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IAG Fails The Weather Test, But All Is Not Lost

Australia | Nov 03 2021

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

A spate of natural perils claims early in the season has meant a downgrade to guidance for Insurance Australia Group. Is existing reinsurance cover sufficient?

-Guidance does not account for benefits of write-backs or motoring infrequency
-Yet existing reinsurance cover unlikely to be sufficient
-Insurance Australia Group stock seen trading at an attractive discount


By Eva Brocklehurst

Severe weather events before the peak natural perils season gets underway have caused Insurance Australia Group ((IAG)) to downgrade its guidance. The first four months of FY22 have exceeded the insurer's perils assumptions by -$280m.

As a result, brokers envisage downside risk to earnings, given the limited reinsurance cover remaining if perils remain elevated. Weather models for the Australian summer signal a La Nina event which is typically associated with wetter conditions and the risk of flood and storms.

October 2021 has turned out to be the worst October for the company in over a decade with total natural perils costs estimated at -$330m. The forecast for FY22 natural perils claims has increased to -$1.05bn and the insurance margin guidance range has been lowered to 10-12% from 13.5-15.5%.

This does not take into account motoring infrequency benefits or business interruption provision write-backs, stemming from the pandemic, and Ord Minnett suspects guidance could end up being too conservative as it does not take into account reinsurance recoveries.

Jarden agrees the guidance is not factoring in much benefit from greater reinsurance protection, calculating the remaining $510m in the allowance would cover three more maximum event losses in addition to $80m worth of mid-sized events.

Macquarie calculates around a $400m will be gained in the unwinding of business interruption provisions in the second half, although this will have an impact through corporate expenses rather than margin.

In addition, the benefits from lower motor frequency savings will fade as the economy re-opens, UBS asserts, remaining cautious about the potential for regulatory fines from the recent business interruption test case that could limit options for capital.

Perils Budget

As a result there will be questions regarding the adequacy of the perils budget despite a substantial increase in the FY22 allowance. Citi believes existing reinsurance cover is unlikely to be enough and the commensurate impact on margin is significant.

The broker factors in a higher allowance and points out the company will start FY22 without the stop-loss cover that was purchased in prior years, having argued the cost did not justify the benefit.

Hence, Insurance Australia is now more exposed, as potentially the worst incidents are still to come. Moreover, Citi believes the reinsurance cost versus the exposure trade-off is only going to become more difficult to manage in future years.

That said, the main impact of the significant increase to the perils allowance for FY22 should be short-term, in the broker's view, unless one expects perils allowances need to be permanently higher and the blow-out is simply not just a La Nina impact.

Investors may be concerned that perils costs have been increasing rapidly, yet Ord Minnett observes experience is still within the bounds of historical volatility and insurers will price retrospectively, basing price increases on average experience over the last five years.

The main concern for Credit Suisse is what the latest guidance signals for the outer years and the latest news is a reminder of the potential for increases to perils in future years that could reduce ongoing insurance margins and increase reinsurance costs.

The broker increases FY23-24 assumptions for natural peril costs, to allow for further evidence of increased frequency of severe events. This is taking to account the volatility that the business may need to assume in future should reinsurance cover be adjusted to manage higher reinsurance rates.

Interest Rates

Citi assesses rising interest rates, given the recent increase in 3-year bond yields, will be negative for earnings over the short term, as the marking to market of the shareholder funds fixed income portfolio has no offset via the claims line.

Further on, the higher yield on insurance funds should help with new business margins and, if interest rates rise further, the positive impact should accumulate. All up, the broker believes the stock still offers a positive outlook and is cheaper than it has been for some time.

Macquarie agrees there will be further pressure on allowances for perils in FY23 as these events are happening early in a La Nina cycle yet, while short-term risks exist to the downside, the stock is seen as attractive, trading at a -9% discount to rival Suncorp Group ((SUN)).

Ord Minnett notes Suncorp has not provided an update on the adverse events of the past weeks, although its reinsurance cover offers better protection from the accumulation of small to medium-sized events.

Given the sharp fall in the share price and the favourable catalysts ahead, Ord Minnett upgrades to Buy from Accumulate while Jarden believes the reaction in the share price is overdone and the dividend yield remains attractive.

Jarden, not one of the seven stockbrokers monitored daily on the FNArena database has a Buy rating and $5.65 target. The database has five Buy ratings and two Hold. The consensus target is $5.35, signalling 18.1% upside to the last share price. The dividend yield on FY22 and FY23 forecasts is 3.8% and 5.1 %, respectively.

See also, Treasure Chest: IAG Re-Rating? on June 28, 2021.

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