 million related to our management of these reciprocal insurance companies and expect this income to increase in the future with greater utilization of the reciprocal insurance companies. Let me now turn the call over to Bill for some further financial highlights. Bill?

William E. Hitselberger

Thanks, Michael. On Slide 8, you can see that our loss ratio for the third quarter with 60.8% compared to 77.6% for the same time period last year. We experienced a very quiet 2012 third quarter with no reserve development and no storm losses.

In the third quarter 2011, our loss ratio included 12.3 points associated with Hurricane Irene and 2.6 points associated with adverse reserve development.

Excluding the impact of the severe weather and reserve development, the net loss ratio improved to 60.8% in the third quarter 2012, compared to 62.7% in the third quarter 2011.

The improvement in the loss ratio in 2012 is due to our continued shift away from middle-market liability lines of business and a focus on property and short-tailed assumed reinsurance lines of business.

While we've seen rate improvements in 2012, we have not released much of it into our loss ratio.

Page 9 of the presentation details our expense ratio for the stock companies for the third quarter of 2012 as compared to the same period in 2011. The commission portion of the underwriting expense ratio, net of ceding commission we received, was 19.2% in the third quarter of 2012 compared to 18.5% for the same time period last year. We had expected to see this increase, which is due mainly to our writing more assumed reinsurance business in 2012 as compared to 2011.

This business has a higher commission ratio as the commission also reimburses the reinsurer for their direct expenses.

By the fourth quarter, this year-over-year 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 2012 and 2011.

Underwriting expenses, excluding the reciprocals, were $137.6 million in the quarter representing an increase of 8.9% over the same period in 2011.

The increase in expenses was primarily due to increased business production. We have also continued our spending to support our ongoing efforts to build out our information technology infrastructure in support of our personal lines policy administration and claims processing technology. The other underwriting expense component of the ratio net of fees was 12.5% in the third quarter 2012 compared to 12.3% for the same time period last year.

In the beginning of 2012, we changed our loss cost allocation. And this change increased our underwriting expense ratio by about 1 point as compared to last year. The organic growth initiatives that Michael mentioned earlier have led to increased scale savings in 2012, and we have seen a reduction in our other underwriting expense ratio into 2012 from this increase in scale as the rate of organic growth is significantly outpacing the rate of growth in other underwriting expenses.

This improvement, while offset by the change in methodology in allocating loss adjustment expenses, will continue to become more apparent in the fourth quarter of the year and into 2013 as the costs associated with the personal lines technology platform begin to decrease.

On Page 10, I'll make some comments about our investment income. As of September 30, 2012, our invested asset base was $2.6 billion, excluding the reciprocal exchange investment, up $126 million from the year-ago period.

Operating cash flows were $127 million year-to-date September 30, 2012, compared to $124 million year-to-date September 30, 2011.

Tax equivalent book yields in our portfolio have been flat at between 4.5% and 4.8% since the second quarter of 2011. We have seen a flattening of tax-adjusted book yields since 2010, which is the result of deployment of invested assets into higher-yielding corporate securities and also opportunistic increases in our tax exempt portfolio to combat the steady decrease in the reinvestment rates.

We have been allocating funds into dividend paying equity securities, which has helped us to improve the tax equivalent portfolio yields. We continue to make alternative investments in real estate and other private ventures in 2012 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 investment as classes to enhance our investment return.

In the third quarter of 2012, we also closed on our minority investment in Canopius Group, Ltd. This investments is recorded on its own line in the balance sheet, investment in unconsolidated affiliates.

We expect to generate positive operating returns from this investment beginning in the fourth quarter of 2012. Despite the reinvestment rate challenges that we have been seeing, our net investment income remained flat compared to the third quarter of last year. The actions we have been taking in asset classes other than fixed maturities have allowed us to mitigate the impact of a flattening yield environment. In summary, we have seen stable tax equivalent book yield returns since year-end 2010 and an upward movement in our total portfolio investment return due to continued positive operating cash flows, as well as to our revised asset allocation and alternative investment strategy.

Let me make some comments on Superstorm Sandy on Page 11. While not affecting our third quarter numbers, I want to talk -- update everyone on Superstorm Sandy and its effect on Tower. Sandy hit New Jersey on Monday, October 29 and caused an immense loss of property due to storm surge flooding and wind damage.

Tower's Jersey City and New York City offices were closed for a week as a result of the storm, but our claims teams were online immediately after the storm to assist our insured customers. The storm is expected to generate claims for Tower primarily in New York, New Jersey and in Connecticut.

Our current after tax estimate for the fourth quarter net losses from the storm are between $55 million and $68 million. We expect to see most of this loss arising from our direct insurance business.

We retain the first $75 million of losses before our direct insurance business is covered by reinsurance. After this, we are reinsured on a 100% basis up to a loss layer of $150 million.

We will pay reinstatement premiums on this layer of the treaty to provide this additional protection through June 30 on any losses that we recover under the treaty. Such reinstatement premium will vary but may amount up to $20 million. We currently expect the loss for our direct insurance business to be contained in our first layer of reinsurance, but we have included in the presentation details of the reinsurance protection that exists above $150 million in losses. In addition, we expect to record a loss of between $15 million and $20 million from our assumed reinsurance business. Despite this loss, our assumed reinsurance is still on target to be profitable for the year.

Finally, we purchased industry loss warranties this year to protect our aggregate Northeast exposure as a result of the growth in our assumed reinsurance business. These treaties will provide recovery to Tower in the event that the reinsured industry loss exceeds certain thresholds. If the industry loss exceeds $10 billion, Tower will recover $10 million against its losses. And if the industry loss exceeds $15 billion, Tower will recover an additional $10 million against its losses.

On Page 12, I just wanted to give you an update on our proposed merger transaction. Since our July 30 announcement about our merger with the Bermuda reinsurance operations of Canopius, we have been working diligently to put all of the necessary steps in place, so that we can complete the merger when we believe that market conditions are favorable to Tower shareholders.

The SEC process -- common process is ongoing, and we hope to be in a position to close the transaction before year end.

On the regulatory approval process, we continue to make progress. We have discussed this transaction with all the states in which we are domiciled and are continuing to keep them apprised of our progress. We are attempting to have these 2 items completed to be in a position to affect the merger before year end. We are confident that the new merged business has a significant structural advantage over Tower's current model. That said, we will be assessing market conditions, and we will effect the transaction only when we believe that the market conditions are advantageous to our current shareholder.

This concludes the prepared portion of our remarks, and we would now like to open the call to questions. And, Sayeed, if you could, please, give instructions for people if they have questions?

Question-and-Answer Session

Operator

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

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

I have a question. I just want to clarify on Slide 11 the way that the Sandy loss has been communicated. When you talk about the direct insurance loss being $90 million to $95 million, is that the actual loss? Or are you assuming an actual loss that's higher, but the $90 million to $95 million number is an actual loss that's higher in the first layer of reinsurance, but at a net -- but including reinstatement premiums?

William E. Hitselberger

Yes. I'm sorry, Randy. That's a very good question. In our current assumptions, what we've done is we've assumed that we incur losses up to our first reinsurance layer. And so we would retain $75 million net, which is our cover before reinsurance. And what we've done in terms of coming up with that $95 million number is assumed a full use of the second layer of reinsurance and a full reinstatement. So if we -- and I think, as you know, if we had a loss that was contained within that layer of reinsurance and not at the top of that layer, our reinstatement premiums would be reduced commensurately of the $95 million in terms of full reinstatements.

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

Understood. That's helpful. Because something more towards $150 million would probably be more consistent with your market share overlay in the tri-state area. It's helpful to have a box around all this stuff early in the process. And one other question, if I could, on the personal lines segment. I guess I didn't pick this up in the commentary. But it seemed like it was, in absence of CAT, the loss ratio there was pretty high this quarter. And so I was wondering if there's anything unusual that drove the underlying loss ratio higher in the third quarter of 2012.

William E. Hitselberger

No, Randy, I think there's obviously, in our book, there's going to be some anomalous quarters. We didn't see any significant activity. My best guess right now is there might have been a little bit of noise on the personal order side. But at a 60% loss ratio, we're pretty comfortable with the return. We'd like it -- I think our view is, over time, that loss ratio will be more mid 50s and low 60s.

Michael H. Lee

Yes. And I think, Randy, I think the concern there more is the elevated expense ratio due to the buildup of our personal lines system and the fees that we have to pay to OneBeacon for the technology services agreement.

So that was around 38% or so. So that should be -- that should decrease sharply. So I think when you take the homeowners' loss, which is fairly low, and then higher auto losses, you get to about 60%. And then if the expense ratio comes down to low 30s, we think we could consistently achieve low 90% combined ratio for this business.

Operator

Our next question comes from Bob Farnam from KBW.

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

A follow-up question on Sandy. So if it turns out that the industry's losses are higher than the $15 billion, then you're going to be getting back an additional $10 million from the industry loss warranty. What does that do if this -- for example, the losses to you guys gets above that third reinsurance layer, where you're getting 70% reinsured? What does that do to your estimates given that type of scenario?

William E. Hitselberger

Well, if we get into the third layer, Bob, we would pick up 30% of that layer. So there's -- that layer is $75 million. So obviously, the 30% of that is $22.5 million. Good news is that the reinstatement in that layer is just about $6 million, so significantly lower. And then, just to go to an extreme -- in our next layer, we have $175 million of reinsurance protection. The aggregate reinstatement for that is $15 million.

So I think we're pretty confident that the growth that we would have, if it turned out to be materially worse than current industry expectations, would really not be a significant event from our perspective.

Michael H. Lee

Yes. And just to add to what Bill said, I think after Irene, we substantially strengthened our reinsurance program by purchasing these loss warranty covers, and then reduce our net exposure. And by placing 100% above 75%, that's $75 million, that's in excess of 75%. So I think we're in very good shape. As I mentioned before, this is really going to be an earnings event, not a capital loss event. Our book value for the year should be just about where it was as of the end of the second quarter. So we think there is more of an upside for us. There's going to be substantial market opportunities. We haven't fully assessed what the market environment's going to be like. But I think we're very well-positioned because from a risk management standpoint, we had the reciprocal structure, and that gives us a lot of flexibility in terms of augmenting our homeowners capacity, as well as mitigating the earnings volatility by shifting more of our writings in the northeast, into the reciprocals, while we diversify the stock companies away from the northeast and grow in other areas.

So this is a plan that we have put together, and we're executing on that. And over the next several years, I think our earnings volatility would be mitigated each year, as a result of the greater utilization of the reciprocal exchanges.

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

Right. And as for the reciprocals, if there's a need to infuse capital in there, is that something that you guys would be responsible for or what? Like how, if Sandy losses hit the reciprocals enough, would you be responsible for adding capital there?

William E. Hitselberger

Well, I mean, obviously, it would be something that we would have to evaluate. But the good news for us, Bob, and we don't spend a lot of time focusing investors' attention on it, because the reciprocals really don't impact operating earnings. The reciprocals have a reinsurance program that attaches at a much, much lower level than Tower's. The reciprocals have quota share reinsurance protection on their property, and also a CAT structure that has much lower losses. I think in our earnings release, our expectation for the reciprocal loss is under $8 million after tax. I can tell you that almost under any circumstance, they don't blow through their covers, and their reinstatements are significantly lower. So we don't view this, as Michael said, we'd certainly don't view it as a capital event for Tower stock companies. We also, I just want to make sure you understand this, it's clearly not going to be a capital event for the reciprocal businesses. Adirondack has had a very, very good operating year so far. And New Jersey, while smaller, we think that the loss will be contained in their insurance program.

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

Great. And one more question for me before I requeue. So in the assumed reinsurance business, you expect $15 million to $20 million. Is that -- is there a limit in that type of business for higher-than-expected losses? I mean, is that reinsured at some points as well?

William E. Hitselberger

Yes. Yes, and that's a good question. The reinsurance loss is going to come from 2 separate businesses. It's our Lloyd's assumed business and it's also the property retro access. The property retro access has clearly defined loss limit. And the reinsurance that we have from Lloyd's is covered by their assumed reinsurance, and is also limited. I just -- in terms of just understanding our reinsurance, we expect, even with the fourth quarter loss, we expect that business to generate a pretty good operating profit for us on a year-to-date basis. And the fourth quarter, clearly, will be a loss quarter for that business unit. But on a full year basis, it will be very profitable for us.

Michael H. Lee

Just to add to what Bill said, we also designed the assumed reinsurance business, so that it doesn't -- it's not additive to our northeast exposure. So most of the programs really have a focus outside the northeast. So I think that was something that we're very cognizant of, when we design these reinsurance programs, assumed reinsurance programs. So we think that those numbers are fairly conservative, and we feel pretty comfortable that the losses will not exceed the estimates that we just provided.

Operator

[Operator Instructions] Our next question comes from Ron Bobman from Capital Returns.

Ron Bobman - Capital Returns Management

I have one remaining, the loss estimates that relate to Sandy that you provided, do they assume any benefit from the 2 ILWs? And then related, what are the actual triggers? Is it a PCS-reported trigger or some other reported trigger?

William E. Hitselberger

Ron, it's Bill. To be honest with you, on the ILWs, I think it's the ISO accumulation. I'm not 100% sure I can track that, and I'll send that back to you. The -- when in terms of our ranges, what we did is the low-end range assumes that we have a full recovery under both ILWs, and the high end assumes that we have a recovery under one of the ILWs. Given the industry expectations, we're extremely confident that we're going to recover under one event, under the low one, which is the $10 billion, because we haven't seen any estimates that are below $10 billion. But to your point, if the industry loss is below $10 billion, we won't recover on either of the ILWs. But my expectation is that our assessment of our losses would come down and offset that.

Ron Bobman - Capital Returns Management

Okay. Just so I understand because it sounds a little bit counterintuitive, the low end of your loss estimate that you provided from this storm assumes the benefit of 1 ILW...

William E. Hitselberger

No, it assumes the benefit of 2 ILWs. So -- and in terms of establishing the range, I mean, obviously, what we do on the low end of our range is we have the low-end estimate of our losses and the high-end estimate of the recovery of those independent ILWs. The high-end estimate includes the high end of our estimates of the range, and then a recovery only under one of the ILWs.

Ron Bobman - Capital Returns Management

Okay, okay. The -- and another question, on your assumed reinsurance business, where you're -- you mentioned sort of limitations on the quarter shares. So should we think of those quarter share treaties as having -- each of those contracts having aggregate caps as to how much losses can be ceded to you? Or do you also actually have protection separate and apart from the treaty with the individual clients that protects you from quarter share losses?

Michael H. Lee

Yes. I think most of the assumed, this is Michael, most of the assumed reinsurance business is similar to Tower, in that they're writing primary business. And as a result of that, they have appropriate levels of reinsurance protection that protects their net position. So we will take let's say, 10% of their net position, which is protected by ceded reinsurance. So that is something that from a risk management standpoint that we look at, so we're going to get benefit from the inuring reinsurance that's in place to protect their net position, as well as the fact that we only, on a pro rata basis, probably participate less than 10% of that net position for most of the programs. So we feel extremely confident that our exposure is limited because most of our assumed reinsurance partners do protect their net position. In addition to that, they have fairly hefty catastrophe budget. And their -- each year's budgeting allows for them to draw from that catastrophe budget to smooth out their earnings. So with one particular assumed reinsurance partner, I know that they have a sizable CAT budget that will protect their net position. So all in all, we're quite comfortable with our exposure.

Operator

Our next question comes from Robert Paun from Sidoti & Company.

Robert Paun - Sidoti & Company, LLC

Just a few questions. First on the terminated program business. Can you talk a little bit more on the decision there? Was it inadequate rate? And are there any other programs that could be terminated this quarter or that have already been terminated in the first few weeks of the fourth quarter?

Michael H. Lee

Yes. That's an excellent question, and it's something that I think is important in describing our business profiles. Since, I guess, fourth quarter of 2009, internally, we went through -- we've been going through a process of cleansing our book. We've been in markets that are very competitive. And if you'll take a look at our 3 segments or 3 core areas, commercial, specialty and personal, the most of the re-underwriting has been done in the commercial area, in the middle market area. And our focus in the commercial general area is to go back to writing small accounts. So when we started this process, maybe we had 40%, 30%, 40% of our business in the commercial middle -- commercial general area with middle-market business. That's been trimmed down. I don't know the exact numbers, but I would venture to guess it's probably around -- middle-market business is only about 20% or so of our total commercial general business.

As far as the program business, we cancel all program business, non-risk bearing program business, and replace that with assumed reinsurance business in the specialty area with underwriting managers, who are assuming risk. So we made that change, and this is -- I guess, we're in our third year of re-underwriting. And we think that going into 2013, we've eliminated all of the business that we feel -- we felt were positioned in very competitive markets, irrespective of whether we saw rate increases or not.

So we've been scoring our business, and we came up with what's called market profile grading system, and we've been evaluating our businesses based on this grading system that not only looks at the actuarial results, but also looks at the market conditions underlying these various programs or businesses. And a very good example is what we did with California workers comp business. We cut that in half this year, and we're probably looking at that being less -- around 5% to 6% of our 2013 business plan. And we made a substantial -- we took substantial action in the, I guess, throughout 2013 to focus on small workers comp business and to non-renewed middle market workers comp business. And to put a cap on the amount of California workers comp business that would be part of our overall business. And with that, I think even despite the fact that we're seeing some rate increases in that market, we made that decision because we just felt that we wanted to construct our portfolio, so that we're not in these competitive markets. So what we're seeing generally is our improving markets. But this time around, we're not looking at that. But we're looking at the business, and evaluating whether the businesses could withstand the market cycles, and in positioning ourselves in markets that are less vulnerable to market cycles. So that is a multiyear project that we've been involved with. And I think this quarter, we should put an end to that project, and I think we're very happy about the composition of our business and the business mix. So we feel that we have a very good book of business, that with the run rate, around 60% to 62% loss ratio, we feel that, that's very solid. And that gives us the ability to achieve a combined ratio in the low 90s, as we increase our volume, achieve scale and lower our expense ratio to low 30s. So we feel pretty confident in our ability to gradually lower the combined ratio and thereby, increase our return on equity.

Robert Paun - Sidoti & Company, LLC

Okay, that was helpful. Just another question related to the CAT losses. If the string of storms that we've seen, including the hurricanes, superstorms, tornadoes, if they were to continue for the next several years, what are your thoughts on what needs to be done? And I know you've purchased more reinsurance, but what about the terms and conditions of the policies? Would you be changing deductibles, larger rate increases? Any comments there would be helpful.

Michael H. Lee

Yes. I think we're generally not CAT-prone. I mean, having gone through Irene and Sandy, I know that, that statement is somewhat -- may not resonate well with investors. But we generally are not positioned in areas where you have frequency from CAT loss, losses. Having said that, given what has happened, I think we have to continue to execute on our plan, which is to put more of our business, especially personal lines, into the reciprocal insurance exchanges. And we feel that over time, this business is very profitable. And if you look at over 20 years, the loss ratio on homeowners business has been extremely profitable, except as a publicly traded company, obviously, you don't want that earnings volatility. So rather than eliminating this business, I think minor tweaks are necessary, and that really involves us shifting more of our business into the reciprocal insurance exchanges, and limiting our concentration in the northeast with our stock insurance companies. And we have plans to do that, and we're building a system to be able to expand throughout the country and reduce our writings in the northeast through our stock insurance companies. I also think that we'd probably need to look at terms and conditions. I think we need to look at the hurricane deductibles and the wind deductibles. And working with the regulators, we need to make those changes, given that this type of loss is about frequency. And the number of losses, I think, what may be in order is for terms and conditions to change, so that the insured pick up a portion of those losses, not a significant amount, but even if you increase the deductible by $1,000, just tweaking the terms and condition would significantly mitigate the loss impact.

So that's something that, I think, is an actual consequence of what happened, with Irene and Sandy, these discussions will take place in the marketplace. And I'm sure corrective actions will be implemented, working with regulators to enable insurance companies to achieve the profitability they're seeking to continue to provide capacity to the northeast. So I've been through these different events, whether it's 9/11, or other events and throughout our history. And what I usually find is that after these types of events, you do have contraction in terms of underwriting capacity. And you do a get an opportunity to take corrective actions in order to restore the profitability, whether that be rate increases or change in terms and condition, and I fully expect that to happen. From our standpoint, if that doesn't happen, then we're not going to continue to provide underwriting capacity. And we're one of the largest market share in the northeast, and we'll take the leadership role and make sure that we take corrective underwriting action, take the proper corrective underwriting action to restore the underwriting profitability that we need in order for us to continue to provide capacity to the northeast. So we'll be focusing on that. But I think, overall, if you look at it from a historical perspective, we think this business has demonstrated to be very profitable. And after these 2 events, I think the market conditions will improve, and will allow us to recoup some of the losses that we incurred in the last 2 years.

Operator

[Operator Instructions] Our next question comes from Sam Hoffman from Nomura.

Samuel Hoffman

I had 2 quick questions. The first one is, can you talk about what you're expecting in terms of the increased cost of reinsurance and how that would flow through your financial statements? Does it go through ceded premiums or is it kind of an offset ceding commission revenue?

Michael H. Lee

Well, that goes through ceded premiums. I think it's a little too early right now, Sam, to put out a prediction of reinsurance costs. We -- our CAT program reinsures in July. Our quarter share program reinsurance for our property renews in January. So we are already in the market. One of the things I will say is that from our standpoint, we expect to do probably better than the industry because even with this loss, this is the first time in over 20 -- since our history started, that we've ever ceded a loss into our reinsurance program. So we would see reinsurance going up. We're not a serial feeder of losses. I think we will fare better than most.

Michael H. Lee

Yes. As what Bill said, Sam, I mean our reinsurance, ceded reinsurance cost is probably about $60 million to maybe $70 million. The losses to the reinsurers probably will not come close to that or it may come close to that, but not substantially over that. Over the past 22 years, that layer -- the reinsurers have not been touched. So I'd be surprised if there's a substantial increase in our reinsurance costs, given our performance over the past 22 years. So this would be the first time that the reinsurers on our program will be affected by a hurricane or by this type of event. So I think we're -- as Bill mentioned, because of the fact that reinsurers have money, made money despite what has happened this year and previous year, I think I don't see a substantial spike up in the reinsurance cost for our program. And if that happens, I think we have the ability to use the reciprocals. We have the ability to adjust by using our reinsurance entities in Bermuda. And especially with the Canopius transaction, we think that we can take advantage of that structure to be able to mitigate our reinsurance cost.

Samuel Hoffman

So your guidance doesn't assume any increase in cost of reinsurance?

William E. Hitselberger

I think what would happen is again, let me reiterate it. We don't think we're going to have a significant increase in reinsurance. We don't -- we think that increase will be less than 10%. We think that will be offset by the increase that we have in our charges to our ensured. So we don't anticipate that having a significant -- being a significant issue for us.

Samuel Hoffman

Okay. And second question is, was there any reserve development strengthening or release in the quarter?

William E. Hitselberger

No, I think we had mentioned that. You'll see in the -- when the Q gets filed. I think by segment, there was a net. So I think either one segment had a charge of $200,000, the other segment had a reserve release of $220,000. So I think overall, our development was -- it was less than $10,000 or $20,000.

Operator

Our next question comes from John Thomas from William Blair.

John Thomas

Rate environment and personal lines for you guys right now?

William E. Hitselberger

Pardon me, John. Can you just repeat that? I think you were cut off a second?

John Thomas

Okay. The rate environment and personal lines, both on the personal auto side and from motor side?

Michael H. Lee

Okay. We're seeing, especially after the CAT models changed the -- after RMS released version 11.0, we've been seeing a very firm market or a very firming market for homeowners business. For auto, it -- we're not -- we don't have a significant amount of business in auto, and most of that is written in the reciprocal insurance exchanges. So as far as homeowners is concerned, I think we have been seeing increasing rate environment. And certainly, after Sandy, I think you can anticipate that we'll be seeking rate increases to address to -- so that we will be able to regain the loss of capital resulting from this event.

So I think going forward, we're going to have to reevaluate what we need in terms of rate increases and working with the regulators. We're going to make the appropriate adjustments, but it's too early to tell. But certainly, I think including, in addition to rate increases, we'll be looking at modifications to terms and conditions, and that may even have a greater impact on our profitability. But overall, we think that given that our losses are manageable from this event, going forward, impact on our business is definitely going to be positive. And we see an opportunity to be able to grow our business, and to achieve greater level of profitability.

John Thomas

Okay. And then for the Tower personal insurance, what would you say would be a target expense ratio without the temporary elevation because of the technology cost?

Michael H. Lee

I think 30% is something that we could expect. There's quite a bit of expenses that's already dragging our results. And once we finish the personal lines technology product, project, we think the expense ratio will decline substantially. In addition, as we expand -- as we complete the system and we expand the writings and increase the scale of the personal lines business, the expense ratio should decline just from the increasing scale.

So what we're unable to do right now is really move rapidly outside the northeast because we're building the system. Once we build the system, I will be able to expand and be able to grow that business off of the same base of expenses that we have supporting that infrastructure. And as a result of that, we should see some scale savings and lower our expense ratio because the loss ratio is quite good, and all that we need to do is lower our expense ratio to make this business very profitable.

John Thomas

All right. And then on the assumed reinsurance, is that mostly your reinsurance reinsuring property risk? Or is that the whole policy in general? And just geographically, what type of risks are you reinsuring? Is it correlated with your current business or is it diversified?

William E. Hitselberger

Predominantly, it's predominantly non-correlated. We write -- assumed reinsurance is really 2 things, John, it's our Lloyd's quota share. And remember, those Lloyd's quota shares are also -- they have their own assumed reinsurance. But they're picked to withstand significant large losses. The other thing we write is what we call our property retrocessional access program, and that's predominantly for areas outside of the northeast. We have very, very minimal exposures. And as Michael had mentioned earlier, I think our view is we write that business as a way to protect ourselves against the cost of our northeast reinsurance programs.

Operator

Thank you. Ladies and gentlemen, this concludes our conference call for today. You may all disconnect, and have a wonderful day.

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