Monday, 17 August 2015

Australia's Largest Insurers: IAG and QBE

The insurance sector is usually characterised as a defensive sector with large margins and low claims, preferred by investors for its stable dividends. Currently it faces increased pressure to reduce premium pricing given increased money supply.

QBE Insurance Group (QBE), a global insurance provider, has been a target of aggressive overseas acquisitions during the 2008 GFC, many of which have performed below expectations. However its Australian and New Zealand operations, which comprise of 28% of the business, are demonstrating consistent strong performance with the depreciating dollar boosting North American and European operations.

Insurance Australia Group (IAG), because it is a domestic insurance firm, has had relatively larger exposure to the natural disasters Australia experienced this year such as tropical cyclones and NSW and Brisbane hailstorms. It does boast catalysts for positive growth nonetheless with its recent acquisition of Wesfarmer’s WFI and Lumley insurance underwriting in 2014, and a strategic relationship with Warren Buffett’s Berkshire Hathaway. These two insurance giants have quite different company profiles and financial health, management style and outlooks which make them worthy of comparison.

Financial risk
Both QBE and IAG are exposed to financial risk, though due to the strong presence of APRA over the insurance sector, such risk should be manageable. IAG had a regulatory capital position of 1.6 times the prescribed capital amount (PCA) at the start of this year, which is weaker than last year. Nevertheless after its strategic relationship with Berkshire Hathaway, this is forecast to improve to 2 times. 

QBE at the start of this year had a regulatory capital position of 1.7 times the PCA, and this has been consistent with historical figures. QBE also has a short duration, fixed interest portfolio that can benefit from the Fed rate hike. Financial health therefore is strong for both companies with excess capital for regulatory requirements.

Increased natural disaster costs and subdued equity markets during the half year ending December 2014 caused IAG’s margins to reduce to 6.6 percent. Their rise in gross written premium (the premium before reinsurance costs) was largely driven by the addition of the Wesfarmers underwriting business, rather than organic growth, and therefore their performance was flat compared to previous years yet results were solid after taking into consideration the difficult domestic conditions. Over 2015 and 2016 combined pretax synergies are expected to cumulate to an annual $230 million. 

QBE’s gross written premium on the other hand fell 9 percent as a result of poorer North American business performance. Nonetheless recent results have demonstrated a stronger group insurance margin due to favourable currency movements. The depreciation of the Australian dollar offset the weak earnings from North America and Europe for QBE while IAG faced challenges with Australia’s increased natural disaster claims over this period.

IAG’s growth in gross written premium is expected to be driven by the expected contributions from Wesfarmers underwriting integration and in line with their half year result, at 19.5% revenue growth and 20.84% ROE. Under IAG and Berkshire's 10 year quota share arrangement, IAG reduces its capital requirements by $700 million, and gains $500 million from Berkshire Hathaway to use for further expansion. This strategic relationship can also provide greater capital flexibility, acting as a catalyst for IAG to expand overseas particularly to pursue growth opportunities in Asia and strengthen its domestic presence in the medium to long term. 

Conversely QBE is expecting a 3-5 percent decline in gross written premium, though offset by improvements in its insurance margins to 9 percent. These improvements stem from the transformation of its senior management team, improvements in the US market and further weakening of the Australian dollar amongst investor sentiment for a US Fed Rate hike. European conditions remain weak though its challenges faced by the North American operations should be resolved by its early June actions – the sale of its Mortgage and Lender Services business, which is expected to free up in excess of $100 million capital that will be reinvested elsewhere. This does reduce its gross written premiums by $400 million though should improve their North American operations budgeted 2016 combined operating ratio by 1.5 percent and return on allocated capital by 1.8 percent. The $120 million after tax net loss for the fiscal year 2015 given recent underperformance in this overseas region can be argued to be due to one off, non cash costs and write offs from the divestment, and the transaction should be viewed as a positive for the future.

Share Value
IAG and QBE trade at 14.4 and 16.4 price earnings ratios respectively, with the industry average at 15.7. For IAG, earnings per share should fall for fiscal 2015 due to the Wesfarmers acquisition and Berkshire Hathaway relationship. Nonetheless for investors interested in dividend potential, IAG should be their preference as over the past two years IAG has paid a fully franked dividend yield of 6.5 percent. This is a dividend payout ratio of 50-70 percent of cash revenue.

IAG’s share price history could suggest its short term underperformance is attributed to temporary issues.
1 year   -2.23%
3 year   +65.7%
5 year   +64.74%

Meanwhile QBE provides a fully franked dividend yield of 2-3.5 percent, with a target dividend payout ratio of 50 percent of cash earnings. Their earnings should also improve from the weaker Australian dollar, though their dividend yields are still below the market’s gross dividend yield of 4 percent. Management's recent decision to review QBE’s dividend policy in response to its strong capital position indicates potentially higher dividends.

QBE’s share price history could suggest it is improving from its previous issues – though this could be due to external factors such as a favourable exchange rate.
1 year   +24.13%
3 year   +6.65%

5 year   -27.03%

Australian Financial Review, Business Insider, Sydney Morning Herald, Morningstar

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