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Morningstar | QBE’s FY18 Result a Little Softer than Expected but Still Impresses. FVE AUD 12.50 Unchanged

No-moat QBE Insurance’s 2018 cash profit was modestly below our forecast due to softer investment returns, but the strong underlying performance impressed. Earnings quality sets the foundation for good growth expected in 2019 and 2020. Management is applying the basics of running an insurance company--consistently good decision-making on underwriting, pricing, and claims. The insurance result was in line with guidance with combined operating ratio, or COR, of 95.7% within the 95-97% target. Investment returns were soft, but not surprising considering increased uncertainty in global equity markets in late 2018. Importantly, management delivered on its operational goals in 2018 including a significant improvement in COR, remediation of the underperforming Asian operations, cost reductions, asset sales, and portfolio exits. The net cost of catastrophe claims reduced significantly to USD 523 million in 2018 compared with USD 1.2 billion in 2017.

Our cash earnings forecasts for 2019 are broadly unchanged at USD 952 million, as is our AUD 12.50 fair value estimate. At current prices the stock is fairly valued, trading 6% below our valuation. Since end December 2018, the stock has increased 22% on the back of increasing confidence management can deliver a sustainable improvement in future earnings. Turning the business around required changes in insurance portfolios, cost-cutting, tighter underwriting standards and greater accountability across the group.

The 2018 cash profit of USD 715 million was a substantial recovery from the USD 262 million cash loss in 2017. The statutory profit increased to USD 390 million from a massive loss of USD 1.5 billion in 2017. Underwriting losses in 2017 were the worst year on record for the global insurance industry. Despite a slightly softer than expected 2018 cash profit, the final dividend surprised on the high side at AUD 28 cents per share, or cps, 60% franked. The total dividend of AUD 50 cps exceeded our AUD 46 cps forecast.

Dividends for the 2018 fiscal year were franked at a weighted average 46.8% with the interim franked at 30% and the final franked at 60%. From the start of calendar 2020, management is guiding for franking of only 10% as the proportion of international income increases. The 2018 dividend payout of 70% of cash profit was modestly higher than the firm’s target of up to 65%, but reflects the positive outlook, stronger balance sheet, and modest business growth. Our longer-term payout forecast averages 60%.

We like the progress made derisking global operations, reducing complexity, and removing costs. In addition to wide-ranging internal changes, an improving external environment is providing a meaningful boost to performance with increasing premium rates across the globe. But previous expectations of higher interest rates and improving global economic conditions look to be slowing. We like the more sustainable business model and improved risk selection.

The core business is doing well, and we expect further progress in 2019. Guidance for 2019 is a COR of 94.5%-96.5% and investment returns of 3.00%-3.50%. The cash return on equity for 2018 of 8% was a significant improvement on 2017 but remains subpar and below our 9% cost of equity. The adjusted insurance margin of 7.3% still needs to be managed higher, and we forecast further improvement to 9% in 2019 and an average of 10.5% during our five-year forecast period.

Despite average premium increases of 5% in 2018 across the group, customer retention remained high at 81%. Average premium rate increases were just 1.8% in 2017. The key North American operations reported a 4.1% uplift in premium rates in 2018, Europe reported a 4.4% increase, and Australia and New Zealand 7.3%. Premium rate increases in Australia and New Zealand in 2018 followed an already strong performance in 2017.

Gross written premium increased 2% to USD 13.66 billion and was up 3% on a constant currency basis. We expect further solid rate increases in 2019 that will underpin near-term earnings. All three business divisions delivered solid underlying performances with the improvement in North American operations a standout. The business has a long history of disappointment, but in 2018, North America delivered a strong turnaround with a COR of 96.9% (down from a very disappointing 108.8% in 2017) and an insurance profit margin of 6.2%. The COR is a key measure of insurance performance and is calculated by dividing total insurance costs (claims cost, acquisition and underwriting expenses) by net earned premium.

The focus on improving culture within the organisation is a highlight, particularly following the adverse findings of the Royal Commission into misconduct in the Australian financial services industry. We are confident the effort to develop talent and culture will benefit the group long term.

The improved cash profit benefited prior period reserve releases increasing to USD 113 million in the year, representing 1.0% of net earned premium, compared with USD 52 million, or 0.4% of net earned premium a year ago. Adjusted attritional claims improved 220 basis points to 52.3%. The increase in risk-free interest rates resulted in a net USD 13 million underwriting benefit in 2018 compared with USD 68 million benefit in 2017, offsetting the reserve release benefit.

Balance sheet settings improved with key capital ratios increasing following a tough natural peril experience in 2017. The PCA multiple of 1.78 times is high end of the insurer’s target of 1.6 to 1.8 times. Gearing improved with the debt to equity ratio easing to 38.0% from 40.8% at Dec. 31, 2017 but is still above the firm’s benchmark target of 25%-35%.

Approximately AUD 330 million worth of shares were bought back in 2018 with the firm’s yearly buyback target of up to AUD 333 million unchanged. The three-year AUD 1.0 billion buyback program was announced in February 2017 and to date AUD 472 million of QBE Insurance shares have been acquired and 44.2 million shares or 3.2% of issued capital cancelled.

Investment income declined to USD 547 million in 2018 from USD 758 million in 2017 with the annualised investment return easing to 2.2% from 3.1% a year ago. Returns were impacted by rising U.S. Treasury yields mark to market, wider global credit spreads, lower returns from growth assets, as well as asset sales and debt and equity buybacks reducing investment funds. The investment portfolio declined to USD 22.9 billion from USD 26.1 billion at Dec. 31, 2017.