Minimal Volume Growth Besets Insurers

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

A positive premium rate cycle should bring elevated revenue growth for general insurers but brokers note this is being offset by a loss of volume.

-Vulnerability to low interest rates differs across general insurers
-Perception that business opportunities are fewer for general insurers
-Cost inflation could be the last straw for non-listed health insurers
 

By Eva Brocklehurst

An absence of negative news in the insurance sector and no major disappointment at the FY19 results have been unable to offset the myriad issues stemming from previous regulatory investigations, and fierce competition is rearing again. Hence, brokers observe share prices, overall, have been stymied by caution.

Revenue growth has been minimal, although margins have improved. Credit Suisse notes a positive premium rate cycle should bring elevated revenue growth and higher margins but this is being offset by a loss of volume. All insurers are effectively just paying out close to 100% of earnings rather than undertaking "capital management", because of the minimal volume growth being achieved.

Still, balance sheets are strong and the broker assesses Insurance Australia Group ((IAG)) is the one most likely to be in a position to return excess capital. Citi concurs with the likelihood of a buyback, although this is dependent on a satisfactory exit from the company's Indian joint venture.

Nevertheless, the broker considers the valuation full and FY20 likely to be more challenging. Meanwhile, execution on AMP's ((AMP)) strategy is likely to take several years and remains far from guaranteed.

AMP is the only Outperform-rated insurer for Credit Suisse, amid valuation support, even if only partial credit is given for implementing its strategy. There is potential for a significant re-rating over the medium term, in the broker's opinion, as actions are implemented.

Despite firming commercial premium rates, underlying returns are still below target for the insurers and UBS points out a low investment yield outlook may continue to be challenging for general insurers in terms of investment income. There is an offset. Usually a low interest rate environment is coupled with low inflation. If inflation is below what is assumed in setting reserves, and the difference is released from reserves, this will benefit margins.

There are differences between the companies. UBS envisages greater longevity and underwriting margin expansion for QBE Insurance ((QBE)) and, although QBE carries higher interest-rate leverage, lower inflation should support stronger reserve releases for longer.

QBE now has cover for weather-related volatility which Credit Suisse assesses is balanced. A benign second half in 2019 could mean the company delivers 10-20% earnings upside, while there is -30-35% risk on the downside from extreme weather conditions.

Suncorp ((SUN)), on the other hand, is more exposed to lower interest rates than IAG. This stems from the latter's lower CTP mix, because of a lack of Queensland exposure, and quota reinsurance cover in NSW. The company also has smaller reserves relative to pre-tax profit because of the quota share.

Both IAG and Suncorp have exceeded natural perils allowances in FY19, having done so in the last nine or 10 out of the past 12 years. However, the degree has been less significant and, at the risk of being found wrong, Credit Suisse considers the downside earnings risk in FY20 is less than in previous years.

Suncorp has increased its natural hazard allowances by further $100m in FY20 and added $200m in stop-loss cover. Hence, events that are more extreme than those experienced in the past decade would be required for the company to downgrade earnings on weather-related claims in FY20.

Upside is limited too, Credit Suisse acknowledges, as a lot of the protections are in the reinsurance cover and not in the allowance itself. Such comprehensive downside protection is not present for IAG and this allows for more earnings upside potential in a benign year.

Competition

Competition has intensified across the insurance industry as new contenders enter the market for Australian personal lines. Coupled with a slowdown in the economy, Macquarie suggests this heightens the importance of cost reductions for both IAG and Suncorp.

An early disruptor, Youi Australia continues to invest in new expansion strategies while even more new entrants are appearing. Both IAG and Suncorp identified a lack of new business opportunities in their FY19 results yet Macquarie notes new business premium written by Youi increased 20.1%.

The broker believes this perception of few business opportunities was caused by a combination of factors, including a lack of weather events that slowed industry churn, and weaker construction activity and motor vehicle sales, which have constricted overall volume growth.

Macquarie points out there is also a misconception the original challenger brands are the largest threat to incumbents. These brands such as Youi, Holland and Auto & General have grown from nothing 15 years ago to a 10% market share in FY19. However, a new breed of challengers have entered with a focus on the broker channel and are making up ground quickly.

Macquarie points to figures that show almost every insurer outside the top five grew faster than the industry average in FY19 and there are many that were only established in the last 24 months that are underwriting around $100m.

There are also the automobile clubs, which have strong capital bases and lack a desire to make excess profits, posing a different type of threat to incumbents. Macquarie notes each of the four main automobile clubs have been growing faster than industry averages for the last few years and a geographic focus has provided a comfortable price advantage.

Health Insurers

Health insurers may be executing well on what they can control but lower rate increases and falling participation levels dampen Citi's enthusiasm. The broker expects Medibank Private ((MPL)) will reach 27% market share by FY22 but top-line growth will be constrained by lacklustre industry growth and gross margins are likely to fall. Nib Holdings' ((NHF)) earnings guidance may prove conservative but the stock appears too expensive to the broker.

The two health insurers are confident about the trends in chronic disease management, the acquisition of healthier lives and a greater share of new entrants. There are also more facilities to take claims out of the hospital setting.

As a result, Macquarie suspects both listed providers will be well placed to capture a disproportionate amount of new business, and consolidation of the sector is likely to accelerate. Company-specific costs are considered just as important as industry trends. Cost inflation is strengthening and this could be the last straw for non-listed funds, the broker asserts.

The number and percentage of policyholders paying the lifetime health cover loading has been declining since 2015 as younger lives leave the system. Macquarie assesses, should this trend continue for the next 12 months, an additional -100 basis points of industry margins may be removed from the industry.

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