Description

James River Group Holdings, Ltd. ("James River ", or "the Company") is a Bermuda-based insurance holding company which owns and operates a group of specialty insurance and reinsurance companies.

Situation overview

On October 8, 2019, James River announced the early termination of a material contract with an affiliate ride-sharing company Uber, Raiser LLC, and disclosed adverse development of $55-60 million directly related to this account in its commercial auto line of business. 

Not surprisingly, the JRVR stock price was down 22% following the announcement, and the sell-side community responded negatively (2 of 4 equity research coverage analysts downgraded JRVR).

The two main reasons for the market’s concern were (a) the relationship with Uber / Raiser represented approximately 25% of gross written premiums (~$300 million) in full-year 2018 for James River and (b) post-reserve charge, questions remain if the reserves associated with Uber policies will be adequate to support their run-off.

Thesis

The market has overreacted to an event that will likely improve James Rivers’ business in the long run (24-36 months) and now presents a buying opportunity into a specialty insurance company that is among the best run of the last 15+ years.

Business overview

James River tends to focus on accounts associated with small and medium-sized businesses in the United States.

Substantially all of James Rivers’ business is casualty insurance and reinsurance, and for the year ended December 31, 2018, they derived 99% of our group-wide gross written premiums from casualty insurance and reinsurance.  Casualty insurance is written in either the standard (or “admitted”) or the excess and surplus (“E&S”) / “non-admitted” market.  The standard market is much larger (94% of total U.S. P&C gross written premiums) but less profitable (102%+ average combined ratio in the last 15 years) than the non-admitted market.

The E&S market tends to be more profitable (96% average combined ratio in the last 15 years) than the standard market as of the result of freedom of rate (no regulatory approval needed for price increases) and form (no regulatory approval for policy terms and conditions).  For the year ended December 31, 2018, James River wrote 68% of its consolidated gross premiums written in the non-admitted market (56% primary and 11% via reinsurance).  The Raiser / Uber business is reported in the E&S segment under “Commercial Auto.”

The remaining 32% of James Rivers’ gross written premiums is made up of admitted fronting business (27% of consolidated gross premiums written) and traditional admitted workers’ comp (5% of consolidated gross premiums written).  The fronting business earns premiums and fees in exchange for providing other carriers access to James River paper when they may not have a proper license, product suite or rating to serve its desired market.  Additionally, the fronting business will provide paper to a program business supported by a reinsurer or alternative capital provider.  James River retains only a small portion of the risk of each fronting program (usually around 10%).

Historical performance

Prior to the issues experienced with the Uber account beginning in the 2017 calendar year, James River was one of the best performing E&S underwriters of the past 15+ years.

Their 2007-2016 E&S loss ratio was 55% vs. the industry average of 65% and only underperformed the market in two separate years (2007 and 2016) by a total of 4.3 percentage points.  JRVR’s outperformance in this time period was supported by aggressively contracting its book quicker than the industry during a soft market (2007-2010) and growing equally aggressively ahead of the industry during a hard market (2011-2016) – a hallmark of a competent insurance management team.  As a result, in this same period, James River released $120 million from its reserves, and since the Company’s formation in 2002, had no unfavorable E&S development in any calendar year.

Since its purchase by D.E. Shaw in 2007 (D.E. Shaw exited in 2013 via IPO) to year-end 2017, the Company grew TBVPS plus cumulative capital return ($370 million of dividends and share repurchases) by a 9.0% CAGR and grew the base in each and every year.  Total shareholder return of 75% since the IPO to year-end 2017 was best in class amongst available public peers (AMSF, MKL, RLI, NAVG, WRB, ARGO) and beat the median (58.6%) by 15%+ during this time period.  The Company’s operating return on tangible equity during this time period averaged 13-16%, which generally was best or within the top three in a given year amongst the peer set.  The stock price since the IPO in 2013 more than doubled from $21 to $44 in February 2017 prior to unfavorable development related to the Uber account.

The Uber account issues began to emerge in 2017 and 2018 results, as James River booked unfavorable development on E&S business for the first time in its history of approximately $35 million over the two calendar years.  The E&S loss ratio spiked to 80% and 79%, respectively as a result.  The operating ROTEs of the business declined below 10% in 2017, and despite the issues persisting, recovered slightly to 14% in 2018.  From February 2017 to April 2019, the share price of the Company was down from $44 to $38 largely as a result of the overhang on the stock resulting from the uncertainty around the Uber issues.

Investment strengths 

Management team

James River is run by its co-founder J. Adam Abram, well-known in the excess and surplus insurance market.  He founded the Company in 2002, taking it public in 2005, selling to D.E. Shaw in 2007, and re-IPO-ing the Company in 2013.  He previously capitalized a E&S business, Front Royal, in 1992 and sold to Argo Group International in 2001.

Adam stepped back from the Company’s management in January 2018 to a non-executive Chairman role, and promoted James River COO Bob Myron to the CEO role.  Unfortunately, Bob could not fulfill the CEO duties due to health issues, so in August 2019 Adam was brought back by the Board to the CEO role.  Timing here is convenient, as Adam is likely the best person for the job to right the ship in the face of the Uber issues.

Adam’s management style at James River is a hallmark of the most successful insurance companies - sound underwriting through opportunistic deployment of capital to maximize returns.  The team’s objective is to generate compelling returns on tangible equity, while limiting underwriting and investment volatility. Management accomplishes this by earning profits from insurance and reinsurance underwriting on a consistent basis while managing capital opportunistically to grow tangible equity per share.  Growth (or shrinking) is a by-product of this strategy, and not a pre-ordinated concept in an annual budget.  What the market gives, James River will take.  The historical E&S performance from inception through 2016 is a testament to this strategy.  Companies like RLI Corp (RLI), Arch Capital (ACGL) and Markel (MKL) have successfully executed this strategy for many years in the specialty insurance space, and James River is another, less well-known example.

A great example of the strength of the James River management team bench is the story of Kinsale Capital Group (KNSL), a pure play E&S writer founded by James River employees (notably CEO Mike Kehoe, the former President of James River from its founding in 2002) in 2010 that was taken public in 2016.  Kinsale has surpassed all expectations, returning shareholders over 450%+ since its IPO and trading at the highest valuation levels of any insurance carrier in recent history – 7x+ tangible book value per share and at a 250%+ premium to net investments (float) per share.

Refocusing on core E&S business

The Uber issue at James River will allow Adam and the management team to focus on the core E&S market, which commercial auto generally falls outside.  Investors had anticipated adverse development on the Uber business given results in 2017-18, but believed that the core E&S business would win out, which supported valuation levels prior to the announcement of the latest Uber reserve build and the unexpected early cancellation of all Uber policies.

While in the short-term, this stock declined significantly (approximately 34% from peak levels), management is clearly trying to put a line of business that has been distracting and not profitable behind them.  This will allow them to focus on core E&S lines, which is experiencing the best market conditions in multiple decades.  The E&S market is currently on fire, experiencing strong prices increases across all lines of business, and dislocation from its two major market participants (AIG Lexington and Lloyd’s).  An aggregation of all national stamping offices (E&S regulators) reported a 13% increase of 1H 2019 over 1H 2018 premiums.  For full year 2018, 11% growth was reported.  The support for Kinsale’s aforementioned record valuation level is partially a result of this market phenomenon.  Key drivers of the rate increases across all E&S lines underlying the premium growth are the losses on property lines of the E&S market, which James River does not have exposure to. 

Core E&S is James River’s core competency and the growing E&S market will likely quickly replace the loss of the 25% (~$300 million) of Uber’s gross written premium with stable, more profitable business.  The Uber business is in high demand from other larger auto-focused carriers and would have likely been bid further inside of profitable levels for James River upon scheduled renewal in 2020.  By 2021, without any incremental reserve issues on residual Uber business, the lost earnings will likely be in the rearview mirror.

Takeout candidate

After a large wave of P&C consolidation (~$35bn) from mid-2017 through 2018, very few high-quality, $1-5bn market cap commercial lines carriers remain.  For larger strategic buyers looking for exposure or more scale in the E&S market, James River is now available at some of the lowest trading multiples in its history (at or below 2x tangible book value) and is significantly cheaper than Kinsale, the only pure play E&S writer available (7x+ tangible book value).

While Adam is an excellent CEO at the moment to handle the issues Uber has presented, he isn’t considered to be a long-term solution in the CEO seat, given his age and previous desire to step aside.  A viable “succession plan” would be to sell the Company.  Most of his net worth has been divested from James River in the earlier succession plan in 2018, so he is not dis-incentivized to sell at lower than historical valuations.

Key Risks

Reserve issues around run-off of Uber policies (non-core E&S – commercial auto)

As discussed above, the biggest question here is if recent reserve actions are enough to stem the bleeding from the cancelled Uber commercial auto policies going forward.  The revenue and earnings impact of the Uber policy cancellation will be felt in 2020, with the majority in 1Q 2020 as most of the policies premiums are written and earned in this quarter with minimal lag, the majority of which is likely already priced into the stock at current levels.  What is not priced in, however, is any incremental reserve actions necessary over and above the nearly $100 million that have been added to reserves on the commercial auto line since 2017.  Management’s decisive action and track record should lend some air-cover, but it will not last long if reserve builds recur.

Social inflation

James River, like any other liability insurer, is subject to “social inflation” a phenomenon that has been increasing jury trial awards settling liability claims.  Broadly speaking, social inflation refers to the views, opinions and reactions of consumers interacting with institutions.  The acute perception of economic disparity in the U.S., a deep-seated institutional distrust and the perception of the value of an injury all translate into the expected value of claim outcomes.

The challenge for liability underwriters, actuaries and others trying to quantify social inflation’s impact, is its non-linear trajectory.  When a verdict is reached that is unprecedented or even very high, a new value is established for the next case and potentially other claims in a carrier’s inventory.  The worst case outcome is a risk portfolio that is potentially sub-optimally positioned or priced.

For James River, this may manifest itself especially on Uber claims higher than today’s reserve position, given Uber’s high profile, and experience to date.

Valuation

James River trades today at ~2.0x tangible book value, ~15x 2020 EPS and at a 38% discount to its net investments (float) per share.  Its closest peers (RLI and KNSL) trade in the ~4.0-7.0x tangible book value range, ~35-40x 2020 EPS and an 80-250% premium to their net investments per share.

Upside

While it’s unlikely that James River reaches these valuation levels given a variety of factors (not pure play E&S like Kinsale, and RLI has a much longer underwriting track record), it is not unreasonable to suggest the stock would recover to a 2.75x tangible book value level, which would represent a share price of $50 and a gain of 44%.

If James River were to trade in-line with its net investments (float) per share, $57, this would represent a gain of 64%.  Net investments (float) per share values high-performing insurance companies as a growing stream of low-to-no cost investment capital depending on underwriting results.  Gary9 has an excellent write-up of ACGL from 2004 that describes this construct in detail for more information.

Additionally, there is more likely additional upside to James Rivers’ published results over time in the E&S lines, as since inception, the Company has released $120 million from core E&S reserves (ex-Uber), a trend that is likely to continue given the E&S market’s favorable conditions.

Downside

More downward pressure on the current stock price of $35 will come in the form of additional reserve issues related to the Uber business, and could escalate out of control if the market loses confidence in the reserve story.  Another reserve charge of the magnitude of the original ($60 million) would likely trigger a smaller correction (say 5-10% to $31-33) since the majority of the recent decline was attributed to the announcement of the cancellation of $300 million of top line premium and the associated earnings.  Given the history here, albeit very unlikely, multiple additional reserve charges of this size would likely take the stock down to 1.5x tangible book value ($27 or 22% downside) which seems like a very low probability event given management’s track record and where the stock is valued today.

Catalyst

-          Refocus on core E&S business, continued strong performance

-          No lingering reserve issues from Uber cancellation

-          M&A takeout