Rising Climate And Compliance Costs Will Pressure Margins And Keep Shares Fairly Valued

Catalysts

About Tower

Tower is a New Zealand based general insurer focused on retail house and motor customers, underpinned by risk based pricing and a digital first operating model.

What are the underlying business or industry changes driving this perspective?

• Although Tower has grown its low risk house portfolio and materially reduced expected average annual flood losses, the normalization of weather patterns from the recent unusually benign period could lift claims frequency and erode underwriting margins and earnings over the next few years.
• Despite strong progress in digitization and AI enabled process automation, the rising complexity and cost of technology, data platforms and contact center investments risks keeping the management expense ratio at the upper end of guidance, delaying improvement in net margins and profitability.
• While partnerships with Kiwibank and Westpac broaden distribution, the shift toward volume driven growth in a soft rating environment means limited ability to reprice for higher hazard and reinsurance costs, which may cap gross written premium growth and compress future earnings.
• Although risk based pricing for flood, sea surge and landslip strengthens portfolio resilience, heightened climate adaptation demands and evolving regulatory expectations could increase compliance and remediation costs, putting pressure on net profit and capital buffers.
• While Tower’s capital and solvency position is currently strong, ongoing customer remediation programs, potential adverse development on legacy earthquake claims and higher catastrophe retentions may constrain capital flexibility, limiting capacity to sustain elevated dividends without impacting future earnings resilience.

Assumptions

This narrative explores a more pessimistic perspective on Tower compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts. How have these above catalysts been quantified?

• The bearish analysts are assuming Tower's revenue will grow by 6.8% annually over the next 3 years.
• The bearish analysts assume that profit margins will shrink from 13.6% today to 9.6% in 3 years time.
• The bearish analysts expect earnings to reach NZ$71.9 million (and earnings per share of NZ$0.21) by about December 2028, down from NZ$83.7 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 10.5x on those 2028 earnings, up from 8.1x today. This future PE is greater than the current PE for the AU Insurance industry at 8.1x.
• The bearish analysts expect the number of shares outstanding to remain consistent over the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 7.1%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• Record FY 2025 profitability and elevated dividends have been supported by unusually benign weather, low large event costs of $7.2 million and a soft claims environment. A reversion to more typical or adverse climate patterns and higher catastrophe frequency would lift claims ratios and potentially compress earnings and net margins over the medium term.
• The strategy to drive gross written premium growth primarily through volume rather than rate, in a highly competitive soft rating cycle with declining average premiums, risks underpricing risk and could limit Tower's ability to offset rising reinsurance, climate and regulatory costs. This may pressure revenue quality and net margins.
• Heavy long-term investment in digitization, AI, technology platforms, partnerships such as Westpac and expanded marketing is keeping the management expense ratio elevated at 31 to 32 percent, with targets of 28 to 30 percent pushed out. If efficiency gains or revenue uplift underdeliver, sustained cost pressure could erode earnings and delay margin expansion.
• Ongoing non underlying items such as strengthened Canterbury earthquake provisions, customer remediation charges of $10.9 million after tax and software impairments highlight legacy and systems risks that may recur as the business grows and regulations evolve. These factors could weigh on reported profit and constrain capital available for future dividends and reinvestment.
• Ambitious medium term targets to reach at least $750 million in gross written premium by FY 2028, broaden growth through new channels and become a market leader rely on successful execution of partnerships, product innovation and large scale digital adoption. Any shortfall in customer uptake, retention improvements or partner sourced business could result in slower revenue growth and weaker earnings momentum than currently envisaged.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bearish price target for Tower is NZ$1.8, which represents up to two standard deviations below the consensus price target of NZ$2.12. This valuation is based on what can be assumed as the expectations of Tower's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of NZ$2.45, and the most bearish reporting a price target of just NZ$1.8.
  
• In order for you to agree with the more bearish analyst cohort, you'd need to believe that by 2028, revenues will be NZ$749.9 million, earnings will come to NZ$71.9 million, and it would be trading on a PE ratio of 10.5x, assuming you use a discount rate of 7.1%.
  
• Given the current share price of NZ$1.97, the analyst price target of NZ$1.8 is 9.4% lower. The relatively low difference between the current share price and the analyst consensus price target indicates that they believe on average, the company is fairly priced.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.