ValueLine: Why I like QBE

PORTFOLIO POINT: There are many insurance stocks on the ASX but only one is attractively priced.

Who would buy insurance stocks just now? What with the increasing frequency of catastrophic events, a highly competitive marketplace and impenetrable financial results you could be forgiven for wondering what could be attractive about investing in insurance.

Well '¦ the world’s greatest living investor, Warren Buffett, can see the attraction. His Berkshire Hathaway is a major shareholder in General Re and Geico.

No surprise then that while uninitiated shareholders run for cover every time they hear of another earthquake, a select group know that the best-run insurers have more money at their disposal than many fund managers and consistently deliver profits.

Indeed some insurers are so well protected against events such as freak storms that sometimes they even make money out of them.

A well-run insurance company can be one of the truly great businesses to own and, as I explain today, with the right tools and a bit of homework you should be able to identify the insurance business that completes your portfolio.

In Australia the three major general insurance companies are QBE Insurance (QBE), IAG Insurance (IAG) and Suncorp (SUN). These companies are distinct from life insurance specialists who are another kettle of fish and perhaps the subject of another column.

QBE has been regarded as the premier listed insurance company for many years. Led by long-term chief executive Frank O’Halloran, the company has been one of the few in Australia to successfully execute a growth-by-acquisition strategy. More recently it has been sold down after results came in at the lower end of its guidance; QBE closed yesterday at $21.03 and is on a price/earnings (P/E) multiple of 10.8 times.

IAG, on the other hand, trading at $3.99 on a P/E of 16.7 times, has been something of a disappointment to shareholders, especially after it rejected a takeover bid from QBE at $5.14 a share in 2008 and later returned to the market for a capital raising.

Unlike QBE, IAG’s acquisition strategy has been far less successful; triggering the replacement in 2007 of chief executive Michael Hawker with Mike Wilkins, which was a popular move among my investment peers.

Suncorp, currently trading at $8.63 and on a P/E of 25 times, is a little different. It’s a mix of regional banking assets and an insurance business: in other words, an unfashionable conglomerate. Suncorp has had particular trouble integrating its acquisition of Promina, made back in 2007, which diluted equity per share and returns on equity. Newly minted chief executive Patrick Snowball has begun a strategy of selling non-core assets and refocusing the business.

How the business works

Insurance companies make money two ways. The first is exactly as you might think: by writing policies, collecting premiums and paying claims. Very easy to explain, not so easy to perfect.

An insurance business books a profit from these activities when claims and operating expenses are deducted from the premiums. This is also known as the underwriting profit. Margins from this side of the business can be quite skinny if the company is run poorly because for every AAA lifetime rated driver that has never made a claim there will be a hailstorm that wreaks $400 million worth of damage in just a few hours.

And it’s the proceeds from investing these premiums that constitutes the second revenue stream for insurers. Warren Buffett explained how this works rather eloquently in most recent letter to shareholders earlier this month.

“This collect-now, pay-later model leaves us holding large sums – money we call 'float’ – that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit. Though individual policies and claims come and go, the amount of float we hold remains remarkably stable in relation to premium volume. Consequently, as our business grows, so does our float.”

What this means is that if an insurance business can make an underwriting profit then not only is the cost of the float free, but the company gets paid for holding it while also receiving the proceeds from investing the float at the same time.

This is what makes the insurance business so attractive and why the competition among insurers is so intense.

In fact so intense, that at times that many businesses are prepared to maintain underwriting losses just to secure the returns from the float. According to the Australian Prudential Regulation Authority (APRA), the industry as a whole maintained an underwriting loss from 1995 to 2002.

Another aspect of the insurance business that is poorly understood is reinsurance. This is where the business covers itself by taking out another policy with a third party to cover any unforeseen claims. IAG and Suncorp have announced in recent days that their exposures to the recent hail storms in Victoria were limited to $135 million and $200 million respectively. QBE has yet to make a statement.

What is more interesting is that reinsurance can also deliver windfall payments to insurance companies. Suncorp’s claims from floods in southeast Queensland are expected to rise in coming weeks; if those claims and the ones from hail storms rise above $250 million in total, Suncorp will be eligible for a bonus reinsurance payment of $335 million.

Now that you understand how an insurance company works, it’s worth considering whether any are worth buying right now.

A glance at the earnings profiles of Suncorp, IAG and QBE reveals QBE to be the most desirable of the three. Analyst forecasts for future earnings among our three insurers are also relatively positive.

Keep in mind, however, that analysts are notoriously poor at predicting change and because IAG and Suncorp’s earnings profiles are strongly correlated to stockmarkets, these forecasts are unlikely to survive a severe stockmarket shock.

While first prize is a company whose earnings are expected to be meaningfully higher in the future, it is return on equity (ROE) that drives valuations.

On that score, QBE again tops its peers with forecast ROE of 16.9% in 2010, 17.3% in 2011 and 17.4% in 2012. The latest JP Morgan Deloitte report also ranks QBE the most highly regarded insurer in the country by intermediaries, ahead of its rivals.

IAG ranks second in terms of return on equity with 14.2% in 2010, 13.5% in 2011 and 14.1% in 2010. Suncorp brings up the rear with 6.2% in 2010, 7.3% in 2011 and 8.3% and 2012. The kinds of returns you might expect from term deposit with far less risk.

It is perhaps worth singling out QBE again because it’s the one company in this group that is trading at a price approximating its current intrinsic value of $19.83.

Suncorp, on the other hand, is worth $4.86, a significantly lower valuation than the current price of $8.57 and a lower valuation than in the past thanks to a reduction in equity due to dividends exceeding earnings and dilutive capital raisings, including a $7 billion issue of shares in 2007 to fund the “merger” with Promina, and another $2 billion between 2007 and 2009.

IAG’s intrinsic value is around $3.19 or 20% below its current price of $3.96.

However, in addition to preferring a business at a discount to intrinsic value, I also want a business where the value is rising at an attractive clip.

On that score, of IAG’s 10% growth over two years, QBE’s 19% and Suncorp’s 60%, only Suncorp is demonstrating potential. Unfortunately, even accounting for these gains, in 2012 the intrinsic value of Suncorp will still be below the current price.

Insurance companies are a curiosity from a financial statement perspective and, as of today, that’s all they should be from an investment perspective too.

With a gun to my head and forced to make a decision, I would bet with Frank O’Halloran at QBE every time.

QBE’s proximity to intrinsic value is, relatively speaking, the most attractive of the three.

In my opinion, this is due to the “disappointing” results mentioned earlier and in part to negative sentiment surrounding its exposure to the US dollar. Of course sentiment can change in the blink of an eye: witness CSL’s recent approval with analysts who now look past its US dollar exposure to the “wonderful” business performance underneath.

ValueLine is not forced to make investments in any business unless all the boxes are ticked and so with regards to insurers I’ll wait for a bigger discount to intrinsic value to emerge before committing myself.

Roger Montgomery is an independent analyst and managing director at rogermontgomery.com.