Insurance Australia seems to be weathering recent storms
Insurance Australia (IAG) is a company we hold as part of the Rivkin Blue Chip Portfolio, a strategy popular with Rivkin members. IAG has been in the news recently due to increased claims as a result of storm activity on the east coast of Australia, however here we aim to cover some more of the fundamental aspects of the company. Insurance can be a tricky business to evaluate due to the uncertainty surrounding the timing and amount of actual claims. Even after a claim is made, the amount of the insurance payment can take several years to be fully known and the timing of the payment may occur several years after the actual claim was made. This means that for an insurance company, re-statement of previous years accounts is common, as the extent of losses in that period become more fully known. An analyst therefore, must look carefully to ensure that the company isn't boosting profits in the current period by writing new high risk premiums that will lead to future losses once all claims are realised on those policies.
Having said this, there is no evidence of high risk underwriting occurring at IAG. Gross premiums written have been steadily increasing over the past five years with an EBITDA margin that has fluctuated between 7 and 18%. The dividend yield for 2015 presented in the chart below is lower than the prior couple of years due to a smaller than expected final dividend payment, however a 10 cent special dividend in the current year made up for the reduced final dividend, bringing the true dividend yield over the trailing 12 months up to 6.8%. After accounting for franking credits, this is a gross dividend yield of 9.76%, one of the highest in the ASX100.
As a good example of loss uncertainty for many years after a claim, IAG is still unsure of the final claims cost from the Christchurch, NZ earthquake that occurred in 2011. As of 30 June 2015, 78% of claims by number had been settled however claim reserves had to be increased due to adverse court judgements and an increase in expected repair and rebuild costs. This highlights another problem for insurance companies, something called judicial inflation, resulting from the tendency of judges to rule in favour of the policy holder rather than the insurance company, thus forcing the insurance company to cover damages that were not originally contemplated by the insurer when the policy was written.
A key source of income for insurance companies is the investment return on the premium revenue. Consider the average insurance product. The customer pays premiums to the insurance company starting from the beginning of the policy and the insurance company takes the risk of a claim at some point in the future. This time delay between premiums received and claims paid allows the insurance company to earn investment income on the difference. For IAG, investment income has increased significantly since 2013 (from $270m to $562m) however underwriting profit has dropped. Investment income in 2015 accounted for over 50% of the total insurance profit. This is concerning going forward as it means that IAG's future performance may be heavily dependent on continued investment performance.
An exciting growth opportunity for IAG lies in its Asia operations, with Malaysia and Thailand currently representing the majority of the Asia revenue. Although the Asia gross written premiums are only a tiny percentage of total written premiums, the growth in 1H 2016 was 20% from the previous half.
A significant news event for IAG occurred last year when it announced a strategic partnership with Berkshire Hathaway. The agreement included Berkshire taking a 3.7% stake in IAG via a $500m placement as well as a 20% quote share agreement (meaning that Berkshire receives 20% of IAG's premium revenue but pays 20% of claims costs). Berkshire's long experience in the insurance industry should bring material benefits to IAG over the longer term. Furthermore, the reduced regulatory capital requirements as a result of the quote share were expected to allow IAG to further push growth opportunities in Asia.
Going forward, the question for IAG investors will be the sustainability of the dividend. In 2015, approximately 100% of earnings were paid out as dividends. However, if the company can maintain this level of dividends, the gross dividend yield of 9.7% will start to look very attractive to investors.
Source: Reuters, Rivkin June 2016