2024-01-10 02:30:39 ET
Summary
- W. R. Berkley stock has been on a good run in recent times, buoyed by a favorable operating environment for commercial insurers.
- The company has a history of consistent underwriting profitability, with its combined ratio improving to the 90% area, while the higher interest rate environment is also benefiting investment income.
- While these tailwinds have led to a material uptick in W. R. Berkley's overall profitability, its current book value multiple fully reflects this, and investors should use the opportunity to realize profits.
Shares of W. R. Berkley ( WRB ) have been on a solid run over the past couple of years, delivering a circa 35% total return (~16% annualized) in that time amid a favorable macro environment for commercial insurers.
Operating conditions for Berkley are about as good as it gets at the moment, with pricing providing nice support to underwriting profitability and investment income getting a jolt from higher interest rates. While profitability has expanded as a result, I do think we are close to a cycle high point here. With Berkley's current valuation having also expanded significantly, I believe now might be a good opportunity for investors to realize profits here, and I open on the name with a Hold rating.
A Solid Player In A Tough Industry
Non-life insurers like Berkley essentially generate earnings from two sources: underwriting (i.e. premiums net of claims and expenses) and investment income earned by investing premiums before claims are paid.
Because insurers make money by investing premiums, there is often an incentive to be aggressive on pricing. This is because a modest degree of underwriting losses can be more than offset by investment income. As a result, many P&C insurers have a history of negative underwriting profitability, meaning overall profitability basically becomes linked to interest rates.
With the above in mind, Berkley is probably a candidate for best-in-class operator. It has a history of consistent operating profitability, averaging a combined ratio of 93.2% over the past ten years. Said differently, Berkley has retained around $7.80 for every hundred dollars of premiums it has written over the past decade after paying out claims and its own operating expenses.
This is a very good performance, helped by the fact that the company doesn't operate in the most commodified areas of the non-life market (e.g. personal auto insurance). Rather, it is more of a niche operator in specialty lines of the commercial sector, so pricing pressure from competition is slightly less of an issue.
Because Berkley consistently earns an underwriting profit, its overall earnings tend to be relatively stable compared to peers that lean more heavily on investment income. There is still a cyclical dimension to things (more on that a bit later), but its earnings don't exhibit the same "boom and bust" pattern that many insurers do.
This is a key differentiator between Berkley and its peer group and it is one of the reasons why it has registered long-term outperformance. For instance, over the past ten years its total return has more than doubled that of the SPDR S&P Insurance ETF ( KIE ):
A Favorable Macro Environment
Currently, Berkley is in a sweet spot as both components of its income are hitting cycle highs. In terms of underwriting, the pricing environment is currently very favorable, with large price hikes and tighter underwriting standards leading to historically strong combined ratios. In its most recent quarter (Q3 2023), Berkley reported $2.85 billion in net premiums written, an increase of just over 10%. Average rate increases excluding workers’ compensation came in at 8.5%, so pricing rather than volume is doing most of the lifting in terms of growth. At 90.2%, Berkley's combined ratio was a full 3ppt below its ten-year average in Q3.
At the same time, higher interest rates have provided a significant tailwind to investment income. Berkley reported an average annualized book yield on its fixed-maturity portfolio of 4.2% through Q3, up from 2.6% in 2022. As a result, net investment income swelled to $739 million in the period, up from $548 million over 9M'22. Berkley's investment portfolio has a relatively low duration to match its liabilities, so a large portion has already repriced to reflect the current higher interest rate environment.
These two tailwinds have also greatly improved the company's profitability metrics. Operating EPS was $1.35 in Q3, up from $1.01 in Q3 2022, while for the nine-month period it was $3.48, up from $3.22 per share in 2022. Q3 ROE was a shade under 20%, while for the nine-month period it was closer to 19.5%. This is around 6ppt above its ten-year average.
Current Valuation Reflects All Of This
The main issue I have with WRB stock is that the market has fully priced in this uptick in profitability. Based on its current share price of $72.27, Berkley trades for over 2.6x book value per share, significantly higher than its historical average multiple and fully reflecting the higher ROE the business has been posting.
My main concern is that Berkley is currently posting cycle high profitability. Now, I should point out that the company does still have drivers for growth. For example, its fixed-maturity portfolio yield was still rising as of Q3, with the annualized book yield registering 4.5% in the quarter, 30bps higher than the 4.2% YTD average I quoted in the prior section. Alongside growth in written premiums, that should lead to higher investment income in 2024. Similarly, while I think the tailwind from the improving combined ratio is done, YoY growth in written premiums can still lead to growth in underwriting earnings. Finally, Berkley has been a modest buyer of its own stock. The company reported 257.8 million shares outstanding as of October 30, 2023, around 5% below its 2023 weighted average through Q3. Together, this can lead to solid EPS growth this year, which is indeed what analysts expect .
I see a bigger risk over the medium-term. Eventually the commercial insurance market will soften as higher profitability inevitably attracts more competition. Pricing will weaken and at best Berkley's underwriting profitability will hold steady while growth in written premiums will slow. Likewise, the tailwind to investment income will subside and reverse as the outlook increasingly points to interest rate cuts. That will be a headwind to Berkley's ROE, P/B and ultimately shareholder returns. From these levels, Berkley stock runs a high risk of being dead money over the next few years. Current shareholders might want to use the current favorable macro environment and valuation to realize some profits here, while prospective investors should avoid the stock at this stage.
For further details see:
W. R. Berkley: Shares Fully Valued Amid A Favorable Macro Environment