The premium benefits of the Wesfarmers-IAG deal

Wesfarmers' sale of its insurance underwriting division to IAG has advantages for both parties. It will de-risk Wesfarmers' retail-based portfolio and will allow IAG to become a market leader in intermediated insurance.

Wesfarmers prides itself on its financial discipline, but it has traditionally been far more of a buyer than seller of corporate assets. The $1.85 billion sale of its insurance underwriting business to Insurance Australia Group, however, made compelling sense for both vendor and buyer.

Wesfarmers’ Richard Goyder said today that the sale process had started with unsolicited approaches from a number of parties, and that the decision to sell accords with the way Wesfarmers runs its portfolio and assesses value for its shareholders.

It has been evident for some years that despite ambitions to grow the insurance business, Wesfarmers had experienced some frustrations in a sector that has been heavily consolidated over the past decade or so. This left its own operations sub-scale relative to the dominant competitors like IAG and QBE, and insignificant in the context of the group’s other major business units.

More recently, it had been trying to expand its insurance business by underwriting Coles-branded products. It had some success, gaining about 200,000 customers via that channel. But organic growth is incremental and long term, and doesn’t offer the synergies of large-scale acquisitions.

Moreover, as Goyder said, while the underwriting business has improved its performance recently, it hasn’t delivered satisfactory returns over the past five or six years relative to the risks and volatility it has generated. Selling it (but not Wesfarmers’ insurance broking business) de-risks the Wesfarmers portfolio of businesses, now dominated by its retail operations.

At 13.6 times earnings before interest and tax, IAG’s attractive offer would have helped Wesfarmers reach the decision to sell. This offer will generate a pre-tax profit of $700 million to $750 million and vindicate the investment the group has made in the business.

The cash and capital released from the biggest divestment in its history will give Wesfarmers options either to return capital to shareholders or to return some extra diversity to the retail-centric portfolio via acquisition, now that Wesfarmers has most of its retail brands (except Target) performing strongly.

Assuming it gets past the Australian Competition and Consumer Commission, IAG’s deal is compelling in a market where domestic insurance assets of any scale are now scarce. This explains why it was prepared to pay a handsome price and emerge successful from a contest that is reported to have had a number of interested parties.

The two portfolios are highly complementary and will make IAG the market leader in intermediated insurance across Australasia, pushing past QBE. It provides a much stronger presence in the small and medium-sized enterprise segment, as well as producing a more balanced geographical presence across the states and regions. It will increase IAG’s premium base by about 18 per cent to more than $4.3 billion.

It will also give IAG access to the Coles customer base, with the parties entering a 10-year distribution agreement.

In a demonstration of the benefits of the scale that Wesfarmers pursued without sufficient success, IAG expects to reap $140 million a year of pre-tax synergies from combining the businesses. It believes the purchase can be modestly accretive in the first year and at least 5 per cent accretive in the second, although that excludes the $120 million cost of the integration.

After the ill-fated and horrendously costly (and aborted) expansion into the UK and with ambitions to expand cautiously into Asia, the argument for bulking up its core domestic operations and garnering those synergies is a persuasive one.

IAG’s Mike Wilkins has a demonstrated ability to manage cost outcomes and to improve the quality of the domestic franchises. The Wesfarmers deal will create a new opportunity to improve the IAG platform.

To protect its balance sheet strength, IAG has financed the deal mainly with new equity. It has announced an underwritten $1.2 billion institutional placement to be followed by a non-underwritten share purchase plan capped at $200 million. It is also raising $300 million of subordinated debt.

So, it has the deal, it has the funding, and the integration plan has already been developed. All it needs is to get the acquisition past the regulators. The consolidation of the general insurance industry (and the extent to which QBE, IAG and Suncorp dominate) will make the ACCC the most significant threat.

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