Feature Stories | Oct 19 2023
This story features INSURANCE AUSTRALIA GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: IAG
As we begin a period of El Nino, analysts suggest Australia’s general insurers are set to enjoy a period of significant earnings upside.
-El Nino to reduce insurers’ catastrophe risk
-Higher rates mean stronger income
-Inflation easing on cost of repair/replacement
-Significant upside risk to earnings
By Greg Peel
After three years of La Nina conditions, the Bureau of Meteorology has officially declared Australia has now entered a period of El Nino. From cold and wet to hot and dry.
This implies catastrophe costs for insurers should now be more benign than they were in the previous years, which brought floods, hailstorms and cyclones.
Ah yes, I hear you think, but El Nino means bushfires. Remember the summer of 2019-20? And we’ve already seen fires break out across the country and it’s only October. Surely, catastrophes during El Nino are just as bad.
Well, apparently not.
During El Nino systems, notes Wilsons, the costs associated with an increased frequency and severity of bushfires has historically been more than offset by a reduction in the occurrence of cyclones, storms, hail, and flooding, which are on average much costlier to insurers.
Since 1967, bushfires have accounted for only around 12%, or $20bn in today’s money, of the insurance industry’s total catastrophe losses, compared to the combined contribution of cyclones, hail, flooding, and storms, accounting for around 76% or $122bn real.
Given insurance industry catastrophe losses are, on average, significantly lower during El Nino periods, Wilsons has become increasingly confident in its thesis that natural perils cost inflation should ease over the medium term, and could surprise consensus expectations to the downside.
Jarden has also studied the data going back to 1967, but given growing climate change impacts, has focused more on the past 5-10 years in assessing catastrophe (CAT) budget adequacy, enabling the analysts to “independently and more effectively” assess a key component of underlying insurance trading ratio (ITR) margin guidance.
Put simply, the ITR measures an insurer’s payouts and expenses as a ratio of premium income and investment income, ie profitability. The lower the ITR, the better.
Insurers hold provisions for potential payouts in the form of CAT budgets.
For Insurance Australia Group ((IAG)) and Suncorp Group ((SUN)), Jarden concludes estimated FY24 CAT budgets appear adequate relative to trailing ten-year trends, with IAG 15% above its ten-year average to FY23, and Suncorp sitting 6% ahead. While budgets appear more in line or slightly below trailing five-year trends (IAG 0%, Suncorp -4%), Jarden notes this included three higher activity La Nina years.
Best Income Outlook in Years
Insurance companies collect premiums from customers and invest the proceeds into cash and fixed income instruments. Claims payouts draw upon the income derived from investments. To be profitable, an insurer needs to earn more in premiums and investments than it pays out in claims.
Up until 2022, the investment side of the equation has been tough for insurers given low and near-zero rates prevailing since the GFC and through covid. In the shortest space of time ever experienced, interest rates are now back at levels not seen since before the GFC, providing insurers with historically more normal investment income.
However, interest rates have risen in the face of runaway inflation brought about by covid-era constraints and the Ukraine War. Like any other business, insurance companies have suffered from inflation as the cost of payouts has risen due to the rising cost of labour, raw materials, autoparts and so forth, increasing the cost of replacement and repair.
Inflation is now easing – swiftly at first, but now at a slower pace given lingering issues. Lingering issues such as sticky services inflation, rising petrol prices and elevated rents will keep the RBA cash rate at least at peak level for a period of time yet, or we may see another hike or two. Thus investment income can remain solid while cost of labour and goods cost inflation decline.
Insurers have countered inflation cost and elevated CAT claims in the past three years by increasing insurance premiums. Insurers also pay for insurance (reinsurance) to provide at least some buffer against CAT payouts, and the more the payouts, the higher is next year’s reinsurance premium.
Investment income aside, insurers must recover higher reinsurance costs again by passing them on to customers.
Which begs the question: Given the current cost of living situation, can Australians continue to afford ever higher insurance premiums?
The cost of home/car insurance has risen substantially in high-risk areas such as floodplains and bushland sites with insurers eyeing off climate change with dread. In some cases, premiums have simply become too financially overwhelming for customers. In other cases, insurers are now refusing to offer insurance at all.
While this might seem to some morally unjust, it must be remembered insurance companies are businesses, not charities. Listed insurers are beholden to shareholders. In past decades, governments federal and state have privatised what were once government-owned insurers that could act in the best interests of customers, despite the risks and cost. Not so anymore.
But despite the rising cost of premiums, Wilsons has found cost of living pressures have not had a material impact on customer churn across the general insurance sector. IAG’s retention rates remain “very strong”, the company has noted, at 90-95% for its Direct Insurance Motor and Home segments, and the business continues to add customers in spite of the significant increases in premiums paid by policyholders.
This is consistent with the analysts’ view that general insurance is a largely non-discretionary expenditure item that will remain relatively resilient through consumer slowdowns, with recent natural disasters ultimately highlighting the value of being insured to safeguard assets against catastrophes.
The degree of demand inelasticity among policyholders gives Wilsons confidence the industry is well placed to pass on future cost inflation as it occurs, such as structural growth in CAT losses due to climate change.
All The Little Ducks
Upside drivers for insurance company earnings:
-El Nino brings lower CAT claims
-Lower CAT claims lead to lower reinsurance cost down the track
-Higher interest rates lead to stronger investment income
-Higher premiums add to earnings and policyholders are “sticky”
-Insurers’ cost inflation is easing, implying stronger earnings margins
Jarden notes climate models suggest El Nino should remain in place until at least the end of February, hence more favourable CAT trends could persist through the key summer months ahead. Jarden also notes longer-term weather patterns point to potential for extended benefits into FY25.
El Nino/La Nina swings are driven by warmer/cooler ocean temperatures between the east and west of the Pacific Ocean. Australia is also impacted by the Indian Ocean, which gives us the “Indian Ocean Dipole”. The IOD is similarly impacted by temperature differences from east to west, and can intensify or counter the Pacific influence.
As we all know, the wall on which the BOM’s dartboard hangs is full of small holes. El Nino periods can be long or short, they can be counter-influenced by the IOD, and quite frankly, are a guessing game. Jarden complicates the issue by drawing upon yet another measurement –Pacific Decadal Variability –which, as the name suggests, is a longer-term model.
Jarden cites research from insurance industry advisor Aon:
"The current build-up of upper ocean heat content in the subtropical south-west Pacific – caused by three consecutive La Nina events on top of persistent La Nina-like PVD conditions for the past 24 years – means the PDV is nearing a tipping point, where a moderate El Niño event in the 2023-2025 period could flip the PDV to the El Niño-like phase for the ensuing decade".
Around the turn of the century, Australia experienced the “millennium drought,” which began with drier conditions appearing as early as 1996, which intensified in 2001-02, and by 2003 was deemed the worst drought in Australia’s recorded history. It ended in 2010 when Na Lina appeared.
A sustained El Nino through summer could support IAG/Suncorp FY24 earnings upside risk of just over 20%, Jarden estimates. Given balance sheets are in good order, the analysts expect any FY24 upside to flow through to stronger dividend yields, though they note longer-term weather patterns point to potential for extended benefits into FY25.
With CATs now an upside risk to accelerating underlying ITR profits, Jarden retains a positive sector stance with Suncorp (Buy) preferred over IAG (Overweight).
Note that Jarden uses a five-tier ratings system. Overweight sits between Buy and Hold.
Wilsons suggests IAG is poised to deliver the strongest earnings per share growth over the next 3-5 years out of the ASX-listed general insurers, with risks skewed to the upside versus consensus in the analysts’ view.
Citi put out a note in early September stating,” In our view, QBE remains inexpensively priced and a clear top pick in insurance on a 12-month view”.
Key to Citi’s forecasts on QBE Insurance ((QBE)) is expectation of strong earnings growth beyond FY23 “particularly if it can improve returns from its North America business”. QBE’s offshore exposure distinguishes it from IAG and Suncorp.
For the record, all of the six brokers monitored daily by FNArena have Buy or equivalent ratings on Suncorp, except for Ord Minnett (Hold). It should be noted there is a twist, in that Suncorp is trying to sell off its bank business.
IAG draws three Buy ratings from the same brokers, two Hold and one Sell (UBS).
Ord Minnett has again the only Hold rating for QBE, among five Buys.
Note that ratings reflect earnings expectations vis a vis current share price valuation on a relative, not nominal, basis.
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.
FNArena is proud about its track record and past achievements: Ten Years On