Long-suffering shareholders in Insurance Australia Group and AMP know a thing or two about risk. Owning an insurance policy may bring peace of mind but owning shares in the insurer is a recipe for high anxiety.
Insurance is a highly volatile, high-risk, high-return business. The knock-on effects of the September 11 terrorist attack, the collapse of HIH, investment losses from the global market meltdown and rising premiums have underscored the risky side of the business.
What shareholders are now asking themselves is how long will it be until they can enjoy the rewards of the risk-reward trade-off. The answer depends in part on the type of insurance company you invest in and the speed of the sharemarket recovery.
Cavil Singh, head of broking investments at Godfrey Pembroke, says investing in insurers is potentially very rewarding but advisers should explain to their clients that the potential for higher returns comes at the price of additional volatility.
A recent survey of the industry by KPMG pointed out that 2001 was one of the worst underwriting years on record because of the convergence of negative events. The global industry was simultaneously hit with a massive increase in claims and a rapid decrease in investment income.
Consequently, most analysts agree that industry rationalisation will continue across the general and life-insurance sectors. Rationalisation in the health-insurance sector is about to be kicked off with the Government's planned sale of Medibank Private.
Six big players dominate general insurance IAG (the old NRMA Insurance), Suncorp-Metway, CGNU, Allianz Australia, Royal & Sun Alliance and QBE, in that order. Between them they have 75 per cent of the local market. Suncorp bought the AMP/GIO general insurance business a year ago, IAG is in the process of buying CGU and New Zealand-based NZI from Britain's Aviva for $1.8 billion. Further consolidation is likely.
Matthew Booker, a Merrill Lynch insurance analyst, is one of many who believe IAG paid too much for the Aviva assets. IAG is trading at about $2.42, a shade above its lowest level since its August 2000 float at $2.75.
"From a structural and strategic point of view, we like the acquisition,'' says Booker, but in the short term he has concerns about the dilution of earnings per share and the group's solvency position, which is at the lower end of the comfort range.
IAG will partly fund its acquisition with a share placement for existing shareholders. Small shareholders will be offered between $500 and $5000 worth of IAG shares at a price based on a 5 per cent discount to the 10-day trading average before the offer closes on November 21. Shareholders may pay as little at $2.30 a share, undoubtedly a good entry price, but analysts say the market needs to see that the chief executive, Michael Hawker, can achieve results from his new acquisition before the shares start to outperform.
IAG has some parallels with Suncorp's position, which is an indication of the job Hawker has ahead of him. Suncorp's share price, currently about $11.93, is $3 below its pre-September 11 high despite having produced some synergies from its GIO purchase a year ago.
Most analysts believe Suncorp is fairly priced but not as compelling as IAG or QBE at these levels. The market was also spooked by the sudden departure of Suncorp's chief executive, Steve Jones a theme it shares with IAG and AMP, which both have new chief executives.
For investors willing to wear a little risk to increase their rewards, general insurance provides good opportunities for profits for the companies that survive.
General insurers incurred underwriting losses for the sixth year in a row last year but there were already signs of improvement despite the difficult market conditions. Premiums were rising, companies were making better underwriting decisions and getting out of unprofitable markets.
General insurers are also less dependent on investment income than the life-insurance industry, which will continue to bear the brunt of poor investment decisions in a depressed global equities market.
The life sector is increasingly dominated by the big banking and fund management companies AMP, National/MLC, Commonwealth Bank, AXA and ANZ/ING. Premium income fell 4.6 per cent last year to $36 billion, the first year of negative growth in a decade, and investment income fell a whopping 57 per cent to $7.5 billion due to the global equity market shakeout.
Larger market falls this year do not augur well for the beleaguered life-insurance sector and there is concern that investors sitting on big equity losses will not be rushing to buy new or more expensive insurance products.
On the positive side, much of the premium flows to life insurers is coming through the compulsory superannuation system.
The investment losses haven't cut into local life insurers' capital position but AMP's exposure to Britain's market through its Pearl Insurance subsidiary has created capital adequacy concerns there. The British market doesn't enjoy the same level of compulsory contributions, investment losses have been catastrophic, with the FTSE Index performing as badly as the US Dow Jones, and the market is dominated by capital-guaranteed products, which means insurers have to dip into reserves to maintain payouts to investors.
The oversubscription of AMP's recent $1.15 billion reset preference share issue has patched up the hole in its capital reserves in Britain, but a fall in the FTSE before Christmas would spring another leak.
Booker says AMP, which has 70 per cent of its assets in Britain, is the only insurer to admit it is technically insolvent, which has harmed its brand name there. Because of the difficult trading environment in Britain, Booker says it is difficult to give a positive recommendation on AMP.
One analyst from a major funds management group said: "The AMP only has 4 per cent of the UK life-insurance market and it's hard to see them building on that. It's also hard to see advisers recommending AMP products in the UK if there are capital adequacy concerns.''
AMP's problems will take time to work through and the market won't have a clear idea how its new chief executive, Andrew Mohl, plans to proceed until the company conducts market briefings on December 4.
Still, most analysts agree that Mohl is saying and doing the right things, focusing on its two core businesses, AMP Financial Services and Henderson Global Investors. Non-core businesses such as its Virgin Direct joint venture, AMP Bank and stakes in Suncorp-Metway and AXA are likely to be sold off.
AMP is currently trading at about $12.63, off its lows but down 36 per cent on its 12-month high as loyal shareholders are only too aware. The outlook is uncertain for at least three to five months, but at these levels the stock is potentially good value.
Health insurance is more fragmented, with 44 local players, most of them mutuals. Analysts believe that Medibank Private, the largest player with 30 per cent of the market, will probably be sold to an outsider, rather than its main local rivals, AXA and MBF.
KPMG insurance group partner Andries Terblanche says the recent insurance industry woes and greater regulatory scrutiny should lead to improved corporate governance and a return to more profitable underwriting for the sector.
"Companies are starting to understand the cost of their products better than in the past and are now unwilling to write business that is not sustainable,'' he says. "The price war between companies has been brutal, and they have focused too much on the competition and not enough on the profitability or viability of products over the long term.''
Analysts point out that investors need to be aware what they're getting themselves into. Insurance stocks are volatile, they provide poor dividend yields compared with the banks despite trading on similar price-earnings multiples, and each sector of the insurance industry has a different risk profile and a different market cycle.
Godfrey Pembroke's Singh recommends investors look at the different risk profiles of different insurance sectors. For example, the general insurance sector has been exposed to the threat posed by terrorism and there is a high risk of further unforseen terrorist events. However, general insurer QBE has produced excellent returns in recent years for investors who are comfortable with the risk it is exposed to.
If investors feel more comfortable diversifying their insurance risk, then Suncorp-Metway provides exposure to bank assurance (banking plus insurance) and wealth management, while AMP provides access to life insurance and funds management.
Analysts' picks
Tim Rocks, equity strategist at Macquarie Equities, is optimistic about the general-insurance sector because of the industry consolidation, which has accelerated with IAG's purchase of CGU.
He says mergers should deliver better pricing power and improvements in margins for those left standing. He says the underlying businesses of general insurers are improving significantly and that volatility is simply "noise'' masking the true story.
"Volatility will continue to hit sentiment but there are opportunities to buy with a three-to-five-year view,'' Rocks says. "All general insurers are going to benefit from tightening so it's not too tough to pick Suncorp-Metway, IAG or QBE as beneficiaries.''
Merrill Lynch insurance analyst Matthew Booker says QBE is the pick of the sector because it operates in a counter-cyclical industry where significant levels of capital have been destroyed by equity markets, the World Trade Centre bombing and previous years' losses from US casualty and asbestos-related claims. In other words, QBE is a survivor, with a solid dividend yield and good management.
"QBE is leveraged to the upswing in rates which could continue to rise for the next two to three years,'' says Booker. "[QBE's] in one of the few industries where prices are going up.'' However, he warns investors to be aware of the risks inherent in the business.
JB Were also rates QBE as its pick of the sector. It has fewer company-specific issues than its rivals, it deals in commercial rather than personal insurance (IAG and Suncorp are more exposed to personal insurance) and is best placed to take advantage of the global upturn. Were has a 12-18 month valuation of $8.90 on the stock compared with the current price of about $7.61.
Godfrey Pembroke's Cavil Singh says"QBE is reasonably priced at these levels and so is AMP''. However, he says the risk with AMP is with its capital requirements in Britain, especially if the FTSE index falls by the end of the year necessitating another issue or placement.
