A Compelling Value in Niche Insurance

Erik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon, co-editor of Morningstar OptionInvestor, and today it's my great pleasure to welcome Drew Woodbury, who is an equity analyst covering insurance companies. Drew, thanks for coming.

Drew Woodbury: It's good to be here, Erik.

Kobayashi-Solomon: So, last week I wrote something about W.R. Berkley, a bullish article using option strategies. I just want to get a little more color on Berkley. So, when we were chatting before, you were telling me they're kind of a niche player, and they insure some interesting risks. Can you tell me a little bit about their niche business?

Woodbury: Well, the thing about Berkley is that they own a collection of subsidiaries where they are all involved in niche underwriting of their own.

Kobayashi-Solomon: They kind of grew by acquisition, right?

Woodbury: To some extent, and then some of them are homegrown, so it's a combination of both.

Kobayashi-Solomon: I see.

Woodbury: So, they insure anything from offshore oil rigs, to professional sports teams, to museum and art galleries. It's a wide range of products. The one thing that they do is they try and only underwrite things that are less commodity based. So, for example, they don't underwrite any personalized products, which they believe are more commodities.

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Kobayashi-Solomon: I see. So, that keeps them out of the commodities space.

Woodbury: Yeah, and that, they believe, helps them avoid a lot of competition. Those areas are a little less competitive than the normal ones.

Kobayashi-Solomon: Looking at the dynamics of the industry, I know that AIG has been doing a damn the torpedoes, damn the profits, full speed ahead kind of a business strategy, just trying to get business in the door. This has been putting pressure on pricing.

Just recently, AIG has sold some of its assets, it's got some cash inflow, it's been able to pay back some of the TARP money. Do you think this is going to maybe take the edge off of AIG's aggressiveness in terms of pricing?

Woodbury: Well, I think the cash in from the sales has definitely helped them. They do have more room to go as far as paying back the government. The one thing that's important to remember is that although AIG gets a lot of fingers pointed at them by the industry and people outside the industry, a lot of that is merited, but at the same time, the industry has a group-think in regards to pricing. 

So, as I mentioned earlier, a lot of these products are commodities, so industry players are forced to match prices or lose business. So, there's a trade-off between those two. So, they all go down together, I guess.

Kobayashi-Solomon: I see. So, this fits in really well, actually. When we were talking before, you said that the insurance business has been in a trough since 2005, and that seems like an awfully long time to be in that trough part of this cycle. Do you see any catalysts for these insurance companies to quit the group think, to firm up pricing a little bit?

Woodbury: Well, the insurance industry pricing is generally based upon capital, which is closely related to the capacity of the industry. So, in 2008, there was a large hit to capital from hurricanes, and then add on to that the financial crisis, which hurt a lot of investment portfolios of insurance companies. So, we had thought for awhile that the capacity would exit the market from that, which would maybe help firm up prices, but the government backstopped a number of companies, and in 2009, the rally in the capital markets helped a lot of the distressed companies claw their way back to a capital position.

Kobayashi-Solomon: I see.

Woodbury: So, now we're thinking that the economy will have to show material signs of improvement. Insurers are having a difficult time passing along price increases to financially strapped customers. So, once the economy improves, then we maybe will have a chance that the prices will increase.

So, as you said, it's been a fair amount of time for price declines, so prices won't decline forever. It's just a question of when and what's the catalyst at this point.

Kobayashi-Solomon: So, actually, there was kind of a missed opportunity let's say. The government intervention plus this rapid rise in capital markets...

Woodbury: That's impossible to tell. In hindsight, that's what we had thought before, but maybe that wouldn't have been the case. Maybe something else would have happened.

Kobayashi-Solomon: Since we've been in a trough for so long, I think the valuations for insurance companies are generally pretty attractive. What do you think about sector evaluations and how does Berkley's compare to the sector?

Woodbury: Well, we think the property casualty industry is pretty undervalued, generally. They're trading right around book. Some companies are trading a little bit below book value.

Kobayashi-Solomon: Usually they're trading for, let's say 1.5 times book.

Woodbury: Yeah, right around there. Maybe 1.2, 1.3 depending. Then they go up to Berkley, which is historically traded on a premium, which we believe is merited. Over the past five, 10 years they traded about 1.9 times book.

Kobayashi-Solomon: I see.

Woodbury: Right now, they're at about 1.1, 1.2 depending on what day you look at it. One of the things we think is maybe holding down the stock right now is that they compensate their underwriters for long-term value generation rather than on the business they write in a particular period. So, when premiums are declining, they incent their underwriters to decline business, which they don't believe is good at the given price.

Kobayashi-Solomon: So, they're telling these guys don't chase business. Don't just try to get sales in the door; let's make sure this is profitable.

Woodbury: Exactly. So, when premiums are declining, as they are now, their profitability ratios will look a little bit worse compared to what they historically have done.

Kobayashi-Solomon: But it seems like long run, that's a better business strategy, right?

Woodbury: We definitely believe so. And then when the market hardens, the fixed costs of the compensation create a lot of operational leverage. That will help profitability multiply if the market hardens.

Kobayashi-Solomon: Well, Drew thanks a lot for coming. I sure appreciate it.

Woodbury: Thank you for having me.

Kobayashi-Solomon: And thank you for joining us, and please stop by the Morningstar OptionInvestor site. You can find many more great option ideas based on Morningstar's fundamental research.