IAG On Negative Credit Watch

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This story features INSURANCE AUSTRALIA GROUP LIMITED.
For more info SHARE ANALYSIS: IAG
The company is included in ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

Insurance company insures against storm damage – La Nina unleashes her fury on East Coast Australia – insurance company pays out and thus has a poor half in profit terms. If it were this simple then there would be little more to say about the current status of Insurance Australia Group ((IAG)) other than it was a case of tough luck and surely it won’t happen that severely again for a while. Although, adding to the woe is the coincidental fall in equity markets where a lot of the premiums are invested. Fair enough, but the markets will turn around eventually as well.

In which case, IAG at a knock-down price looks like good value.

And indeed that was the case on Friday, as the shares opened 5% lower but rallied back to almost unchanged despite the broad market posting a loss. IAG shares are down 4% at lunchtime today, but then so is the entire financial index following Friday’s fall on Wall Street.

But is IAG’s only problem a bit of a tough market? According to management that’s the case. Management took the time to state just how strong the company’s capital position was as the result was released. See – it paid out a full 225% of earnings as dividends. Everything must be fine.

One is reminded of similar comments from US banking CEOs last year, just before dividends were cut, heads rolled, and overseas sovereign capital was quickly solicited at great expense. That is not to imply IAG management is going down the same path as Citigroup’s (now replaced) management, but questions are being asked.

Merrill Lynch is leading the charge. The analysts noted IAG managed to bolster the state of its minimum regulatory capital requirement during the first half by increasing its level of reinsurance and diverting allocation away from growth assets. This is how it was able to still make a 225% payout. Management used the payout as evidence of the strength of the company’s balance sheet, but then refused to provide guidance on whether the ratio would be maintained. Instead, IAG “switched on the DRP”.

While some companies may prefer to deny it, dividend reinvestment plans (DRPs) are a backdoor way of “raising” capital. By offering incentive to shareholders to forgo a cash payout and reinvest dividends into new shares of the company at no cost, that company is hanging onto cash it would otherwise lose. A DRP is effectively a rights issue without the commission. The company still has to rely on shareholders finding the option of more shares attractive, unless it goes that one step further and has the DRP underwritten by a third party for a guaranteed discount. That’s when you know a company’s capital position may not be what it may seem. IAG’s previous DRP was underwritten.

Now ratings agency Standard & Poors has put IAG on “negative credit watch”, which is not good news for an insurer. As Merrills put it: “The house is not made of straw but it’s certainly not bricks and mortar on the capital front either. The wolf is at the door”.

Merrills has put a Neutral rating on IAG, and warns investors may be ignorant of the challenge the insurer has in front of it to recover from its current woes. Macquarie goes one step further, recommending Underperform and suggesting IAG will “bump along the bottom” until there is a clear recovery in the UK business and until “clarity emerges regarding the group’s clearly tight capital position”.

JP Morgan agrees, and notes the downside risk to dividends given capital constraints. JPM sees no reason to change from Underweight.

ABN Amro, however, has ignored capital considerations in its decision to raise its rating on IAG from Hold to Buy. ABN is focused on the company raising premium rates to compensate for the raft of claims both in Australia and overseas. With the share price having been hit and a turnaround in the offing, ABN has upgraded and raised its target to $4.80 – the top of the FNArena database range. ABN Amro was also a keen supporter of the big Australian banks, until recently.

But Deutsche Bank agrees, maintaining its Buy rating and its equivalent target of $4.80. It comes with a caveat, however, in that the analysts see the share price in a holding pattern at present implying investors will have to be patient.

The B/H/S ratio in the database is now 2/5/2. The average target is $4.38 on a range from $3.60 (Citi) to $4.80. Last trade $3.62.

Just how safe is IAG really? There have been a lot of capital surprises in this market lately.

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