QBE's premium offering

QBE’s history all started back in 1886 when a Scotsman by the name of James Burns looked at ways in which he could protect his company’s ships and cargo against damage and loss. As a result, The North Queensland Insurance Company was formed. Within four years Burns’ company had established 36 agencies across Australia, Hong Kong, London, New Zealand, Singapore and the Pacific Islands.

Together with the merchant and shipping endeavours established by his father (Burns Philp), these agencies leveraged local trading economies to become a worldwide force. The company later made a number of landmark acquisitions and finally became known as QBE Insurance Group when Queensland Bankers & Traders Insurance merged with Equitable Life & General. QBE’s rapid growth and global expansion has characterised the company’s long journey. Today, QBE is recognised and respected globally.

On Australia’s stock exchange, QBE is the largest international general insurance and reinsurance company. QBE operates in 45 countries and employs more than 10,000 staff. In terms of operations, QBE underwrites commercial, industrial and individual insurance policies. It also manages Lloyd’s syndicates and provides investment management services to retail and commercial customers alike.

QBE offers a variety of insurance products; from professional indemnity for corporations to general motor vehicle insurance for the public. In deference to the company’s roots (shipping and cargo), it also continues to offer marine and engine insurance.

As expected for a global company, QBE offers these products in formidably competitive and cyclical markets. In Australia, the company’s primary competitors are Insurance Australia Group (IAG), Suncorp, CGU and Allianz. Through a range of growth initiatives though, the company continues to operate as a leader in its field.

Most recently, QBE acquired Praetorian Financial Group, Winterthur US and Seguros Cumbre SA de CV; a small Mexican insurance company. Combined, these are expected to produce over $3.6 billion of premium income in the first full year.

In the absence of large payout events, insurance companies generate high underwriting profits. As these profits from the previous year are put to work underwriting new business; the result is greater competition, lower insurance premiums and lower underwriting profits. Then along comes a catastrophe and the marginal players suffer while the larger participants ratchet up premiums and the cycle begins again.

Insurance economics: the basics of float

Float is money that doesn’t belong to the insurer but is temporarily held. Float arises because premiums are paid upfront though the services provided – namely insurance protection – but delivered over a period that usually covers a year; and loss events are not immediately compensated through paying claims, because it sometimes takes many years for losses to be quantified, reported, negotiated and settled.

Legendary investor Warren Buffett says: “Float is wonderful – if it doesn’t come at a high price.” The cost of float is determined by underwriting results (either profits or losses) the difference between premiums received and expenses and losses that are ultimately paid. When an underwriting profit is achieved the float is free or better than free. When an underwriting profit is achieved, an insurance company is actually paid for holding other people’s money. It’s better than a bank.

Buffett says insurers have generally earned poor returns for a simple reason: “They sell a commodity-like product. Policy forms are standard, and the product is available from many suppliers, some of whom are mutual companies (“owned” by policyholders rather than stockholders) with profit goals that are limited.”

“Moreover, most insureds don’t care from whom they buy. Customers by the millions say “I need some Gillette blades” or “I’ll have a Coke” but we wait in vain for “I’d like a National Indemnity policy, please.” Consequently, price competition in insurance is usually fierce. Think airline seats.”

From an internal perspective, QBE mitigates and minimises its own business risk by utilising reinsurance contracts. In keeping with this low-risk theme, the company has relatively low exposure to equity markets through its investment books, as shown in graph 3.

QBE’s retail clients generally deal directly with one or more of the company’s ubiquitous service centres. Conversely, most corporate and government customers transact through agents or insurance brokers. Although the loyalty of retail and commercial customers is a monument to the company’s legacy, sponsorship also forms a large part of QBE’s brand awareness and public exposure.

Business Performance

Table one provides a clear insight into the underlying economics of QBE, including a forecast as to how the business is expected to perform in 2007. We begin in 2002 with a global insurance business comprising $2621 billion in shareholders equity (net assets).

This equity was invested in various resources (people, furniture, computers, and buildings, policies). All those resources required in carrying on the operations of an insurance business. After management’s decisions ensured the employment of this equity, by the end of 2002, a net profit after tax of $572 million was delivered and shareholders received dividend income of $244 million ($267 million after taxing into account the benefit of franking credits).

To grow the business (employ more staff, expand overseas), $328 million of after tax profits were retained and a further $414 million in equity was raised from investors (shareholders). QBE didn’t have any trouble finding individuals to stump up additional capital when they were generating a return on equity of 21.7% (we note the value of the business would be higher if no dividends had been paid and less dilutionary equity raised).

As all of the net assets (equity) and resources available are again fully employed, net profit after tax increased in 2004 and a larger partially franked dividend (profits earned from overseas operations do not get the benefit of franking credits) is paid. Again, a portion of profits were retained and further capital raised to fund expansion. Incremental capital is now being compounded at even higher rates of return on equity – 25.3%.

The business continued expanding operations both locally and overseas through 2005 and 2006, employing retained profits and new ordinary share capital. Table 2 provides a snapshot of the growth in the level of shareholders equity (net assets) being employed.

A reflection of excellent management, low level of natural disasters and catastrophic loss events, is that profitability as measured by return on equity has risen as more capital has been employed.

From 2002 to the most recent full financial year, shareholders’ equity in the business has grown by 135% over the past five years to almost $6.2 billion, return on equity has increased from 21.7% to 32.3% and dividend cheques are 1.5 times larger than those being paid in 2002. Few companies have the ability to achieve these results.

Future Prospects

Based on past performance, QBE is a well-managed insurance company with a solid history of steadily increasing after tax profits and dividends while retaining, raising and compounding significant amounts of incremental equity at high rates of return. Clime’s forecast for 2007 the financial year (the company’s balance date is December) shows this trend should continue for this year at least.

Profitability will continue to be driven by the company’s strong positions in Europe and American markets, where a large part of QBE’s property, marine and energy sector premiums have experienced strong increases. These sectors make up a significant proportion of the group’s product portfolio.

A strong market position has been further enhanced by the acquisition of Praetorian Financial Group, Winterthur US and Seguros Cumbre SA de CV. It is conceivable that management will continue to search for further global opportunities (100 acquisitions have been made in the past 25 years) in line with their stringent criteria to maximise shareholder wealth.

As QBE continues to grow, increased levels of premium income (subject to the cycle discussed earlier) will see the investment team continue to manage larger and larger amounts of funds – hence higher levels of investment income. Although there is an expectation of paying out a portion of those premiums under insurable events, QBE’s investment strategy is conservative. This ensures the preservation of capital and a highly liquid investment portfolio to meet future claims / liabilities.

The main risk to QBE is a series of catastrophic events creating a spike in insurance claims. It is agreed by many in the industry that global warming could materially change the probability of catastrophes, increasing both the frequency and intensity of storms.Such events are unpredictable, but a globally diversified insurance portfolio, maintenance of an equity portfolio at less than 10% of total investments, coupled with derivative protection to minimise interest rate risk on a significant fixed interest portfolio and conservative provisioning for losses, are all factors that drive confidence in management’s ability to mitigate controllable risks. The company will, however, need to carefully set premiums in future years based on new probabilities rather than based on past occurrences.

Business Valuation

An investment in QBE has outperformed the ASX All Ordinaries Accumulation Index with a 12 –month growth rate of 58%. The company has also outperformed the index with a compound average annual growth rate of 42% over five years, 22% over 10 years, and 24% over 20 years, creating significant wealth for shareholders. While short-term share price movements often reflect market sentiment more than fundamental value, such stellar performance over a 20 year period is testament to the quality of QBE.

At present levels, QBE’s share price of $35.19 is only slightly higher than Clime’s valuation of $33.15. As the market gyrates, long-term investors will be given the opportunity to purchase this great business at a great price.

Table 5 reveals the past four years of QBE’s economic performance. Also shown is the split between profits retained in the business (blue upper portion of each bar), those amounts being paid out to shareholders as dividends (red lower portion of each bar), and Clime’s forecast for the full 2007 financial year ending December 31. The recent financial data is one reference to what the business and management might achieve going forward.

During the August 16 correction (which was exacerbated by the temporary close of the Sydney Futures Exchange), the share price of QBE dipped as low as $25.55. Compared to the current Clime valuation of $33.15, this represented a 23% discount to intrinsic value. However, disasters within stockmarkets are not the only opportunity to purchase insurance businesses at great prices.

Since the industry returns are highly correlated to large-scale catastrophes, mispricing often follows such events. As “short-termism” sets in, markets tend to value insurance businesses based on their disaster-affected financial performance. For long-term investors, this short-term mindset presents the perfect opportunity to invest in a business with excellent long-term prospects.

Businesses such as QBE are much more valuable than their performance at their most vulnerable time. Our only caveat is QBE’s business writers need to be very careful about how they price premiums in a world that is warming and thus increasing the frequency and size of possible claims (through more frequent and severe storms).

Russell Muldoon is a senior analyst with Clime Investment Management group, www.stockval.com.au.