Investment view
Trough earnings, reflecting a scratched and beaten up IAG. The last few years have been tough for IAG – a combination of self-inflicted earnings wounds and a difficult claims environment has weighed on earnings. Since 2018, IAG’s earnings have shrunk by half. A $750m capital raising in 2020 to address the balance sheet, has increased the share count by 15%. This leaves FY22E EPS at 18cps, 65% below FY18 levels. IAG’s share price is approaching 10-year lows, the key question is whether all the bad news is reflected in the price.
Ambitious looking consensus earnings recovery. In our view, the consensus earnings recovery looks aggressive, which assumes EPS recovers to be ~15% below peak FY18 by FY25E. Whilst IAG is pushing through mid-to-high single-digit price insurance premium increases across the core home and motor insurance books, premium increases are required to offset rising claims inflation. The market currently assumes margins will expand by close to 1% in FY23.
Rising reinsurance rates could pressure margins. Global reinsurance (insurance for the insurers) rates are rising in the high single-digits, driven by higher claim costs, increased financial impact of large catastrophes, and pricing power. Suncorp Corp (SUN) in early July flagged “material hardening” in reinsurance rates. IAG will update the market at FY22 Results 12 August.
Weather is likely to remain a headwind. La Nina (wetter than average) weather patterns in Australia are typically associated with higherthan- average claim costs, impacting insurance profitability. Whilst highly unusual, the current two-year La-Nina pattern could extend into 2023, potentially delaying the margin recovery. The BOM1 currently assigns a 50% probability to La-Nina in 2023.
Balance sheet contains optionality. IAG booked a $1.2bn provision in 2021 for COVID claims around Business Interruption insurance. The claims remain subject to legal appeal in the courts. It remains uncertain, how much IAG will need to pay out to policyholders. Our base case is that IAG is over-provisioned. A $600m surplus equates to 25cps per share, which could potentially fund capital management.
Hold recommendation. QBE and SUN are preferred. IAG is scratched and beaten up at present, with the share price close to an 8-year low. The early signs of business improvement are underway. We are conscious of not being too negative on our call given how much bad news has been thrown at IAG since 2019. In our view, the market is too optimistic about the earnings recovery into FY23/24e.
Investors can play insurance themes (rising premiums and rates) more cleanly through QBE Insurance Group (QBE) and Suncorp Group (SUN). The insurance brokers of AUB Group (AUB) and Steadfast Group Limited (SDF) – which are leveraged to insurance premium growth, but without any carrying insurance underwiring risk also present a cleaner way to play the insurance sector.
Risks to investment view
The business of providing insurance inherently involves the pricing of risk. A wide range of variables including factors outside of the company’s control can have a material influence on both the earnings and capital base of company.
Lower than expected insurance premium increases or high claims inflation could eat into the current expectations for improved earnings. Higher than expected reinsurance costs could also impact earnings.
IAG currently has outstanding legal action surrounding business interpretation insurance claims. Whilst IAG has provided $1.2bn for this issue, it is not yet clear if the legal case will consume all that provision. A $600m surplus equates to 25cps per share, which could potentially fund capital management. This would be viewed favourably by the market.
Evidence of margin expansion would increase the confidence of investors around an earnings recovery story for IAG which would leave our Hold recommendation looking to conservative. 1 http://www.bom.gov.au/climate/enso/outlook/
Figure 1: Industry large claim costs have been steadily rising. La NIAG (wetter) periods see higher losses
Source: BOM, ICA, Sandstone Insights. La NIAG periods in Yellow Bars
Figure 2: IAG investment income should improve in the coming years driven by higher bond yields
Source: Refinitiv, Sandstone Insights.
Figure 3: IAG insurance margin has averaged ~15% in recent years. Market consensus is too ambitious on medium-term margin recovery
Source: Company Data, Sandstone Insights
Figure 4: IAG surplus capital under various business interruption payout scenarios
Source: Sandstone Insights
Figure 5: IAG PER at an 8-year low suggests value in the current share price
Source: Refinitiv, Sandstone Insights. Nov 2020 – Feb 2021 Smoothened
Figure 6: IAG P/B lowest in >10 years, suggests the market is not paying up for any potential recovery
Source: Refinitiv, Sandstone Insights.
Figure 7: ROE - IAG is no longer over earning
Source: Company Data, Sandstone Insights
Figure 8: IAG dividend yield is in line with the market
Source: Sandstone Insights
