Berkshire Hathaway in 2026

The following article originally appeared in the May 2016 issue of The Manual of Ideas which was published on April 20.

Introduction

Berkshire Hathaway Mill - New Bedford, MABerkshire Hathaway’s long history dates back to the nineteenth century but the company was effectively “founded” by Warren Buffett when he assumed control in 1965.  The story of Berkshire’s evolution from a struggling textile manufacturer to the sprawling conglomerate we know today has been well documented and will be scrutinized by students of business for decades to come.  Berkshire is also still a work in progress.  Mr. Buffett remains firmly in charge of the company at age 85 and shareholders could very well continue to benefit from his leadership well into the 2020s.

Over the past 51 years, Berkshire has compounded book value per share at a stunning annualized rate of 19.2 percent and has retained all earnings except for a ten cent per share dividend paid in 1967 and minor repurchases made in recent years.  With a market capitalization of approximately $350 billion, Berkshire is currently the fifth largest company in the United States.  Berkshire was already a very large company ten years ago.  Over the past decade, shareholders’ equity has increased from $91 billion to $256 billion which has been mostly attributable to retention of nearly all earnings.  Net income was over $24 billion in 2015, up from $8.5 billion in 2005.  From 2006 to 2015, book value per share compounded at an annualized rate of 10.1 percent while the stock price compounded at 8.4 percent due to a modest contraction in the price-to-book ratio.

As Berkshire’s capital base continues to grow, it will become increasingly difficult for Mr. Buffett or his successors to redeploy earnings at acceptable rates of return.  If Berkshire compounds book value at 10.1 percent over the next ten years, shareholders’ equity would stand at approximately $670 billion by early 2026 and market capitalization is likely to exceed $1 trillion.  How likely is such an outcome?  In his 2014 letter to shareholders, Mr. Buffett warned that “eventually – probably between ten and twenty years from now – Berkshire’s earnings and capital resources will reach a level that will not allow management to intelligently reinvest all of the company’s earnings.”  At that point, Berkshire will have to return cash to shareholders in the form of dividends or share repurchases.

Berkshire Over the Past Decade

Before considering Berkshire’s prospects over the next decade, it is worth examining the evolution of the company over the past ten years.  How did Berkshire compound book value per share at an annualized rate of over 10 percent starting with a capital base that was already very large in 2006?

The property and casualty insurance business has been a major source of Berkshire’s growth since National Indemnity was acquired in 1967.  Through its insurance subsidiaries, Berkshire has been able to benefit from underwriting profits in addition to harvesting returns from investing policyholder “float”. Berkshire’s large holdings of marketable securities have been funded with both shareholders’ equity and policyholder float.  However, Berkshire has never restricted its non-insurance investments to marketable securities.  Starting with the acquisition of See’s Candies in 1973, Berkshire began moving into high quality non-insurance subsidiaries.   As Berkshire grew over the years, Mr. Buffett began a more significant realignment of Berkshire with an emphasis on adding a diverse stream of non-insurance profits.  This trend has accelerated over the past decade as the table below illustrates:

Berkshire EBIT 2006-2015

We can clearly see that pre-tax operating income has shifted dramatically toward non-insurance businesses.  Most obviously, Burlington Northern Santa Fe provided more pre-tax income in 2015 than the consolidated insurance business (underwriting profits and investment income).  In 2006, Berkshire was still four years away from acquiring BNSF.  Berkshire’s collection of operating businesses that are not enumerated in the table also provided more pre-tax income than the insurance group in 2015.

The chart below excludes the impact of realized investment gains, eliminations, and unallocated interest and provides another view of the shift toward non-insurance operations since 2006:Berkshire Pre-Tax Operating Income

We can see that based on this measure, the insurance group’s contribution has fallen from 57 percent of pre-tax income in 2006 to 26 percent in 2015.  The overall trend, although irregular, is quite clear.  The pie chart below illustrates Berkshire’s diverse sources of operating income for 2015.  Berkshire is often referred to as an insurance focused conglomerate.  While this characterization was arguably true in 2006, insurance plays a much less prominent role today.

Berkshire 2015 Pre-Tax Operating Income

Berkshire has added numerous non-insurance operating businesses since 2005 including PacifiCorp, Business Wire, Marmon, Burlington Northern Santa Fe, Lubrizol, NV Energy, Van Tuyl Automotive, and several others including a number of “bolt-on” acquisitions made by Berkshire subsidiaries.  Berkshire’s acquisition of Precision Castparts closed in early 2016.

How did Berkshire go about funding these acquisitions which collectively have transformed the earnings power of the company?  With the notable exception of the Burlington Northern Santa Fe acquisition, which was made partially through the issuance common stock, Berkshire has avoided diluting existing shareholders and has leveraged its free cash flow to fund acquisitions.

Over the past decade, Berkshire posted cumulative net income of $140 billion, cash flow from operations of $200 billion, and free cash flow of $113 billion, which we define as operating cash flow less capital expenditures.  Berkshire invested $62 billion in businesses acquisitions over this period.  In addition, the company allocated $35 billion toward net purchases of equity securities and $34 billion toward the purchase of other investments including financial crisis-era investments in Goldman Sachs and General Electric, as well as more recent investments in Bank of America, Restaurant Brands International, and the Kraft Heinz Company.

It is clear that Berkshire has grown over the past decade primarily through the successful acquisition of several non-insurance subsidiaries utilizing strong cash flow.  These non-insurance subsidiaries will continue to generate significant free cash flow over the next ten years.  It is very likely that the insurance subsidiaries will remain major contributors as well through generation of underwriting profits and investment income.  Insurance results are likely to be quite volatile but, barring a major insurance acquisition, will represent a much less important part of Berkshire ten years from now.

The Next Decade

Berkshire Hathaway has a “high class” problem:  The powerful cash generation capability of the company tends to snowball which makes the task of deploying cash flow more difficult over time.  Berkshire had over $61 billion of cash equivalents at the end of 2015, excluding cash held in the railroad, utility, and financial products groups.  Operating cash flow has averaged over $30 billion during the past three years.  Berkshire can deploy cash in any of the following ways:

  1. Cash can be reinvested within the same operating company in which it is generated.
  2. Cash can be reallocated between operating companies.
  3. New partially or wholly-owned subsidiaries can be acquired (insurance or non-insurance).
  4. Marketable securities can be purchased.
  5. Cash can be returned to shareholders via dividends, repurchases, or both.

If none of the options listed above are taken, cash will continue to build up on the balance sheet over time.  Historically, shareholders have been content to see Berkshire’s cash balance build up since this has provided Mr. Buffett with “ammunition” to opportunistically deploy when the right opportunity presents itself.  Cash flow generated in a given year need not be deployed within the same year but could instead collect on the balance sheet awaiting the emergence of a huge “elephant” sized acquisition that will consume the free cash flow generated over multiple years.  However, until an attractive “elephant” emerges, large amounts of cash on the balance sheet will dampen Berkshire’s overall return on equity and depress the growth of book value per share.

The exhibit below gives a sense of the scale of Berkshire’s “high class problem”.  We can see that retained earnings have ballooned over time.  Berkshire’s retained earnings account stood at $47.7 billion at the end of 2005 and grew to $187.7 billion at the end of 2015.  Another way of looking at this statistic is to note that nearly 75 percent of all earnings Berkshire has retained throughout its long history have come from earnings over the past decade and over 47 percent have been earned over just the past five years.

Berkshire's Shareholders' Equity 1994-2015

The implications of Berkshire continuing to retain all earnings over the next decade while growing book value per share at a compound rate of approximately 10 percent are staggering.  If we take Berkshire’s 2015 net earnings of $24 billion as a baseline, reinvestment of all earnings would need to result in enough incremental earnings power to generate approximately $62 billion of net income for Berkshire by 2025.  We would expect retained earnings to increase by about $420 billion over the next decade.  Berkshire’s shareholders’ equity would approximate $675 billion by the end of 2025 based on these assumptions.  With this kind of track record, the market would most likely value Berkshire in excess of $1 trillion.

Is it possible for Berkshire to redeploy over $400 billion within its existing businesses, through acquisitions, or toward marketable securities over the next decade?  Even allowing for the fact that the assumptions made here are necessarily imprecise, it is clear that the capital allocation task at hand over the next ten years will be far more difficult than it has been over the past decade.  Very few publicly traded companies are large enough for Berkshire to purchase a meaningful stake in the stock market.  While there are many companies in the $5-20 billion range that Berkshire states is its preferred acquisition target size, it is likely that much larger acquisitions will be necessary to fully allocate Berkshire’s cash flow in the future.

There is no doubt that Berkshire could deploy over $400 billion over the next decade.  There are always deals to be done, at a sufficiently high price.  However, elevated valuations in public and private markets would make it difficult for Berkshire to acquire businesses that offer incremental returns that will make it possible for Berkshire itself to compound book value at 10 percent going forward.  Opportunistic investments could be made during periods of stress in the financial markets, but perhaps not at a size necessary to absorb all of Berkshire’s available cash.

Conclusion

Berkshire’s management will eventually fail to find enough attractive investment opportunities to intelligently deploy all of the company’s free cash flow.  It is obvious that Berkshire will look like a radically different company in 2026 if it is able to find enough reinvestment opportunities to continue compounding book value at approximately 10 percent annually.  Berkshire would have shareholders equity approaching $700 billion and a market capitalization very likely to exceed $1 trillion.  The composition of Berkshire at that point would look nothing like the company we observe today and even less like the Berkshire of ten years ago.

Achieving this outcome would be a remarkable management accomplishment.  Given Mr. Buffett’s history, if he is able to continue running Berkshire for a majority of the next decade, it would be unwise to rule out this rosy outcome.    However, it seems more likely that Berkshire will begin returning cash to shareholders at some point within the next decade even with Mr. Buffett in charge.  If private and public markets for businesses remain elevated, the probability of cash return over the next several years will be very high.  If valuations plummet, cash return is less likely although still possible.

Mr. Buffett has indicated that Berkshire’s board of directors will consider repurchases as a means of returning cash to shareholders.  Repurchases, if made at levels at or below intrinsic value, can be more efficient than dividends because only shareholders who are voluntarily departing will face tax consequences.  If repurchases cannot be made at prices that make sense, cash dividends will have to be initiated and all shareholders would face the tax consequences.

Berkshire’s current repurchase limit of 120 percent of book value would have to be increased substantially in order to make repurchases of any significant size possible.  Since 120 percent of book value is far below any reasonable assessment of Berkshire’s intrinsic value, it follows that Mr. Buffett and the board of directors would have to agree to increase the repurchase limit in order to return material amounts of cash to shareholders.

Up to this point, the goal of repurchases has been to increase the per-share intrinsic value for continuing shareholders so a low limit makes sense.  Berkshire has not been in a position where it had to return capital to shareholders.  Bargain repurchases will always make sense but when Berkshire has no choice but to return capital, it will have to decide between dividends and repurchases.  At that point, even repurchases at intrinsic value would serve continuing shareholders well because it would spare them from undesirable tax consequences.  Whether an increase in the repurchase limit is something under consideration is perhaps one of the most important questions facing Berkshire shareholders today and a topic worthy of discussion at the upcoming annual meeting.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

Company Profile: W. R. Berkley Corporation

WRB LogoW. R. Berkley Corporation is an insurance holding company operating in a variety of niche markets requiring specialized knowledge regarding a particular territory or product line.  The company was founded in 1967 by William R. Berkley who currently serves as Executive Chairman.  The founder’s son, W. Robert Berkley, Jr., has been with the company for eighteen years and became Chief Executive Officer in 2015.

W. R. Berkley has expanded mostly through organic growth over nearly a half century.  Of the company’s 51 operating units, 44 were organized and developed internally.  From 1974 to 2015, management compounded per-share book value (with dividends included) at an annualized rate of 17.3 percent compared to 10.8 percent for the S&P 500 over the same period.  With common stockholders’ equity of $4.6 billion at the end of 2015 and a current market capitalization of $7 billion, management continues to believe that the company’s business model can achieve long-term risk adjusted returns of 15 percent after tax.

Company Culture

There is usually a negative correlation between the length of a proxy statement and the utility of the document for investors.  Despite filing a lengthy proxy, the material presented by W. R. Berkley provides quite a bit of insight into the firm’s culture, much of which is based on how employees are compensated for long term performance.  Unlike many other businesses, the performance of an insurance company can only be evaluated over long periods of time.  This is because loss reserving can resemble more of an art than a science.  The estimates made for a given fiscal year are certain to be incorrect in the long run because actual losses will almost always vary from estimates.  High quality insurers put in place systems to reject inadequately priced business even if it means that premium volume will decline.  Additionally, conservative insurers will usually err on the side of overestimating reserves which can generate “favorable development” in subsequent years as reserve estimates are revised downward.

The exhibit below, which is taken from the company’s proxy, illustrates the insurance cycle and management’s approach to dealing with each phase of the cycle.

Classic Insurance Cycle

Every insurance company will claim to follow W. R. Berkley’s approach during soft markets which involves being willing to sacrifice volume for profitability.  However, this is much harder in practice than in theory since underwriters are often tempted to retain market share even if the business they are underwriting might prove unprofitable in the future.  If this unwarranted optimism filters into reserving judgments, unpleasant surprises are sure to follow in future years as “unfavorable development” results in charges for prior years when management was insufficiently conservative.

W. R. Berkley’s compensation philosophy appears to be aligned with management’s approach to the insurance cycle.  Annual cash bonus payments primarily emphasize the extent to which the company’s annual operating return on equity achieves the long term 15 percent target.  Long term incentive plan awards are tied to book value per share growth, are subject to claw-backs, and payouts below target levels have not been uncommon.  In order to encourage long term behavior, restricted stock awards remain deferred, even after fully vested, until the executive is no longer employed by the company.  Hedging is not permitted.

The summary compensation table from the proxy appears below:

WRBComp

Aggregate compensation is certainly generous but at least appears to be based on factors aligned with shareholder wealth creation.  Perhaps most notably, William R. Berkley continues to maintain a substantial interest in the company with 20.4 percent of shares outstanding. While it would be nice if Mr. Berkley adopted Warren Buffett’s “founder’s philosophy” of taking only symbolic pay, this is perhaps unrealistic for most companies so we prefer to focus on whether the incentives are properly aligned with smaller minority shareholders.

Strong Underwriting Record

W. R. Berkley targets a combined ratio in the low 90s and this goal has been met over the past decade with an average combined ratio of 93.6 percent.  A combined ratio under 100 percent indicates that the company operated with underwriting profits.  The combined ratio is the sum of the loss ratio and expense ratio.  The chart below shows W. R. Berkley’s net premiums earned along with the loss, expense, and combined ratios over the past decade:

WRB 2006-15It is interesting to note that management’s actual behavior has been consistent with the philosophy illustrated in the “classic insurance cycle” exhibit that appears above.  Premium volume was reduced early in the decade as pricing was inadequate to induce management to write policies, but has picked up in recent years as pricing firmed.

We should note one trend in the chart which is very important:  As premium volume decreased from 2006 to 2009, the expense ratio increased quite substantially.  This is because management did not attempt to reduce operating costs commensurate with the decline in premiums.  Should we regard this as good or bad?  Shouldn’t management aggressively seek to cut costs during times when business slows down?  While cutting wasteful spending is always a good idea, aggressively cutting headcount during soft markets creates perverse incentives for underwriters to look for business regardless of ultimate profitability.  We can see that the expense ratio has decreased somewhat in recent years although it is still elevated compared to 2006-2008 levels.  Presumably, the company is in a good position to work on expense ratio reductions now that premium volume is growing again.  We regard the track record over the past decade to be a good indicator that the company’s stated culture is, in fact, something that employees are regularly practicing rather than just serving as talking points from investor relations.

Business Segments

W. R. Berkley operates in three segments:  Insurance – Domestic, Insurance – International, and Reinsurance.  Domestic insurance is, by far, the company’s most important segment accounting for 77 percent of revenue and 83 percent of pre-tax income in 2015.  International insurance accounted for 13 percent of revenue and 11 percent of pre-tax income while Reinsurance provided 10 percent of revenue and 6 percent of pre-tax income.  The exhibit below provides a summary of business segment performance over the past four years. The company had a different segment organization prior to 2012.

Business Segment Data

Domestic insurance gross premiums in 2015 came from the following lines:  Other liability (31.8%), workers’ compensation (27.9%), short tail lines (21.2%), commercial auto (9.7%) and professional liability (9.4%).  The segment is highly decentralized with a large number of independently operating units none of which provides more than eight percent of gross premiums.  These businesses appear to participate in niche markets that focus on industries and products where in depth knowledge and expertise can add value.  This is evident based on the combined ratio of the group which is the lowest of all company business segments.

International insurance writes business in over sixty countries through a decentralized operating structure.  The segment is heavily focused on short tail lines, representing over fifty percent of gross premiums, and posted a combined ratio under 100 percent in three of the past four years.  The reinsurance group appears to run opportunistically with premium volume varying more than the other segments and showing declines over the past three years.   Primary markets include the United States, United Kingdom, Continental Europe, Australia, South Africa, and the Asia-Pacific region.  The reinsurance combined ratio has been under 100 percent in three of the past four years.

Overall, W. R. Berkley is primarily a domestic specialty/niche insurer with that segment driving overall company performance.  Given management’s willingness to reduce premium volume during soft markets and the demonstrated track record, particularly in the domestic specialty markets, it appears that the company has a good chance of achieving its targeted combined ratio in the low 90s over long periods of time.

Investments

Along with underwriting profits, insurance companies derive profits through the investment of shareholders’ equity and policyholder float.  Float represents funds that are available for investment during the time between receipt of premiums and the eventual payout of policyholder claims.  Although float is a balance sheet liability, it has a positive value to shareholders as long as the cost of float (underwriting losses divided by float) is below the rate of return achieved through investment of the funds.  As we have seen, W. R. Berkley has achieved combined ratios under 100 percent over the past decade which means that policyholder float has been available for investment at negative cost.

Most insurance companies invest primarily in fixed income securities and typically attempt to match the duration of the fixed income portfolio with the expected duration of its liabilities.  W. R. Berkley’s investment strategy has attempted to limit the duration of the fixed income portfolio (3.3 years as of December 31, 2015) and to supplement returns through investment in equity securities, merger arbitrage strategies, investment funds, private equity, loans, and real estate projects.

The exhibit below, taken from the company’s 2015 10-K, shows the composition of the investment portfolio at the end of 2015:

WRB Investments

Fixed maturity investments, at $12.4 billion, represents 77.3 percent of the investment portfolio and exceeds policyholder float, which we estimate to be approximately $9.9 billion.  Over time, the company has shifted away from equity securities which represents less than 1 percent of the portfolio.  Instead, management has put cash to work in a number of alternate asset categories including investment funds (7.3% of the portfolio), real estate (5.8%), merger arbitrate (2.3%) and a portfolio of loans (1.7%).

In addition to the investment portfolio, the company has wholly owned investees which are not included in the investment portfolio but provide revenue to the company reported in the income statement.  These businesses are managed through Berkley Capital LLC.  Berkley Capital’s investment criteria and portfolio companies are listed on their website.  Although granular disclosure of the results of these subsidiaries is not provided in W. R. Berkley’s annual report, the strategy is interesting to note because it seems to emulate Berkshire Hathaway’s strategy in some ways.

The annual report provides some limited insight into the strategy behind the company’s non-traditional investments:

“As interest rates declined in recent years, it became difficult to maintain a high-quality portfolio with a duration that reflects the average life of our liabilities, and still obtain adequate yields. The variables under our control are the quality, duration and liquidity of the fixed-income portfolio.  We were neither prepared to reduce the quality of our portfolio, nor were we willing to extend the duration since that could exacerbate our potential exposure to inflation. Thus we felt we had two alternatives. The first was to marginally reduce short-term liquidity by buying securities that might not provide immediate liquidity, but were of the highest quality. The second was to expand our investments in private equity, limited partnerships and real estate to improve returns. We have experience in all of these areas, and they have delivered excellent returns over many years.

Investments in these areas now represent an amount equal to approximately half of our shareholders’ equity. So far, this strategy has proven to be rewarding. Although the income is not reported in as consistent a manner as income from bonds, the internal rate of return is well above the 3-4% we would have received from fixed-income securities, and we have not sacrificed quality or increased risk. In addition, because accounting rules require us to carry many of these investments under the equity method, there is a significant amount of unrealized gains embedded in our portfolio that is not recognized on our balance sheet. The single most visible investment of this type is Health Equity (HQY), which we took public in 2014. If we were to sell our interest in any of these projects in any given year, our ROE would be positively impacted.”

Although the move toward non-traditional investments seems to be at least partially driven by the low interest rate environment, success in this area could result in W. R. Berkley finding additional opportunities for reinvestment.  Since the company has regularly returned cash to shareholders via dividends and repurchases over the years, additional opportunities for internal reinvestment could result in more attractive (and tax efficient) growth for continuing shareholders in the long run.

Conclusion

W. R. Berkley is a very high quality insurance company.  While the company has not posted underwriting results on par with RLI Corporation, which we recently profiled, the valuation assigned by the stock market is much more reasonable.  Book value per share was $37.31 as of December 31, 2015 and shares recently traded at about $56.50.  A price-to-book ratio in the 1.5x range doesn’t appear to be unreasonable for a company with W. R. Berkley’s track record and, by this measure, the shares trade at a level that compares favorably to Markel Corporation.  We have covered Markel on a number of occasions over the past year and have noted its emerging status as a “mini-Berkshire”.

Recently, Morningstar published an article calling into question Markel’s status as a “mini-Berkshire” and suggesting that W. R. Berkley offers a better value.  Although W. R. Berkley’s price-to-book ratio is indeed lower than Markel’s, it doesn’t appear that W. R. Berkley is as far along with its development of non-insurance subsidiaries compared to Markel.  The Morningstar analyst puts an emphasis on underwriting profitability as an indicator of whether an insurer has an enduring “moat” and doubts whether Berkshire’s approach of reinvesting in non-insurance subsidiaries can be successfully emulated. He claims that attempting to emulate Berkshire could take management’s focus away from underwriting performance.

We will probably not know the outcome of Markel’s attempts for many years but it is clear that the company is explicitly trying to emulate Berkshire.  The same does not appear to be the case for W. R. Berkley.  Based on management’s statements, it seems like the shift toward private equity and other non-traditional investments has a great deal to do with the current low interest rate environment.  It will be interesting to see how W. R. Berkley’s investment strategy evolves once the interest rate environment eventually normalizes.  The company is definitely worth tracking for anyone interested in exposure to a U.S. focused niche insurer with potential upside from wise investments.

Disclosure:  No position in W. R. Berkley.

 

RLI Corp: Profile of an Extraordinary Insurer

RLILogoRLI is a specialty insurer offering a variety of property and casualty insurance coverages and surety bonds in a number of niche markets.  The company was founded in 1965 by Gerald D. Stephens who observed a need for contact lens insurance and founded Replacement Lens, Inc.  Over the years, the company expanded into a number of commercial property and liability fields that were historically underserved and required specialized expertise.  From a standing start fifty years ago, RLI has grown into a company with revenues of $795 million and shareholders’ equity of $823 million at the end of 2015.  The company has posted twenty consecutive years of underwriting profitability.  This record of success has not been lost on market participants.  RLI’s market capitalization is currently $2.8 billion, or 3.4 times book value.

Strong Record of Underwriting Profitability

The insurance industry is generally highly competitive and has a mediocre record of aggregate underwriting profitability.  Many insurers struggle to achieve breakeven results on underwriting and rely primarily on fixed income investments to provide a return to shareholders.  The low interest rate environment in recent years makes underwriting profitability imperative for any insurer seeking to deliver a reasonable return on equity, but the commodity-like nature of insurance and increasing capital coming into the market makes underwriting at a profit difficult.  The niche markets that RLI focuses on in the specialty admitted and excess and surplus markets are generally less competitive and offer skilled underwriters more opportunities.

The exhibit below, which is taken from RLI’s 2015 annual report, compares RLI’s statutory combined ratio against the overall industry’s performance, as reported by A.M. Best:

RLI vs Industry Combined Ratio

On a statutory basis (which differs in certain ways from the GAAP figures referred to elsewhere in this article), the insurance industry has essentially operated at break-even levels on average over the past decade while RLI has posted an average combined ratio of 82.6.  A combined ratio of 100 represents underwriting break-even while figures below 100 represent underwriting profitability.  The combined ratio is the sum of underwriting losses and expenses divided by earned premiums.

The exhibit below shows a more detailed breakdown of RLI’s GAAP combined ratio over the past fifteen years broken down into the underwriting loss and expense ratios.  We can clearly see that RLI has an unusually strong record of profitability relative to the industry.

RLI Combined Ratio 2001-15

What accounts for consistent underwriting profitability in an environment where the industry as a whole struggles to break even?  The niche focus clearly plays a major role.  As an example, one of RLI’s specialty personal property products covers recreational vehicles.  Compared to the massive and highly competitive market for auto insurance, which is dominated by a few much larger players, RV insurance is a small niche where industry expertise and longstanding relationships are likely to play a significant role.  By employing underwriters with in depth understanding of the RV market, along with similar niche product segments, RLI can price insurance competitively but with enough margin of safety to make underwriting profits more likely.  RLI’s skilled underwriting team is clearly part of the company’s “moat” when it comes to beating the overall industry’s combined ratio over long periods of time.

Conservative Reserving Philosophy

Every publicly traded insurance company includes information on loss reserving in annual reports and other filings.  RLI’s disclosures are extremely detailed and serve as a good primer on insurance loss reserving for anyone interested in learning much more about how reserve estimates are made.  The nature of reserving involves numerous assumptions and estimates and depends on the judgment of management.  If there is one universal truth when it comes to insurance companies it is that the current year loss figures are certain to be wrong!  The only question is whether management tends to err on the side of caution or not.  Except for insurers specializing in short tail property coverages, the conservatism of management’s estimates can only be inferred over a period of many years.

Insurance companies include an exhibit in annual reports commonly referred to as a “loss triangle”.  This exhibit shows the net liability for unpaid losses at the end of each of the past ten years along with a re-estimate of this loss figure for every subsequent year.  For example, RLI initially estimated its net liability for unpaid losses at the end of 2007 to be $774.9 million.  This liability was re-estimated each subsequent year.  At the end of 2015, the figure was estimated to be $554.6 million.  This implies that the estimate eight years earlier was too high by over $220 million, which is referred to as a redundancy.  Over the years, RLI recorded these redundancies as favorable development.

RLI’s loss triangle, which appears in the company’s annual report, is shown below (click on the image for a larger view):

RLI Loss TriangleIt is clear that RLI has demonstrated a very conservative reserving philosophy over time.  One might ask whether being overly conservative with loss estimates could be as undesirable as being too aggressive since ideally one would like to be right on target so that each year’s underwriting loss accurately reflects actual losses during that year.  RLI management states that they would rather be conservative given that the niche market segments in which the company operates can produce results with higher than average variability.  This seems like a plausible rationale in favor of RLI’s historical approach.  While there can be no assurance that reserve estimates will continue to be conservative going forward, past results demonstrate an attitude that is unlikely to suddenly shift in favor of recklessly aggressive estimation practices.

Limited Premium Growth … Demonstrating Discipline

Over the past decade, RLI’s earned premium volume rose from $491 million in 2005 to $700 million in 2015, representing annualized growth of 3.6 percent.  Premium volume actually declined in two of the ten years.  While it would be wonderful to observe rapid premium volume growth, apparently RLI’s management was restrained in terms of what business to accept in order to maintain historically high underwriting profitability.  RLI could no doubt have grown premium volume much more rapidly by compromising on underwriting standards and pricing policies more competitively.  However, it is certain that doing so would have impacted underwriting profitability.

The exhibit below shows RLI’s earned premium volume and underwriting profitability over the past ten years (figures in thousands):

RLI Premium Volume & Profitability

A disciplined insurer must be willing to turn away business when pricing is inadequate.  Almost any insurer will say that this is the case but few have the discipline to act on it.  One section of Warren Buffett’s 2004 letter to Berkshire Hathaway shareholders profiles National Indemnity Company.  Mr. Buffett discusses how National Indemnity allowed premium volume to shrink dramatically for well over a decade until appropriate pricing returned.  This letter is highly recommended to anyone interested in the insurance industry.

Limited Float Growth … A Consequence of Discipline

One of the consequences of RLI’s underwriting discipline is that float growth has been limited over the past decade.  Float represents funds that are held by an insurance company that are expected to eventually be paid out to policyholders over time.  While float is held it can be invested for the benefit of shareholders.  RLI’s float grew from $909 million at the end of 2005 to $999 million at the end of 2015.  The annualized growth rate is less than one percent.  Due to RLI’s policy of returning all free cash flow to shareholders over time (which we will discuss shortly), shareholders’ equity and total investments have also remained rather static.

The exhibit below shows total investments, shareholders’ equity, and float over the past ten years.  RLI runs a conservative investment portfolio which was comprised of 79.3 percent fixed maturity investments, 19.3 percent equity securities, and 1.4 percent short term securities at the end of 2015.  Figures in the exhibit are in thousands.

RLI Float 2006-2015

It should be noted that other insurance companies, such as Berkshire Hathaway and Markel, have managed to grow float at more satisfactory rates over the past decade while producing underwriting profits.  RLI’s management has a long history of success and clearly believes that growth over the past decade could not be accomplished without compromising the company’s underwriting profitability.  One might consider whether RLI was excessively conservative but it is difficult to make any conclusive statements on this point.  In general, it is better for an insurer to err on the side of caution rather than aiming for potentially risky growth.

A Cash Flow Machine … But Limited Reinvestment Opportunities

As we have seen, RLI has not been a “growth company” over the past decade but the company has been a cash flow machine.  Return on equity has averaged nearly 16 percent, driven mostly by underwriting profitability and supplemented by investment returns.  Over the past ten years, RLI has produced nearly $1.2 billion of free cash flow and has returned almost all of this cash flow to shareholders in the form of repurchases and dividends.  The company pays a regular cash dividend and has paid supplementary special dividends as well in recent years.

The exhibit below shows RLI’s free cash flow, dividends, and net repurchases over the past ten years (figures in thousands).

Free Cash Flow

It is notable that RLI has a flexible policy when it comes to cash return.  From 2006 to 2010, the company repurchased shares.  From 2010 to 2015, special dividends were the primary means of returning cash.

The fact that the company has been returning cash to shareholders should be unsurprising given the limited growth in the size of the business over the years.  RLI could have retained earnings for investment purposes but apparently does not seek to build up a larger equity portfolio or acquire non-insurance businesses.  RLI does own a minority stake in Maui Jim, which sells premium sunglasses, but this ownership interest came about due to the company’s historical roots in contact lens insurance products and does not represent any strategy of pursuing non-insurance investments.

Investors Have Not Ignored RLI’s Success

Anyone reading this article probably has a good sense of the fact that RLI is a very good insurance company with a long track record of success.  This impression would be further reinforced by reading recent annual reports.  Where’s the catch?  It appears that market participants generally understand how attractive RLI’s business is and have acted accordingly.

The following exhibit shows RLI’s total return to shareholders compared to the S&P 500 and the S&P 500 P&C index:

RLI Stock Performance

A significant portion of the return has come from dividends, particularly the special dividends disbursed in recent years.  However, the market has also assigned a much higher price-to-book value to RLI as the following exhibit demonstrates:

RLI P/B Ratio

The company’s price-to-book ratio rose from 1.84 at the end of 2005 to 3.27 at the end of 2015 and stands at approximately 3.4 today.  We can see from the exhibit that the price-to-book ratio was as low as 1.3 at the end of 2001.  Clearly the market has massively increased the valuation assigned to RLI and this trend has been magnified in recent years.

Conclusion

RLI is among the best insurance companies in the industry with an enviable long term record of underwriting profitability.  However, the company has failed to grow rapidly in recent years as inadequate business was rejected in order to maintain underwriting profitability.  The company has continuously generated significant free cash flow that could not be reinvested in the business.  As a result, management pursued a repurchase program when the stock price was not as elevated relative to book value.  More recently, as the valuation increased, cash has been returned to shareholders primarily through special dividends.

Although there is much that is positive to say about RLI, it is difficult to justify the current valuation especially in light of the limited growth and lack of compelling reinvestment opportunities.  Although returning cash to shareholders is the right thing to do under the circumstances, the stock’s elevated level is likely to force management to pay special dividends, which are taxable to most shareholders, rather than to repurchase shares.

We have profiled Markel Corporation in the past and note that the company has been able to grow more rapidly, both organically and through acquisition, over the past ten years and to do so while maintaining underwriting profitability.  Although Markel’s average combined ratio is quite a bit higher than RLI’s combined ratio, Markel has retained all earnings and finds ways to redeploy funds internally.  Markel also has a growing non-insurance group offering shareholders more diversification and making it more likely that the company will avoid taxable distributions to shareholders.  At a price-to-book ratio that is less than half of RLI, Markel seems like the better value at current prices.  Interestingly, Markel has long held a significant investment in RLI.

The following video is worth watching to understand more about RLI’s history and leadership.  Gerald D. Stephens, the company’s founder, and Jonathan E. Michael, RLI’s current Chairman and CEO, discuss the company’s founding, history, and philosophy in some detail.  If we want to understand RLI’s moat, we need to understand the company’s culture and this is an excellent place to start.  (RSS Feed subscribers can click on this link for the video.)

Disclosure:  No position in RLI Corp.  Individuals associated with The Rational Walk LLC own shares of Markel Corporation and Berkshire Hathaway.