IAG: Result 2012

Insurance Australia Group’s share price has increased 16% since our last update on 17 May 12 (Hold – $3.39), finally eclipsing the price from our initial upgrade in Blue sky for IAG? from 4 Dec 09 (Long Term Buy – $3.83). Even if you didn’t act on subsequent recommendations at lower prices, such as the upgrade to outright Buy on 9 Aug 11 (Buy – $2.82), you would have earned an annualised return (capital gains plus grossed up dividends) of around 5.5%. That’s in the face of the worst year of natural disaster claims in history in 2011 and relatively poor investment returns. While 5.5% isn’t satisfactory, it shows how patience and buying with a margin of safety affords a degree of protection.

The full year result showed that IAG’s underwriting performance doesn’t hold a candle to QBE’s (while not directly comparable, IAG’s combined operating ratio was 101.2% whereas QBE’s ratio was 94.0%). IAG has only produced an underwriting profit once in the past five years, and has relied on investment returns to turn a profit. Returns on technical reserves almost doubled to $924m in 2012, but there were other positives as well.

Gross written premium increased 12% to $9bn due to premium increases, higher volumes and acquisitions. CGU, which operates through a network of insurance brokers, almost doubled profit to $258m. Overall underlying net profit increased 16% to $598m (excluding amortisation and write-offs of $333m, mainly due to the UK business, which is now almost profitable) and underlying earnings per share increased from 24.0 to 28.2 cents. The final dividend was increased from 7.0 to 12.0 cents (fully franked, ex date 30 Aug), bringing the full year total to 17 cents and putting IAG on a 4.3% fully franked yield. Despite $400m of acquisitions mostly across Asia, IAG’s minimum capital requirement ratio of 1.74 sits comfortably above the minimum 1.50 required by regulators.

The company also expects a better year this year, forecasting a 9-11% increase in gross written premium and an insurance margin of 11-13%, up from 10.6% this year. So with the share price slightly above our Take Part Profits limit what should you do now?

On one hand IAG is reaching its potential under chief executive Mike Wilkins, and we’d expect a higher share price if Wilkins can turn the UK business around or offload it. On the other hand, the company’s forecast price to earnings ratio of around 14 and price to book value of 1.8 isn’t obviously cheap, particularly when the company has become a riskier proposition since our original recommendation due to overseas acquisitions.

For now we’re reducing the portfolio limit to 5% due to the lower margin of safety at this price, but slightly increasing the Take Part Profits price in the recommendation guide. If you have better investment alternatives, you could consider selling out all together. But we'll wait for the share price to increase above $4.20 before downgrading. HOLD.