Interesting results from Tower Group (Nasdaq: TWGP) tonight. Although the company beat estimates for the quarter, the company's guidance for next year is pretty uninspiring. Barring a good explanation or abject conservatism on the call (a nicer way of saying “sandbagging”), I expect this stock will be weak.
Tower announced that gross premiums rose almost 33% in the fourth quarter, while the combined ratio was below 92%. Even more impressive is the company's 31.8% expense ratio – a slight improvement from the third quarter and the lowest level Tower has seen in years. It is also interesting to see that the company has a significantly lower loss ratio in its personal segment (48.1%) than in its commercial segment (66.5%). It seems to be an unfortunately reality that the company's acquisitions have lead to a higher loss ratio than in the past.
Insurance markets are still not particularly healthy for the company. To that end, the company saw rates rise 3% overall on its renewal business (5.2% in personal, 1% in commercial), with an overall retention ratio of 82%. That tells me that insurance companies are happy to compete on price and are likely pricing business for a loss. Any veteran reader of Berkshire Hathaway's (NYSE: BRK.A) annual reports will know that Warren Buffett often talks about how most insurance companies operate with underwriting losses and this is part of the reason why – losing discipline on price to get business.
Making matters worse, this is not a great investment environment for insurance companies. Although recognized investment income jumped 40%, the yield declined to 4.7% from 5.5% a year ago.
Turning back to the guidance issue, the company is looking for earnings of $2.70 to $2.90 next year. Taking the midpoint, that means about 10% growth. That does not bother me as much as the implied ROE – something on the order of 10% or so and well below what the company has offered before as a target of 13-15%.
To an extent, I can see how the company gets at this number. The pricing environment gives the company the losing choice of either refusing to write bad policies or seeing customers walk away from fair prices and buy their insurance from less disciplined companies. Moreover, the investment environment is doing them no favors now and it wouldn't seem that there's obvious leverage left on the expense side.
Factoring in a new lower ROE (13%) and maintaining a discount rate of 11%, I get a price target of $32.25 for these shares. That's not a terrifically exciting target price, particularly in this kind of insurance market. I might be wishy-washy on holding a stock with such modest appreciation potential, but I think there is a lot of quality in Tower Group and I think the company can lever its recent acquisitions over time. Moreover, I do think that, over time, mid-teens ROEs are certainly possible.
I always keep an eye on the insurance sector, but there is not a lot that excites me today. MetLife (NYSE: MET) and Aviva (NYSE: AV) look kind of interesting, and Ace (NYSE: ACE) and Arch Capital (Nasdaq: ACGL) are kind of cheap. Beyond that, though, W R Berkley (NYSE: WRB) is the only intriguingly cheap insurance company on my list.
So, I'll sit tight for now but I can't deny a bit of an itch to switch over from Tower Group into WRB at today's relative valuations.
I would HOLD shares of Tower Group
Disclosure: I own shares of Tower Group