Fairfax media reported yesterday that embattled insurer Tower Limited (Australia) (ASX: TWR) could be a potential takeover target, after its shares dived earlier this month following an increase in its contingent liabilities for the Canterbury earthquake.

Tower shares are now down 49% for the year.

A possible takeover target?

As a small insurer operating in New Zealand and the Pacific islands, Tower has been described as an ideal bolt-on acquisition for the likes of Insurance Australia Group Ltd (ASX: IAG) or Suncorp Group Ltd (ASX: SUN), which already have significant operations in the region. Tower also has a strong local presence in the Pacific Island markets, which could be a source of growth in coming years due to rising local asset values and low levels of insurance.

At its half-year results in May, the company reported an underlying profit of $7.6 million which, if doubled to approximate the full-year result, suggests the company is trading on a Price to Earnings (P/E) ratio of around 13 times. This is substantially below IAG’s rather lofty ~20-ish, and also below Suncorp’s ~16. Tower has additionally suggested that operating conditions could improve in the second half, although it also has a number of claims still to process regarding the Canterbury earthquake.

Would a takeover offer be a smart move?

I’m not a fan of insurers buying other publicly listed insurers, because the takeover process usually results in the buyer paying a substantially higher price than they would have if the negotiations were private – and price is a crucial consideration when buying cyclical insurance businesses. Additionally, buying a competing insurer doesn’t usually bring any special advantages like patented processes or extra manufacturing capacity – only brands, staff, buildings, and their expertise.

In this case a theoretical buyer would get a foothold in the Pacific islands, where Tower’s local-region expertise will prove quite useful. Tower is currently trading at a discount to its most recent Net Asset Value, making it more attractive to buyers.

With impairments to IT assets and further increase in Canterbury claims – plus the potential takeover premium – Tower is unlikely to be a bargain. Its key markets are growing much faster than Australia is, but Tower is a small company and I wouldn’t be all that excited about a potential acquisition if I was a Suncorp or IAG shareholder.

Surely Tower buyers could make a quick buck, though..?

Buying Tower to make money in the short term is an interesting premise though. The company intends to pay 2016 dividends that are in line with 2015, which would mean payment of ~8 cents per share and a yield of ~9% from the final dividend in February. As mentioned above, it’s also trading at a discount to its Net Asset Value and an individual investor could get in quick before bigger players make a takeover bid…IF they make a takeover bid.

The possible downside is that you get left holding the bag if no takeover offer emerges, the company has to invest heavily in upgrading its IT systems, and it records significantly higher provisions as a result of its remaining Canterbury claims.

But hey as they say – no risk, no reward.

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Motley Fool contributor Sean O'Neill has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.