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Treasure Chest: IAG Re-Rating?

Treasure Chest | Jun 28 2021

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

FNArena's Treasure Chest reports on money making ideas from stockbrokers and other experts. Insurance Australia Group may be in line for a re-rating as the prospect of a cyclical recovery is getting better

-Insurance sector earnings likely to be at trough levels
-Potential release of business interruption provisions unlikely in 2021
-Amid conservative provisions, Insurance Australia Group seen offering value


By Eva Brocklehurst

Will Insurance Australia Group ((IAG)) emerge as the winner in 2022 out of a sector that has been severely hurt by the pandemic? Wilsons among others believes so. The broker envisages strong potential for re-rating amid similarities between how the stock has been priced today and how the large banks were treated in the depths of the pandemic.

The pandemic has now meant insurance sector earnings are a trough levels, having underperformed the market by almost -25%, and with this prospect of stronger execution at the company level the outlook for a cyclical recovery is getting better.

Wilsons considers IAG the highest quality local insurer, although it share price has materially lagged its peers such as Suncorp ((SUN)) and QBE Insurance ((QBE)).

The main issue for IAG is the potential of a claims emerging from business interruption insurance, although the broker suspects the company may have over provisioned by a factor of more than 2x.

Ahead of the pandemic, low inflation and interest rates made it difficult for insurers to increase premiums, while the threat of disruptors to the Australian market continued. Earnings of all three insurers then came under pressure, largely from the material provisions required to address the pandemic.

Incidentally, Macquarie believes a contraction in profitable products in the sector could be a sign Insurance Australia may turn to acquisitions to support a better outlook for investors. This view coincided with Commonwealth Bank's Comminsure portfolio being up for grabs (subsequently nabbed by industry disruptor Hollard).

In terms of natural perils, IAG has estimated FY21 net natural perils will be $720-743m, just short of the stop-loss protection to retain natural perils costs of $743m post-quota share.

Citi expects the natural perils allowance will rise to at least $725m in FY22. The broker envisages upside potential in the share price from business momentum, anticipating a higher underlying margin in the second half and improving top line commercial business.

Business Interruption

The industry has been fighting a decision by the NSW Court of Appeal Appeal that a pandemic is an insurable event and the High Court has now upheld the Court of Appeal judgment in relation to the Insurance Council of Australia's first industry test case, by denying the application for special leave to appeal.

UBS suggests the focus will now be on subsequent test cases around the definition of the disease, proximity of an outbreak to a business and prevention of access to premises because of a government mandate.

The second test case will consist of nine separate small business claims from a range of businesses, expected to front the courts in August. UBS also notes Suncorp is unlikely to be affected by the High Court decision while the provisions made by IAG appear most conservative.

The broker suggests, as few claims are been reported thus far, uncertainty will continue until future test cases are resolved and any potential release of provisions for business interruptions are unlikely in 2021.

Wilsons acknowledges IAG is potentially more vulnerable to an adverse ruling from the courts, forcing the industry to pay out on business interruption claims, yet also points out the UK has undergone a similar process, with lockdowns in that country stretching for almost 190 days compared with a shorter period domestically.

The broker calculates Insurance Australia would need to have 37,000 claims, or half of all business interruption policies, at the UK average pay-out of $54,000 to consume the entire $2bn in gross provisions, which seems unlikely.

Excluding any writing back of provisions Wilsons calculates growth in net profit over the next three years of around 5%. This is based on premium growth of just 2.5%, which could be conservative against the backdrop of firming home and motor insurance premiums. All up, the broker suspects a resolution of the business interruption insurance issue will lead to a relief rally in the stock.

Credit Suisse agrees Insurance Australia offers value at current levels, given the conservative provisions have been factored into earnings amid the tailwinds from a hardening insurance cycle.

Morgans agrees the valuation of IAG is undemanding, with future margin improvements likely as price increases roll through the book and pandemic-related provision releases are made over the medium term.

FNArena's database has five Buy ratings and two Hold. The consensus target is $5.47, suggesting 8.2% upside to the last share price.

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