Insurance companies have largely missed out on a lot of the recent stock market rally. True, reinsurance companies like Arch Capital (Nasdaq:ACGL) and RenRe (NYSE:RNR) have done well as these markets have started to harden and company-specific risk and capital models have shown their quality. But in the P&C and specialty insurance markets, times have been tougher and that has kept a lid on W.R. Berkley's (NYSE:WRB) stock.

There is nothing in the numbers from Berkley's first quarter to promise an immediate turnaround, but patient investors should give this name a long look. This is not Berkshire Hathaway (NYSE:BRK.A), but insurance companies that consistently earn better than their cost of capital are valuable wealth-building enterprises, and Berkley has a very good track record on that score. (For more, see Intro To Insurance: Property And Casulty Insurance.)

Tutorial: Introduction To Insurance

First Quarter Results a Mixed Bag
Top line results should offer some encouragement. Net premiums grew about 10% this quarter, and the company reported that pricing improved by about 1%, while renewal retention rose to about 80%. There was a fair bit of turbulence on the individual unit level, but four of the five units showed net premium growth. The alternative markets unit was the lone decliner (down almost 5%), while specialty grew almost 19% and international jumped almost 38%.

Results were hurt by a higher than expected combined ratio - that is, the combination of what the company had to spend on regular operating expenses as well as paid out claims. Expenses were actually well controlled, as the expense ratio declined a bit from last year and ticked up just slightly on a sequential basis. Losses were higher, though, rising about 2% from the fourth quarter, due in part to weather-related claims.

The company did report about six cents of earnings from investment funds and that could be somewhat problematic. These earnings are not always included in insurance company operating earnings, and the company excluded them during the credit crisis (when this was a very volatile line-item). Though there are arguments in favor of this treatment, some may view it as convenient and cherry-picking.

Tough Conditions ... But a Hopeful Future
Whether investors consider big names like Allstate (NYSE:ALL) and Travelers (NYSE:TRV) or more esoteric ideas like ACE (NYSE:ACE) and XL Capital (NYSE:XL), the concerns about the insurance sector are pretty consistent. Pricing has been a significant issue, but it tends to be a self-correcting problem - companies that are too aggressive with pricing get wiped out (or severely squeezed) when disasters roll in later and threaten the capital base.

To that end, Berkley's management commentary about better pricing is encouraging. Moreover, the company is seeing improving retention which suggests that customers are finding fewer cheaper options.

Investments Still Challenging
Insurance companies are also under pressure from the interest rate environment. Berkshire Hathaway is unusual in the large amount of equity securities that it holds; most insurance companies hold the bulk of their assets in fixed-income securities. For Berkley, that's nearly 81% of the portfolio, with almost half of that in state and muni issues. Combine the general low-rate environment and all the worries about state and municipal defaults, and it's easy to see why insurance companies have gotten the stink-eye from some investors.

The Bottom Line
Berkley continues to show decent book value growth and there is nothing to suggest that the company's historically good underwriting standards have changed. The worry here and now is if, when, and how the company will be able to regain strong returns on equity. In insurance, it's pretty simple - higher ROE means higher valuation.

Berkley has a history of producing returns on equity in the high teens and twenties, far above the current level of 12.6%. Most analysts are assuming that the firm will not return to mid-teen ROEs in the foreseeable future. Some of that may be fair (as companies grow, certain metrics become harder to maintain), but more aggressive investors may want to consider a different viewpoint. If Berkley's ROE stands at 13% in five years' time (and thereafter), the stock is undervalued, but if that ROE can climb back to 15%, it is undervalued to an extent that value investors ought to really take a serious look. (For more, see The 6 Strangest Insurance Policies Ever.)

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