Equity Strategy
18 October 2023
El Niño: Heating up the Investment Case for Domestic Insurers
Insurance Fundamentals Remain Robust

The investment case for the Australian general insurance sector remains attractive, supported by:

  • Strong momentum in the premium rate cycle. 
  • The prospect of claims cost pressures easing after a tough period for natural perils.
  • An improved outlook for future investment returns given recent strength in bond yields.
  • Insurance should be relatively resilient through a consumer slowdown. 

The latest updates from the ASX-listed general insurers during reporting season, and the declaration of an El Niño event by the Bureau of Meteorology (BOM) have reinforced our constructive outlook for the domestic insurance sector, with our investment thesis for Insurance Australia Group (IAG) remaining intact. 

The Premium Rate Hardening Cycle Is Gaining Momentum

Figure 1: IAG is increasing premiums at an above-trend pace

The listed Australian general insurers, IAG, Suncorp (SUN) and QBE Insurance (QBE), have highlighted a continuation of favourable pricing conditions in the domestic general insurance sector. 

Repricing trends have gathered momentum with SUN and QBE guiding to ~10% of Gross Written Premium (GWP) growth in FY24, while IAG has guided for ‘low double-digit growth’, which will drive insurance margins (and therefore profits) higher over the coming financial years as repricing ‘earns through’ to the bottom line. 

Encouragingly, the industry backdrop has remained rational this cycle, with the four major general insurers all generally moving in tandem with an overarching focus on improving profitability after a significant increase in reinsurance and perils costs/allowances, rather than vying for market share. 

There is upside risk to IAG’s premium growth in FY25E, in our view, with consensus forecasts currently implying a relatively quick easing of this rate cycle, although hardening cycles can last several years (and we are only relatively early into this cycle). 

While consensus expectations have materially increased for FY24 GWP over the last 12 months, analysts are still only forecasting more or less ‘trend’
premium growth in FY25, which could prove conservative. 

Figure 2: IAG: Premium expectations for FY24 have risen significantly, but consensus estimates for FY25 remain conservative

Cost Disinflation a Medium-term Tailwind

The premium rate hardening cycle has been driven by the significant costs insurers have incurred in recent years.

  • Natural perils costs – La Niña climate patterns throughout 2020-2022 contributed to a significant increase in catastrophe losses, which should normalise over the medium term with the declaration of an El Niño system (more below). 
  • General inflation – The cost of servicing insurance claims has risen in line with broader inflationary trends- that is, increases in the cost of labour, raw materials, motor vehicles, auto parts, etc. Looking forward, cost disinflation (and deflation) is underway within parts of the supply chain (e.g. used car prices), which should provide a tailwind to insurer profitability over the near to medium term. 
  • Reinsurance costs – The increased volatility of natural disasters in recent years has impacted the risk appetite of reinsurers and driven up the costs of reinsurance globally. Reinsurance is an important risk management tool used by insurers to reduce their financial exposure to significant tail risk events. 
Figure 3: Insurance catastrophe losses have fallen sharply in 2023

El Niño Periods Feature Significantly Lower Catastrophe Losses

The recent declaration that Australia has entered an El Niño climate pattern, following 3 years of La Niña, strengthens the investment case for general insurers, as this environment increases the likelihood that natural perils cost inflation will ease over the medium term. 

The differences between the two systems include: 

  • La Niña – characterized by cooler-than-average sea surface temperatures in the Pacific Ocean and increased atmospheric instability, which promotes ‘wetter’ conditions with increased cloud cover and rainfall. The risk of flooding, hail storms, and cyclones is significantly higher amidst La Niña conditions.
  • El Niño – features warmer-than-average sea surface temperatures in the Pacific Ocean, resulting in ‘hotter and drier’ conditions with less atmospheric moisture and reduced rainfall. The risk of bushfires is significantly higher during El Niño events.

During El Niño systems, 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 ~12% ($20bn, real terms) of the insurance industry’s total catastrophe losses, compared to cyclones’/hail/flooding/storms’ combined contribution of ~76% ($122bn, real terms). 

Figure 4: Australian catastrophe losses have been much lower during El Niño systems

Given insurance industry catastrophe losses are, on average, significantly lower during El Niño periods, we have become increasingly confident in our thesis that natural perils cost inflation should ease over the medium term, and could surprise consensus expectations to the downside.

Figure 5: IAG’s natural perils costs could surprise to the downside over the medium term

Positive Operating ‘Jaws’ will Drive Improved Profitability

The ‘earn through’ of ongoing premium increases, combined with cost disinflation, should drive an improvement in IAG’s insurance margins and its return on equity (ROE) over the coming years, supporting attractive shareholder returns.

IAG has guided to an insurance margin of 13.5% - 15.5% in FY24, compared to 9.6% in FY23. This aligns with the company’s ‘through the cycle’ aspiration of achieving insurance margins of 15% and a ROE of 13-14%. 

There is further cyclical upside to IAG’s margins and ROE over the medium term, in our view. In prior cycles, these measures have peaked in the ‘high teens’, although this is not currently being reflected in consensus estimates, which look conservative, creating the potential for analyst upgrades down the line.

Figure 6: IAG: premiums are poised to outpace claims, driving improved margins
Figure 7: Consensus margin forecasts are conservative relative to recent cycles
Figure 8: IAG’s ROE is back in its target range, but remains well below prior cyclical highs

Strongest Investment Earnings Outlook in a Decade

After years of subdued investment returns, the insurance industry is now poised to generate strong investment profits, following this year’s run up in interest rates and bond yields. 

IAG’s ~$12bn investment portfolio consists predominantly of its technical reserves (i.e., its float of collected premiums), which are invested into cash and fixed interest securities. Over the medium term, we will see a significant uplift in investment earnings reflective of the higher available returns from cash and fixed income, allowing insurers to once again generate attractive, annuity-like investment earnings that supplement their underwriting profits. 

In FY24, IAG is expected to generate net investment income of $524m (57% of IAG’s total net income), which is close to a threefold increase on FY21 ($139m). 

Figure 9: IAG’s investment earnings have been upgraded in line with rising bond yields

Insurance Has Been Resilient amidst the Softening Consumer

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’ 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 our 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 us confidence the industry is well placed to pass on future cost inflation as it occurs (such as structural growth in catastrophe losses due to climate change). 

Figure 10: Insurance has been the fastest growing category of household spending in the past 12 months


Insurance Australia Group (IAG) Offers the Purest Exposure to Australian General Insurance

IAG is held within the Focus Portfolio as our top insurance pick, given:

  • Market leader – As the leading general insurer in Australia and New Zealand, and the only ‘pureplay’ Australia-focussed general insurer listed on the ASX, IAG provides the most leverage to the attractive fundamentals of the domestic general insurance sector.
  • Strong underwriting record – Over the Past 5 years, IAG has demonstrated strong underwriting skills, including an average combined ratio (i.e., losses from claims paid plus expenses incurred, divided by earned premiums) of ~89%, which compares favourably to QBE and SUN at ~98% and ~92%, respectively. A a lower combined ratio indicates better underwriting profitability (i.e., a better pricing of risk). 
  • Strongest earnings outlook – IAG is poised to deliver the strongest earnings per share (EPS) growth over the next 3-5 years out of the ASX listed general insurers, with risks skewed to the upside (vs consensus), in our view. 
  • Undemanding Valuation - IAG's forward price to book ratio, at ~1.9x, sits below its 10 year average of ~2.1x, which we view as undemanding considering the strong cyclical tailwinds and IAG's medium-term earnings trajectory.
  • Capital management upside - IAG is the only ASX-listed general insurer currently conducting capital management activities; it is currently ~35% of the way through its $350m on-market buyback. There is scope for further capital management over the medium term, given IAG’s strong balance sheet, improving profitability, and considering the likelihood (in our view) of further Business Interruption (BI) provision releases (provision is currently ~$400m), following favourable court rulings.
Figure 11: Comparison of ASX-listed general insurance companies
Company Name Ticker Fundamental metrics (NTM) Industry metrics Consensus earnings Company description
P/E P/B ROE Combined ratio CY24 CY25 3 yr CAGR (FY0-FY3) EPS revisions - last 6 mths
Insurance Australia Group IAG 15.3 1.9 14% 89% 29% 9% 37% 7.6% IAG is the leading personal lines insurer in Australia (~30% home/motor market share) and New Zealand (~60% home/motor market share). IAG is the only 'pureplay' exposure to the Australia-Pacific general insurance sector on the ASX and therefore, offers the most leverage to the attractive underlying fundamentals of this market.
QBE QBE 9.2 1.4 18% 98% 25% 3% 27% 7.4% QBE is a large global general insurance and reinsurance company with a diverse service offering throughout ~50 countries, including ~25% exposure to the Australia Pacific market. QBE's track-record has been mixed historically with a number of unprofitable acquisitions offshore destroying shareholder value, albeit the new CEO is generally well regarded.
Suncorp SUN 13.1 1.3 10% 92% 8% 5% 7% 5.6% Suncorp operates the 2nd largest general insurance business in Australia and New Zealand, and owns a 'sub-scale' regional bank. We are cautious towards regional banks at this point of the cycle. Uncertainty remains around SUN's planned spin off of its retail bank after the ACCC made the decision to deny authorisation of the sale of Suncorp Bank to ANZ.

Source: Refinitiv, Visible Alpha, Wilsons.


Key Risks Facing IAG

ASIC proceedings on loyalty discounts add uncertainty, but only to a small proportion of IAG’s book

  • The Australian Securities and Investments Commission (ASIC) recently announced civil proceedings against IAG for allegedly misleading customers about loyalty discounts available for certain types of home insurance offered by SGIO, SGIC and RACV.
  • IAG has firmly disputed these claims and will defend itself in the Federal Court. If unsuccessful, IAG could face fines and remediation costs.
  • IAG’s potential exposure is uncertain at this stage, with no provision currently held, although potential costs have been estimated to be significantly less than IAG’s existing BI provisions which we expect to be largely released over the medium term. 
  • The policies under scrutiny represent a small proportion of IAG’s total book. It is estimated that IAG’s total home GWP in Victoria, South Australia and Western Australia (where SGIO, SGIC and RACV operate) represents only ~5% of group GWP. 

Greensill Capital claims: Despite the media attention, IAG has ‘no net exposure’ 

  • IAG has disclosed $7bn of legal claims related to trade credit insurance policies issued by a former commercial partner (BBC) to Greenshill Capital before the latter became insolvent in 2021. 
  • IAG owned a 50% stake in BCC until April 2019. 
  • IAG maintains it is not liable for the claims made under purported Greenshill policies. IAG is not bound by the policies because they were issued outside the terms of BCC’s underwriting authority. Moreover, even if IAG is bound by the policies, they do not provide cover for the alleged losses claimed.
  • IAG has highlighted it has no ‘net’ payout exposure to policies sold through BCC and that the $7bn face value of claimed amounts is ‘not a meaningful indication of any potential exposure,’ given its reinsurance arrangements, among other recovery rights. 
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