Assessing QBE's storm damage

As if a record year for natural disasters wasn't enough, the financial crisis has continued to hit QBE's bottom line.

QBE’s Frank O’Halloran had a dismal Christmas and today shared some of his misery with his shareholders, with the QBE share price plunging after he revealed the group’s 2011 earnings have been nearly halved and its final dividend will be slashed by more than 60 per cent – after just about everything that could go wrong for an insurer did go wrong, mostly at year’s end.

QBE has long prided itself on its conservatism and its resilience, with good reason given its track record. Insurance is, however, about taking calculated risks and no one in the industry, including QBE, factored in a record year for catastrophes, compounded for QBE by the impact of the deepening eurozone crisis on its reserves.

The sharemarket was blindsided by today’s market update, mainly because QBE had, as recently as August, been projecting an insurance margin of at least 11 per cent for 2011 on $US15 billion of net earned premium. Today it said the margin was expected to be only 7 per cent to 7.5 per cent.

It had, in August, estimated that its large individual risk and catastrophe claims allowance would be about 13 per cent of net earned premium. Today it said it was likely to be about 15 per cent – $US1.21 billion more than in 2010. In fact, at the start of last year QBE had allowed 9 per cent for those large risks and believed it was positioning itself conservatively on the basis that the experience of the preceding seven years averaged 8.1 per cent.

The reason it took until today for QBE to reveal that blowout in claims was that so much of it relates to catastrophes that occurred right at the tail end of last year – mainly the floods in Thailand, crop damage caused by hail storms in the US and the Christmas storms in Melbourne. O’Halloran said these events cost the group more than $US500 million and likened 2011, in terms of the insurance industry, to 2001, when September 11 decimated the sector.

As if a record year for natural disasters was insufficient, the financial crisis also hit the group, albeit more in accounting than fundamental terms.

QBE invests conservatively, almost entirely in high-quality fixed interest securities. Even though it took no impairment charges on its investment portfolios, unrealised losses on its investment portfolio of $US160 million – and further unrealised losses because of the effect of the big fall in risk-free rates on the discount rates used to calculate outstanding claims provisions – reduced underwriting profit by $US200 million.

That reflects the continuing impact of the financial crisis and the responses of central banks to it.

Where QBE had anticipated an average risk-free rate of 2.6 per cent when discounting claims in 2011, and a gross investment yield on its policyholders’ funds of 2.7 per cent, it estimates the discount rate was actually about 2.15 per cent and the investment yield 2.1 per cent.

QBE still expects to generate an underwriting profit in 2011 – no mean feat given the year and the fact that even in 'normal' years most insurers struggle to made money at an underwriting level, relying on their investment earnings – but to protect its capital adequacy, where it targets at least 1.5 times the regulatory minimum, it is slashing its final dividend from 66 cents to 25 cents a share.

O’Halloran is more positive about the outlook for 2012, citing very strong premium rate increases in most markets, QBE’s response to the incidence of catastrophes – it isn’t taking a chance that the 2011 experience won’t be repeated – and increased reinsurance cover.

It is targeting a combined operating ratio of 89 per cent this year (against 2011’s 96.5 per cent), with an underlying insurance profit margin of about 15 per cent, despite increasing its allowance for large risks to 10 per cent of net earned premium, net of reinsurance recoveries. Reinsurance costs will be five per cent higher, approaching 12.5 per cent of gross earned premium.

O’Halloran touched only briefly on the subject that the market had expected the briefing to focus on: the reports that QBE had been caught up in an investigation into profiteering and price-fixing in the lender-placed insurance sector in the US. QBE entered that business when it acquired some insurance businesses from Bank of America last year.

Today O’Halloran said the reports that New York’s financial investigator is looking at a number of banks and insurers related to an investigation that had already been underway in a number of states for some years. He added that QBE had been fully across the issues being probed by the investigators before it made the acquisition.

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