By Drew Woodbury
The property-casualty insurance industry is cyclical, fluctuating between states of increasing prices (hard market) and decreasing prices (soft market) based on levels of industry capital and capacity. When capital is abundant, as we have seen over the past couple of years, insurers compete viciously for the best opportunities, driving prices downward. Without fail, the soft market eventually leads to irrational pricing. Because insurance is essentially a commodity product, most of the market is forced to match these irrational prices or risk sacrificing market share and growth. Eventually a catalyst, often a catastrophe, occurs that forces market participants to re-evaluate previous loss assumptions and companies begin to realize that they have less capital to cover their losses than they previously believed. The insurers that were most aggressive during the soft market are forced to scale back their underwriting or, in some cases, exit the market completely. This then sets the stage for harder pricing.
That leads us to the current state of the market, where insurance prices have been declining for a number of years. While a turn in the cycle is inevitable, the question is when that change will happen. We previously thought the hit to capital that many insurers felt during the financial crisis coupled with a strong hurricane season in 2008 might be the catalyst to push prices higher. However, government support of troubled institutions, the rally in the capital markets, and a benign hurricane season in 2009 has allowed many of the most financially strapped companies to claw their way back.
Earlier in 2009 we had begun to see signs of differentiation between the companies hardest hit by the financial crisis and those that made it through with their balance sheets largely intact. We thought that customers might increasingly search out more stable companies in a flight to quality. But government support to a number of insurers including AIG (NYSE:AIG) and Hartford Financial Services (NYSE:HIG) allowed some of these distressed competitors to continue writing business at irrational prices. In some cases, we have heard competitors talk about distressed carriers cutting prices dramatically on renewal business in order to keep business and cash flow coming in the door. Additionally, the insurers whose investment portfolios were hit hardest by widening spreads during the financial crisis benefited the most when the markets rallied in 2009, allowing them to largely mend otherwise stressed balance sheets, growing book value disproportionately in the process, and restore their capital losses.
As 2009 progressed, we'd thought a hard market could still be on the horizon if another event, such as a difficult catastrophe season, would allow for differentiation among companies. But the 2009 hurricane season was essentially a nonevent, giving struggling companies a reprieve from further stresses to capital.
While we have seen a few carriers, including Travelers (NYSE:TRV) and Chubb (NYSE:CB) able to pass along rate increases, widespread price spikes that accompany a hardening market have largely been absent. Most carriers cite the weak economy as the culprit in their inability to pass along rate increases to financially strained customers, making us believe that, barring a large natural catastrophe, the economy will need to show meaningful signs of improvement before widespread rate increases will be possible.
In the interim, we think investors would be best served sticking with the highest-quality names. Another fall in the capital markets remains a risk, and we think the strongest names provide relative downward protection in that scenario and are also best poised to exploit a hardening market when it occurs.
Along this theme, a high-quality insurance company whose stock looks cheap to us is W.R. Berkley (NYSE:WRB). The first thing we like about Berkley is its business model. Rather than offering standard lines of insurance--a commodity--the company offers specialized property-casualty insurance to niche segments of the market. Berkley's staff of expert underwriters has deep experience in their respective markets, many of which have less competition than traditional insurance products. Because the risks are so unique, customers often don't shop on price alone. This strategy has allowed Berkley to generate excess returns over its history, a trend we expect to continue into the future. Due to its strong business model and superior returns, we believe the firm should trade at a premium to its property-casualty insurance peers. The current market price, equivalent to less than 1.1 times end of 2009 book value, ignores these returns and lumps Berkley in with more traditional insurers.
Due to its long-term focus, W.R. Berkley incentivizes its underwriters to decline business when prices aren't favorable. As a consequence, during the soft market, premiums at Berkley have been declining more rapidly than peers. What's more, given that it compensates its employees for the long-term value they generate, the firm continues to pay underwriters regardless of the stage of the market cycle. As premiums decline, the largely fixed nature of its compensation structure has caused W.R. Berkley's combined ratio (insurance expenses/earned premiums) to tick upward. We are not concerned by this trend, however, as the firm's loss ratio (claims divided/earned premiums) has remained low, indicating that the company continues to underwrite profitably. Given that W.R. Berkley has preserved capital during the soft market, it will have more capacity to write very profitable business when the pricing cycle turns. This was the case during the previous hard market, during which earned premiums increased 44% in a single year.
The company was founded more than 40 years ago by Bill Berkley, who serves as chairman and CEO to this day. His vast industry experience and unique long-term perspectives on the insurance markets are closely monitored by market participants. Berkley has been one of the most unwavering executives calling for a turn in the pricing cycle after many years of price declines. As insurance earnings are based on estimates of future losses, he believes that the industry is turning a deaf ear to the unprofitability of business currently written. His prediction originally called for price changes to turn upward at the end of 2009 or the beginning of 2010. Since then, he has backed off a little bit but still predicts that the hard market will come at the end of 2010 when prices will increase 8%-10%.
We're not convinced Berkley has the time right, but we do believe a hardening market isn't too far away, although rate increases will be more muted than previous cycle turns. We believe that price increases in the near future will be more subdued than they otherwise might have been as a result of a more gradual market recovery. Regardless of the magnitude of the cycle turn, Berkley's shares look undervalued and we believe they represent a good opportunity for investors interested in the insurance space.
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