Brokers Neutral On IAG Deal

This story features INSURANCE AUSTRALIA GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: IAG

Insurance Australia Group has done another quota share deal, this time with a group of reinsurers. Brokers suggest the advantages are already factored into the stock.

-Swaps volatility for a fee-based income stream, lowering risk
-Upside considered largely factored into the stock
-Return of capital expected end FY18, or FY19
 

By Eva Brocklehurst

Insurance Australia Group ((IAG)) now has a quota share covering 32.5% of its book. Should it be valued differently? Following on from the inaugural deal with Berkshire Hathaway, the company has signed agreements with Munich Re, Swiss Re and Hannover Re. These agreements cover consolidated business in Australasia and Thailand, unlike the Berkshire Hathaway deal which just covered Australia.

While suggesting this is is a good deal for IAG, Ord Minnett cannot see how it makes sense for the reinsurers. The deal results in the three reinsurers receiving 12.5% of the gross earned premium and paying 12.5% of the claims and expenses. In addition, Insurance Australia will receive an exchange commission in the form of a fixed fee and additional profit share arrangement.

The company expects most of the expense savings, the turn in the cycle or reserve releases would return to its coffers, retaining 90-95% of the upside on a group basis. Citi assesses this is statement includes both the original Berkshire Hathaway deal and the more recent deal and implies IAG may have given away around 25% of the upside on the business quota share.

The broker believes the stock is still expensive, although the news flow is likely to remain strong. The new quota share swaps volatility for a fee-based income stream and lowers risk. The company should now be able to generate a 15% return on equity on the 32.5% of its business. While this suggests a premium to historical trading multiples is justified, even so, Citi suggests the stock is fully valued.

Given the percentage of the book now running limited balance sheet risk, Deutsche Bank believes IAG should be valued closer to an insurance broker and uses Steadfast Group ((SDF)) as its base. As the terms of the deal are around five years the broker questions whether this should be thought of as a long-term funding… or does it more closely resemble a debt security?

Macquarie estimates the reinsurance counterparties involved in the deal will be wearing an underwriting loss but international capital diversification benefits and investment opportunities also need to be recognised as incentives to participate in these deals.

The primary benefit of such a deal is reduced volatility and, in turn, the stock should attract a higher PE multiple, in Macquarie's opinion. Nevertheless, this broker believes this is already captured in this share price and investors should now focus on the pricing cycle and cost reductions heading into the next result.

Outlook

The company indicated it was satisfied with the current level of reinsurance and the deal is effective from the second half of FY18. Guidance for FY18 has been reaffirmed, and a 250 basis points uplift is expected in the second half from the new quota share arrangement. Ord Minnett makes additional earnings upgrades beyond the reinsurance deal to reflect increased confidence that the cost savings and cycle changes will benefit the company.

UBS notes, unlike the Berkshire Hathaway deal, the market already anticipated and re-rated the stock ahead of this agreement. UBS estimates the pro forma capital mix post capital management would shift to 52% tangible equity, 28% debt and 20% quota share reinsurance.

As a result debt plus reinsurance rises to 91% of tangible equity, from 67%. This introduces greater risk on the capital renewal front and a staggered maturity profile. On the other hand a broader number of providers for the quota share reduces the risks.

Morgan Stanley finds the deal broadly neutral prior to any capital management initiatives. The FY18 natural perils allowance falls to $627m after the deal, from $680m. Assuming the excess capital is return via a share buyback, and adjusting for the reduced earnings on shareholder funds, the broker considers the deal around 1% accretive.

Capital Return

Citi envisages potential for a return of capital as early as the first half of FY19 and assumes a buyback of $500m, while Macquarie expects a $400m buyback will be announced at the first half result and includes this in forecasts for the first half of FY19. Still, the broker points out current share price makes the impact of such actions relatively inefficient. Despite favourable near-term earnings trends Macquarie continues to believe there are challenges for the industry longer term.

Morgans believes the deal will reduce risks and could preserve potential earnings upside. The capital release should allow a $300m buyback, maybe by the end of FY18. Morgans agrees the impacts of the quota share a largely neutral at the earnings per share level, ex-capital management. A strong first half is expected, with a near-term tailwind from cost reductions.

Credit Suisse allows for a $250m buyback in FY18 and a further $350m in FY19, acknowledging clarity on a few of the moving parts is required before allocating upside and capital management opportunities to specific periods.

FNArena's database shows six Hold ratings and two Buy. The consensus target is $6.77, signalling -7.1% downside to the last share price. Targets range from $5.95 (Macquarie) to $7.50 (Credit Suisse). The dividend yield on FY18 and FY19 forecasts is 4.0% and 4.3% respectively.

This stock is not covered in-house by Ord Minnett. Instead, the broker whitelabels research by JP Morgan.
 

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