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Morningstar | IAG’s 1H19 Result Hampered by Higher Natural Peril Costs. FVE AUD 7.50 Unchanged

As expected, no-moat-rated Insurance Australia Group's first-half fiscal 2019 performance was heavily affected by severe hail storms in December 2018, reducing the reported insurance margin to 13.7%. Despite the increase in natural hazard costs for fiscal 2019, our positive view is intact with the firm supported by a strong capital base, robust long-term profitability, and a positive business outlook. Despite the sharp increase in natural peril costs, we like the underlying performance and make no change to our AUD 7.50 fair value estimate. At current prices, the stock is fairly valued.

Previously announced storm claims costs drove a 33% reduction in the insurance profit to AUD 496 million with the reported insurance margin down 420 basis points to 13.7%. Cash earnings fell 49% to AUD 319 million, with the 14% decline in the fully franked interim dividend to AUD 12 cents per share, or cps, was supported by a higher payout. We liked the 4% increase in top line insurance premium income and the 70 basis points increase in underlying insurance margin to an impressive 16.2%. Top line revenue growth was due to premium increases and a positive New Zealand exchange rate. Volume growth was largely flat over the period.

Capital is well above internal targets and regulatory requirements with limited material operational demand for capital. Due to high natural peril costs and lower than expected investment returns, we reduce our fiscal 2019 full-year forecast cash profit to AUD 921 million from AUD 1.0 billion. Our outer-year earnings forecasts are broadly unchanged. Despite the spike in the interim payout ratio to 88%, the full-year guidance target range of 60%-80% is retained. Our fiscal 2019 forecast dividend of AUD 37 cps, including the previously announced AUD 5.5 cps special dividend, is intact. We estimate a franking rate of 85% for the final fiscal 2019 dividend to be declared in August 2019 and subsequent dividends.

Management confirmed total first-half fiscal 2019 natural peril claim costs of AUD 414 million pretax post quota share, exceeding the first half allowance by AUD 110 million. Statutory NPAT of AUD 500 million benefited from the approximate AUD 200 million profit on the disposal of the Thailand business. The Indonesia and Vietnam divestments are expected to complete by end fiscal 2019. The firm continues to assess options for its India and Malaysia joint ventures.

The subdued 13.7% first-half reported insurance margin was driven by higher than expected natural peril costs, additional regulatory costs, and lower reserves. Fiscal 2019 guidance for the reported insurance margin in the 16%-18% range is maintained. The fiscal 2018 reported insurance margin of 18.3% is unlikely to repeat in fiscal 2019 and following the blow out in first-half catastrophe costs. We expect a reported insurance margin closer to 16%.

The business optimisation strategy is on track and importantly we expect most savings to accrue to the benefit of shareholders. But we cannot ignore the potential for strategy execution setbacks that could put expected cost savings at risk. To achieve the firm’s medium term 15% ROE target, management need to achieve insurance margins in the 15%-16% range. We expect the ROE to average 16% over our five-year forecast period, comfortably exceeding the 15% target. We forecast negative EPS growth for fiscal 2019 due to the higher natural peril costs, but for the following five years we forecast impressive average annual EPS growth of 10% ending fiscal 2024.

The company's impressive execution of strategy continues to support our confidence in the firm achieving its medium-term targets. Expanded reinsurance and quota share arrangements are working to reduce natural disaster claims volatility and we expect further moderation going forward. Management’s 3-5 year through-the-cycle financial targets are unchanged including a 15% ROE, sustainable and attractive dividends, top quartile total shareholder returns, and compound EPS growth around 10%. Insurance Australia Group delivered cash ROE of 10% for first half fiscal 2019, below the medium-term target range, but expect a better result for full-year fiscal 2019. A key plank of the ambitious EPS target is a major uplift in operational efficiency and a long-term reduction in the operational cost base. The insurer confirmed AUD 40 million in net cost savings for first-half 2019, on track to deliver AUD 100 million pretax benefits.