Weekly Broker Wrap: Insurers, Banks And ASX Shape Up For More Business

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

-More competition coming in insurance?
-Pressure on insurer investment income
-Banks getting back into construction lending
-Which engineering stocks are best placed?
-ASX eyes the funds management business
 

By Eva Brocklehurst

As the financial year-end draws closer so too do the deadlines for insurance renewals, particularly for the commercial segment. Commercial business represents 25% of Insurance Australia Group's ((IAG)) and Suncorp's ((SUN)) gross written premium (GWP) and 70% for QBE Insurance ((QBE)). IAG and Suncorp have both indicated they would like to grow their share of commercial. In UBS' view this must involve some margin trade-off, given the flattening prices and increased competition in this market segment.

Modest increases could still be achieved in small-medium enterprises but corporate and middle market rates are at risk of being flat, in UBS' view. Both local and international insurers, notably AIG, have a healthy appetite for larger commercial risks in the growth-constrained Australian economy. Berkshire Hathaway is setting up a new division to target US commercial lines and UBS notes this is being staffed with AIG defectors. The most direct implication is for QBE's Program segment, which has GWP of $1.5 billion, as this competes in similar specialised US markets. Program has been a problem for QBE in recent years and, as the big US players start competing aggressively, QBE will have its work cut out to stabilise and grow North American GWP.

After attending to recouping higher reinsurance costs and restoring margins, Suncorp and IAG are keen to get growing. UBS suspects they may have a challenge on their hands and high single digit GWP growth looks hard to achieve. The broker, from discussions with various industry contacts, believes the corporate end of the market is tough, particularly in mining and related services, and this will filter down to increase the competitor activity in the smaller corporates. In the case of property rates, indicators are that these are likely to be flat to slightly lower at the June 30 renewals. UBS has observed a "new mood" at AIG, since it re-branded from Chartis Australia in February. Globally, AIG has restructured its reinsurance programs, enabling greater levels of exposure to individual risks. Hence, it can become more aggressive in the Australian marketplace.

Investment income contributes 35-40% to IAG's and Suncorp's insurance profit and 25% for QBE. A reduction in Australian bond yields has been one of the key downside risks to earnings in 2013, in Credit Suisse's view, only to be pushed out as the Reserve Bank stays on hold and bond yields factor in a lesser likelihood of cuts to the cash rate. Moreover, rising yields in the US are having little impact on QBE's earnings. QBE's US dollar investments account for around 33% of the portfolio but contribute far less to investment earnings. QBE's investment income is primarily driven by Australian yields. The pressure for QBE is higher, as opposed to Suncorp and IAG, because of the large exposure to floating rate notes, pressured by the fall in the bank bill swap rate and a narrowing of corporate credit spreads.

The insurers, having differing investment strategies, are hard to compare. Suncorp invests in inflation-linked bonds and has offsetting hedges from life insurance. QBE has the most exposure to changes in bond yields. Overall, based on movements in the yield curve and credit spreads, IAG should be seen benefitting most from the conditions at year-end when the next set of results is published. Suncorp will get a similar benefit in general insurance but this will be partially offset by a hit to life insurance. QBE's investment income will be under pressure but the benefits from US long-dated yields should assist. Credit Suisse's preferences, in order, are QBE, IAG and SUN.

Historically, Australian banks' loan growth has tended to outstrip deposit growth, leaving a so-called funding gap that has been filled through wholesale funding. Credit Suisse notes a funding surplus in the latter half of 2010 was driven from strong deposit growth, rather than weak lending growth. This contrasts with two years earlier when there was a slowing in lending growth and subsequent funding surplus. Both these periods were followed by a substantial decline in mortgage price dispersion among the brands in banking, potentially to reduce the funding surplus. As the recent decrease in the funding gap has occurred, driven by weakening of lending growth, Credit Suisse expects the major banks might turn to pricing loans more competitively.

Citi observes that major banks are getting back into construction lending. New construction lending in the December quarter rose 160%, albeit from a low base. The March quarter is also expected to show continuation of this strength. In this new cycle, outside of listed property companies and private equity, only the four major banks are significant lenders for construction. Regionals appear unwilling and foreign banks are largely absent in this arena. Loan demand form the listed property trusts is expected to be muted as the sector is now better capitalised, after being too reliant on bank sources back in 2008. Low absolute rates available from US private placements are also constraining property trusts' demand on the banks.

This leaves the banks chasing less-qualified borrowers, in Citi's view. Those that are less able to re-capitalise if circumstances change. Citi also notes spreads between prime yields and borrowing costs are now more favourable, indicating a new cycle is developing. This suggests construction loans with a reasonable level of rental commitment are becoming more bankable. The major banks have the field to themselves but the contraction in mining capex could leave them exposed to projects that look good because of low borrowing costs, rather than because of prospective business demand.

Looking more closely at the engineering & construction (E&C) sector, Citi has assessed the impact of the resources downturn for earnings and valuation across the stocks covered in the sector. Miners are deferring projects and cutting operation costs and for E&Cs this results in increasing pressure on volumes, price and margins. Stress testing earnings forecasts under a bear case scenario leaves Leighton Holdings ((LEI)), Boart Longyear ((BLY)) and Monadelphous ((MND)) most at downside risk, in Citi's opinion. The broker has trimmed FY13 earnings estimates by up to 2% and FY14-15 by up to 16% across the sector. Downer EDI ((DOW)) is the most preferred exposure and Leighton the least.

LNG business is the longer-dated hope for the construction sector. Australia has 18 LNG projects that are in construction or proposed, representing total capex of US$368 billion and annual production of 120m tonnes. While iron ore's civil, mechanical and electrical capex is seen peaking in FY12-13 and coal likewise in FY13-14, LNG is not seen peaking until FY15.

ASIC has released a consultation paper on ASX's ((ASX)) managed funds services, AMFS. This is ASX's proposition to process retail investor applications and redemptions for managed funds via the CHESS system as it seeks to compete for funds under management with the more traditional "platforms", such as those of AMP ((AMP)), IOOF ((IFL)) and BT Investment ((BTT)). The value proposition for ASX, according to JP Morgan, is lower transaction costs, ability for fund manager to access investors directly and for advisers to take clients "off-platform". It also provides a new revenue source for ASX. AMFS will be limited to simple managed investment schemes and exclude schemes with illiquid assets or hedge funds. Of note, self managed super funds (SMSF) are heavy users of online brokers, the primary distribution channel for AMFS.

There are hurdles. Brokers may not sign as it could cannibalise their business, moving clients from direct share into managed funds. Also fund managers that are owned by major platform providers may not want to undermine their distribution channels. JP Morgan does not think this proposition will be a game changer for ASX but does suspect certain platforms will have more to lose, particularly those wishing to consolidate the SMSF space or those that have a large exposure to SMSF assets under management, on which they would be collecting administration fees up to 0.5-1.0% per annum.
 

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