What now for Suncorp?

In the past few days two companies from different industries have had takeover bids rejected on the basis that they were too cheap. The differing reaction of shareholders speaks volumes about the future outlook for the companies and the industries in which they operate.

The first was QBE, which bid $4.60 for IAG, and the second was BG Group, which offered a 50% premium to buy Origin Energy. In the case of QBE, shareholders were horrified that IAG rejected the offer; but Origin Energy shareholders applauded their board for taking a long-term view.

The problem with general insurance companies is they are virtually impossible to understand. They lack transparency and often underlying profitability is masked by reserve releases.

For the next 12–18 months the insurance cycle is expected to remain weak and the industry itself has, historically, been fairly poor in predicting the turning of the insurance cycle. (See James Kirby’s interview with Lloyds’ Insurance chief Richard Ward, Lloyd’s: The view from the top.)

The listed general insurance sector in Australia is dominated by IAG, Suncorp-Metway and QBE Insurance Group, all of which are battling their own problems as premium income softens, competition remains strong, and insurance margins shrink.

nHow Australia's insurers are performing
	ASX	Price*	52wk High	52wk Low	P/E Ratio	Dividend	Franked	Yield
Suncorp Metway	SUN	$14.10	$21.50	$11.08	13.4	107¢	100%	7.59%
QBE	QBE	$24.10	$35.49	$19.50	10.7	122¢	50%	5.06%
Insurance Australia Group	IAG	$3.93	$6.13	$3.21	22.5	29.5¢	100%	7.51%
* At close, Tuesday, June 3

In the past year, shares in all three companies have been battered. QBE has fallen from $35.49 to $24.10, IAG has gone from $6.13 to $3.93 and Suncorp has gone from $21.50 to $14.10.

In the short term, share prices in the insurance sector are more likely to be boosted by takeover activity rather than improved business fundamentals.

In the case of IAG, its share price was as low as $3.30 before QBE came along with a $4.60 bid. After rebuffing QBE’s offer, the company tried to pacify shareholders by offering up a new chief executive and promising a review of its entire business by early July.

But the risks to IAG in the short term are many: it is under pressure to cut its earnings forecasts in 2009; to cut its dividend, which analysts argue is unsustainable at current levels; and sell its struggling UK-based Advantage/Hastings business, which loses $60 million a year. Whatever it does with its UK business will involve cutting the carrying value on the balance sheet.

As Merrill Lynch analyst Andrew Kearnan says: “The board, which lacks hands-on insurance expertise, has overseen a poor strategic agenda. In our view, more changes will be necessary before credibility can be restored in the marketplace."

For Suncorp-Metway, the story is much the same. It paid $7.9 billion for Promina last year and, on a share price basis, the merger has been an unmitigated disaster. Put simply, almost three quarters of what it paid for the company has been lost from the combined entity.

Besides having to downgrade its earnings, Suncorp is also in the process of merging Promina with the rest of its business. Merging two businesses is never easy but integrating two general insurance businesses is fraught with hidden pitfalls such as under-reserving, the potential loss of good people and the possible inheritance of bad policies. Suncorp has already had a taste of this with the $1.26 billion purchase of GIO in 2001, which was anything but an easy integration.

Suncorp chief executive John Mulcahy raised eyebrows when he first announced the merger with Promina on the basis that the merged entity would be earnings per share dilutive until after 2010.

The best Suncorp can hope for is that one of the big banks or QBE Insurance makes a takeover bid for the group and splits it up.

Wilson HTM banking analyst Brett Le Mesurier has calculated that QBE could afford to make a $19.50 bid for Suncorp, a 35% premium over Friday's close. He estimates that QBE could afford to pay up to $10.5 billion for the general insurer and a bank could pay up to $9.6 billion for the banking and wealth management business. A $19.50 bid price would represent 13.4 times 2009 earnings and 3.4 times net tangible assets.

Though QBE is in a stronger position, it also has a few issues. It generates more than 80% of its earnings overseas. A strong Australian dollar will put pressure on its earnings.

Globally, commercial premium income is also falling. The US-based Insurance Information Institute forecasts that net written premium (NWP) will grow at their slowest rates for more than a decade.

In a recent report on the general insurance sector, JP Morgan says: “In our view, profitability in the industry remains at unsustainably high levels, which is likely to attract further competition.

“In addition, while reserve releases look set to slow, their presence in the near to medium term is likely to continue to mask underlying profitability allowing some to offset rate reductions. The one factor we feel could turn the cycle sooner than expected relates to capacity. Overall though, we still see room for competition and a continuation of the cycle.”

One of the great unknowns facing the general insurers is when the insurance cycle will turn in their favour. What is known is the commercial cycle has further to run and the global commercial cycle is still in decline and will remain so for at least 12 months.

JP Morgan conducted a survey of the sector to get a better indication of what is going on. It found that the market is expecting rates to fall further in the coming year (which is consistent with commentary from the latest results season), and for rates to stabilise next year.

Adele Ferguson is a business commentator for The Australian newspaper.