I've got two insurers in my crosshairs. The first, Progressive (NYSE:PGR), writes personal and commercial automobile insurance. The second, WR Berkley (NYSE:BER), writes insurance in its specialty (i.e. professional liability, workers' compensation, aviation), regional (small to mid-sized business risks), reinsurance (insurance for insurers), and international segments.
I also have to give a holler to other best-in-breed insurers: Berkshire Hathaway (NYSE:BRK-B), Markel (NYSE:MKL) and White Mountains (NYSE:WTM). But Progressive and Berkley are what I consider thoroughbred insurers -- they have stellar management, great underwriting cultures, and most importantly, great returns on equity (ROE). (Over the long term, a stock's return approximates its return on equity.)
WR Berkley reported great fourth-quarter numbers: an 18% increase in net income, an 86.5% combined ratio, and a 31% ROE. According to management, this is the 17th consecutive quarter of 20%-plus ROE, and the company thinks it can continue that through 2007.
Listening to WR Berkley's conference call is a delight. The CEO, William Berkley, is an owner-operator who shoots from the hip. For example, Berkley mentioned that management was less than thrilled with the quarter's premium growth, remarking, "It was a disappointment." He also has the self-deprecating style of someone who is confident enough to volunteer his mistakes. (It probably helps when the company is named after you, too.) In the earnings call, he mentioned that 1988 was the year of his worst mistake, when he cut back on growth in light of a softening pricing environment. He felt his decision ultimately cost the company $1 billion.
During the earnings call, there was a question about whether compensation was tied to volume (volume-based compensation is the root of all evil in almost every business -- mortgages, banking, software, you name it). Berkley replied that no one at WR Berkley is paid on volume, ever, and jokingly added that he was insulted by the question.
Looking ahead, WR Berkley plans to grow premiums 5%-8%, helped by organic growth from some new lines. Management also thinks pricing is still rational, with the company's average pricing down less than 5%; Berkley mentioned that retention rates held up in the high 70% to 90% range, depending on the particular line. The company also hasn't had any pushback from its distributors for higher commissions.
Another positive result was that Berkley achieved its 86.5% combined ratio without cutting reserves. (When an insurer thinks its reserves are too conservative in light of positive developments, it can cut reserves and run this through the income statement.) Almost every property and casualty insurer has been cutting reserves this year to reflect favorable reserve development, but WR Berkley actually increased its reserve development (thus decreasing net income) by $7 million for the quarter.
In response to a question about why WR Berkley was zigging when others were zagging, CEO Berkley responded that his sons were working at WR Berkley, and he needed to make sure the reserves are conservatively stated, even in the best of times. He stated that of the roughly 220 insurers that have gone bankrupt in the past 10 years, about half did so because of inadequate loss reserves.
This conservative attitude, coupled with WR Berkley's low expense ratio and organic float-generating ability, puts it on my most-wanted list. As of the end of 2006, WR Berkley has more than $3.50 worth of investments for every $1 in equity. If we assume a 5% net investment yield, this already gives WR Berkley a 17.5% pre-tax ROE ($3.50 x 5% / $1) -- which explains how the company is able to consistently post ROE exceeding 20%.
For some further reading on the insurance industry:
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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.
