A while ago, I wrote a piece on Tower Group after its stock price imploded, before it went down more, and attracted an acquisition offer from entities affiliated with the main owner of AmTrust Financial Services for $3/share. ?Here’s another letter, from a different respective reader:

Hello, David:

I’ve been a longtime reader of your columns (back to RealMoney) and have a lot of respect for your opinion as an investor and analyst, particularly your insights into insurance companies.

Merger arb has been a (small) part of my toolkit for the last 15 years but haven’t yet seen an insurance merger quite as complicated as TWGP’s acquisition by ACP Re and AFSI.? With an 8% discount to the offer price and about 4 weeks until the shareholder meeting, this one looks intriguing.

There’s a (wordy) analysis of the deal terms here:? http://seekingalpha.com/article/2106193-towers-merger-offers-opportunity-for-double-digit-annualized-returns .

A couple of specific questions about the deal, if you feel inclined to respond:

1.? Does Karfunkel’s potential conflict of interest in selling the part of TWGP he doesn’t want (commercial, personal) to the publicly traded company he chairs (AFSI) raise enough of a red flag that regulators may intervene?

2.? Are the NOLs owned by TWGP usable by ACP if there is a reverse takeover (TWGP the surviving entity) under Bermuda law?

3.? Does the price at which Karfunkel is selling the pieces to public entities using mostly public shareholders’ money raise any red flags to you?

As I said, I respect and enjoy your work and hopefully you enjoy it enough to continue.

First I will handle the questions. ?Then I will hand out a few opinions.

On question 1, the answer is not likely. ? The regulators will disallow any situation where an acquisition would significantly impair the ratio of capital to required capital to bear risk [RBC]. ?Now, shareholders could be another matter. ?In this acquisition, two public companies that the Karfunkel families control are buying up the renewal rights to Tower Group Commercial Lines business (AmTrust Financial – AFSI), and Personal Lines business – (National General Holdings Corp -?NGHC, which recently went public).

With renewal rights, the AFSI & NGHC acquire the assets and the right to renew existing business at terms mutually acceptable to clients & companies, but they do not acquire anything that pertains to claims from business existing prior to the deal. ?In return, they pay money to ACP Re, Karkunkel’s private company owned by his grantor trust.

On question 2, the answer is not likely. ?When Argonaut bought out PXRE in a reverse merger, the NOLs were disallowed. ?Now, I’m not a tax expert, so maybe someone reeeeally clever can fox their way around this, but to me the answer is no.

On question 3, the answer is I don’t know. ?The public companies that he controls have the advantage that they aren’t taking on much risk in a renewal rights transaction. ?Whether they are paying the right price or not depends heavily on whether the reserving for claims at the Tower Group entities is overstated or understated. ?Prior under-reserving may not have been fully corrected. ?With smaller companies near bankruptcy, like Tower Group, there is the risk of death via many cuts.

That brings me to my main insight. ?Though there are no financing contingencies to this deal, ACP Re can walk away with no penalty if it merely wants to do so. ?If they find a material adverse change, the deal can die, and TWGP will have to pay ACP Re a breakup fee.

Like Fairfax Financial’s offer to buy Blackberry, Prem Watsa had the equivalent of a “free look.” ?Tower Group is desperate enough that they gave a “free look” to the Karfunkels and their allied companies. ?The deal is not a lock, and a lot depends on what is written when the late 10-K is finally filed.

Why delay the 10-K? ?My best guess is trying to get the claim reserves right. ?After having to revise reserves twice before, the odds of further revisions are significant. ?You have to understand that claim reserves for P&C companies are not a science, particularly for long-tailed lines, and Tower Group was overly aggressive in those lines.

But delay in filing the 10-K is not a positive sign. ?If you have confidence in the actuarial analysis of reserves, why delay the filing? ?Every other aspect of a P&C insurance company can be calculated within a few weeks of the year’s end. ?No mysteries, except for the reserves.

So, if ACP Re concludes that the likely claim payments from the legacy business are likely to be larger than the net amount they are paying for the legacy business ($67 million), ACP Re can walk away, with no breakup fee. ?In that scenario Tower Group could head to bankruptcy.

So, when I consider the arbitrage opportunities available by buying Tower Group common stock, I would pass. ?As a rule, I don’t short, though I would be tempted to do so here. ?Tower Group is a very complex company for its size, and as such, I have less confidence in its financials. ?Complexity in financial companies creates inflexibility, which can lead to trouble when regulators deny moving cash from one company to another, which might lead to default on debts.

Avoid this situation, and all of the companies involved. ?Buffett has his “Too Hard” pile. ?This one is too hard, because no one can know the claims that will be paid from aggressively written legacy business.

Full disclosure: no positions in the companies mentioned