RLI Corp: Massively Overvalued Vs. Better Performing Peers

| About: RLI Corp (RLI)

Summary

RLI and Markel are compared with Berkshire and three other insurance companies.

Markel's valuation is fair or slightly rich when compared with similar performing peers.

RLI's valuation is at least 100% richer than competitors that have produced similar or better returns on shareholders equity.

This article compares simple valuation metrics for a sampling of property-casualty insurance and reinsurance companies whose clients are mainly businesses rather than individuals. The companies are ACE Limited (NYSE:ACE), Arch Capital Group, Ltd. (NASDAQ:ACGL), Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B), Markel Corp. (NYSE:MKL), Everest Re Group Ltd. (NYSE:RE), and RLI Corp. (NYSE:RLI).

Markel and RLI were selected because their shares delivered exceptional returns in 2015. Markel's share price increased 29.4%, while RLI's shares returned 30.9% including dividends. Berkshire was included because Markel and RLI are often compared with Berkshire. Like Berkshire, Markel and RLI invest a significant percentage of shareholders' equity in non-insurance companies, either directly or by owning shares of public companies, but Markel and RLI are still mainly insurance companies, while Berkshire is not. Insurance premiums make up around 20% of Berkshire's operating revenues vs. almost 80% for Markel and 100% for RLI (The percentage would be closer to 90% if RLI's 40% share of Maui Jim's revenues were consolidated into RLI's financials.) The other companies were selected more or less at random, except that they are all well-run organizations that have delivered very good returns over time.

Based on this analysis, Markel's valuation is fair to rich and RLI is massively overvalued when compared with competitors in similar or better market positions that have earned similar or better returns on shareholders' equity over the past 10 years.

The tables below provide a high level overview. The first table summarizes total revenues for the first nine months of 2015 and shareholders' equity as of September 30, 2015. The second table summarizes the percentage of net earned premiums by major business segment for the first three quarters of 2015.

ACE

ACGL

BRK.A

MKL

RE

RLI

2015 Revenues

14,308

3,035

159,001

3,950

4,276

587

SH Equity

29,127

6,937

251,321

7,704

7,486

883

Click to enlarge

ACE

ACGL

BRK.A

MKL

RE

RLI

Domestic Insurance

46.3%

61.3%

68.1%

54.8%

61.6%

100.0%

IX Insurance

37.6%

NA

NA

22.9%

15.7%

NA

Reinsurance

5.0%

32.4%

31.9%

22.4%

22.7%

0.0%

Life Insurance

11.1%

0.0%

NA

0.0%

0.0%

0.0%

Mortgage Insurance

0.0%

6.3%

0.0%

0.0%

0.0%

0.0%

Click to enlarge

The data in the tables and charts was derived from SEC filings (2005 10-K and 2015Q3 10-Q), with the exception of historic dividend and stock split information (used to calculate returns on book value), which are from Yahoo Finance.

"IX" is short for international. "NA" indicates segments that were not reported in third quarter 2015 10-Qs. They are believed to represent relatively small percentages of the totals.

Premiums for these companies derive primarily from commercial lines except for Berkshire. GEICO accounted for approximately 80% of primary insurance premiums, and 55% of Berkshire's total insurance premiums for the first three quarters of 2015.

METRIC COMPARISONS

The first comparison is the ratio of share price to common equity per share, often referred to as the price to book value ratio. It is illustrated in the table and chart below. The ratio for 2005 compares the share price at year-end 2005 to book value per share as of year-end 2005. The current price to book ratio compares the closing share price on January 8 to book value per share as of September 30, 2015.

Price to Book Value

ACE

ACGL

BRK.A

MKL

RE

RLI

2005

1.353

1.619

1.492

1.822

1.567

1.839

Current

1.223

1.435

1.283

1.517

1.008

3.004

% Chg

-9.6%

-11.3%

-14.0%

-16.7%

-35.7%

63.4%

Click to enlarge

At the end of 2005, these companies were earning relatively rich underwriting margins in the 15%-20% range. Since then, market conditions have gotten much worse. Current underwriting margins are much lower, probably around 5% for these companies with the possible exception of Everest, which focuses on reinsurance where price reductions have been more severe. At the same time, fixed income yields have been cut in half, perhaps worse. Overall, it is probably reasonable to estimate that economic profit margins (underwriting margins plus the present value of investment income earned on new contracts) were over twice as high at the end of 2005 as they are now, on average.

Reported GAAP results have remained fairly stable despite a sharp decline in fundamentals because these companies established conservative reserves for future claims when underwriting conditions were better. Now, they are setting less conservative reserves for current policies at the same time that reserves from older policies are being reduced, which boosts GAAP income.

Book value multiples have decreased in most cases, but not enough to compensate for the reduction in margins and poor underwriting outlook. However, most of the multiples make sense on a relative basis. The one exception is RLI, which now trades at a much richer multiple now than in 2005 even though RLI is facing margin pressures similar to ACE, Arch and Markel.

The following table and chart provide ratios of market capitalization divided by annualized revenues for 2015 to date. This ratio is sometimes referred to as price to sales, or more accurately, price to revenues, because investment income is included.

Price to Revenues

ACE

ACGL

BRK.A

MKL

RE

RLI

2005

1.221

1.268

1.672

1.363

1.424

2.238

Current

1.868

2.460

1.521

2.220

1.323

3.388

% Chg

53.0%

94.1%

-9.0%

62.9%

-7.1%

51.4%

Click to enlarge

Price to book ratios suggest that these companies have become significantly worse investments now than they were 10 years ago, but price to revenues paint a much worse picture. Despite precipitous declines in insurance underwriting margins and investment yields, share prices as a percentage of revenues have increased by at least 50% for all of these companies except Berkshire and Everest. For Arch, it has nearly doubled. Unless there have been major improvements in these companies' businesses, this suggests that all of these companies except Berkshire are much worse investments now than they were in 2005.

It is also interesting to see how these companies have grown revenues over the past 10 years. The table and chart below illustrate this. For ACE, Berkshire, and Markel, acquisitions have contributed significantly to overall revenue growth. For the other companies, share repurchases have resulted in significant revenue growth per share even though overall revenues have increased at a much lower rate.

Annual Revenue Growth

ACE

ACGL

BRK.A

MKL

RE

RLI

Overall

3.9%

2.5%

10.3%

9.0%

2.3%

3.3%

Per Share

2.6%

8.9%

9.6%

5.1%

6.7%

5.1%

Click to enlarge

With the exception of Berkshire, none of these companies have grown much organically, and no company stands out as exceptional vs. the others. Maintaining similar growth rates over the next few years will be more challenging than it has been over the past 10 because the insurance underwriting environment is currently much more competitive than it was, and it is becoming more competitive. Strong insurance revenue growth was a positive over the past 10 years. Over the next five years, strong premium growth will be a negative except in unusual circumstances.

The last metric to be analyzed is return on book value, which includes growth in book value per share and dividends. It is compared with price to book and price to revenue ratios.

ACE

ACGL

BRK.A

MKL

RE

RLI

Annual Return on BV

11.3%

15.9%

10.1%

12.6%

12.9%

10.5%

Price to Book Value

1.223

1.435

1.283

1.517

1.008

3.004

Price to Revenues

1.868

2.460

1.521

2.220

1.323

3.388

Click to enlarge

The relative valuations are reasonably sensible except for RLI. RLI's annual return on book value is lower than any company except Berkshire, yet its valuation multiples are much richer.

Qualitative comparisons are subjective and therefore imperfect, but the following table attempts to summarize typical views among insurance industry professionals about the market segments that these companies operate in and their competitive positions within those segments. It also shows underwriting expense ratios for the first nine months of 2015. Expense ratios are listed because they are very important in competitive environments.

ACE

ACGL

BRK.A

MKL

RE

RLI

Market Segments

OK

OK

OK

OK

Poor

OK

Market Position

Very good

Very good

Very good

Very good

Good

Good

Expense Ratio

30.0%

35.6%

18.1%

40.4%

26.6%

41.5%

Click to enlarge

As this table suggests, most of these companies enjoy very strong competitive positions and operate in better than average insurance market segments, with the exception of Everest. Everest has an excellent track record of targeting profitable market segments, but currently finds itself operating in extremely competitive reinsurance segments. In addition, there is a perception within the industry that Everest's broker and client relationships are strong, but perhaps not the best of the best.

RLI enjoys good relationships with clients and brokers and focuses on better than average segments. However, RLI also faces increasing competition from larger companies with more name recognition that operate at lower expense ratios. RLI's surety segment has generated excellent returns over time and minimal losses in 2015 to date. All indications are that this is an excellent segment over the long term, but it is natural to be concerned that RLI might be required to pay significant losses because troubles in the energy industry result in failures of RLI insureds to perform. This is unlikely to impair RLI's capital base, but it could worsen financial results that are likely to deteriorate regardless.

CONCLUSION

Valuation metrics for most of these companies make sense in the context of book value growth, revenue growth, and current market positions. The notable exception is RLI, which is overvalued by more than 100% relative to the others based on this analysis. With the exception of very attractively valued, well-run companies, investors would do better by avoiding property-casualty insurance companies for the time being.

Disclosure: I am/we are short RLI.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long ACE, BRK-B, RE