I. Sector landscape and outlook
The Australian Insurance industry has been under pressure over the recent years, primarily due to increased intensity of natural calamities and lower yields on fixed-income assets. And, now with COVID 19 putting livelihoods and businesses off track, major impacts could be on investment income, expenses due to support packages and operations. But businesses have adapted to these conditions, especially general insurers, and better response should follow by management next time. General insurers are now equipped with substantial reinsurance in addition to regulatory capital. Premium increases have been around 2-3% annually in the general insurance industry since 2013.
There have been meaningful divestments of life business by industry leaders or major banks, and Westpac is assessing its non-core businesses. Moreover, Haynes Royal Commission’s repercussions are noticeable in the industry.
Global insurance companies have acquired substantial life insurance business from major banks, and most recently, AMP Limited completed the divestment of its life business. Core insurance-focused businesses have acquired these life insurance businesses.
Regulatory Framework of Insurance Companies
The Australian Prudential Regulation Authority (APRA) regulates the insurance industry, and it is supported by the Australian Securities & Investment Commission (ASIC) and Council of Financial Regulators.
Investment allocation of insurers remains conservative with higher allocations to debt securities, but there are signs of allocations into illiquid and foreign investments, primarily from life insurers due to extended durations and shortage of domestic bonds with higher yields.
Insurance companies adhere to regulatory capital requirements, which were implemented in 2013, by APRA. Also, the regulator oversees the industry through Level 2 and Level 3 supervision designed for general insurance groups and noncapital prudential framework for conglomerates, respectively.
General Insurers are required to value liabilities using discounted cash flow at a risk-free discount rate and assumptions. General and life insurers must address investment risk, which is also supervised Level 3, under the Risk Management Strategy.
Figure 1) General/Life Insurance Business Capital Structure
Source: Kalkine
Capital adequacy requirements for general and life insurance are regulated under separate standards, and minimum requirement determined by the regulator is called Prescribed Capital Requirement (PCR). Regulatory capital is classified as Tier 1 and Tier 2 capital, and Common Equity Tier 1 should exceed 60% of the prescribed capital level.
CET1 is the highest quality of capital with the business, and additional Tier 1 includes capital that can absorb losses on a going-concern basis. Tier 2 capital consists of funding instruments like subordinated debt that provide further strength to the entity.
General Insurance
According to latest quarterly general insurance statistics by APRA, the general insurance industry was not profitable in March quarter, incurring a loss of $997 million compared to $220 million profit in the same period last year.
Australia experienced one of the most damaging bushfires last year, and storm events at the beginning of 2020; this was responsible for negative underwriting results for the industry at -$991 million, down 269% against the same period last year. As a result of COVID-19 impact on the markets, general insurers recorded a negative $81 million of investment income.
Figure 2: Year end results of General Insurance Industry (In billions)
Source: APRA
General insurers also reported an increase in gross earned premiums, especially in fire, ISR and professional indemnity. They also incurred higher gross incurred costs due to strengthening of long tail claims reserves as bond yields fell along with markets in the wake of COVID 19.
Figure 3: Q/Q results of General Insurance Industry (In billions)
Source: APRA
During the March quarter, the gross earned premium increased 2.2% over the previous quarter, and gross incurred claims increased 46.1% to $15.3 billion. The net loss ratio for the March quarter was 85%, up from 69% in the December quarter. However, PCA coverage ratio was largely unchanged at 1.67x compared to 1.68x in the previous quarter.
Industry Biggies Take Proactive steps: QBE Insurance Group has recently raised capital to further strengthen its capital position in the wake of the crisis. Investments in technology in the past years enabled the company to service customers. QBE has also experienced strong premium growth this year.
In May, Insurance Australia Group had reported that there was limited scope to pay a final dividend based on investment income outcomes and forecast FY20 insurance profit. Perhaps heavy allocation to growth assets have taken a toll in shareholder’s fund portfolio, but proceeds from the sale of interest in SBI General Insurance had largely provided cover against negative outcomes.
Let us now look at the performance of the health insurance industry.
Health Insurance
Quarterly Private Health Insurance Statistics by APRA suggest that premium revenue was up 2.5% to $25 billion in March compared to $24.4 billion in the same period last year, while benefits totalled $21.51 billion against $20.74 billion in March 2019.
Over the year to March 2020, pre-tax profit of the industry fell 26.9% to $1.31 billion from $1.8 billion. Investment income declined to $95 million from $416 million in March 2019, primarily due to COVID 19 market impact.
Figure 4) Health Benefits Funds Profit After Tax Breakdown for 12 Months to March 2020
Source: APRA
Gross margin was one percentage point lower at 13% as total fund benefits increased by 3.7% against 2.5% increase in premium revenue over the year to March 2020. Private Health Insurance industry held $15.4 billion of total assets.
With the understanding of the general and health insurance industry performance, let us now gauge the risks that the insurance industry faces.
Major Headwinds & Risks
In recent years, the performance of the insurance industry is majorly impacted by subdued underwriting results as well as lower interest rates. Insurance companies invest largely in bonds, and lesser allocation is given to other risky asset classes, including equity.
- Drought, bushfires, storms are responsible for most of the impact on profitability over the recent years. Given the uncertainty of the occurrence of natural calamities, the catastrophic events continue to be a risk for insurance companies.
- Interest rates are likely to remain at current levels until there is any progress towards employment generation and price stability. Moreover, it would take some time for interest rate hikes at least until recovery.
- Investment income is likely to remain under pressure, primarily due to large allocations in fixed-income assets with lower yields, and COVID-19 induced uncertainty in investment markets.
Now let us look at the role of technology within the insurance industry.
COVID-19 and technological advancements
Insurance is an essential service and was not impacted largely on an operational basis, but investment income of businesses is likely to see some fall among other influences on insurance businesses. Since markets have recovered from March lows, there could have been some alleviation of poor investment performance.
With consumers increasingly going digital, the capabilities of insurance businesses need to be enhanced further. The disruption in the channel composition of insurers on account of digital and direct sales provide additional cost benefits to the insurance entity.
Data analytics and artificial intelligence would help to provide prospective customers, self-service features, and better customer touchpoints. It is time for traditional insurers to keep pace with changing industry trends.
Large businesses with economies of scale could benefit from collaborations with InsurTech businesses. With more customer data through applications, insurance companies will be able to forecast risk efficiently.
Claims and associated processes have been the driver of customer satisfaction, and insurers in many parts, for products like vehicle insurance, have moved towards mobile application based systems where customers upload pictures/videos for accident damage.
The insurance industry is going through testing times and the companies’ financial performance is likely to be under pressure in the near term owing to COVID-19. However, a steadfast focus on economic recovery by the policymakers could help the industry wade through the challenges. The recovery in fixed income yields could aid the investment portfolio of insurers in the coming future. Considering the frequent natural calamities in Australia, the insurance industry has to be on its heels as far as risk assessment is considered, albeit the legacy players appear to be time tested and better prepared for future such calamities, especially with reinsurance cover.
II. Investment theme and stocks under discussion (IAG, QBE, MPL and SDF)
After understanding the recent trends in the industry, let’s now look at four players from the industry those are listed on the Australian Stock Exchange. To assess the same, companies’ stocks are evaluated based on ‘Price/Book Value’ methodology.
1. ASX: IAG (INSURANCE AUSTRALIA GROUP LIMITED)
(Recommendation: Buy, Potential Upside: Low Double Digit, Mcap – A$ 13.3 Billion)
Insurance Australia Group Limited is engaged in the underwriting of general insurance and related corporate services and investing activities. The group provides a wide range of personal and commercial insurance products in Australia and New Zealand.
Valuation
Our illustrative valuation model suggests that the stock has a potential upside of ~17% on 23 July 2020 closing price. We have considered Suncorp Group Ltd (ASX: SUN), QBE Insurance Group Ltd (ASX: QBE), and Medibank Private Ltd (ASX: MPL) etc., as a peer group for the comparison purpose. At the same price, the stock was offering a dividend yield of ~6.9%.
2. ASX: QBE (QBE INSURANCE GROUP LIMITED)
(Recommendation: Buy, Potential Upside: Low Double Digit, Mcap – A$ 14.2 Billion)
QBE Insurance Group Ltd is an Australia-based general insurance and reinsurance company. The Company offers commercial, personal and specialty products and risk management solutions.
Valuation
Our illustrative valuation model suggests that the stock has a potential upside of ~15% on 23 July 2020 closing price. We have considered Suncorp Group Ltd (ASX: SUN), Insurance Australia Group Ltd (ASX: IAG), and AMP Ltd (ASX: AMP) etc., as a peer group for the comparison purpose. At the same price, the stock was offering a dividend yield of ~6.3%.
3. ASX: MPL (MEDIBANK PRIVATE LIMITED)
(Recommendation: Hold, Potential Upside: High Single Digit, Mcap – A$ 8.21 Billion)
Medibank Private Limited is an integrated healthcare company, which is engaged in in the business of underwriting and distributing private health insurance policies and health solutions to Australians.
Valuation
Our illustrative valuation model suggests that the stock has a potential upside of ~8% on 23 July 2020 closing price. We have considered NIB Holdings Ltd (ASX: NIB), Pinnacle Investment Management Group Ltd (ASX: PNI), and Platinum Asset Management Ltd (ASX: PTM) etc., as a peer group for the comparison purpose. At the same price, the stock was offering a dividend yield of ~6.4%.
4. ASX: SDF (STEADFAST GROUP LIMITED)
(Recommendation: Watch, Potential Upside: Mid-Single Digit, Mcap – A$ 3.01 Billion)
Steadfast Group Limited is engaged in providing insurance broking and underwriting services.
Valuation
Our illustrative valuation model suggests that the stock has a potential upside of ~5% on 23 July 2020 closing price. We have considered AUB Group Ltd (ASX: AUB), Insurance Australia Group Ltd (ASX: IAG), and AMP Ltd (ASX: AMP) etc., as a peer group for the comparison purpose. At the same price, the stock was offering a dividend yield of ~3.6%.
Note: All the recommendations and the calculations are based on the closing price of 23 July 2020. The financial information has been retrieved from the respective company’s website and Refinitiv, Thomson Reuters.
*Please be aware that dividends are variable and not guaranteed.
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