There is an old management joke that when a new CEO takes a job, the predecessor hands over three envelopes to open when things go pear shaped. In the first envelope the message reads "blame your predecessor". The second letter 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, and the third letter said "blame previous management".
Neal opened his first envelope three months into the job when he blamed super storm 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 he 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.
The second envelope was opened earlier this year when Neal 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 apocryphal 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.
His new manager of the North American business told investors that previous decisions were not sufficiently data-based. This does raise questions as to what the basis of decisions was. At least we can be sure future decisions are data-based; they must have plenty of data backing last week's downgrade.
The debate is whether Neal will have to resort to the fatal fourth envelope or be able to rebuild the group's smashed credibility and fix the mess in the US while ensuring its European business - which includes a number of Lloyd's of London syndicates - doesn't come unstuck.
The jury is out. 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 things might 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. There have been few analysts who have called this correctly in 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 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 and disappointments jangle their nerves.
To this end 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 had a tepid reaction, with the stock rising almost 2 per cent to $10.50, but 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 further worsening in the company's figures it is likely to lead to a downgrade, which would not bode well.
The reality is taking the top job at QBE was always going to be tough given the company's acquisition frenzy in 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 a share price heading towards $40 a share, and investors applauding every acquisition because of what it did for the stock price.
During his 16-year reign, O'Halloran bought more than 100 companies in areas it sometimes knew little or nothing about, but which were earnings accretive from day one. He was lauded as a modern day 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 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 the 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 between the group companies.
It was only a matter of time before things would start to unravel, as evidenced by the growing frequency of profit warnings over the past five years. 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, RenaissanceRe's crop division and Balboa, the forced place lending business.
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 analyst 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 $2 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." It resulted in QBE announcing a $330 million write-down of intangibles and a warning premiums will fall from $1.6 billion in 2012 to $960 million in 2013 and $800 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 under-pricing. 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 ($560 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, reserving practices, little business in run-off and a history of prior year reserve release over many years.
Van der Schalk argues that structurally the European business suffers 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 says he is also concerned about Europe. He says its fortunes in Europe may come under pressure as the profitability of its exposure to the Lloyd's syndicate 386 reduces and price pressures continue across the European market. Syndicate 386 is a Lloyd's of London syndicate, which is majority owned by QBE and which parted with its underwriter, Ash Bathia, midyear.
The syndicate is a long tail business in a soft market, and with the "profits" they have made, they are widely believed to be under reserved now, according to reports out of Britain. But in this case the Lloyd's names have a share of this one and so they will share the pain if and when it comes.
Another area of concern is its internal reinsurer Equator Re. While most insurers buy reinsurance from other companies, QBE places some with other companies but "reinsures" a lot internally through Equator Re, which has its headquarters in Bermuda. As a senior insurance executive said: "In reality this is not of course reinsuring but retaining it on their own balance sheet, so instead of laying it off its losses reappear in another part of their 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's response: "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 their subsidiaries against equity in the holding company of an estimated $US13 billion. The difference appears 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.
It is in sharp contrast to Suncorp's Patrick Snowball whose 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 may even be able to return some to shareholders - something he recently did through a special dividend, and some suggest there is more to come.
There is no such expectation for QBE. In fact, speculation swirls around whether or not there will be a capital raising next year. If so, it may be inspired by adverse developments in Europe, a concept hotly denied 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.
“I’m as certain as I can be that we’ve taken the corrective action that we need to.’’
QBE chief executive John Neal
“Once again the company has been overly optimistic in its outlook… even an outsider can visualise problems that surprise management. The reason for this is unfathomable.”
BBY analyst Brett Le Mesurier