QBE Insurance (QBE)

Friday 1st August 2014

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Fat Prophets

QBE Insurance (QBE)

What’s new?

The market was starting to give QBE Insurance some credit following previous profit downgrades but any illusions were disrupted last week. The skeletons this time have emerged at the company’s Latin American business which is set to negatively impact the half year earnings results.

The insurer expects to report a net profit of around $390 million for the six months ended June 30 2014, compared with a profit of $477 million last year.

The company is strengthening claims reserves to the tune of $170 million in Latin America, one of the company’s smallest business units (8 percent of total gross written premiums). The majority of this amount relates to the company’s Argentine workers’ compensation business, higher than expected large individual risk claims, (around 10% of net earned premium) and an ‘adverse’ discount rate impact of around $120 million.

The announcement is arguably another red flag, but emotion should be taken out of the equation when considering the implications and investment thesis behind QBE.

The Latin American operations are relatively small and the reserves ‘upgrade’ follows the company’s own review of their adequacy in response to claims experience, legislative changes, and deteriorating economic conditions in Argentina. Taking a prudent ‘hit’ now is erring on the side of caution and also avoiding kicking the can further down the road which arguably has compounded problems in the past.

Outlook

The Group’s core measure of profitability, the combined operating ratio, is now expected to be 96 - 97% for the first half. This compares to consensus expectations of around 93%. The insurance profit margin is set to come in at 7 - 8% compared with market forecasts of around 10%.

More encouragingly, the Australian & New Zealand Operations are set to report a robust underwriting result. Europe is meanwhile said to be on track while Asia Pacific is also growing profitably.

There have also been positive developments in the troubled North American business with operations generating an underwriting profit and the combined operating ratio improving on last year. Management are also continuing to take costs out of the business.

Overall QBE is looking for gross written premiums to come in around $8.5 billion, (versus $9.4 billion last year, but a third of the reduction is due to FX movements) which is below the company’s $8.9 billion budget for the half. The company notes that conditions remain competitive and it has sensibly refrained from chasing business at the expense of quality of return hurdles.

Price

QBE’s share price reacted badly to the warning with a sense of ‘here we go again’. However the shares have since reclaimed some ground with the market appreciating QBE still trades at a discount to peers.

Worth Buying?

Despite the latest market misstep, we continue to believe that the foundations exist for a successful turnaround for QBE. Costs are being trimmed across the business, which will boost operating leverage to a recovery in the premium cycle. Investment income should also rise over the medium to longer term due to the company’s short duration fixed interest portfolio.

QBE’s valuation meanwhile is modest at 11.5 times 2014 earnings estimates and under 10 times 2015 earnings. The prospective dividend yield is 4.2 percent, rising to 5.1 percent in 2015. Whilst not without risk, the shares look good value.

Disclosure: The author,and interests associated with him, hold shares in QBE Insurance.

Greg Smith is the Head of Research at Fat Prophets.

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