As I've remarked more than once in recent months, the melt-up in the insurance sector has taken most of the value out of the sector. So it would seem to be with Allied World Assurance (AWH). I really like what this company has done with its transition towards small/mid-market specialty casualty underwriting, and I think the company's reserve quality and balance sheet are both high quality. I also like the company's plans and prospects for ongoing premium growth in a variety of specialty niches and segments. All of that said, even projecting double-digit earnings growth and ROE isn't enough to generate a truly compelling fair value today.
Focused On The U.S., Smaller Accounts, And Specialty Casualty
Part of the generation of insurance companies that came into existence after the 9/11 attacks, Allied World has changed its focus quite a bit over the years. The company has significantly prioritized its U.S. underwriting operations, growing the proportion of gross written premiums from 13% in 2007 to 42% in the third quarter of 2013.
During that time, Allied World also transitioned from writing primarily large-account excess and surplus insurance to smaller specialty casualty business. With a high degree of skill in pricing complex risks, Allied World generates significant percentages of its premiums from areas like professional liability, healthcare, and other specialty casualty. As companies like W. R. Berkley (WRB), ACE (ACE), and Aspen (AHL) have shown, there can be a lot of profitability in niche casualty underwriting; by the same token, Argo (AGII) has also shown that it can be challenging and that there are no free lunches here.
Quality Underwriting Underpins Growth
One of the strongest positives for Allied World in my opinion is its very strong underwriting record. The company doesn't underwrite all that much short-tail risk, and less than 30% of the company's business is in property insurance or reinsurance. Allied World has been consistently conservative with its reserves, though, and has been enjoying significant earnings tailwinds from favorable reserve developments. To understand the other side of the story, I'd suggest investors explore the case of Tower Group (TWGP), where poor underwriting has devastated the company's capital position and share price.
Allied World is likely still over-reserved, as 2009 is looking like a pretty epic year and has yet to really start releasing reserves into earnings. Allied World is not perfect, though, and investors should take note that the company has recently found that it needed to strengthen reserves for some of its U.S. errors and omissions business.
Driving Growth Through Hiring And Business Expansion
Like Aspen, Allied World has been on a growth kick. While insurance companies can grow simply by raising and/or redeploying capital into new lines of business, the smart companies (and I would include companies like Arch Capital (ACGL), Aspen, and Allied World in this group) focus just as much attention on hiring the right people - targeting proven underwriters from established insurance companies to head their new lines. With that, Allied World has been taking talent from insurance companies like AIG (AIG) and Markel (MKL) to support their growth in markets like marine, aviation, construction, environmental and crop insurance (or reinsurance in the case of crops).
This has been a notable growth driver for the company. While the company hasn't seen as much pressure on rates (due, I would think, to its greater focus on specialty casualty than property) as others, these moves into new businesses have had a lot to do with Allied World's mid-to-high teens premium growth this year.
I would also note, though, that this growth has not come at the expense of discipline. While Allied World has been hiring new underwriting teams and expanding into new lines, and that typically involves investing resources ahead of expected returns, the company's expense ratios have been trending quite well against the peer group - around 29% to 30% against a group average closer to 34%.
Well-Positioned To Deliver High-End Growth
Seeing as how Allied World has only mid-single digit share in the majority of its underwriting lines, I see no near-term ceiling to the company's growth. True, companies like Aspen are expanding their own specialty businesses and Berkshire Hathaway (BRK.A) is moving more into primary insurance (in areas like excess and surplus), but I believe there is still ample opportunity for a savvy underwriter with a niche focus and a willingness to work with smaller clients. I would also note that Allied World could likely take on more leverage to accelerate its growth if the situation required it.
Interestingly, there's still a pretty significant spread on expectations for Allied World and still some skepticism about its ability to maintain premium growth and underwriting profit margins. I'm more bullish about the company's growth prospects, and I'm willing to estimate a five-year ROE of 11% and a five-year earnings growth rate of around 10%.
The Bottom Line
Despite what I believe to be superior growth characteristics and a very solid balance sheet, Allied World does not look like a particular bargain right now. Even with my willingness to project a higher ROE down the line than most sell-side analysts, an excess return analysis suggests a fair value of around $116 to $117 today. Likewise, the company's ROE/TBV suggests a fair value in the range of $110 to $120. You could drive a target closer to $130 if you were wiling to give even more credit to the company for its growth, but that seems like an aggressive move given how strong the markets have been.
If Allied World isn't really cheap today, that's no great surprise - other quality insurance companies like Arch Capital or W.R. Berkley seldom trade all that cheap either. That leaves investors with a less than ideal set of choices. You can buy Allied World today with the expectation of just an "okay" rate of return and/or wait for the strength of the company to play out over the long term, or you can wait in the hopes of a pullback that may not come (or may start at an even higher level).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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