W.R. Berkley Stock: Pricing Pressure Could Weigh On Shares (Downgrade) (NYSE:WRB)

Shares of W.R. Berkley (NYSE:WRB) have been a strong performer over the past year, gaining over 40%, though the stock has dropped about 10% from its March highs. I last covered WRB in October when I rated shares a “buy,” given my view underwriting results were improving and elevated interest rates would support earnings. Shares have surged past my $70 price target, and while they have returned a seemingly strong 20% since my recommendation, the market has gained 24%. With updated financial information, now is a good time to determine if WRB has further upside or if investors should look elsewhere for outperformance. While results have been strong, forward-looking commentary is somewhat disappointing, and I am downgrading shares to a hold.

In the company’s first quarter reported on April 23^rd, WRB earned $1.56, which did beat estimates by $0.13. The company is seeing both solid underwriting results and strong investment income. However, it appears that a one-off item boosted investment income beyond normal trends, and I am concerned underwriting results could decelerate. Last quarter, its earnings mix was nearly equally weighted between these two components. WRB earned $309 million in pretax underwriting income, up 31.8%. Pre-tax net investment income rose 43% to $320 million.

Looking first at investment income, elevated bond yields are a definite and persistent tailwind for the company. It has a $27.5 billion investment portfolio, largely in fixed income. This fixed income portfolio is fairly conservative with an AA- credit quality and just a 2.5 year portfolio duration. This duration is up slightly form 2.4 years previously, as WRB is modestly extending duration to lock in the current rate environment for longer, which is prudent.

Now, overall its portfolio generated a 4.78% annualized yield in Q1. There was a 5.1% core yield, which excludes investment funds return (more on that below). This portfolio yield was aided by an Argentinian inflation-linked bond position. Argentinian bonds have performed well given political reforms underway in that country, which was a meaningful tailwind for results. The majority of this position has matured, so they are not likely to provide material gains from here, which is why I view this as akin to a one-time windfall. It is a trade that went very well for WRB, but it will not generate much net investment income in coming quarters. Excluding Latin America, its portfolio has a 4.2% book yield, and so given the actual core return, the Argentinian gain may have been as much as $58 million, nearly $0.20 per share.

Now, its book yield is still up from 3.6% last year as the company rolls over maturing bonds at higher yields. With prevailing interest rates above the book yield level, I would expect book yield to continue to rise at least over the balance of the year. My current view is the Federal Reserve is likely to reduce rates just 0-2 times, late this year, and engage in a gradual rate cutting cycle in 2025. With just a 2.5 year duration, by late 2025, WRB may be rolling over bonds at lower yields than its portfolio, which could begin to reduce core investment income. Still, excluding-Argentina, I expect core investment income to rise for at least another 4-6 quarters.

Now, aside from its core portfolio, WRB also has some private investments, primarily via its $1.6 billion in investment funds. The funds reported a $29 million loss in Q1. I would note there is a one-quarter lag, given delays in reporting, so Q1 results reflect what happened in the funds during Q4 2023. Transportation and financial services were the two weak points driving losses. Management noted that it believed funds were marked a bit more harshly due to the end of the calendar year, and given the solid equity market performance, I would expect improvement in Q2. Assuming at least neutral returns in core funds and the loss of the Argentinian tailwind, we should see investment income reset closer to $300 million in Q2 and rise modestly over the balance of the year.

Turning to its insurance underwriting, I see more deceleration risk. In Q1, net premiums written rose by 10.7% to $2.9 billion, primarily due to rate increases. Insurance premiums rose 11.9% to $2.4 billion, and reinsurance premiums rose 4.2% to $400 million. Because the company has been raising rates (as has the industry), we are seeing underwriting profits improve. All else equal, charging a higher rate to insure the same amount of exposure should enhance an insurer’s profitability. Indeed the company reported a 1.8% combined ratio improvement to 88.8%, aided by lower catastrophes with current accident year ex-cats flat at 87.7%. There were just $31 million of cat losses, a $17 million improvement. WRB also had an immaterial $1 million of prior year favorable developments.

As a reminder, a combined ratio of 100 means an insurance company’s underwriting unit is breaking even; it pays out as much as it earns in premiums. I view 85-90% as a healthy combined ratio for a niche insurer like WRB, and it is operating safely in this range. In 2021-2022, insurance companies saw underwriting profits get squeezed as underlying inflation increased the cost of claims. With premiums often set annually, it took time for insurers to recoup pricing, and WRB now has, which is why it has seen underwriting profit recover so meaningfully. As you can see, P&C premiums have accelerated sharply since 2021. While a bit off the peak, they are still running up 5%. That is faster than overall inflation, which means insurance margins should stay buoyant and potentially rise further this year.

This is a reason why I have been broadly positive on the P&C insurance sector, having listed Chubb (CB) as a preferred name for several quarters. WRB has benefitted from this trend in recent months, and its underwriting improvement has been consistent with my expectations. Unfortunately, some of its go-forward rhetoric on its last earnings call was a bit surprising to me and is likely a reason we have seen shares retrace.

While the company continues to anticipate 10-15% business growth, it is seeing slowing momentum in property insurance, with the exception of commercial auto, a segment which has taken longer to recovery and is still firming. Management went as far as saying that in reinsurance the property cycle has “run its course.” On a risk-adjusted basis, it now sees premiums as declining. This commentary has been somewhat unique to WRB and is also not yet apparent in the macro-level data. Now, it operates in a diversified set of 60 lines, and so some of these more niches area may be seeing more competition. After the difficult cat season of 2022, a lot of capital left the reinsurance space, pushing prices up, and those high prices may now be bringing capital back in.

Weakening pricing dynamics is rarely a positive. Management did say that “just because pricing is peaked, doesn’t mean there’s not still good margin to have.” This is true; last quarter, WRB generated a return on equity of nearly 23%. Even if we see the combined ratio decline a bit, it could generate a 20% ROE, which is still “strong,” though it would imply a lower level of profitability. More tellingly, management did not execute on any share buybacks. Given where the stock is, WRB said on the last earnings call they “have not felt as though it’s the best mechanism to return capital to shareholders.” With just a 0.6% dividend yield, repurchases are a critical form of capital return.

Management essentially said they viewed the stock as relatively expensive vs the ability to deploy capital in the business. WRB has a $30.34 book value, so it trades at 2.6x book value. While its ROE is 23%, at this multiple, its return vs market cap is just 8.7%, which may explain why management has viewed repurchases as a less than ideal use of capital. More to the point with investment income likely to moderate, its ROE is set to fall, even holding underwriting flat. I am increasingly concerned that we see underwriting results moderate somewhat too.

Excluding Argentina, I expect WRB to earn about $5.50-$5.70 this year, below its $6.24 Q1 annualized pace, given these headwinds. This still is a solid overall level of results to be clear; the challenge is with WRB trading well over $70, the good news is in the price, particularly with more bearish go-forward commentary than peers. Shares are about 14x earnings; this is actually a 10% premium to Chubb, which I view as the premier operator and which is not seeing as much pricing pressure. As such, WRB is relatively expensive in my view, and I worry sequentially declining earnings in Q2 could be a headwind for shares. Below 15x earnings, I do not see WRB as a pressing “sell” as the rate environment is still favorable. However, I expect shares to be dead money and underperform peers. As such, I am moving WRB to a hold and would rotate into other insurers like Chubb.