Description

Acquire best-in-class specialty insurer James River Group Holdings (“JRVR”) at 30+% discount to peers in wake of market overreaction to reserve strengthening and overnight equity offering.

Insurance entrepreneur Adam Abram founded James River in 2002. The company boasts an exceptional underwriting track record with one blemish – writing commercial auto policies for Uber. California ambulance chasers have driven massive inflation in costs to settle claims, and JRVR put this book into run-off as of December 31, 2019. Continued adverse development drove a $76mm charge during Q4 ’20 and culminated in a $170mm charge alongside a $200mm overnight equity offering priced 33% in the hole.

I believe the company has now conservatively reserved the Uber business and will likely pursue a reverse reinsurance transaction to remove the overhang. Once gone, investors will see an advantaged specialty insurer delivering double digit premium growth with an above-peer mid-teens ROTE. I forecast earnings above consensus, and I see the company achieving a share price of at least $52 if valued near the low end of peers. The investment further benefits from M&A optionality as JRVR’s modest size and attractive E&S and fronting franchises make it an enticing target for larger insurers.

Uber Exposure Resolved  

Uber has plagued JRVR dating back to 2017, with the company taking adverse development charges every year since (compared to the typical positive developments in JRVR’s other lines). Shares plummeted during October 2019 due to a ~$50mm charge and the announcement that JRVR would cease writing Uber business. Founder Adam Abram reinserted himself as CEO earlier that summer and served in the position until hiring Frank D’Orazio, the COO of Allied World (a specialty insurer acquired by Fairfax in 2017) in November 2020.

Shortly after Frank’s appointment, the company reported a $76mm Uber charge on February 25, 2021, followed by a $170mm charge and associated equity offering on May 5, 2021. Despite the tumultuous history, I see good reason to believe the company is now appropriately provisioned. New CEO Frank D‘Orazio declared eliminating the overhang surrounding the Uber run-off as his “personal goal.”

As a first-time public company CEO, I consider it both logical and prudent for Frank to provision the account to whatever extent necessary to insure against further adverse development. Competent and experienced insurance executives appreciate the importance of market confidence, and JRVR’s valuation has clearly suffered relative to peers due to the Uber overhang. This belief is consistent with his recent public statements that the commercial auto exposure “has been eliminated”, “addressed with certainty” and “put behind us for good”. Moreover, management noted that the company explored a reverse reinsurance transaction prior to the most recent charge, and they intimated that the charge is in line with indications they saw from the market. I offer the following quotes:

• “We believe the overhang related to commercial auto has been eliminated, and that we are now fully able to focus on our prospective business and what continues to be a historically strong E&S marketplace.” – Investor Presentation

• “Since joining James River in November of 2020, my primary objectives have been: first, to ensure that the company remains fully focused on the market opportunities we have in front of us, as we continue to strengthen our position as a best-in-class E&S carrier with an expanding fronting and fee income business; and secondly, I've made it my personal goal to be able to eliminate the overhang surrounding our Commercial Auto runoff portfolio.” – CEO

• “While I intend to share commentary with you in just a few moments about my first objective and significant accomplishments our underwriting segments have been able to achieve in the first quarter, it's more appropriate that I start with a major step that company took in the quarter to put the concerns with our Commercial Auto runoff portfolio behind us for good.” – CEO

• “On a combined ratio basis, core E&S produced 83% for the quarter. This is a reminder of what our overall E&S segment is capable of from an earnings perspective now that our runoff portfolio has been addressed with certainty. Our core E&S division, which has grown by 86% over the last 2 years, enjoys an industry leadership position in its space and should be approaching a $1 billion segment by the end of 2022, a major milestone for the company.” – CEO

• “Recent claims emergence pattern and internal actuarial work gives us significant comfort around current carried reserves.” – Investor Presentation

• “As you may recall from our Q4 call, I previously voiced an interest in exploring the potential to reduce tail risk and move to a higher end of the range of outcomes in this portfolio. I believe that many of the structures potentially available in the legacy reinsurance marketplace could require a meaningful risk-sharing or co-participation feature, frictional costs and additional premium features as well as a defined limit. I feel very comfortable that our new ultimate reserve levels are likely at similar levels as the legacy market may view.” – CEO

Though investors cannot obtain total clarity on the Uber reserves, management has offered some data to help handicap the chances of reserve prudency. The Uber business has now been in run-off for 17 months and new claims are infrequent. Commercial auto reserves are currently $450mm, +33% since Q4’20 and above Q4’19 levels. There are 8,000 remaining open claims, 60% below Q4’19 levels. The most recent charge results in ~$56k reserves per claim, an amount 150% above Q4’19 levels and >40% above the average amount paid per settled claim during Q1’21.

Growing, Attractive Core E&S Franchise

The Uber fiasco has not impacted JRVR’s core E&S business, which has grown GWP at a 27% CAGR over the last four years and experienced 17 consecutive quarters of positive renewal rate increases. I expect continued double-digit growth as the company benefits from a hardening insurance market. Founder Adam Abram recently noted this is one of the most favorable markets he has witnessed in 30 years. Management expects core E&S GWP to approach $1bn by the end of 2022. The core E&S business is highly profitable and can achieve a low to mid 80s combined ratio. As shown in the second table, the core E&S business has experienced consistent and substantial favorable reserve development, evidencing conservative underwriting and reserving. JRVR also benefits from a growing fronting business, which offers a capital-light source of fee-based earnings.

Upside to Consensus Estimates

I estimate 2022 EPS of $2.90, or 17% above consensus estimates. Key assumptions include:

• $78mm E&S underwriting income driven by 16% GWP growth through 2022 and an 86% combined ratio.

•  $15mm specialty admitted underwriting income driven by growth in the fronting business.

• $8mm casualty reinsurance underwriting income driven by reduced prior year adverse development due to recent reserve strengthening and improved renewal pricing.

• 15% tax rate, benefitting from the Bermuda-based reinsurance subsidiary.

Potential M&A Target

James River’s high-quality E&S franchise and modest size make it an ideal M&A target for large insurers seeking E&S exposure. Relevant precedent transactions include Markel’s 2017 acquisition of State National for $919mm, or 2.9x book value and 18.1x P/E, as well as James River’s 2007 sale to DE Shaw for $575mm, or 2.6x book value and 14.6x P/E. Specialty insurer valuations have increased since the State National deal.

Valuation

At 12x my estimate for 2022E earnings, James River trades at a substantial discount to E&S peers, many of which have lower returns, growth, and E&S exposure.

I believe that JRVR will close the valuation gap with peers once it fully resolves the Uber overhang and continues to demonstrate superior core E&S underwriting. Greater E&S and fronting exposure enable JRVR to earn higher returns on equity than peers. E&S insurance is usually more specialized, less competitive, and higher margin than standard insurance, while fronting is capital light and high margin. At 18x 2022E earnings, a slight premium to the lowest peer multiple, I see current fair value of $52 / share or upside of 48%. With time and consistent execution, the company’s multiple may expand closer to RLI and KNSL which would yield a substantially higher valuation. 

Catalyst

·         Uber portfolio runoff and absence of additional reserve charges

·         Reinsurance transaction for Uber portfolio

·         Growth in core E&S and fronting businesses

·         Sale of the company