Better times ahead for listed insurers?
After an extended run of disappointing performance from Australia’s largest non-life insurers, there have more recently been some positive signs. Over the past 12 months IAG’s share price has increased to around $5 from around $3 and, more recently, the QBE share price has risen from around $10 to over $12, partly on the back of press reports that cost reduction initiatives are planned. In light of these developments, it may be appropriate to consider whether these businesses face a brighter future.
Insurance is considered by some analysts to have a profit cycle driven by pricing. Under this model, the industry can enjoy strong profits for a period of time before competition gets the better of it, and prices are driven to unsustainably low levels. After a time, the industry is forced to adjust prices upwards to properly reflect risk, and profitability is restored.
On a superficial analysis, this model seems to fit the facts of the last 10 years. If we look at return on equity for IAG and QBE, it does appear to have followed a cyclical path, peaking in 2005 for IAG, and 2007 for QBE, before apparently bottoming out around 4 years later. IAG reached the bottom earlier, and has now enjoyed several years of increasing ROE, and this is reflected in its more recent share price performance. However, it should also be noted that IAG CEO Mike Wilkins joined in 2008, and its performance improvement in recent years may owe something to his involvement.
The pricing cycle theory for insurers has some intuitive appeal, however, there are other factors that have a significant impact to profitability. One of these is the investment returns insurers can earn on their capital. By way of background, when an insurer receives up-front premium income from its customers, it has the ability to invest that money for the benefit of its shareholders. The shareholders aren’t immediately entitled to the capital itself, as it may be needed to pay claims made by the customers, but until the claims outcome is known, shareholders get the benefit of income earned on that capital.
Recently, investment returns have been poor. Regulatory requirements mean that the money must be allocated largely to low-risk, interest-bearing investments, and interest rates currently are low. Over time, interest rates should return to more “normal” levels which will boost investment returns. On this front, I should also note that a quick look at QBE’s balance sheet shows investments to be dominated by short term and floating rate investments, which means that QBE will benefit relatively quickly from any recovery in rates. IAG’s balance sheet is less transparent, and it not clear to me how much of the investment portfolio may be in longer-tem, fixed rate securities, which could delay the benefits to shareholders.
Another driver of profitability is the occurrence of severe, adverse weather-related events, including floods, fires and storms. Clearly these are bad news for insurers and, as I understand it, the actuaries that analyse risk for the insurers are becoming convinced that the frequency of these events has increased over time. Precisely why this is happening and what it means for the future is beyond the scope of this discussion, but the implications for a risk-averse value investor are clear enough: the price rises needed to ensure profitability for insurance companies will be larger than they might otherwise be.
A final factor to touch on is the impact of the internet. If the “price cycle” view of the insurance industry is correct, then it follows that brands have some power, but consumers will also switch brands in response to a better offer. To the extent that price drives consumer decisions, it seems that the internet adds materially to the challenges faced by the large insurers. Firstly, there are the new entrants with an online business model and potentially lower cost structures than the incumbents, and secondly there are the comparison sites which inform consumers as to where their best options may lie. Over time, these influences seem likely to significantly constrain the pricing power of the larger insurers.
Taken together, these factors paint a somewhat mixed picture. The recent experience of poor investment returns should improve over time, but there may be longer-term structural challenges in relation to pricing. To my mind, the investment case at the moment is less than compelling. Market prices for IAG and QBE look to be broadly consistent with their estimated intrinsic values, but the issues identified above argue the need for a material discount to intrinsic value. For now, we will watch with interest from the sidelines.
Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Charlie Dalziell
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My issue with insurers is that for decades insurance margins were 4-8% while now the new “normal” is 11-15% margins. Back in the 90s, QBE ran an underwriting loss of 5% of net earned premium and you always felt comfortable that reserving was very conservative. These days underwriting profits are expected by the market and budgeted for by companies. The entire sector is much more profitable than it was for decades prior to 2005. How can you be sure companies are reserving properly and how long can companies keep earning such high returns on equity in an industry with very low barriers to entry?
Take a closer look at QBE’s balance sheet and you may wonder why they have $4bn in debt. Why does a business with huge operational leverage need debt? Also take out the “intangibles” on the balance sheet and you will see that NTA to total tangible assets is a ratio of 1:20. Australian banks are considered to be highly leveraged at 1:10. QBE is the most leveraged company in the entire ASX, and this is a company that is selling insurance globally covering things like natural disasters!