Left to Right: W. Robert Berkley, Jr., President and Chief Executive Officer
William R. Berkley, Executive Chairman
To Our Shareholders:
By most measures, our performance in 2017 was outstanding even though we did not achieve our long-term targeted return on equity of 15%. While many sectors of our industry suffered adverse consequences, we were able to overcome most of those issues and still deliver an excellent 11% risk-adjusted return to our shareholders.
Our results were especially noteworthy because they were achieved in the face of low interest rates, high catastrophic losses and substantial competition in the pricing of insurance products. The management of our Company has a total focus on optimizing riskadjusted returns. This year’s results clearly demonstrated that focus.
An annual letter is a reflection of how the Company has done in the most recent year, yet it is important to recognize that results in any given twelve month period can be diminished or enhanced by actions taken to create a better long-term outcome. We always have to consider what we have accomplished in building and improving our enterprise for the long run in order to deliver on our objective of long-term value creation for shareholders. In addition to managing our volatility and protecting against the unforeseen event, we constantly invest in a better future for our Company by building intellectual capital through technology, new products and new businesses. Many of these endeavors can impact our annual results, but they build more attractive economics over the long run. For example, investing a portion of our portfolio for total return results in us giving up some ordinary investment income but provides us with a potential stream of substantial capital gains. The consequences of this may be less operating income than we otherwise would have, however it can increase our potential for total earnings over the term of the investment. Similarly, starting new companies will result in an increase in expenses for their initial startup period, yet it provides for better returns with less risk once they have reached scale. We always look for high-quality companies to buy. Most of the time, prices and balance sheet or cultural issues make startups a better long-term proposition. We find few great companies available for sale at a rational price.
Consequently, understanding the performance of our Company requires a clear conceptual appreciation of all aspects of the property casualty insurance business. We must recognize that we earn profits from underwriting and investing. These are highly variable elements that require expert judgment to implement the appropriate strategy at any moment in time, always requiring a balance of optimism and caution. Both areas require forecasting interest rates and inflation — each of which is necessary for the pricing of our future business and the investment of our funds as we look ahead. With respect to our product pricing, the starting point is always the prior year prices, which include an assumption of adequacy in prior year loss reserves. One then must look forward based on trends, court decisions and medical costs to attempt to forecast the required future pricing level necessary for an adequate return. The uncertainty in investment markets is always self-evident, but recent volatility, taken together with the fact that interest rates are at historically low levels and are just beginning to rise, makes that uncertainty even greater. Combined with concerns about future inflation, these factors altogether result in unprecedented risk and uncertainty.
This level of concern is so substantial that we require a higher risk-adjusted return. However, over the last several years, rather than allowing for better margins, the environment has become even more competitive. The industry experienced historic catastrophic losses over the most recent year, yet there continued to be significant price competition. Pricing in most lines of business does not seem to have increased concomitantly to reflect this actual level of risk. While overall the current level of pricing does not fully reflect our expectations for achieving acceptable returns, we still believe that many areas of the business do offer satisfactory returns and we constantly see attractive opportunities. A good example is the high-end personal lines market. We have invested substantially in the establishment of Berkley One as our entry into the high-end personal lines space, building a first class team of people with a strategy to deliver the very best service to both our brokers and agents as well as our ultimate customers. This is a market that is service focused. Prices are important, however this group of customers recognizes that prompt, effective claims service is the key to value insurance purchasing.
In that overall context, 2017 was an excellent year for both underwriting and investment results, particularly in light of the many headwinds our industry faced. Underwriting results, excluding the losses from the unusual catastrophe activity, were remarkably stable. Our underwriting discipline, with respect to both pricing and risk selection, was enhanced by our decentralized structure that enabled us to focus on the parts of the market where adequate pricing persisted and de-emphasize those sectors with less attractive margins. As a result, we were pleased with the underwriting results for almost all of our domestic specialty businesses and continue to see improvement in our market position, with adequate if not robust pricing. Our regional commercial insurance business had more variation due to the higher level of natural disasters than we have seen in recent times. Overall, several of the companies delivered outstanding results and we anticipate improvement in the others, barring similar catastrophic activity. We believe opportunities in the domestic insurance area will continue, and we stand to gain a larger share of the marketplace as our expertise and outstanding market-facing relationships continue to give us a competitive advantage.
Internationally, we continue to seek profitable opportunities. Our Latin American businesses have performed in an outstanding manner, and we built a new enterprise in Mexico. Australia and Asia represented the continued building process towards delivering profitable results, with a first step towards increased penetration in Asia and improvement on the underwriting results in Australia. Europe presented challenges in a number of areas. Pricing was extremely competitive and brokers, especially those serving the U.K. market, seem to have a different view of how gross premiums should be divided. The level of commissions and expenses in Europe makes this market extremely difficult. We expect that our recent realignment in London will bring about substantially improved results.
As one would expect, our overall reinsurance business faced challenges with the extraordinary level of industrywide catastrophic events. Our relative performance was excellent, and while our results were in line with our expectations for such events, in an absolute sense they were certainly disappointing. The reinsurance business, by its very nature, is more volatile than the primary insurance business, and we would expect it to generate better than average returns. However, we along with the rest of the market, have not been so rewarded in recent years. As we look forward, it is difficult to understand why reinsurance prices are not going up more substantially. We expect this to self correct over time with increasing prices, especially on property catastrophe business. Casualty business is also expected to be impacted. Accumulated profits in the property business, driven by several years of benign catastrophes prior to 2017, have evaporated and can no longer subsidize this market.
In spite of our strong results, we recognize that change is constant and we have the responsibility to be certain that our Company is always positioned to be competitive. Our business, just like the rest of the financial services industry, is being impacted substantially by technology. Artificial intelligence is having an effect on underwriting across the board, but the least complicated risks will be especially impacted. Expertise has become more important; sorting and organizing data is becoming more and more valuable. Scale of enterprise, and thus the accumulation of data, is in fact, becoming a competitive advantage. It will be difficult for small enterprises to take full advantage of technology that is offered only on a large scale. Technology will not only be important in underwriting decisions and risk selection, but also in data mining and processing. The size of our Company provides us with ample scale to effectively mine and analyze our data, while our structure enables us to utilize it in the most useful way. We continue to invest heavily in these areas, as well as in technology companies that we believe offer products that we, and others in our industry, can use.
Our investment returns were also outstanding in 2017. Our core portfolio delivered growing income with a relatively stable yield and a shortened duration. Our alternative investments provided both higher returns and significant realized investment gains. When interest rates began to decline several years ago, we had to search for other ways to get adequate risk-adjusted returns in our overall investment portfolio. Fixed-income securities and cash still represent nearly 80% of our investment portfolio. We have maintained an average duration approximately one year shorter than the duration of our liabilities to minimize the exposure to inflation and to take advantage of the concomitant future increase in interest rates. The risk-adjusted returns in areas such as real estate and private equity investments represented the chance for irregular but higher rates of return. We decided that this was the course for us to take, even though, unfortunately, the gains on some of the most attractive alternatives were not valued equally by security analysts. Modifying our investment strategy to include private equity as well as real estate has generated returns well above those available in fixed-income securities or in the stock market in general.
We continue on this course and today approximately 8% of our investments are held in a real estate portfolio that has delivered returns more than double those available from our fixed-income securities. At the same time, a real estate portfolio gives us some level of protection from the risks of inflation, which we find quite attractive given the kinds of inflation risks embedded in our liabilities. Our investments in private equities, with low to no leverage, represent businesses that, in our view, have opportunities to expand or are in industries that are poised for consolidation. As a result, we have generated substantial returns in this area and we expect that as long as we focus on that which we understand better than our competitors, we will be able to continue delivering these outstanding returns. We also have invested in a number of private partnerships that have delivered better than average returns, allowing us to diversify our risk and bring our portfolio into other attractive segments of the market.
This year was also important because two major issues occurred on a macro basis. After an eleven-year effort, the playing field was leveled under the U.S. Tax Code for American insurance groups and offshore competition on U.S. generated business. With the support of most of the domestic insurance industry, we were successful in persuading Federal lawmakers to eliminate an unfair advantage in the Tax Code. Previously, offshore groups were afforded special benefits in writing business through a U.S. subsidiary and moving it to a taxadvantaged locale through an accounting transaction. We thank everyone who joined with us, along with Federal representatives and policymakers, for facilitating this equitable change. In addition, we were fortunate that a substantial change in the federal corporate tax rate reduced our statutory rate from 35% to 21%.
W. R. Berkley Corporation continues to focus on optimizing risk-adjusted returns. We believe we can accomplish this by focusing on meeting our customers’ needs and serving them effectively through the appropriate distribution channel. Together, we can be sure the ultimate customer is focused on why they buy insurance — the appropriate and fair settlement of a claim — as the foremost concern. We are optimistic about 2018 and beyond as we anticipate improving returns from both rising insurance prices and increased interest rates. At the same time, the recently enacted corporate tax reform has created improving prospects for a strengthening economy. Our Company is well positioned to benefit from these changes in the environment.
W. R. Berkley Corporation could not succeed without our nearly 8,000 committed employees and thousands of brokers and agents who work diligently on our behalf. Our enterprise thrives because of the thoughtful advice of our Board and the many committed people who help make everything work to deliver on our promise to our customers, employees and shareholders. Everyone must win or we all lose. Thank you all.
William R. Berkley, Executive Chairman
W. Robert Berkley, Jr., President and Chief Executive Officer