2023-10-24 00:20:25 ET
Summary
- W. R. Berkley's shares have underperformed, but solid Q3 results and insurance pricing gains may boost them.
- The company's insurance operations have recovered from hurricane losses, and its investment portfolio is well positioned for rising interest rates.
- Higher premiums and improved underwriting results have led to a lower combined ratio, supporting future profitability.
Shares of W. R. Berkley ( WRB ) have been a poor performer over the past year, shedding about 12% of their value. However, the company reported solid Q3 results that may help to get shares moving higher again. Pricing gains have helped the company’s insurance operations recover from a weak Q1 , and its conservative investment portfolio is well positioned to benefit from rising interest rates.
In the company’s third quarter , it earned $1.35 per share in adjusted EPS as revenue rose by 11% to $3.03 billion. This beat consensus by $0.17 and was up 34% from last year as both underwriting results improved and investment income increased. It is important to remember that last year hurricane Ian caused significant catastrophe losses. This year, the hurricane season and catastrophe environment were relatively mild, and that played a role in flattering results.
Importantly, net premiums rose by $270 million or 10.5% to $2.85 billion. Higher premiums increased WRB's float, or insurance reserves to $18.3 billion from $17 billion at the start of the year, which is an important metric we will discuss later in context of the investment portfolio. Last year, higher inflation was weighing on the insurance industry as it became more expensive to fulfill claims, increasing the severity of losses and depressing profitability. This year, the industry has been able to regain pricing, even as overall inflation has cooled, restoring profitability.
W. R. Berkley was no exception to this trend as its pricing was up 8.5%, excluding workers' compensation. This means higher prices essentially accounted for 80% of WRB’s premium growth with a 2% increase in actual policies. This should be an encouraging development for future losses as these higher premiums de-risk WRB’s exposure to higher costs of claims to an extent. This theory was borne out in the data as WRB’s combined ratio (which is the total cost of its policies as a share of premiums) was 90.2%. In other words, WRB is making $9.80 for every $100 of premiums it underwrites.
The combined ratio for its insurance operation was down slightly at 91 v 91.2 last year. However, its reinsurance and excess combined ratio was stellar at 84.6 v 98.6 last year. Now, I would note that reinsurance catastrophe losses fell from $43 million in 2022 to $15 million this year, playing a meaningful role in this improved combined ratio. As noted, last year was unusually bad for catastrophes, and this year was unusually mild. There is a degree of randomness and luck to timing of catastrophes, and this factor does exaggerate the improvement in WRB’s insurance operation.
Consolidated insurance pre-tax income of $420 million was up 47%. $33 million of this gain was due to catastrophes, so pre-tax income was a part of WRB’s improvement, but not the entire driver of results. Overall, this was a solid quarter of underwriting and pricing gains as they filter through to more of WRB’s outstanding insurance-in-force should support continued improvement in its combined ratio next year.
Now, with the premiums WRB collects, it invests those funds until it has to pay out a claim. The growing size of its reserves means it has more funds to invest and earn income on. In essence, WRB, like any insurance company, is borrowing from its policyholders. However because it has a combined ratio below 100, it is making money on this activity, unlike a loan where you pay out interest. In a sense, its float is like owing debt with a negative interest rate where you pay back less than you borrow. This is especially powerful when interest rates are higher, allowing WRB to earn a wider spread on its float. That is exactly what happened last quarter with is investment income jumping $68 million or 34% to $271 million.
Of its $26.1 billion investment portfolio, about $24 billion sits in in its core portfolio. Investment funds, like private equity, are very volatile and tied to market conditions—given the more challenged macro backdrop, earnings here fell by nearly 90%. I also view its arbitrage trading account as a less reliable source of income quarter by quarter relative to the core portfolio, which has $19 billion in fixed income.
This fixed income portfolio is extremely high quality—the average rating is AA-. About 15% is invested in US government and municipal debt, just 28% is in corporate debt. WRB is not taking much credit risk in this portfolio. Only $630 million, or about 2.5% sits in commercial mortgages, only a fraction of which are in offices, limiting its exposure to this challenged sector. WRB has a high-quality portfolio where it is collecting interest, providing a high degree of visibility to earnings.
Critically, WRB has a very short duration portfolio, just 2.4 years. This is because its policies are relatively short-dated and it could need to pay premiums quickly. WRB wants a liquid portfolio with limited exposure to interest rates, so that should it have to, it can sell bonds at par to pay claims. Now in practice, because it is growing premiums written, the business is generating cash flow from which to pay claims, and even has cash left over to deploy into markets.
Moreover because its bonds are short-dated, it is able to rollover maturities into new bonds with higher rates. This is why its core portfolio income has risen so much; it has 15-20% of bonds maturing a year, bought when rates were a lot lower in 2019-2021 that it is now investing at 5+%. With each day as another bond in its portfolio matures and it reinvests, its run-rate interest income moves higher. WRB has a ~4.22% yield on its core portfolio, based on last quarter’s results. As this has converged towards market levels, the rate of investment income increase will slow from here. However, we are likely to see 10-20bp increases in the investment yield over each of the next several quarters, just as it rolls over maturities. This combined with a slight improvement in the combined ratio due to higher premium prices should power attractive low double-digit earnings growth.
This strong earnings power is enabling a solid pace of capital returns. The company declared a $0.50 special dividend in September , taking this year’s capital return to $772 million. Interestingly, WRB did just $2.9 million in share buybacks in Q3, taking its total to $430 million year to date. That is a meaningful slowdown, and it appears management is shifting its capital return policy more towards dividends than buybacks, but flexibility is likely to remain. The combined capital return yield (dividends + buybacks) will be about 5% this year.
Even assuming catastrophe losses revert halfway between this year and last year’s level and that investment fund performance does not rebound at all, with rising core investment income, WRB would maintain $5-$5.20 in go-forward earnings power. That leaves shares with a 12x multiple, which is not particular expensive. Given its exposure to interest rates as a primary driver of earnings, the multiple is likely to be below-market, but shares could move back to $70-75 or 14-15x earnings as investors appreciate the power of its core investment income.
Another way to consider its valuation is that WRB generated a return on equity of 21.7% on a book value of $26.80. Now this book value subtracts out its insurance reserve, but as noted above, WRB earns money on this float given its sub-100% combined ratio. This is why P&C insurance companies by and large trade at large premiums to their stated book value as subtracting out the entire value is very conservative. At an 8% required rate of return, even assuming some degradation in earnings due to normalization in catastrophe losses, WRB could trade at 2.5x stated book value, or about $67, given its ROE.
Combining these two approaches, given my view we should higher premium prices translate to better underwriting margins and a continued increased from investment income, I see shares rising to about $70 over the next year, providing about 11% upside. This still would not get shares back to where they were earlier this year but would point to a continued recovery in shares seen over the past few months as markets grow more comfortable with its underwriting results, making WRB relatively attractive investment.
For further details see:
W. R. Berkley: Solid Q3 Results Should Support Shares