RenaissanceRe: Old-Fashioned Value?

Right now, it's challenging to find anything in the market trading at a large discount to its intrinsic value (although Tom Gardner's Motley Fool Hidden Gems newsletter can help). Nonetheless, good hunting can turn up a prize or two. Take note of these statitics. There is a conservative company that, for 10 years, has compounded its book value at an average rate of 22% a year and earnings at 20% per year, and yet is still trading at a forward price-to-earnings ratio of 8.5. The company is RenaissanceRe Holdings (NYSE:RNR).

RenaissanceRe's primary business, like that of Berkshire Hathaway (NYSE:BRKA) (NYSE:BRK.B) subsidiary GeneralRe, is reinsurance. RenaissanceRe has historically focused on catastrophe reinsurance. Suppose that an insurance company has many customers in Tokyo and realizes that claims resulting from a gigantic rampaging lizard could cause the insurer to go bankrupt. That insurer can buy insurance from RenaissanceRe to guard against such an event. If Godzilla rises from the sea, RenaissanceRe would compensate the insurer for part of the cost of the claims. In 2000, 80% of RenaissanceRe's revenue was derived from catastrophe reinsurance, but today only 50% is derived from this source.

More recently, RenaissanceRe has begun writing more specialty reinsurance, covering risks such as workers compensation and terrorism. It's also begun writing individual risk insurance (not reinsurance), primarily catastrophe-exposed commercial insurance. Specialty reinsurance and individual risk insurance now make up 18% and 32% of RenaissanceRe's business, respectively.

How does insurance work?
Insurance companies make money in two ways. First, they can make "underwriting profits" by collecting more premiums from customers than they pay out to settle insurance claims and run the business. Second, the insurance company can earn investment gains. It can often be years between when customers pay for their insurance and when they make a claim. For instance, I pay monthly life insurance premiums now, but I would be miffed if my wife had to make a claim on that life insurance even 10 years from now. So, until the regrettable day when she does make that claim, the insurance company can invest the premiums and make investment gains. Many insurance companies pay out more money than they collect, but are still profitable because of the investment gains that they have made sitting on the premiums.

In general, underwriting profits are better than investment gains, since they are not so dependent on interest rates or the direction of the stock market.

The importance of combined ratio
The metric for evaluating an insurance company's underwriting is called the combined ratio. The combined ratio is the amount of money the insurance company will pay out for claims and expenses, divided by premiums it receives, expressed as a percentage. So, a combined ratio of 90% is great, since the insurer will pay out 10% less than it takes in, while a combined ratio of 110% is bad, since this means the company is losing money on its underwriting.

Show me the money!

Now let's look at some of RenaissanceRe's metrics over the last 10 years compared with a couple other insurance companies and the reinsurance industry in general:

The most startling statistics are the combined ratio and return on equity. A combined ratio of 90% is considered great, and a ratio averaging 59% over a 10-year span is stunning. Consequently, it isn't surprising that about two-thirds of RenaissanceRe's earnings are underwriting profits, while only one-third are investment gains.

A 27% ROE is exceptional also, particularly compared to the overall reinsurance industry's 4.4%.

How has RenaissanceRe been able to sustain these numbers? First, its high profits and strong balance sheet give it a competitive advantage because the company is perceived to be a high-quality, reliable reinsurer. This strength recently resulted in its credit being upgraded to AA- by Standard & Poor's. Second, its technology for evaluating catastrophe exposure is among the most sophisticated in the business. Third, RenaissanceRe is very focused on writing profitable business.

Most insurers claim that they only want to write profitable business, but when insurance prices fall in a highly competitive "soft" market, they sell at unprofitable prices in an attempt to retain their market share. RenaissanceRe, on the other hand, is so focused on maintaining quality that its revenue fell during the soft markets of 1996-1998. However, that quality underwriting helped ensure a combined ratio of 70% in 2001, when the average reinsurer had a combined ratio of more than 140%.

But what does it cost?
It's satisfying finding a strong business, but much more fun finding a strong business at a good price. On the face of it, a price-to-earnings ratio of 8.5 and a PEG of under 0.5 seems low. Using more complicated models, suppose RenaissanceRe's return on equity is 22% this year, declines by 0.5% each year for 20 years, and that it pays a divided of 10% of its earnings. Then in 20 years, RenaissanceRe's book value per share would be $500 and each share would have paid $61 in dividends. If you assume an 8.5 PE at the time, and discount the future share price and dividends by 10% per year, then the present value would be about $90/share.

Such calculations are extremely sensitive to the inputs. If you use a 12% discount rate, the value falls to about $65/share. Or, if you assume that the return on equity falls by 1% per year until it reaches 12%, then the value is about $58/share. On the other hand, if the P/E rises to 10, and it takes 30 years for the return on equity to fall to 12%, then it is worth about $160 now.

RenaissanceRe: undervalued?
Based on these calculations, RenaissanceRe is at least reasonably valued, and possibly quite undervalued. This begs the question of why RenaissanceRe is cheap, particularly compared to the overall market. There are several reasons.

First, insurance companies are often valued at a multiple of book value. By that metric, RenaissanceRe, at 1.8 times, isn't cheap. It's cheaper than AIG (NYSE:AIG) at 2.6 times, and Progressive (NYSE:PGR) at 3.8, but more expensive than Allstate (NYSE:ALL), Hartford Financial Services Group (NYSE:HIG), and Chubb (NYSE:CB) at 1.6, or the median insurer's multiple of 1.3. On the other hand, considering its strong balance sheet, combined ratio, and return on equity, RenaissanceRe does deserve to trade at a premium to other insurers.

Second, we're currently in a "hard" market, where insurance costs are high and underwriting profits are higher than they would be normally. Thus, insurers in general may appear cheap based on earnings simply because the market does not believe that current earnings are sustainable. In fact, RenaissanceRe's earnings per share was $8.52 in 2003, and the company forecasts $6.10 to $6.50 this year.

Lastly, in the past few years, RenaissanceRe has shifted from primarily writing catastrophe reinsurance to also writing specialty reinsurance and individual risk insurance. With this switch, there is risk that RenaissanceRe will not be as successful in these new areas as it was in the old. Difficulties can be particularly costly in insurance, where it can take years for mistakes in current underwriting to become apparent. So, perhaps RenaissanceRe's new business should not be valued at the same multiple as the older business. RenaissanceRe is attempting to reduce this risk by focusing on its specialty, catastrophe-related issues, in the new areas.

Overall, while not without risks, RenaissanceRe seems like a well-managed company, trading at a price that is at least reasonable, and possibly cheap.

Still on the hunt for undervalued companies? Each month, Tom Gardner picks two stocks that he thinks aren't getting their due. Try Motley Fool Hidden Gems free for 30 days.

Richard Gibbons owns shares of RenaissanceRe Holdings.

Richard Gibbons is a freelance writer biding his time in Vancouver. He welcomes your thoughts and perspectives via email . The Motley Fool is investors writing for investors .