Berkley Maintains Reality Focus, Sticks With Forecast Of Imminent Market Turn

“This is a marathon business, not a sprint.”

That is how William R. Berkley, chairman and chief executive officer of W.R. Berkley Corporation, explains the patience that he and the rest of the management team have exercised through a period of 15 quarters when the specialty insurance organization reported no growth on the top line of its financial statements.

During second-quarter 2010, gross written premiums finally rose 5.6 percent at the Greenwich, Conn.-based firm–a jump mainly attributable to 21 startup operations the firm launched in the past five years. The startups contributed $50 million–more than offsetting market-driven declines in existing business for the first time in two years.

“We have a long time horizon,” Mr. Berkley told NU, responding to the question of why his company had not given up on any of the young operations because of their lack of production in prior quarters.

“As long as they stick with our plan and maintain underwriting discipline and focus, we're patient people,” said Mr. Berkley, who delivered the Derek Hughes/NAPSLO Educational Foundation Lecture at the annual meeting of the Kansas City, Mo.-based National Association of Professional Surplus Lines Offices, Ltd. in Atlanta last month.

Addressing part of the 2010 NAPSLO Annual Convention conference theme–”Adding Value, Promoting Growth”–during a pre-conference interview, Mr. Berkley explained how his firm has been identifying specialty businesses over the last few years–businesses poised to promote further growth when the hard market returns.

“We believe that in the enterprise known as insurance you succeed because of expertise. So we look for people with particular expertise,” he said.

Because the company has been willing to make investments in talented people with specialized know-how in 21 coverage niches including aviation, accident and health, offshore energy, and agribusiness, it has recorded higher expense ratios than competitors in recent years.

“When the business is at its worst, that is when the best people get disgusted at managements that demand volume,” he said, explaining the timing of the people-investments at a recent investor conference. “We can afford to have higher expenses,” he said, highlighting the company's historically lower loss ratios.

“Our combined ratio is lower than the industry, but not by as much nor as consistently as the loss ratio. That's by plan, by strategy, not by accident.”

With bottom-line profits intact, Mr. Berkley has seen no need to cut any of the newest teams of professionals loose for failing to boost top-line revenues.

“Even we have limits to our patience, but you have to get to a hard market and see how you do,” he told NU.

REALITY CHECK

Mr. Berkley's belief that the hard market is almost here is well known. For at least two years, he has expressed the view that the market would turn in the fourth quarter of 2010, and with the timing just weeks away at the time of the interview, he did not waver much from that view.

“I am a realist, not an optimist,” Mr. Berkley said. “I look at the facts. I look at the marketplace and see it as it is.”

“Many people we compete with, in fact, are optimists. They see the world as they'd like it to be.” As a result, “I may have anticipated a market change sooner,” he said. “That's because of realism.”

Mr. Berkley said his “simple view” hinges on several factors–inadequate prices, low levels of investment income and the depletion of prior-year reserve redundancies.

He highlighted the last factor during a media briefing in May 2008, when he remarked on the speed with which insurers have been taking down reserve redundancies in recent years, suggesting that regulatory initiatives aimed at making financial disclosures more transparent, such as Sarbanes-Oxley, helped spur the takedowns.

A lack of substantial redundancies to cushion the blow “will cause the realities” of the downward pricing cycle–underwriting losses–to “hit home more quickly,” he said, predicting “very bad results” would appear in 2010.

Looking back on his prediction two months ago, Mr. Berkley recounted other factors that were visible in 2008–a worsening economic climate and downward price trends. “The question was when and what would bring about a turn in the cycle, and my view was that you would get flattening-to-slightly improving economic activity, and you'd effectively get people having used up all the past [loss reserve] redundancies.”

“Historically, when people have used up past redundancies and start to accumulate deficiencies from the current down cycle, that's when it starts to turn,” he said.

“We think the industry is, in fact, not making any money overall currently,” he added, noting that pricing levels now are effectively equivalent to where they were in 2000 and interest rates are down well below where they were in 2000.

“So while people are reporting profits, it is because they are taking down past redundancies, or taking down reserves where there is no redundancy, thus creating deficiencies,” he said.

“In our view, the balance sheets for much of the industry are getting weaker,” he continued. Many insurers are near the point where their actuaries and accountants will soon recognize that they are not making any money and that reserve cushions are depleted with deficiencies starting to build.

They will have no choice but to raise prices. “I think that happens in the middle of fourth-quarter 2010″ as they pull together year-end numbers, he said.

“Could it be 2011? Surely, but there's no question that pricing is inadequate,” he said.

HARD MARKET STATE OF MIND

Mr. Berkley did not predict that any balance sheets were weak enough to fuel insolvencies withdrawing capital from the market. He also threw cold water on the notion that capital shortages are a necessary condition for cycle turns, when asked about the prior turn, which occurred after the failures of Reliance and Frontier.

“There has never been a shortage of surplus in any turn of the cycle going back to 1974. That's never driven it,” he said.

“In fact, the industry was writing at 1-to-1 in 2001 when the cycle turned.” Historically, in earlier periods when the cycle changed, such as in the mid-80s, capital adequacy was always about the same. “There was never a capital shortage.”

The demise of Reliance and Frontier, however, did have some cycle impact, according to Mr. Berkley. “When they went broke in one month, October of 2000, it changed people's state of mind.”

The events “got everyone to focus on their own vulnerabilities,” he said.

“It's what is in their minds. That's the cornerstone issue. It isn't reality,” he said, drawing a parallel between market cycles and romance. “You wonder, how could that person be in love with this other person? It's what's in their mind.”

It is Mr. Berkley's view that blow-ups–like the demise of Frontier and Reliance, and catastrophic events–move price increases up past double digits, but they don't drive the initial turn. “Pricing cycles turn slowly. They go up 1 percent, 2 percent, 5 percent, 7 percent,” he said in a previous interview.

The October 2000 events fueled long-haul trucking price hikes of 30 percent, he recalled, adding that prices in the first half of 2001 were up probably 15-18 percent across the board–”not enough to make it a really hard market.”

The market didn't get very hard until after the 9/11 attacks took place. “Capital did not drive it,” he stressed.

GROWTH OVER DECADES

“My view is that the market will turn in the fourth quarter, but everyone should understand there is nothing I will do differently if the cycle turns in the fourth quarter of this year or next,” he said during a presentation at the September Keefe Bruyette & Woods conference. “We will run our business exactly the same way.”

Over the course of more than four decades, Mr. Berkley has been building his business of 43 different operating units–developing 36 internally and acquiring only seven. The group, with $3.4 billion of net written premiums in 2009, ranked as the 21 largest in the nation, according a ranking published in National Underwriter magazine in July and compiled by Highline Data.

Describing internal development activity, Mr. Berkley said: “We're always looking for outstanding teams of people and leaders. We also look for people that have a cultural fit–who want autonomy, but who can operate within a box.”

Once the company identifies a specialty team, “we sit down and we agree on the box within which they're going to operate. It may be bigger than where they were. It may be smaller than where they were,” he said.

The startups are nurtured with centralized support in areas like actuarial and accounting. Otherwise, business leaders are left to manage their individual operations without meddling from the home office.

The operations can be anywhere in the United States, or anywhere in the world, he said, referring to recent units set up in Australia, Canada, Hong Kong and Brazil.

Mr. Berkley explained the 2009 formation of W.R. Berkley Syndicate 1967 at Lloyd's as one that expands distribution relationships and brings more of a focus on non-casualty business, also highlighting the talents of CEO Mike Sibthorpe and Alastair Blades, head of underwriting.

“This is a business of people. You find terrific people and the right opportunity.”

The most recent U.S. startup, Richmond, Va.-based Verus Underwriting Managers, which will be headed by former NAPSLO Vice President Dale Pilkington, is also expected to expand the group's distribution network. The group of wholesalers that the Verus team has relationships with is a bit different from those already doing business with W.R. Berkley, Mr. Berkley said.

Verus joins NAPSLO member firms Admiral Insurance, Carolina Casualty and Nautilus in the E&S world.

On occasion, Mr. Berkley said the niche of a startup may overlap businesses that W.R. Berkley is already in. A number of startups in recent years, for example, involve professional liability, while others marked the organization's first entrance into a new specialty line, like offshore energy.

Asked if overlapping specialties ever trigger internal consolidations, Mr. Berkley noted that a combination of regional companies in 1999 marked the only time this happened. “We realized that while a specialty company can do $50- or $100 million and still be viable, a regional company had to have $150-$200 million.”

At the moment, he said there are no plans to consolidate any recent specialty startups. “We have to wait until the market hardens. When we started them up, we expected each to be able to attain enough scale to operate independently.”

THE EARLY YEARS

One of Mr. Berkley's most entertaining stories relates to his first attempt to merge two companies–Houston General and Traders & General–in the early 1970s.

“Houston General was a fabulously well-managed, highly automated company. They knew exactly what they were doing. Unfortunately, they were losing money,” he told National Underwriter magazine in 1998. “At Traders & General, they literally wore green eyeshades [and] kept track of claims on Popsicle sticks, [but] that damn backwards company made unbelievable amounts of money.”

The young entrepreneur decided to combine the two insurers that he had acquired for a money management firm he started as a Harvard business school student. “I ended up with a bigger company that didn't make any money,” he said.

Even before Harvard business school, Mr. Berkley was an investor, buying his first stock at age 12. “It was Continental Vending,” he recalled, noting that he spent the next few years learning about investing. “I was probably 14 when I subscribed to Fortune, and I read about Lee Iacocca taking over Chrysler. I called him, and he actually talked to me,” Mr. Berkley remembered.

In 1963, Mr. Berkley, then an NYU student, said he started a hedge fund after reading about A.W. Jones, who had the first one. “That evolved into managing other people's money.” At Harvard Business School three years later, the hedge fund evolved into another, which was effectively the predecessor to W.R. Berkley Corp.