The general insurance industry has been under pressure in recent years due to a number of costly natural disasters and poor investment returns amidst (previously) low interest rates and depressed bond yields.
However, we have a favourable outlook towards the sector at this point of the cycle as general insurers are poised to benefit from growth in premiums which is likely to outpace future cost inflation over the medium-term. Insurers are also well placed to grow their investment earnings significantly as they benefit from higher interest rates and bond yields.
The combination of these tailwinds should underpin strong growth in insurance profits, underpinning our bullish sector view, with our key pick being Insurance Australia Group (IAG) (Focus Portfolio 3%).
Natural disasters have driven higher claims costs
General insurers have faced a challenging backdrop in recent years, contending with devastating bushfires in 2019/20, the COVID-19 pandemic and associated business interruption claims, and this year’s La Niña driven flooding across South-East Queensland and New South Wales.
The financial toll of natural disasters has been elevated well above historical norms, not to mention the profound social impacts. For general insurers, this has led to a higher number (and higher value) of claims from policyholders to compensate them for damage to their homes, cars, and businesses. It has also resulted in rising reinsurance costs, which is a trend that is anticipated to continue through FY23.
Positively though, the industry has successfully increased premium rates over the last year, enabling insurers to offset rising costs.
The major players have guided that this trend will continue over the medium-term.
Climate change is another significant long-term risk facing the sector, which could increase the frequency and severity of tail events in the future and result in a structurally higher rate of cost inflation for insurers. However, we are sanguine that actuaries will be able to effectively re-price policy premiums as required to account for changing climate-related risks.
Investment returns are coming off multi-decade lows
Insurers’ investment earnings have also plunged to multi-decade lows.
As premiums are collected upfront and paid out as claims to policyholders in the future, insurers hold a large ‘float’ of capital to invest – typically in government bonds, credit and cash – to generate an investment profit.
Historically, investment returns have been a meaningful contributor to overall insurance profits, helping to smooth out earnings in more volatile periods when underwriting results disappoint.
However, over the last decade, persistently low interest rates and depressed bond yields have put downward pressure on investment returns.
FY22 was a particularly brutal year for investment earnings as bond markets posted their worst return in decades. This saw domestic general insurers incur sizable (largely unrealized) capital losses on their fixed interest investments as bond yields pushed sharply higher and credit spreads widened considerably.
On the bright side, the capital losses associated with rising yields are merely a short-term headwind to earnings. Looking further out from FY23 onwards, the higher underlying yield on fixed interest assets and cash will become a significant medium to long-term tailwind for investment earnings.
General insurers have performed poorly
Unsurprisingly against a difficult industry backdrop, the major ASX listed general insurers have all lagged the broader ASX 200 index over a 3 and 5 year time frame, before staging a recovery this year to date.
We believe the risk of further natural disasters has continued to weigh on sentiment in the sector and that there is excessive pessimism factored into valuations.
However, everything considered, we have a positive medium-term outlook for general insurers as they are poised to benefit from a number of tailwinds, which are detailed below.
The Investment Case for Insurance Companies
Higher premiums are supportive of margins
The recent underwriting performance of the industry has been sound in the face of challenging conditions.
Gross written premiums have risen across the industry as insurers have been repricing their policies to sufficiently offset expected claims inflation. The key priority of the major players has seemingly been on margins and not market share.
Recent guidance from the major ASX listed insurers has remained constructive and generally points to gross written premium (GWP) growth in the mid to high single digits range over the next 12 months.
Supported by premium rate increases, the industry’s net loss ratio (i.e. incurred claims / earned premiums) is now in good shape at 54%, down from the December 2020 peak of 87%.
While the risk of higher-than-expected natural hazard and reinsurance costs cannot be ignored as Australia faces its third consecutive La Niña period, given the supportive premium pricing backdrop, we think insurers are well placed to grow their margins over the medium-term in line with their guidance.
The outlook for investment earnings has improved markedly
Insurers are a significant beneficiary of higher interest rates.
Investment returns are set to improve markedly from FY23 as short-term mark-to-market losses unwind, and due to the higher underlying yield to maturity of bonds and better interest rates available from cash.
We expect this setting to underpin stronger investment earnings, bolstering overall insurance profits in the coming years.
High Court business interruption decision a tailwind for insurers
The High Court’s recent decision to deny appeals relating to the second business interruption (BI) test case is a positive outcome for insurers. It means the original judgement delivered by the full Federal Court earlier this year, which was largely in favour of the insurance industry, now stands as final.
The original judgement finds in most cases insurers were not liable to indemnify the policyholders for COVID-related BI claims. Therefore, insurers won’t have to pay the majority of BI claims, which will allow them to reduce their BI provisioning substantially, freeing up capital on their balance sheets.
General Insurance Opportunities on the ASX
Our preference is towards the Australia-focused general insurers IAG and Suncorp Group (SUN).
| Company Name | Beta | Forecast Multiples | Insurance Industry Metrics (12 mth fwd) | Cash EPS CAGR % | Dividend Yield % | ROE | ROA | ||||||
| PE (12 mth fwd) | Long-term PE (FY5) | P/B (12 mth fwd) | Loss Ratio | Expense Ratio | Combined Ratio | FY0-FY3 | FY0-FY5 | 12mth fwd | Long-term (FY5) | (FY1) | (FY1) | ||
| Insurance Australia Group Ltd | 0.32 | 14.7 | 11.0 | 1.7 | 65.6 | 18.8 | 88.3 | 44.0% | 25.5% | 5.3% | 6.7% | 13.5% | 3.2% |
| Suncorp Group Ltd | 0.86 | 11.5 | 12.3 | 1.1 | 70.9 | 17.2 | 93.1 | 24.6% | na | 6.7% | 6.5% | 9.5% | 2.0% |
| QBE Insurance Group Ltd* | 1.02 | 7.5 | 7.5 | 1.4 | 63.4 | 23.3 | 92.5 | 17.5% | 9.2% | 6.3% | 8.4% | 8.9% | 2.1% |
*QBE is a December year end.
Source: Refinitiv, Wilsons.
IAG (Focus Portfolio 3%)
IAG is the largest general insurer in Australia. The company owns a portfolio of brands which includes NRMA Insurance, CGU Insurance, SGIO, SGIC, Swan Insurance, among others.
We are attracted to IAG given:
- Strongest earnings recovery. As sector fundamentals improve, IAG is expected to deliver the best medium-term cash EPS growth of the ASX listed general insurers, driven by continued premium rate increases. We see upside risk to consensus figures, which look conservative considering the positive industry trends - particularly if CAT event damage normalises towards historical averages (and premiums remain sticky). We are confident IAG can increase its ROE materially above the long-run average consistent with past cycles, which should underpin attractive shareholder returns.
- Undemanding valuation. IAG’s price-to-book ratio has fallen since mid-2019 to more than 1 standard deviation below its 5-year average, despite its above-average earnings outlook relative to both peers and its own history. IAG now trades at a price-to-book discount to the ASX 200, and its premium to the sector has decreased significantly. We think IAG’s premium is warranted given its industry leadership and its superior EPS growth and ROE.
- The High Court decision could underpin capital returns. IAG is the biggest beneficiary of the High Court’s recent BI decision. Since the outcome, IAG has reduced its BI provisions by a fairly conservative 37% from $975m to $615m, which funded a $350m share buyback. Meanwhile, SUN has announced the majority of its smaller $179m BI provision will be released. Therefore, we expect IAG to further reduce its provisioning over time, which could support more capital management initiatives.
Suncorp Group – hidden value potential
SUN is Australia’s #2 general insurer. It owns AAMI, GIO, Bingle, APIA and Shannons, among other brands.
Earlier this year, SUN announced its plans to spin-off Suncorp Bank to ANZ for a purchase price of $4.9 billion. The majority of the net proceeds from the transaction (estimated at $4.1 billion) will be returned to shareholders via capital management initiatives.
We view the simplification of the Suncorp business favourably, however, there is uncertainty around the deal’s approval and timing.
If completed, we think the spin-off could unlock hidden value for SUN shareholders given its insurance business trades at a material implied discount to its closest pureplay peer, IAG.
While we believe IAG deserves a premium, SUN’s implied discount of ~29% vs IAG looks excessive.
Therefore, we see potential for SUN to re-rate higher (although we still think a discount is warranted) if and when the transaction reaches completion (expected in 2HCY2023).
| Current PE (FY23) | 11.5 |
| Current Market Cap ($Am) | 13,703 |
| less: net proceeds of Suncorp Bank ($Am) | 4,100 |
| Market Cap post spin-off | 9,603 |
| divided by: estimated Insurance NPAT (i.e. ex Suncorp Bank) FY23 | 920 |
| Implied PE post spin-off (FY23) | 10.4 |
| IAG PE (FY23) | 14.7 |
| Difference % | -29% |
Source: Refinitiv, Wilsons.
Written by
Rob Crookston, Equity Strategist
Rob is an experienced research analyst with a background in both equity strategy and macroeconomics. He has a strong knowledge of equity strategy, asset allocation, and financial and econometric modelling.
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