Fair Weather Prevails For General Insurers

This story features INSURANCE AUSTRALIA GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: IAG

-General insurer margins recover well
-Balance sheets strengthen
-Dividends should be the reward
-Life insurance the most unsettled
 

By Eva Brocklehurst

Insurers are complex entities and free cash flow is an increasingly important metric for insurance investors. Cash is a way to compare insurers across regions and accounting regimes. Citi expects a greater correlation between cash flow and stock valuations going forward in the US and Europe and increasing focus on this topic in Asia. The broker is voting for more transparency and believes those companies focused on cash will benefit.

The most comparable measure globally is free cash flow (FCF) and currently Europeans deliver the greatest disclosure while Asia is patchier. Citi estimates an average global insurer holding company free cash flow yield of 7%, based on 2014 estimates, and found the highest yields are in Europe. Insurers are generating a healthy level of capital, with FCF of around 60% of net income globally. In addition, most companies have high cash flow coverage of dividends, supporting dividend growth.

It seems it's calm and clear on the domestic front. Insurance Australia ((IAG)) and Suncorp ((SUN)) have seen insurance margins recover to near all-time highs, benefiting from a lack of natural peril claims, positive investment markets and, most importantly, further improvement in underlying margins. While Credit Suisse expects a slowdown in premium rate increases in 2013, insurance margins are not expected to decline. One of the main headwinds facing insurers in 2012, declining investment income, has stabilised with the recovery in bond yields, and all three listed general insurers – IAG, Suncorp and QBE Insurance ((QBE)) boast significantly stronger balance sheets.

Credit Suisse has recently moved Suncorp and QBE back to a Neutral rating and maintains a Neutral rating on IAG. For the August reporting season, the broker expects there is upside risk to IAG and QBE results and downside risk to Suncorp. On a one to two year view there's upside risk for all three and the key downside risk is a decline in bond yields. QBE remains the broker's preferred pick in the sector. Underlying earnings improvement is expected, driven by the exit from poor performing portfolios, premium rate increases and expense savings. In addition, QBE has significant upside from the recent increase in bond yields, with any increases flowing through immediately to earnings compared with a delayed effect for most of its peers. Citi finds QBE solid and conservative and further capital initiatives should also improve the balance sheet. QBE may be in turnaround mode but the broker is looking for a cheaper access point.

Domestic general insurers should reward investors with dividends, in Citi's view. The dividend forecast for IAG in FY13 of 36c implies 25c for the second half. On Citi's estimates this would only equate to around 64% of cash earnings, well inside the target 50% to 70% pay-out range. While IAG faces the prospect of a slowdown in premium rate increases, the broker expects further insurance margin improvement in the second half  and FY14. In addition to underlying improvement, with a comprehensive reinsurance cover in place and a more conservative natural peril allowance, Citi thinks IAG has the most leverage to favourable general insurance conditions and less downside risk, justifying a price/earnings premium to its peers. IAG's FY14 guidance should reflect further underlying margin improvements. 

Citi expects expect growth in Suncorp's core earnings to be mid-single-digit in the near term, with potential upside to earnings and capital management from further cost cutting and balance sheet efficiencies. Suncorp continues to have a more aggressive natural peril allowance than IAG and QBE which presents earnings risk in the broker's view, in addition to around 15% of base earnings coming from the life insurance book. Citi forecasts a 42c second half pay-out for Suncorp. Although Suncorp is likely to report only a small second half profit, given losses on disposal of the non-core bank, its surplus capital position should still support a sizeable dividend. The broker has a Buy call on the stock.

First quarter Australian life insurance statistics show that steady growth in the life insurance segment has continued. Total in-force annual premiums increased by $216m over the quarter to $11.5bn, up 10.2% on the previous corresponding period. At an industry level new business growth declined, down 18.2% and down 20.4% quarter on quarter. The trends in lapses did improve over the last quarter. Lapses have been a key focal point for BA-Merrill Lynch, the trend being driven by a combination of product design, adviser churn and the economic backdrop.

Of the listed life companies, AMP ((AMP)) continues to lead the pack with a market share of 15.3% and Merrills is forecasting Australian life insurance earnings to represent around 20% of group-wide underlying earnings. With the recent downgrade, the wealth protection segment is now expected to deliver a $54m first half profit including $32m in experience losses. Half of the adverse claims experience relates to income protection and half to term products. For Suncorp, Merrills forecasts life insurance earnings to be around 7-8% of future divisional profits. In June, Suncorp agreed to pay $23m for breaches. including failing to disclose policy upgrades to life insurance customers, which may present some drag to the annual results.

One of the more unsettling items for life insurers has been the magnitude of claims. Reinsurance Group of America has announced an increase in the after-tax charge to increased claims liabilities in Australia. There appears to be a number of environmental factors in the current Australian market leading to a significant rise in claim levels, according to RGA. While AMP is increasing its focus on the drivers of elevated claims, as the largest life insurer in Australia it cannot but be affected by industry trends. Reinsurance is unlikely to be a material offset to these issues, in Macquarie's view.

The structural issues in the life sector that the industry is trying to address include product design – specifically around mental health in income protection, lapse rates, claims management, increased propensity to claim. and pricing structures where some premiums increase as policy holders age. Macquarie has downgraded AMP to Underperform on the basis of the RGA report, noting that the underlying problems of increased life claims are structural and not easily fixed.
 

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