IAG: Result 2018

Insurance Australia Group's (IAG) strategy is somewhat unique among insurers. It increasingly farms out its unpredictable business in return for predictable fees. Known as a quota share agreement, other insurers are taking more of the insurance risk and paying IAG for the privilege to do so.

This has a few significant consequences. First, earnings volatility is reduced (something that the market seems to appreciate). Secondly, margins are widened. And finally, less capital is needed to support the reduced insurance risk, which again lifts profitability metrics.

All this can make IAG's underlying performance harder to understand, but the 2018 results are clear: the insurer is performing well.

While gross written premium grew a mere 2%, margins rose materially thanks to the quota share agreement. Margins were also improved by favourable weather leading to fewer claims, as well as some changes to actuarial assumptions.  

IAG's biggest segment is Australian Consumer, accounting for over half of the group's gross written premium. The division mostly sells home and motor insurance but it's a solid performer with fat – and improving – margins. Insurance profit grew 3% for the year to $971m.

Segment earnings rose more at the Australia Business division, which recorded a 23% increase in insurance profit to $216m. Improved pricing was the main driver, but margins are still less than half that of the Consumer segment.

IAG's New Zealand business was perhaps the best performer, where a sharp improvement in margins led to a 74% increase in insurance profit to $218m.

IAG premiums are unlikely to record strong growth in the medium term – a few percent per year is all we can expect in mature markets. Earnings can grow at a faster rate by keeping a tight grip on claims and managing expenses. IAG is in the process of materially reducing costs and its quota share arrangements will also help margins. But these measures can only be pushed so far in the long run.

With that reality in mind, we have some doubts about management's target of around 10% annual earnings per share growth for the next few years. Nonetheless, investors should benefit from IAG's capital management initiatives, such as the announced special dividend of 5.0 cents per share.

IAG is a high-quality insurance business, but with the stock trading on a forward price-earnings ratio of 19 and at 5.5 times tangible book value, we don't see a large enough margin of safety to warrant an upgrade. HOLD.