We are really pleased to have W. R. Berkley with us. Berkley has been presenting at our conference for years, I think just about every year. At the company, after 49 years, there is a new CEO leading the company this year. October of last year, Rob Berkley was appointed CEO of the company. He had been serving as President and COO before that, for six years before that. Other than working for a pretty small boutique investment bank called Merrill Lynch years ago, Rob has spent his entire career at W. R. Berkley. Rob has presented many times at our conference, we are really pleased to welcome you this year as the CEO of the company. The guy in the end, oh, I'm sorry. That's the Chairman, Bill Berkley.
Bill, as you know, has been here for many years presenting, we're happy to have Bill here as well. Rob, I think I might start with maybe a bigger picture question, give you a chance to sort of talk a little bit about the company, I'll phrase it this way. If I asked you about the company's three strategic priorities for 2016, how would you list them?
Well, first of all, when we think about our business, we always start from the perspective of risk and return and making sure that we continue to focus on that. As the market continues to change, we not lose sight of that. That has to be a priority 1 as to how we select and price risk. Certainly, in addition to that, we are conscious of a fair amount of disruption that's going on in the marketplace right now, we're investing a fair amount of time trying to think about how we capitalize on that opportunity. One would be opportunities stemming from some of the M&A activity that's been going on over the past several quarters.
Two, certainly there are several very large market participants that are going through a moment where they are reflecting on their strategies and trying to assess what the business will be going forward. Thirdly, we certainly are spending a good deal of time, and our Chairman will be talking about it, I suspect, a little bit later, trying to think about how we want to position the investment portfolio going forward, how we think about interest rates, how we think about inflation.
Got it. As we look at 2016 relative to 2015, for your company, last year was relatively light from a cat standpoint. Pricing pressure is arguably getting tougher. Interest rates obviously still low. Investment environment in general is tough. Yet on the conference call, you seem to suggest you think you can and will improve the ROE. Can you talk about the offsets to those pressures that I listed and how you are able to do that in 2016?
First off, one needs to recognize how the timing, if you will, of how earned premium comes through. We have a fair amount of visibility as to the rate that is going to be coming through with the earned premium that will be coming through in this year. In addition to that, we're no different than many companies. We've identified parts of our portfolio where we felt as though there is opportunity for improvement. Commercial auto would be an example, and that's been something that we've been working on for some period of time now. As a result of that, we think many of the opportunities to improve have been capitalized on, and that is going to begin to gradually come through in our results. Certainly part of our international operation, particularly in Europe, we've had some challenges there as well.
Again, not dissimilar to the comment about Commercial auto, it's something that we've been working on, and we feel as though that we are well on our way to a better place. We perhaps take a slightly different approach than some of our peers. Our view is we want to find problems and issues in a very timely way, and we do not want to hide from them or pretend they don't exist. We'd rather deal with them head on, acknowledge the issue, address it, and be in a position to move forward. Much of the comment about the opportunity for improvement in 2016 has to do with some of the issues that we've been grappling with, and we think, again, we are in a better position, and some of those issues are behind us.
In addition to that, again, as far as the investment portfolio goes, I think there may be a comment made perhaps by our chairman a little bit later about how we see some gains coming through in the alternative portfolio.
On the earned premium aspect, which you mentioned, you do have visibility into that. If you think about 2015, price increases had slowed essentially to a halt by the second half of the year. It feels as if the earned premium in 2015 that you know about could be under some pressure anyway because the pricing had been coming down. Is this more of a business mix issue to some extent?
I think to a certain extent, it's a business mix issue. I think also to a certain extent, it's how we're seeing some of the prior years develop out and what that means for our loss picks going forward and how we see some of the more recent years potentially developing out. One of the questions that we have received from you and others over time when we were getting significant rate increase in the past several years, why was that not having a more direct impact on the loss ratio that you were using? The answer was, we had a fair amount of uncertainty or concern around what inflation might do, and we concluded that it was better to take a measured approach. In addition to that, just one could make a similar comment about trend overall if you include frequency.
As we see those trends proving to be a bit more benign, it would suggest that perhaps we will, over time, see more margin in the business.
The other thing you guys have talked about, and you mentioned it here, was some of the opportunities you see, whether it's hire people, M&A, pick up business. Do you hesitate a little bit to form startups or to invest in people when the pricing environment is getting more challenging?
We are certainly conscious of that. We're conscious of the environment. Obviously when we start a new operation, whether it be a standalone business within our group or a division of an existing operation, we want to make sure that we have an understanding that the business will be able to get to some level of profitability and have a viable economic model over some period of time. Is it something that's factored in? Absolutely. Having said that, we take a long-term view. We are not an organization that is driven solely by quarterly earnings. We are interested in trying to build franchise value for the long run.
To the extent that there is a unique opportunity in the marketplace as a result of people and the skills that they have to help us move our organization forward, we are not going to be shy to invest in a thoughtful way.
Let's shift to the investment portfolio. A couple of times I've heard people, just this morning, someone said, "It's a tough credit environment, but this is not 2008, 2009." Yet you look at some of the European banks and they're trading below crisis levels. Maybe this is a question for Bill, Rob, you can chime in as well. How concerned are you about the current environment given some of these stock price movements of banks in Europe and the U.S.?
Well, I think, first of all, you have to understand that European banks have multiple levels of problem. The survivability of the EU and how and what happens, what are they going to do when they have across EU loans if something happens there, as well as a far less robust economy. There's just no question the EU banks have far greater problems than most U.S. banks have. I don't think you have people feeling tied to that banking system, which is how things used to be.
In the U.S., we have a much better economy. We have one negative being an election that is unlike one we've seen in a long time, which causes. Certainly far better than Europe and most of the rest of the world. I think that, yes, we're not getting great yields in the month of January. The five-year treasury is 50 basis points lower. It's hard to get good returns without taking greater risks, and the greater risk part of the bond portfolio, for those who have invested there, which we do not do, has suffered. You have to find places that offer opportunities. For us, it's places that don't give you liquidity, but give you high quality. We'll do a deep in the money, short-term mezzanine loan that's 50% loan to value and has 17 months to go and get a 2.5% yield, 3% yield.
There are opportunities. You just have to search harder for them. You have to take advantage of the strengths that we have compared to a lot of other investors, which is we have lots of liquidity, we have constantly increasing liquidity, and we have to search out things to do.
Can you talk about some of the alternative investments or the non-fixed income investments in the portfolio, how you see them evolving over the next several years as far as potential gains could go?
Well, we own a very large piece of HealthEquity, slightly more than 20%. While the stock is down substantially, the company's doing great as far as we can tell, as far as we understand. We're not insiders. We're not there, but everything we know, which is just what the public knows, this is a great business, and health savings plans is something we recognized was the future of the health insurance business a long time ago. We think it's a great business. Right now, we have $several hundred million at today's market value of unrealized gains, and we have a number of other businesses that have several hundred million of gains in the portfolio, in our aviation business, in a number of places. In addition, we're a substantial real estate owner. We own buildings in New York that we're developing.
We own buildings in Washington, and we're building a building in London. In addition-
It's not a small building, by the way. I was there recently. I saw the sign there.
No.
It's pretty significant.
No. It's as good a location as you can get. We expect that there'll be substantial gains, and we may well take partners in all of these things. In fact, in some of them, we may sell the buildings. We have sold other buildings before. We have told people we would expect generally $100 million or more of gains a year, but you do have more variability when you shift a portfolio to realize gains from investment income. We still think our goal is to optimize the risk-adjusted returns. We look at it that we need to get a better return when we take that volatility and uncertainty of timing, but as long as we're confident about the return, and it's substantially higher than what we can get in fixed income, it's still attractive. We'll continue to do that instead at a reasonable level.
Got it. I'm going to shift to a business that doesn't get a lot of attention, that's the reinsurance business. I went back and looked, the underwriting results there really have not been nearly as good as the rest of your business. You're right around a break-even, maybe a slight profit. What is the strategic rationale for remaining in that business?
The reinsurance business at this stage, or the industry overall, is clearly going through a challenging moment. I think that's pretty evident to many or all. The relationship between capital and expertise has evolved, many of the challenges that the reinsurance marketplace is facing seems to be somewhat masked by a benign cat period as well as historic positive development coming through. It is our view that the reinsurance industry is not going to go away in totality. We think ultimately there is an opportunity to bring expertise to bear to a part of the ceding community that actually will value that. We are focusing more and more on cedings that will not just view us as an opportunity to arbitrage our capacity, but an opportunity to tap our intellectual capital.
I think the business for us has shrunk quite a bit, it's certainly possible it will shrink over time. To the extent that you see it grow, it will be because we are growing in certain niche areas based on product or geography, again, where we're able to differentiate ourselves. The returns are clearly, when you look at the overall dilutive. Having said that, we don't believe that at this stage that it's a business that doesn't have a future. Quite to the contrary, we think with our approach, there is an opportunity to build a business that can generate reasonable returns. I think one thing that's important to keep in mind is that all returns are not created equally, one needs to take into account the type of risk or volatility in some cases that come along with those returns.
When you look at our reinsurance business, we do not have anything approaching the volatility that many of our peers have. It's certainly something that we spend a good deal of time focused on, quite frankly, it's a part of the business that we are committed to, we are committed to in what we believe over time will be a worthwhile use of capital.
On the international business, you acknowledge results there have not been as good as you would like, and you're taking actions to improve them. Can you talk about what the actual problem has been? Why have the results lagged your expectations?
I think fundamentally, it was a people issue. Our view is that an insurance business, when you distill it down to its fundamentals, it's a pile of capital, if you will, and it's people and their expertise and their knowledge. In a couple of pieces of our international business, we made a mistake, a misassessment about a few people, and we've addressed those issues, and we have a great deal of confidence in the team that we have today. Again, to the point earlier, we think we're well on our way to a better place. That takes time.
Yeah. Another topic that we've talked about with you guys for some time is the tax rate. Robert, Bill, if you want to chime in on this, but you've talked about a desire to lower the tax rate. I guess the only way really that you could see it being done is some sort of inversion. That may be a bad word, but that's the kind of transaction people are thinking about. Question is, one, is that correct? Two, what are the issues? If you said to yourself, "Gee, we want to do an inversion," what's the laundry list of issues you need to think about before you engage in that sort of transaction?
Well, you want to go first?
Why don't you go ahead now?
I think first of all, there are other ways, the bond market doesn't allow it, which is having decreased our share of a portfolio that's represented by municipal bonds, has driven our tax rate up by probably three points because the relative yield on municipal bonds, even adjusting for taxes, is such that owning municipal bonds has not been attractive. That's one way you can, in effect, reflect a modestly lower tax rate. We've been working on the issue of leveling the playing field for many years. There are a number of alternatives that we've approached. We at first thought the government would see the light as every congressman and senator who I talked to said, "Oh yes, this should change for government." This should change has a very long time horizon, however.
Having not seen any change after eight years of lobbying, we've come to the conclusion that we need to take some affirmative action, and we're trying to consider where that is and how that is. I might add that lower interest rates also lower the benefits of that differential of taxes because one of the benefits they get is moving loss reserves offshore, and it's at a discounted rate. As the discount comes down, which obviously it does with the current interest rates, their benefit from that comes down. Then you get into the issue of transfer pricing, and is transfer pricing acceptable the way they do it? That's a whole another issue. Inversions or thinking about would we move offshore, we've always said it's not our first choice, but it's not a choice we'll ever close our minds to, and it's something we'll consider.
At the core of our company is a culture and an attitude, and we wouldn't want to do it in a way that we would threaten that culture.
Moving to the U.S. market, an important line of business for you guys is workers' comp. I know, Rob, you have extensive experience in that line. Last three or four quarters, it has been growing quite a bit. What's been driving that growth?
I think fundamentally, in several of the markets that we participate in, we like the underlying fundamentals. While perhaps rates do not continue to move up, in some places they've plateaued, in some places they're modestly eroding. We like the margin. It's important to make the comment or wave the flag. This is not the case in the workers' comp market across the board. There are parts of the workers' comp market that are a mess. In many of the parts of the market that we participate in, again, we think the opportunity to deploy capital and generate attractive returns is very real. To the extent that we can increase our footprint while the margin is there, that's something that we want to do, and we are finding ways to do that.
Undoubtedly, there will be a moment in time where you start to see that trend reverse, and you will see our business shrink. We are not shy to do that as we have in the past. For example, our monoline comp company in California last time around peaked out at about $250 million, and then we shrank it down to $50 million. When we see the opportunities, we want to maximize it. When it's not there, we will do what we need to do to protect the capital.
Are there any questions from the audience? Just raise your hand. We've got mics floating around the room. The other question I get about the industry is some of these facilities that have emerged in London. You guys do participate in the London market.
We do.
Have you been involved with any of these broker facilities that have come up?
Well, I think the term facility is a pretty broad one. Certainly the ones that over the past couple of years have gotten the headlines where you effectively are giving both your pen from an underwriting perspective as well as a claims perspective, and you pay a very large commission for that. That is not something that we have elected to participate in. Ultimately, from our perspective in the insurance business, our value added is in our selection and pricing of risk, as well as the handling of claims. To the extent that you delegate that, I think it begs the question, where is the value added? Ultimately, going back to a comment earlier, risk and return, a key component of that is controlling the risk.
We think when you delegate the type of authority we were just talking about, it can, in some cases, become much more challenging to control the risk to our level of satisfaction.
I think the other thing about that, Jay, is it tends not to give the best risks the best pricing. I think fundamentally it's one of the things that the industry is going to have to start to address as technology allows people to see what they pay and see where things are. The cost of insurance is something both the underwriters and the brokers are going to need to address with more focus.
Let's think about the cycle broadly. Maybe there isn't a cycle anymore, but one of the theories people have is that the industry has gotten smarter over the years. You don't have the highs and the lows.
It doesn't always feel that way, Jay.
Well, that was my question to you. Are you seeing that as you see behavior among your competitors? You think people have gotten smarter? Bob, you've been around a long time, Bill even longer. You both probably have a perspective on it.
Go ahead. You've been around longer.
I think that historically, the very large companies set targets for volume, and the people in the field went after those targets. I think there's a little less pressure for that, and there are more constraints on pricing. We were in Europe, and it was interesting to hear that certain underwriters on the boxes at Lloyd's had authority to lower prices up to 10%, up to 19%, but after that, they had to refer back. I think the craziness is less. The world is still very competitive, but we don't have giant companies in there doing incredibly dumb things as a general rule. There are still very aggressive companies charging unrealistic prices and hiding those results for an extended period of time. This is a business where if you grow fast enough for an extended period of time, you can hide those bad results for quite a while.
That hasn't changed.
Any thoughts, Rob, on that?
I think clearly the industry in some ways has changed. Yes, we have better data. Yes, we have better analytics. I think perhaps the change is places where there's less room for human emotion to drive the decision and more driven by analytics. I think there tends to oftentimes be more discipline. Having said that, there is a bit of a concentration issue because when the analytics are wrong and a lot of the decisions were made based on analytics or predictive modeling, that leverage can cut both ways. Clearly, we are seeing a greater level of discipline as a result or stemming from analytics.
Having said that, what I would define as SME or more middle-market business, certainly in the specialty space where there is less of a data set and the underwriting and selection process is perhaps less automated, there is still a fair amount of irrational behavior from time to time, which quite frankly works to our benefit in the long run.
Any questions out in the audience? Well, you talk a lot about pricing in the business, there's two sides to a margin. From a claim standpoint, it does appear outside of maybe commercial auto and some other specific areas that the environment has stayed fairly benign. Most companies have had favorable development. Do you see some sort of permanent change in the tort environment that has allowed this to happen?
From my perspective, Jay, I think that clearly it takes time for the courts and their appetite or their temperature to really take hold and be seen in a visible way in the marketplace. I think that ultimately, when the day's all done, much of the industry has benefited from a relatively benign period when it comes to frequency, again, as well as inflation. That has been a pleasant surprise, which has driven a lot of the positive development. I think clearly our general observation is that from an insurer's perspective, directionally, the courts are moving in the wrong direction, and society is moving in somewhat more of a litigious direction.
Again, when we think about our loss costs, presumably when the industry is thinking about their loss costs, certainly one needs to take into account the recent past, but one needs to be very careful not to necessarily assume that that will be the future. We certainly are seeing in some of the claims activity early evidence that would suggest that the behavior of the courts is changing gradually.
Interesting you don't hear that much, something to watch out for. I think the industry has gotten lulled into this very nice sense of security about those trends.
In all likelihood, it will become more visible to the broader audience, in our opinion, perhaps when you get out to later in 2017 and into 2018. Again, it takes time. It takes time for the courts to shift.
It also is impacted by general economic activity. When general economic activity is not very good or certainly not very positive, people have a different view of the world. As the economy does better and as people have jobs, their view of entitlement and all that goes with it gets more serious. You're going to see that becoming more and more the case as our economy does better.
Got it. We are running out of time. We are out of time, actually. Guys, thank you very much for your time and sharing your views today.
Thank you, Jay.