What Are We Missing on QBE

You know what worries me most about QBE? Floods? Storms? Earthquakes? Global warming? Interest rates?

No; none of the above. They are all part and parcel of owning an insurance business. What worries me is that the case for buying the stock is so simple you can work it out on the back of an envelope.

Net earned premium                          $16bn
Insurance margin                              15%
Insurance profit                                 $2.4bn

That’s a pre-tax return of 19% on the current market cap. And it attributes no value to the $7bn odd of net shareholder equity. If you assume zero interest rates – no investment income whatsoever – you’d still make 14% pre-tax.

Insurance is a volatile business but, as I said in the September Quarterly Report, there are plenty of good reasons to think the average profitability will be higher, not lower, than the numbers estimated above.

Here’s what Standard and Poor’s had to say about yesterday’s downgrade:

QBE announced today that exposure to a number of catastrophes during the second half of 2011 and the adverse impact from challenging investments markets will weaken its insurance margin to 7.0%-7.5% for 2011, compared with its expectation disclosed in August 2011 of 11%. As a result, its profit after tax for 2011 will be 40%-50% lower than the prior year. Standard & Poor's believes the strength of QBE's diverse business and financial profile allows its rating to withstand some negative cyclicality in its underwriting performance such as what has occurred in 2011. Nevertheless, the rating may come under pressure should there be an indication of a structural decline in earnings or sustained underperformance against peers.

We note that QBE expects to make an underwriting profit in 2011 in what has been a record year for natural weather events globally and that premiums for many of its product lines are increasing. While regulatory capital adequacy has softened since June 2011, the company's decision to materially cut its dividend should assist in maintaining a minimum capital ratio requirement above the 1.5x minimum target set by the company.

We agree with Standard and Poor’s. Now that is something to worry about. Can someone give me a hand, what are we missing here?

Update: See Narrowneck and Clear Head on QBE for some weekend clarity.