There’s nothing like a mild spring and summer (so far) to improve the earnings outlook for an Australian insurer. No floods, few storms, but some nasty loss-generating fires, the absence of major quakes in New Zealand and Asia and good weather (which means fewer car crashes), and so it is with Insurance Australia Group (IAG).
On top of that add some lower than expected claims from its long term insurance business, and there’s reason to talk about a record result, not that the market was impressed with IAG shares falling 2.9% to $5.60, almost three times the rate of fall in the wider market.
Yesterday’s sharp upgrade from Insurance Australia Group should now be followed by similar positive statements from competitors such as Suncorp (SUN), Wesfarmers (WES) and QBE (which should have benefitted from a mild hurricane season in the US, though tornados and now the severe winter storms might hurt business).
IAG upgraded its profit guidance for the year to June, by allowing for the higher than forecast release of funds put into reserves in expectation of a certain rate of claims which didn’t happen, as well the strong performance from its domestic arms.
The company said it normally budgets for releases of 1% to 2% a year, but this year it could be as high as 4%, depending on what happens over the rest of the year.
The improvement in the level of reserves release follows better than forecast claims experience on what are called ‘long tail’ claims – or insurance claims that linger for years such as accident, asbestos, workers compensation and other casualty-based claims. The better than forecast claims experience means the company now believes the level of claims over the year will be lower than budgeted for, or the level of payment will be lower.
Claims reforms in NSW and other states in the past couple of years (especially in Workers Compensation in NSW) seems to be resulting in a lower level of long tail claims for insurers like IAG.
As a result of all of this, IAG, which owns major insurance brands NRMA and CGU, yesterday revised its estimated 2013-14 reported insurance margin to 14.5% to 16.5% – a significant boost from the 12.5% to 14.5% target range set last year in the wake of the 2012-13 profit and annual meeting.
The margin for the six months to December could be higher – around 17.5%, or a gross profit margin of 17.5c for every dollar of premium income received.
IAG 1Y – IAG revises full year guidance
The group however lowered its revenue, or gross written premium guidance by 2%. IAG now expects to post 3% to 5% GWP growth, down from the previously 5% to 7%.
“While our financial results for 1H14 remain subject to finalisation, including board approval, we expect to record a strong first half underlying performance which builds on the improvement evident in prior periods,” IAG boss Mike Wilkins said.
“The reported result is also expected to benefit from higher than originally anticipated reserve releases.”
Mr Wilkins said the group anticipated reporting an insurance margin of around 17.5% for the six months to December with the company’s profit results next month.
Commonwealth Bank insurance analyst Ross Curran said, “IAG have come out with a very strong insurance margin in the first half”.
“The margin beat was mainly driven by reserve releases on their long tail business. This demonstrates that the company has been conservative in its pricing in recent years,” Mr Curran said.
The update comes a month after IAG revealed it made a $1.85 billion bid for Wesfarmers’s insurance division.
The deal is expected to propel IAG to the top of the insurance game in Australia and New Zealand, making the company the biggest insurer in Australia.
The transaction would also make IAG the country’s biggest commercial insurer, topping QBE and the No. 1 motor insurer, with a combined 38% market share.
In its statement, IAG listed four major factors behind the improved outlook.
An underlying insurance margin¹ of around 13.5%; net natural peril claim costs slightly in excess of the related allowance of $320 million; reserve releases of over 4% of net earned premium (NEP) following favourable experience in Australian long tail classes; and a favourable credit spread impact of around $40 million.
"This expected first half outcome includes strong underlying performances from each of the businesses in Australia and New Zealand, as well as a small contribution from our Asian operations," said Mr Wilkins.
IAG said the revised reported insurance margin guidance for FY14 includes an unchanged assumption regarding full year net natural peril claim costs of $640 million, and the expectation of no material movement in foreign exchange rates or investment markets in 2H14. Prior period reserve releases are now expected to represent around 3% of NEP in FY14, compared to the previous expectation of 1-2%.
"The revised guidance for FY14 includes no contribution from the Wesfarmers insurance underwriting businesses in Australia and New Zealand, the acquisition of which was announced on 16 December 2013. It remains the Group’s expectation that this transaction will complete in the second quarter of calendar 2014 following the receipt of all necessary regulatory approvals," the company said.
The takeout: On the face of it, an update, but as one analysts wrote this morning, it could also be seen as an earnings downgrade because of the higher than normal level of reserves release and the slowdown in revenue growth.
It can be seen as both and upgrade, and a downgrade. The market reaction yesterday would suggest the latter is the popular takeout so far as big investors are concerned.
Reserves releases are both good and bad news for insurers, as is the original level of reserving (and re-reserving, that is adding more to reserves, is a very bad sign and indicative of poor management).
Often the reserves releases are made to try and achieve a balance between conservative insurance management policies, and making sure shareholders get good profit growth and returns.
Suncorp used higher than expected reserves releases in the wake of the GFC as it battled to clean up its banking business and pay for the costly acquisition of Promina and its group of brands (AAMI mainly). Suncorp survived, and so will IAG, but for some analysts, the high level of release suggests that IAG is trying to hide a slowing in its overall business – the fall in revenue growth was the giveaway.
The interim figures next month will tell the full story – if IAG can manage a sharp rise in profits from a lower rate of growth in revenue because costs are under control, that might be enough to convince big investors. If it can’t then there could very well be a re-rating, downwards.
