Summary:

AXIS Capital is a Bermudian insurer founded in late 2001.  Though the company stumbled in 2011—even against the context of catastrophe losses exceeding $100 billion—it has achieved an enviable record since inception.  Return on equity has averaged 14.2%, diluted book + dividends have compounded at 13.7% and aggregate reserve development is over $2.5 billion, positive in each year to date.  Mr. Market now offers up AXIS at 86% of book value on what I believe is the cusp of a hardening of the P-C cycle. 

The Cycle:

Early in 2011 Vinlin wrote up WR Berkley for VIC with an excellent summary of the soft insurance cycle that has prevailed since 2005 and how cycles turn.  I would encourage anyone interested in AXIS or the industry to read this analysis.  Subsequently, a number of catastrophes (Japan earthquake/tsunami, Australian floods, New Zealand earthquake, Hurricane Irene, Thai floods) have eroded industry capital further and demonstrated to many management teams, including AXIS, a lack of sufficient pricing in their books of business. 

Bill Berkley, who was one of the earliest insurance CEOs to call they cycle turn, is increasingly optimistic.  On his Q4 conference call several weeks ago he noted,  “It would seem as though, with every passing day,  the industry continues to further set itself for a classic hard market. . . .

Market participants are not only looking to raise rates, but also narrow their risk appetite.” 

John Charman, the founder and outgoing CEO of AXIS, is optimistic but more cautious:  “ The relentless race to the bottom of the cycle that we’ve witnessed in competitive pricing may have run its course at long last.  As we have said for some time, the eagerly awaited cyclical upturn will not occur all at once . . . We expect that the firming process, which has already begun in some products, will be gradual, gaining ground risk by risk, product by product, geography by geography, and year by year.  , , , The current market may require several years to regain some of the pricing eroded over the last five or six years.”

Balance Sheet:

Needless to say, balance sheet strength is paramount in this industry.   AXIS is very well capitalized at $6.4 Billion, of which 15% is long-term debt and 8% preferred stock.  Net reserves at year-end are $6.7 billion, of which 63% are IBNR.  As noted above, AXIS has a very strong history of favorable reserve development.  Here are the rating agencies:

S&P:  A+

Moody’s:  A2

Best:  A (positive outlook)

Earlier this month in an investor presentation, CFO and incoming CEO (takes effect this May) Albert Benchimol stated, “We actually have capital well in excess, not just of our current rating, but of the next rating levels and that’s where we want to be.”

Invested assets are $13.5 billion, or $94/share net of debt and preferred.  So $1 invested in the stock currently buys $2.90 in investments.  Of this cash and fixed maturities are 87%.  The average quality rating is AA- and the duration is 2.8 years.   I would gauge overall investment performance over the last few years as pretty good but not great. This company is focused much more on successful underwriting than trying to achieve a great deal with its investments.

Capital Management:

AXIS has shrunk its share base by 30MM shares, or 19%, over the last three years—cumulatively at less than 90% of diluted book.  Management is clearly willing and able to continue aggressive repurchases but is mindful of the need to preserve the ability to capitalize on an improving set of opportunities in the market place.  The company has increased the dividend each year to a current level of $0.96/share.

One Look at the Future:

Earnings forecasts in this industry are a fools’ game.  Assume, though, that the cycle is beginning a slow turn for the better.  Further assume that persistent low interest rates—at least for the next couple of years—make it difficult for AXIS to achieve its target of a 15% return on average common equity.  With moderate catastrophe losses (more like 2010 than 2011), I don’t think it’s crazy for AXIS to earn low double-digit ROEs over the next three years and also to maintain a moderate buyback program.  This would produce EPS of $5-6 in 2014 and, I think much more importantly, a $50 2014 year-end book value.

Historically, AXIS has traded at or a premium to book value in all but two years, 2009 and 2010, when it peaked at 93% of book in both years.  So I don’t think it is crazy to think that the stock could trade near book in two or two and a half years.  This strikes me as a very attractive potential return without inordinate risk. 

Note that Arch Capital (see my VIC analysis from 5/09), which is the company most similar to AXIS but which has done a better job over the last couple of years, now trades at 114% of book.  This is actually in line with levels at which AXIS has traded since its inception and it is possible it will get there again—especially in an improving cycle and greater levels of investor confidence (now diminished by relatively poor performance in 2011 and the impending management change).