QBE vs IAG: where the upside and risks are

Tuesday, October 10th, 2017

2017 is set to be the worst year on record for insured catastrophe losses. With some three months to go, 2017 insured losses of around US$150 billion are set to exceed the $120 billion of 2005 and $134 billion in 2011. Hurricanes Harvey, Irma, Maria and the Mexican earthquakes will add around $128 billion to $22 billion of losses from the June half.

What does this mean for QBE Insurance Group, the ASX’s only global insurer? The company has increased its own allowance for 2017 large individual risk and catastrophe claims to $1.75 billion, forecast a $600 million detraction from 2017 pretax earnings and downgraded its 2017 combined ratio guidance from 94.5-96.0 per cent to 100-102 per cent (a ratio above 100 per cent means an underwriting loss). This will mean QBE cannot fund an unchanged final dividend of 33 cents and investors should expect something more like 12 cents.

QBE is now the worst-performing ASX 200 non-bank financial stock of the financial year to date after the earlier 21 June downgrade to earnings guidance due to inadequate risk management in certain emerging markets. This makes the stock interesting, as underperforming large-cap stocks tend to revert higher given the pressure on boards and management to restore positive returns. Underperformance by a large company is never tolerated for long and backing ASX large company turnarounds is a consistently reliable investment strategy.

At the time of writing, 6 October, the stock was trading marginally above levels before the hurricanes and earthquakes downgrade on 3 October. This correctly reflects the suddenly better outlook for QBE’s 2019 earnings since the hurricanes and earthquakes. The low returns world of recent years has encouraged the inflow of globally mobile capital to markets with low barriers to entry, like commercial property catastrophe insurance. Bond yields and borrowing costs have been so low that expectations of returns on this capital have been only mid-single digit in some markets like the US. The destruction of some US$150 billion of insurance industry capital this year, due to the hurricane and earthquake losses, and the need for insurers to rebuild earnings and returns mean premiums and returns on capital will rise for the few insurers with 2018 reinsurance costs mostly already locked in – like QBE. A 10 per cent increase in property insurance rates in North America and non-Asian emerging markets would boost QBE’s 2019 earnings by around eight per cent. Meanwhile QBE is leveraged to higher US bond yields and a lower Australian dollar, both of which we expect.

The optimism in QBE’s share price above $10 could however be premature. Investors should expect new CEO Pat Regan, who starts on 1 January, to top up 2018 provisions and announce the board has slashed the 2017 final dividend and paused or deferred the current $1 billion buyback. This is negative newsflow and it should coincide with an opportunity in QBE shares but given the bullish revenue outlook we do not expect the stock to fall to the November 2016 low of $9.23. The landing point will be closer to $10.

Insurance Australia Group, focused mainly on Australia and New Zealand and not exposed to the hurricanes and earthquakes, has had a different journey this year. The stock is only down some eight per cent from its year-high of $7.01. Unexpectedly high commercial claims meant the second-half result missed market expectations and consensus earnings forecasts have rebased lower. The result depended heavily on provision writebacks way above trend, so the underlying insurance margin was soft. This also means the 2018 margin guidance is not conservative, as it factors in either more above-trend provision releases or substantial underlying margin expansion.

But we like the longer-term margin expansion potential now the various Australian brands have been aggregated into one Australian division. There is also potential to reduce costs further by simplifying processes and systems. Work is advanced to reduce 32 policy and claim systems to two, IAG has begun to rationalise its product range from 1,500 to ~400 and its insurance licences have been consolidated from nine to two. The momentum on costs increases our confidence IAG can achieve its commitment to reduce gross operating costs by at least 10 per cent or $250 million pretax by the end of 2019.

The 20 cent final dividend surprised on the upside and signals IAG’s confidence in its strong capital position, which is at the upper end of or above its targets and can easily fund volume growth. Additional capital will be released from the business in coming years and by 2020 IAG could have over $600 million of excess equity. This equates to over 25 cents of returnable capital.

Also IAG management expressed interest in doing more ‘quota share’ reinsurance deals like the 2015 deal with Berkshire Hathaway, where Berkshire receives a fifth of IAG’s premium revenue and pays a fifth of its claims. We like this idea because while earnings might diminish as IAG becomes more of a distributor than an underwriter, this should be more than offset by a price-earnings multiple rerate to reflect lower earnings volatility. We think IAG is worth $6.50 per share and interesting below $6.20.

 

Originally published in The Australian on Tuesday, 10th October 2017.

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