Has IAG Peaked?

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-Pulling further costs out
-FY14 margin likely the peak
-Premium growth slowing
-Subdued Asian contribution
 

By Eva Brocklehurst

Benign weather meant the second half of FY14 was favourable for Insurance Australia Group ((IAG)). The general insurer announced a new Australasian operating model which, with the incorporation of the underwriting business formerly owned by Wesfarmers ((WES)), means an extra $90 million in expected annualised savings will be realised within two years, adding to the $140m in pre-tax synergies previously identified.

Companies impress when they show that, once revenue pressure mounts, they can pull costs out of the business. Credit Suisse observes this is common for financial services companies at present. The $90m pre-tax saving is technically equivalent to 90 basis points of additional insurance margin in FY15 but the broker does not assume that the savings will actually deliver an improved margins, rather they will assist in maintaining the margin and preventing a decline.

IAG has upgraded its expected FY14 insurance margin to 18.0-18.3%, well ahead of prior guidance of 14.5-16.5%. Most brokers think this will be a peak, if indeed it is achieved. A lack of natural peril claims and falling credit spreads are the primary reasons for margin improvement. Citi thinks the cost savings should help in FY15 but there is a risk these savings are ultimately whittled away by competition. JP Morgan had expected margins would peak in FY15 but it seems the trend became more favourable earlier. UBS suspects the current environment is the best it can be for a general insurer. The company is approaching FY15 in good shape and remains the broker's preferred domestic general insurer. JP Morgan observes the added $90m is a large increase in expected savings. If the company is indeed expecting more benefits from restructuring, the broker is comforted by the fact that some proportion is visible to shareholders.

UBS is troubled by the elephant in the room – the question of top line growth, or lack thereof. Market dynamics suggest further expansion would be difficult. UBS estimates IAG can deliver a 14.4% margin in FY15, assuming total underlying margins actually reduce because of the acquisition mix and more aggressive pricing, with excess reserve releases providing the tailwind. Credit Suisse observes the spread gains the insurer has obtained show that not only have base government bond yields fallen in the past six months, but so have spreads. The investment margin impact on FY15 is currently 50 basis points on the broker's calculations and, in a soft environment for premium rates, this needs to be funded internally. 

Brokers observe the growth in premium is slowing, in both commercial and home insurance. FY14 has also been affected by the removal of the fire service levy in Victoria. Having previously downgraded gross written premium (GWP) guidance to 3-5% from 5-7% in FY14, IAG is now guiding to just 3%. Credit Suisse observes this implies GWP growth of less than 2% in the second half. As is the case with most financial services companies in Australia, IAG faces a low growth environment in the coming years and Credit Suisse believes this is why the company has decided on cost reductions as a means to assist earnings.

In a low premium rate environment IAG has limited opportunities and squeezing further growth from the existing customer base becomes harder. Moreover, an increased exposure to commercial lines after the Wesfarmers insurance division acquisition increases downside risk in Credit Suisse's view. The broker retains an Underperform call. Macquarie warns that IAG's share price now reflects a favourable claims environment and having pre-released its results, the company is not in a position to surprise the market at the upcoming reporting season. Macquarie has eased its recommendation to Neutral from Outperform as a result. CIMB also believes further upside will be more difficult to achieve and finds it hard to envisage catalysts for the stock, with business margins arguably at cyclical highs amid a soft earnings growth profile.

IAG expects natural peril claims of around $550m in FY14, implying $220m in the second half which is $100m below the second half allowance. The company has acquired standalone reinsurance protection for the combined Australasian underwriting business, which comprises a main catastrophe cover for up to $1.35bn, including one pre-paid reinstatement, with IAG retaining the first $50m of each loss. As a result, IAG's maximum event retention has increased to $225m for FY15, from $175m. Credit Suisse observes, with a lack of premium rate increases now being achieved in the market, the increased natural peril allowance as a result of the additional risk will need to be financed by cost savings elsewhere.

The company has stated it is confident of improved returns from the Asian operations over the medium to longer term. Acknowledging it may be implying too much from the statement, Credit Suisse suspects this suggests near-term expectations remain low regarding an earnings contribution from Asia. This is consistent with the broker's broader view about the increased challenges in the Asian market.

There are no Buy ratings on the FNArena database, rather six Hold and two Sell. Targets range from $5.48 to $6.20 and the consensus is $5.85, suggesting 5.9% downside to the last share price. The dividend yield on FY14 and FY15 forecasts is 5.4% and 4.8% respectively.
 

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