IAG buys Wesfarmers' insurance arm

Insurance Australia Group (IAG) has agreed to buy Wesfarmers' insurance business for $1.85bn by raising capital and taking on more debt. The deal is expected to close in the second quarter of 2014 following regulatory approval.

The purchase includes the WFI and Lumley insurance brands which produce $1.6bn in premiums. That's around one fifth the size of IAG’s existing business, and the acquisition price of 1.2 times gross written premium is virtually in line with IAG's current valuation. The combined entity will roughly boast a 24% share of the intermediated (or indirect) insurance market (i.e. the insurance market that uses brokers - see Hail the insurance middle man), knocking QBE Insurance from the top spot with its ~20% share. While it's a large purchase for IAG, it's small beer for Wesfarmers and it doesn't impact our view of the company or its valuation.

The acquisition also comes with a 10-year distribution agreement with Coles and Wilkins expects to cut $140m of costs from the business within the first two years. We'll take Wilkins at face value, as cutting costs is what he does best. WFI and Lumley are expected to make a modest contribution to earnings per share within the first couple of years of ownership.

The acquisition is being funded with $300m of debt, $1.2bn from a fully under-written institutional placement offer pitched at $5.47 per share and a potentially unfair $200m share purchase plan (SPP) for individual shareholders that isn't under-written (to ensure you make the most of the SPP even if you don't want to buy more shares you can read How to profit from a share purchase plan). You can only apply for a maximum of $15,000 worth of shares, but check the application forms once they're sent out in case you can apply for any shortfall, should you be so inclined.

Management also reiterated previous guidance for 2014, which includes a 5-7% increase in premiums (excluding any impact of the acquisition). The stock should emerge from a trading halt on 17 December so, although we're a long way from upgrading to Buy given the cyclical nature of the insurance industry, with the company’s share price falling 7% since IAG downgraded to Sell on 4 Nov 13 (Sell – $6.10) we're upgrading to HOLD.