IAG's investment portfolio: watch out below
With stock markets at record highs and interest rates at record lows, insurers are on a tightrope.
When you take out an insurance policy, you pay your premium up-front but generally only make a claim months or years later. In the meantime, insurers such as Insurance Australia Group (ASX: IAG) get to hold on to the cash.
This money doesn't belong to shareholders as it will eventually be paid out to policyholders – it's shown on the balance sheet as a liability. But, until it's paid out, IAG gets to invest it and keep the interest and investment income.
IAG's investment portfolio is gargantuan, topping $12bn. As you might expect, the portfolio can be a huge driver of an insurer's performance if it can make good investment returns. In 2017 investment income from IAG's portfolio accounted for 39% of pre-tax profit.
The Institute of Actuaries of Australia says local insurers have 'complete freedom of insurer action in relation to investments, with appropriate additions to solvency where this action results in additional risk'. In other words, insurers can invest the funds in stocks, bonds, Tasmanian goat farms – just about anything, so long as they hold enough capital overall to please the regulators.
Despite the freedom, IAG tends to play it safe because the company's policies, such as car insurance, are generally short term. As such, 87% of the portfolio is invested in cash and fixed interest securities, including all the technical reserves that cover liabilities.
Prepare for volatility
However, that figure hides a major shift in the portfolio's composition – the consequences of which may only be known years down the track. Since 2015, IAG has reduced the proportion of its portfolio invested in cash and bonds from 91% to 87%. The allocation for technical reserves hasn't changed, but the proportion of shareholder equity allocated to stocks and other volatile assets has increased from 41% to 47% over the past two years.
In 2017, the total investment portfolio generated $519m of income for IAG, compared to $597m in 2016, and well below the $816m earned in 2015. The culprit has mainly been lower returns from fixed-interest investments and lower technical reserves.
This isn't to single out IAG. Most insurers worldwide are feeling the pain of declining yields on their large bond holdings and, over the past couple of years, have shifted their portfolios to equities, where returns have been stronger.
The trouble is that the time to make this shift was probably nine years ago, when stocks were trading at bargain valuations – not now when they're at record-high valuations after the second-longest bull market in history.
If stock markets keep going up, IAG will benefit from the increased allocation to shares, but that same allocation also makes IAG's earnings more volatile. If the stock market falls materially, IAG's portfolio will be hit hard and hundreds of millions could be wiped from shareholder equity.
Insurers are in the unenviable position of having billions to invest and a choice between two ugly alternatives: buy equities with no margin of safety, or buy bonds and lock shareholders into years of pitiful returns. We don't know how this story will end, but the current chapter isn't promising.
Want access to our latest research and new buy ideas?
Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.Sign up for free
Join the Conversation...
There are comments posted so far.