Description

"RenRe") (RNR) is one of the largest Bermuda based reinsurers that specializes in property and casualty (P&C) reinsurance. RNR is primarily known in the market for having sophisticated weather models to inform their underwriting. Additionally, RNR in recent years has been acquisitive, namely they acquired Tokio Millennium Re in early 2019 which added significant scale to their reinsurance underwriting capabilities. RNR primarily underwrites property and casualty reinsurance contracts, however they are one of the 'first-movers' in the insurance linked securities ("ILS") market, and other forms of alternative capital which will provide upside as describe below.

Thesis: RNR provides an opportunity to take advantage of the to take advantage of the 'hardening' P&C market, at a relatively cheap entry price (based on current trading multiples). There is a significant amount of upside locked in the further adoption of ILS, and RNR's recent performance in ILS.

For more background, please see RNR's most recent annual report as they describe their business operations.

P&C / Reinsurance Market Backdrop

There are three main macro dynamics that are currently effecting the reinsurance market as a whole: 1) hardening primary carrier P&C rates 2) consolidation 3) creation of 3rd party and alternative forms of capital.

(Skip if you understand reinsurance) Before getting into the specifics of each of these, broadly speaking, reinsurance essentially provides outsourced capital for primary carriers to utilize for underwriting. For instance, a normal P&C underwriter, for example Hartford or CNA, may want to retain the relationship with a given party and so they will continually underwrite a policy, but the policy underwritten they may not want to hold reserves against, the risk may be too large, or they are capital constrained. In this instance, they would go to the reinsurance market and a 3rd party (and more typically a group of 3rd parties) would enter into a 'reinsurance treaty' and take the risk onto their books and in exchange receive the premium that was originally underwritten. Reinsurance in this way can be characterized as a 'safety valve' for the primary insurance market. So although the dynamics effecting the primary insurance market are linked tightly, they are slightly detached form overall market trends. One important note is that the Bermuda reinsurance market, and particularly RNR, is primarily used for catastrophe risk policies (Windstorms, hurricanes, wildfires etc.).

Hardening P&C Market: With this in mind, the first dynamic to understand is the hardening P&C market. The P&C market for the last 5 years has been in a soft market, where premium and underwriting rates have been declining based on the amount of capital, and pricing power that has been granted to the end consumer (businesses and individuals).Rates have increased ~8% QoQ in 2022.

The main catalyst for this is that P&C underwriters are being more conservative on either the terms and conditions of policies, or raising the premium rate. This is an important dynamic as the previous hard market that was seen in P&C (~2010-2012) was driven by lack of capital capacity, and NOT the terms of conditions. This hardening market is terms and conditions driven, which makes it a more sustainable or systemic change in the market as there is now a paradigm being put into place about the normative pricing of policies in this new market (i.e. post-COVID / accident / natural disaster prone environment). The last hardening rate cycle lasted ~2 years, because after this period of time the underwriters were able to rebalance their balance sheet, and have enough capital to begin competing on rate again. Whereas this cycle should last much longer as it is driven by the underwriters as a collective either wanting more restrictive terms, or higher pricing. Overall, all the rate increase, or better policies (which translates to higher gross margin from less payout) should be passed through to the reinsurance market. Additionally, this benefits RNR specifically as in this new paradigm, underwriting expertise is valued more rather than cheap access to capital. RNR is one of the most respected reinsurance underwriters given their investment into technology and their weather models, which in turn should give them a competitive advantage. Finally, RNR has very strong underwriting relationships with carriers that it has continually put first rather than underwriting any policy, this is shown by their 1/1 renewal cycle results.

Consolidation: Consolidation in the reinsurance market has been rapid, and the main effect that it has had on the market is an over supply of capital. Several reinsurance companies (AXS, ACGL, ARGO, SPNT) are all over capitalized and have low underwriting leverage. The main influence that this has had into the market is that it has driven companies to differentiate on underwriting and relationships, versus availability of capital, which as described above, benefits RNR.

ILS / Alternative Capital: Traditional underwriting has been supplemented by 'alternative capital' primarily the ILS market. The ILS market provides investors a security that is uncorrelated to the market, because it is correlated to a P&C policy. The primary ILS instrument is a Catastrophe Bond (Cat Bond). What is important to know is that the ILS market has been growing rapidly. The number of transactions increased ~50% in 2020, and the overall market has grown to ~$6bn per quarter vs ~$3bn in 2019. Although issuance declined in 2022, it is still materially higher than pre-COVID levels (~50% increase)

This benefits RNR significantly as RNR is one of the 'first movers' who have a very high degree of investment into the ILS space compared to their competitors who aren't largely focused on this space. Specifically, RNR recently raised an additional $730m for it's ILS and third-party vehicles for the 1/1 and 6/1 reinsurance renewal cycles, and their fee income rose 27% to $147m ($111.5m in management fees and $16m in performance fees up from $96.4m and $420K in 2019), in 2020 related to ILS specifically. Their 3rd party AUM for ILS is now ~$6bn, making them the market leader in the space. Additionally, their seat is extremely difficult to disrupt as the pricing and underwriting of the ILS market is heavily driven by catastrophe models and third party validation, which RNR is known for in the market. I fully expect the overall ILS market to continue at this pace of growth, if not faster, for two reasons 1) investors are continually seeking uncorrelated market yield and risk and 2) ILS is becoming a more mature market. 1) Investors, especially in today's market dynamics, are stretching to find yield that is uncorrelated to the overall stock / credit markets, and particularly securities that are derisked to inflation. ILS is poised to benefit from this as yield and pricing is based on catastrophe driven models versus economic indicators or growth. 2) As ILS becomes a more mature market, additional capital will flow into the market as it is 'legitimized'. Currently there are only a handful of ILS fund managers / buyers, but as this asset class becomes more normalized, there could be a significant inflow of capital which would serve as a tailwind to RNR's underwriting and management expertise.

RNR Operating Performance and Pricing

With these three macro trends in mind, RNR has had a moderate performance in it's core underwriting segment. They grew gross premiums from $7.8bn to $9.2bn in 2022 and delivered ~97.7% combined ratio (loss + expense ratio) for their core underwriting segment. The usiness suffered losses through the year largely due to their investment portfolio, and I believe those are true one-time losses that will stabalize this year. This would lift profitability considerably and present a strong opportunity to have an effecient rereinsurer with considerable fee revenue. On a normalized basis, I believe that the combined ratio will stay in the mid-90s, consistent with historical performance over the last 5 years, which would increase net profit margin by ~5-10% assuming all else equal which should increase EPS by ~$3-5 or 10%. There is conviction around the normalized 90% combined ratio based on the increase from rate hardening, as well as their property segment dragging down the total combined ratio by deliver ~100% (vs casualty segment delivering ~95%). Their fee income from 3rd party ventures (a proxy for their ILS underwriting segment) declined to $118m from $128m. The decline was given the total market decline in 2022, but I believe this will pick back up in 2023 - 2024 given market appetite to invest in securities not correlated to the market. This is expected to continue to grow in the mid double digits as the ILS underlying market grows at a similar rate. RNR is unlikely to grow at a slower pace than market given its market dominance. Currently their fee income represents ~20% of their total net income, and would expect for this to potentially represent ~25% due to mix shift and growing at a much faster pace than their core underwriting segment.

RNR's 1/1 renewal cycle was mediocre, and will need to improve in 2H22, so the 6/1 renewal cycle will be very important for its overall underwriting performance.

In terms of pricing, RNR currently trades at 1.9x P / BV, which is higher than pre-COVID levels considerably and represents the market buy-in to the fee revenue stream. I still think there is mild expansion here to the 2.0x+ range given where ACGL (another specialty reinsurer) trades. ACGL shares similar characteristics in that they have a strong fee revenue stream (mortgage insurance) supported by a solid reinsurance platform. I would put my price target on RNR at $250-$260 which represents 25-30% upside to current trading. This assumes that RNR continues its underwriting performance and fee income growth, but doesn't include the upside to trade like ACGL. In the upside case, where RNR is valued as a specialty or fee based insurer, my price target is $300 - $325 representing 50-60% upside to current trading which is in line with valuations for other mid-sized specialty insurers such as WRB and JRVR (small cap specialty insurers like KNSL and PLMR trade at 5x+ BV).



Disclaimer: The information contained herein reflects the views of the author as of the date of publication. These views are subject to change without notice at any time subsequent to the date of issue. The author has an economic interest in the price movement of the securities discussed in this presentation, but the author’s economic interest is subject to change without notice. All information provided in this presentation is for informational purposes only and should not be deemed as investment advice or a recommendation to purchase or sell any specific security. While the information presented herein is believed to be reliable, no representation or warranty is made concerning the accuracy of any data presented. In addition, there can be no guarantee that any projection, forecast or opinion in this presentation will be realized. All trade names, trademarks, service marks, and logos herein are the property of their respective owners who retain all proprietary rights over their use. This presentation is confidential and may not be reproduced without prior written permission from the author.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

6/1 renewal cycle

ILS market pickup

Continued underwriting performance