Description

Markel (MKL) is one of the most widely recognized insurers within the value investing community and the company has been written up four times on VIC (2010, 2013, 2019 and 2021).  The company has long espoused the benefits of solid underwriting, investing for the long-term, and a strong company culture.  The simple, yet not easy, formula has helped compound book value by roughly 15% annually since its 1986 IPO.  While the long-term valuation creation is phenomenal, the more recent history has been disappointing.  Although book value has advanced at an 11% CAGR over the past five years, MKL’s stock price has only risen by 6% annually over the same time.  There are various reasons for underperformance including disappointing results within the company’s reinsurance business, underperformance during COVID as event cancelation exposure forced the company into a more defensive investing posturing, underperformance at the company’s insurance linked securities businesses (ILS), concerns about the opacity and business quality at the company’s Ventures business, and (perhaps strongest recently) concerns about social inflation’s negative impact on the Markel’s general liability, professional  liability and other long-tail lines of business.  

Markel’s current valuation (~1.3x book) is compressed relative to its 10-year average of ~1.6x book value despite the growth of the Ventures portfolio over the past five years, where book value arguably does not fully capture intrinsic value.  Interestingly, one can see the steady growth in intrinsic values over the course of the four historical write-ups of MKL – while returns varied over the various write-up periods, Markel’s stock price followed its intrinsic value higher in between all write-up periods.  While the absolute size of the discount varied over the various write-ups, the best takeaway was the simple insight that solid underwriting, structural leverage and common sense can drive compounding far longer than might be appreciated at any single point in time.  I watched MKL for multiple years before purchasing shares during the Altera acquisition in 2012/2013.  I have been tempted to sell at various times, but (re)convinced myself multiple times to hold onto the name and then purchased additional shares during COVID and then again earlier this year when the company reported Q4 results and announced substantial reserve additions. Social inflation/litigation finance concerns are real and there is admittedly an inherent opaqueness on reserve adequacy levels.  That said, the company’s longer-term history provides comfort.  Additionally, the value case is helped by progress at Ventures and the basic structural investing leverage – this same basic formula that has worked well historically should continue to increase value in the years ahead.  

Markel thinks about its intrinsic value through the lens of its insurance, investment and ventures businesses and therefore it makes sense to go through each segment.   

Insurance

As has been discussed in previous write-ups, Markel has a strong underwriting track record, including a GAAP combined ratio below 100% in 17 of the past 20 years (2005, 2011 and 2017 the exceptions) and annual favorable reserve releases for the past 20 years.  That said, the reinsurance division has underperformed (From 2014-2021 the Reinsurance segment experienced a reported combined ratio of 104%, with 2017-2021 all greater than 100%), prompting MKL to exit the property reinsurance market.  Markel has noted that the returns on its balance sheet are higher than those demanded by external investors seeking return diversification for catastrophe reinsurance, thus prompting the company to handle property exposures through its ILS operations.  As a result of this change, MKL should have less volatility within its reinsurance business.  

Additionally, over the past 2 years MKL has had reserve additions in multiple quarters in its larger US general liability and professional liability lines, lines that are among the most susceptible to the much-discussed social inflation/litigation finance headwinds.  Most of problems in these longer-tail lines appear to be concentrated within the 2015-2019 accident years, a time when the litigation finance industry was scaling, and this certainly has impacted severity estimates.  MKL would also note that its 2015-2019 actuarial analysis (along with the entire industry) also underestimated claim frequency as closed courts during COVID disguised frequency patterns.  The continued negative reserve experience during 2022/2023 prompted MKL to undertake a more thorough reserve analysis at the end of 2023 and this review ultimately led to substantial reserve additions during the fourth quarter of 2023 (MKL reported releases for the entire 2023 – the additions in general/professional lines were offset by releases in international, property, marine and energy and other lines).  MKL noted that the recent additions were from the most recent accident years, not just the 2015-2019 that drove issues across the industry.  Additionally, MKL exited certain products or subclasses representing less than 2 percent of insurance segment operations on an annual basis and the company has increased reserve margins on new business.   MKL has expressed confidence that the above reserve additions, business curtailments and increased initial loss margins have helped the company address lingering litigation finance/social inflation concerns.  MKL will nearly certainly fall short of its “10/5/1” to generate $10 billion in annual premiums within 5 years at $1 billion of underwriting profit (90 percent combined ratio).  MKL would note that these aspirational goals assumed that interest rates would remain near zero and therefore at higher rates, the same 90 percent target would not necessarily be required to hit company ROIC targets.  

Despite MKL’s longer-term successful reserve history, recent skepticism is understandable.  Over the past 11 years, P&C favorable reserve releases have boosted P&C operating earnings by just under 12 percent.  This number was only 5 percent in 2023, and the big concern among the sell side community is that social inflation trends (particularly litigation finance) will continue to negatively impact longer-tail lines while favorable releases in workers compensation lines that drove a good portion of industrywide reserve releases will begin to wane.  

Morgan Stanley did an industry actuarial reserve analysis of various US lines of business (Markel’s international businesses would not be included but ~80% of MKL’s gross written premium in insurance/reinsurance are from US risks) and found that the longer-tail lines of businesses appeared to still have reserve deficiencies despite meaningful additions over the past several years. 

Estimated Adverse/(Favorable) Reserves for the P&C Industry Over Time

Other Liability Claims Made (Occurrence):  Initial Loss Ratio vs. Current Ultimate Loss Ratio

Other Liability Claims Made (Occurrence):  Reserve Development

Markel certainly has not been immune to these trends.  MKL has heavy exposure to the longer-tail lines (~$4 billion of total $7.2 billion in total premiums comes from general liability and professional liability), which are particularly vulnerable to some of the negative social inflation trends.  And as previously noted, after two consecutive quarters of reserve additions in 2023, Markel took a more thorough review of its reserve levels and made substantial additions at the end of 2023.  It should also be noted that despite these Q4 additions, Markel did still have favorable overall development, albeit substantially smaller than prior years.  In 2022 and 2023 favorable development represented 0.3% and 1.5% of beginning reserve levels versus 4.6-6.4% over the five years prior to 2022.  

Obviously, Markel’s real differentiator over the years has been its conservative underwriting.  Management’s constant refrain about “more likely reductant than deficient” is borne out by results.  That said, even the staunchest Markel bull must acknowledge some concern over these recent trends.  MKL has mentioned litigation finance multiple times over the past several years of earnings calls and noted that claims take longer to settle and that the company believes litigation finance has played a role in elongated settlement processes.  Jefferies looked at statutory reserve additions (again, US only and the analysis varies depending on the line examined) and noted that Markel has suffered more deterioration than competitors in certain lines.  As an example, on claims made policies within other lines, a review of statutory filings shows that Markel increased loss picks to some of the highest levels on record and above the industry.

MKL:  Other Lines (Claims Made) Initial Loss Pick by Accident Year

Markel notes that reporting differences make industry comparisons “apples to oranges” but directionally Markel has suffered some deterioration in recent accident years, albeit in the context of a company that still has had nearly 20 years of favorable annual releases.  

MKL:  Other Lines (Claims Made) Loss Ratio Over Time

If there was a permanent deterioration in the profitability of longer tail lines, then this could severely damage the MKL investment case.  That said, MKL has navigated all sorts of insurance cycles over the years and its historical results do suggest that the company deserves some benefit of the doubt on reserve adequacy.   Reserve development over the next 1-2 years will be important to monitor. 

Another question that sometimes arises centers around MKL’s ~mid thirty’s expense ratio, especially given Kinsale’s investment success and the spotlight that Kinsale has shined on its specialty best ~low 20s expense ratio.  MKL has noted that Kinsale (KNSL) focuses on a narrow set of business within the specialty business – while MKL runs into KNSL in certain businesses (selective small account D&O as an example), there is not a lot of overall business overlap.  MKL notes that a lot of KNSL’s expense advantage stems from the company’s focus on narrow corners of the E&S business, particularly where there is simply a regulatory need to obtain insurance and customers focus less on KNSL’s strict terms and conditions.  Additionally, KNSL has generally worked with specific wholesalers (Ryan Specialty), not the larger brokers, and been aggressive on negotiating commissions as well as paying out claims.  From MKL’s vantage point, KNSL lower expense base primarily stems from its successful market segmentation, not from an inherent technology/competitive advantage.    Over time, MKL does believe there are expense opportunities (consolidating legacy systems, moving more operations to the cloud, etc.,) but MKL’s primary expense benefit will likely stem from increased operating leverage as result of greater scale.  

Investments

As has been well discussed in past writeups, Markel matches its fixed income portfolio (in currency and duration) with its loss reserve estimate and investments surplus capital in equities and ventures.  MKL’s higher equity exposure (Equities represent nearly 70 percent of book value) distinguishes Markel from most other insurers and this higher equity exposure allows greater compounding, albeit with increased volatility.  Over the past five years, MKL’s equity portfolio has compounded at ~14.5% (roughly 100 basis points annually below the S&P 500) but has outperformed the S&P 500 over long stretches of time, including 19 of the past 26 years.  

Tom Gayner is among the most well-known value investors.  While he has a strong long-term track record, views about Gaynor among professional investors are somewhat mixed.  In my experience, many are less enamored with Tom’s more diversified portfolio (the top 10 names are “only” ~40% of the investment portfolio with Berkshire by far the largest holding).  Additionally, Tom could be characterized as more a big picture thinker and less focused on the minutiae of individual investments (not necessarily a bad thing) and therefore not considered to be in the same investment category as Warren Buffett (who is?) or say Prem Watsa.  Tom would not have the investment bandwidth to say buy credit default swaps…but, in fairness, he would also not find the need to fully hedge value names in the aftermath of one of the largest market declines in a generation.  I think it would also be fair to observe that Tom would be more apt/qualified to talk about Disney’s brand strength and compare this with other great consumer franchises versus providing a detailed analysis of the changed media industry dynamics or breaking down the unit economics of streaming offerings as (for example) WinBrun has done for the VIC community.  Regardless, the big picture approach has worked well with $6 billion+ of unrealized long-term capital gains, including $1 billion from Berkshire alone.  In numerous interactions with Gayner over 15+ years at Markel, value investing events and Berkshire meetings, I have always found him to be approachable, honest, and quite open/comfortable discussing his own limitations.  Tom also deserves substantial credit for the formation and growth of Markel’s Ventures operations over the past ~20 years, which have created real value for MKL shareholders.  In my view, Tom views his role as something akin to “do no harm” to Markel’s continual compounding.  Markel’s public investing portfolio will likely continue to focus on larger cap value names and therefore +/- performance versus the broader index is highly possible/likely.  While this might be a turnoff for many investors, I think this misses how Markel’s structural investment leverage should drive continual compounding over time.  

Ventures/ILS   

Two of the most common lamentations about Markel Ventures has been the concern that these are a collection of average businesses, and that limited disclosure makes any analysis difficult.  Disclosure certainly could be better, and this would allow a detailed analysis of individual businesses.  That said, business quality concerns are overstated as the entire portfolio appears to earn high double-digit/low-teens unleveraged returns on capital after tax-affecting amortization charges and making some adjustment for excess cash.  While MKL has held cash at the Ventures level, MKL has no regulatory restrictions on upstreaming Ventures dividends and therefore Ventures’ profits are free to support underwriting, investments, or capital returns.  Through growth and new acquisitions, Ventures has significantly scaled and become a larger share of total value over the last several years – I imagine many MKL shareholders (myself included) are surprised at the size of the business today versus expectations five+ years ago.  It is highly likely there will be future additions to the portfolio.  While there is cyclicality to several Ventures’ businesses, their returns will be uncorrelated to MKL’s core insurance business, and this should prove advantageous during periods of insurance dislocation.  It is also worth noting that there have only been ~$19mm of total goodwill impairment charges at Ventures on ~$3.7 billion dollars of total acquisitions.  

NOPAT adds back (tax affected) amortization charges.  

The steadiness in Ventures is contrasted by the choppiness (to be kind) in MKL’s insurance linked securities (ILS) business.  MKL strongly believes that alternative capital will continue flocking into the insurance space and the company believed it could capitalize on these trends through its two most recent ILS acquisitions (Nephila and State National).   As was discussed in prior write-ups, ILS manager CATCO was a complete wipeout – MKL has acknowledged mistakes here and noted that the volatility of the risks taken on (with the benefit of hindsight) were inappropriate.  While results have certainly been better than CATCO (low bar), Nephila has also had its challenges with investor redemptions and losses given the run of natural disasters over the past several years – total AUM has shrunk from ~$12 billion at the time of acquisition in 2018 to ~$6.8 billion as of March 31, 2024.  Management has noted that most Nephila funds are now above their high-water mark and therefore the business could see a meaningful increase in profitability assuming the business can earn performance fees as well as management fees.  Importantly, the vast bulk of Markel’s larger property exposure reinsurance business has been shifted to Nephila, which should limit volatility within Markel’s reinsurance operations.  By contrast, results have been strong at State National’s fronting operations, which generates fees as it writes business on behalf of management general agents or capacity providers and cedes substantially nearly 100% of the risk to reinsurers.  MKL has noted that it plans to expand State National operations globally this year.  State National is almost certainly worth more than the 12x after-tax multiple assumed in the total valuation while Nephila has an opportunity to meaningfully increase earnings should it generate performance fees.  That said, these businesses remain small relative to total company value.  

Valuation

In its annual letters, MKL notes that it estimates the value of its insurance/investments and then makes some estimate of Ventures/ILS business and then compares these estimates versus the current stock price.  Its insurance/investment valuation is similar to the “two columns” approach that has commonly been used to value Berkshire Hathaway.  This valuation approach rests on the key assumptions that if a company underwrites at breakeven or better and if the insurance operations do not shrink in size, then shareholders get the full benefit of investments and cash.  

For the Ventures portfolio, I assume an arbitrary EBITDA multiple of 9x (Markel generally has purchased businesses around this range) and adjust for any non-intercompany debt and minority interests.  The resulting equity value implies a multiple of ~20x net income (including amortization charges – or ~17x excluding tax-affected amortization charges).  Intercompany Ventures debt is eliminated in consolidation while the small amount of company specific debt is included in consolidated debt which I include when valuing insurance/investments.  While one can argue that the cyclical nature of several MKL businesses might warrant a lower multiple, I believe that that MKL uses a higher estimated value given the non-capital-intensive nature of many of its businesses.  It should also be noted that past deal structures allow MKL to deduct goodwill for tax purposes for a couple of its acquisitions, which does provide a small benefit to returns on capital/free cash flow that is not fully captured in ROIC/total value.  For the ILS businesses, the vast majority of ILS net income comes from State National (Nephila was not profitable in 2022).  A multiple of only 12x after tax earnings would imply that State National and Nephila are worth less than what MKL paid for the two combined businesses (State is likely worth more, Nephila likely less).  If State continues to scale and/or Nephila starts earning performance fees, then the earnings stream and multiple can rise over time.  

I thought it would be helpful to apply the above methodology to each year of previous MKL write-ups on VIC (I used end of year numbers for easy comparison, including 2023 (but current stock price) for this write-up).  Again, while one could argue that there were slightly better entry points in past periods versus now, there appears to be solid upside at current levels and (more importantly) strong visibility on future compounding in the years ahead.  Adverse social inflation/litigation finance are certainly a trend worth watching but as noted, I do believe MKL deserves some benefit of the doubt given past results.

Looked at slightly differently, MKL had net investment income of ~$735 million in 2023 and this number can grow to $900-$1000 million over the next couple of years.  Assuming another ~$500mm of Ventures operating earnings (excluding amortization/adjusting for minority interests), $150 million of ILS earnings and a high single digit return on MKL’s ~$10.5 billion equity portfolio and no underwriting profit, then MKL trades at ~12x earnings assuming ~$180 million of interest expense, a 22 percent tax rate and $36 million of preferred dividends.  Certainly, there will be volatility on the equity returns and therefore results will be far from linear.  History suggests that MKL can generate combined ratios below 100 percent and there likely is upside to MKL’s Ventures and ILS operations, especially as Ventures will continue acquiring companies over time.  Most sell side models will not include equity gains in operating earnings but instead show projected returns in their book value estimates.  Finally, it should be noted that MKL has been actively repurchasing shares, buying back $450 million during 2023 and a further $160 million during the first quarter of 2023.  Markel issues few shares and therefore buybacks materially impact the total share count and per share value.  

Risks

-Reserve additions/deterioration in long-term profitability of general/professional liability lines

-Continued social inflation/litigation finance scaling  

-Severe market drawdown

-Nephila blowup

Catalyst

-Lack of general liability/professional liability reserve additions

-Continued share repurchases

-Continued Ventures scaling 

-Improved Nephila results