Blue Skies for Insurers, Or Not?

This story features SUNCORP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: SUN

– History suggests insurers should enjoy a positive earnings cycle ahead
– Weather remains the big unknown
– No support from rising interest rates in sight
– Stockbrokers line up their sector preferences

By Greg Peel

A week ago the Citi analysts were looking at numbers which suggested $250m might be the upside cost to insurers from Tropical Cyclone Oswald and its aftermath – that which provided recent heavy east coast rain in Australia and a second year of heartbreak, in three, for many SE Queenslanders. As one typical Queenslander put it on the news, “We had a 100-year flood in 2011 and another one in 2013. What the hell does 100-year flood mean?”

By mid last week insurers were talking a cost of $300m, before reinsurer Munich Re responded with a $500m estimation. By week’s end, notes BA-Merrill Lynch, insurers were preparing for even more still. Suncorp’s ((SUN)) current catastrophe claim budget for the second half of FY13 is $250m. Merrills is factoring in, for Suncorp specifically, $140m from floods, $40m from bushfires, $100m for net claims of under $5m and $70m for other events, totalling $350m.

2011 represented the second worst year for catastrophe insurance claims in Australia in four decades. Far and away the worst, in 2011 dollars, was 1974 (Brisbane flood, Cyclone Tracy), while 1999, 1989 and 1984 all represented noticeable catastrophe “spikes”. For no particular scientific reason, it is extraordinary how each of these five spike years ushered in a suddenly very low catastrophe period in ensuing years. And to maintain this trend, the year 2012 featured very low claims levels too. If history is any guide, insurers should be able to look forward to a period of minimal claim levels ahead.

Which means that 2013 to date must have insurance companies feeling a little queasy.

The two most fundamental drivers of insurance company earnings are interest rates – and we’ll get to those shortly – and the catastrophe claim cycle. As long as “cat” claims maintain their cyclical trend – peak years followed by periods of calm – insurance company earnings will also cycle. When insurance companies suffer peak cat years, they burn or overshoot reserves and are faced with higher reinsurance costs ahead. However, peak cat years also give insurance companies an excuse to raise premium rates, which has two benefits. The first is to help them re-establish reserves.

The second is the opportunity to increase profit margins given the new, higher premium regime will remain in place throughout the subsequent cat claim trough. Hence insurance companies typically post their best results (notwithstanding interest rates) in the years following a peak cat year.

Peak cat years also tend to be wet. While bushfires are no less tragic, floods are financially more devastating and indiscriminate. Wet years also multiply motor accident claims. It was only a decade or so ago we learned of this rascal of a young boy called El Nino, and we cursed him for a long and soul destroying drought. By last year we had become equally frustrated with his no less disobedient sister La Nina, to the point we all sighed with relief when the Department of Meteorology told us recently El Nino was on his way back. Better still, we might even be due for a “neutral” period in Southern Oscillation Index terms, in which both children are sent to their rooms.

Having crunched the numbers and adjusted to 2011 levels, JP Morgan analysts calculate that the average cost of claims in Australia is $1bn per year, dropping to $0.8bn in neutral years but rising to $3bn for La Nina periods.

The question for those looking to ride the insurance cycle upswing (further) is thus: has La Nina really gone away for now? The people of Bundaberg, for one, might not believe so.

Trust in the cat-related insurance cycle requires a level of faith. But that doesn’t mean science has not taken the issue of El Nino and La Nina further. As I wrote in June last year (Herding Cats), making reference to an article I wrote in February 2011, a yet to be universally accepted theory is that the shorter, sharper Nino-Nina cycles are overlaid by longer cycles of  wet and dry. Major droughts tend to occur, history has indicated, when El Nino arrives within a longer dry cycle. Major floods occur when La Nina arrives in a wet cycle. The other way around, the impact of either is tempered. The question is: having endured the most recent long dry cycle (which included a decade of drought,) have we now entered a long wet cycle? The 1974 floods and cyclones occurred when La Nina arrived in a long wet. The 2011 floods, followed closely now by the 2013 floods, hint that the long dry, the end to which was overdue, has quite possibly given way to a new long wet.

If so, El Nino will not have much of an impact if he is indeed heading this way. La Nina, on the other hand, will certainly not be welcome.

It is not only insurers who have been a little spooked by the 2013 weather to date — insurance sector analysts are also experiencing just a little doubt.

Insurance companies do not price their premiums such that there will always be enough money to cover claims even in peak years, leaving the rest as profit. The business is too competitive to allow that luxury and besides, insurance would be way too pricey for most customers against the risk. Hence it is insurance companies who must take the risk and run a fine balance between premium prices and reserves. Fundamental to maintaining sufficient reserves, while at the same time operating profitably and paying attractive dividends, is the investment of premiums collected. Insurers must invest their cash to beat inflation and provide for “long tail” claims, such as life insurance, down the track.

Insurance companies are not cowboy punters. They invest in mostly government and semi-government fixed income assets. The Australian ten-year bond yield has been trading at historic lows in recent times. Elsewhere in the world, real rates (net of inflation) are negative. Until the interest rate environment changes, insurance companies will struggle to secure investment returns.

Weather is in no way correlated to global monetary policy. Hence those analysts who are positive on the prospects for Australian insurers over the next few years are putting faith in a cyclical return to a period of low cat claims. Business-related claims are, however, very much beholden to the economy. That we are now seeing an unprecedented level of global central bank monetary policy easing is a reflection of the GFC and its lengthy fallout. That we are now seeing a return to risk appetite among investors suggests easy policy might just be starting to work. If so, business-related insurance claims should fall in the years ahead.

So if we take the prospect of lower cat claims, lower car accident claims in drier weather, and lower business-related claims in a healthier economy, and assume other claims such as life insurance follow a steady trend, and combine those with higher premium prices charged, insurance companies should indeed be looking at a period of higher margins and profits ahead even if interest rates remain low.

Morgan Stanley suggests insurance underwriting margins, and hence earnings, are not yet at their peak in Australia and believes there is room for upside surprise. The peak should hit in FY15, the analysts suggest, by which time global interest rates should begin to recover to deliver further upside potential.

Morgan Stanley also notes that the last positive cycle for insurers, 2002-05, was enhanced by strong reserve releases due to tort and regulatory reform (following the collapse of HIH) which laid the foundation for a more favourable industry structure. There followed the GFC of course, and collapsing interest rates, and then the recent cat spike, so only in this next cycle, perhaps, can insurers begin to enjoy the spoils of reform.

This only leaves interest rates as the issue, assuming cat claims behave themselves. JP Morgan notes yields on insurance sector investments were around 1.2% lower at the beginning of 2013 than the beginning of 2012. “For long tail products, where claims generally take longer to settle,” notes JPM, “this can make substantial differences to returns in the absence of adequate premium rate increases”.

Judging by yesterday’s Reserve Bank policy statement, the Australian cash rate still has room to fall from here (3%) before any talk of it rising. The US Federal Reserve recently switched to a target of 6.5% for the US unemployment rate, from a previous “not before mid-2015”, as to when its funds rate could be lifted from its current zero-0.25% range. It is assumed the ECB will eventually need to cut from its current 0.75% rate. The UK is at 0.5%, Japan 0.1%, Switzerland zero, Canada 1%, and even India saw a rate cut last month, just to name a few.

Global interest rates will rise down the track, and quite possibly very quickly. But not yet. Hence the completely unknown factor of “the weather” is even more important than under “normal” circumstances.

As we await earnings reports from the major insurers this month, we must also note that they have already enjoyed share price bounces off earlier lows, to varying degrees. This has quite a bearing on revised broker recommendations.

Citi rates Suncorp as its only Buy in the insurance space, despite the recent strong rally in share price. AMP ((AMP)) comes in as second preference with a Neutral rating, bearing in mind that AMP is weighted towards life insurance and that its wealth management business is what is currently driving the share price. The analysts are expecting a solid earnings result from Insurance Australia Group ((IAG)), but believe valuation is stretched at the current share price. Hence Neutral. QBE Insurance ((QBE)) needs to strengthen its balance sheet and reduce costs, and the analysts are hoping for such news at the upcoming earnings release. In the meantime Citi thinks it’s too early, and rates QBE Neutral and fourth pick.

Merrills also has Suncorp (Buy) as first pick followed by AMP (Buy). Insurance broker Austbrokers Holdings ((AUB)) comes in third with a Buy followed by QBE (Neutral), IAG (Underperform) and NIB Holdings ((NHF)) also on Underperform.

Morgan Stanley differs slightly in suggesting it is Suncorp which has run too far, while IAG, albeit not as attractive as it was, still has upside potential. MS agrees with Citi that QBE “demands patience” but disagrees on AMP, feeling the stock is now fully priced. The analysts’ order of preference is thus IAG (Overweight) at number one followed by QBE, Suncorp and AMP, all on Equal-weight. “Equal-weight” is the equivalent of “market-weight” or Hold/Neutral. Morgan Stanley's industry view is "Attractive".

Turning to the full FNArena broker database, FNArena’s Stock Analysis shows Buy/Hold/Sell ratios for the aforementioned stocks as follows: SUN 5/2/1; AMP 3/4/1; AUB 3/1/0; QBE 2/6/0; IAG 1/5/2, NHF 1/2/1.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms