Clouds clearing at QBE

In his recent letter to Berkshire Hathaway shareholders, Warren Buffett warns that ‘a sound insurance operation needs to adhere to four disciplines.

It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively evaluate the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that will deliver a profit, on average, after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can’t be obtained.’

In summary, a quality insurer should be profitable, ruthless on cost control, have a conservative balance sheet and a strict culture of underwriting discipline. Up until 2011, QBE, led by chief executive Frank O’Halloran, had distinguished itself on most of these measures. We’ll discuss QBE’s balance sheet shortly.

In 2011 (QBE has a calendar year end) gross written premium increased 34% to US$18.3bn. But with large individual risk and catastrophe claims increasing 118% to $2.4bn, the underwriting profit fell 58% to US$494m. With investment income increasing 18% to US$776m, net profit fell 45% to US$704m and earnings per share fell 47% to 64.7 US cents.

The result was that the final dividend was cut from 66 cents to 25 cents (franked to 25%, ex date 5 Mar), bringing the annual total to 87 cents.

It’s important to set this result in context. Unlike many of its peers, amid a record year of losses for the industry, QBE still produced an underwriting profit. Remember, too, that the combined operating ratio—a key measure of insurance company profitability—was 96.8%, up from 89.7%. Any insurer that paid out less in claims and expenses than it took in premiums in 2011—that is, had a combined operating ratio below 100%—produced an exceptional result.

O’Halloran retiring

But it wasn’t enough to save O’Halloran’s job. He’ll step down as chief executive on 17 August and join the board as a non-executive director.

O’Halloran’s internal replacement is John Neal, currently chief executive of Global Underwriting Operations. He’s held senior positions at QBE, chiefly in Europe, since selling his business to the company in 2003.

Assuming he wants to adhere to Buffett’s principles, what should Neal do?

With an acquisition-led growth strategy and unpredictable profits, it would be reassuring to see him eliminate QBE’s dividend and pay down debt instead. If, unlike O’Halloran, he ignored the company’s share price and ran the company in the best possible way for long-term shareholders, so much the better.

Unfortunately, this is unlikely. Neal said as much at the results presentation, suggesting shareholders should expect evolution not revolution. But assuming he maintains the company’s underwriting discipline—and with O’Halloran on the board, he almost certainly will—one shouldn’t be too concerned.

The company also announced a $600m capital raising to repay subordinated convertible debt that won’t satisfy regulatory capital standards under APRA’s Basel III regulatory framework. Here was a missed opportunity to solve that problem by cutting the dividend instead of potentially diluting shareholders. Cutting the dividend would go some way towards restoring the balance sheet, which has been stretched by the events of 2011; another year of catastrophes like last year would likely trigger a larger capital raising at a lower price.

Under the share purchase plan (SPP) element of this capital raising, eligible shareholders (see Table 2) have the opportunity to purchase shares up to the value of $15,000. The price will be either the lower of $10.70, which large investors paid in the recent institutional raising, or a 2% discount to the volume average weighted price in the five trading days leading up to the close of the offer. Look out for the details in your letterbox, but we will not be increasing the suggested portfolio limit for risk-tolerant investors above 7%, which implies shareholders near the limit might need to sell stock to take up their entitlement.

We also highly recommend reading How to profit from a share purchase plan and waiting as long as possible before making a decision. Investors not wishing to increase their stake in QBE should watch for an arbitrage opportunity, while those wanting to buy more shares may yet receive a cheaper price on market.

But bear in mind that applications might be scaled back, so you might not receive all the shares you apply for if the purchase plan is oversubscribed, particularly if you already have a large holding. We’ll update the situation closer to the offer closing.

The year ahead

So what of the future?

In accordance with Buffett’s third rule, average premium rates are expected to increase 7% this year, from 5% year to date. This offsets the ‘modest’ increase in QBE’s reinsurance costs, which also provided broader protection.

The company is also withdrawing coverage in areas where it is unprofitable or too risky, increasing deductibles (excesses) and demanding more onerous terms and conditions from customers. 

It’s early days but large, individual risk and catastrophe claims are currently running at 1% of annual forecast net earned premium of around US$16bn. This time last year they were 4.5%. That’s encouraging.

Based on the company’s forecast, QBE should produce earnings per share of around $1.25 in 2012, placing it on a price-to-earnings ratio of 9.4. That’s particularly attractive given investment income is currently depressed due to low interest rates.

There are many moving parts in QBE's business but over the long-term we expect the company’s strong underwriting discipline to produce attractive returns. Should interest rates return to more normal levels, profits should increase dramatically.

‘There are a lot of ways to lose money in insurance’ cautions Buffett, ‘and the industry is resourceful in creating new ones.’ QBE’s results show that it’s adept at sidestepping trouble, although we reiterate that risk-tolerant investors should stick to our recommended portfolio limit of 7%. Conservative investors should stay below 4%, or steer clear altogether.

Despite the share price increasing 5% since QBE clawed by cats from 13 Jan 12 (Strong Buy – $11.10), we’re sticking with STRONG BUY.

The model Growth and Income portfolios own shares in QBE Insurance.