QBE vs IAG: has the storm passed?

Financial journalist
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Are QBE and IAG disaster-free SMSF investments? It is easy to make the argument that insurance is not a good business in which to invest, being by definition exposed to risk. And risk is not a nice word to self-managed super fund (SMSF) investors.

Certainly the insurance sector copped a battering in 2011, pounded by events such as the January floods in Queensland, followed closely by Cyclone Yasi, the Christchurch earthquake in New Zealand and the triple-whammy of earthquake, tsunami and radiation leak that hit Japan.

And those were just the catastrophes most prominent in our region. Globally, according to reinsurance giant Swiss Re, 2011 was the insurance industry’s second-worst year on record, generating about US$116 billion in claims for the industry.

Stormy weather for QBE

A look at Australia’s leading insurance stock, QBE Insurance (QBE), tells you all you need to know, with net profit down 45% in 2011 (the company uses the calendar year as its financial year), due to what the company said was a “record level of catastrophes”. The dividend was cut by almost half, “to preserve capital,” matching the halving in the share price between January 2010 and now.

Then, in the half-year ended June 2012, QBE lifted its net profit by 13% – which fell short of expectations – and reported an interim dividend that was down by 35% on the first half of 2011. But what really grabbed the market’s attention was the insurer missing its forecast insurance profit margin of 14% and issuing its third downgrade this year for the outlook of the insurance margin, from 13% to 12%.

(The insurance margin is the critical driver of an insurance company’s profit: it measures the company’s profit – which comes both from underwriting profit and the investment income earned on claims reserves – as a proportion of its net earned premium.) When that news was dropped on the sharemarket, QBE shares plunged by 11%.

And then came Tropical Storm Sandy, which devastated the east coast of the United States and put QBE’s share price under pressure given that about 36% of its income comes from the US. One broking firm said claims caused by Sandy could be enough to force QBE into a capital raising of up to US$750 million to shore up its reserves. There will certainly be claims on QBE – brokers estimate up to US$250 million, which would represent about 3% of second-half premium income.

While that is easily manageable considering QBE’s US$28 billion in invested reserves, if claims come in any higher than that, the insurance margin of 12% starts to come under pressure. In that case, profit and dividends come under pressure, too.

Checking on QBE’s exposure whenever there is a natural disaster anywhere in the world is an occupational hazard for the insurer’s shareholders. Their company is a global insurer and re-insurer, doing business in 52 countries spread throughout Australia, Asia-Pacific, the Americas, and Europe.

QBE is a great Australian business success story, but the stock has had a couple of tough years – the share price has fallen from $25 in January 2010 to levels around $13.

IAG on the rise

That is not common to all insurance stocks: for example, Australia’s largest domestic general insurance business, IAG – the former NRMA – has moved from $4 in January 2010 to $4.60 (despite a visit to $3, in January 2012.) IAG also operates in New Zealand, the United Kingdom, and Asia under a portfolio of brands including NRMA Insurance, CGU, SGIO, Swann and Buzz Insurance; NZI and State (NZ); Equity Red Star (UK); and Safety and NZI (Thailand).

IAG has worked its way back impressively from a disastrous 2007/08 financial year, during which it lost credibility through four profit downgrades. These were driven by a combination of increasing claim costs due to severe weather, underperforming UK acquisitions, and the company’s decision to reject an $8.7 billion offer by its rival QBE without consulting investors – which claimed the scalp of CEO Michael Hawker and six members of the executive team.

Under current CEO Michael Wilkins, IAG has diversified into Asia, a strategy that is paying off and helping to lift its share of gross written premiums in the high-growth region – although the Asian operations are not yet profitable. Its other two main strategies involve boosting profitable growth in its home markets of Australia and New Zealand, and improving the performance of its operations in Britain.

In the 2012 financial year, IAG increased its cash earnings by 17.5%, to $583 million on the back of an 11.7% rise in gross written premium (GWP) to $8.99 billion. The dividend was increased by one cent to 17 cents.

Comparing the outlooks

When assessing the earnings outlook for insurance stocks, there are four main considerations: (i) premium revenue; (ii) the insurance margin; (iii) investment earnings on shareholders’ funds; and (iv) the combined operating ratio (COR), which shows the percentage of premiums received that are paid out in claims and expenses.

On the first point, premium rates are under pressure around the world because the insurance industry has put aside much more in capital against claims than it had a decade ago – in other words, it is in much stronger shape.

QBE expects to achieve “low single-digit” growth in gross and net premium for FY12, after 3% growth in 2011. IAG expects gross written premium growth of 9–11% in FY12, down from 11.7% in FY11.

IAG lifted its insurance margin significantly in FY12 to 10.6%, up from 8% in FY11. In October, IAG said it was on track to deliver its full-year guidance of an improved insurance margin of 11–13%.

QBE said in October it was on track to meet its previous guidance of reporting an insurance profit margin that was above 12%. However, it has yet to update this guidance in the wake of Tropical Storm Sandy.

As for investment earnings on shareholders’ funds, both companies have done well, but lower interest rates around the world make it increasingly harder to earn decent returns. QBE’s first-half report said it earned a net yield on its portfolio – which is 98% invested in cash and fixed-interest – of 4.8%, compared with 3.7% in the first half of FY11. In its full-year report, IAG said it earned “more than 100 basis points (1%) above the risk-free rate.”

On the COR front – where a ratio below 100% means the insurer made an underwriting profit, while a result above 100% means an underwriting loss – QBE has been one of the industry’s standout performers for some time. At the June half-year, QBE’s COR was 92.9%, down from 95.7% in the first half of 2011. The company’s guidance for FY12 is for a COR of “less than 90%.”

Meanwhile, IAG reported a COR for FY12 of 101.2%. But that’s OK because as a mainly commercial specialty insurer, QBE’s profit margin should be higher than that of IAG.

Dividends and franking

Complicating the situation is the fact that the pair is far from being dividend superstars.

In FY12, market consensus expects QBE to pay 82.5 cents a share, followed by 87.1 cents a share in FY13. At $12.94, that places QBE on a prospective nominal yield of 6.38% for FY12 and 6.73% in FY13.

Sounds promising – but unfortunately, QBE has been too much of a global success story to make that yield work for SMSF investors. QBE does not earn enough Australian-sourced profit to offer full franking. At present, 15% franking is as good as it can do.

On 15% franking, to an SMSF in accumulation mode that FY12 yield becomes 5.75%; the FY13 yield comes down to 6.08%. To a nil-tax-rate SMSF in pension mode, the yields are 6.78% for FY12 and 7.16% in FY13.

IAG yields less, nominally – but because it does pay a fully franked dividend, that situation improves a bit. In FY12, market consensus expects IAG to pay 22 cents a share, followed by 24.7 cents a share in FY13. At $4.68, IAG is priced on a nominal yield of 4.70% in FY12 and 5.28% in FY13.

Full franking credit rebates lift this, for a SMSF in accumulation mode, to about 5.7% in FY12, and 6.43% in FY13. To a fund in pension mode, IAG is priced at about 6.7% in FY12 and about 7.5% in FY13.

That is more like what an SMSF expects – but until they are paid, these dividend projections are merely opinions, as QBE shareholders can attest being still burned by the 2011 payout cut. The salient point for SMSF investors is that premium rates in the insurance business are cyclical and claims are literally unpredictable. All the reinsurance protection and capital management skills in the world can’t get around that.

The bottom line

The quandary for SMSF investors is that while IAG is projected to yield more in FY13, QBE is generally considered a higher-quality earnings flow. It might be more realistic to conclude that on present settings, neither of these stocks suit SMSFs.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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