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We are downgrading our recommendation on shares of Tower Group Inc. (TWGP - Analyst Report)   to ‘Underperform’ from ‘Neutral’ following the disappointing second quarter results, which was due to a charge related to reserve strengthening and weather-related losses.

The company reported an operating loss of 39 cents per share. While it bettered the Zacks Consensus Estimate for a loss of 41 cents, it was down from last year's operating earnings of 63 cents.

We also remain on the sidelines because of the huge execution risk associated with the recently announced merger transaction with Canopius Bermuda.

Tower also has a substantial exposure to catastrophe losses. Though it has reduced the number of polices in Massachusetts and Rhode Island, we believe it is exposed to high catastrophe losses in the Northeast region of the U.S., inducing earnings volatility.

Also, a weak investment yield continues to be a concern for Tower. In response to this environment, management implemented a strategy to purchase dividend paying common stocks to enhance investment income. The company is also evaluating alternative investment classes to further enhance investment income. Though management is trying different ways to offset pressure from a low interest rate, we are not sure whether the company will be successful with this strategy.

On the positive side, Tower will gain substantial scale and size advantages upon successful completion of the merger, enabling it to access three major insurance markets: the U.S., Bermuda and London. The company also anticipates that the merger will add to earnings, with 2013 operating earnings per share improving by approximately 4% - 6%.

Tower’s inorganic and organic growth initiatives undertaken over the recent years are also bearing fruit. This was witnessed when premiums written increased by 14.9% to $538 million in the second quarter.

But again we cannot ignore that the highly competitive property and casualty environment, which is characterized by significant price competition, will keep pressure on top line growth.

Tower currently retains a Zacks #5 Rank, which translates into a short-term Strong Sell rating.  Its peers, Assurant Inc. (AIZ - Analyst Report), The Travelers Companies Inc. (TRV - Analyst Report), and Chubb Corp. (CB - Analyst Report), are carrying our ‘Neutral’ recommendation currently.

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