Insurers in the eye of an imperfect storm

Lee Harvey Oswald may have been the patsy in the Kennedy assassination saga; however, as Cyclone Oswald moves away from the East Coast I wonder whether today’s patsies are the shareholders of general insurers IAG and QBE.

Investing in an insurer is very opaque for a minority investor. It is incredibly challenging to form a view from the outside as to whether management has made an adequate assessment of risk, has charged an appropriate price to insure that risk, and has held sufficient reserves to cover eventual claims. It is very likely that investors will read about the bad news on the front page of a newspaper rather than foresee losses. So decisions for investors and management are often reactive rather than proactive in the insurance space.

Almost as important is the ability of insurance management to invest the regulatory capital and reserves of their companies. Prudent management of capital is necessary to achieve equity growth and ensure that shareholders are not called upon to meet underwriting losses.

A review of total shareholder returns over the last 10 years

Over the last 10 years QBE has delivered a market index return, while IAG has just managed to get a nose ahead following the recent yield-driven rerating. (I have excluded Suncorp from comparison here since I regard the group as a bancassurance stock rather than a general insurer). Readers who attended last year’s Eureka Congress might remember my view that index performance is a measure of the average and the mediocre. Therefore, at the very least, listed companies need to outperform the index over five to 10 years to justify the consideration of long-term investors.

While the performance of QBE (below) in the first five years appears impressive, it is less so after you note the low base that it started from following its September 2001 near-death experience. Indeed, after its recovery, QBE has meticulously drifted back to the line of mediocrity. What this tells me is that if QBE’s share price rises in coming months (and I suspect it will), it will because of index investment flows into the market rather than a rally based on an improving business performance.

It is the size of both companies that insures (pardon the pun) their inclusion in a conventional index-based portfolio. My view is that neither company qualifies as a long-term investment despite their place in the index.

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Cyclone Oswald has resulted in 5,600 claims received by IAG as of January 30, 2013. No doubt IAG investors are hoping the balance sheet is adequately provisioned (and it clearly is) for this event. However, they can never be sure as to what catastrophe lies ahead.  QBE is clearly exposed to huge catastrophic losses, with the most recent “super storm” Sandy delivering losses of $350 million to $400 million.

At times the insurance industry strives for growth through setting insurance premiums that are too low for the inherent risks, much like an expensive equity market that assures minimal prospective returns. Insurers were happy to insure Queensland homes a few years ago but we see reports of home owners who are not offered insurance today. Has the likelihood of a future flood increased dramatically from a few years ago, or has the perception of that likelihood just changed?

While IAG and QBE underwrite risk, the shareholders are the ultimate underwriters of disaster and we see this through the continual capital raisings that dilute profitability. Since 2003 IAG has raised an additional $3.6 billion and QBE has raised an additional $4.8 billion. Unfortunately the return on incremental equity stands at 7% for the pair. Given the risk of disasters, which wipe out profits, reduce dividends and induce capital raisings, this level of profitability is far too low.

Figure 2

Source: Company Annual Reports

Investors chasing yield have pushed IAG up by 34% over the last six months, to the point where it now looks discernibly expensive. The future yield is expected to be 4.9%, which assumes the business continues with a very high payout ratio.

With a total capitalisation of currently $10,228 million, the market is happy to pay 2.4 times the total equity of IAG. The long-term average normalised return on equity is 7.4%.

Would you pay $240 for a $100 bank deposit earning 7.4%? Obviously, paying a multiple above equity, for low-returning equity, can only deliver a poor result to investors over time. It is clear the market is either expecting a dramatic improvement in future business performance or the investors of today are making a considerable mistake.

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QBE’s market price is currently much closer to value, but it is not attractive at current prices. Over the last nine years the growth in equity has outpaced that of earnings and this represents declining profitability. One reason for this is the decision by QBE management to invest its capital and reserves in low-yielding debt securities. Insurance companies have an access to a free float of prepaid premiums, and these are usually invested in short-dated liquid debt securities. The strategy to invest capital in such assets may reduce volatility, but it drives down return on equity and results in capital being raised when underwriting losses occur.

Capital management at QBE has been suspect and not in the best interest of shareholders. Management has continually asked shareholders to chip in new capital (which is post tax) while handing back a tax liability in the form of a partially franked dividend.

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Investing is about allocating today’s purchasing power in order to have more tomorrow. Achieving this goal is as much about avoiding the losers as it is about picking the winners. IAG and QBE have had mediocre track records for business performance and I see nothing today that convinces me this will change in the future. Therefore the growth portfolio does not include either QBE or IAG.

John Abernethy is the chief investment officer at Clime Investment Management.

If you’re a sophisticated investor, wholesale investor or have $500,000 or more to invest, Clime is offering you the opportunity to discuss your portfolio and investment options with John Abernethy. Click here.

Clime Growth Portfolio

Return since June 30, 2012: 28.43%
Returns since Inception (April 19, 2012): 19.42%
Average Yield: 5.66%
Start Value: $111,580.24
Current Value: $143,300.50