QBE's scramble to claw back credibility

There is an old management joke that when a new chief executive takes a job, the predecessor hands over three envelopes to open when things go pear shaped. The first envelope contains the message: "Blame your predecessor"; the second reads: "Announce a reorganisation"; and if that doesn't work, reach for the third envelope, which advises: "Prepare three envelopes".

In the QBE version of the joke, Frank O'Halloran handed John Neal four envelopes when he left the insurance giant in August 2012. The first read "grab on to the most newsworthy natural disaster to blame a downgrade". The second suggested a "transformation program" to deflect disappointing news. The third letter said "blame previous management".

Neal opened his first envelope three months into the job when he blamed superstorm Sandy in the US on its shock profit downgrade, a $500 million capital raising and a hefty cut to its insurance margin. At the time there was scepticism that the storm was responsible for all of QBE's woes, particularly given Neal had told the market three weeks earlier the company was on track to deliver an insurance margin of 12 per cent and a strong recovery.

Neal opened the second envelope earlier this year when he announced he would take the knife to costs, including slashing staff, changing senior management and making the overall business more efficient and transparent. This "transformation" was announced against a backdrop of a weak full-year result and a cut to dividends.

As things continued to unravel, Neal opened the third envelope on December 9, blaming former management on a forecast net loss of $250 million and more than $1 billion in write-downs in its North American operations.

"In North America, we grew too rapidly. We didn't have the right processes in place to control and manage that business and we certainly didn't have the right leadership," he told investors. His new manager of the North American business told investors that previous decisions were not sufficiently data-based. This does make one wonder what was the basis of decisions. At least we can be sure that future decisions are data-based, which means they must have plenty of data backing last week's downgrade.

The debate now is whether Neal will have to resort to the fatal fourth envelope or will he be able to restore the group's credibility and fix the mess in the US while ensuring its European business, which includes several Lloyd's of London syndicates, doesn't come unstuck.

Since the announced losses earlier this week, Neal has been doing the rounds of investors to try to win support. Some analysts continue to recommend the stock as a buy, believing the worst is over and there is "value at the current level", while others remain sceptical, warning that things may continue to deteriorate in the US and start to unravel in Europe.

Those that have a buy rating also had one before the previous downgrade. Very few analysts have called this right over the past few years: Brett Le Mesurier of BBY and Jan van der Schalk of CLSA, who were not invited on a trip to the US last year before the famous downgrade.

Against this backdrop investors have been voting with their feet, wiping more than 30 per cent off the share price as the complicated structure, financial opacity and continual downgrades jangle their nerves.

Neal felt compelled to issue a follow-up statement to quell fears of "capital strain". In a statement to the ASX he said: "As we expected QBE's insured financial strength (IFS) ratings have now been affirmed and this confirms the ongoing strength of QBE's insurance business." The market reaction was tepid: the stock rose almost 2 per cent to $10.50, but was still well below its close before it went into a trading halt last Friday at $15.45.

The credit rating agencies reviewed QBE's ratings after the shock losses on Monday, with three of the four agencies placing it on negative ratings watch. If there is any further worsening in the company's figures, it is likely to lead to a downgrade, which would not bode well.

The top job at QBE was always going to be a tough one, given the company's acquisition frenzy over the past couple of decades.

In 1998, QBE decided to increase its premium income through acquisitions. Unlike most other companies, QBE handled acquisitions - including due diligence and negotiations - in-house. By 2006 it was one of the biggest insurers in the world, with shares heading for $40 apiece, and investors applauding every acquisition because of what it did for the share price.

During his 16-year reign, O'Halloran bought more than 100 companies, some in areas QBE knew little or nothing about, but which were earnings accretive from day one. O'Halloran was lauded as a management hero, a financial alchemist, who, like magic was able to turn some questionable acquisitions in far-flung places into raging successes, on paper at least.

It prompted CLSA analyst Jan van der Schalk to remark: "This is a complex, global, operation still digesting a rash of acquisitions effected only to pimp-the-top-line-ride. When there is no trust, there is no adequate reward, and management's mindset towards investors has to change. We can't see it." Van der Schalk has a target price of $9.89 on the stock and a sell recommendation.

Determining the performance of QBE's overseas divisions is not easy. The company's balance sheet contains more than 130 controlled entities, which are accounted for on a consolidation basis. This makes it difficult to understand the financial position of individual group companies and the relationship among them.

It was only a matter of time before things would start to unravel. The latest troubles have their origins in the US business, which grew from $US1.4 billion in 2005 to $US6.6 billion in 2012, mainly due to a spate of acquisitions including Praetorian, Winterthur and RenaissanceRe's crop division.

To put the acquisition spree into financial context the business has almost doubled in the past five years, yet the insurance profit has halved. In 2007 it was generating insurance margins of 22.2 per cent, compared with an estimated 6 per cent for 2013 and 10 per cent for 2014. According to BBY's Le Mesurier, if the company repeats its adverse claims development next year, its insurance margin could fall to about 5 per cent.

QBE's problems in the US are many. As online insurance bible Insurance Insider says: "It executed a circa $US2 billion bet on the US lender-placed sector - via a series of acquisitions - but that market is now shrinking following a series of regulatory probes, not least by New York's financial services regulator, Benjamin Lawsky." This resulted in QBE announcing a $US330 million write-down of intangibles and a warning that premiums would fall from $US1.6 billion in 2012 to $US960 million in 2013 and $US800 million in 2014.

Other problems include its US crop insurance and a big exposure to casualty and workers' compensation businesses, which have been decimated due to years of fierce competition and underpricing. The US casualty business nearly brought Lloyd's down 15 years ago and QBE has lots of it. US insurer Tower Group recently announced a $US500 million loss in the second quarter due to its exposure to workers' compensation.

But Europe is potentially a ticking bomb, despite assurances from Neal that the business there is long term and stable, supported by long-serving staff and reserving practices, little business in run-off and a history of prior-year reserve release over many years.

Van der Schalk argues that the European business suffers structurally from the same long-tail issues as the US, it just lags. "Remember Italian medical malpractice issues six months ago? We would like to see a USA 'have the drains up' process on Europe," he warns.

Le Mesurier is also concerned about Europe. He says QBE's fortunes there may come under pressure as the profitability of its exposure to the Lloyd's Syndicate 386 falls and price pressures continue across the European market. Syndicate 386 is a Lloyd's of London syndicate majority owned by QBE. It parted with its underwriter, Ash Bathia, mid year.

The syndicate is a long-tail business in a soft market, and with the "profits" it has made, it is widely believed to be under reserved now. But in this case the Lloyd's names have a share of this one, so they will share the pain if it comes.

Another area of concern is its internal reinsurer Equator Re. Most insurers buy reinsurance from other companies. QBE does so too, but "reinsures" a lot internally through Equator Re, which is headquartered in Bermuda. As a senior insurance executive said: "In reality this is not reinsuring but retaining it on their own balance sheet, so instead of laying it off, its losses reappear in another part of the network."

While all insurance companies have varying degrees of complexity, it seems few are as difficult to understand as QBE. So, too, is the jargon it uses to respond to questions. When asked about its capital position in the US and whether it is represented by goodwill, the company said: "The segment note represents a consolidated view of the net assets of the group split between the divisions, however, being consolidated eliminates capital issued to the divisions. The North American division holds over $2.4 billion of capital and has one of the stronger balance sheets in the group, with AM Best nominating that the North American group has a BCAR [Best's Capital Adequacy Ratio] rating well above the levels of its peer group."

The reality is the holding company's 2012 accounts show $US18 billion worth of shares in subsidiaries against equity in the holding company of an estimated $US13 billion. The difference seems to be provided by debt.

The fact that consolidation eliminates capital issued to the divisions implies that some of this capital must be created by the company itself, which is interesting.

Suncorp CEO Patrick Snowball provides a sharp contrast. His immediate strategy when he took the job was to simplify the company. He saw that by making the sources and uses of capital clear, he would be rewarded by shareholders and might even be able to return some to shareholders - something he recently did through a special dividend.

There is no such expectation for QBE. In fact, the rumour is there may be a capital raising next year. If so, it may be inspired by adverse developments in Europe, a notion hotly rejected by Neal.

He has no intention of opening the fourth envelope, but if things take a turn for the worse, Santa may bring him a letter opener next year.