You know what worries me most about QBE? Floods? Storms? Earthquakes? Global warming? Interest rates?
No; none of the above. They are all part and parcel of owning an insurance business. What worries me is that the case for buying the stock is so simple you can work it out on the back of an envelope.
Net earned premium $16bn
Insurance margin 15%
Insurance profit $2.4bn
That’s a pre-tax return of 19% on the current market cap. And it attributes no value to the $7bn odd of net shareholder equity. If you assume zero interest rates – no investment income whatsoever – you’d still make 14% pre-tax.
Insurance is a volatile business but, as I said in the September Quarterly Report, there are plenty of good reasons to think the average profitability will be higher, not lower, than the numbers estimated above.
Here’s what Standard and Poor’s had to say about yesterday’s downgrade:
QBE announced today that exposure to a number of catastrophes during the second half of 2011 and the adverse impact from challenging investments markets will weaken its insurance margin to 7.0%-7.5% for 2011, compared with its expectation disclosed in August 2011 of 11%. As a result, its profit after tax for 2011 will be 40%-50% lower than the prior year. Standard & Poor's believes the strength of QBE's diverse business and financial profile allows its rating to withstand some negative cyclicality in its underwriting performance such as what has occurred in 2011. Nevertheless, the rating may come under pressure should there be an indication of a structural decline in earnings or sustained underperformance against peers.
We note that QBE expects to make an underwriting profit in 2011 in what has been a record year for natural weather events globally and that premiums for many of its product lines are increasing. While regulatory capital adequacy has softened since June 2011, the company's decision to materially cut its dividend should assist in maintaining a minimum capital ratio requirement above the 1.5x minimum target set by the company.
We agree with Standard and Poor’s. Now that is something to worry about. Can someone give me a hand, what are we missing here?
Update: See Narrowneck and Clear Head on QBE for some weekend clarity.
Hi Steve,
I came across this article before Christmas which is written Amit Wadhwaney of Third Avenue Funds, its rather long but I was interested in it as it applies to QBE:
http://sportgamma.net/2012/01/06/605/
Good idea Nulds, I’ve replaced the long copy with a link. Well worth a read for those who haven’t already.
After reading this article, should I still be counting QBE and IAG as “Financials”? Is there a case for removing them from that group?
I think you need to make an assessment of the investment portfolio. If your insurer is down the risk curve trying to generate high returns on the float, then I think you’re squarely in the financials category. If it’s primarily an operating business and taking the least risk possible with shareholders’ funds and the float, then less so.
Whichever way you look at it, though, they lend a lot of money just like banks do. I agree with the author that they don’t have the same liquidity risks but they definitely have the same credit risks.
What are you missing Steve? A long term view perhaps. This company has been through its most profitable seven years at the insurance level in HISTORY (until 2011) with average insurance margin over 18% in the past seven years – COR averaging around 88.5% and mid to high single digit returns on NEP from investments. In the late 90’s and early naughties, QBE made nothing like 15% insurance margins. If you want to see how, go to page 135 of the 2010 annual report and check out the reserve redundancy from 2003-2006 which accumulated to $1.248billion (5.5% of NEP per year). However, since the last year of big redundancy (2006), QBE’s NEP is up 2.5 fold from $6billion to over $15billion. It’s obvious despite the size of the global insurance market that if you grow at that rate, your ability to stay in niches gradually disappears – note the comments about the Thai factories in the latest management discussion for example. There’s a clear belief that the businesses QBE has acquired in recent times can’t make these kind of returns. Now some companies run amazing insurance businesses and price brilliantly, deriving significant redundancy of reserves – check out BRK’s triangulations for example (David A – you might revise your view on BRK insurance). So the “it’s too good to be real” accusation against QBE management is not unique. The other issue is “what do you want as an insurance investor?” BRK and FFH investors want growth in book value; QBE’s TANGIBLE book value has grown from $3.96 in December 2002 to around $4.50/share over NINE years (thats 1.4% per annum)- through its most profitable ever period. It reflects an excessively risk averse stance on investing shareholders (not policyholders) funds and overdistribution of dividend, which are largely unfranked. The stance on SHF investments arguably reflects their view on making acquisitions, and they don’t want the capital adequacy issues that would come with investment market volatility. So add together peak underwriting earnings having passed, low return on policyholder funds, risk averse stance on shareholder funds investment, massive increase in premium from acquisitions which the market doesn’t yet have a real handle on whether its good or bad, no real growth in tangible book over nine years and an uncertain succession plan (but it won’t be an outsider). All these variables tell you this has to be a low rated security until they are gradually solved – which won’t be in one year.
There is something to be said for numbers that are just too good to be true. If ever there was a case it would have to be Qantas. Many years before the proposed private equity debacle they could only manage profits in the range of $250-$400 million. Mention private equity and suddenly it goes to more than 1 billion. post private equity and the profit is 350 million again. Not a single question was raised. For mine QBE may be in the same boat.
Thanks Andrew, very helpful. It is important to recognise the differences between QBE and Berkshire though. Buffett wants the capital so he can invest it, so BRK keeps all of the profit and grows the NTA. QBE wants generate profit writing insurance and pay it out to shareholders. Both strategies can be very successful. QBE hasn’t grown its NTA significantly but it has paid out $7.21 per share of dividends over the 7-year period you reference. What’s wrong with a business that throws off plenty of cash, grows its insurance profits and doesn’t tie up any of your capital?
Also, what do you mean by ‘peak underwriting earnings having passed’? After a year of catastrophes I’d expect the underwriting earnings to be at the bottom of the cycle, not the top. I understand the investing side of the equation but what makes you think underwriting profits will drop from here given the whole industry is talking 10-15% premium increases?
Last comment – is it value? At $11.27/share, you have $4.50 ish of tangible book value and so are paying $6.77/share – or $7.55billion – for the insurance operations. At a 10% insurance margin (1.53billion) less debt costs (about $230million) pre tax profits on this basis would be around $1.3billion. Tax at 15% = $1.1billion or $1 a share. All in US$ but assume its an A$. So that’s a P/E below 7x, at a more sustainable insurance margin. If the reserves are 5% adverse (gross – and there’s no evidence at all to say they are) then that’s about another $760million or 70c after tax off the values (although it would be a hell of a sentiment knock and capital adequacy threat). So at current levels, I reckon its about a 7.5x (low taxed = 9.1x fully taxed) insurance P/E on more sustainable insurance profit assumptions with a written down reserve structure. That’s a pretty low rated security -the question is, is it low enough?
You have subtracted the debt in your tangible book value and subtracted the interest from earnings. Perhaps that’s the right thing to do though given they are earning nothing on investing the book value.
Steve – (1) because the business had massive reserve redundancy in the 2003-2006 period, which I don’t think will be repeated (2) 107.2 109.6 110.8 110.1 107.2 106.6 115.5 113.2 112.5 109.5 108.1 111.3 111.0 108.7 105.4 101.7 100.2 (*) 100.4 99.3 99.5 100.3 103.9 102.5 109.6 97.7 93.8 91.2 89.1 85.3 85.9 88.5 89.6 89.7 94.9 (E) which is QBE’s COR from 1979 to 2011(E)respectively with me being too lazy to adjust the (*) figure when June Y/E (1994) shifts to December so there’s 6 month of overlap. You tell me if you think the recent COR looks depressed in a long term context. (3) How many times have insurance executives told you “it was a bad year but we’re getting premium rate increases”? If it’s lower quality business, it doesn’t matter what you’re paid. We really don’t know if QBE have picked up some underpriced stuff along the way (4) If business is so good in the cat market, watch for start ups out of Bermuda – that soon sends rates back down again so you get a short period of good earnings. Agree your point on QBE paying out dividends in the past (and growing debt…..), but if you buy now, that’s not much use (especially with a dividend cut which IMHO is the BEST thing out of this).
Agree 100% on the dividend cut. Combined operating ratios SHOULD be much lower given substantially lower interest rates. The historical correlation is very high (see the quarterly report I referenced in the blog post).
Your not alone in your thinking on this Andrew. I ran a set of numbers in 2009 (only to ’92 not ’79) and reached a similar conclusion that the most recent COR’s didn’t look representative of what I thought should be happening.
When I broke the COR down to find an explanation I saw the commission ratio was barely changed over 17 years and the expense ratio was pretty stable for the past 12 years leaving only the claims ratio as the dramatic improver from the high 60’s/low 70’s to the mid 50’s. This was a huge improvement and coupled with the acquisitions the driver of QBE’s earnings growth. The only explanation I could observe for the favourable claims ratio (being either excess premiums or low levels of claims) was that post Sep 2001 premiums dramatically increased year on year for a couple of years, then, when premiums should have started to reflect competition around 2004/5 we had the worst set of natural catastrophes in dollar terms that I could find data on (up to 2009). This kept premiums high instead of correcting lower and by good luck or management QBE had higher than usual re-insurance cover in the financial year 2005. So twice in six years something terrible had happened to the industry and twice QBE came out of it well.
QBE’s claims ratio has since been climbing from a 2007 low at the very time interest rates have been falling suggesting competition for premiums was increasing. This is supported from what Buffett/Munger said at their 2010 Berkshire Hathaway meeting in not expecting much in the way of float growth for many years to come – i.e. further pricing pressure.
I doubt I know the insurance industry as well as some reading this blog but I’m still undecided if QBE hasn’t just been very fortunate in the past.
I’ve made similar broad calculations and reached the same conclusion, SJ. Though my working assumption is for a more conservative insurance margin of 10%-12% over time. The other thing I like (which you’ve mentioned in the past) is the currency diversification. If the AUD takes a knock, then QBE’s foreign income is going to become more valuable to Aussie investors. But you really get that potential for free at these prices.
I’ve often wondered how QBE’s combined ratio is so much better than anyone else’s – even Berkshire Hathaway’s insurance operations. Is it a case of too good to be true? If the combined ratio rose over 100% for a sustained period of time, the negligible earnings on the investment portfolio will be a real problem.
I spoke to one fund manager some months ago who said they would not invest in QBE while existing management was in place as they simply did not believe the reported numbers. At the time I took it as an interesting comment about a remote possibility. Having looked again at QBE after last week’s downgrade I believe the business is worth much more than the market’s current assessment UNLESS it has some “rented suits” in its books.
maybe next time a link…….
Final comments on reserving. QBE have had six consecutive years of “reserve releases” to add to profit between 2005-2010, averaging about 3.6% pa of NEP or increase to their insurance margin. This is a mixture of conservative “central estimates” in the 2004-2008 period and release of the additional “risk margins” above these estimates during that time – logical since if your “base case” is too conservative, then any additional conservatism can be released. This can be seen in the “claims incurred” note (usually note 8) to the QBE accounts. I accept there are other things mixed in – unwinds of discount rate etc. Given the latest results, I suspect these magnitude of releases will be coming to an end. The annual report will be the most interesting in years to give you an idea of where to place your forward forecast insurance margin. At these low investment yields, 15% doesn’t seem realistic longer term. If you adjust for these “prior year developments” COR average over the last 9 years is about 91.6%; a 4% yield would give closer to a 12.5% margin. I’m not critical of QBE for these “releases” – the simple fact is that they were conservative – part of the plus for management – but that the 2004-2007 period was RIDICULOUSLY profitable for them. It might happen again if markets harden – that’s the punt you take if you reckon insurance margin is going to exceed 15% longer term IMHO. For disclosure purposes I have no position (long or short) in QBE though I’m mulling over taking one.
Nobody here has made any reference to the LMI business and the RIF (risk in force) on QBEs book!?!
Its interesting that you have brought up LMI Carl.
This could be the “black swan” to QBE’s earnings and future.
Although many see a property market crash as unlikely due to low unemployment rate and try not to spend too much time on predicting macroeconomic events, its still important to run the numbers on the impact to QBE if there were to be a large correction in the resi property market.
I’ve no idea how much LMI QBE carries, but I know its one of the major players.
One can’t ignore that there is a chance (however small) that Australia’s unemployment could get to 7-8%. If it did, there are many large companies that would be affected, although most would still survive. I am going to put it out there that if unemployment in Australia reached 7% or more, the impact it would have on property prices, the negative equity of the borrowers and the continued flow on effects would mean that the loss on the LMI business would be huge.
I haven’t analysed this in any more detail because I’m not interested in taking a position in QBE anyway due to its exposure to LMI. I could be overassuming the risk, but I’m happy to miss out if I’m wrong.