Wednesday, October 3rd, 2018
Every time there is a natural disaster, investors ask what it means for insurance stocks, so QBE Insurance Group is topical after the damage last month to the US states of North and South Carolina from Hurricane Florence, the first major hurricane of the 2018 Atlantic hurricane season. Florence came during the current turnaround led by CEO Pat Regan, where we can also update readers.
We are positive on QBE, expect consensus earnings upgrades and value the stock at $12.60. QBE is well-positioned halfway through its second half, seasonally the worst half for catastrophe claims, because the first half was benign. This means QBE has close to the full US$900 million of its aggregate reinsurance program available to absorb losses. Applying the group’s market shares to the potential loss ranges, its net claims bill for Florence looks like US$50-$100m, leaving plenty of room for further claims from hurricanes and smaller events. So at this stage it does not look like QBE will have to downgrade its earnings guidance due to catastrophe claims.
There are several other reasons to expect significant shareholder value creation from QBE. First, the global insurance pricing cycle is trending very favourably. QBE’s average premium rate increases accelerated to 4.6 per cent in the first half with the second quarter faster at 5.1 per cent. By region, QBE raised premiums by 3.1 per cent year-on-year in North America, 4.8 per cent in Europe, 6.6 per cent in Australia and New Zealand and 0.3 per cent in the Asia-Pacific. This upturn has further to go given peers are also raising rates in all major markets.
Second, there is substantial upside from QBE’s portfolio remediation program, which should impart earnings momentum. Asia and the US are not hitting targets and about a third of QBE’s portfolio ex-Asia is losing money. To reduce the losses, QBE has divided its business into 100 ‘cells’ globally and done over 300 reviews of its first half underwriting performance. The enhanced focus, accountability and transparency should drive better decisions on customer mix, claims actions, and rate increases. QBE trialled its approach, which it calls Brilliant Basics, in Australia and sliced attritional claims (smaller ongoing claims not from catastrophes) by around 500 basis points. We look for similar outcomes in the firm’s other regions. Reducing the share of lossmaking businesses to more like 10 per cent and achieving no worse than underwriting breakeven in Asia could drive mid-teens earnings growth in 2019 – a welcome boost in an industry which grows at low single-digit rates.
An attractive feature of QBE’s remediation focus is the absence of targets for revenue growth. This does not mean QBE is ex-growth; instead it means margins and return on equity are higher priorities than growing the group by taking on under-priced risks as QBE did in its earlier wave of ~100 acquisitions. In our view insurers should avoid unprofitable business all the time but in QBE’s case it’s better late than ever. QBE must raise its sustainable return on equity into the low teens if it is to justify its existence to shareholders.
QBE’s buyback of its undervalued shares should assist here. The firm reiterated its commitment to A$1 billion of capital management over the next three years and we note the capital position currently appears strong.
Value investors should identify catalysts they expect to push share prices to their valuations. The upcoming catalyst for QBE is its market update, due in the December quarter, with details of the next operating cost reduction program. This makes sense given the firm is walking away from unprofitable volumes. Given management’s early progress elsewhere, we expect investors will ascribe a solid probability of success here too with the result consensus earnings forecasts adjust higher.
QBE also remains attractive for its exposure to rising US interest rates. Last week the US Federal Reserve guided to a terminal Funds Rate of ~3.4 per cent for this tightening cycle, which is also probably where the 10-year Treasury yield will peak. This compares with 3.07 per cent at the time of writing. Higher US yields increase QBE’s interest income and reduce the discounted value of future claims.