QBE clawed by cats

There have been two very bad days in Frank O’Halloran’s 14-year tenure as QBE Insurance chief executive. The first was 17 September 2001, when he was forced to admit that QBE’s reinsurance protection was insufficient to cover the September 2001 terrorist attacks, forcing a capital raising.

The second was yesterday, when a contrite O’Halloran announced that the company was likely to deliver a 2011 profit around half what the market was expecting. In summary, QBE will report a profit 40%-50% lower than last year’s US$1,278m in February, implying a small loss in the second half (the company reports on a calendar year basis).

This is clearly a very big discrepancy and highlights the risks inherent in the insurance business. In QBE: A buy amid the storms on 22 Sep 11 (Strong Buy – $12.17), we explained that the first half of 2011 was already looking like the worst year ever for catastrophes (colloquially known as ‘cats’ in the industry). O’Halloran noted in yesterday’s announcement that the second half was hardly better.

Key Points

Several catastrophes hit late in the half, including the Western Australian bushfires and Melbourne storms. But this year’s floods in Thailand have caused the biggest problem, with QBE’s assessors apparently unable to provide damage estimates before late December because of access difficulties. These disasters mean QBE’s expected 2011 catastrophe claims allowance has blown out by $500m to $2.3bn (almost double that of 2010).

Two other issues will also hurt the 2011 result. First, the European crisis has resulted in credit spreads increasing, leading to $160m of unrealised losses on the company’s bond portfolio (the company restricts investment to high quality debt securities, with management explicitly noting there is no exposure to the weaker Eurozone countries).

Lower rates

Second, lower sovereign interest rates are having an effect on the discount rate used to value claims provisions. As interest rates have fallen liabilities have risen, leading to a $200m unrealised loss. While these last two issues are essentially accounting quirks, they do illustrate the many factors that can influence insurance company profitability in the short term.

Together, these three issues mean the company has downgraded its forecast 2011 insurance profit margin from 11.0% to 7.0%-7.5%. So, what does this mean for shareholders?

Less than you might think. We explained on 22 Sep 11 that insurance companies won’t wear the cost of more catastrophes in the longer term. Instead, you will.

In fact, it’s already happening; management explained on the conference call that 10%-15% increases in premium rates are being pushed through in property lines. It’s pleasing to see evidence that insurance premiums are behaving exactly as they should after a difficult year—they’re going up.

Management is optimistic about 2012. Taking into account premium increases, reinsurance protections, and a catastrophe claims allowance higher than average (but lower than that of 2011), management believes the company can return to a 15% underlying insurance profit margin in 2012.

Very cheap

Conservatively assuming net earned premium of $16bn this year, the margin implies an insurance profit of $2.4bn (compared to $1.1bn in 2011). From this we need to add investment returns on $11.2bn of shareholders’ funds, deduct the interest on QBE’s own $4.8bn of debt and pay the tax man his share (usually around 15%-20% for QBE because so much of its revenue is generated overseas). All up, QBE should report a profit of more than $2bn in 2012 and beyond. Like all good investment ideas, you don’t need a calculator or spreadsheet to know that $2bn of profit is a very healthy return on the current $12.7bn market capitalisation.

In the short term, though, shareholders will feel the pain of a catastrophe-ridden year. The final dividend will be dramatically cut from 66 cents to 25 cents, making a total of 87 cents for the year. While painful, this is a sensible move, preserving the balance sheet and helping to prevent the capital adequacy multiple falling to less than its current 1.5 times the regulatory minimum. Were it less than this figure, a capital raising might be required.

It’s been a terrible year for the insurance industry in general and QBE in particular. So the fact that the company has managed to achieve a combined operating ratio of 96.5 in the face of so many catastrophes is most impressive. In 2012, the company is targeting a combined operating ratio of 89%.

Shareholders in insurance businesses should expect the occasional grim year and 2011, like 2001, are prime examples. If the industry were to face another string of catastrophes in 2012—major earthquakes in Tokyo and California, for example—there could be widespread market dislocation and capital raisings aplenty. QBE would not escape.

Interest rates could also fall further if a Japanese-style deflation takes hold. In that case, the company would report more increases in claims liabilities as discount rates fall. Premium increases would occur but with a lag, and profit would take another hit in the meantime.

Buying into maelstrom

We’re adjusting the recommendation guide prices lower to reflect both the additional catastrophe claims and the higher risk that accompanies a slightly less comfortable capital position. The nature of the insurance industry is that risk is ever-present, which is why we’re sticking with the existing 7% portfolio limit.

Value investing and buying into a maelstrom are frequent bedfellows. This week’s events have been an example of this fact. The market is much too pessimistic about QBE’s prospects, and what was already an inexpensive stock has become cheaper still. That’s why we’re increasing the holding in the Growth portfolio (see below).

QBE’s share price is down 9% since 22 Sep 11 but it remains our only STRONG BUY. Expect a full review following the release of the company’s 2011 final results in late February.

The model Growth and Income portfolios own shares in QBE Insurance. We’re buying 293 shares in the Growth portfolio at a price of $11.10 to take the holding to 1,043 shares.