When property and casualty insurers and reinsures don't have to deal with any major loss events, the results, in Ben Graham's words, can be quite satisfactory. And so it was for AXIS Capital
For the fourth quarter, net premiums earned checked in at $689 million -- a roughly flat performance. However, last year's hurricane losses forced AXIS to increase its loss reserves, and this increased float was invested into stocks and bonds; total investments at the end of 2006 increased to $7.6 billion from $6.4 billion last year. As a result, last year's pain is this year's gain, and the increased net investment income allowed AXIS to increase net income 22% to $290 million versus last year's fourth quarter.
For the year, net premiums earned increased 5.5% to $2.7 billion, and higher net investment income and lower hurricane losses allowed AXIS to increase net income nearly tenfold, to $997 million from $100 million. In 2006, the company's combined ratio (a measure of underwriting profitability; the lower the better) was 77.3%, compared with last year's 101.8% ratio -- a performance that implies a 1.8% underwriting loss versus a 22.7% underwriting gain this year. Last year's combined ratio included 39.9% worth of losses caused by hurricanes Katrina, Rita, and Wilma -- losses partially offset by 15% of favorable reserve development in 2005, versus 8% this year.
For the year, return on equity was 26.7%. (Anything between 10% and 15% is considered adequate.) The nearly $1 billion in 2006 net income increased the company's book value to $4.4 billion. That made AXIS shares seem cheap at a market cap of $5.3 billion, which would imply a 5.3 trailing-year P/E ratio and a 1.2 price-to-book multiple. However, past performance, as always, is no guarantee of future results.
My point isn't to discourage potential investors, but rather to point out that reinsurers write excess-of-loss contracts that aren't triggered unless a big loss event happens. Thus, their results are highly volatile, and although reinsurers can't set aside reserves for future unforeseen losses, the good years -- for example, when a company posts a 26.7% return on equity -- come when a reinsurer builds loss reserves. The reinsurer can't directly book the loss reserves; rather, the great results in good years serve as a cushion for the bad ones.
This isn't a criticism against AXIS, for whom reinsurance accounts for 45% of gross premiums written. AXIS seems to be a solid insurer, and it's impressively managed -- enough to still make a profit last year. But even though the company has posted a stellar 17% average ROE since its inception, don't expect a gaudy 26.7% ROE every year.
Although insurance pricing seems to be softening a bit in certain pockets, management provided a solid outlook. The company noted that it hasn't seen major slippage in harsher conditions or terms. International catastrophe insurance pricing was off 5%-10% for the company, and the company remarked that continental Europe has "an abundance of capacity," but management reiterated that it maintained discipline and that pricing was far from irrational.
The company believes that two mitigating factors should prevent pricing from excessive softening: new reinsurance capital (i.e., hedge and private equity funds) from disciplined sources, and the trend toward having primary insurers retain the lower-level loss layers. These factors mean the company must maintain underwriting discipline. If it can, it should do well.
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.