Berkshire's a Good Insurance Operator but a Bad Role Model
Markel's 'mini-Berkshire' premium is unwarranted, and W.R. Berkley is a better choice.
While we don't dispute the value Berkshire Hathaway (BRK.A)/(BRK.B) has created through its insurance operations, we think investors draw two incorrect conclusions from its success. First, we think many are drawn to insurers that attempt to generate alpha on the investment side, while we believe the only sustainable competitive advantages are on the underwriting side. Second, we think many investors' view of reinsurance is too favorable, which is dangerous, given current reinsurance trends. While a number of insurance companies have drawn comparisons with Berkshire over time, we believe Markel (MKL) enjoys the strongest reputation as a "mini-Berkshire." We think the comparison is inaccurate and the premium the market appears to be willing to pay is unwarranted and likely to disappear, given the company's potential headwinds. We think W.R. Berkley (WRB) is the closest comparable to Markel--and more attractive, given better underwriting results and a much more favorable multiple.
P&C Insurers Have Two Sources of Income, but Only One Moat Source
Insurers have two potential sources of income: investment income and underwriting profits. Combined, these two streams determine the return on equity a company generates. Berkshire Hathaway has outperformed on both sides, thanks largely to its competitive advantages, disciplined underwriting, and Warren Buffett's investing skills. Hypothetically, other insurers could have advantages on either or both sides, and we think Berkshire's success leads many investors and companies to believe that attempting to generate alpha on the investment side is a legitimate long-term path to success in insurance. But in practice, we believe it is highly unlikely that any other insurance company can replicate Berkshire's investment results, and we also believe the attempt to do so can actually distract management from more reliable paths. We focus exclusively on underwriting profitability to separate out quality companies in the sector, as we think that is the only sustainable source of advantage.
For property and casualty insurers, underwriting profitability is measured through the combined ratio, which is essentially a reversed underwriting operating margin. A ratio below 100% indicates an underwriting profit. Underwriting profits are not easy to come by, with the industry averaging a combined ratio of 99% over the past 10 years.
The primary way for a P&C insurer to give itself a competitive edge is to focus on the least commodified areas of the insurance market. The term "specialty line" is often used in the insurance industry to describe this type of line. While the term is often used loosely and is not precisely defined, some areas such as excess and surplus lines are clearly specialty. In our view, though, other areas also qualify as specialty. We would classify specialty lines as lines with somewhat distinctive risks that require extensive experience or special relationships to underwrite effectively. For instance, we view commercial policies in an industry such as mining, which generates unusual risks, as specialty. Chubb (CB), Travelers (TRV), and W.R. Berkley are examples of narrow moats built along these lines, in our view.
On the other side of the coin, insurers can lower costs by scaling their business through an effective distribution platform. However, this isn't as simple as bigger being better. The business model must be scalable, with a material fixed-cost component to customer-acquisition costs, since the largest cost component, claims, is variable. Personal lines tend to be more scalable because they do not require as many specialized underwriters and are often sold through scalable channels, most notably the direct channel. Progressive (PGR) and Geico are examples of narrow moats built along these lines, in our view.
Markel Not a 'Mini-Berkshire'
While a number of insurance companies have drawn comparisons with Berkshire over time, we believe Markel has maintained the strongest reputation as a "mini-Berkshire" in the eyes of investors. We believe a deeper look at Markel only highlights how difficult it would be for any insurer to replicate the success Berkshire has enjoyed and why pursuing a path built on generating excess investment returns might actually distract management from its most value-creative strategies. While we believe Markel has a solid franchise, we don't think it has an economic moat, and we think the mini-Berkshire narrative has led to an unwarranted premium on the shares.
Markel's strategies mimic Berkshire's in a number of ways, and on the surface, the company has made a number of changes to resemble Berkshire more closely over time. We see five main points of similarity: (1) Markel devotes a relatively large portion of its investment portfolio to publicly traded equity securities. (2) Co-CEO Tom Gayner's investment philosophy resembles Warren Buffett's in many ways. (3) Since 2005, Markel has steadily acquired a diversified set of noninsurance companies and allows their managers autonomy in their day-to-day operations. (4) Markel's acquisition of Alterra in 2013 increased its reinsurance operations to 22% of premiums, making reinsurance a material portion of its operations. (5) While it does buy back small amounts of stock, Markel retains the vast majority of its capital.
Does Markel Generate Alpha or Risk on the Investment Side?
The most obvious question is whether it is reasonable to expect Markel to generate alpha on the investment side. While we respect Gayner's stock-picking skills, we think the company's investing scorecard is mixed and there are meaningful differences between Markel and Berkshire's capital positions that make Markel's approach more risk-assumptive than value-creative.
We see a lot to like in Gayner's investment approach and think it fairly closely mirrors both Warren Buffett's philosophy and Morningstar equity research methodology. Gayner advocates what he calls the "four lenses" approach, which consists of looking for companies with (1) profitable businesses, (2) honest and talented management teams, and (3) reinvestment opportunities and/or capital discipline, which can be purchased at (4) fair prices. His investing record using this approach has been impressive, having beaten the S&P 500 Total Return Index by almost 2 percentage points on average over the past 10 years. However, this outperformance can disappear for stretches. Markel's outperformance was negligible from 2005 to 2009, then particularly strong from 2010 to 2014 before underperforming in 2015. The company's current equity holdings do look fairly attractive, with 12 of its top 20 holdings carrying a Morningstar wide moat rating and these holdings trading at an average price/Morningstar fair value estimate of 0.95, suggesting some modest upside.
Still, when it comes to driving book value growth, which is Markel's and Berkshire's preferred metric for tracking performance, the contribution of this outperformance is fairly slight, with the decision to allocate a relatively high portion of the investment portfolio to equities being a much bigger factor during the bull market run of recent years. We estimate that even if Gayner can maintain his historical rate of outperformance, this would add about 1% to annual book value growth, suggesting that investors who believe in his investing acumen should only pay a slight premium.
Putting Gayner's alpha aside, while both Markel and Berkshire devote a relatively high portion of their investment portfolio to equities, we believe there are fundamental and important differences in their approaches. We think analyzing Markel's approach requires a comparison with not only Berkshire but a peer group of insurers. We use narrow-moat P&C insurers as the peer group, as we believe competitively advantaged insurers are the best comparison to assess whether Markel's investment approach constitutes a material advantage. We highlight the investment portfolio relative to reserves, as the primary purpose of the investment portfolio is to provide funds to pay claims, and policyholders must be served before equityholders.
We start by comparing Markel with the peer group. Markel's total investment portfolio relative to reserves is in line with the peer group of insurers, but its mix differs, with a heavier weighting toward equities. Unlike its peers, which maintain a cushion with cash and fixed- income investments a bit higher than reserves, Markel retains no meaningful cushion and invests essentially all of its funds in excess of reserves in equities. As a result, we believe Markel's asset allocation is more risk-assumptive than the peer group. We don't mean to suggest that Markel's strategy is reckless or meaningfully raises its odds of financial distress--only that that its asset allocation increases its reliance on equity returns to drive book value growth and exposes it to downturns in the market. For instance, in 2008, Markel's book value per share fell 16%.
Comparing Markel with Berkshire shows a more dramatic difference. While Berkshire's cash and fixed-income portfolio doesn't cover its reserves, its total investment portfolio covers its reserves almost 2 times. In light of this, we think Berkshire's investing approach is not risk-assumptive but appropriate in light of the excess capital it has retained. Further, any comparison between Berkshire and Markel or any other insurer would seem unwarranted, given the dramatic difference in Berkshire's capital structure. We believe the strong book value growth Markel has enjoyed in recent years is more a function of a higher equity allocation in the midst of a bull market run as opposed to a sign of a sustainable competitive advantage.
While Gayner ostensibly employs the same four-lenses approach to noninsurance mergers and acquisitions, results in this area have been less pleasing. The company appears to try to follow roughly the same process as Berkshire, taking an opportunistic approach as opposed to building out synergistic franchises in any particular areas. As a result, the company's portfolio of noninsurance operations is scattered, ranging from a high-speed baking equipment manufacturer to a provider of executive health programs. Markel also makes occasional investments in residential real estate businesses. Like Berkshire, Markel offers selling managers the ability to cash out while maintaining autonomy over day-to-day operations, with the hope that doing so makes Markel a preferred buyer.
While Markel roughly follows the same process as Berkshire, its results appear to be different. These businesses have averaged a 15% tangible return on invested capital over the past four years, which would seem to support the idea that they collectively benefit from solid competitive advantages. But ROIC including goodwill has averaged just 6% over that period, which would argue against the idea that Markel's willingness to allow managers autonomy allows it to buy these businesses at attractive prices.
While it could be argued that future growth could ultimately justify the price paid, we think the fact that ROICs remain unimpressive years into this effort at the very least supports a skeptical view. In our view, the ROIC results suggest that these deals have been modestly value-destructive and that shareholders would be better served if the company simply returned its excess capital and focused on its insurance operations.
Looking at the company's investment performance (including its noninsurance M&A) and its asset allocation, we think Markel's approach is best described is risk-assumptive as opposed to value-creative. As such, we don't believe investors should pay any kind of meaningful premium for Markel's investing approach or acumen.
On the Underwriting Side, Markel Is Good, but Not as Good as It Could Be
Markel does focus on specialty, noncommodified lines, and we believe this is the most common path to a moat for P&C insurers. Markel is the sixth-largest writer of excess and surplus lines in the United States. Outside of excess and surplus lines, the company operates in a number of areas that fit our definition of specialty lines, ranging from executive liability to commercial equine insurance. But Markel's underwriting performance has fallen a bit short of the level we look for in awarding a narrow moat rating.
In our view, the best comparison for Markel, in terms of business lines, is W.R. Berkley. Both companies focus on commercial specialty lines and have reinsurance and international operations. We believe W.R. Berkley's strategy of focusing strictly on outperforming on the underwriting side is the correct one and that the firm benefits from both a narrow moat and exemplary stewardship, which Markel lacks, in our view. We think contrasting the two shows that a focus on alpha on the investment side might actually be a slight negative, as it could distract management from optimizing underwriting results, which we believe are the only sustainable source of a moat for P&C insurers.
Markel's underwriting results are solid, but the company has been modestly outpaced by W.R. Berkley. Markel has averaged a combined ratio over the past 10 years of 94.6%, compared with 93.6% for W.R. Berkley, despite a very strong showing for Markel in 2015.
We think W.R. Berkley also outperforms in terms of stability, which is another factor in considering moats, as it makes us more certain of the firm's ability to sustain its performance. In considering stability, we focus on the loss ratio, as we believe there are valid strategic reasons for variability in the expense ratio. The range of Markel's loss ratio results over the past 10 years has been almost 3 times as wide as W.R. Berkley's, providing further evidence of W.R. Berkley's underwriting edge and managerial discipline.
The differential between the two companies' underwriting results comes entirely from the expense ratio. The expense ratios of both companies ebb and flow over the course of the pricing cycle. We view this positively, as we believe it reflects underwriting discipline and the leveraging and deleveraging of fixed administrative expenses given potential constraints on the volume of attractive business available to underwrite. W.R. Berkley consistently outperforms on this front. Given the similarity between the two companies' lines, we don't see a reason there would be a major structural difference in their cost structures. As such, we question whether Markel's focus on the investment side distracts management from running its underwriting operations as efficiently as possible, and this limitation might be the factor hindering the company from fully exploiting the potential moat it could have from focusing on specialty lines.
Markel's Move Into Reinsurance Was a Move Away From a Moat
In 2013, Markel acquired reinsurer Alterra for $3.3 billion, making reinsurance a material portion of its operations. While the price looked reasonable at 1.2 times book value, we don't like the deal strategically. In our view, reinsurance is a volatile industry in which it is very difficult to build a moat. As such, we think the Alterra acquisition represents a shift away from the potential moat Markel has in its core business. Further, given recent trends in reinsurance markets, we believe the acquisition could prove ill-timed.
Berkshire Hathaway is probably the highest-profile player in reinsurance, and we think many investors extrapolate its success into a perception that this is a reasonably attractive industry. In our view, reinsurance is an unattractive industry, characterized by fairly weak returns and elevated uncertainty. At first glance, reinsurance could be viewed as a specialty line, as reinsurance policies are typically highly customized and complex and reinsurance relationships tend to be fairly stable. But purchasers of reinsurance are generally as sophisticated as sellers, which we think moots any potential advantages along these lines.
Since 2001, reinsurance has seen an average return on capital of 6.5% versus an average of 6.3% for primary P&C carriers. But we think this is actually a poor showing. First, reinsurance is a higher-risk activity, and the negligible gap in returns does not appear to compensate for this, suggesting reinsurance underperforms on a risk-adjusted basis. Second, mutuals, which are not necessarily profit-oriented, make up a substantial portion of the primary market. Five out of the top ten primary carriers are mutuals, and these top five alone make up about 25% of the market. To test whether publicly traded carriers are more profitable than mutuals, we looked at the underwriting results of about 30 publicly traded carriers versus consolidated industry results. Our group of publicly traded carriers averaged a combined ratio of 96% over the past 10 years, significantly lower than the 99% average for the industry as a whole. This provides strong evidence that mutuals materially reduce the reported profit for the industry and publicly traded primary carriers actually materially outperform reinsurers in terms of returns and risk. We estimate that if the entire industry produced a combined ratio in line with the publicly traded insurers, the average industry return would improve by a little over 2 percentage points.
Berkshire has had success in reinsurance, having meaningfully outperformed the industry in terms of underwriting, with a combined ratio that has been 5 percentage points below the industry level, on average, since 2001. But Berkshire's edge has largely disappeared since 2009, which we attribute to the fact that industry underwriting profits have been particularly strong in recent years, limiting the scope for outperformance. In our view, Berkshire's success in reinsurance is due to two main factors. First, its reinsurance operations are very well managed, and we think that in insurance, the quality of management is of roughly equal importance to that of the moat, due to the cost uncertainty and leverage inherent to the industry. Second, we think Berkshire's structure supports underwriting discipline. For Berkshire, reinsurance is just one of a number of investment options the firm might pursue at any particular time. For companies where reinsurance is a major part of operations, we think maintaining the discipline to sit idle during periods of inadequate pricing is much more difficult to sustain.
Reinsurance Is Headed Toward a Difficult Period
We think an overly optimistic view of the reinsurance industry is especially dangerous now, given recent trends in the industry, as reinsurance pricing, particularly property catastrophe pricing, has been falling dramatically. So far, the negative effect on profitability has been offset by a fairly benign catastrophe environment. But industry participants largely agree that reinsurance pricing is weak and potentially inadequate for the risks that have been assumed. Periods of weak pricing in reinsurance, just like in primary insurance, are not uncommon. But in our view, the rise of the catastrophe bond market raises questions about whether the industry is moving through a soft period in the cycle, or if a structural shift has taken place as a new type of capital now occupies a meaningful position in the industry.
In our view, even long-term investors looking at the insurance space shouldn't ignore the cyclical outlook, and in reinsurance the magnitude of these shifts can be dramatic. Paul Ingrey's insurance cycle clock provides a good qualitative framework to view the state of the industry. We believe we are currently between 3 o'clock and 4 o'clock, with declining pricing but still stable profitability. If the future conforms to past cycles--which we believe is the most reasonable assumption--the reinsurance industry is on the cusp of a difficult period. As such, we think Alterra could turn into a material drag on Markel's performance, although the company is attempting to be disciplined.
Mini-Berkshire Narrative Draws Attention Away
From Better-Valued Quality Names
The validity of the mini-Berkshire narrative that surrounds Markel would be academic, if not for the fact that the market appears to be willing to pay a substantial premium for the company's shares based on this idea. Markel trades at a significant price premium to its most similar domestic commercial P&C insurance peers, and it is the only one in the group to trade above 2 times tangible book value, with the average for the rest of the group being only 1.4 times. Given the company's solid but not especially impressive underwriting results, we can only attribute this premium to the mini-Berkshire narrative and the market's perception that Markel can create significant value on the investment side.
We see potential for the market to reassess the multiple it awards Markel going forward. We think strong book value growth is the key quantitative prop to maintain the mini-Berkshire narrative, and it will be difficult for Markel to maintain the annualized book value per share growth rate of 14% it achieved from 2009 to 2014. First, given the recent direction of equity markets, the tailwind Markel has enjoyed from the bull market is unlikely to persist. Despite record underwriting profits in 2015, book value grew only 3% for the year, due partially to equity losses. ROE, which excludes unrealized gains on the investment portfolio, has averaged only 6% over the past five years (8% on a tangible basis), highlighting the company's dependence on appreciation in the equity portfolio to drive strong book value growth. Further, Markel's exposure to reinsurance could be a material drag on underwriting performance if recent pricing decreases result in deteriorating underwriting performance, as we believe they will.
While we don't see any compelling bargains in P&C insurance at the moment, we think W.R. Berkley is the best choice for investors looking to shift away from Markel. W.R. Berkley is the closest comparable in terms of business lines but has significantly less exposure to reinsurance, and its focus on casualty lines further insulates it from the most problematic areas. We also believe it is a better underwriter. Management focuses on underwriting results and is well known in the industry for its discipline in this regard. We think the current market multiple on the stock modestly underestimates the potential for the company to improve underwriting results over time due to a better pricing picture in the casualty lines it focuses on and the ability to scale international operations.
Brett Horn does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.