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W.R. Berkley (NYSE:WRB)

Q2 2014 Earnings Call

July 29, 2014 9:00 am ET

Executives

William Robert Berkley - Chairman, Chief Executive Officer and Member of Executive Committee

William Robert Berkley - President, Chief Operating Officer, Director and Member of Executive Committee

Eugene G. Ballard - Chief Financial Officer, Principal Accounting Officer and Senior Vice President

Analysts

Amit Kumar - Macquarie Research

Max Zormelo - Evercore Partners Inc., Research Division

Michael Steven Nannizzi - Goldman Sachs Group Inc., Research Division

Jay Adam Cohen - BofA Merrill Lynch, Research Division

Joshua D. Shanker - Deutsche Bank AG, Research Division

Operator

Good day, and welcome to W.R. Berkley Corporation's Second Quarter 2014 Earnings Conference Call. Today's conference is being recorded.

The speakers' remarks may contain forward-looking statements. Some of the forward-looking statements can be identified by the use of forward-looking words, including, without limitation, believes, expects or estimates. We caution you that such forward-looking statements should not be regarded as a representation by us that the future plans, estimates or expectations contemplated by us will, in fact, be achieved. Please refer to our Annual Report on Form 10-K for the year ended December 31, 2013, and our other filings made with the SEC for a description of the business environment in which we operate and the important factors that may materially affect our result. W.R. Berkley Corporation is not under any obligation and expressly disclaims any such obligation to update or alter its forward-looking statements, whether as a result of new information, future events or otherwise.

I would now like to turn the call over to Mr. William R. Berkley. Please go ahead, sir.

William Robert Berkley

Thank you. Good morning. We were really pleased with our quarter. We think it continues to demonstrate our capacity to generate returns in excess of 15%, and we expect that'll continue through the year. Rob Berkley is now going to talk about operating results and then we'll go over to Gene, who will talk about financial results, and then I'll come back and give you a general overview. So Rob?

William Robert Berkley

Yes, thank you. Good morning, everyone.

Market conditions during the second quarter remained somewhat of a mixed bag, not dissimilar to what we've seen over the past few quarters. The level of competition continued to vary greatly by territory, product line, even down to classes within product lines.

The domestic insurance market -- in the domestic insurance market, the casualty lines continued to be amongst the most promising. Workers' compensation, in particular, continues to be a bright point. Having said that, we would caution people not to paint with too broad of a brush. This can very much vary based on region.

Property margins in general is somewhat flattish. Having said that, cat-exposed property remains under growing pressure. Our speculation is this may be a result of the increasing amount of property cat capacity that is available in the reinsurance market and where the pricing for that reinsurance capacity has gone over the past 12, 18, 24 months.

Professional lines continued to vary greatly. In particular, the excess public D&O and professional liability for large law firms is under a good deal of pressure. Having said that, by and large, the professional market is somewhat flattish, also not dissimilar from the property market, but there are a few product lines where there are opportunities to grow the business.

Consistent with our comments in the past, commercial auto remains an area of concern from our perspective in the domestic insurance market. We believe this continues to be an area that is poised for a hardening.

On the international insurance front, again it varies greatly by territory. Having said this, the U.K. and Europe overall remain exceptionally competitive. Additionally, the Canadian insurance market as well as the Brazilian market remain flavors of the day.

The global reinsurance market is the part of the industry that gives us the greatest reasons to pause. There continues to be a lack of balance between supply and demand. Many participants appear to have an unquenchable thirst for premium, which seems to be addressed through the eroding underwriting discipline.

In regards to the company, net written premium for the quarter was approximately $1.49 billion. This is an increase of 11% when compared with the corresponding period last year. This result was led by our domestic insurance segment, which grew at a rate of approximately 16%. 4 of the 16 points of growth was associated with rate with the balance coming from exposure. On the other hand, our global reinsurance segment's net written premium was down 17%. This was primarily a result of market conditions and our colleagues exercising the appropriate level of discipline. We applaud this behavior.

The loss ratio for the quarter was at 61.2%. This includes $40 million of cat-related losses. While this level of cat activity is modestly above what we had expected, generally speaking this type of cat activity is not unusual for us in the second quarter due to severe consecutive storms.

The expense ratio continued to move in the right direction, coming in at 33.2%. This represents an improvement of more than 0.5 point when compared to the second quarter of '13. This progress is a result of many people's efforts, in particular our colleagues in the reinsurance segment. We expect this overall trend to continue, though on occasion we may need to take 1 step back in order to take 2 forward.

When you put all the pieces together, the company achieved a combined of a 94.4%, which is more than 2 points of improvement when compared to the same period last year.

While others are going to be going into some level of detail with regards to their balance sheet, I'd offer the comment that we remain very comfortable with our aggregate loss reserves. This is demonstrated not only by the $24 million of net positive development we had in the quarter but also the fact that this is the 30th quarter in a row of net positive reserve development.

While it continues to be evident that this is not a classic insurance cycle, we remain quite encouraged by the number of opportunities that we see before us to achieve attractive return. We remain focused on trying to find the appropriate balance or the optimal balance we like between rate increase and exposure growth. As we examine our policy year numbers, our confidence continues to grow in our ability to improve our results on a reported basis from here.

William Robert Berkley

Thanks, Rob. Gene, you want to go through the numbers, please?

Eugene G. Ballard

Okay, thank you. As you can see, we did have a very strong quarter with a 55% increase in net income to $180 million and a 65% increase in net income per share to $1.35.

I'll start with just a few more details on underwriting. As Rob said, we -- our premiums grew 11% to $1.5 billion. The increase was led by the domestic segment, which was 16% with workers' comp up 26% and other liability up 15%. International premium has increased 10% in terms of U.S. dollars and by 20% in regional currencies. And if you look at the growth in terms of regional currencies, it was primarily from business in Australia and Latin America. Reinsurance premium's decline of 17% was due to a decline in treaty business in both the U.S. and the Asia Pacific region.

Our overall underwriting profits increased 82% to $80 million. Our reported loss ratio declined 1.6 points to 61.2%, and our accident year loss ratio before cat declined 1.5 points to 6.0%. The accident year improvement was led by the domestic segment, which improved 3 points as earned price increases continued to outpace loss cost trends.

Cat loss is at $40 million or 2.8 points when compared with $34 million 1 year ago. This year, we had cat losses from 12 named events in the quarter, the largest of which was a $9 million, 15-storm event in late April.

Favorable reserve development was $24 million and resulted from reserve releases from the domestic segment that were partially offset by a modest increase in reserves for the international business.

The overall expense ratio of improvement was 6/10 to 32.2%. It reflects a decline in both our net commission ratio and our internal expense ratio and was led by our reinsurance business, which improved by 3.5 points. It gives us an overall combined of 94.4%, an improvement of 2 points from 1 year ago.

Investment income was down 3% to $139 million as a result of a decline in the annualized yield in our fixed-income portfolio to 3.7% from 4.0% 1 year ago. This reflects a reduction in our average duration from 3.1 years at June 30 down to 3.3 years at March 31.

Our earnings from investment funds and the arbitrage trading account were in line with the prior year quarter.

Realized gains were $109 million, up from $33 million 1 year ago. The gains in 2014 included a gain of $85 million from the sale of an office building in London. Our realized gains for the first 6 months were $162 million and for the last 3.5 years were $619 million, which is an average gain of $177 million per year.

Pretax unrealized gains also increased by $189 million from the beginning of the year to $586 million at June 30. The average credit rating of our portfolio remained unchanged at AA-.

Corporate and other expenses were in line with the prior year except for the foreign currency movements. We reported a modest loss of $2 million in the quarter for foreign currency movements, which is in line with our average gain or loss for a given quarter, any given quarter, but much less than last year's second quarter, which had a gain of $7 million.

Our effective income tax rate was 31.6% in the quarter compared with 27.5% 1 year ago. The tax rate was higher in 2014 because a greater portion of our pretax earnings were attributable to income with tax at 35%. That includes realized gains as well as underwriting income. The 2014 tax rate on operating income, that is before realized gains, was 29.2%. That gives us a net income of $180 million, an annualized return on equity of 16.6% for the quarter, and our book value per share is up 10.5% from the beginning of the year to $36.20 at June 30, 2014.

William Robert Berkley

Thank you, Gene. So we were quite pleased with the quarter. We continue to try and find investment opportunities that will give us gains or income to maintain the decline in interest rates or to offset rather the decline in interest rates. It's the nature of our business, being primarily casualty, requires investment returns to achieve our 15% goal, which means given interest rates and given our desire not to extend the duration, which we think adds substantially to our balance sheet risk and the risk to our owners, and given our desire not to change the quality of our portfolio materially, we conclude the only alternative is to go for gains that, while not as easy to model, offers some fairly predictable over an extended period of time gains.

And as I continue to say, this was a particularly good quarter. What we're hoping for is to earn $25 million or more a quarter. And we'll be able to deliver on that from our ordinary portfolio, and we would expect that we'll be able to continue that going forward. And that's still our objective.

The building we bought, we bought with the expectation of selling it and not to hold it for a long time. We just saw good opportunities to sell. We have other real estate that we'll own for a very long time and other real estate that we own with the goal of selling it.

We continue to work hard to find alternative investments, and we believe we'll be able to continue achieving the goals that we've set forth.

The basic business is more competitive than we would have expected. But as Rob mentioned, price increases still exceed loss cost trends. That's a good thing. It makes us want to grow and expand where we can. That doesn't mean we're going to grow and expand to every place. It means there are plenty of opportunities. You have to find them and you have the find ways to take advantage of them.

So we think it'll be an excellent year. We think we'll achieve our 15% after-tax goal, and we're quite enthusiastic over the balance of this year and we don't see anything that's going to change dramatically next year.

With that, Andrew, we're happy to take questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Amit Kumar from Macquarie.

Amit Kumar - Macquarie Research

Just a few questions. The first question relates to the discussion on domestic insurance, on pricing exceeding the loss cost. Could you sort of help us understand how you expect the pricing versus loss cost delta to play out for the remainder of 2014? And at what point does it inflect?

William Robert Berkley

This is Rob. Our view right now is we're probably getting, give or take, around 200 basis points over loss cost as being additive to margins, if you will. I think trying to speculate exactly how it will unfold over the balance of the year, we'll have to see. Having said that, our hope and, it's beyond hope actually, expectation based on what we're seeing so far is -- give or take, where we see things now is not a bad indicator for where we see things over the next call it 6 months.

Amit Kumar - Macquarie Research

Got it. I guess the only other question I have is going back on the discussion on comp. And I know we discussed this Q1, 2. How should we think about, I guess, the new business component versus the renewal business component in this unit? I guess I'm trying to say real loud the impact of pricing versus areas where others might be withdrawing due to issues.

William Robert Berkley

So your question is the growth that we're having, how much of it is driven by rate versus exposure? I'm not sure if I...

Amit Kumar - Macquarie Research

Yes, yes. That's correct. And comp specifically.

William Robert Berkley

Yes, honestly, it really varies by territory. There are certain areas of the market where we're very happy with the returns that we believe that we are achieving and we are willing to accept rate increases that are very modest. And actually, in some cases, we may be willing to accept rate that is flat but expiring because we're encouraged again by what the return opportunities are. Having said that, there are other parts of the country where, from our perspective, you need a meaningful amount of additional rate to achieve those returns. When you look at our overall growth in comp, I think it would be fair to assume that it is some combination, but it is going to -- as far as exposure versus rate, but it is going to vary by territory.

William Robert Berkley

I mean, one thing you might take note of that surprised everyone, and that is, medical costs last year went down for Medicaid which was a real surprise to everyone. So when we talk about loss cost and trends and looking ahead, I think there's so many new variables with changes. It's a tough thing to predict for anyone out far ahead.

Operator

Our next question comes from the line of Vinay Misquith from Evercore.

Max Zormelo - Evercore Partners Inc., Research Division

This is actually Max Zormelo on Vinay's line. My first question is on share buybacks. There's quite a pullback this quarter, and I'm wondering if that's function of the growth opportunities you are seeing in the market or if it's -- that's your stock price? Can you give us some color on that, please?

William Robert Berkley

As we've always told people, we're opportunistic buyers of stock. I mean, it takes several things. Number one, it takes price we're willing to pay; and number two, it takes availability of shares because the nature of our rules, we can't just drive the stock up, we have to buy in certain environments. So when the stock starts to move up and we're not in the marketplace, we can't see. We can't drive the stock up. So we have to have availability on downtick. We can't buy in all kinds of issues when we're in a blackout period. So after the end of the quarter when actually there were some times we would have liked to buy, we couldn't buy it because we were blacked out. So no, we haven't changed our view. We still would have to have an appetite to buy a stock back. And no, it's -- it looks more trendy than it is. It's just the way the opportunities fall out given our judgments and what the market does at any moment in time.

Max Zormelo - Evercore Partners Inc., Research Division

Okay, that's helpful. Second, I have a couple of numbers ones. The tax rate, as you mentioned in your prepared remarks, was higher. I'm just wondering, what drove that? And also going forward, what should be the expected tax rate for the rest of the year?

William Robert Berkley

It's too high, I can tell you that. Well, but Gene...

Eugene G. Ballard

Yes, so what drove it is we -- a greater proportion of our taxable income in the quarter was more stuff that's taxed at 35%. So the realized gains, perhaps very large in the quarter, that's all 35%. And the underwriting is growing faster -- the earnings from underwriting is growing faster than the earnings from investment income. That's taxed at 35%. So you'll see that trend when that happens.

William Robert Berkley

One of the problems is if you take the position of somebody who is trying to model this is, if you don't count the capital gains as income, which is 35%, that raises the tax rate because it's so significant overall probably by at least 2 points, maybe 3, because that's at a full 35%, whereas the non-capital gains probably is more like 28%. Do you understand what I mean?

Max Zormelo - Evercore Partners Inc., Research Division

I understand. And I did take that into consideration, but I think it still comes out closer to 30%, right? Is it something...

William Robert Berkley

No, I think it's around 28.5%.

Max Zormelo - Evercore Partners Inc., Research Division

Okay. All right. And then one more, if I may. But despite pressures..

William Robert Berkley

By the way, that's too high anyway, so.

Max Zormelo - Evercore Partners Inc., Research Division

The 28% is still too high, right?

William Robert Berkley

28% -- I think it's 28.5%. And yes, it's too high. It's terrible.

Max Zormelo - Evercore Partners Inc., Research Division

But would you expect the full year to come at around the same rate?

William Robert Berkley

I would expect on ordinary income, the full year will be around the same, maybe slightly lower but not much.

Max Zormelo - Evercore Partners Inc., Research Division

Okay. And last one, the expense ratio in the reinsurance segment declined quite meaningfully this quarter. I'm wondering if there were some onetime items in there.

William Robert Berkley

No, I think that -- well, there may be a little bit of that, by and large, it's a reasonable run rate to assume going forward. Having said that, obviously if we try to expand the business or develop it in other territories, there could be some expense associated with that. So long story short, if the business continues with the platform that it has today, then I think what you saw is a reasonable run rate.

Operator

Our next question comes from the line of Michael Nannizzi from Goldman Sachs.

Michael Steven Nannizzi - Goldman Sachs Group Inc., Research Division

I just have one question on reinsurance and kind of the market conditions there. Are you looking to sort of take advantage of better terms and conditions in your reinsurance buying? It looks like the seeding percentage didn't go up. But I'm just trying to understand how we should think about that lever for you guys going forward.

William Robert Berkley

Yes, Mike, this is Rob. As it relates to -- from the perspective of us being a buyer of reinsurance or a seeding business, we're certainly aware of the market conditions and what the market will bear, and there's always the tug-of-war between is it a -- is it that attractive and that compelling the type of seeding commission you can get, that is overwhelms what you believe is the underlying profitability of the business? And would you rather retain it? And we buy more than 100 different programs, and we go through them one by one and try to examine, are very better off buying or are we better off retaining? Additionally, as we've talked about, I believe it was last quarter, we are examining in general whether we should be buying the same amount the same way going forward.

Michael Steven Nannizzi - Goldman Sachs Group Inc., Research Division

Got it. And then -- yes?

William Robert Berkley

I think we could add a little bit to that, Michael, and say that clearly, we understand what's going on in the marketplace. And where our opportunities are appropriate, we'll take advantage of it. But our own business is getting better, so you need -- you have to look at the changes in your own business vis-à-vis the changes in terms and conditions.

Eugene G. Ballard

I'll just add one quick point to that. The gross premiums for the quarter are up 10%, and the seeding premiums for the -- written premiums for the quarter are up 2%.

Michael Steven Nannizzi - Goldman Sachs Group Inc., Research Division

Right, got it. Okay, that makes sense. And then I remember there was a time we talked about startups and kind of the amount of premium growth coming from sort of the legacy businesses and the sort of startups. And I know we haven't really talked about those for a bit, but just trying to get an idea of the sort of geography of the written premium growth is. How much of that is coming from the more established platforms versus maybe some of these newer platforms that have scaled or recently scaled or are still scaling?

William Robert Berkley

At this stage, Mike, as you have referenced a moment ago, in the past, a lot of the growth was coming from the younger operations. While they've remained meaningful contributors to the overall growth, more recently, as market conditions have continued to improve, we have seen a greater contribution from the more mature businesses. So depending on how you define startups or younger businesses versus more mature businesses and where one wants to draw that line, we could try and break out percentages for you. But having said that, I think at this stage, once -- it would be safe to assume that there's a notable contribution coming from both mature businesses as well as some of the younger ones.

Michael Steven Nannizzi - Goldman Sachs Group Inc., Research Division

Great. And then just last one, if I can. On the workers' comp book, has the growth been balanced between excess and primary? Or has it been more one or the other? And I'm just trying to sort of balance the growth that we've seen there, which would seem to be exposure growth, I think, in reference to a prior question as well. How do we balance the sort of competitiveness that you're seeing with the continued opportunity that you found for growth there?

William Robert Berkley

Yes, the first part of the question, the lion's share of the growth is coming as a result of the primary comp, not the excess comp. And then as far as what's driving the growth, it really varies by territory. There are some territories where in order for us to be willing to write the business, we are looking for meaningful rate. There are other territories where, quite frankly, we are very happy with the available margin and it is the growth that's being driven by exposure. So it really can vary state to state. And then actually, in some -- particularly in some of the larger states, it can vary by region within that state.

Operator

Our next question comes from the line of Jay Cohen from Bank of America.

Jay Adam Cohen - BofA Merrill Lynch, Research Division

Yes. I'm not sure I quite got this on the prepared comments, but I believe you said that the underlying loss ratio for the domestic business improved by about 3 points from the year earlier. Is that accurate?

William Robert Berkley

Yes.

William Robert Berkley

Right.

Jay Adam Cohen - BofA Merrill Lynch, Research Division

I guess, Gene, then the follow-up is or the question is, it looked overall for the company, the loss ratio got better by about 1.5 points, which would suggest, obviously, there's pressure elsewhere. We don't see the actual number yet because we don't have the breakdown of the development. But where is that -- where is the pressure coming from that's offsetting the improvement in the U.S?

Eugene G. Ballard

Right. It was -- there's some increase quarter-over-quarter in the international. As to your loss ratio, although it's still very good, below 60%, but it's a little bit higher than it was a quarter ago. And reinsurance has not changed too much. But...

Jay Adam Cohen - BofA Merrill Lynch, Research Division

What's going on internationally? Is that just kind of one-off events? Or is there real underlying pressure on the margins? Should we expect that to continue internationally?

Eugene G. Ballard

Well, as I said, I think it's -- in terms of the loss ratio, it's still pretty good. And it's just slightly higher than it was a quarter ago. So it's not a -- not something that's going to be a problem going forward.

Operator

Our next question comes from the line of Josh Shanker from Deutsche Bank.

Joshua D. Shanker - Deutsche Bank AG, Research Division

My question revolves around the alternative investment portfolio. Historically, it's been fairly correlated with the prior quarter's market returns, and -- which were flat and did -- had a very nice quarter in 2Q '14. I'm wondering if the composition has changed at all.

William Robert Berkley

No, not really. Not really. I think that several -- one of our big alternative investment portfolios achieved their hurdle rates, so they got their carries dropped in, which for the -- for a quarter or 2 will reduce our returns as they get their hurdle rates caught up. But nothing really. It's just -- it's going along and it's doing pretty well. And I think that for the year, it'll be in line with our expectations, but that's the only thing that's changed in the alternative investment portfolio.

Joshua D. Shanker - Deutsche Bank AG, Research Division

So just -- I'm not so familiar, I think. So this quarter, it had a little extra, which might come out a little bit in the next couple of quarters?

William Robert Berkley

I'm sorry?

Joshua D. Shanker - Deutsche Bank AG, Research Division

Because if they received their carry, you were saying it was a little bit higher here. It might be...

William Robert Berkley

No. What I meant is we -- that the alternative investments didn't do quite as well as they might have because we had -- we accrued the carried interest over the next 2 quarters for 1 of our big alternative investments. So the quarter we just reported and the next quarter, we'll be impacted as we -- as a significant portion of our investment returns will go towards their carried interest. But that's the only change in our alternative investments. In fact, the alternative investment had an excellent quarter in the second, and we would expect the same in the third.

Operator

[Operator Instructions] And I'm seeing no other questioners at the queue at this time.

William Robert Berkley

Okay. Thank you very much. Have a great day. We're quite happy about where things are going, and we see a great balance of the year.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This now concludes the program, and you may all disconnect. Everyone have a great day.

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