Value Investors Club / Tower Group, Inc. (TWGP)

Description

Excellent insurer growing at >25% with 15+% U/W margins, 20+%ROEs, excellent management and a unique niche business model with multi-line, low-severity, short-tail risk business has traded down to compelling levels. Recent headlines affecting financials, fears of subprime exposure in investment portfolios and the start of the hurricane season has taken several small-cap insurers down significantly. While many insurers have some exposure to sub-prime investments, losses from hurricanes and to much anticipated softness in pricing, Tower has minimal to no exposure to any of the abovementioned issues. The business has minimal risk of a softness in pricing due to its niche, small-$ policy business and minimal “real” competition. We have followed and owned Tower since 2004 when it came as an IPO and have great confidence in the ability of Tower’s management to excel at growing its business substantially while controlling its risks and generating high levels of underwriting and investment profitability. We think that investors would be hard-pressed to find an insurer like Tower with its growth prospects and its compelling valuation. At 7.5x its ‘08x earnings and 1.4x its ’08 book value per share, the insurer offers compelling value. At 1.7x current book, it trades at a severe discount to where it should trade given the fact that while most insurers are likely to suffer declines in their book values through the wind-blowing season, Tower is likely to have added to its book value significantly.

We believe Tower’s superior growth prospects and its highly profitable business model are relatively undiscovered on the Street. Tower’s valuation should benefit from a) an increase in the overall valuation multiples of the P&C industry relative to the market (as most P&C stocks currently trade at the low to mid-end of their five year P/E ranges); and b) increased recognition of Tower’s efficiency and growth within the P&C sector. With outsized growth prospects and a uniquely profitable and seasoned business model, we think Tower could show significant share price appreciation over the next 18 months, as we expect the company to report solid growth and profitability metrics for FY07 and FY08. Whenever we take a significant position in a company, we ask ourselves if the market woke up to a market cap double of where the stock is currently, would the market be very skeptical of the new market cap or would it accept it pretty effortlessly – if the answer is yes it would accept it effortlessly, we think the stock has room for much appreciation. If Tower guides to an EPS number of anything close to $3.00 for ’08, the stock (with some help from a generally improved insurance/financials sentiment) could easily trade at a 13x multiple or a $39-$40 stock price – that would not be an unreasonable multiple for a company with very credible management, top-line and bottom-line growth in excess of 25%, combined ratios (with reserve redundancies) of 83% and ROEs exceeding 20%.

Tower Group, Inc. (TWGP) is a unique P&C insurer that primarily serves small and medium businesses in the New York State and the surrounding tri-state area. It has a highly profitable, demand-driven business model that has shown underwriting margins far exceeding the P&C insurance industry in the last decade. We have owned and followed Tower since it came public under $10 in 2004 but have as much, if not more, conviction in Tower’s ability to excel and exceed investor’s expectations. Tower has excellent management that is conservative and driven to benchmark the best in the industry and beyond. The CEO, Michael Lee, son of Korean immigrants grew up in NYC and was a practicing lawyer when he started working on deals in the insurance space in the late 80s. He founded Tower in 1989 with family money and has since been in the business of insuring small and medium sized businesses in the 5 burroughs of NYC. He continues to own close to 13% of the company. Tower is unique in the sense that it is very smart at writing low-risk, low-severity, no CAT exposure policies and managing underwriting very well. It does not insure any high-rises in midtown or downtown Manhattan but focuses on mom and pop businesses, artisans, under $1M restaurants, apartment buildings and modestly priced dwellings. They are unique because they don’t typically face any competition from the big players because the big insurance companies focus more on building scale in mono-line segments and don’t have the inclination nor the infrastructure to process a lot of low-dollar amount policies. Tower’s main competiton comes from the smaller, lesser-capitalized players typically without access to public capital markets and AM Best ratings.

• Unique business model in a large underserved market with limited competition. Tower offers a wide range of products for low-risk residents and small businesses in the New York and tri-state area. The company targets short-tail, low-severity risks with no exposure to complex deals, giving Tower more control over pricing than its larger peers. TWGP targets only demand-driven markets that it can foresee profitable underwriting for several years. Given the small- policy amounts it writes, it typically finds no competition from big players.
Tower has always focused hard on underwriting profitably (U/W margins above 20% for years) and has also stood out in its high level of claims efficiency. They have a seasoned in-house legal team that vigorously manages the claims process with its third parties. Tower has on an average outperformed its P&C peers by atleast 18% over the last 10 years. The recent decline in the U/W margins in the years since they did their IPO is not an indication of declining profitability but more an indication of moving from a model with high level of agency business to one with deployment of capital to write risk on a principal basis. With the sponsoring of Castlepoint Reinsurance that provides Tower with a reliable source of quota share reinsurance and risk sharing (through pooling) arrangements, Tower will now, on an increasing basis, be able to access more premium, generate substantially more fee income and generate ROEs north of 20% while limiting share dilution.
Tower has emphasized building an efficient technology platform that can effectively handle increasing volumes of small-dollar policy amounts across multiple lines in niche and profitable areas in inner-cities. Alongwith an efficient in-house claims handling department, Tower has a strategy to build books of business through independent agents by primarily acquiring their business through renewal rights transactions. Preserver Group acquisition was different since it was a complete acquisition that gave Tower new products and new geographies and was an excellent fit to their underwriting culture. To provide an effective source of capital for their growing premiums, they sponsored Castlepoint in Bermuda. With Castlepoint, Tower was able to remove uncertainties in long-term reinsurance pricings for their product and also be able to write more business by ceding more to Castlepoint while generating commissions that also lower expense ratios. Castlepoint also provides Tower with an opportunity to place more premium with Castlepoint through risk-sharing (pooling) arrangements.

Michael Lee and his senior management team (including his CFO) are seasoned and experienced in profitable niche underwriting. Their focus on efficient claims management yields above-average margins. Tower also focuses hard on benchmarking its performance to industry leaders and to best practices among top corporate performers in general.
Tower’s reserves to surplus ratio now stands at 20%, far below many of its peers. Tower writes and reserves against short-tailed business and has not had any adverse development in the last 18 quarters. Tower’s reinsurance recoverables’ are very manageable since it collateralizes more than 80% of their recoverables’ balance. Tower had an adverse reserve development just prior to their IPO when they used to do more agency and less principal business. The adverse development in the reserves was less than $3M in amount and while it appeared large relative to their much smaller book of business prior to the IPO, it was not reflective of their underwriting or their reserving ability. Tower has since recorded reserve redundancies for the last 18 quarters.

Tower has $630M of cash and investments and has insignificant sub-prime exposure. Cash and Invested Assets grew by $116M in the last 12 months and should continue to grow and be managed conservatively.

How does the financial model work? Tower has grown at 36% CAGR from 2001-2006 while maintaining profitable underwriting margins. Its recent quarter showed growth in excess of 25%. Tower has consistently maintained that they have enough business opportunities to grow organically by more than 20-25%. More top-line premium is also added from renewal rights transactions and their latest Preserver Group acquisition (for which they did a secondary offering and increased book value). Preserver provides them with new product lines and new geographies in the Northeast. Tower is also expanding their product offerings through wholesale distribution in Florida and Texas. In addition, Castlepoint will provide them with additional sources of indirect capital by being ceded to.
Gross Written Premium of $432M should grow atleast 20% to $500M in 2007 plus another $80M should be recorded from the Preserver acquisition, making it a total of around $580M in the current year (’07). They are likely to cede 45% of this to Castlepoint and other reinsurers (‘for ’07 and completely cede to Castlepoint for ’08). The company should generate around $300M in Net Premiums Earned. Tower is confident they should generate around 58% in net loss ratios and 24% net expense ratio for both ’07 and ’08. Ceding commission revenues from premiums ceded to Castlepoint (up to 50% of GPW ceded at 32-34% fees or up to $260M earning fees of $75-$80M reduce the underwriting expenses thereby reducing expense ratio from 27-28% to 24%). With combined ratios of around 83% and accompanying reserve redundancies (since the company regularly reserves conservatively) that should yield underwriting profits of around 17% or $51M. Add to that investment income of around $38M on around $630M of invested assets for ’07. On Pretax income of $89M, diluted shares of 23.3M yields an EPS of around $2.49 for ’07 – a 36% increase from ’06 levels.
In ’08 this growth should be supplemented by around 20-25% organic growth on the business and new revenues from wholesale business in new states, cross-selling of Tower’s products through Preserver Group’s agents, additional fee income from Tower placing premium through pooling arrangements in addition to placing it with Castlepoint and possibly some new business from renewal rights transactions. In ’08, Tower could earn GPW of around 720M (we think it could earn more) investment income of $50M and EPS of $3.25. Tower has built an extremely leverageable model that can earn substantial fees and commissions in addition to earning underwriting profits. With only 23.3M shares outstanding, Tower needs to generate excess fees of only $17M pre-tax to generate $0.50 in additional “surprise” EPS. Therein lies an important element of bottom-line growth in Tower’s model. Please see the table below for more financial information.

Tower’s Key Competitive Advantages
Innovative product development and marketing. Traditional insurance companies develop products based on their own predefined underwriting criteria and then market those products. Tower’s strategy is to first identify the market need and then expand the product line by segmenting the insurance market, identifying the profitable segments, and then marketing its products within those profitable segments. Having gained the reputation of being responsive to the needs of its chosen market, Tower concentrates on developing the underwriting criteria to produce underwriting profits.

Large, underserved market. Northeast market represents total premiums of $82B.

Opportunistic capital allocation. Tower keeps an eye on different market segments and develops products in those segments with the best opportunity for underwriting gain based on market conditions. Tower expands its product lines in those profitable segments with significant premium volume and opportunity for market penetration, and maintain the product line but reduce premiums in segments where underwriting profits would get tough to come by.

Cost-effective and profitable underwriting. Using technology, efficient business processes, and economies of scale, Tower is able to reduce underwriting expense and succeed in the small-premium-size segment (under $25,000) where other companies are unable to successfully compete. Tower exploits its flexible operating platform to shift its focus as market conditions change.

An in-house claims and legal staff enables Tower to defend against frivolous claims, maintain prompt response to the needs of policyholders, and control loss adjustment expenses. Tower’s reputation in claims administration has opened opportunities to act as third-party claims administrator for other insurance companies.

Proven management capability. Tower’s senior management has an average insurance industry experience of over 20 years. The management has an enviable track record of successfully developing and implementing strategies that have allowed Tower to prosper during both hard and soft markets. Despite its limited capital at inception, it was able to grow its premium base and gain market share from other insurance companies with greater financial resources and higher ratings.

Key Business Attributes and the Competitive Landscape

Tower writes insurance primarily for small and mid-size businesses in urban and residential areas. Policies cover real estate, both retail and wholesale, and small businesses and modest dwellings of residents in Manhattan and the surrounding boroughs. Competition is not that significant, in our opinion, as most of the big insurers choose not to insure low-hazard and low-premium policies. On the commercial side, Tower faces competition primarily from some local mutual companies like Greater New York Mutual Insurance and the Magna Carta Public Service Mutual Company in addition to Travelers. On the personal side, it competes with Allstate, State Farm, and St. Paul, though it goes head on only with some local mutuals like Commercial Mutual and Otsego Mutual.

Since premium face amounts are relatively small — average annual premium amounts of $25K per policy for commercial lines and around $3K for personal lines, pricing is also far less prone to cyclicality as evidenced by larger face-amount policies written by other insurers.

While servicing its customers in a quick, customer-friendly, and efficient manner, Tower employs its experienced in-house legal team to vigorously defend claims from third parties. Tower has developed a reputation in the market for its hard stance on questionable claims from third parties. Tower is also unique in inspecting each risk and property in person before the company covers the risk and writes a policy. Physical inspection is typically not done by other insurers before they cover a risk and write a policy.

Tower’s approach to selecting a market is unique because of its inherent demand-driven nature. Tower enters a market very selectively and only does so upon extensively studying the market for its low penetration and profitable underwriting characteristics. Once it enters a market, Tower should continue to service it at a scale that is appropriate for its profitability and competition levels. Like other insurers, it does not feel compelled to mitigate declining profitability levels with increasing volumes. Tower may choose to exit a market or sustain existing levels of premium volumes as long it continues to believe that the segment is profitable.

We believe Tower has proven itself a shrewd underwriter with underwriting margins on an average of 11.7% for the last 5 years, ahead of the industry average by at least 18% points. We believe Tower’s superior underwriting results are a product of its pricing power, favorable competitive dynamics, efficient claims management process, and its focused management.

Financial Snapshot 2002 2003 2004 2005 2006 2007E 2008E

Gross Written Premiums 106.7 134.5 177.8 300.1 432.7 582.0 720.0
Ceded Premiums Written 79.4 105.5 79.7 88.3 187.6 260.0 302.0
Net Earned Premiums 26.0 22.9 45.6 164.4 224.0 301.0 400.0
Total Revenues 62.7 74.7 107.7 219.8 299.3 347.0 457.0
Net Investment Income 1.9 2.3 5.1 15.0 23.0 38.0 50.0
Net income (loss) 5.3 6.1 9.0 20.8 36.6 58.0 76.0
Diluted EPS 0.94 1.09 1.06 1.03 1.82 2.49 3.25
FD Shares O/S 5.8 5.7 8.6 20.1 20.1 23.3 23.3
Cash and CE 3.4 30.3 55.2 38.8 100.6 100.6 100.6
Total Investments 39.6 57.4 228.4 357.2 464.0 610.0 750.0
Reinsurance Recoverables 55.1 84.8 101.2 104.8 118.0 158.6 210.7
LT Debt (incl. Deb & Pref) 3.0 29.2 47.4 47.4 68.0 68.0 68.0
Surplus Capital 9.1 13.1 129.4 144.8 223.9 330.2 405.9

Net Loss Ratio 62.9% 65.7% 59.4% 58.8% 60.3% 58.8% 58.8%
Net Expense Ratio 18.5% 4.4% 16.2% 29.3% 27.3% 24.1% 23.8%
Net Combined Ratio 81.4% 70.1% 75.6% 88.1% 87.6% 82.9% 82.6%
Underwriting Margin 18.6% 29.9% 24.4% 11.9% 12.4% 17.1% 17.4%
Book Value Per Share (EOY) 2.0 3.0 6.6 7.3 9.2 14.2 17.4
ROE 43.9% 22.3% 14.9% 22.0% 21.3% 20.6%
Leverage (Earned Prem/Avg Surplus) 2.1 0.6 1.2 1.2 1.1 1.1

A.M. Best Rating B+ B++ A- A- A- A- A-

Share Price 25.0 25.0
P/E 13.7 ('06) 10.0('07) 7.7('08) x
P/BK 2.7('06) 1.8('07) 1.4('08) x

Catalyst

- recognition of Tower’s superior, low-risk, high-growth model
- better-than-expected financial results for ’07 and ’08 causing analysts to revise their estimates up for 2008

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			2007	2008
Price:	25.00	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	575	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT