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Background:

Renaissance Reinsurance (NYSE:RNR) was founded in 1993 in Bermuda with a focus on high-severity, low frequency events. Today, RenRe mostly underwrites global property catastrophe reinsurance and to a lesser (but still significant) extent specialty reinsurance. Despite underwriting risks globally, RenRe's underwriting is pretty U.S. centric with ~63% of premiums coming from the U.S. and Caribbean.

Combined Ratio and Underwriting Discipline:

RenRe has a very strong underwriting history with an average combined ratio of 66.4% since inception. Compared to the historical average combined ratio of Bermuda reinsurers of ~90% (2002-09) and to the following Bermuda based competitors (only a few of its competitors for illustrative purposes; similar underwriting volume and P&C reinsurance focus) RenRe shows a very strong underwriting record with the only other similarly successful underwriter being Lancashire.

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*Allied World Assurance re-domesticated to Switzerland

Other Indications of Management's Mantra That Underwriting Comes First:

  1. Management doesn't mind contracting the float if there are no good underwriting opportunities (its float contracted ~40% from a high of $2.2B in 2005 to a low of $1.34B in 2010)
  2. 2012 net premiums written were basically flat with 2003 net premiums written (not chasing growth)
  3. RenRe's reserving is very conservative. Reserve developments have also been consistently strong with reserve redundancies in each of the last 16 years.
  4. RenRe is also well capitalized with loss reserves of $1.7B vs. a $6.7B portfolio as of September 2013.

Return on Equity:

Historical long-term average returns on equity in the Canadian and U.S. P&C insurance and reinsurance industries have been 8-10%. RenRe has strongly outperformed in this area as well with an average 21.3% RoE since inception. This is not the result of an aggressive investment portfolio as RenRe's portfolio has historically been mostly in highly-rated fixed maturity investments (RenRe's 11 year average yield-on-investments is 4.6%; 75% of the 2012 investment portfolio is in fixed maturity investments with 20% in U.S. treasuries). Also, since 2001, an average of 54% of pre-tax income has come from underwriting and 37% from investment income which shows RenRe's focus on underwriting.

Valuation:

RenRe currently has a diluted market cap of $4.2B (44.1M shares at $95/ share). There are two ways to look at RenRe's valuation, the first one being a calculation of its normalized Free Cash Flow relative to its current market cap.

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This is only a rough calculation of FCF (explanations are at the end of the write up*) based on which RenRe can earn around $490M in a normal environment (at the current level of premiums) wherefore it currently trades at around 8.5x normalized FCF, i.e. an 11-12% equity yield.

Another way to look at it is that RenRe should be able to earn around 14% on equity (FCF/ equity) going forward (even though it has earned 21% since inception, the more recent numbers are quite a bit lower which we will go with to be conservative. RenRe has on average generated 15.5% and 14% of FCF on equity over the last 11 and 6 years respectively) which would mean around $460M in free cash flow and around a 9x multiple.

These two ways of looking at RenRe's valuation are fairly synonymous to looking at RenRe's P/B together with RoE but this way provides more of a breakdown (into combined ratio, return on portfolio etc.). For the record though, P/B currently trades at 1.4 times book.

Capital Allocation:

Over the last 6 years, RenRe has been putting most of its free cash flow towards share repurchases, mostly when the P/B was at or below 1.2 times. Since 2007, RenRe has repurchased (on a diluted basis) just under 39% of the company ($1.78B in gross repurchases) and distributed $400M in dividends. Through its dividends and repurchases, RenRe has returned ~100% of FCF since 2006.

Management states that in the absence of opportunities in the insurance market, it intends to continue distribute most of its FCF through repurchases if the shares trade at a reasonably low level; at the current 10-12% FCF yield that would still be pretty good capital allocation.

Management:

An investment in RenRe is very much an investment in its management as that's the source of its underwriting discipline and profits. While Neill Currie, one of the founders, retired as CEO in 2013, Kevin O'Donnell who has been with the company for 17 years and has been the Global Chief Underwriter from 2010-2012 and President of RenRe Ltd. since 2005 has now taken the helm. Since he was very much involved with RenRe's underwriting previously there shouldn't be a major change in mentality now. Execs and directors also have a total 8% stake in RenRe wherefore they are fairly strongly aligned.

Risks:

1) There has been a lot of talk about federal catastrophe funds (U.S. and other countries) with the intention of lowering the cost of insurance. Those funds would provide below market rate (re)insurance and therefore reduce rates/ increase capacity in some of RenRe's markets.

a. Looking at the example of Florida which established such a fund in 2007 illustrates that this should not be a long-term problem. Florida established a reinsurance fund with annual capacity of $16B and increased the capacity of the state-sponsored primary insurer in 2007. The reinsurance limit was increased to $28B in 2008. In 2009, upon recognition of inadequate pricing and high probability of short-falls in funding if there was a major event, legislation was approved to reduce the size of the reinsurance fund by $12B over five years and raise prices at the primary insurer (at a max of 10%/ year) as well as the reinsurance fund (TICL portion). In 2012, a new bill was introduced to further cut coverage and raise rates because of the underfunding, however, while it passed the Florida Senate Banking and Insurance Committee vote, it did not pass full legislature. This shows that Florida is already back-tracking on its CAT fund without any major event having occurred yet in Florida. This cheap insurance has also strongly weakened primary insurers who can't get adequate pricing anymore wherefore this is not sustainable in the long run. A large event and the subsequent losses would most likely significantly reduce the size state-run (re)insurance operations and further increase rates.

2) U.S. legislation intended to change taxation of (re)insurers operating directly or indirectly in the U.S., i.e. ensuring tax payments to the IRS. The first legislation being considered concerns the deductibility of premiums that a U.S. based insurer cedes to an offshore affiliate (i.e. ceding the premium to a foreign subsidiary to move taxation to a lower-tax regime). The second legislation being proposed would cause insurers that operate indirectly in the U.S. (e.g. substantially all of the execs and senior management living primarily in the U.S.) to be taxed at U.S. rates despite being officially headquartered somewhere else.

a. Around 1/3 of the world's top 50 reinsurers are headquartered in Bermuda due to the 0% tax rates. Either of the two legislations, if enacted, would affect a lot of reinsurers which would subsequently have to pay a substantial tax. However, reinsurers have over the long-term adjusted their prices to generate 8-10% RoE, whatever obstacle was thrown in their path. Whether it is a major cat, a low interest rate environment or a sudden increase in taxes, the costs will over the long-term simply be passed through to the insureds. While there might be 1 or 2 years of lower returns initially, the pricing will soon enough reflect the tax change to yield the average 8-10% RoE. Also, under its current formulation, RenRe does not consider the second bill to affect it; whether or not that's the case, if it affects RenRe and everyone else, pricing will simply adjust itself in the long-run.

Conclusion:

At a 10-12% FCF yield and reinvestment at a 10-12%+ yield, RenRe is still a fairly good investment. However, you can't expect much organic growth in the long run as their focus on pristine underwriting largely prohibits them from increasing their underwriting volume by any significant extent in the long run, so it's pretty much like a 10-12% bond with automatic reinvestment (due to the repurchases). An investment in RenRe requires a long-term horizon due to the volatile nature of the insurance industry as well as the potential for adverse short-term impacts of changes in legislation. The share price will probably be a bumpy ride, but based on RenRe's aggressive share repurchases that would actually be something to hope for (especially since you can't expect much long-term organic growth).

I really like the company and the valuation is definitely not bad but for the time being I am only putting it on my watch list.

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*Detailed FCF calculation:

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FCF normalized using RenRe's 2012 net premiums earned (fairly conservative as it is ~10% below its 10 year average premium volume) and subtracting normalized claims expense, acquisition cost, operational expense etc. (normalized at their long-term averages relative to net premiums), adding total investment income at a 4.5% yield on the current portfolio (4.5% = historical yield), and adjusting for the difference in Black Scholes comp and intrinsic value of options actually exercised in 2012.

Source: Renaissance Reinsurance: The Disciplined Underwriter