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Markel Should Benefit From Strong Industry Price IncreasesMarkel Should Benefit From Strong Industry Price Increases Brett Horn Senior Equity Analyst Business Strategy and Outlook | by Brett Horn Updated Jun 25, 2021 Markel has built a reputation as a "mini-Berkshire," and while we think it has developed a solid franchise, we believe the premium the market has historically awarded the company based on this narrative is not fully justified. We think the primary reason Markel draws interest is how it differentiates itself in terms of capital allocation. Most insurers actively return the bulk of their free cash flow, but Markel retains the vast majority of its capital; its goal is to compound this capital at high rates of return over a long period. However, this is much easier said than done, and we think expecting Markel to replicate Berkshire Hathaway's historical performance is unrealistic. While Tom Gayner has a good investing record, the company's M&A efforts look like a mixed bag to us, and we see its equity-heavy investing approach as more risk-tolerant than value-creative. Over the past year, the coronavirus dominated both the industry's and Markel's results. However, industry losses have proved manageable. Markel recognized COVID-19 claims losses in 2020 that were high relative to peers, but the company has a history of being conservative in reserving, and the company's losses were not severe enough to meaningfully impact its financial position. Going forward, the events of the past year appear to have acted as an additional spur to pricing. While higher pricing is necessary to some extent to offset lower interest rates and a rise in social inflation, piricing increases appear to be more than offsetting these factors. As a result, Chubb and peers are experiencing a positive trend in underlying underwrting profitabiltiy, and we see potential for a truly hard pricing market. For most of the postcrisis period, capital market conditions, characterized by low interest rates and a bull equity market, have been essentially ideal for Markel's equity-heavy approach. While the company ultimately weathered the COVID-19 crisis, it showed how two seemingly uncorrelated risks (equity market movements and claims losses) could potentially become quickly and unexpectedly correlated. Economic Moat | by Brett Horn Updated Jun 25, 2021 In general, insurers do not benefit from favorable competitive positions. Industry competition is fierce, and the products are essentially commodities. Furthermore, most participants do not know their cost of goods sold for a number of years, allowing them to underprice policies without knowing it. Firms have a large incentive to chase growth without regard for profitability, a cycle that repeats itself as competitors are forced to match artificially low prices or risk losing business. That said, we do believe the space contains some moaty franchises. While Markel has generated a reputation as a mini-Berkshire, we do not believe it benefits from a moat. In terms of underwriting, the company falls a bit short of the level we think is necessary to award a narrow moat. Markel does focus on specialty, noncommodified lines, and we believe focusing on specialty lines 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. As a result, the company historically has produced very attractive loss ratios. However, its elevated expense ratio has limited underwriting income over time. Expense ratios in specialty lines are typically higher than in other lines, but Markel's expense ratios are high even relative to other specialty insurers. The company's relative inefficiency on this score is one of the main obstacles to developing a moat, in our view. Markel significantly expanded its presence in reinsurance through the purchase of Alterra in 2013, and reinsurance now accounts for a little over 20% of premiums. In our view, this move was a further obstacle to developing a moat. We think moats are very hard to come by in reinsurance, and this area is significantly more volatile than Markel's historical operations. We believe the company's perceived ability to generate alpha on the investment side is the primary attraction for many investors. CIO Tom Gayner has an impressive record, as he has beaten the S&P 500 by almost 3 percentage points on average over the past five years. We like his investing approach, as it closely mirrors our methodology. However, we think the company's asset-allocation decisions (and the bull market) have been a much bigger factor in driving book value growth in recent years. We estimate that even if Gayner is able to replicate the alpha he has generated historically, this would add only about 1 percentage point to annual book value growth, suggesting his investment skill is not enough to significantly affect our view of the company's prospects. Further, the company acquires noninsurance operations as part of its investment strategy. While Markel believes these companies can grow over time to justify the prices paid, at this point we think a skeptical view of potential value creation in this area is warranted. Fair Value and Profit Drivers | by Brett Horn Updated Jun 25, 2021 We are increasing our fair value estimate to $1,096 from $1,007 per share, primarily due to equity market movements and time value since our last update. Our fair value esimate is equivalent to 1.2 times year-end book value and 2.0 times tangible year-end book value. We assume premiums rise at a 6% compound annual growth rate over the next five years, with the company benefiting from a stronger pricing environment in the near term. Our assumptions result in an average combined ratio of 95%, better than the 97% average the company has posted over the past five years, as we expect a stronger pricing environment to improve underwrting results. However, we generally expect underwriting profits to start to narrow a bit in the back half of our projection periods, as we expect higher interest rates to lead to lower underwriting profitability for the industry over time. Our projections include one large loss year for the company's reinsurance operations to reflect the volatility of this line. On the investment side, we assume improving fixed-income results over time as the interest rate environment improves, but we expect overall investment returns to moderate as the recent bull market proves unsustainable. We project the company's noninsurance operations to grow at a high-single-digit rate over the next five years and maintain recent margin levels. Our projections do not include any unannounced acquisitions. These assumptions result in an average return on equity (including unrealized equity gains) of 10% following 2020. We use a cost of equity of 9%. Risk and Uncertainty | by Brett Horn Updated Jun 25, 2021 As with other insurers, Markel's biggest risks are claims in excess of the amount reserved or material impairments in its investment portfolio. The addition of Alterra and the larger exposure to reinsurance activity increased underwriting risk, in our view, as reinsurance is a fundamentally more volatile activity than primary insurance. We believe Markel's equity-heavy investing approach generates more risk than the average P&C insurer carries on the investment side, and a decline in the equity market could ding the company's capital position and weigh on results. Using year-end 2020 figures, we estimate that a 10% decline in the value of the company's equity portfolio would reduce tangible book value by 8%. Some ESG issues for P&C insurers arise in a second-hand fashion. For commercial insurers, insuring industries with a high level of ESG risk could draw criticism and potentially lead to lost revenue if the situation becomes unsustainable. Insurers can also draw criticism on the extent to which the insurer incorporates ESG into its investment decisions. But we see this issue as relatively minor, as shifting investment practices should be a relatively easy fix. The biggest issue for P&C insurers is climate change, as insurers typically cover weather-related losses, and climate change is likely to increase the frequency and severity of extreme weather events. Insurers’ profitability could be significantly impaired if they do not recognize these risks and adjust their underwriting practices accordingly. While Markel faces all of these issues, we do not see any particular flags for the company. We are reducing our uncertainty rating to high from very high. We had increased our uncertainty rating early in the pandemic primarily to account for the legal uncertainty surrounding business interruption claims. While some uncertainty still remains, we believe legal rulings to date have largely gone in the industry's favor. Capital Allocation | by Brett Horn Updated Jun 25, 2021 Our capital allocation rating for Markel is Standard. In our opinion, the company’s balance sheet is sound, its capital investment decisions are fair, and its capital return strategy is appropriate. The company has two co-CEOs, Tom Gayner and Richard Whitt. Gayner and Whitt are also on the company's board. Gayner runs the investment side and is involved in the company's M&A decisions, and we view his position as co-CEO as a sign that Markel will continue to focus on trying to drive value on the investment side. We give management credit for developing its portfolio of specialty lines businesses over the years and we like that the company is very conservative when it comes to reserving. However, we believe relatively high operating expenses limit the benefit of its niche strategy and hinder the formation of a moat. We're skeptical about the push into reinsurance, as we believe this line adds to volatility and dilutes any competitive advantage the company might enjoy in primary lines, even though a relatively benign catastrophe environment generally aided underwriting results in the years following the acquisition. Gayner's record as an equity investor is impressive, and his "four lenses" investing approach (profitable and sustainable businesses, credible and capable management, reinvestment opportunities at high returns on invested capital, and fair valuation) mirrors Morningstar's equity research methodology in many ways. But we are somewhat skeptical about the company's move toward acquiring noninsurance companies starting in 2009. Further, we think the company's asset-allocation policy in the investment portfolio is somewhat risk-assumptive. Although this positioning has been a positive during the long bull market run in recent years, the volatility the company has seen during the pandemic highlights the potential downside of this approach. While we appreciate management's desire to build value on both sides of the insurance profitability coin (investment and underwriting income), we think this approach will lead to somewhat mixed results for Markel. Our view is that superior underwriting results are more sustainable, and we prefer management teams that focus on discipline and execution on this side. In December 2018, Markel announced that the government was investigating loss reserves at CATCo, which Markel acquired in 2015. In light of this, Markel wrote down the goodwill associated with this business to zero, resulting in a $179 million charge. While Markel has had M&A successes, this acquisition was clearly a mistake. We think the market gives Markel too much credit in terms of its ability to create value by recycling capital into acquisitions, and this event supports our view. |
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