EUR 850.00 For Business Accounts Only

Morningstar | IAG on Track for An Earnings Rebound in FY20. FVE AUD 7.50 Unchanged. See Updated Analyst Note from 22 May 2019

We like the outlook for a rebound in earnings for no-moat general insurer, Insurance Australia Group, in fiscal 2020 due to modest growth in gross written premium, or GWP, productivity savings and tightly managed claims costs. Insurance Australia Group benefits from large scale in a mature market dominated by four large competitors controlling over 80% of the Australian market. Rational pricing and an oligopoly structure underpin insurance margins and earnings. Following our post result management catch up, we confirm the firm’s strategy to optimise core insurance operations while focusing on longer-term complementary growth options. Guidance is confirmed for fiscal 2019 of GWP in the 2%-4% range and a reported insurance margin between 16% and 18%. There is no change to our positive view on earnings, and at current stock prices the firm is fairly valued. Our AUD 7.50 fair value estimate is unchanged.

Fiscal 2019 results are due Aug. 8, 2019 and we forecast a cash NPAT of AUD 921 million and total dividends of AUD 37 cents per share, including the AUD 5.5 cps special dividend paid in the first half. Despite a spike in the interim payout ratio to 88%, the full-year guidance target range of 60%-80% is retained. Dividend franking rates are guided to decline from the second half of calendar 2019 with a future franking rate in the 70-100% range. We estimate a franking rate of 85% for the final fiscal 2019 dividend to be declared in August 2019 and subsequent dividends.

The general insurance market in Australia is growing GWP in the 3%-5% range comfortably above GDP growth. Beyond fiscal 2020 we expect annual EPS growth around 10% supported by increased investment in digital, analytics and artificial intelligence. The firm has called out investment opportunities in adjacent businesses, such as mobility, home and the SME sector. Our fiscal 2019 cash NPAT forecast is based on GWP growth of 3.5%, a combined operating ratio of 88% and a reported insurance margin of 16.5%.

Fiscal 2019 GWP and reported insurance margin guidance is based on net losses from natural perils of AUD 608 million in line with the firm’s allowance, reserve releases of approximately 2% of net earned premium and no material movement in foreign exchange rates or investment markets in the second half. The balance sheet is in a strong position. Following a disappointing first half for investment returns, we expect a strong rebound in second half fiscal 2019 with strong equity, fixed interest and property market returns.

Management indicated natural peril costs are in line with the second half run rate of approximately AUD 300 million and the full year allowance of AUD 608 million should be achieved. The Townsville floods and hail storms in Sydney will weigh on second half natural peril costs.

Improved pricing in the commercial lines continued to benefit GWP and the firm expects average pricing in Australia of approximately 6% in fiscal 2019. But offsetting this positive is a small loss of volumes with customer retention rates around low to mid-80% levels. A tightening pricing cycle in Australia is consistent with global commercial insurance markets, with the stronger returns benefiting the global reinsurance markets. The annual reinsurance renewal was completed effective Jan. 1, 2019 with the firm taking advantage of slightly lower reinsurance rates to increase the amount of reinsurance contracted.

We expect the firming cycle to last at least another 12-18 months in Australia with commercial premium increases in the 5%-6% range, as the large insurers need to increase returns on equity to more satisfactory levels. Insurance Australia Group reported a cash return on equity of just 10% in first-half 2019 and needs to get the key shareholder number closer to 15%. We forecast an average ROE of approximately 16% through our five year forecast period.

The firm’s business optimisation program is bearing fruit with targeted cost savings and synergies confirmed. The firm is on track to realise approximately AUD 100 million in benefits in fiscal 2019, but additional regulatory and compliance costs of approximately AUD 30 million will detract. Fiscal 2019 is the third year of the multiyear project, with annual savings of approximately AUD 250 million pretax expected from fiscal 2020.

The New Zealand business continues to perform strongly, with very benign natural peril events and better premium pricing. But we expect natural perils will revert to “normal” levels eventually and the pricing tailwind is slowing.