Conservative QBE Still Looks Attractive

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This story features QBE INSURANCE GROUP LIMITED, and other companies.
For more info SHARE ANALYSIS: QBE
The company is included in ASX20, ASX50, ASX100, ASX300 and ALL-ORDS

By Greg Peel

Back in February, the analysts at Deutsche Bank described it as a “watershed event” when general insurer QBE Insurance ((QBE)) failed to meet expectations for its half-yearly profit. Just as there are toddlers in drought-stricken areas who do not have any experience of rain, young insurance sector analysts will have only known QBE to exceed guidance in their entire careers to date. QBE has proven no less than a raging success story as an insurer, rising from $10 at the beginning of 2004 to $30 at the beginning of 2007.

So is it all over? Has QBE finally seen the end of its days in the sun? The prognosis for the insurance industry both in Australia and the US is hardly a rosy one.

In the US it’s all about the credit crunch, which first created a very big scare from the monoliners. Large US monoline insurers are very exposed to debt security write-downs from the banks, having been swept up in the euphoria surrounding instruments such as CDOs. At one point it looked like America’s biggest insurers could go under, and smaller companies did. The virus has now spread further into general insurance, as the onset of a US recession augurs badly for business failures and consumer defaults. While such a period should require higher premiums as a trade off, increasing premiums in the current market may not be commercially viable. Margins are under pressure.

The state of play in Australia is not quite as dire as that in the US – at least not yet. As interest rate costs rise for all and sundry the ramifications have yet to play out. Australia has also seen a significant increase in violent weather, where drought has turned to flood in rural areas and urban areas are being constantly hit by fierce storms. Call it climate change, call it a natural swing back to La Nina conditions, but either way more exposed insurers such as Suncorp-Metway ((SUN)) have been looking to the skies with trepidation.

While all this has been going on, equity markets have been correcting 15-25%. Insurance companies rely on financial market investment of their premiums in order to maintain margins and keep premium costs at affordable levels, while all the while attempting to provide value for shareholders. Weaker markets mean insurance company margins are being hit from both sides.

QBE has seen its share price fall from $35 to $20 in the 2008 malaise, although recent renewed optimism has taken it back to $25. Now that we have hit at least a temporary period of lower volatility, it’s a case of whereto from here. QBE held its AGM on Friday.

The good news is management reaffirmed 2008 guidance of 19-20% insurance margins, in a balance of 7.5% growth in gross written premiums (GWP) and 10% growth in net earned premiums (NEP). In 2007 management guided for an 18.5-20% margin increase but achieved 22.2%. Management now expects margins to fall by 3% instead of 4% previously. This is because the main renewal month of January saw only 2% reductions.

And the good news also is despite all that is wrong with the US, QBE has actually seen its average rate increase by 0.1% in its US portfolio as compared to a 0.1% decrease in 2007.

From the investment perspective, QBE spent 2007 100% hedged against adverse equity market movements. So none of this credit crunch correction has had an effect, other than the cost of hedging. Now that we have corrected to what may yet prove to be the near term bottom, QBE is unwinding its hedges. It is now down to 50%, and will keep going, thus allowing the company to take advantage if markets become more buoyant..

But perhaps the news that analysts picked up on most is the company’s “catastrophe allowances”. QBE has increased these from a rate of 6.6% of NEP in 2007 to 8.5% today, and losses above 8.5% up to 10.3% have been protected by reinsurance. Analysts agree these allowances are very conservative. Macquarie notes for catastrophe claims to exceed the level of allowance in 2008 they would have to exceed those of 2005, when a young lady by the name of Katrina made her presence felt.

To put 2005 into perspective, Macquarie notes average catastrophic losses in the period from 1990 to 2004 of roughly US$30bn per year. In 2005 claims were US$100bn. 2006-07 saw a return to normal programming.

Thus analysts agree QBE is facing various headwinds, but has every chance of exceeding guidance in 2008, just like it always did in the past. Macquarie notes the average return on equity for global insurers was less than 16% in 2007 while QBE chimed in with 26%.

QBE is showing a 7/3/0 B/H/S ratio in the FNArena database with an average 12-month target of $29.99. Last trade $25.12.

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