Tough Times For Insurers

Our listed general insurers aren't going broke any time soon. But that doesn't make them great investments.

The insurance industry is all about cycles '” of premiums, claims and investments. In this review, we’ll examine the current state of those cycles and what that might mean for the country’s listed general insurers.

The first cycle to look at is the one governing the policy premiums an insurer receives. This is driven both by the level of economic activity (which increases demand for insurance) and by the level of competition in the market. Typically what happens is that a few good years of claims experience (see below) increases everyone’s appetite for writing insurance, and premiums fall (the market “softens”). This then goes too far; the industry takes some nasty hits; the appetite for writing insurance drops away; and premiums start to rise again (the market “hardens”).

While the various classes of insurance behave differently, the Australian market had generally been “hardening” from 2001 (following the collapse of HIH Insurance) until early in 2005. This hardening market also coincided with a favourable claims environment. The extended drought means there have been fewer storms than usual, and reform of the laws covering negligence claims has also reduced payouts.

With more coming in and less going out, the bit that stays in the company '” the “underwriting result” '” has been very healthy. But the Australian insurance landscape wasn’t always so pretty. Figures from APRA, the insurance regulator, show that the industry operated at an overall underwriting loss from 1995 through to 2002.

In most of those years, however, the industry actually managed to eke out a profit. The reason for this relates to the third cycle: investment performance. Insurers collect premium income in advance, while they pay out resulting claims some time later. In the meantime, the funds (known as the “float”) are invested for the insurer’s account, on top of the insurer’s own shareholders’ funds.

Typically the float is placed in low-risk, fixed-interest-type investments. And it’s the earnings from such investments that allowed the Australian general insurance industry to produce profits in 1995, 1996, 1997, 1998, 2001 and 2002, despite running an underwriting loss in each of those years.

Add together an insurer’s underwriting result and the investment earnings on its float and you’ll come up with its “insurance trading result”. The overall profit figure comes from adding together the insurance trading result and the investment earnings on its shareholders’ funds.

Having run through some insurance basics, let’s consider the current trends. First, premium rates appear to be softening. For example, in Promina’s latest annual report (it has a December financial year end), managing director Michael Wilkins described the market as being “characterised by margin pressure”. Similarly, at Insurance Australia Group’s annual meeting in November last year, chief executive Michael Hawker made several references to increased competitor activity in commercial lines.

And we’ve been hearing a lot of scuttlebutt from businesses that are enjoying significant falls in their premiums. From areas as diverse as gold miners to hospitals, we’ve heard reports of 30–40% premium reductions for the same cover people were getting last year.

Although both Promina and IAG emphasise that they’re maintaining “underwriting discipline” (that is, not taking on risks that might be expected to generate losses), it seems clear that we’ve seen the top of this particular cycle.

With regard to claims, the drought can’t last forever, even though it might not feel like that to some people. And the favourable government reform of negligence laws would have to be seen as a one-off.

Cyclone Larry served as a reminder recently that insurance is a risky business. Suncorp-Metway, for example, announced on April 7 that it expected to suffer a net pre-tax loss from Larry of $80–$85 million.

Forecasting the claims experience of insurance companies is an impossible task. But, in the present circumstances and being conservative by nature, we’re inclined to expect less favourable conditions than the industry has seen in recent times.

The same can be said of the investment returns on shareholders’ funds. We’re not ones for forecasting the short-term direction of financial markets, but the recent performance has been extremely good by historical standards. In the half-year to December 31, for example, IAG’s investment earnings on its shareholders’ funds accounted for $342 million, or almost half of the group’s pre-tax profit.

Even a stockmarket bull would have to concede that this investment performance is highly unlikely to continue. And from a more bearish stance, market falls and investment losses are perfectly possible. This makes the use of a simple price/earnings multiple misleading. It’s better to focus on earnings from the insurance trading result and then consider the investment returns on shareholders’ funds separately.

HEADWINDS

All up, it looks to us as though the recent tailwinds behind the general insurance industry are likely to fall away and perhaps turn into headwinds. But we’re pleased to say that the companies themselves look well prepared in terms of reserves.

Predicting the sum of money to be put aside to cover all future claims from current policies is something of a black art. Using statistics, an insurer’s actuaries will start by making their best guess as to future claims. On top of this “central estimate”, every insurance company then sets aside a financial buffer in case the central estimate is wrong. In the lingo, it’s called a “prudential margin” or “risk margin”.

Promina’s latest figures provide an example. The company’s actuaries calculated that the likely amount of claims that will be made by customers, in today’s dollars, amounted to $1751.2 million as at December 31. The expenses associated with handling those claims were estimated at $99.2 million. To these precisely computed figures, Promina then added a nice, round $370 million of “risk margin”.

So you can see that it’s all a bit of a guessing game. But, having surveyed the latest figures for each of Australia’s listed general insurers, we are very impressed with the conservative approach they’ve adopted.

QBE Insurance provides a shining example of this prudence. Although it’s one of the largest domestic players, the bulk of its business is conducted internationally and it suffered significant losses due to the September 11 terrorist attacks in 2001. Since then, QBE has become a paragon of conservative reserving.

For example, following the devastation of Hurricane Katrina last year, the company announced that any resulting claims would be “within the substantial allowance for large losses and catastrophes included in our insurance liabilities held at June 30, 2005”. In other words, QBE’s risk margin more than covered its financial losses from Katrina. The company made a similar announcement following the Boxing Day tsunami in 2004 and the four hurricanes that hit the US in August and September 2004.

We’re also reassured to see QBE being run by a dyed-in-the-wool insurance man, Frank O’Halloran. That’s more than can be said for Promina, IAG and Suncorp. The former being run by a long-time funds management executive and the latter pair by ex-bankers. And although we would normally be alarmed by a company that has made more than 90 acquisitions in the past 20 years, QBE has done just that and done it very well.

Our sole problem with QBE is its price. The stock has risen 32% since we last reviewed it, in August 2005 (our verdict was to Sell). Although our estimate of intrinsic value has risen substantially over the past 12 months, it is still comfortably below the current share price. Better value elsewhere.

Suncorp-Metway is different to the other stocks in this review as it has substantial operations in banking and funds management. It was also one of our top Buy recommendations three years ago. But the price has doubled since then. And the company’s current managing director, John Mulcahy, changed Suncorp’s investment approach at almost exactly the wrong time, in 2003, costing shareholders hundreds of millions in forgone profits.

We first recommended taking some profits at $18.55 in February 2005. The price has risen a little since March this year when we suggested taking part-profits at $19.83 and, as with QBE, we’d be interested in buying back in, but only at well below today’s price. For the time being our recommendation remains to take part-profits.

Management at Promina seems intent on stuffing more debt into the group’s balance sheet. In its recent annual report, management jubilantly announced that the group’s gearing ratio “increased from around 12% at the end of the last financial year to 18.1% on our way to the optimal gearing ratio of 25%”.

Increasing the group’s financial gearing at this point in the cycle may prove profitable, but it comes at the expense of greater risk. Combine this with a share price that’s up 17% since issue 172/Mar 05 (Sell'”$4.75) and we remain cautious. Better value elsewhere.

Our least favoured insurance stock is IAG. First, we’re not fans of the group’s international expansion plans. Since July last year, IAG has completed four international acquisitions: two in Thailand, one in Malaysia and one in China. And it seems that we’re not the only ones that are concerned.

In a recent APRA bulletin, the regulator made the following statement in relation to an unnamed “ASX listed” insurer: “Of course, pursuing options other than domestic organic growth does not necessarily mean a significantly increased risk to Australian policy holders. However, experience in other industries has shown that boards and senior management can take their 'eye off the ball’ domestically when seeking growth opportunities in overseas markets.” Who said regulators only ever sound the alarm after a disaster?

IAG is also taking an aggressive approach to investing its shareholders’ funds. In February last year the group began to invest in hedge funds and, by the end of December, 7.7% of IAG’s shareholders’ funds had been placed in these vehicles. On top of that, an additional 61.2 percentage points of shareholders’ funds were invested in equities (both Australian and international).

While IAG’s share price is down significantly from its high of $6.95 in February last year, it’s up 4% since November 2005, when we recommended selling at $5.35, and our view remains very negative. Sell.

The one pocket of value we see in the sector is tiny upstart Calliden. We explained the situation when we reviewed it in January this year (Speculative Buy'”$0.375) and, for what it’s worth (which probably isn’t much), we note that AMP recently became a substantial shareholder in the group.

The share price is little changed since March 2006 (Speculative Buy'”$0.46) and we continue to recommend the stock as a Speculative Buy, for no more than 2% of your portfolio.