Monash sees blue skies ahead for these insurance stocks

Fires. Floods. Wars. Not to mention a global pandemic that’s been roiling economies around the world since early 2020. There’s a seemingly never-ending list of catastrophes with which we’ve had to contend in recent years. And when you look at equity market sectors, general insurers have worn a lot of fallout from these calamitous events.

But it seems insurance companies might have rounded the bend, benefiting from rising interest rates and increasing premium levels across the policies they write. One of Australia’s best-known companies in the space is Insurance Australia Group (ASX: IAG) – the name behind brands including NRMA. Its management reported on Friday that full-year cash profits had fallen more than 70% to $213 million. But it has booked big jumps in its gross written premiums and is pointing to further rises ahead.

IAG and other retail-focused insurers such as Suncorp contrast quite sharply when viewed alongside QBE, another large-cap general insurance company, as Monash Investors co-founder and portfolio manager Shane Fitzgerald explained on Friday.

In the almost 10 years since Monash launched, it has never owned an insurance company. That is, until about eight months ago when QBE was added to the portfolio.

“Because of the certainty that we can see in the earnings and higher interest rates, the premium increases working through the portfolio, the fact that their balance sheets now are very strong – coupled with greater certainty versus the broader market and their PE discount relative to the historical norms – it all stacks up that it’s a good bet,” says Fitzgerald.

In the following interview, he delves into the FY2022 results delivered by QBE, and to a lesser extent IAG, on Friday and Thursday, respectively. He also rates the market reaction to the results and discusses the insurance sector more broadly, giving his outlook over the next few years.

QBE ASX:QBE KEY RESULTS

• Revenue up 26% to US$11.5 million
• Net profit down almost 66% to US$151 million versus first-half NPAT of US$441 million
• Dividend down 18% to 9 cents a share, payable on 23 September

IAG Group ASX:IAG KEY RESULTS

• Revenue down 3% to $18.3 billion
• Net profit down almost 72% to $213 million versus first-half NPAT of $747 million
• Dividend declined to 5 cents a share, from 13 cents in the prior corresponding period

Note: This interview took place on Friday 12 August 2022. QBE is currently held in the Monash Absolute Investment Fund.

What were the key takeaways from these results? What surprised you the most?

Broadly speaking, we currently like the general insurance space for the principal reason that we're seeing strong premium rate increases across the industry. In fact, we've seen strong premium rate increases now for a good three to four years. This is particularly the case of QBE, which is predominantly a business-to-business insurer. And one way you can see that translate in the current results is that Suncorp achieved top line revenue growth of around 10%, largely driven by rate increases. IAG achieved premium rate growth in the mid-5 % range, also driven by rate increases.

So, the rate increases are stronger in the commercial lines of insurance that QBE writes. The other big difference between these two companies is that QBE is much more a global insurance company, with big operations in North America, Europe, and around the world, whereas IAG is mostly an Australian-based insurance company.

Premium rate increases are a good thing for insurance companies because they take between 18 months to two years to work their way through the profit and loss statements. They don't just have an instant P and L impact from a price increase coming through.

With the rate increases coming through, the first place you see the strength of the result coming through is in the strength of the reserves that the company sets aside for future claims. QBE has now built up its reserves to a very high “probability of adequacy”. This reflects how confident they are that the reserves they’ve set aside are adequate.

The other key indicator is in the regulatory capital basis of the two stocks, and QBE’s regulatory capital is now at the top end of its target range.

In the case of QBE, we’ve had four years of premium rate increases, which gives us very strong confidence about the quality of the earnings they're producing now. And more importantly, confidence in the prospect of higher margins and higher profits over the next few years.

Both companies are also benefiting from increasing interest rates globally, which benefits their premium float. This increases the earnings from their investment portfolios and adds to their margins.

We think you're going to see solid earnings growth out of both these companies. And in the case of QBE, it is stronger purely based on its business mix. This period is where we’re seeing a more powerful dynamic for QBE.

The other attribute of the QBE result is that it was relatively clean. With the IAG result, there’s some noise about what they've done with a couple of the numbers. But there is always a lot of moving parts in the insurance companies’ earnings statements, so sometimes you’re just splitting hairs.

These aspects of the results weren’t a surprise but were a very happy confirmation. What I think will become the surprise is just how much the margins in this business can expand over the next one to three years.

What was the market’s reaction to these results? Was this an overreaction, an under-reaction or appropriate?

QBE was up 5% on the day and IAG is up around 50 basis points. So, there was a much stronger reaction to QBE than what we're seeing in IAG today.

I would say it's probably an appropriate reaction.

Would you buy, hold or sell IAG and QBE on the back of these results?

We would say “Buy” on QBE and it just keeps coming back to what we've been talking about, with QBE relatively cheaper than IAG and also in an absolute sense compared to the market. And we would give IAG a “Hold”.

What’s your outlook for these insurers, and the sector more broadly, for FY23?

It’s pretty clear that management has a very strong capital position with an opportunity to report higher earnings over the coming one to three years.

Over the last 10 years, QBE has traded at around a 20% discount to the average multiple of the market. This is typical for insurance companies because they run big balance sheet risk given the threat of a big hurricane or cyclone hitting the coast. But right now, QBE is trading at a 40% discount.

On the other hand, IAG is trading much more in line with its historical average.

QBE is on a forward PE multiple of around 9 or 9.5, while IAG is on a PE of around 12 - so QBE is cheaper in both an absolute and a relative sense.

Uncertainty about what earnings will look like over the coming years is one of the themes in the market currently. Given the economic uncertainty globally, will the US tip us into a recession? How long will the inflation stay? Will we see some demand destruction because of inflation, the high oil price or other factors? But when I look at the insurance sector, I can see a good case for strong profit growth from these companies. It’s almost baked into their numbers from the premium rate increases that have been occurring in their portfolios over the last few years. The market hasn't seen that come through in the P and L statements yet, but they will.

Are there any risks to these companies, and their investors, that investors should be aware of given the current market environment?

The biggest risk is always that a portfolio is under reserve because something changes in the risk dynamic of that portfolio. Inflation is probably the biggest risk now. But inflation is also quite a short-term dynamic. And that highlights another big distinction between QBE and IAG, in that it’s a long-tail insurer, which means the risks it underwrites have a longer duration.

For example, if you're insuring someone's house or car, they either smash up their car or their house has a claim within the full period – or it doesn't.

But in the case of QBE, for corporate liability insurance you don't quite know when that liability's going to fall, which makes it longer duration.

So, inflation can have a more powerful bearing on IAG’s numbers than QBE’s. For example, the inflation we've seen in cars and automotive parts, and the inflation of the cost of repairing houses because of rising trade wages, and building material supply shortages – those things all affect IAG.

The two biggest drivers of inflation now are petrol prices and food. But commercial insurers are insuring the risk for companies – their factories burning down or the professional indemnity cover of their directors. Food or petrol price inflation aren’t a driver of the inflation pressures in their portfolio.

Now, if inflation becomes endemic and we see 6% inflation for years, that becomes a problem for all the insurance companies. They’d need to have reserves at a higher rate than they are now, which would eat into profits. But I don't think anyone's thinking that inflation will stay in the mid to high single digits for a long period of time. 

That's the biggest risk but I don't think it's very likely for either company. Though if it was to happen, it’s worse for IAG because of its short-tail insurance portfolio.

From 1-5, where 1 is cheap and 5 is expensive, how much value are you seeing in the market right now? Are you excited or are you cautious on the market in general?

Rating: 3

The market's pretty choppy now, but I think it looks okay overall. Though there is the earnings uncertainty since inflation spiked a few months ago.

I've got a lot of grey hair, I’ve been in the market for a long time, but I haven't been a professional fund manager in an inflationary environment. And some people in the marketplace have never seen inflation throughout their working lives. Big changes like this take time to wrap your head around.

But we are now much closer to the market being able to fully wrap its mind around the risk of inflation and the flow and effects. The uncertainty in the marketplace is not as high as it was a few months ago.

I think we're likely to see the market move higher from here, but I maintain that earnings certainty is probably the biggest issue right here and now. But for us, the overall level of the market isn’t something that drives our return. We’re about high conviction and finding the individual stocks in the market.

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