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Is it time to buy QBE?

Is it time to buy QBE?

QBE shares are trading at their lowest price since 2007, and they’re trading at Skaffold’s estimate of Intrinsic Value. They could be a compelling investment if premiums rise, US bonds collapse (interest rates therefore rise) and return on equity improves.

The release yesterday of QBE’s 2011 financial results, along with news of its planned $500 million capital raising ($450 million of which has now been raised from institutional investors), reminded me that there are many investors who may not understand the machinations of an insurance company. With that in mind, I thought some practical help in this regard would benefit those investors trying to make a decision about whether the lowest prices in QBE shares since 2007 represent good value.

Insurance companies can generally be divided up into two main businesses: underwriting, which is the practice of writing and collecting premiums on insurance policies, and paying claims on some of them; and the investment of those premiums – also known as ‘float’ or reserves – for the benefit of the companies’ owners.

It may surprise you to know the insurance business is relatively easy to understand, if you think about it from your own perspective. You pay an insurance company money to cover you for the risk of something undesirable befalling you. The amount of money you pay to the insurance company is the premium. Thousands of customers do exactly the same thing but not all of them will make a claim on their insurance policy. So the company attempts to make a profit from collecting and aggregating the premiums, paying commissions and expenses to the staff and resellers who market the insurance policies and then paying some portion of those premiums back out in claims.

At any period in time, there are insurance policies just written, insurance policies about to mature and insurance policies anywhere in between – and some of them will receive claims against them. At any point in time there is a pool of money that can be invested. These represent the unclaimed premiums on policies that are yet to mature. The income or profits earned from investing this, as well as claimed and immature premium revenue, is the second source of an insurer’s profit.

Many investors find analysing a balance sheet and profit and loss statement challenging. Analysing the reports of an insurance company is made doubly difficult by the fact that insurance companies use unique language to report their results.

Typically, insurance company results are displayed in two ways: there is the underwriting result, which is the result that excludes investment returns, and the insurance result, which includes investment returns.

The first line of an insurer’s profit and loss statement is the gross written premium. This is the total amount of money the company received in the form of payment for insurance policies for that year.

Now you may recall I mentioned earlier that at any period in time there are insurance policies just written, insurance policies about to mature and insurance policies anywhere in between. There are different contingent liabilities associated with the time remaining to maturity of a policy and maturity of a policy does not always occur at the end of the company’s financial year. For that reason, when premiums are adjusted for the period to which remaining possible (contingent) liability exists, the adjusted revenue is referred to as the gross earned premium. Some insurance companies also report this number.

From your perspective, the total amount of premium you pay represents the gross written premium, but if you paid for your insurance policy two months before the end of the company’s financial year, then the gross earned premium would be the amount you paid adjusted for two months.

By subtracting reinsurance costs from gross written premium, the net written premium is produced. If timing adjustments or accrued adjustments for contingent liabilities are made at this point, the result is net earned premium.

To recap, net earned premium is simply the revenue from writing all policies, less reinsurance costs and adjusted for timing.

Subtracting claims and expenses from the net earned premium produces the underwriting result which, you may recall, excludes investment returns. Adding investment income on the float or reserves to the underwriting result produces the insurance result.

Without trying to confuse you, the insurance result does not include investment returns on the shareholder capital part of the business. The shareholder capital part of the business raises equity capital from the owners to meet capital adequacy or prudential regulation requirements and these funds may also be invested.

With a typical industrial business, we might assess its performance using the profit and loss statement and a variety of ratios, such as gross profit margin, net profit margin or EBIT margin. We can do the same thing with insurance companies, but the ratios are given different names.

If we divide the insurance result (think of the insurance result as the EBIT of the whole company) by the net earned premium (which you should think of as the net revenue), we produce the insurance trading result (ITR). The insurance trading result is like the EBIT margin in that it is a pre-tax number – it also excludes interest on any debt.

There are rough rules of thumb about what numbers like the ITR should be. One dollar of premiums can be supported by about $0.50 of equity. If the insurance trading result is 10%, then the result is equivalent to a 20% return on equity. And if an investor is seeking a 10% required return, the right price to pay for an insurer might be double their equity.

The loss ratio is the ratio of paid claims to the net earned premium during the year. By comparing the amount paid out to the amount received, it measures the insurance companies’ effectiveness in pricing and predicting insurance policies and claims.

The expense ratio measures the proportion of sales the company expended on overheads. It measures operating expenses by comparing them to premium income. It is an efficiency measure, much like the cost to income ratio used by banks.

Finally, the combined ratio: this is a measure of profitability of daily operations. A ratio below 100% indicates that the company is making underwriting profit, while a ratio above 100% means that it is paying out more money in claims that it is receiving from premiums.

The combined ratio is reported in the context of the underwriting and insurance profit. It combines the claims ratio and the expense ratio. Remember, the claims ratio is claims owed as a percentage of revenue earned from premiums. And the expense ratio is operating costs as a percentage of revenue earned from premiums. The combined ratio is calculated by taking the sum of both types of incurred losses and expenses (underwriting expenses, including commissions, as well as claims) and then dividing them by earned premium. In short, combined ratio is the amount that revenue was eroded by to leave the profit margin, and doesn’t include investment income.

QBE reported its combined ratio had risen from 89.7% in 2010 to 96.8% and attributed the increase to higher costs (reinsurance and claims) associated with more frequent catastrophes and a higher net present value of claims due to a lowered discount rate (thanks to historically low interest rates overseas).

Even if the combined ratio is above 100%, a company can potentially still make a profit, because the ratio does not include income received from investments.

At the risk of completely losing you, the profit reported by the insurance company is in many ways like the profit reported by an airline – it is an accounting construct. You see, the item labelled ‘claims’ doesn’t correspond to actual cash claims made. Instead, it is invented by the accountants and actuaries and infected by an adjustment to the reserves. If you think of the reserves or float – the aggregated premiums received – as a liability or an amount set aside to cover future claims, then the claims item is an estimate based on current rates and the costs of those claims. As reported by QBE in its 2011 results this week, it is also impacted by changes to discount rates.

Table (E) on page 129 of QBE’s just-released annual report displays the adjustments made to the company’s flood or reserves as a result of a change in these estimates. The change to the reserve (you can see this by running your eye down a column) has an impact on the reported profit through the claims item in the profit and loss statement. For example, in 2004 the reserve changed from $3.4 billion at the end of the year of accident to $2.8 billion seven years later. This is a net benefit of $600 million to profits over that period. In the 2011 QBE result, an amount of $US64 million has been reported as “saving on prior year central estimate”.

Armed with this information, you are now a few steps closer to appreciating QBE’s results.

In 2011, QBE produced an underwriting profit of $US494 million compared to $US1.2 billion in 2010. QBE’s gross written premium (the total amount of money the company received in the form of payment for insurance policies for that year) rose 34% to $US18.3 billion, thanks in no small part to acquisitions. Net earned premium income (the gross profit after reinsurance and adjusted for timing) rose 35% to $US15.4 billion. Large individual risk and catastrophe claims amounted to 15.3% of net earned premium versus 9.5% in 2010 (see table).

The large number of painful hits to the company from these events have made it somewhat gun shy and it has pulled back some of its business lines in regions where reinsurance is too expensive. This may or may not be the right move. Only time will tell.

The insurance profit margin (contribution to profit from underwriting and investment income as a percentage of net earned premium) fell to 7.1%, compared with 15% in 2010.

The inefficiency of the stockmarket, however, was revealed when the company said its results were in line with the guidance it gave in January. In that trading update, the company gave guidance for all the above ratios, but analysts were left to translate the ratios into a net profit after tax figure. As at Monday this week, that translated consensus profit figure was $A936 million and 84 cents per share.

Yesterday, with its shares in a trading halt, QBE’s net profit came in at $US704 million ($A657 million) and EPS of $US0.61 cents per share ($A0.57 cps). The company also announced a capital raising through a bookbuild with a $10.50 floor, to raise $500 million, replacing Tier 2 convertible debt that under new APRA guidelines cannot be regarded as regulatory capital. This will dilute next year’s earnings.

You can see from the graph below that the reason for QBE’s terrible share price performance since 2007 is the fact that returns (the blue line) on ever increasing equity (the growing grey columns) have fallen from 26% in 2007 to less than 8% in 2011.

If, with your newfound understanding of the insurance business, you are interested in buying QBE at the lowest prices since 2007, then you need to be confident that the return on equity will begin to rise to levels that are materially above those available in a relatively risk-free bank account. And for this to happen, premiums will need to seriously pick up while claims remain low and nature stays quiet for a while.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 15 March 2012.

INVEST WITH MONTGOMERY

Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

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.

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19 Comments

  1. If the EPS growth forcast is correct i imagine the the intrinsic value would be much higher then what it is now , even after the capital raising dilution…

  2. How does an increase in rates impact present holdings? I am thinking that $1,000 in 5 year treasury with 1% yield has a value when redeemed of $1050 (give or take). If interest rates rise tomorrow to 2% then someone buying $1000 in treasuries expects to get $1100.

    Does this make the treasuries purchased yesterday worth only $954 in order to match today’s return?

  3. I expect QBE GWP’s will increase via premium increases and bolt on aquisitions over the short to medium term, my concerns lies in the profitability of the business going forward and in the investment returns on the float.

    The majoirty of QBE revenue is generated within the US and Europe. Rates within these continents are zero bound and given QE, inflation will start to tick up. This means that one would expect to see negative real returns on their floats reducing their overall profitability.

  4. Some years ago I was at a conference and some papers were presented on the nature of insurance claims. They were fractal. Also some recent papers suggest that severe storms (in particular the severity) have/will increase with the increased CO2. Also there is the unknown of increased el Nino, or La Nina (less de nada?). On energy rather than statistical arguments the increase in CO2 gives higher air temperatures, and consequently higher water vapour, thus increased severity (
    Insurance companies will surely increase premiums to cover these events. We all pay (the external costs). Some companies, directors, shareholders, employees of course benefit from the externalities.

      • The Insurance companies are passing it if on in spades,

        My house insurance has gone for $700 to $1700 in 3 years.

        Yes we in Qld we have the odd flood or three lately and this is being passed on for sure.

        Cheers

  5. From Third Avenue Funds on Insurance businesses – fantastic reading for those interested.

    Amit Wadhwaney writes about how insurance companies hold up during financial crises in the Third Avenue Funds 2011 Annual Report:

    INSURANCE COMPANY INVESTING DURING FINANCIAL CRISES

    As if the scrutiny to which financial services companies worldwide had been subjected of late was not intense enough, two events that took place during the most recent quarter have managed to place financial stocks ever more firmly under the microscopes of skeptical investors worldwide. The first event – though probably the less important one in the short term – was the much ballyhooed downgrade of U.S. federal debt by Standard & Poor’s in August. Secondly, the worsening of the European sovereign debt crisis and the ongoing, though to date, futile attempts of European governments to defuse it have exacerbated investor fatigue. Though nothing particularly new – the prospect of a default by one or more European countries has worried investors for more than two years now – these concerns intensified over the summer and turned into a full-blown panic by the end of August of this year. Market commentators launched into elaborate speculations about the impact of a sovereign default on the financial system. As wild rumors swept the markets, common stocks of financial institutions sold off indiscriminately.

    We are often asked by fellow investors in the Fund about our exposure to financial institutions, particularly those in Europe. The first relevant point to make is that we have avoided investing directly in European banking stocks throughout the ongoing sovereign turmoil (and, truth be told, throughout the Fund’s history). However, our portfolio has, in fact, included holdings in European insurers (since 2008). Some of these holdings – most notably Allianz SE and Munich Re – have inspired questions and concern from market participants, perhaps understandably so, given the significant role that each of these institutions plays in Continental European and global financial services markets. However, lumping together insurance companies, particularly wellcapitalizedones like those that can be found in the Fund, with commercial and investment banks may very well prove misguided. Indeed, we believe – based on our experience in observing financial crises that have taken place globally over many years – that not only are insurance companies much more resilient than banks, but, in fact, they can become beneficiaries of disruptions in financial markets, with the related benefits ultimately accruing to shareholders such as the Fund.

    In our shareholder letter accompanying the Second Quarter 2009 report (for the period ending April 30, 2009), we discussed in some detail the characteristics of insurance company investments that we find attractive, focusing particularly on safety and the preservation of capital. In summary, we seek out common stocks of insurance companies that possess the following attractions: they reliably generate cash from underwriting, use conservative reserving and accounting policies, do not take undue risks in their investment portfolios, have excess capital, and avoid borrowing money at the holding company level. Insurance companies that pass our selection criteria – which seem simple enough, but at times have proven to be a set of hurdles surpassed by few – tend to be far more resilient than their competitors. Moreover, our experience has shown that insurance companies fare better in financial panics than do banks, for the reasons outlined below. It is instructive that much ink has been spilled over the prospects and dangers of a European banking crisis, but the term “European insurance crisis” remains unknown to Internet search engines.

    Insurance companies have a number of characteristics that support their resilience in a financial crisis:

    1. INSURANCE COMPANIES DO NOT NEED ACCESS TO LIQUIDITY

    The most important difference between banks and insurance companies can be found in the structure of their balance sheets. In general, banks borrow short term (via deposits or wholesale funding) and lend long term. The upshot of this fact is that many banks need recurring access to short-term funding to keep their business model chugging along. Their dependence on the health of wholesale financial markets may seem inconsequential while the good times roll (say, in 2006 or 2007). But, alas, all good things must come to an end, or to a temporary respite at the very least. And when they do, banks’ reliance on wholesale funding markets becomes a far more serious limitation. Indeed, any disruption of those markets, or concerns about the solvency of the particular bank in question, could quickly lead to liquidity issues. These liquidity issues, in turn, can ultimately result in a fate that very well might have been nearly unimaginable during better times: a permanent impairment of capital, perhaps via forced capital raising (perhaps with the bank’s hand forced by government, for example), or even the outright liquidation of the bank.

    Such an outcome should, indeed, be frightening for investors. But, as compared to banks, we believe the business model employed by insurance companies, in general, is much more resilient, and it does not share this dependence on short-term liquidity in order to operate. Insurance companies tend to do a better job, consciously, of matching the duration of their assets and liabilities (if anything, their assets tend to be shorter duration than their liabilities). As long as they avoid excessive debt at the holding company level and remain well capitalized at all levels of the corporate structure, they generally do not need to access wholesale financial markets to fund their continuing operations. In short, the business models of well-capitalized insurance companies, such as those held in the Fund, are generally not dependent upon wholesale financial markets, whose notoriously fickle nature at times (such as during credit crunches) could threaten to bring capital market-dependent banks to their knees.

    2. ASSET AND LIABILITY MATCHING BY COUNTRY AS WELL AS BY DURATION

    Insurance companies have a well-deserved reputation for being exceedingly complicated. But as frustrating as it may be to encounter unnecessary complexity in life, at times it may be useful to heed the advice of Albert Einstein, who famously warned, (note: we are paraphrasing here) “Everything should be made as simple as possible, but no simpler.” In the case of insurance companies, we believe that, ironically enough, their complexity can provide not only protection and robustness, but, ultimately, opportunity for investors. A large insurance group, such as an Allianz or a Munich Re, which operates across multiple geographies and/or business lines, is typically organized within a publicly-listed entity. While the common stock of this listed entity is what investors actually trade on stock exchanges, functionally the listed entity acts as a holding structure for its collection of local, separate operating insurance entities. That each of these individual operating subsidiaries has its own balance sheet is a fact which is obscured by accounting consolidation for financial reporting purposes, which basically aggregates all of the subsidiaries’ assets and liabilities in the financial statements reported by the listed holding company.

    While this fact may seem to be simply an accounting technicality, in actuality it has interesting implications for the robustness of the listed insurance holding company. Each of the aforementioned, individual local entities is compelled to satisfy its own local regulators that it has sufficient capital for its operations, and can be, in effect, ring-fenced from the rest of the group. This could prove to be a useful characteristic in times of stress. Suppose, for example, that there is ultimately a catastrophic failure of the “Euro Project,” perhaps resulting in the ejection of a country from the Eurozone. In this draconian type of scenario, it is worth noting that a local insurance subsidiary operating in the country which has been kicked out will likely havematched its assets in that country with its liabilities. That would not change the fact that, if a country were to be ejected from the Eurozone, it is likely that the assets of an insurance company operating there would experience some impairment. However, this asset impairment would be mitigated by a concomitant decline in liabilities.

    To make this abstract scenario more concrete, take the German insurance company (and Fund holding) Allianz, which reports large gross exposure to Italian government bonds, a fact which from time to time elicits concern from investors for obvious reasons. But in fact, Allianz’s Italian subsidiary is the second largest insurance company in Italy, and it holds Italian fixed income securities to balance its Italian liabilities. The likely consequence of this is that any redenomination of Italian assets (e.g., from euro to lira) would be matched by the same redenomination of Italian liabilities, with a muted net impact on the consolidated group.

    Furthermore, this concept of self-contained or selfsustaining insurance units would take on even greater importance in another, more draconian scenario. Suppose, for example, that a country were to institute capital controls. One might become concerned that the insurance subsidiary operating in that country might not be able to access capital from its holding company abroad, given said capital controls. But even in this case, the local insurance subsidiary operating there, with matched assets and liabilities, would be able to use the cash flow from its maturing assets to meet its local liabilities, without needing to access capital from the holding company outside of the country.

    3. SHARING OF LOSSES WITH POLICYHOLDERS

    European life insurance contracts are often based on the idea of policyholder participation: profits (and losses) from the insurer’s investment portfolio are shared between policyholders and shareholders, sometimes with a rigid ratio. Therefore, money defaults and impairments of investment assets do not fall directly to shareholders’ equity; the net impact to shareholders is smaller than the gross exposure might suggest.

    Specific arrangements on policyholder participation in profits and losses differ greatly from country to country and from product to product, making it difficult to generalize. Local regulators have the final say on the allocation of profits and losses and on minimum guaranteed returns.
    Insurance companies have built up reserves for investment losses (from excess profits in previous years), and are able to draw these reservesdown under adverse conditions. In effect, these reserves provide an additional cushion protecting the financial strength of insurance companies.

    Although the encouraging attributes highlighted above might be considered to be theoretical, actual historical experience has, in fact, confirmed the greater resilience of the insurance model, versus the banking model, during periods of adversity. When insurance companies become impaired, it tends to be as a result of underwriting mistakes; it is relatively less common for an insurance company to blow up because of investment mistakes. And as noted
    above, one of our criteria that the Fund’s insurance investments must meet is a demonstrated ability to underwrite profitably over a reasonable period of time. We believe that insisting on this attribute significantly limits the odds of being felled by the banana peel that has often been the culprit behind most insurance company impairments.

    If anything, financial crises provide opportunities to insurance companies to take advantage of their excess liquidity, at times when their banking and investment banking counterparts might be paralyzed by distress. A sterling example of such a maneuver was Munich Re’s acquisition of Hartford Steam Boiler from AIG in the depths of the 2009 financial crisis, at such an attractive valuation that it led former AIG Chairman and CEO Hank Greenberg to send an angry, open letter to AIG’s Board of Directors. More recently, Allianz has expressed interest in providing liquidity to the sovereign credit market by participating in a public/private bond insurance program, at the right price.

    In conclusion, we will continue to monitor European developments closely. We believe that the companies in which we have invested are resilient and will emerge from the crisis unimpaired, while offering attractive prospective returns to long-term investors.

  6. I think economics of the insurance business is sound unlike brick and mortar retail which is experiencing fundamental changes to their business models due to online retailers. The biggest problem with electronics retailers is the barrier to entry is very low thereby it attracting competition until the above average profit margins are brought down to average. Airlines, telcos all fall in the same category.

    When company like JBH which is the lowest cost retailer I have seen is experiencing difficulties you can’t help but remember quote from Buffett, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. ”

    Buffett would have been one of the first to exit or even reduce his insurance business exposure if he didn’t believe in the economics of insurance.

    Only thing you need to worry about is the price you pay and kind of management you get. QBE did offer both in Jan 2012.

    Couple of insurance quotes I have received recently had premiums increased between 20%-40% even without me making a claim. So I can guarantee once there is some normalcy with natural disasters profits for insurance companies is going to be very satisfactory.

    Why don’t I believe even though insurance is like commodity to experience the same level of competition as retailers? Because, unlike mom and pop who might take insurance with the cheapest insurer. Big businesses insure with companies that are financially strong and therefore can pay it’s claims if there is a need. They don’t mind paying slightly higher premium rates to get that sort of safety. QBE draws a lot of its business from big businesses.

    Do I own QBE – YES. Would I buy more at this price – NO, but price under $12 might get me interested.

    • Sorry correction…Airlines and Telcos do have a high barrier to entry but what they lack is sustainable competitive advantage. But given brilliant management you might make money even with airlines and telcos. Vaguely remember Southwest airlines in US is quite profitable and so is Carlos Sim (Richest man) who is a telecom mogul in Mexico.

    • Although don’t entirely agree with your thoughts on retail (that can be a discussion for another day), i agree completley with your thoughts on insurance.

      When there is a sense of normalcy in regards to natrual disasters than insurance companies should be performing quite well, especially as those previous natural disasters will mean more people think about insurance and the insurance companies can justify significantly higher premiums to cover them for it.

      The biggest problem for me with insurance and QBE is probably the best on the australian market, is that you can’t really predict what natural disasters will be, where and how often they happen. Obviously linked to the whole political debate around climate change you will likely hear of all kinds of scenarios, but this is hardly a high level of debate to get information from as it is incredibally partisan. Science could help but there is always the question of who is doing the funding. The other thing is that you can look backwards and see what has happened previously and try to use that as a guide. Or just believe that the business is sound and the underwriters are good at making sure that they leave themselves without risk.

      But still, insurance is an interesting business, the ability to take advantage of “float” is evident in the history of Berkshire and provides an attractive add on for a company like this.

  7. I have QBE shares that are underwater, but will tale up the rights as it averages me lower and they are at a reasonable discount.

    • Hypothetically, if you were intent on keeping the same level of exposure to QBE, you improve you entry price by selling the old QBE ($15k?) once you have been allocated your new QBE.

  8. When it comes to QBE, the phrase circle of competence comes to mind. They are outside mine, so I won’t be considering them.

  9. Great post Roger, i have been looking for something like this for a while. I knew the very basics of insurance companies from following the history of Warren Buffet but you have put it all together.

    On the topic of QBE, i read an article recently where they say they are looking for some more acquisitions. Don’t know if this is accurate or not and i have not really delved deep into QBE as on the list of attractive companies they are nowhere near the top. I have heard that they have done a good job with these acqusitions. Obviously the frequent “catastrophic” events have made a big impact on their resutls but is there a chance that the drop in return on equity might have something to do with the bolt-ons not generating enough earnings to sustain the return on incremental equity?

    As i said, i have not really had an in depth look into it so i could be obviously wrong but thought i would throw the question out there.

    • Hi Andrew,

      The bolt ons become the group and are the group. The market share buying strategy should work if premiums continue to rise. For me I wonder whether being gun-shy after a run of losses is a wise thing if permanent – they have exited geographies where the reinsurance is too high.

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