A Long-Proven Winner Is Being Underestimated

Strong sector performance has led to a lack of quality insurance companies trading at any meaningful discount to fair value. Property catastrophe reinsurance maven RenaissanceRe (NYSE: RNR  ) , or RenRe, looks like a bit of an exception. Of course, exceptions elicit the question, "What's different here?" In the case of RenRe, it looks like investors are concerned about the acknowledged weakness in catastrophe premiums next year, as well as the possibility that the favorable reserve development well has started running dry.

Next year will almost certainly be a down year for catastrophe reinsurance premiums, but I think investors may be acting a little hastily in assuming that RenRe's growth in specialty and Lloyd's can't cushion the blow. Moreover, I think RenRe, along with Arch Capital (NASDAQ: ACGL  ) and Axis Capital (NYSE: AXS  ) , is in on the very highest level in terms of management quality and underwriting skill. Perhaps it's smarter to wait for the insurance sector as a whole to pull back, but RenRe's relative underperformance makes it more interesting to me these days.

When good weather Is bad news
It may sound counter-intuitive, but catastrophe reinsurers like RenRe and Arch Capital are going to suffer in 2014 for a lack of serious storms in 2013. Although it's true that hurricanes cause damage that requires companies like RenRe to pay out claims, the best underwriters end up paying less (on a relative basis) than inferior companies. Those inferior companies then find their capital depleted and must raise rates as a result. In other words, "enough but not too many" storms help underpin stronger overall operating conditions for those companies like RenRe and Arch that are best at pricing and diversifying risk.

Well, the 2013 storm season is basically over, and it was an exceptionally calm one. As a result, expectations are that catastrophe property reinsurance premiums will fall about 15% for policies in 2014. RenRe management expects to fare a little better, guiding to a 10% decline in Managed Cat premiums, but that's still a significant decline for a business that made up about half of gross written premiums in the third quarter.

Lower catastrophe premiums will sting, but not paralyze, RenRe
One of the strongest marks in the plus column for Arch Capital and Axis is the extent to which management there can, and does, reallocate capital as markets shift. For a company like Arch or Axis, then, a big decline in catastrophe property reinsurance premiums isn't as big of a deal -- management responds by shifting capital to higher-return opportunities in areas like casualty insurance or reinsurance, or its relatively new mortgage reinsurance operations.

RenRe is not structured with that same level of flexibility. RenRe is uncommonly good at underwriting catastrophe property reinsurance, and that is the driver of the business. That said, I think the Street may be giving too little credit to the company's growing specialty and Lloyds businesses. These businesses saw premium growth of 59% and 39% in the third quarter, and management has guided to 15% and 20% growth in 2014.

While investors may worry about the extent to which it seems as though every insurance company is trying to grow its specialty business (including Aspen (NYSE: AHL  ) , ACE (NYSE: ACE  ) , Allied World (NYSE: AWH  ) , and Endurance (NYSE: ENH  ) ), the particulars are important. "Specialty" actually covers a very wide range of insurance lines, and there's still more than enough room for RenRe in areas like political risk, surety, and so on.

I would also point out that there are ways for RenRe to cushion the blow from lower catastrophe premiums. RenRe has a substantial competitive edge in managed vehicles in catastrophe underwriting and can often cherry-pick business. There's also the issue of ceding -- RenRe's retention ratio fell from 77% to 70% in the third quarter, and ceding business is a way of preserving ROE in more challenging markets (and gives the company the chance to arbitrage appealing retrocessional prices).

Profitability and capital in good shape
I'm confident the declines in catastrophe in 2014 will compress profitability and ROE, but I'm not worried about the overall position RenRe is in today. Like Arch, RenRe writes for profits, not premiums, meaning it won't chase business that doesn't meet its return requirements. Given the mid-teens average ROE over the past decade, I'd argue RenRe management knows what they're doing.

I think there's also a real possibility to drive more profitability from the Lloyds business. RenRe has been patiently building this business over several years and is at or near full scale. I believe RenRe's Lloyds operations are highly scalable, meaning the company can redirect a lot of capital there (and write significantly more business) with only minimal incremental cost -- and that's good for profits.

I'm also not worried about the company's capital position. While the third quarter saw the lowest level of reserve release in four years, I believe it's a bump in the road and not a sign of future trouble. More to the point, I believe RenRe has substantial surplus capital that can be deployed into attractive markets or returned to shareholders.

The bottom line
I'm expecting RenRe to see a gradual decline in its ROE, mostly just because of the law of large numbers. While RenRe presently has a trailing average ROE 14.5%, I'm valuing the company on the basis of a long-term average of 12.5%. With that, an excess return model suggests a fair value of around $109 to $110 today. The tangible book value multiple implied by RenRe's near-term ROE doesn't result in quite such a high target ($97), but it still makes RenRe one of the few insurance stocks trading below fair value on a TBV basis.

It's tough to recommend buying RenRe in the face of what is likely to be declines in premiums and reported underwriting profits. That said, the shares already look too cheap to me, and if they sell off or continue underperforming, value-oriented investors should take advantage of the chance to buy a very good company at a reasonable multiple.

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