Australia | Jul 04 2019
Is the party over for Australia's insurance sector? Catastrophe budgets need to rise, amid elevated compliance costs, and the question is whether price increases can continue to mitigate the downside.
-Falling yields require premium rate increases to neutralise margin risks
-Market share losses could accelerate as new operators enter the market
-General insurers have capital options and cost reductions as a positive
By Eva Brocklehurst
After two years of increasing premium rates Australia's insurance sector could be at a fork in the road. Will the defensive traits of general insurers counter elevated volatility and the continued uncertainty that overhangs the wealth sector more broadly?
Catastrophe budgets will need to rise amid elevated compliance costs, although general insurance remains Morgan Stanley's preferred exposure, despite falling yields and slowing premium rate momentum. Reasons behind the broker's view centre on momentum in commercial premiums, margin upside and capital options. Admittedly, falling yields require premium rate increases to neutralise the margin risks.
Australia is the only major market to have increased prices for commercial lines since 2013, which leads Macquarie to believe the pricing cycle could be over sooner than previously expected, and price increases should moderate over the next 12 months. Australian insurance pricing cycles typically last 7-8 years and insurers have been re-pricing at above-industry averages, which could accelerate market share losses as new operators enter the market.
Traditional reasons for premium rate increases such as reinsurance costs, offshore events and man-made incidents do not hold in the Australian market at present, and Macquarie suspects this explains why international insurers such as AIG, Zurich, Liberty and Chubb are expanding risk appetite in Australia.
Macquarie believes companies with a skew towards strata and SME (small-medium enterprise) risks such as Steadfast Group ((SDF)) and QBE Insurance ((QBE)) could experience a more extended cycle, while those with an emphasis on personal lines such as Insurance Australia Group ((IAG)) and Suncorp Group ((SUN)) in the direct channel could have a shorter cycle.
Insurers Versus Insurance Brokers
Macquarie's analysis shows the premium rate cycle, which occurs as premiums are written, is a strong leading indicator for the investment case of insurance brokers, while margin expansion, as premiums are earned, is a better indicator for insurers.
M&A and increased commissions from placement platforms may extend the cycle this time for insurance brokers, the broker contends, while the need to increase the perils allowance could mean insurers miss out on the benefits typically awarded at the top of the cycle.
The myriad issues plaguing insurers are behind the broker's continued preference for insurance brokers such as Steadfast and AUB Group ((AUB)) over IAG and Suncorp.
QBE Insurance, which continues to exhibit strong fundamentals, is Morgan Stanley's top pick, with more than 5% earned rate increases and improving attritional losses. The broker also points out relatively benign catastrophe costs over the year to date can provide the capacity to absorb any crop losses.
On the other hand, Morgan Stanley believes IAG has had a strong run and downgrades to Equal-weight. While the investment case is robust, on the back of momentum in commercial rates, cost reductions and capital initiatives, the company is considered at risk of a rising catastrophe budget, amid lower yields and elevated compliance costs.
Suncorp is also downgraded to Underweight, as Morgan Stanley suspects the second half will show the business struggling to meet expected volumes in personal lines. There is also the need to re-price for a higher FY20 catastrophe budget as well as the impact of lower yields.
Credit Suisse has no Outperform ratings in the large cap insurance sector, continuing to envisage earnings risks across the board. The broker agrees with Morgan Stanley in that, if one has to hold an insurer, there is some support for QBE at current levels, albeit interest-rate reductions in the US remain a negative overhang.
That said, for the sector overall, the downside may not be all that significant. Domestically, Credit Suisse prefers Suncorp over IAG at current levels, as the valuation gap has opened up again and there is near-term earnings risk for Insurance Australia.
AMP ((AMP)) is without a strategy, in the broker's view, and difficult to own on a fundamental basis. Beyond general insurers, Credit Suisse retains an Underperform rating for Medibank Private ((MPL)), which faces a period of lower earnings growth while trading well above the rest of the sector.
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